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BSAIL
BA LLB Ist Sem
E notes
Econmics 1705

UNIT - I

CENTRAL PROBLEMS OF ECONOMY

Q. What are the various central problems of an economy? Why does these arise? Explain.
Ans. What is 'Economics'
The word “ECONOMICS” was derived from the Greek words “Oiko” (a house) and “nomia” (to
manage) which meant “household management” or “management of house affairs”.
An economy is the system according to which the money, industry, and trade of a country or region
are organized.
In other words, Economy is the use of the minimum amount of money, time, or other resources needed
to achieve something, so that nothing is wasted.
Definitions of Economics
Adam Smith’s Wealth Definition (1776)
Adam Smith defined economics as “a science which enquires into the nature and cause of wealth of
nations”. He emphasized the production and growth of wealth as the subject matter of economics.
Welfare Definition (1890):
In 1890, Alfred Marshall stated that “Economics is a study of mankind in the ordinary business of life; it
examines that part of individual and social action which is most closely connected with the attainment
and with the use of material requisites of wellbeing”. It is on one side a study of wealth; and on the other
side, a study of human welfare based on wealth.
Scarcity Definition (1932)
According to Lionel Robbins: “Economics is the science which studies human behaviour as a
relationship between ends and scarce means which have alternative uses.” He emphasized on ‘choice
under scarcity’. In his own words, “Economics is concerned with that aspect of behaviour which arises
from the scarcity of means to achieve given ends.”
Modern Definition of Economics (2011)
According to Prof. A.C.Dhas, “Economics is the study of choice making by individuals, institutions,
societies, nations and globe under conditions of scarcity and surplus towards maximizing benefits and
satisfying their unlimited needs at present and future”. In short, the subject Economics is defined as the
“Study of choices by all in maximizing production and consumption benefits with the given resources of
scarce and surplus”.
Thus it can be said that
“Economics is a social science concerned with the production, distribution and consumption of goods
and services.” It studies how individuals, businesses, governments and nations make choices on
allocating resources to satisfy their wants and needs, and tries to determine how these groups should
organize and coordinate efforts to achieve maximum output.
Central Problems of Economy
The economic problem – sometimes called the basic or central economic problem – asserts that an
economy's limited resources are insufficient to satisfy all human wants and needs.
An economic problem is the problem of scarcity of resources in the face of desired ends. Solution of
such problems essentially requires raising of resources to the level of the desired ends.
Central problems arise in an economy due to scarcity of resources having alternative uses in relation to
unlimited wants.
The Central Problem of all economies is scarcity.
Limited Resources + Unlimited Wants = Scarcity
Scarcity forces individuals, firms, governments and societies to make choices.
Various Central problems of economy can be explained as-
1. What to produce, i.e., what commodities are being produced and in what quantities?
The first basic problem of an economy is to decide what type of goods it should produce whether capital
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goods or consumer goods. This problem involves selection of goods and services to be produced and the
quantity to be produced of each selected commodity.
Every economy has limited resources and thus cannot produce all the goods. More of one good or
service usually means less of others.
For example, production of more sugar is possible only by reducing quantity of other good. Production of
more war goods (like gun) is possible only by reducing the production of civil goods (like wheat). So, on
the basis of the importance of various goods, an economy has to decide which goods should be produced
and in what quantities. This is a problem of allocation of resources among different goods.
The problem of “What to produce” has two aspects.
(i) What possible commodities to produce: An economy has to decide, which consumer goods (rice,
wheat, clothes etc.) and which of the capital goods (machinery, equipment’s etc.) are to be produced. In
the same way, economy has to make a choice between civil goods (bread, butter etc.) and war goods
(guns, tanks etc.).
(ii) How much to produce: - After deciding the type of goods to be produced, it involves decision
regarding the quantity to be produced of consumer and capital goods or civil and war goods and soon.
2. How to produce, i.e., by what methods are these commodities produced?
The other problem related to the economy is how to produce the goods. This problem is essentially
concerned with the choice of technique of production. Generally, techniques are classified as
 Labour intensive techniques (LIT)
 Capital intensive techniques (CIT)
In Labour Intensive technique, more labour and less capital (in the form of machines etc.) is used. In
Capital Intensive technique, there is more capital and less labour utilization.
If, in an economy labour is available in large quantity(abundance), it may use labour intensive
techniques. On the other hand, if labour is less in number(scarce), capital intensive techniques may be
used. For example, in India, LIT is preferred due to abundance of labour, whereas countries like USA,
England etc. prefer CIT due to shortage of labour and abundance of capital.
But, while choosing between different methods of production, methods should be adopted which bring
about an efficient allocation of resources and, thereby, increase the overall productivity in the economy.
3. For whom to produce, i.e., how is society’s output of goods and services divided among its
members?
The third central problem of the economy is the allocation of goods among the members of the society.
The problem “For Whom to Produce” is related to the manner in which the national product will be
distributed among different individuals and classes of persons.
This problem refers to selection of the category of people who will ultimately consume the goods i.e.
whether to produce goods more for poor and less for rich or more for rich and less for poor. Since
resources are scarce in every economy, no society can satisfy all the wants of its people. Thus a problem
of choice arises. Goods are produced for those people who have the paying capacity. The capacity of
people to pay for goods depends upon their level of income. It means this problem is concerned with
distribution of income among the factors of production (land, labour, capital and enterprise), who
contribute in the production process. The problem can be categorized under two main heads: -
(i) Personal distribution: - It means how national income of an economy is distributed among different
groups of people.
(ii) Functional distribution: – It involves deciding the share of different factors of production in the total
national product of the country.
4. How efficient is the society’s production and distribution?
This question is directly related to the first three questions. Having raised the first three questions—
what, how and for whom — it is natural to ask whether the production and distribution decisions are
efficient.
Production is said to be efficient if it would be possible to produce more of at least one good without
simultaneously producing less of any other good just by reallocating existing resources. The goods that
are produced are said to be efficiently distributed if it would be possible to redistribute them among the
individuals in the society and make at least one individual better off without simultaneously making
anyone worse off.
5. Problem of Efficient or Full Utilization of Resource:
An important question that can be asked about the working of an economy is: Are the resources being
used efficiently? Since Resources are scarce, it is obviously desirable that they should be most
efficiently used, i.e., the production and distribution of the national product should be efficient.
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As Under-utilisation of resources leads to wastage of scarce resources. This leads to inefficiency of

production & distribution causes falls in national income and growth.
Production is called to be inefficient, if it is not possible to produce more of one good without reducing
the output of other goods in the economy. In the same way, the distribution is inefficient if it is not
possible to make anyone /persons better off without making any other person/persons worse off through
any redistribution system.
6. Problem of Growth of Resources:
Another important issue to know whether the resources of an economy are increasing, static or
declining. The growth of resources implies increase in productive capacity of an economy over time.
If an economy is unable to increase its resource availability, then it becomes difficult to develop its
economy.
7. Problem of Economic Growth:
Presently every economy whether rich or poor is facing with the problem of economic growth. Its aim is
rapid economic growth in order to raise the living standard of its people. It also means that the rate of
economic growth should be higher than the growth of population. It is possible only by optimum
utilizalisation of resources and creating more employment opportunities with increasing resources.
Conclusion - To conclude, we must note that there are two branches of modern economic theory i.e.
Micro Economic Theory and Macro Economic Theory. Micro theory known as price theory, deals with
the allocation of resources in the market economy. Thus, what to produce, how to produce and for
whom to produce is decided as the basis of price-mechanism. On the other hand, macro theory deals
with the fuller utilization of resources. It studies about the growth of resources along with other
problems such as unemployment, poverty, inflation and other such like problems.
Q. Discuss nature & scope of economics.
Ans. What is 'Economics'
The word “ECONOMICS” was derived from the Greek words “Oiko” (a house) and “nomia” (to
manage) which meant “household management” or “management of house affairs”.
An economy is the system according to which the money, industry, and trade of a country or region
are organized.
In other words, Economy is the use of the minimum amount of money, time, or other resources needed
to achieve something, so that nothing is wasted.
Definitions of Economics
Adam Smith’s Wealth Definition (1776)
Adam Smith defined economics as “a science which enquires into the nature and cause of wealth of
nations”. He emphasized the production and growth of wealth as the subject matter of economics.
Welfare Definition (1890):
Alfred Marshall stated that “Economics is a study of mankind in the ordinary business of life; it examines
that part of individual and social action which is most closely connected with the attainment and with the
use of material requisites of wellbeing”. It is on one side a study of wealth; and on the other side, a study
of human welfare based on wealth.
Scarcity Definition (1932)
According to Lionel Robbins: “Economics is the science which studies human behaviour as a
relationship between ends and scarce means which have alternative uses.” He emphasized on ‘choice
under scarcity’. In his own words, “Economics is concerned with that aspect of behaviour which arises
from the scarcity of means to achieve given ends.”
Modern Definition of Economics (2011)
According to Prof. A.C.Dhas, “Economics is the study of choice making by individuals, institutions,
societies, nations and globe under conditions of scarcity and surplus towards maximizing benefits and
satisfying their unlimited needs at present and future”. In short, the subject Economics is defined as the
“Study of choices by all in maximizing production and consumption benefits with the given resources of
scarce and surplus”.
Thus it can be said that
“Economics is a social science concerned with the production, distribution and consumption of goods
and services.” It studies how individuals, businesses, governments and nations make choices on
allocating resources to satisfy their wants and needs, and tries to determine how these groups should
organize and coordinate efforts to achieve maximum output.
Nature of economics

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Nature of Economics - Science or an Art:

Nature of economics

ECONOMICS AS ECONOMICS AS AN
SCIENCES ART

Positive Economics Normative Economics

Economics as a Science:
(a) Science is a body of knowledge which shows relationship between cause and effect: Economics
is a body of generalisations or laws and like science shows cause and effect relationship. For e.g. - The
law of demand in economics says “when price of a commodity rises (cause), its quantitydemanded falls
(effect).
(b) Science is capable of measurement: Like science, economics is also measured. For e.g. in
economics, measurement is in terms of money.
(c) Science has a methodological apparatus: Economics can also be studied using various methods
for e.g. Inductive Reasoning and Deductive Reasoning are the two methods of studying economics. (d)
Science has an ability to forecast: Like science, the various laws of economics can help in forecasting
which are beneficial for making policies. For e.g. - Consumer demand, supply of a product etc. can be
predicted using various laws.
Economics is not a Perfect Science:
(a) Reliance cannot be placed on accuracy of economic laws as these are based on humans who are
unpredictable.
(b) Economics does not have controlled experiments (i.e. the conditions are not stable) as a result actual
results differ from predicted ones.
(c) There is no fixed pattern of human behaviour which may be used to formulate economic laws.
(d) While deriving economic laws only the "most important” causes are considered, which reduces the
reliability of economic predictions. Hence, economics is not an exact science but it can be termed as a
science on account of nature and quality of its reasoning.
Economics as an Art:
(a) Art tells us how to do the thing i.e. to achieve an objective. Economics is also used for achieving a
variety of goals. For e.g. All policies etc. made in economics has the ultimate objective of solving
economic problems.
(b) Art is the practical application of theoretical knowledge Like Art, Economics also practices its
theoretical laws. For e.g. The various policies are made only after having a theoretical knowledge of the
society and country as a whole. Hence, economics is also an art.
Economics as a Positive or Normative Science:
 “Economics is a science and economics is a positive science mean the same thing”
 “Economies as an art and normative economics means two related but different things”
Let us see what positive/normative science is:
(a) Positive Economics:
 It investigates “what is”.
 It does not pass value judgements.
 It is not concerned with welfare propositions.
 This approach of economics was propounded by Lionel Robbins.
(b) Normative Economics:
 Normative is derived from the word “Norm” or “Standard” which implies “what ought to be”.
 It passes value judgements.

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 It is concerned with welfare propositions.

 It decides standards which should be adhered to in achieving economic objectives.
 This approach was propounded by Alfred Marshall.
Hence, economics is both a positive and normative science however in spite of using normative
economics, our economy cannot reach a happy state of affairs because of the following reasons:
(a) Lack of uniformity in choice of objectives so the question of “what ought to be” remainsundecided.
(b) Lack of information of the economy due to which we cannot ascertain which steps should be taken
to achieve the goals.
(c) Several courses of action cannot be attained at the same time.
Scope of Economics
Economists use different economic theories to solve various economic problems in society. Its
applicability is very vast. From a small organization to a multinational firm, economic laws come into
play. The scope of economics can be understood under two subheads: Microeconomics and
Macroeconomics. Let’s discuss these in detail:
Microeconomics: Microeconomics is the study of examining every individual economic activity,
industries, and their interaction. It mainly observes how a person earns and spends his income. Besides
it, the nature of microeconomics has certain key areas that must be taken into consideration.
 Elasticity: Elasticity is used to determine the ratio of change in the proportion of one variable to
the change in the proportion of another variable. Commonly used elasticity in the market: price
elasticity of demand, the income elasticity of demand, the price elasticity ofsupply etc.
 Theory of production: In this study of production, the input is converted into output efficiently.
Production can include storing, shipping, packaging, and manufacturing.
 Cost of production: In this theory, it states that the object price is determined by the price of
resources. The cost can be comprised of land, labour, capital and technology.
 Monopoly: A monopoly can be defined as the state where a single firm is the one and only
supplier of a specific commodity.
 Economics of Information: Information economics is a kind of theory, which shows how
information can affect economic decisions.
 Oligopoly: It is termed as the situation where the small numbers of sellers dominate an industry
or a market.
Macroeconomics
It is the study of an economy as a whole. It explains broad aggregates and their interactions “top down.”
Macroeconomics has the following characteristics:
 Growth: It studies the factors which explain economic growth such as the increase in output per
capita of a country over a long period of time.
 Unemployment: It is measured by the unemployment rate. It is caused by various factors like
rising in wages, a shortfall in vacancies, and more.
 Inflation and Deflation: Inflation corresponds to an increase in the price of a commodity, while
deflation corresponds to a decrease in the price of a commodity. These indicators are valuable to
evaluate the status of the economy of a country.
Economic and Welfare
Definition of economic welfare:
The level of prosperity and quality of living standards in an economy. Economic welfare can be
measured through a variety of factors such as GDP and other indicators which reflect welfare of the
population (such as literacy, number of doctors, levels of pollution etc.)
Economic welfare is a general concept which doesn’t lend to easy definition. Basically, it refers to how
well people are doing. Economic welfare is usually measured in terms of real income/real GDP. An
increase in real output and real incomes suggests people are better off and therefore there is an increase
in economic welfare.
However, economic welfare will be concerned with more than just levels of income. For example,
people’s living standards are also influenced by factors such as levels of health care, and environmental
factors, such as congestion and pollution. These quality of life factors are important in determining
economic welfare.

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Factors influencing economic welfare

1. Real income – influencing potential consumption

2. Employment prospects – unemployment significant cost
3. Job satisfaction – satisfaction at work as important as income and wage
4. Housing – High income but unaffordable housing diminishes economic welfare. Good, cheap
housing essential to economic welfare
5. Education – opportunities to study through lifetime, influence welfare
6. Life expectancy and quality of life – access to healthcare, also are lifestyles healthy, e.g. levels
of obesity/smoking rates
7. Happiness levels – normative judgements on whether people are happy.
8. Environment – economic growth can cause increased pollution, which damages healthand living
standards.
9. Leisure time – high wages due to working very long hours diminishes economic welfare. Leisure
has economic value.
ECONOMIC SYSTEM

MEANING OF ECONOMIC SYSTEM

An economic system is an organized way in which a country allocates resources and distributes goods
and services across the whole nation. In other words, an economic system defines how all the entities in
an economy interact.
According to Prof. Loucks, "An economic system consists of those institutions which a given people or
nation or a group of nations have chosen or accepted as the means through which their resources are
utilized for the satisfaction of human wants."
This definition helps us to identify certain features of an economic system which will enable us to
understand fully and clearly the meaning of an economic system-
1. A Group of People
An economic system deals with individuals and explains how individuals are engaged in the production
for the satisfaction of their wants.
2. Scarcity of Resources
An economic system exists due to the basic fact that the resources are scarce with which the goods and
services can be produced.
3. Organization of the Process of Consumption
An economic system is concerned with the organization of production and also with the consumption. If
there is no one to consume, then why will production take place?
4. Economic Institutions
Economic institutions relate to all those organizations, which help in providing a flow of goods and
services to the people. The set of institutions that characterizes an economy is known as an economic
system.
5. Flexibility
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Economic systems are not static but dynamic. They keep on changing, and may be destroyed, replaced,
modified and re-modified by the members of the society in the capacity of producers, financers, trade
unionists, etc.
6. Coordinated system
An Economic system is a coordinated system, having harmony, uniformity, and homogeneity among
various units comprising it.
Types of Economic Systems
With the passage of time, many economic systems have emerged on the basis of the changes that have
taken place in the ownership of means of production and the organisation of production. In the historical
order, before capitalism Slavery System and feudalism were prevalent. During 18th century industrial
revolution took place in England, as a result of which the use of capital increased considerably; therefore,
the Capitalism System emerged. After the great revolution in 1917 in Russia, Socialism emerged as
another economic system. In real life, we find mixed economy, which is a combination of Capitalism and
Socialism.
Let us now discuss the different types of economic systems in detail: -
(I) CAPITALISM
Meaning
A capitalist economy is that economy where all the three central problems, viz. what to produce, how to
produce and for whom to produce are solved by private individuals and institutions. In other words,
Capitalism is a system of economic organization featured by the private ownership and the use for private
profit of manmade and nature made capital:' In the operation of this type of economy, the interference of
the State is negligible. Property is owned privately and all economic activities are guided by the desire for
profit. It is also known as "free market economy" and "laissez faire economy." This kind of economy
emerged out of the Industrial Revolution of England during 1760-1820. The industrialization and
economic development of U.K, U.S.A and other Western European countries of the world have taken
place under the conditions of capitalism.
Features
Let us now discuss the essential characteristics of a capitalist economy.

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1. Right of Private Property

Individuals are free to enjoy the property in any manner that they like and this is applicable for
production goods also like land, capital, equipment machinery, etc. Every Individual has a right to
acquire private property, to keep it, and after his death to pass it on to his heirs. This creates inequalities
‘in the distribution of income and wealth. But this right is restricted. For example, a person may be
forbidden to produce dangerous drugs, or to run a gambling house, etc. Even under capitalism, the
government owns a lot of property in form of roads, railways, dams, etc.
2. Right of Inheritance
Every Individual has a right to pass his property on to his heirs after his death. This acts as a powerful
incentive for savings and capital formation. The very basis of capitalism is supported by this right of
inheritance.
3. Freedom of Enterprise and Occupation
Every Individual is free to take up any occupation that he likes or start any business he likes and to enter
into contracts or agreements with his fellow citizens in a manner most profitable to him. However, in
reality, there is no absolute freedom in these respects. Family influences, resources of an individual,
prejudices and other social restrictions stand in the way of a person choosing the occupation that he likes.
4. Free Market
In a capitalist economy, markets are completely free, i.e., there is no monopoly and imperfections which
may stop other firms to enter the market and start production. Consumers are free to buy goods according
to their choice and the labour market is also free.
5. Profit Motive
Under capitalism, all economic activities are guided by the sole objective of profit motive. Every
producer aims to maximize his profits by producing those goods whose price is maximum and cost is
minimum. Hence, what to produce and how much to produce is determined by individual profit, rather
than social benefit.
6. Price Mechanism
It is the price which equates the demand and supply of commodities and factors of production. For
example, if supply is short, then the demand, the price rises. As a result of rise in prices, the demand
comes down and price also comes down. In this way both the excess supply or excess demand is taken
off the market.
7. Class Conflict
The society in this type of economy stands divided into two classes-the "haves" and "have not’s".
According to Marx, this conflict is inherent in a capitalist economy and cannot be avoided. Conflict
between labour and capital is going on in all capitalistic countries and there seems to be no near solution
of this problem.
8. Competition
The producers compete with one another to get the consumer's choice or in selling the commodity as
much as they can through advertisement. They may cut the price or improve the quality of the product
or offer other incentives. Similarly, there is competition among the workers for jobs, but they also
combine in trade unions to fight the capitalists. The producers also form associations to safeguard their
interests. Thus, under capitalism, combination and competition go side by side.
9. Minimum Government Interference
Under capitalism, the Government interference in the economic activities is least. The producers and
consumers are free to take independent decisions interference. However, modern capitalist economies
are not totally free from Government
Merits of Capitalism
A Capitalist economy has survived and existed in many of the countries world since long due to its
many advantages, which are, disused below—
1. Automatic Working
Capitalism does not require any central directing authority functioning. The central problems of the
economy, viz., what to produce and in what quantity, how to produce and for whom to produce, are
solved with the help of price mechanism which is automatic.
2. Higher efficiency and incentive to Hard Work

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Under Capitalism, the entrepreneurs are induced to work hard and work more efficiently to earn higher
profits. The hard working and more efficient labourers get higher wages, which acts as an incentive for
the others also. In this way, the total output of the country increases.
3. Higher Rate of Capital formation
Under this system, the incomes increase and as a result there are more savings. Profit motive provides
incentive for higher investment, which results in higher rate of economic growth.
4. Optimum Utilization of Resource
Every person works according to his interest under capitalist economy and therefore uses the resources
in the optimum manner. Mutual competition also leads to optimum resource utilization.
5. Technological Progress
In a Capitalist economy, every producer tries to reduce his cost and maximize the output. This leads to
competition among them. The desire to survive and earn higher profits has led to the development of
new and improved techniques of production.
6. Increase in Production
In a Capitalist economy, production can be carried out on a large scale, providing many economics of
scale. As a result of industrialization and technological advancement, production increases considerably
and increases the incomes of the people. Thus, the improvement in the standard of living takes place at a
very fast rate.
Demerits of Capitalism
Capitalism has been criticized by economists and philosophers on many grounds. The following are the
main grounds on which it is attacked-
1. Inequality of Income
In Capitalist economies, a very small section of people owns and controls a considerable part of
National product and wealth. As a result of this, one can witness affluence along with acute poverty,
multi-storied buildings along with slums, etc. Extreme inequalities are undesirable from moral,
economic social and political point of view.
2. Wasteful Competition
In Capitalist economies, every producer tries to increase his production to earn move profits. This may
result in over production of some goods and under production of others. Producers even go in for
excessive advertisements to push up their sales. At times, a situation may arise when there are many
production units engage in the production of same commodity. Cut throat competition does not confer
any corresponding social benefit, though it may be advantageous to the firm concerned.
3. Economic Instability and Unemployment
In a capitalistic economy, instability exist due to the operation of different phases of trade cycles.
Production decisions are in the hands of producers, hence there is always a possibility of over
production or under production. Boom periods are followed by depressions. Boom leads to inflation,
whereas, depression result in unemployment.
4. Misallocation of Resources
Production under capitalism is not undertaken merely to satisfy the basic needs of the masses of people.
The productive resources are utilized for the production of luxuries for the rich, which have a higher
profit margin than for producing the goods required for mass consumption. Due to the inequalities of
Income and wealth, the demand depends on the purchasing power of the people and the rich people are
able to exert greater pull in the product market.
5. Self-interest in Place of Social Welfare
Under Capitalism, the motive of self-interest rather than the motive of social welfare prevails. The
producers try to maximize profits at the cost of workers and society. They produce those goods, which
give maximum profits but these goods might be harmful for the society or may not be necessary. The
consumer may thus become a victim of exploitation in the hands of producers as his choices and

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preferences are influenced by manipulative trade practices.

(II) SOCIALISM
Meaning
Socialism is an economic system where means of production are owned and managed by the whole
community. The state owns all wealth and capital, controls and manages the entire productive activities
and social welfare is the motivating force behind all productive activities. According to H.D. Dickinson,
"Socialism is an economic organization in which material means of production are owned by whole
community and operated by representatives of the people who am responsible to the community
according to a general plan."
Karl Marx who wrote in 1867 his famous book "Das Capital", the Bible of socialism, is considered to
be the father of scientific socialism. Soviet Russia was the first country in the world to establish a
communist economy based on Marxian principles. Later on, other countries like China, Vietnam,
Poland, Cuba, Germany, etc. had adopted this system.
Let us now discuss the main features of socialism-
1. Social Property
Under Socialism, all the means of production such as land, factories, banks, trade etc. are owned by the
state. But it is not essential that every single productive resource must be owned by the state. It may be
sufficient if the major and key means of production are in the hands of the government. In some
countries, private property on a very small scale exists.
2. Social Welfare
The motivating factor of economic activities under socialism is social welfare and not private profit. The
work which is performed by market mechanism under capitalism is performed by central economic
authority under capitalism. The planning commission keeps social welfare uppermost in consideration.
The state provides medical aid, education facilities, etc. for the benefit of a common man.
3. Economic Planning
Socialist economy is basically a planned economy. The allocation of productive resources is done
according to the direction of central authority. The planning commission formulates five-year plans for
economic development which are implemented through various governmental agencies. Planning takes
the place of market mechanism in a socialist economy.
4. Economic Equalities
Under Socialism, industrial and business enterprises belong to the state, thus there is little possibility of
owning wealth by private individuals. Perfect economic equality is not the aim of socialism, but there are
to be no glaring inequalities. Socialism aims at giving a fair share to all in the national income 11olig with
providing equal opportunities of employment to all. It recognizes that some income differences are
essential due to differences in skill, talents, dud productivity of individuals.
5. Absence of Competition
Under Socialism, Government is the only producer and therefore there is no scope of competition
among different production units. The spirit of co-operation and mutual goodwill prevails under
socialism. Absence of competition results in utilization of the national resources.
6. Classless Society
The socialists believe in a classless society where the distinction between the "rich and the poor" and
"the haves and the have not’s" has completely disappeared. In a socialist state every individual enjoys
equality of opportunity regardless of caste, creed, family and religion. All the people earn their income
in the form of labour income.
7. Government is the only Producer
In a Socialist economy, the production of various commodities is and the control of government.
Government is the only producer and hence, all the three central problems, what to produce, how to
produce and for whom to produce are solved by the government. The right to take decisions about these
problems lies with a central planning authority.
Merits of Socialism
1. Better allocation of Resources
As compared to capitalism, the productive resources of the country are more economically and optimally
allocated among the various productive uses. The central authority determines the allocation of recourses
among the various productive uses; which is in a better position to assess the basic needs of the people.
The consumers' demand and preferences can be estimated from the purchases made by them in the

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market. Also there is no wasteful expenditure on advertisement, etc. under socialism.

2. Eliminates Economic Instability
Socialism eliminates trade cycles which cause hardship to the people. The means of production are
owned and controlled by the state and as such the level of investment and the level of aggregate demand
can also be effectively determined. This ensures economic stability. Socialist economy is basically a
planned economy; therefore, there will be no over production or under production, leading to economic
stability.
3. Social Welfare and Social Security
The Socialists believe that people should be given protection against uncertainties relating to income,
work and living conditions and the burden of this provision should be borne by the entire society.
Therefore, the government undertakes various social security measures such as compensation for
unemployment and accidents, sickness and maternity benefits, old age pension, death grants, etc. The
state also provides the basic facilities of housing, education and health to the people. Thus, a socialist
state is truly a welfare state.
4. Equitable Distribution of Income
Under Socialism, the inequalities of income are reduced to the minimum and the national income is more
equitably and evenly distributed. No one is permitted to earn large unearned incomes, viz. rental and
interest incomes. Every individual is given equal opportunity to develop his latent faculties and get
necessary training and education.
5. Rapid Economic Growth
Another important benefit of Socialism is that it promotes rapid economic growth though economic
planning. A planned socialist economy functions according to the programme and in a systematic and
orderly manner. The rates of savings and investment can be greatly increased, which are essential for
rapid economic growth. In words of Pt. Nehru, "it is only through planned approach on socialistic lines
that steady progress can be attained."
6. Elimination of class struggle
A socialistic economy is a classless society and therefore, there is no scope for class struggle. The State
is the employer, who is guided by social welfare motive. All people earn their income by working for the
state and get the income in the form of labour income. The distinction between "rich and poor" and “the
haves and have not’s" completely disappears under socialism.
Demerits of Socialism
1. No Incentive for Hard work
Under Socialism, the people are made to work according to the dictates of the central authority. They
become merely wage earners and their jobs are eliminated, the stun protected whether they are efficient
or inefficient. When personal gain is eliminated the stimulus to self-improvement will disappear and
there will be no incentive for hard work. Pigou remarked that "a government could print a good edition
of Shakespeare's works, but it could not get them written."
2. Loss of Economic freedom
A serious charge against socialism is that when freedom of enterprise disappears even the freedom of
occupation will go. Workers will be assigned certain jobs and they cannot change them without the
consent of the planning authority. Similarly, the consumers are compelled to accept whatsoever
commodities are produced by the government. There is no freedom of spec or expression in socialist
countries.
3. Concentration of Economic and Political Powers
Under Socialism, the State is not merely a political authority but it also has unlimited authority in the
economic aspects. Thus, all power is concentrated in the hands of the state and it has absolute authority
in the country. Hence, there is every possibility that a few politicians and bureaucrats may become
dictators in the country.
4. Loss of Consumers' Sovereignty

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Socialism does not recognize consumers' sovereignty. Production is not guided by the taste and
preferences of the consumers. Consumption has to adjust itself to production. Thus, a consumer may not
be able to maximize his satisfaction. The state fixes the price for the goods, which may be arbitrary. A
socialist economy produces goods and services of a limited variety, which the central planning authority
decides to produce denying the consumers the choice among varieties of goods.
5. Bureaucracy and Red Tapism
Bureaucratic running of the economic machinery is the most important criticism of a socialist economy.
The civil servant does not feel the same keen self-interest as the employer of a private organization and
knows that he will be promoted on the basis of seniority rather than on the basis of extra work their self-
interest as the alertness. Therefore, he will be guided merely by rule and precedent; no initiative and
resourcefulness. There is routine and red tape and no room for extraordinary people. Files may go on
moving from one place to another, from one table to another, leading to delays and wastage of time.

(III) MIXED ECONOMY

Meaning
In the modem world what we find mostly are mixed economics. Mixed economy means that it is
operated by both private and public enterprise. The concept of mixed economy was propounded by J.M.
Keynes during the world depression of 1930s. At present we have two types of mixed economics. The
first type of mixed economy is that in which the means of production are in the private hands and the
government indirectly intervenes in its economic affairs. The government regulates and controls the
activities of private enterprises. This type of mixed system is called "Mixed Capitalist System". In such
type of economy, the government produces only defence goods and public utility services. This type of
mixed economy can be seen is most of the developed countries of the world like UK, USA, and
Germany, etc.
The second type of a mixed economy is that in which the government also directly participates in the
production of various goods and services along with regulating and controlling private enterprises. The
government may put direct controls such as price-control, licensing system, control over imports etc. or it
may use various monetary and fiscal policies. This type of economy exists in most of the developing
countries. Indian economy is an example of this type of mixed economy. Mixed economy is said to be a
middle way between capitalism and socialism.
Features-
The following are the features of a mixed economy.
1. Co-existence of private and public sector
In mixed economics, both private sector and public sector co-exist. The industries of the country are
divided into two parts, in one part are the industries, the responsibility for the development of which is
entrusted to the state and they are owned and managed by the state. Other industries are left under the
authority and control of private entrepreneurs. Generally, the basic and key industries like industries
concerned with the production of defence equipment, atomic energy, heavy engineering industries, etc.
are put under the public sector and the consumer goods industries like sugar, oil, textiles, etc. are left in
the hands of private sector. Thus public sector dominates those areas of production which require huge
investment with low rate of profitability.
2. Economic Planning
Economic planning is essential for the economic growth and development of the economy. Both public
and private sectors are required to bring about balanced growth of the economy. Planning can take the
form of various policies. Incentives and disincentives, through various monetary, fiscal, trade and other
policies.
3. Government Regulation and Control of Private Sector
In a mixed economy, the government regulates and controls the private sector, so that it may function in
the interest of the whole economy rather than exclusively for the interest of private entrepreneurs. For this
purpose, it introduces licensing system, various monetary and fiscal policies, anti-monopoly controls, etc.
4. Greater Social Welfare
Basic objective of a mixed economy is promotion of social welfare. The government makes conscious
efforts to promote the welfare of the people through various social security schemes to help the poor and
backward classes. The government protects the interests of the workers by formulating various Labour
Laws, Factory Acts, fixing the working hours and minimum wages. It also provides education, health
facilities, etc.

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5. Price Mechanism
In a mixed economy price mechanism plays a dominant role but not as dominant as under capitalism.
Price mechanism functions subject to certain regulations through price controls, fixation of minimum
wages, etc. For example, price of essential commodities, such as petroleum prices, gas prices, etc. are
fixed by the government.
6. Flexibility and more economic freedom
In a mixed economy, the roles, of public and private sectors are clearly defined, but in the event of some
necessity, these roles can be changed. Categorization of industries in public and private sectors does not
mean that they cannot be interchanged. If need be, industries assigned to public sector can be assigned to
the private sector and vice versa. For the operation of private sector, there is complete economic freedom.
This motivates people to work hard and produce more, thereby increasing the overall economic welfare.
7. Balanced Growth
Mixed economy promotes balanced growth in the economy. The government sets up industries in those
regions where the private enterprise fails. Similarly, it establishes those industries, which the private
sector will not establish due to their being capital intensive or where the gestation period is very long or
where the profitability rate is low. But the setting up of these industries is important for the overall
development of the economy.
8. Reduction of Inequality of Income and Wealth
In a mixed economy, the existence of public sector does not allow inequalities in the distribution of
income and wealth to grow beyond a limit. Even the working of the private sector is regulated by the
government. The government may adopt measures like progressive taxation, levy of death duties, etc. to
reduce unequal distribution of income and wealth.
Merits of mixed economy
1. Healthy Competition
Mixed economy promotes healthy competition between public and private sectors as a result of which
people work hard and produce more. The producers try to find out new techniques of production to
reduce costs and the resources are efficiently and optimally allocated among various uses.
2. Rapid Economic Development
In a mixed economy, due to healthy competition between the public and private sectors the resources are
used more efficiently. This results in increasing the rate of economic growth in the country. It is
particularly important for less developed countries where economic development is to be initiated.
Public ownership of means of production ensures that economic growth is achieved along with social
justice.
3. Economic Freedom
The greatest view of capitalism, i.e., economic freedom also exists in a mixed economy. This motivates
people to work hard and produce more. Consumers are also free to choose goods and services they want
to consume. People are free to choose occupation.
4. Proper Allocation of Resources
In mixed economy, planning of the resources for their different uses is done. This ensures that the
resources are utilized in the best possible manner. The planning authority divides the resources
appropriately among the public and private sectors keeping in mind the overall interest of the economy.
5. Flexible and Ensures Balanced Growth
Under mixed economy, the role of public and private sector is well defined. But the government can
change its decision according to the needs of the country. Categorization of industries in public and
private sectors does not mean that these have been placed in watertight compartments. If need arises, the
government can change certain industries from private sector to public or vice versa. This also ensures a
balanced growth of the economy.
6. National Welfare
Profit motive is not the only objective for undertaking economic activities. Though, public sector is
guided predominantly by social welfare motive and the private sector is guided by profit motive only.
But private sector cannot maximize profit at the cost of social interest. In case of clash of interest, the
social interest is to be considered for the welfare of the nation. It is because of this consideration that
generally public utility services and basic and key industries are kept under the public sector.
Demerits of Mixed Economy
1. Conflict between Public and Private sectors

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In capitalism, coordination is brought by price mechanism and in socialism; it is brought by the central
planning authority. But in a mixed economy, there is a lack ofcoordination due to the collusion and non-
operation between the private and public sectors. In such a situation a mixed economy may not be able to
function properly.
2. Instability
Mixed economy is short lived because after some time it conveys either towards a capitalist economy or
towards a socialist economy. Sometimes, it is also possible that in future some private undertakings are
nationalized. Because of this fear of nationalization, the private sector may not take much interest in
producing more and improving the technology.
3. Loss of Efficiency
In a mixed economy, both sectors suffer due to lack off efficiency. In the public sector, it is so because
civil servants may not perform their duties with responsibility. And in the private sector, efficiency
decreases because the government imposes too many restrictions in the form of controls, permits,
license, etc.
4. Economic Fluctuations
Under mixed economy, the private sector industries are not controlled effectively. As a result of this,
they are affected by short run demand and supply factors whichresult in fluctuations in the prices of
goods and services. The government may impose excessive controls, licensing system, monetary and
fiscal controls etc. which may become inconvenient.
5. Poor Performance of Public Sector
In a mixed economy, the public sector has a record of poor performance, due to inefficiency, red tapism,
etc. Experience of Indian economy bears testimony to this fact. Mixed economy in India has not been
able to promote fast economic growth nor has it been able to remove the large economic and regional
inequalities of income andwealth.
UNIT - II

Demand, Elasticity Concepts

Q. Define demand. Also explain factors affecting demand.

Ans. Demand in economics is how many goods and services are bought at
various prices during a certain period of time. Demand is the consumer's need or
desire to own the product or experience the service.
Meaning of Demand : Demand refers to
 the willingness and ability to purchase/ buy
 quantity of a commodity
 at a particular price
 during a given period of time.
Definition- According to Prof RG Lipsey, “The amount of a commodity that households wish
to purchase is called the quantity demanded of that commodity”

Individual Demand - The demand for a commodity by a single consumer or a

household is known as “individual demand”
Market Demand- The sum total of demand for a commodity by all the consumers, households
or individuals is known as “market demand”.
Factors affecting Demand - There are several factors which influence the quantity demanded of
a commodity. Important among them are the price of the commodity, the price of related
commodities, and income of the consumer, taste and preference of consumers, size of population
and various other factors. The factors can be explained more briefly with the help of following:
1. Price of Commodity(P): The price of commodity is the most important factor that
determines the demand of a commodity. As a matter of fact, there is inverse relationship
between the price of the commodity and the quantity demanded. It means that the price
and quantity demanded move in opposite direction. For example, lower the price, higher
is the demand. On the contrary, higher is the price; lower is the demand of the
commodity.
2. Prices of Related goods (Complementary and substitutes Goods)(Pr): Change in price
of related goods affect the demand for a commodity. Related goods are mainly of two
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types which are substitute and complementary goods.

Substitute goods are those goods which can be used in place of one another, i.e.,
they satisfy same type of demand, e.g. tea and coffee, gel pen and ball pen etc. In
such case decline in price of one good (say fall in price of tea) inversely affect the
demand of another good (say fall in demand of the coffee). There is a positive
relation between substitute goods price and quantity.
Complementary goods are those goods which are used jointly such as car and petrol, bread and
butter, ink and pen etc. in such cases decline in price of one commodity positively affect demand
of other commodity. The demand for a commodity is affected by the prices of complementary
goods and also of substitutes. When the price of petrol increases the demand for scooter or motor
cycle and car will decrease. Similarly, when the prices of motor cars increased people demanded
more of scooters. The prices of scooters increased.
3. Income of the Consumer(Y): Demand for a commodity is also affected by income of the
consumer. However, the effect of change in income on demand depends on the nature of
the commodity under consideration.
i. If the given commodity is a normal good, then an increase in income leads to risein
its demand, while a decrease in income reduces the demand.
ii. If the given commodity is an inferior good, then an increase in income reduces the
demand, while a decrease in income leads to rise in demand. Example: Suppose, income of a
consumer increases. As a result, the consumer reduces consumption of toned milk and
increases consumption of full cream milk. In this case, ‘Toned Milk’ is an inferior good for
the consumer and ‘Full Cream Milk’ is a normal good.
4. Tastes and Preferences(T): Tastes and preferences of the consumer directly influence
the demand for a commodity. If the consumer has favourable taste and preference for the
commodity, then its demand increases. On the other hand, demand for a commodity falls,
if the consumers have no taste or unfavourable taste and preference for thecommodity.
5. Expectation of Change in the Price in Future(E): If the price of a certain commodity is

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expected to increase in near future, then people will buy more of that commodity
in present than what they normally buy and vice versa. There exists a direct
relationship between expectation of change in the prices in future and change in
demand in the current period. For example, if the price of petrol is expected to rise
in future, its present demand will increase.
6. Change in Weather and Season(W): Demand for certain products are determined by
climatic or weather conditions. For example—in summer there is a greater demand for
cold drinks, fans, coolers etc. Similarly, demand for umbrellas and raincoats are seasonal.
So demand for seasonable good increases and unseasonable goods demand falls.
7. Change in Distribution of Income and Wealth in the Community(D): If there is a
change in income and if there is equal distribution of income and wealth then demand for
many products of common consumption tends to be greater than in the case of unequal
distribution.
8. The Growth of Population and the Number of Buyers in the Market(Pn): The growth of
population is an important and vital factor. A high growth of population over a period of time
tends to imply a rising demand for goods and services. Large number of buyers will constitute
a large demand and vice-versa.
9. Market Size(M): If the size of the market increases, like if a country’s population increases
or there is an increase in the number of people in a certain age group then the demand for
products would increase. Simply put, the higher the number of buyers, the higher the
quantity demanded. For example, if the birth rate suddenly skyrocketed, then there would
be an increase in demand for baby products.
Q2. Explain “Law of Demand”.

Ans. Statement-The law of demand states that other things remaining constant
(cetris paribus) there is a negative, or inverse, relationship between price and
the quantity of a good demanded i.e. if price increases demand will fall and vice
versa(if price falls demand increases).
Assumptions - Law of demand assumes that “other things being constant /remain unchanged” i.e.
the assumption of cetris paribus order. These assumptions are-
 No change in taste, preference, habits and fashion of the consumers.
 Consumer’s income remains constant.
 The price of other goods remains constant.
 Income distribution should not change.
 Size and composition of population should remain same.
 There should not be any possibility of a change in price of the commodity in
near future.
 The consumer should be a rational consumer.

Explanation - The law can be explaining more briefly with the help of
demand schedule and demand curve.
Demand Schedule – Tabular presentation of relationship between price and demand of a
commodity is called demand schedule.
Price(in units) Quantity (in units)
1 50
2 40
3 30
4 20
5 10
The data in table clearly shows that an individual consumer will decrease its purchases as price of
the commodity increases. As if prices are at 1 quantity is at 50 if prices increase from 1 to 2
quantity decreases from 50 to 40. Same follows till price reaches to 5 and quantity falls to 10.
Demand Curve - Graphical presentation of relationship between price and demand of a
commodity is called Demand curve.

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In the given diagram on the x-axis and y-axis quantity (in units) and prices (in units) is taken
respectively. DD shows the demand curve which is downward sloping which means as price
increases demand falls and vice versa.
Reasons for the law of demand or downward sloping demand curve-
1. Law of diminishing marginal utility: As the price of the commodity falls, consumer purchases more
of the commodity so that his marginal utility from the commodity also falls to equal the reduced price.
If the price rises opposite happen.
2. New consumers: When the price of commodity falls many other consumers who were not
consuming the commodity earlier will start purchasing it now because it is within their reach now.
For example, if price of ice-cream family pack falls from Rs. 100 to Rs. 50 per pack, then many
consumers who were not in a position to afford the ice-cream earlier can now buy it with decrease in
its price. Moreover, the old customers of ice-cream can now consume more. As a result, its total
demand increases.
3. Substitution Effect: Substitution effect refers to substituting one commodity in place ofother when
it becomes relatively cheaper. When price of the given commodity falls, it becomes relatively
cheaper as compared to its substitute (assuming no change in price of substitute). As a result,
demand for the given commodity rises. For example, if price of given commodity (say, Pepsi) falls,
with no change in price of its substitute (say, Coke), then Pepsi will become relatively cheaper and
will be substituted for coke, i.e. demand for Pepsi will rise.
4. Income Effect: Income effect refers to effect on demand when real income of the consumer
changes due to change in price of the given commodity. When price of the given commodity falls,
it increases the purchasing power (real income) of the consumer. As a result, he can purchase more
of the given commodity with the same money income. For example, suppose Isha buys 4
chocolates @ Rs. 10 each with her pocket money of Rs. 40. If price of chocolate falls to Rs. 8 each,
then with the same money income, Isha can buy 5 chocolates due toan increase in her real income.
5. Different Uses: Some commodities like milk, electricity, etc. have several uses, some of which are
more important than the others. When price of such a good (say, milk) increases, its uses get
restricted to the most important purpose (say, drinking) and demand for less important uses (like
cheese, butter, etc.) gets reduced. However, when the price of such a commodity decreases, the
commodity is put to all its uses, whether important or not.

Exceptions to the Law of Demand: In certain cases, the demand curve slopes
up from left to right, i.e., it has a positive slope. Under certain circumstances,
consumers buy more when the price of a commodity rises, and less when
price falls, as shown by the D curve in Figure Many causes are attributed to an
upward sloping demand curve.

1. War: If shortage is feared in anticipation of war, people may start buying for building
stocks or for hoarding even when the price rises.
2. Giffen Goods: These are special kind of inferior goods on which the consumer spends a
large part of his income and their demand rises with an increase in price and demand falls
with decrease in price. For example, in our country, it is often seen that when price of
coarse cereals like jowar and bajra falls, the consumers have a tendency to spend less on
them and shift over to superior cereals like wheat and rice. This phenomenon, popularly
known as’ Giffen’s Paradox’ was first observed by Sir Robert Giffen.
3. Status Symbol Goods or Goods of Ostentation: The exception relates to certain prestige
goods which are used as status symbols. For example, diamonds, gold, antique paintings,
etc. are bought due to the prestige they confer upon the possessor. These are wanted by the
rich persons for prestige and distinction. The higher the price, the higher will be the
demand for such goods.
4. Fear of Shortage: If the consumers expect a shortage or scarcity of a particular commodity
in the near future, then they would start buying more and more of that commodity in the
current period even if their prices are rising. The consumers demand more due to fear of
further rise in prices. For example, during emergencies like war, famines, etc., consumers
demand goods even at higher prices due to fear of shortage and general insecurity.
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5. Ignorance: Consumers may buy more of a commodity at a higher price when they
are ignorant of the prevailing prices of the commodity in the market.
6. Fashion related goods: Goods related to fashion do not follow the law of demand and
their demand increases even with a rise in their prices. For example, if any particular type
of dress is in fashion, then demand for such dress will increase even if its price is rising.
7. Necessities of Life: Another exception occurs in the use of such commodities, which
become necessities of life due to their constant use. For example, commodities like rice,
wheat, salt, medicines, etc. are purchased even if their prices increase.
8. Change in Weather: With change in season/weather, demand for certain commodities also
changes, irrespective of any change in their prices. For example, demand for umbrellas
increases in rainy season even with an increase in their prices. It must be noted that in
normal conditions and considering the given assumptions, ‘Law of Demand’ is universally
applicable.
Difference between Change in demand and change in quantity demanded
Demand for a commodity depends on several factors like price, income, taste
and preference of consumers, price of other related commodities, future
expectations of price and population etc. Changes in demand imply two
things: (i) change in quantity demanded (ii) change in demand.
(1) Change in quantity demanded: Change in quantity demanded refers to the change in the
amount of a commodity as a result of change in the price of it. Amount demanded rises or falls
according to the fall or rise in price. In such a case other factors influencing demand are held
constant. The fall and rise in amount demanded due to the change in price is technically called
"contraction" and "extension" of demand.
The demand function or the demand curve never changes. The change takes place
in the same demand curve. The existing demand curve contains the changes in the
different price-quantity combination. In case of change in quantity demanded
movement takes place along the existing demand curve.
(2) Change in demand: 'Change in demand' means changes in demand due to the change in
the factors other than price. Those other factors are income, taste and preference, population,
future expectation, prices of other related commodities etc. Price remaining constant these
factors bring about a change in demand which is called "Change in demand". The change in
demand involves "increase" and "decrease" of the demand for a commodity.
The change in demand implies a change in the demand function itself. In case of
change in demand the entire demand schedule and demand curve change. With an
increase in demand curve shifts upward and with a decrease in demand curve
shifts downward. Thus change in demand takes place on different demand curves.

Elasticity of Demand
The law of demand states the negative relation between price and quantity. However, it does not
explain how much change in quantity demanded in response of change in price. Thus the concept
of elasticity introduced by economist Alfred Marshall. As the word Elasticity means
sensitiveness or responsiveness of change.
Thus elasticity of demand means responsive change in demand due to the change in price.
Meaning of Elasticity of Demand: The Elasticity of Demand is a measure of change in the
quantity demanded in response to the change in factor affecting demand of the commodity.

Price Elasticity of Demand: It refers responsive change in quantity demanded

of a commodity due to change in its price. The suggested mathematical method
to measure the elasticity of demand:

According to this formula, the elasticity of demand can be defined as a percentage changein
demand as a result of the percentage change in price. Numerically, it can be written as:

Where,
ΔQ = Q1 –Q (Change in quantity), ΔP = P1 – P(Change in Price)
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Q1= New quantity, Q= Original quantity

P1 = New price, P = Original price
Definition of elasticity of demand
According to Prof. Boulding “Elasticity of demand measures the degree of responsiveness of
the quantity to a change in the price”.
Types of Elasticity:

Price Elasticity- is the responsive change in demand due to

change in price. Ed=%change in quantity demanded / %
change in price
Income Elasticity- is the responsive change in demand due to change in the consumer’s
income. Ed= % change in quantity demanded / % change in income
Cross Elasticity- is the responsive change in the demand for a commodity due to change in the
price of another commodity.
Ed= % change in quantity demanded of one commodity/ % change in price of other commodity
Degrees of Elasticity of Demand:
Different commodities have different price elasticity’s. Some commodities have more elastic
demand while others have relative elastic demand. Basically, the price elasticity of demand ranges
from zero to infinity. It can be equal to zero, less than one, greater than one and equal to unity.
1. Perfectly Elastic Demand: Perfectly elastic demand is said to happen when a little change in price
leads to an infinite change in quantity demanded. A small rise in price reduces the demand to zero.
In such a case the shape of the demand curve will be horizontal straight line as shown in figure 1.

The figure 1 shows that at the ruling price OP, the demand is infinite. A slight
rise in price will contract the demand to zero. A slight fall in price will attract
more consumers but the elasticity of demand will remain infinite (ed=∞).
2. Perfectly Inelastic Demand: Perfectly inelastic demand is opposite to perfectly elastic demand.
Under the perfectly inelastic demand, irrespective of any rise or fall in price of a commodity, the
quantity demanded remains the same. The elasticity of demand in this case will be equal to zero (ed
= 0).

In diagram 2 DD shows the perfectly inelastic demand. At price OP, the

quantity demanded is OQ. Now, the price falls to OP1, from OP, the demand
remains the same. Similarly, if the price rises to OP2 the demand still remains
the same.
3. Unitary Elastic Demand: The demand is said to be unitary elastic when a given
proportionate change in the price level brings about an equal proportionate change in quantity
demanded. The numerical value of unitary elastic demand is exactly one i.e. Marshall calls it
unit elastic.

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In figure 3, DD demand curve represents unitary elastic demand. This

demand curve is called rectangular hyperbola.
4. More than unitary (Relatively Elastic Demand): Relatively elastic demand refers to a situation
in which a small change in price leads to a big change in quantity demanded. In such a case
elasticity of demand is said to be more than one (ed > 1). This has been shown in figure 4.

In fig. 4, DD is the demand curve which indicates that when price is OP the
quantity demanded is OQ1. Now the price falls from OP to OP1, the quantity
demanded increases from OQ1 to OQ2 i.e. quantity demanded changes more
than change in price.’
5.Less than unitary(Relatively Inelastic Demand): Under the relatively inelastic demand, a given
percentage change in price produces a relatively less percentage change in quantity demanded. In
such a case elasticity of demand is said to be less than one (ed < 1). It has been shown in figure 5.

In fig. 5, DD is the demand curve which indicates that when price is OP the
quantity demanded is OQ1. Now the price falls from OP to OP1, the quantity
demanded increases from OQ1 to OQ2 i.e. quantity demanded changes less
than change in price.’
Methods to measure elasticity of demand-
Some of the methods used for measuring price elasticity of demand are as follows:
1. Total Expenditure Method
2. Proportionate Method
3. Point Elasticity of Demand

1. Total Expenditure Method: According to this method, elasticity of demand can be measured
by considering the change in price and the subsequent change in the total quantity of goods
purchased and the total amount of money spent on it.
Total Outlay or expenditure = Price X Quantity Demanded
There are three possibilities:
(i) If with a fall in price the total expenditure also falls, and with a rise in price the total
expenditure also rises, so the elasticity of demand is less than one i.e. Ed < 1 as there exist
positive relationship between total expenditure and price.
(ii) If with a rise or fall in the price the total expenditure remains the same, the demand will
be unitary elastic or Ed = 1.
(iii) If with a fall in price the total expenditure increases or with a rise in price the totalexpenditure
falls, in that case the elasticity of demand is greater than one i.e. Ed > 1 as there exist negative
relation between total expenditure and price.
This can be expressed with the help of a table.

Price Quantity Total Relationship Elasticity

Expenditure(P*Q)
1 6 6 Positive Ed<1
2 5 10
3 4 12 Ed=1
4 3 12 Constant
5 2 10 Negative Ed>1
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6 1 6

In the Table we find three possibilities:

A. Less Elastic Demand: When price is 1 the total expenditure is 6. Now price increases from 1 to 2,
the total expenditure increases from 6 to 10. Thus it is clear that with the fall in price, thetotal
expenditure increases and vice-versa. So elasticity of demand is greater than one or Ed <1.

B. Unitary Elastic Demand: If price is Rs. 3 the total outlay is 12. Now price increases to 4, the total
expenditure remains the same i.e., 12. Thus it is clear that with the rise or fall in price, the total
expenditure remains the same. The elasticity of demand in this case is equal to one or Ed = 1.

C. More Elastic Demand: If price is Rs. 5 total outlay is 10. Now price increases from 5 to 6
the total expenditure falls from 10 to 6. Thus it is clear that with the increase in price, the total
expenditure falls and vice-versa. In this case, the elasticity of demand is more than one or Ed>1.

2. Proportionate or Percentage Method: According to this method, “price elasticity of demand

is the ratio of percentage or proportionate change in the amount demanded to the proportionate or
percentage change in price of the commodity.”

Its formula is as under:

3. Point Method: According to this method, elasticity of demand will be different on each point of
a demand curve. In order to measure Ed at any particular point, lower portion of the curve from
that point is divided by the upper portion of the curve from the same point. Elasticity of Demand
(Ed) = Lower segment of demand curve (LS) / Upper segment of demand curve (US) As seen in
Fig. 4.1, elasticity at a particular point ‘N’ is calculated as NQ/NP.

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Similarly, elasticity of demand on different points of a straight line demand

curve is shown in Fig. 4.2:

 Unitary Elastic Demand: At the mid-point of the demand curve, i.e. at point B, the lower and
upper segments (BD and BE) are exactly equal. Thus, elasticity at point B = LS/US = BD/BE = 1
 Highly Elastic Demand: At every point above f the mid-point B but below E, i.e., between E and
B, the elasticity will be greater than one. It happens because lower segment is greater than the
upper segment. So, Ed at point A = LS/US = AD/AE > 1 (as AD>AE)
 Less Elastic Demand: At every point below the mid-point B but above D, i.e., between B and D, the
elasticity will be less than one. It happens because lower segment is less than upper segment. So, Edat
point C = LS/US = CD/CE <1 (as CD < CE).
 Perfectly Elastic Demand: At any point on the Y-axis (like point E), elasticity is equal to infinity
because at this point, there is no upper segment of demand curve. So, Ed at point E = LS/US= ED/0
=
∞ (as any number, when divided by zero, gives infinity).
 Perfectly Inelastic Demand: At any point on the X-axis (like point D), elasticity is equal to zero
because at this point, there is no lower segment of demand curve. So, Ed at point D = LS/US = 0/ED
= 0 (as zero, when divided by any number, gives zero).
Importance of price elasticity of demand : Importance’s of price elasticity of demand are
given below:
1. Determination of price policy: The concept of elasticity is of great importance to
businessmen to determine the price of product. When the demand of a good is elastic, they
increases sale by lowering its price. In case the demand is inelastic, they are then in a
position to charge higher price for a commodity.
2. Price discrimination: Price discrimination refers to the act of selling the technically same
products at different prices to different section of consumers or in different sub-markets.
The policy of price-discrimination is profitable to the monopolist when elasticity of demand
for his product is different in different sub-markets. Those consumers whose demand is
inelastic can be charged a higher price than those with more elastic demand.
3. Taxation and subsidy policy: The government can impose higher taxes and collect more
revenue if the demand for the commodity on which a tax is to be levied is inelastic. On the
other hand, in case of a commodity with elastic demand high tax rates may fail to bring in
the required revenue for the government. Govt. should provide subsidy on those goods
whose demand is elastic and in the production of the commodity the law of increasing
returns operates.
4. Importance in the determination of factors prices: Factors such as labour plays vitalrole
in the production of goods which are demanded in the market. Thus, factor with an inelastic
demand can always command a higher price as compared to a factor with relatively elastic
demand.
5. Determination of sale policy for supper markets: Super Markets is a market where ina
variety of goods are sold by a single organization. These items are generally of mass
consumption. Therefore, the organization is supposed to sell commodities at lower prices
than charged by shopkeepers in the other bazars. Thus, the policy adopted is to charge a
slightly lower price for items whose demand is relatively elastic and the costs are covered
by increased sales.
6. Output decisions: The elasticity of demand helps the businessman to decide about
production. A businessman chooses the optimum production on the basis of elasticity of
demand for various products. The products having more elastic demand are preferred by
the businessmen and vice versa.
7. International Trade: In order to fix prices of the goods to be exported, it is important to
have knowledge about the elasticity of demand of goods. A country may fix higher prices
for the products with inelastic
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importing country then the exporting country will have to fix lower prices.
8. Formulation of Government Policies: The concept of price elasticity of demand is
important for formulating government policies, especially the taxation policy.
Government can impose higher taxes on goods with inelastic demand, whereas , low
rates of taxes are imposed on commodities with elastic demand.

SUPPLY , ELASTICITY OF SUPPLY

Supply: Supply is the willingness and ability of producers to create goods and
services to take them to market. Supply is positively related to price given that
at higher prices there is an incentive to supply more as higher prices may
generate increased revenue and profits.
Meaning of supply: Supply means
 Willingness and ability to sell
 the quantities of a commodity
 at different prices
 in a given period of time.
It is obvious that if the price goes up, he will offer more for sale due to more
profits. But if the price goes down, he will be reluctant to sell and will offer to
sell less due to fall in profits.
Definition
According to Thomas: “The supply of good is the quantity offered for sale in a given market
at a given time at a various prices”
A General Definition: Supply is the quantity of a good or resource that sellers (or suppliers) are
willing and able to offer to the market for sale under a given set of conditions over a specific
period of time.
Distinction between Supply and Stock:
The terms ‘supply’ and ‘stock’ are often confused. A clear understanding of the difference
between the two is essential. Stock is at the back of supply. It constitutes potential supply. Supply
means the quantity actually offered for sale at a certain price, but stock means the total quantity
which can be offered for sale if the conditions are favourable. At any time, the godowns in the
‘mandi’ may be full of wheat. This is the stock. If the price is low, very little wheat will come out
of the godowns.
The quantity that actually comes out is the supply. The stock will change into supply and vice
versa according as the market price rises or falls. In case of perishable articles, like fresh milk
and vegetables, there is no difference between stock and supply. The entire stock is supply and
has to be sold off for unless it is disposed of quickly, it will perish.
Determinants of Supply: Supply can be influenced by a number of factors that are termed as
determinants of supply. Generally, the supply of a product depends on its price and cost of
production. In simple terms, supply is the function of price and cost of production.
i. Price(P): Price is the main factor that influences the supply of a product to a greater extent. If
the price of a product increases, then the supply of the product also increases and vice versa.
ii. Prices of Inputs: Implies that the supply of a product would decrease with increase in thecost
of production with increase in price of inputs and vice versa. The supply of a product and
prices of inputs are inversely related to each other.
iii. Goal of the Firm: A firm’s goal basically considers as profit maximisation or sales maximisation.
As if the goal of the firm is to maximise its sales so seller would increase supply even at a lower
price. On the other hand, if main motive of the firm is to maximise profits it will supply more at
higher prices.
iv. Number of Firms or Sellers: supply is affected by the number of sellers in the market. As if
number of sellers increases supply increases and if sellers are less supply will fall.
v. Natural Conditions: Implies that climatic conditions directly affect the supply of certain products.
For example, the supply of agricultural products increases when monsoon comes on time.
However, the supply of these products decreases at the time of drought. Some of the crops are
climate specific and their growth purely depends on climatic conditions. For example, Kharif crops
are well grown at the time of summer, while Rabi crops are produce well in winter season.
vi. Technology: Refers to one of the important determinant of supply. A better and advanced
technology causes fall in cost of production and increases the production of a product, which results
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quality seeds increases the production of crops. This further increase the supply of food grains in the
market.
vii. Transport Conditions: Refer to the fact that better transport facilities increase the supply of
products. Transport is always a constraint to the supply of products, as the products are not
available on time due to poor transport facilities. Therefore, even if the price of a product
increases, the supply would not increase.
viii. Government’sPolicies: Implies that the different policies of government, such as fiscal policy and
industrial policy, has a greater impact on the supply of a product. For example, increase in tax
cause increase in cost of production and fall in profits because of that supply of a product
decreases. On the other hand, if the tax rate is low, then the supply of a product would increase.
ix. Prices of Related Goods: Price of related goods also affect the supply. As if prices of related
goods increase the quantity supplied of own commodity falls and vice versa.
Law of Supply

Statement: Law of supply states that “Other things remaining constant, there
exist positive or direct relationship between price and quantity supplied as the
price of a good rises, the quantity supplied increases, and as the price falls the
quantity supplied decreases”.
Assumptions: The assumptions of the law of supply are as under:
1. No change in technique of production: There should not be any change in the technique of
production. This is essential for the cost to remain unchanged. With the improvement intechnique
if the cost of production is reduced, the seller would supply more even at falling prices.
2. There should be no change in transport cost: It is assumed that transport facilities and transport
costs are unchanged. Otherwise, a reduction in transport cost implies lowering the cost of
production, so that more would be supplied even at a lower price.
3. Cost of production be unchanged: It is assumed that the price of the product changes, but there is
no change in the cost of production. If the cost of production increases along with the rise in the
price of product, the sellers will not find it worthwhile to produce more and supply more. Therefore,
the law of supply will be valid only if the cost of production remains constant. It implies that the
factor prices such as wages, interest, rent etc., are also unchanged.
4. The prices of other goods should remain constant: Further, the law assumes that there are
no changes in the prices of other products.
5. There should not be any change in the government policies: Government policy is also
important and vital for the law of supply. Government policies like—taxation policy, trade policy
etc., should remain constant.

Explanation: The slope of the supply function i.e. ΔQ/ΔP is positive. This can
be explaining more briefly with the following schedule and diagram-
Supply Schedule: The tabular presentation of relation between price and quantity supplied
by a producer refers to supply schedule.

Price(in units) Quantity (in units)

1 10
2 20
3 30
4 40
5 50

In the given table, when prices are at 1 quantity supplied is 10 and when price increases from 1 to
2 quantity supplied also increases to 10 to 20. Same follows till price reaches to 5 and quantity to
50. This shows direct relationship between price and quantity supplied.
Supply curve: The graphical representation of relation between price and quantity supplied by
a producer refers to supply curve.

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In the above diagram price and qua ntity supplied are taken on y-axis and x-axis respectively.
SS shows the supply curve which is upward sloping due to positive relationship between price
and quantity supplied.
Reasons for Law of Supply:
Let us now try to understand, why the supply of a commodity expands as the price rises. Th
main reasons for operation of law of supply are:
1. Profit Motive: The basic aim of producers, while supplying a commodity, is to secure maximum
profits. When price of a commodity increases, without any change in costs, it raises their profits. So,
producers increase the supply of the commodity by increasing the production. On the other hand,
with fall in prices, supply also decreases as profit margin decreases at low prices.
2. Change in Number of Firms: A rise in price induces the prospective producers to enter intothe
market to produce the given commodity so as to earn higher profits. Increase in number of firms
raises the market supply. However, as the price starts falling, some firms which do not expect to
earn any profits at a low price either stop the production or reduce it. It reduces the supply of the
given commodity as the number of firms in the market decreases.
3. Change in Stock: When the price of a good increases, the sellers are ready to supply more goods
from their stocks. However, at a relatively lower price, the producers do not release big quantities
from their stocks. They start increasing their inventories with a view that price may rise in near
future. Exceptions to Law of Supply:
As a general rule, supply curve slopes upwards, showing that quantity supplied
rises with a rise in price. However, in certain cases, positive relationship
between supply and price may not hold true. The various exceptions to the law
of supply are:
1. Future Expectations: If sellers expect a fall in price in the future, then the law of supply may
not hold true. In this situation, the sellers will be willing to sell more even at a lower price.
However, if they expect the price to rise in the future, they would reduce the supply of the
commodity, in order to supply the commodity later at a high price.
2. Agricultural Goods: The law of supply does not apply to agricultural goods as their
production depends on climatic conditions. If, due to unforeseen changes in weather, the
production of agricultural products is low, then their supply cannot be increased even at higher
prices.
3. Perishable Goods: In case of perishable goods, like vegetables, fruits, etc., sellers will be ready
to sell more even if the prices are falling. It happens because sellers cannot hold such goods for
long.
4. Rare Articles: Rare, artistic and precious articles are also outside the scope of law of supply.
For example, supply of rare articles like painting of Mona Lisa cannot be increased, even if their
prices are increased.
5. Backward Countries: In economically backward countries, production and supply cannot
be increased with rise in price due to shortage ofresources.
Difference between supply and quantity supplied-

If the supply of a commodity changes due to change in its price, it is called

change in quantity supplied. On the other hand, if the quantity of a commodity
changes due to factors other than the price of the commodity, we call it change
in supply.
Extension and Contraction of Supply (Change in Quantity Supplied):
The change in quantity supplied can be of two types. When the quantity supplied falls due to the
fall in the price of a commodity, it is termed as contraction of supply. Here, supply contracts as a
result of the fall in the price of the commodity. Similarly, when the quantity supplied rises due to
rise in the price of the commodity, it is called extension of supply.
Here, supply extends as a result of rise in the price of the commodity. In both the cases, the law of
supply applies. Thus, the change in quantity supplied is the result of changes in price of the
commodity in question, other things remaining constant. It will be clear from the Fig. that the
change in quantity supplied (both extension and contraction) involve movement along the same
supply curve with the changes in price. In this figure, the movement from point ‘A’ to point ‘B’
represents extension of supply, as quantity supplied has increased from OQ to OQ 1 due to rise in
price from OP to OP2.
Similarly, the movement from point ‘A’ to point ‘C’ represents contraction in supply, as the
quantity supplied has decreased from OQ to OQ2 due to fall in price from OP to OP2
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Fig.- Extension and Contraction of Supply

Change in Supply (Increase and Decrease in Supply):
The change in supply can be of two types. When the quantity of a commodity rises due to factors
(other than price of the commodity in question) like an innovation or the discovery of a cheap raw
material, use of better techniques, decrease in prices of other commodities, fall in excise tax,
expectations of fall in the price of the commodities in future, etc., it is termed as increase in supply.
Increase in supply implies a rightward shift of the supply curve, showing that producers are willing
to supply more at each price (or same quantity at a higher price). It is shown by shift in curve from
SS to S’S’ in Fig. On the other hand, when the quantity of commodity supplied falls at the same
price, it is referred to as a decrease in supply. It is represented by a leftward shift of the supply
curve indicating that producers are willing to supply less at each price. It is shown by shift in curve
from SS to S”S” in Fig. If may be the result of obsolete technique of production, increase in the
price of related goods, increase in the cost of production, rise in excise tax, etc. Thus, change in
supply can be shown by shift in supply curve.

Fig. –Increase (Rightward shift-SS to S”S”) and Decrease(Leftward shift SS to S’S’) in Supply
The important distinction between a shift of a supply curve and a movement along a supply curve
is that, whereas a shift of the supply curve occurs due to a change in conditions of supply, price of
the commodity remaining constant. While a movement along supply curve occurs due to a change
in the price of the commodity, conditions of supply remaining constant.
Meaning of Elasticity of Supply:
The law of supply indicates the direction of change—if price goes up, supply will increase. But
how much supply will rise in response to an increase in price cannot be known from the law of
supply. To quantify such change, we require the concept of elasticity of supply that measures the
extent of quantities supplied in response to a change in price.
Elasticity of supply measures the degree of responsiveness of quantity supplied to a change in
own price of the commodity. It is also defined as the percentage change in quantity supplied
divided by percentage change in price.
It can be calculated by using the following formula:
ES = % change in quantity supplied/% change in price
Symbolically,
ES = ∆Q/Q ÷ ∆P/P
= ∆Q/∆P × P/Q
Types of Elasticity of Supply:
For all the commodities, the value of E s cannot be uniform. For some commodities, the value may
be greater than or less than one.
(a) Elastic Supply (ES>1): Supply is said to be elastic when a given percentage change in price
leads to a larger change in quantity supplied. Under this situation, the numerical value of Es will be
greater than one but less than infinity. SS 1curve of Fig. exhibits elastic supply. Here quantity
supplied changes by a larger magnitude than does price.

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(b) Inelastic Supply (ES< 1): Supply is said to be inelastic when a given percentage change in
price causes a smaller change in quantity supplied. Here the numerical value of elasticity of
supply is greater than zero but less than one. Fig. depicts inelastic supply curve where quantity
supplied changes by a smaller percentage than does price.

c) Unit Elasticity of Supply (ES = 1): If price and quantity supplied change by the
same magnitude, then we have unit elasticity of supply. Any straight line supply
Curve passing through the origin, such as the one shown in Fig. has an elasticity of
supply equal to 1. This can be verified in this way.

For any straight line positively-sloped supply curve drawn through the origin, the ratio of P/Q at
any point on the supply curve is equal to the ratio ∆ P/∆ Q. Note that ∆ P/∆ Q is the slope of the
supply curve while elasticity is (1/∆P/∆Q = ∆Q/∆P). Thus, in the formula (∆Q/∆P. P/Q), the two
ratios cancel out each other.
(d) Perfectly Elastic Supply (ES = ∞): The numerical value of elasticity of supply, in exceptional cases, may
reach up to infinity. The supply curve PS 1 drawn in Fig. has an elasticity of supply equal to infinity. Here
the supply curve has been drawn parallel to the horizontal axis. The economic inter- pretation of this supply
curve is that an unlimited quantity will be offered for sale at the price OS. If price slightly drops down below
OS, nothing will be supplied.

(e) Perfectly Inelastic Supply (ES = 0): Another extreme is the completely or perfectly inelastic
supply or zero elasticity. SS1 curve drawn in Fig illustrates the case of zero elasticity. This curve
describes that whatever the price of the commodity, it may even be zero, quantity supplied
remains unchanged at OQ. This sort of supply curve is conceived when we consider the supply
curve of land from the viewpoint of a country, or the world as a whole.

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Any straight line supply curve that intersects the vertical axis above the origin
has an elasticity of supply greater than one. Elasticity of supply will be less than
one if the straight line supply curve cuts the horizontal axis on any point to the
right of the origin, i.e. the quantity axis.
Measurement of Elasticity of Supply: Basically, price elasticity of supply can be measured by
two methods. These methods are
i. Percentage method
ii. Geometric method
Percentage Method: Percentage method or proportionate method is the
commonly used method of measuring price elasticity of supply. According to
this method, elasticity is measured in terms of rate of percentage change in
supplied quantity to percentage change in price. Under this method, price
elasticity of supply can be measured as

2. Geometric Method: According to geometric method, elasticity is measured at a given point on

the supply curve. This method is also known as ‘Arc Method’ or ‘Point Method’. The
measurement of elasticity of supply for the supply curve SS (say, at point A) is illustrated in Fig.

(i) Highly Elastic Supply (Es > 1): A supply curve, which passes through the Y-axis and meets the
extended X-axis at some point, (say, L in Fig.), then supply is highly elastic. In general, we can say
that a straight line supply curve passing through the Y-axis or having a negative intercept on X-axis
is highly elastic (Es >1).
(ii) Unitary Elastic Supply (Es = 1): If the straight line supply curve passes through the origin (see
supply curve SS in Fig.), then elasticity of supply will be equal to one. In the diagram, Elasticity of
Supply (Es) = 1. Hence the supply is unitaryelastic.

(iii) Less Elastic Supply (Es < 1): Further, if a supply curve meets the X-axis at some point, say, L
in Fig, then supply is inelastic. So, Es < 1, i.e. supply is less elastic.

PRODUCTION, PRODUCTION
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FUNCTION
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Production is a process of combining various inputs in order to make something

for consumption (the output). It is the act of creating output, a good or service
which has value and contributes to the utility of individuals.
In other words, Production may be defined as
 the processes and methods used to transform tangible inputs (raw materials, semi-
finished goods, subassemblies)
 intangible inputs (ideas, information, knowledge)
 into goods or services.
Definition of Production:
According to Bates and Parkinson: “Production is the organised activity of
transforming resources into finished products in the form of goods and
services; the objective of production is to satisfy the demand for such
transformed resources”.
According to J. R. Hicks: “Production is any activity directed to the satisfaction of other
peoples’ wants through exchange”. This definition makes it clear that, in economics, we do not
treat the mere making of things as production. What is made must be designed to satisfy wants.
Production Function
Production Function shows the relationship between the quantity of output and the different
quantities of inputs used in the production process. In other words, it means, the total output
produced from the chosen quantity of various inputs.
Generally, production is the transformation of raw material into the finished goods. These raw
materials are classified as land, labour, capital or natural resources. These may be fixed or
variable depending upon the nature of the business.
Meaning of Production Function: In simple words, production function refers to the
functional relationship between the quantity of a good produced (output) and factors of
production (inputs). Mathematically, such a basic relationship between inputs and outputs may
be expressed as:
Q = f (L, C)
Where Q = Quantity of output, L = Labour, C = Capital
Hence, the level of output (Q), depends on the quantities of different inputs (L, C) available to
the firm.
Definition: According to Prof. Koutsoyiannis “The production function is purely a technical
relation which connects factor inputs and output.”
Nature of production function: The nature of production function depends upon the time period allowed for
adjustment of inputs. Normally we consider two time periods which short run and long run.

Short run refers to the time period over which the amount of some factors
called, “fixed factors”, cannot be changed. Hence output is changed by using
more of variable with fixed factors.
Long run refers to the time period during which all the factors of production can be changed i.e.
all are variable factors.
Difference between Short Run and Long Run Production Function
BASIS FOR SHORT-RUN PRODUCTION LONG-RUN PRODUCTION
COMPARION FUNCTION FUNCTION

Meaning Short run production function Long run production function

alludes to the time period, in which connotes the time period, in which
at least one factor of production is all the factors of production are
fixed. variable.

Law Law of variable proportion Law of returns to scale

Scale of No change in scale of production. Change in scale of production.

production

Factor-ratio Changes Does not change.

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Entry and Exit There are barriers to entry and the Firms are free to enter and exit.
firms can shut down but cannot
fully exit.
Concepts of Output- When more and more units of a variable factor are applied on a given
quantity of fixed factor, its effect on the output can be studied in three different ways, i.e.
Total product (TP): Total product of a factor is the amount of total output produced by a
given amount of factor, other being constant. Total product indicates that volume of goods and
services produced during a specified period of time in a given year
Average product (AP): The quantity of total output produced per unit of a variable input, holding
all other inputs fixed. Average product is found by dividing total product by the quantity of the
variable input.
Average product =Total Output in Units/Units of Factor of Production
Marginal product (MP): Marginal product is the increase in total product as a result of adding
one more unit of input
MP=Change in total product/ change in variable input Or MP=TPn-TPn-1
Law of Variable Proportions: The law of variable proportions shows a particular pattern of
changes in output and is an explanation of short run production function where some factors
remain unchanged. It describes the input-output relation in a situation when the output is increased
by increasing the quantity of one input and keeping the other inputs constant. It is also called
“Returns to a factor”.
Statement of the Law: Law states that “as more and more units of variable factors are increased
with the fixed factor initially total product increases with increasing returns then increases with
diminishing returns reaches its maximum and ultimately total product starts falling”.
Assumptions: Law of variable proportions is based on following assumptions:
(i) Constant Technology: The state of technology is assumed to be given and constant. If thereis
an improvement in technology the production function will move upward.
(ii) Factor Proportions Are Variable: The law assumes that factor proportions arevariable.
If factors of production are to be combined in a fixed proportion, the law has novalidity.
(iii) Homogeneous Factor Units: The units of variable factor are homogeneous. Each unit is
identical in quality and amount with every other unit.
(iv) Short-Run: The law operates in the short-run when it is not possible to vary all factor inputs.
Explanation of the Law: In order to understand the law of variable proportions we take the
example of agriculture. Suppose land and labour are the only two factors of production.
By keeping land as a fixed factor, the production of variable factor i.e., labour can be shown with the
help of the following table:
Units of Units of Total Marginal Stages
Land Labour Product(TP) Product(MP)
2 1 10 10
2 2 30 20 I
2 3 60 30
2 4 80 20 II
2 5 90 10
2 6 90 00
2 7 80 -10 III
2 8 70 -20

From the table it is clear that there are three stages of the law of variable proportion.
In the First stage total production increases with increasing returns (10 to 30 then 60) and
marginal product increases from 10 to 20 then 30 as there are more and more doses of labour
and capital employed with fixed factors (land).
The second stage starts from where the first stage ends or where marginal product start falling.
Here, total product increases at a diminishing rate (80 to 90) and reaches its maximum at 90 where
marginal product is falling and reaches at 0.
The third stage begins where second stage ends. This starts from 7th unit. Here, total product
starts falling (from 80 to 70) and marginal product is negative. At this stage, any additional dose
leads to negative marginal product (-10 to -20).
Graphic Presentation: In fig., on OX axis, we have measured number of labourers while
quantity of product is shown on OY axis. TP is total product curve and MP is the marginal
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Three Stages of the Law:

1. First Stage: First stage starts from point ‘O’ and ends up to point N. Here total product increases
at increasing rate from point O up to point N correspondingly marginal product increases till M .
2. Second Stage: It begins from the point N. In this stage, total product increases at diminishing rate
and is at its maximum at point ‘R’ correspondingly marginal product diminishes rapidly and becomes
‘zero’ at point ‘S’.
3. Third Stage: This stage begins beyond point ‘R’. Here total product starts diminishing. Marginal
product turns negative. In this stage, no firm will produce anything. This happens because
marginal product of the labour becomes negative. The employer will suffer losses by employing
more units of labourers.
In Which Stage Rational Decision is Possible:

Rational Decision: Stage II becomes the relevant and important stage of

production. Production will not take place in either of the other two stages. It
means production will not take place in stage III as total product starts falling
and marginal product becomes negative nor in stage I as here total product is
increasing with increasing returns and marginal product is also increasing so
possibility to increase further total product. Thus, a rational producer will
operate in stage II. Condition or Causes of Applicability:
There are many causes which are responsible for the application of the law of variable proportions. They
are as follows:
1. Utilization of Fixed Factor: In initial stage of production, fixed factors of production like land
or machine, is under-utilized. More units of variable factor, like labour, are needed for its proper
utilization. As a result of employment of additional units of variable factors there is proper
utilization of fixed factor. In short, increasing returns to a factor begins to manifest itself in the first
stage.
2. Fixed Factors of Production: The foremost cause of the operation of this law is that some of the
factors of production are fixed during the short period. When the fixed factor is used with variable
factor, then its ratio compared to variable factor falls. Production is the result of the co-operation of
all factors. When an additional unit of a variable factor has to produce with the help of relatively
fixed factor, then the marginal return of variable factor begins to decline.
3. Optimum Production: After making the optimum use of a fixed factor, then the marginal return
of such variable factor begins to diminish. The simple reason is that after the optimum use, the ratio
of fixed and variable factors become defective.
4. Imperfect Substitutes: One factor cannot be used in place of the other factor. After optimum use
of fixed factors, variable factors are increased and the amount of fixed factor could be increased by
its substitutes. Such a substitution would increase the production in the same proportion as earlier.
But in real practice factors are imperfect substitutes. However, after the optimum use of a fixed
factor, it cannot be substituted by another factor.
Applicability of the Law of Variable Proportions:

The law of variable proportions is universal as it applies to all fields of

production. This law applies to any field of production where some factors are
fixed and others are variable. That is why it is called the law of
universalapplication.
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1. Application to Agriculture: With a view of raising agricultural production, labour and capital
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can be increased to any extent but not the land, being fixed factor. Thus when more and more units
of variable factors like labour and capital are applied to a fixed factor then their marginal product
starts to diminish and this law becomes operative.
2. Application to Industries: In order to increase production of manufactured goods, factors of
production has to be increased. It can be increased as desired for a long period, being variable
factors. Thus, law of increasing returns operates in industries for a long period. But, this situation
arises when additional units of labour, capital and enterprise are of inferior quality or are available
at higher cost. As a result, after a point, marginal product increases less proportionately than
increase in the units of labour and capital. In this way, the law is equally valid in industries.
Postponement of the Law:
The postponement of the law of variable proportions is possible under following conditions:
(i) Improvement in Technique of Production: The operation of the law can be postponed in
case variable factors techniques of production are improved.
(ii) Perfect Substitute: The law of variable proportion can also be postponed in case factors
of production are made perfect substitutes i.e., when one factor can be substituted for the
other.

Law of returns to scale

The law of returns to scale refer to the long run analysis of production. In the
long run all the factors become variable. So output can be expanded by
changing all the factors simultaneously,

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so that the scale of production is changed.

The law of returns to scale explains the proportional change in output with respect to
proportional change in inputs. In other words, the law of returns to scale states when there are
a proportionate change in the amounts of inputs, the behaviour of output also changes.
Statement of Law: "Other things being equal in the long run, as the firm increases the quantities
of all factors employed, the output may rise either more than proportionately, less than
proportionately or in exactly same proportion of the change in quantities of inputs.
Definition: According to Koutsoyiannis “The term returns to scale refers to the changes in
output as all factors change by the same proportion.”
Explanation: Returns to scale are of the following three types:
1. Increasing Returns to scale.
2. Constant Returns to Scale
3. Diminishing Returns to Scale

Explanation: In the long run, output can be increased by increasing all factors in the
same proportion. Generally, laws of returns to scale refer to an increase in output due
to increase in all factors in the some proportion. Such an increase is called returns to
scale. Suppose, initially production function is as follows: P = f (L, K)

Units of Units of Units of change in Total Marginal Returns to

Output labour(L) Capital(K) Labour Returns Returns Scale
and capital
(i.e. input)
1 1 2 1+2 20 20 Increasing
2 2 4 2+4 50 30
3 3 6 3+6 90 40 Constant
4 4 8 4+8 90 40
5 5 10 5+10 120 30 Decreasing
6 6 12 6+12 140 20

The above stated table explains the following three stages of returns to scale:
1. Increasing Returns to Scale: Increasing returns to scale or diminishing cost refers to a situation
when all factors of production are increased, output increases at a higher rate. It means if all inputs
are doubled, output will also increase at the faster rate than double. Hence, it is said to be increasing
returns to scale. This increase is due to many reasons like division external economies of scale.
Increasing returns to scale can be illustrated with the help of given table from unit 1 to 2.
2. Diminishing Returns to Scale: Diminishing returns or increasing costs refer to that production
situation, where if all the factors of production are increased in a given proportion, output increases
in a smaller proportion. It means, if inputs are doubled, output will be less than doubled. The main
cause of the operation of diminishing returns to scale is that internal and external economies are less
than internal and external diseconomies.
3. Constant Returns to Scale: Constant returns to scale or constant cost refers to theproduction
situation in which output increases exactly in the same proportion in which factors of production
are increased. In simple terms, if factors of production are doubled output will also be doubled.
4.
FACTORS OF PRODUCTION
What are 'Factors of Production': Factors of production is an economic term that describes the
inputs that are used in the production of goods or services in order to make an economic profit. In
other words, resources required for generation of goods or services or whatever is used in
producing a commodity is called its inputs/ factors of production. For example, for producing
wheat, a farmer uses inputs like soil, tractor, tools, seeds, manure, water and his own services.
All factors of production are traditionally classified in the following four groups:

Land: The term land in economics is used in a special sense. It does not mean soil or earth surface
alone. Land in economics means naturalbyresources.
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under and over the surface of earth. In other words, land refers to all natural resources which are
free gifts of nature. Land, therefore, includes all gifts of nature available to mankind—both on
the surface and under the surface, e.g., soil, rivers, waters, forests, mountains, mines, deserts,
seas, climate, rains, air, sun, etc.
Definition: According to Marshall: "The land means the material and the forces which
nature gives freely to man's aid in land and water, in air and light and heat".
Importance of Land: Land a factor of production is of immense importance. Land
is the original sources of all material wealth. The economic prosperity of a
country is closely linked with the richness of her natural resources. The quality
and quantity of agricultural wealth a country depends on nature of soil, climate,
rainfall. The agriculture products are the form the basis of trade and industry.
Industry also depends upon availability of coal-mines or waterfall for electricity
production. Thus all aspects of economic life i.e. agriculture, trade and industry
are generally influenced by natural resources which is called as “Land” in
economics. The importance of land is therefore too much as it is influencing
finally the standard of living of the people.
Peculiarities\ Features of Land: Land as a factor of production is quite peculiar. It possesses
some important features, which distinguish it from other factors of production which are given
as below:
1. Land is a free gift of nature: It is not a ‘produced’ or man-made agent. It follows, therefore,
that we have to accept it as it is. No doubt man tries to improve and modify nature. But he cannot
completely master it. A poor soil and a bad climate are great handicaps in the way of industrial
and commercial prosperity.
2. Land is limited in area: Efforts have been made to reclaim land from the sea, and thus add to the
total land surface. Yet these efforts have produced only negligible results as compared with the
total area already in existence. Some land in Holland has been reclaimed from the sea, but it is
after all a small percentage of the total land surface of the world.
3. Land is permanent: It is not easy to destroy it. All other factors are destructible, but land
cannot be completely destroyed. Even the havoc wrought by an atom bomb can be cured and
natural powers restored after some time.
4. Land lacks mobility: Land cannot be moved bodily from one place to another. It lacks
geographical mobility. But it can be put to many alternative uses and is thus mobile
froma different point of view.
5. Land is of infinite variety: Land is not man-made. Nature has so made it ‘hat different pieces
of land present infinite variations. None can say where the sandy soil ends and the clay begins.
One type shades into the other. Such minute variations are not found in any other factor
ofproduction. Besides the situation of different pieces of land also varies.

Factors Affecting Productivity of Land: Different pieces of land differ

in quality or productivity. A number of factors affect the
productivity of land. Productivity of land mainly depends on the
following factors:
1. Natural Factors: Natural factors like the soil, climate, rainfall, topography and nature of the
coast- line determine whether land produces much or little. A sandy soil and dry climate are sure
to make it unproductive. On the other hand, an alluvial soil, a good climate, and timely rainfall
are conducive to rich crops.
2. Human Factor: Man does not easily surrender to nature. If nature is unkind, he fights her and
tries to conquer her. For instance, if rainfall is scanty, he can bring canal water. If soil is poor and
deficient in certain properties, it can be improved by the addition of chemical manures. In fact, man
plays an important part in remedying the deficiencies of nature and contributing to the productivity
of theson.
3. Situation Factor: The situation of land is of great importance. Fertile lands, situated in a remote
corner of the country, away from the market, may be left uncultivated. The cost of
transportingtheir produce may be prohibitive. Such land cannot compare with those pieces of land
which, though not so rich, are near to market.
4. Extensive and Intensive Cultivation: Extensive Cultivation: In extensive cultivation, the
farmer can have as much land as he can manage. The methods of cultivation are generally primitive
and unscientific. The yield per acre is comparatively low, but taken in relation to the capital and
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labour employed, it is large. Virgin lands yield good crops even though much work is not done on
them. When they are exhausted, more land is available. Here seeds are just sown and crops
harvested when ripe. Such methods were followed in new countries like the U.S.A. and Canada a
hundred years back. Intensive Cultivation: Intensive cultivation, on the other hand, implies
constant cropping from the same area. If more and more capital and labour are applied to the same
piece of land, the system of cultivation is known as Intensive. Greater application of labour and
capital involves the use of artificial irrigation, deeper ploughing, sowing of improved seeds, use of
artificial manures and of
modern implements and machinery. In such cases, land yields more per acre. By
cultivating it more intensively, the farmer tries to take the utmost out of his land. This
method is followed in those countries where land area relatively to population is small.

LABOUR

Labour: It can be defined as any exertion of mind or body undergone partly or

wholly with a view to earning some good other than the pleasure derived
directly from the work. In other words "Labour is an important factor of
production. It is described as any human work which is performed with the help
of mind or physique with a view to earn income". In short labour in economic
means that any type of work performed by a labourer with an intention to earn
income.
Peculiarities of Labour: The important peculiarities of labour are as under
1. Labour is Perishable: Labour is more perishable than other factors of production. It means labour cannot
be stored. The labour of an unemployed worker is lost forever tor that day when he does not work. Labour
can neither be postponed nor accumulated for the next day. It will perish. Once time is lost, it is lost forever.
2. Labour cannot be Separated from the Labourer: Land and capital can be separated
fromtheir owner, but labour cannot he separated from a labourer. Labour and labourer are
indispensable for each other. For example, it is not possible to bring the ability of a teacher to
teach in the school, leaving the teacher at home. The labour of a teacher can work only if he
himself is present in the class. Therefore, labour and labourer cannot be separated from each
other.
3. Less Mobility of Labour: As compared to capital and other goods, labour is less mobile.
Capital can be easily transported from one place to other, but labour cannot be transported
easily from its present place to other places. A labourer is not ready to go too far off places
leaving his native place. Therefore, labour has less mobility.
4. Weak Bargaining Power of Labour: The ability of the buyer to purchase goods at the lowest
price and the ability of the seller to sell his goods at the highest possible price is called the
bargaining power. A labourer sells his labour for wages and an employer purchases labour by
paying wages. Labourers have a very weak bargaining power, because their labour cannot be
stored and they are poor, ignorant and less organised. Moreover, labour as a class does not have
reserves to fall back upon when either there is no work or the wage rate is so low that it is not
worth working. Poor labourers have to work for their subsistence. Therefore, the labourers have a
weak bargaining power as compared to the employers.
5. Inelastic Supply of Labour: The supply of labour is inelastic in a country at a particular time.
It means their supply can neither be increased nor decreased if the need demands so. For example,
if a country has a scarcity of a particular type of workers, their supply cannot be increased within
a day, month or year. Labourers cannot be ‘made to order’ like other goods. The supply of labour
can be increased to a limited extent by importing labour from other countries in the short period.
The supply of labour depends upon the size of population. Population cannot be increased or
decreased quickly. Therefore, the supply of labour is inelastic to a great extent. It cannot be
increased or decreased immediately.
6. Labourer is a Human being and not a Machine: Every labourer has his own tastes, habits
and feelings. Therefore, labourers cannot be made to work like machines. Labourers cannot work
round the clock like machines. After continuous work for a few hours, leisure is essential for
them.
7. A Labourer sells his Labour and not Himself: A labourer sells his labour for wages and
not himself. The worker sells work but he himself remains his own property. For example,
when we purchase an animal, we become owners of the services as well as the body of that
animal. But we cannot become the owner of a labourer in this sense.
8. Labour is both the Beginning and the End of Production: The presence of land and capital
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alone cannot make production. Production can be started only with the help of labour. It means
labour is the beginning of production. Goods are produced to satisfy human wants. When we
consume them, production comes to an end. Therefore, labour is both the beginning and the end
of production.
9. Labour Creates Capital: Capital, which is considered as a separate factor of production is, in
fact, the result of the reward for labour. Labour earns wealth by way of production. We know that
capital is that portion of wealth which is used to earn income. Therefore, capital is formulated and
accumulated by labour. It is evident that labour is more important in the process of production than
capital because capital is the result of the working of labour.
10. Labour is an Active Factor of Production: Land and capital are considered as the
passive factors of production, because they alone cannot start the production process.
Production from land and capital starts only when a man makes efforts. Production begins with
the active participation of man. Therefore, labour is an active factor of production.
CAPITAL
Capital: Capital has been as that part of person’s wealth, other than land, which
yields an income or which aids in the production of further wealth.
Forms of Capital
1) Capital and Wealth: The capital is required in production. In modern economy the
production depends not only on land and labour but capital is also equally important. It is also
important to note that if wealth is not used in production process it is not said to be a capital.
For example, basically tractor is capital asset as it can be used in cultivation (production) of
farm, but due to some reason the same is kept unused (idle) for one or two year it cannot termed
as capital for that particular year. It is only wealth. Thus, the unused wealth cannot be
considered as capital. Hence all capital is wealth but all wealth is not capital.
2) Money and capital: In the ordinary language, capital is used in the sense of money. No
doubt money is wealth and part of wealth used in production is called capital. But here in
production process money is not used as such and hence it cannot be termed as capital. Only by
using money we are purchasing capital assets and hence money itself is not capital.
3) Capital is produced means of production: It is manmade instrument of production. Just like
land and labour, capital as factor of production is not original. Since it is man-made it is not
freely available.
Characteristics of capital:
1) Capital is manmade factor of production.
2) It involves time element.
3) Capital may be fixed: i.e. it is durable use pre use producer goods e.g. machinery,
well in agriculture.
Functions of capital:
1) Supply of raw material: The working capital required in production
processrepresents raw material.
2) Supply of appliances and equipment: The fixed capital goods.
3) Provision of subsistence: If capital is available to the poor person, he can utilize it
andrun his family very well. Supposes only 5 to 6 goats maintain by a poor person it will
give him sizeable income to survive his family.
4) Supply of employment: If ample supply of capital is made, it will enhance production
which will in turn give employment.
Importance of capital:

In modern economy capital is very important factor of production

which is essential to undertake production.
Without capital other factors of production (like land, labour) will become
handicap. On the contrary, if apple supply-capital is made the production
and productivity can be increased substantially.
The economic development of any country does not solely depend upon the
available land and labour but how much capital is made available is also
equally important.
The under-developed countries remained, under-developed due to
lack of capital. The ample supply of capital gives boost to
production.
When more production is there, more economic activities can he initiated
and as a result, more employment opportunities can be created.
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More employment further helpful for minimizing the poverty or improving

standard of living of the people.

Entrepreneur
Entrepreneur the fourth in factors of production, is the owner of any business company or
enterprise who is mainly work to earn money by taking initiative and risk. Entrepreneur is
basically taken from French and first time used by Richard Cantillon. The term Entrepreneur
as factors of production used for a person who willingly launch an enterprise and take the
whole responsibility for the consequences and result from the business in the future. is the
owner of any business company or enterprise who is mainly work to earn money by taking
initiative and risk. In other words , the entrepreneur is an organizer. He is the person who
organizes production by bringing together the other three factor of production land, labour
and capital.
Definition: Benham defines: "An entrepreneur as a person who controls the policy of the firm".
Functions of an Entrepreneur: An entrepreneur performs the following functions:
(i) He conceives the idea of launching the project.
(ii) He mobilizes the resources for smooth running of the project.
(iii) The decision of what, where and how to produce goods are taken by the entrepreneur.
(iv) He undertakes the risks involved in production.
(v) He is an innovator. He innovates new techniques of production, new products and
brings improvements in the quality of existing products. He is in fact the
captain of the industry.
(vi) In a Joint stock Organization, the entrepreneurial functions are shared
between the shareholders, the directors and the top executives.

UNIT – III

COST AND REVENUE FUNCTIONS

Cost: An amount that has to be paid or given up in order to get something. In other words Cost is the
value of the inputs used to produce its output; e.g. the firm hires labour, and the cost is the wage rate that
must be paid for the labour services. Concepts of cost : Economic costs include both implicit and explicit
costs.
• Explicit costs include wages paid to employees and the costs of raw materials.
• Implicit costs include the opportunity cost of the entrepreneur and the capital used for production.
Cost of Production is meant the total sum of money required for the production of a specific quantity of
output Definition: According to Gulhrie and Wallace “In Economics, cost is all of the payments or
expenditures necessary to obtain the factors of production of land, labour, capital and management
required to produce a commodity.”
Cost Function: Cost function may be defined as the relationship between costs of a
product and output. C = F [Q]
Where c shows cost, F shows functional relationship, Q shows output
Determination of Cost according to time period i.e., Short run cost and long run cost
Short run cost Conceptually, in the short run, the quantity of at least one input is fixed and the quantities of the other
inputs can be varied. In the short-run period, factors, such as land and machinery, remain the same. On the other hand,
factors, such as labour and capital, vary with time. Following are the cost concepts that are taken into
consideration in the short run:
i. Total Fixed Costs (TFC): TFC refer to the costs that remain fixed in the short period. These costs do not
change with the change in the level of output. For example, rents, interest, and salaries. Fixed costs have to pay even
when the production of an organization is zero. These costs are also called supplementary costs, indirect costs,
overhead costs, historical costs, and unavoidable costs. TFC remains constant with respect to change in the level of
output. Therefore, the slope of TFC curve is a horizontal straight line.
ii. Total Variable Costs (TVC): Refer to costs that change with the change in the level of production. For
example, costs incurred on purchasing raw material, hiring labour, and using electricity. If the output is zero, then the
variable cost is also zero. These costs are also called prime costs, direct costs, and avoidable costs. As TVC changes
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with the level of output because of that shape of TVC curve is inverse S shaped.
iii. Total Cost (TC): Involves the sum of TFC and TVC. It can be calculated as follows:
Total Cost = TFC + TVC
TC also changes with the changes in the level of output as there is a change in TVC.
Figure shows the total cost curve derived from sum of TVC and TFC:

It should be noted that both TVC and TC increase initially at decreasing rate and then they increase at
increasing rate Here, decreasing rate implies that the rate at which cost increases with respect to output is
less, whereas increasing rate implies the rate at which cost increases with respect to output is more.
iv. Average Fixed Costs (AFC): AFC refers to the per unit fixed costs of production. In other words, AFC implies
fixed cost of production divided by the quantity of output produced. It is calculated as: AFC = TFC/Output
TFC is constant as production increases, thus AFC falls. AFC curve is shown as a declining curve, which
never touches the horizontal axis. This is because fixed cost can never be zero. The curve is also called
rectangular hyperbola, which represents that total fixed costs remain same at all the levels.
v. Average Variable Costs (AVC): AVC refer to the per unit variable cost of production. It implies organization’s
variable costs divided by the quantity of output produced. Initially, AVC decreases as output increases reaches its
minimum point. After a crtain point of time, AVC increases with respect to increase in output. It is calculated as
AVC = TVC/Output
vi. Average Cost (AC): AC refers to the total costs of production per unit of output. AC is calculated as:
AC = TC/ Output
AC is also equal to the sum total of AFC and AVC. AC=AFC+AVC
AC curve is also U-shaped curve as average cost initially decreases when output increases and then cost
reaches its minimum and ultimately starts increases when output increases.

vii. Marginal Cost: MC refer to the addition to the total cost for producing an additional unit of the product.
Marginal cost is calculated as:
MC = TCn = TCn-1
n= Number of units produced
It is also calculated as: MC = ∆TC/∆Output
MC curve is also a U-shaped curve as marginal cost initially decreases as output increases reaches its
minimum and afterwards, rises as output increases. This is because TC increases at decreasing rate and
then increases at increasing rate.

Long Run Cost and It’s Types

In the long run, all the factors of production used by an organization vary. Long run is a period in which
all the costs change as all the factors of production are variable. There is no distinction between the Long
run Total Costs (LTC) and long run variable cost as there are no fixed costs.
1. Long Run Total Cost: Long run Total Cost (LTC) refers to the minimum cost at which given level of output
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can be produced. In other words “the long run total cost of production is the least possible cost of producing any given

level of output when all inputs are variable.”

2. Long Run Average Cost: Long run Average Cost (LAC) is equal to long run total costs divided by the level
of output. The derivation of long run average costs is done from the short run average cost curves. In the short run,
plant is fixed and each short run curve corresponds to a particular plant. The long run average costs curve is also called
planning curve or envelope curve as it helps in making organizational plans for expanding production and achieving
minimumcost.

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3. Long Run Marginal Cost: Long run Marginal Cost (LMC) is defined as added cost of producing an additional
unit of a commodity when all inputs are variable. This cost is derived from short run marginal cost. In the graph, the

LMC is U shaped.

Revenue -
The term revenue refers to the income obtained by a firm through the sale of goods at different prices.
Meaning of Revenue: The amount of money that a producer receives in exchange for the sale proceeds is
known as revenue. For example, if a firm gets Rs. 16,000 from sale of 100 chairs, then the amount of Rs.
16,000 is known as revenue. Revenue refers to the amount received by a firm from the sale of a given
quantity of a commodity in the market. It is directly influenced by sales level, i.e., as sales increases,
revenue also increases.
Definition: According to Dooley, 'the revenue of a firm is its sales, receipts or income'.
Concept of Revenue: The concept of revenue consists of three important terms; Total Revenue, Average
Revenue and Marginal Revenue.

Total Revenue (TR): Total Revenue refers to total receipts from the sale of a given quantity of a commodity.
It is the total income of a firm. Total revenue is obtained by multiplying the quantity of the commodity sold
with the price of the commodity.
Total Revenue = Quantity × Price
For example, if a firm sells 10 chairs at a price of Rs. 160 per chair, then the total revenue will be: 10
Chairs × Rs. 160 = Rs 1,600.
TR curve when prices remain same when prices changes:

Total Revenue can also be calculated as the sum of marginal revenues of all
the units sold. It means, TRn = MR1 + M2 + MR3 + MRn
Or, TR = ∑MR
Average Revenue (AR): Average revenue refers to revenue per unit of output sold. It is obtained by
dividing the total revenue by the number of units sold.

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Marginal Revenue (MR): Marginal revenue is the additional revenue generated from the sale of an
additional unit of output. It is the change in TR from sale of one more unit of a commodity. Therefore,

AR and MR curve when prices remain same and when prices changes:

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MARKET STRUCTURES AND PRICE & EQUILIBRIUM DETERMINATION

A market is defined as an actual or nominal place where forces of demand and supply operate, and where
buyers and sellers interact (directly or through intermediaries) to trade goods, services for money or
barter. Markets include mechanisms or means for
 determining price of the traded item,
 communicating the priceinformation,
 facilitating deals and transactions, and
 Effecting distribution.
The market for a particular item is made up of existing and potential customers who need it and have theability
and willingness to pay for it.
Meaning of Market structure: Market structure refers to the nature and degree of competition in the market
for goods and services. The structures of market both for goods market and service (factor) market are
determined by the nature of competition prevailing in a particular market.
Determinants: There are a number of determinants of market structure for a particular good which are as
follows:
 The number and nature of sellers.
 The number and nature of buyers.
 The nature of the product.
 The conditions of entry into and exit from the market.
 Economies of scale.
Forms of Market Structure: On the basis of competition, a market can be classified in the following ways:
 Perfect Competition
 Monopoly
 Monopolistic Competition
 Oligopoly
Perfect Competition Market: A perfectly competitive market is one in which the number of buyers andsellers
is very large, all engaged in buying and selling a homogeneous product possessing perfect knowledge of
market at a time.
Definition: According to R.G. Lipsey, “Perfect competition is a market structure in which all firms in an
industry are price- takers and in which there is freedom of entry into, and exit from, industry.” Characteristics
of Perfect Competition: Following are the conditions for the existence of perfect competition or features
(1) Large Number of Buyers and Sellers: The first condition is that the number of buyers and
sellers must be so large that none of them individually is in a position to influence the price and output
of the industry as a whole. The demand of individual buyer relative to the total demand is so small that
he cannot influence the price of the product by his individual action. Similarly, the supply of an
individual seller is so small of the total output that he cannot influence the price of the product by his
actionalone. Thus no buyer or seller can affect the price by his individual action. He has to accept the
price for the product as fixed for the whole industry. He is a “price taker”.
(2) Freedom of Entry or Exit of Firms: The next condition is that the firms should be free to enter or leave the
industry. It implies that whenever the industry is earning excess profits, attracted by these profits some new firms enter
the industry. In case of loss by the industry, some firms leave it.
(3) Homogeneous Product: Each firm produces and sells a homogeneous product so that no buyer has any
preference for the product of any individual seller over others. Commodities like salt, wheat, cotton and coal are
homogeneous in nature. He cannot raise the price of his product. If he does so, his customers would leave him and

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buy the product from other sellers at the ruling lower price.
(4) Profit Maximisation Goal: Every firm has only one goal of maximising its profits.
(5) Perfect Mobility of Goods and Factors: Another requirement of perfect competition is the perfect mobility
of goods and factors between industries. Goods are free to move to those places where they get the highest price.
Factors can also move from a low-paid to a high-paid industry.
(6) Perfect Knowledge of Market Conditions: This condition implies a close contact between buyers and sellers.
Buyers and sellers possess complete knowledge about the prices at which goods are being bought and sold, and of the
prices at which others are prepared to buy and sell. They have also perfect knowledge of the place where the
transactions are being carried on.
(7) Absence of Transport Costs: Another condition is that there are no transport costs in carrying of product
from one place to another. This condition implies that a commodity must have the same price everywhere at any time.
If transport costs are added to the price of the product, even a homogeneous commodity will have different prices
depending upon transport costs from the place of supply.
(8) Absence of Selling Costs: Under perfect competition, the costs of advertising, sales-promotion, etc. do not
arise because all firms produce a homogeneous product.
Monopoly Market: The word monopoly has been derived from the combination of two words i.e., ‘Mono’
and ‘Poly’. Mono refers to a single and poly to control. In this way, monopoly refers to a market situation in
which there is only one seller of a commodity. In other words monopoly is a market situationin which there is
only one seller of a product with barriers to entry of others. The product has no close substitutes.
Definition: According to D. Salvatore, “Monopoly is the form of market organisation in which there is a
single firm selling a commodity for which there are no close substitutes.” Thus the monopoly firm is itself an
industry and the monopolist faces the industry demand curve.
Features: The features of monopoly are as:
1. One Seller and Large Number of Buyers: The monopolist’s firm is the only firm, is the only seller. But the
number of buyers is assumed to be large.
2. No Close Substitutes: There shall not be any close substitutes for the product sold by the monopolist. One firm
producing a good without close substitutes. The product is often unique. Ex: When Apple started producing the iPad,
it probably had a monopoly over the tablet market or Indian railway.
3. Difficulty of Entry of New Firms: There are either natural or artificial restrictions on the entry of firms into the
industry, even when the firm is making abnormal profits.
4. Monopoly is also an Industry: Under monopoly there is only one firm which constitutes the industry. There is
no difference between firm and industry.
5. Price Maker: Under monopoly, monopolist has full control over the supply of the commodity. As monopolist is
the single seller, therefore, buyers have to pay the price fixed by the monopolist.
6. Full Control over Price: In a monopoly market, restricted entry compress competition and the monopolist enjoys
full control over the market conditions. The absence of competition provides opportunity to seller to charge the product
as per his advantage, targeting profit maximizing price. Thus, a monopolist is a 'price maker' and not a 'price taker',
wherein he decides the price and the buyers has to accept it.
7. Price Discrimination: Price discrimination can be defined as the 'practice by a seller of charging different prices
from different buyers for the same good or service'.
Monopolistic Competition
Monopolistic Competition refers to a market situation in which there are large numbers of firms which sell
closely related but differentiated products. Markets of products like soap, toothpaste AC, etc. are examples of
monopolistic competition. Monopoly + Competition = Monopolistic Competition
Under monopolistic competition, each firm is the sole producer of a particular brand or “product”.

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i. It enjoys ‘monopoly position’ as far as a particular brand is concerned.

ii. However, since the various brands are close substitutes, its monopoly position is influenced due to stiff
‘competition’ from other firms.
So, monopolistic competition is a market structure, where there is competition among a large number of
monopolists.
Features:
The following are the main features of monopolistic competition:
1. Large Number of Sellers: There are large numbers of firms selling closely related, but not homogeneous
products. Each firm acts independently and has a limited share of the market. So, an individual firm has limited control
over the market price. Large number of firms leads to competition in the market.
2. Product Differentiation: Each firm is in a position to exercise some degree of monopoly through product
differentiation. Product differentiation refers to differentiating the products on the basis of brand, size, colour, shape,
etc. The product of a firm is close, but not perfect substitute of other firms.
3. Freedom of Entry and Exit of Firms: Another feature of monopolistic competition is the freedom of entry
and exit of firms. As firms are of small size and are capable of producing close substitutes, they can leave or enter the
industry or group in the long run.
4. Selling costs: Selling costs refer to the expenses incurred on marketing, sales promotion and advertisement of
the product. Under monopolistic competition, products are differentiated and these differences are made known to the
buyers through selling costs. Such costs are incurred to attract the buyers to buy a particular brand of the product in
preference to competitor’s brand.
5. Lack of Perfect Knowledge: Buyers and sellers do not have perfect knowledge about the market conditions.
Selling costs create artificial superiority in the minds of the consumers and it becomes very difficult for a consumer
to evaluate different products available in the market. As a result, a particular product (although highly priced) is
preferred by the consumers even if other less priced products are of same quality.
6. Pricing Decision: A firm under monopolistic competition is neither a price- taker nor a price-maker. However,
by producing a unique product or establishing a particular reputation, each firm has partial control over the price. The
extent of power to control price depends upon how strongly the buyers are attached to his brand.

Oligopoly : Oligopoly is a market situation in which there are a few firms selling homogeneous or differentiated
products. It is difficult to pinpoint the number of firms in ‘competition among the few.’ Withonly a few firms in
the market, the action of one firm is likely to affect the others. E.g. Airlines, Telecommunication sector etc.
Characteristics of Oligopoly: In addition to fewness of sellers, most oligopolistic industries have several
common characteristics which are explained below:
1. Interdependence among firms: In oligopoly market, each firm treats the other as its rival firm. It is for this
reason that each firm while determining price of its product, takes into account the reaction of the other firms to
its ownaction.
2. Large number of consumers: In this market, there are large numbers of consumers to demand the product.
3. Indeterminate demand: The demand curve under oligopoly is indeterminate because any step taken by his
rivals may change the demand curve and firms are interdependent on each other.
4. Lack of Uniformity: Another feature of oligopoly market is the lack of uniformity in the size of firms. Firms
differ considerably in size. Some may be small, others very large.
5. Existence of Price Rigidity: In oligopoly situation, each firm has to stick to its price. If any firm tries to reduce
its price, the rival firms will react by a higher reduction in their prices. This will lead to a situation of price war which
benefits none. On the other hand, if any firm increases its price with a view to increase its profits; the other rival firms
will not follow the same. Hence, no firm would like to reduce price or to increase the price. The price rigidity will

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takeplace.
6. Barriers to Entry of Firms: As there is keen competition in an oligopolistic industry, there are no barriers to
entry into or exit from it. However, in the long-run, there are some types of barriers to entry which tend to restrain
new firms from entering the industry.
EQUILIBRIUM AND PRICE DETERMINATION UNDER DIFFERENT FORMS OF MARKET
EQUILIBRIUM refers to a state of stable conditions in which all significant factors remain more or less
constant over a period, and there is little or no inherent tendency for change. For example, a market is saidto be
in equilibrium if the amount of goods that buyers wish to buy at the current price is matched by the amount the
sellers want to sell at that price. Also called steady state.
Market equilibrium is a market state where the supply in the market is equal to the demand in the
market. The equilibrium price is the price of a good or service when the supply of it is equal to the demand
for it in the market. Market demand = Market Supply
In other words Market equilibrium defines as a situation in which the supply of an item is exactly equal to its
demand. Since there is neither surplus nor shortage in the market, price tends to remain stable in this situation.
According to Miller, “Firm is an organisation that buys and hires resources and sells goods and services”.
Industry is a group of firms producing standardised products in a market.
Determination of Equilibrium Output and Price: Under different market forms equilibrium output and price
determination can be studied according to time period i.e., short run and long run. Short run is a period of time
in which a firm has some fixed costs which does not vary with the change in output of the firm. The change only takes
place in variable factors.
The long run is a period of time in which the firm can change its plant and scale of operations. Thus in the
long-run all costs are variable and there are no fixed costs.
Determination of Equilibrium Output and Price under perfect competition: Under perfect
competition, for the equilibrium and price determination there are two different conditions which are:
Conditions of Equilibrium of the Firm and Industry
A firm is in equilibrium when it wants to earn maximum profits by equating its marginal cost with itsmarginal
revenue, i.e. MC = MR. Diagrammatically, the conditions of equilibrium of the firm are
(1) The MC curve must equal the MR
curve (MC=MR). This is the first order and
essential condition.
(2) The MC curve must cut the MR curve from below and after the point of equilibrium it must be above the
MR (MC>MR)
EQUILIBRIUM IN THE SHORT RUN UNDER PERFECT COMPETITION
A firm in the short run will be in equilibrium when price or average revenue (AR) is greater than or equalto or
less than short run average cost (SAC).
Supernormal Profits: When AR>SAC, it means firms are earning supernormal profits.
Normal Profits: When AR=SAC, it means firms earning normal profits.
Abnormal losses: When AR<SAC, it means firms bearing abnormal losses.

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In the given diagrams output and price is taken on x-axis and y-axis respectively. Price is equal to average
revenue which is equal to marginal revenue in case of perfect competition. Thus, we have a straight line
parallel to x-axis, where P=AR=MR. SAC is the short run average cost curve and SMC is the short run
marginal cost curve.
In Figure a, the SAC lies below the price line P=AR=MR so, SAC is less than the MR. E is the
equilibrium point where MC=MR. The firm supernormal profits shown by the shaded area.
In Figure b, the SAC is tangent to the price line P=AR=MR so, SAC is equal to the MR. E is theequilibrium
point where MC=MR. The firm normal profit shown by the point E.
In Figure c, the SAC lies above the price line P=AR=MR so, SAC is greater than the MR. E is theequilibrium
point where MC=MR. The firm incurs losses shown by the shaded area.
EQUILIBRIUM IN THE LONG RUN UNDER PERFECT COMPETITION
The firm is in the long-run equilibrium under perfect competition when it does not want to change its
equilibrium output. It is earning normal profits. If some firms are earning supernormal profits, new firmswill
enter the industry and supernormal profits will be competed away. If some firms are incurring losses, some
of the firms will leave the industry till all earn normal profits.
In long-run equilibrium when it fulfils the following two conditions.
(1) In equilibrium, its short-run marginal cost (SMC) must equal to its long-run marginal cost (LMC) aswell
as its short- run average cost (SAC) and its long-run average cost (LAC) and both should equal MR=AR=P.
Thus the first equilibrium condition is:
SMC = LMC = MR = AR = P = SAC = LAC at its minimum point, and
(1) LMC curve must cut MR curve from below.

Both conditions of equilibrium are satisfied at point E in Figure where SMC and LMC curves cut from below
SAC and LAC curves at their minimum point E and SMC and LMC curves cut AR = MR curve from below.
All curves meet at this point E and the firm produces OQ optimum output and sells it at OP

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price.
DETERMINATION OF EQUILIBRIUM OUTPUT AND PRICE UNDER MONOPOLY MARKET
Under monopoly, for the equilibrium and price determination there are two different conditions which are:
1. Marginal revenue must be equal to marginal cost i.e. MC=MR.
2. MC must cut MR from below i.e. MC>MR.
1. Short Run Equilibrium under Monopoly:
Short period refers to that period in which the monopolist has to work with a given existing plant. In other
words, the monopolist cannot change the fixed factors like, plant, machinery etc. in the short period.
Monopolist can increase his output by changing the variable factors. In this period, the monopolist canenjoy
super-normal profits, normal profits and sustain losses.
These three possibilities are described as follows:
Super Normal Profits:
If the price determined by the monopolist in more than AC, he will get super normal profits. The monopolist
will produce up to the level where MC=MR. This limit will indicate equilibrium output. In given figure
output is measured on X-axis and price on Y-axis. SAC and SMC are the short run average cost and
marginal cost curves while AR or MR are the average revenue or marginal revenue curves respectively.

The monopolist is in equilibrium at point E because at point E both the conditions of equilibrium are
fulfilled i.e., MR = MC and MC intersects the MR curve from below. At this level of equilibrium the
monopolist will produce OQ1 level of output and sells it at CQ1 price which is more than average cost DQ1
by CD per unit. Therefore, in this case total profits of the monopolist will be equal to shaded areaABDC.
Normal Profits:
A monopolist in the short run would enjoy normal profits when average revenue is just equal to average cost.
We know that average cost of production is inclusive of normal profits. This situation can be illustrated with
the help of fig.

In given Fig. the firm is in equilibrium at point E. Here marginal cost is equal to marginal revenue. The firm is
producing OM level of output. At OM level of output average cost curve touches the average revenue curve at
point P. Therefore, at point ‘P’ price OR is equal to average cost of the total product. In this way,

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monopoly firm enjoys the normal profits.

Minimum Losses:
In the short run, the monopolist may have to incur losses. This situation occurs if in the short run price falls
below the variable cost. In other words, if price falls due to depression and fall in demand, the monopolist will
continue to produce as long as price covers the average variable cost. Once the price fallsBelow the average
variable cost, monopolist will stop production. Thus, a monopolist in the short run equilibrium has to bear the
minimum loss equal to fixed costs. Therefore, equilibrium price will be equal to average variable cost. This
situation can also be explained with the help of given Fig.

In the above Fig. monopolist is in equilibrium at point E. At point E marginal cost is equal to marginal
revenue and he produces OM level of output. At OM level of output, equilibrium price fixed by the
monopolist is OP1. At OP1 price, AVC touches the AR curve at point A.
It signifies that the firm will cover only average variable cost from the prevailing price. At OP 1 price, firmwill
bear loss of fixed cost i.e., A per unit. The firm will bear the total loss equal to the shaded area PP 1 AN. Now if
the price falls below OP1, the monopolist will stop production. It is so because if he continuesproduction, he
will have to bear the loss of variable costs along with fixed costs.
2. Long Run Equilibrium under Monopoly:
Long-run is the period in which output can be changed by changing the factors of production. In other words,
all variable factors can be changed and monopolist would choose that plant size which is most appropriate for
specific level of demand. Here, equilibrium would be attained at that level of output wherethe long-run
marginal cost cuts marginal revenue curve from below. This can be shown with the help of Fig. given below-

In Fig. monopolist is in equilibrium at OM level of output. At OM level of output marginal revenue is equal to
long run marginal cost and the monopolist fixes OP price. HM is the long run average cost? PriceOP being
more than LAC i.e., HM which fetch the monopolist super normal profits. Accordingly, the monopolist earns
JM – HM = JH super normal profit per unit. His total super normal profits will be equalto shaded area PJHP1.
Price-Output Equilibrium under Monopolistic Competition

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Under monopolistic competition, organizations need to make optimum adjustments in the prices and output
sold to attain equilibrium. Apart from this, under monopolistic competition, organizations also need to pay
attention toward the design of the product and the way the product is promoted in the market.Equilibrium in
Short Run: The short-run equilibrium of a monopolistic competitive organization is the same as that of an
organization under monopoly. Conditions for attaining equilibrium are as-
1. Marginal revenue must be equal to marginal cost i.e. MC=MR.
2. MC must cut MR from below i.e. MC>MR.
There occurs three possibilities of equilibrium in short run same as monopoly market which are-
 Supernormal profits
 Normal profits
 Minimum losses
Super-normal Profit: In Figure the short-run marginal cost curve (SMC) cuts the MR curve at E. This
equilibrium point establishes the price QA (= OP) and output OQ. As a result, the firm earns supernormalprofit
represented by the area PABC.

Normal Profit: Given figure indicates the same equilibrium points of price and output. But in this case, the
firm just covers the short-run average unit cost as represented by the tangency of demand curve D andthe
short- run average unit cost curve SAC at A. It earns normal profit.

Minimum Loss: Given figure shows a situation where the firm is not able to cover its short run averageunit
cost and therefore incurs losses. Price set by the equality of SMC and MR curves at point E is QA which
covers only the average variable cost. The tangency of the demand curve D and the average

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variable cost curve AVC at A makes it a shutdown point.

If the firm lowers the price below QA, it will have to stop further production. However, at this price the firm
will incur losses equal to the area CBAP during the short-run in the hope of lowering its costs in the long-run.
Equilibrium in Long Run: In the long run, there is a gradual decrease in the profits of organizations. This is
because in the long run, several new organizations enter the market due to freedom of entry and exit under
monopolistic competition. When these new organizations start production the supply would increase and the prices
would fall. This would automatically increase the level of competition in the market. Consequently, AR curve shifts
from right to left and supernormal profits are replaced with normal profits.

In Figure, P is the point at which AR curve touches the average cost curve (LAC) as a tangent. P is regarded
as the equilibrium point at which the price level is MP (which is also equal to OF) and output is OM. Here
average cost is equal to average revenue that is MP. Therefore, in long run, the profit is normal.
THEORIES OF DISTRIBUTION-WAGES, RENT, INTEREST ,PROFIT

‘Distribution’ refers to the sharing of the wealth that is produced among the different factors of
production. In the modern time, the production of goods and services is a joint operation. All the different
factors of production i.e., land, labour, capital and enterprise are combined together in productive activity.
Definition: According to Prof. Nicholson – “Distribution refers to the sharing of wealth of a nation among the
different classes.”
In economics, the term ‘distribution’ has two components:
(i) Functional distribution,
(ii) Personal distribution.
1. Functional Distribution: Functional distribution refers to the distinct share of the national income received by
the people, as agents of production per Unit of time, as a reward for the unique functions rendered by them through
their productive services. These shares are commonly described as wages, rent, interest and profits in the aggregate
production. It implies factor price determination of a class of factors. It has been called as “Macro” concept.
2. Personal Distribution: Personal distribution on the other-hand, is a ‘Micro Concept’ which refers to the given

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amount of wealth and income received by individuals in society through their economics efforts, i.e., individual’s
personal earnings of income through various sources.
The theory of distribution deals with functional distribution and not with personal distribution of income. It
seeks to explain the principles governing the determination of factor rewards like—rent, wages, interest and
profits, i.e., how prices of the factors of production are set.
Distribution Theories of Wages
Meaning of Wages : Wages are remuneration paid to labour in return for the services rendered. According to
Benham, a wage may be defined as a sum of money paid under contract by an employer to aworker in
exchange for service rendered.
Subsistence Theory of Wages: According to this theory, wages of a worker in the long run are determined
at that level of wages which is just sufficient to meet the necessaries of life. This level is called the
subsistence level. The classical economists called it the neutral level of wages. In this way, thepro-pounders
of the theory believed in the bargaining power of the workers. In such a situation, trade unions play an
important role in increasing wages.
Wages of labour are equal to subsistence level in the long ran. If wages fall below this level, workers would
starve. It will reduce their supply. Thus, the wage rate will rise to the subsistence level. On the other hand, if
wages tend to rise above the subsistence level, workers would be encouraged to bear more children which
will increase the supply of workers, which in turn will bring wages down to the subsistence level.
Wage Fund Theory: The theory of wage fund first introduced in Economics by Adam Smith and later onit
was developed by J.S. Mill. The theory briefly explains that: "Wages depend upon the proportion between
population and capital”. In other words, we can say, wage fund is that amount of' floating capital which is set
apart by employers for paying wages to the labour. The average wage rate is determined by dividing the wage
fund by the total number of workers employed. Formula for Wage Fund Theory: WageRate = Wage Fund/
Total Number of workers Residual claimant theory: It is associated with the name of American economist
Walker. According to Walker: "Wages equal to Whole product minus rent interest and profit". In short, the
theory states that labour receives what remains after payment of rent, interest, profit and taxes out of the
national income.
Marginal Productivity Theory of Wages: Marginal productivity theory of wages is an important theoryof
wages. This theory was first of all propounded by Von Thunen. Later on, economists like Wicksteed, Walras,
J.B Clark etc. modified the theory. The marginal productivity theory states that labour is paid according to his
contribution in production. A producer hires the services of labour because he possesses the ability to
contribute in production. If worker contributes more to production he is paid more wages and if he contributes
less, wages also will be low.
Modern Theory of Wage: Modern theory of wages regards wages as a price of labour and all other
prices determined by the usual supply and demand analysis. According to this approach, wages are
determined by the interaction of market forces of demand and supply.
Demand for Labour: The demand for labour comes from the entrepreneurs as it is used for the production
of goods and services. Thus, the demand for labour depends upon the productivity of labour i.e., the higher
the productivity of labour, the greater will be the demand for it from employers. Thus, demand for labour
depends upon the marginal productivity of labour; since the marginal productivity of labour will slope
downwards after a stage, the demand curve of labour will also slope downward.
Supply of Labour: Supply of labour is the number of hours of work which the labour force offers in the
factor market. The labour can be attracted by offering higher wages, providing training facilities, making

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working conditions pleasant etc., so the supply of labour for the industry is of the normal shape risingupward
from left to the right.
Wage Determination: Wage of particular grade of labour, it is determined by the interaction of the forces
of. Demand for and supply of labour in the competitive market. The determination of wage, rate isexplained
with the help of diagram:

In fig. DD is the demand curve of labour and SS is the supply curve. Wage is determined at the point E where
DD curve intersect SS curve.
THEORY OF RENT
“Rent is the price paid for the use of land.” In simple words, ‘rent’ is used as a part of the produce which ispaid to
the owner of land for the use of his goods and services.
RICARDIAN THEORY OF RENT: Ricardo says “Rent is that portion of the produce of the earth which is paid to
the land lord for the use of original and indestructible power of the soil”.
Assumptions: (i) Rent Under Extensive Cultivation.
(ii) Rent Under Intensive Cultivation
Explanation: Rent Under Extensive Cultivation: According to Ricardo: "All the units of land
are not of the same grade. They differ in fertility and location. The application of the same amount of
labour, capital and other cooperating resources give rise to difference in productivity. This difference in
productivity or the surplus which arises on the superior units of land over the inferior units is an
economic rent".
Rent under Intensive Cultivation: When the land is cultivated intensively, the application of
additional doses of labour and capital brings in less and less of yield due to law of diminishing returns.
The dose whose cost just equates the value of marginal return is regarded marginal or no rent dose.
The rent arises on all the infra-marginal doses. For example, the application of first unit of labour and
capital to a plot of land yields 25 quintals of wheat, the 2nd dose gives 15 quintals of wheat and with
third it drops down to 10 quintals only, the farmer applies only 3 doses of labour and capital as the total
outlay on the third does equals its return. The rent when measured from the third or marginal dose is 15
quintal (25 - 10 = 15) on first dose and 5 quintal on second dose (15 -10 = 5). The third dose is a no rent
dose.
Criticism on Ricardian Theory of Rent:
(i) No Original and Indestructible Power
(ii) Wrong Assumption of 'No Rent Land'
(iii) Rent Enters Into Price
(iv) Wrong Assumption of Perfect Competition
(v) All Lands are Equally Fertile
(vi) Neglect of Scarcity Principle
Modern Theory of Rent: The modern economists like Pareto, Mrs Joan Robinson, Boulding, have
tried to simplify and generalize the ricardian theory of rent. According to them, the same demand and
supply theory of land can be applied to determine rent.
Demand and Supply Analysis:

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Demand for a Factor: The demand for a factor which may be land, labour or capital is a derived
demand. Land, say for instance, is demanded for its produce. The higher the produce, the greater is the
demand for land and vice versa. The demand curve of a factor is, therefore, negatively sloped which
means more land will be used only at lower rents, other things of course remaining the same.
Supply of a factor: The supply of land to a particular use (say industry) is quite elastic. It can be
shifted to other uses by offering higher rent than that being earned by it now. The supply of a factor
(to an industry) is, therefore, rent elastic. If higher rent is paid, the supply of a factor can be increased
by withdrawing it from other uses. The supply curve of a factor (industry) slopes upward to the right.

Determination of rent. The economic rent is determined by the intersection of demand and supply
curves for a factor. In this figure the demand curve for a factor say labour in a particular industry is DD
and the supply curve of workers is SS/. The wage rate or factor price of labour as determined by the
market forces is OW. The total workers employed in a particular industry at OW wage rate is OL. The
total earning of the workers employed is equal to the area OWEL. At wage rate OW, there are workers
who would work, at lower pay but they are also paid at OW wage rate. Those workers whose transfer
earnings are less than this wage rate will be getting economic rent. The total economic rent earned by
all the intra marginal workers is equal in the area WES. The marginal worker i.e., L worker is not
obtaining any rent or surplus.
THEORY OF INTEREST
Interest is a payment made by a borrower to the lender for the money borrowed and is expressed as a rate
percent per year. In the real economic sense, however, interest implies the return to capital as a factor of
production.
Definition : According to Carver – “Interest is the income which goes to the owner of capital.”
Types of Interest:
Net interest: The payment made exclusively for the use of capital is regarded as net Interest or pure
Interest. i.e., Net Interest = Net Payment for the use of capital.
Net Interest = Gross Interest – (payment for risk + payment for inconvenience + cost of administeringcredit)
(b) Gross Interest: Gross Interest according to Briggs and Jordan has said—“Gross Interest is
the payment made by the borrowers to the lenders”.
Gross Interest = Net Interest + payment of risk + payment for inconvenience + cost of administrating credit The
theories of interest are:
1. Marginal Productivity Theory: According to this theory, interest is paid because the funds are borrowed
and used for productive purposes. Interest is determined by the marginal productivity of capital. The borrower will
borrow money up to the level where the interest paid equals the marginal productivity of capital.
2. Abstinence or Waiting Theory: The abstinence theory was propounded by Senior. According to him, interest
is a reward for abstinence. When an individual saves money out of his/her income and lends it to other individual,
he/she makes sacrifice. The term sacrifice implies that the individual refrains from consuming his/her whole income
that he/she could spent easily. Senior advocated that abstaining from consumption is unpleasant. Therefore, the lender
must be rewarded for this. Thus, as per Senior, interest can be regarded as the reward for refraining from the use of
capital.

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3. The Austrian or Agio Theory of Interest or Bohm-Bawerk’s “The Time- Preference Theory”: According
to this theory, Interest is the price of time of reward for agio, i.e., time preference. It has been argued that man generally
prefers present income to a future income and consumption. Thus, Interest is the reward made for inducing people to
change their time-preference from the present to thefuture.
4. Prof. Fisher’s Time Preference Theory: Fisher emphasized that people give more preference to present
enjoyment as compared to future enjoyment. Hence, a given quantity of goods in present gives the same level of
satisfaction as a larger quantity of goods in future. This depends on the level and size of income, distribution of income
during the consumption period, etc.
5. Classical Theory of Interest or Demand and Supply of Capital Theory of Interest: This theory was
expounded by eminent economists like Prof.Pigou, Prof. Marshall, Walras, Knight etc. Classical theory helps in the
determination of rate of interest with the help of demand and supply forces. Demand refers to the demand of investment
and supply refers to the supply of savings. According to this theory, rate of interest refers to the amount paid for
saving. Therefore, the rate of interest can be determined with the help of
demand for saving money to be invested in the capital goods and the supply of savings.

In Figure, SS is the supply curve of saving and II is the demand curve of investment that intersect each other
at Or rate of interest with quantity of saving and investment is OM. OM represents the amount that is lent,
borrowed and used for investment. The rate of interest can be changed by changing the demand and supply
of savings and investment.
6. The Loan-Able Fund Theory of Interest:
According to this theory, the rate of Interest is the price of credit which is determined by the demand and
supply for loanable funds.
Demand for Loan-able Funds: The demand for loanable funds has primarily three sources:
(i) Government,
(ii) Businessmen
(iii) Consumers who need them for purposes of investment, hoarding and consumption.
Supply to Loanable Funds: The supply for loanable funds has primarily three sources:
 Savings
 Dis-hoardings
 Bank credit
 Disinvestment
Determination of Interest Rate: The equilibrium between the demand for and supply of loanable funds (orthe
intersection between demand and supply curves of loanable funds) indicates the determination of the market rate
of interest. It has been shown in the diagram given here.

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In the diagram demand curve for loanable funds (DL) and supply curve of loanable funds (SL) meet at point
E. Therefore, E will be the equilibrium point and OR will be the equilibrium rate of interest. At thisrate of
interest demand for and supply of loanable funds both are equal to OL.
7. Keynes’s Liquidity Preference Theory of Interest or Interest is Purely aMonetary Phenomenon:
Keynes defines the rate of interest as the reward for parting with liquidity for a specified period of time.
According to him, the rate of interest is determined by the demand for and supply of money.
Demand for money: Liquidity preference means the desire of the public to hold cash. According to Keynes,
there are three motives behind the desire of the public to hold liquid cash: (1) the transactionmotive, (2) the
precautionary motive, and (3) the speculative motive.
 Transactions Motive: The transactions motive relates to the demand for money or the need of cash for
the current transactions of individual and business exchanges.
 Precautionary motive: Precautionary motive for holding money refers to the desire to hold cash balances for
unforeseen contingencies. Individuals hold some cash to provide for illness, accidents, unemployment and other
unforeseen contingencies. Similarly, businessmen keep cash in reserve to tide over unfavourable conditions or to
gain from unexpected deals.
 Speculative Motive: The speculative motive relates to the desire to hold one’s resources in liquid form to
take advantage of future changes in the rate of interest or bond prices. According to Keynes, the higher the rate of
interest, the lower the speculative demand for money, and lower the rate of interest, the higher the speculative
demand for money. Algebraically, Keynes expressed the speculative demand for money as Supply of Money:
The supply of money refers to the total quantity of money in the country. Though the supply of money
is a function of the rate of interest to a certain degree, yet it is
considered to be fixed by the monetary authorities. Hence the supply curve of money is taken asperfectly
inelastic represented by a vertical straight line.
Determination of the Rate of Interest: Like the price of any product, the rate of interest is determined at the
level where the demand for money equals the supply of money. In the following figure, the vertical line QM
represents the supply of money and L the total demand for money curve. Both the curve intersect at E2 where
the equilibrium rate of interest OR is established. If there is any deviation from this equilibrium position an
adjustment will take place through the rate of interest, and equilibrium E2 will bere-established. At the point
E1 the supply of money OM is greater than the demand for money OM1.
Consequently, the rate of interest will start declining from OR1 till the equilibrium rate of interest OR is
reached. Similarly at OR2 level of interest rate, the demand for money OM2 is greater than the supply of
money OM. As a result, the rate of interest OR2 will start rising till it reaches the equilibrium rate OR.

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THEORY OF PROFIT
Profit may be defined as the net income of a business after all the other costs—rent, wages and interest etc.,
have been deducted from the total income. Profit simply means a positive gain generated from business
operations or investment after subtracting all expenses or costs.
In economic terms profit is defined as a reward received by an entrepreneur by combining all the factors of
production to serve the need of individuals in the economy faced with uncertainties. In a layman language,
profit refers to an income that flow to investor.
Types of Profit
 Net Profit
 Gross Profit
 Normal Profit
 Abnormal Profit
Theories of Profit: There are various theories of profit which have been advanced from time to timeregarding
the nature of profit in a competitive economy. The most important theories are:
(1) Walker' Rent Theory of Profits.—Walker developed this theory of profits though the original profounder
are Senior and J.S. Mill. Walker regards profits as rent of ability. Just as there are different grades of land, there are
different grades of entrepreneurs. The least efficient entrepreneur recovers his cost of production. Above him are
entrepreneurs of superior ability. Just as rent arises because of the differential powers of a superior land over the
marginal 1and, profit., also, is the reward for differential ability of the superior entrepreneur over the marginal
entrepreneur. Profits do not enter into price like rent. The theory has the same weakness as Ricardo's theory or rent
and was criticised by economists.
(2) Taussig's Wages Theory of Profits.—Prof. Taussig says, "profits are best regarded simply as a form of
wages". Again he states, "profit is the wage of the entrepreneur which accrues to him on account of his special ability".
Taussig and Davonport considered labourer and entrepreneur alike. The service of entrepreneur are considered as a
specialised form of labour. The position taken by Taussig cannot be accepted as there are fundamental differences
between wages and profits.
(3) Marginal Productivity Theory of Profits.—According to Chapman, "The marginal productivity of the
entrepreneur is the amount which the community is able to produce with his help over and above what it could produce
without his help." The marginal productivity theory of profits states that the supply of entrepreneurs is scarce. It cannot
be increased or decreased easily and at once. The demand for the entrepreneurs is growing in this complex society.

UNIT - IV

NATIONAL INCOME CONCEPTS

National Income is the total value of all final goods and services produced by the country in certain
year. The growth of National Income helps to know the progress of the country.
In other words, the total amount of income accruing to a country from economic activities in a year’s
time is known as national income. It includes payments made to all resources in the form of wages,
interest, rent and profits.
From the modern point of view, national income is defined as “the net output of commodities and
services flowing during the year from the country’s productive system in the hands of the ultimate
consumers.”
Definitions of National Income:
According to Pigou: “National income is that part of objective income of the community, including
of course income derived from abroad which can be measured in money.”
Concepts of National Income: There are a number of concepts pertaining to national
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income and methods of measurement relating to them.

A. GDP (GROSS DOMESTIC PRODUCT)

• Here the catch word is ‘Domestic’ which refers to ‘Geographical Area’
• The total value of all final goods and services produced within the boundary of the country
during a given period of time (generally one year) is called as GDP.
• In this case, the final produce of resident citizens as well as foreign nationals who reside
withinthat geographical boundary is considered.
Types of GDP: Real GDP and Nominal GDP
• Real GDP: Refers to the current year production of goods and services valued at base year
prices. Such base year prices are Constant Prices.
• Nominal GDP: Refers to current year production of final goods and services valued at current year
prices.
B. GROSS NATIONAL PRODUCT (GNP)
• Here the catch word is ‘National’ which refers to all the citizens of a country.
• GNP is the total value of the total production or final goods and services produced by the
nationals of a country during a given period of time (generally one year).
• In this case, the income of all the resident and non-resident citizens (who resides in abroad) of
a country is included whereas, the income of foreigners who reside within India is excluded.
• The GNP contains the income earned by Indian Nationals (both in Indian Territory and Abroad) only.
GDP and GNP are measured on the basis of Market Price and Factor Cost.

a) Market Price: It refers to the actual transacted price which includes indirect taxes such as custom
duty, excise duty, sales tax, service tax etc. (impending Goods and Services Tax). These taxes tend
to raise the prices of the goods in an economy.
b) Factor Cost: It is the cost of factors of production i.e. rent for land interest for capital, wages for
labour and profit for entrepreneurship.
C. Net National Product (NNP): NNP = GNP – Depreciation
• It is calculated by subtracting Depreciation from Gross National Product.
• Depreciation –: Wear and Tear of goods produced.
• This deduction is done because a part of current produce goes to replace the depreciated parts of
the products already produced. This part does not add value to current year’s total produce. It is
used to keep the products already produced intact and hence it is deducted.

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D. Net Domestic Product (NDP): NDP = GDP – Depreciation

• It is the calculated GDP after adjusting the value of depreciation. This is basically, Net form ofGDP,
i.e. GDP – total value of wear and tear.
• NDP of an economy is always lower than its GDP, since their depreciation can never be reduced to
zero.
E. National Income at Factor Cost (NIFC):
• It is the sum of all factors of income earned by the residents of a country (Indian) both from
within the country as well as abroad.
• National Income at Factor Cost = NNP at Market Price – Indirect Taxes + Subsidies
F. Transfer Payments
• A payment made by the government to individuals for whom there is no economic
activity is produced in return. For example: Old Age Pensions, Scholarship etc.
G. Personal Income
• It refers to all of the income collectively received by all of the individuals or households in a country.
• It includes compensation from a number of sources including salaries, wages, bonuses,
dividends, profits etc.
• PI = NI + Transfer Payments – Corporate Retained Earnings, Income Taxes, Social Security
Taxes.
H. Disposable Personal Income(DPI)
• It is the amount left with the individuals after paying Personal Taxes such as Income Tax,
Property Tax, and Professional Tax etc. to spend as they like.
• DPI = PI – Taxes (Income Tax i.e. Personal Taxes)
• DPI results into Savings and Expenditure i.e. (Spend and Save).

METHODS FOR THE MEASUREMENT OF NATIONAL INCOME

Methods of Computing/Measuring National Income: There are three methods of
measuring national income of a country. They yield the same result. These methods
are:
(1) The Product Method.
(2) The Income Method.
(3) The Expenditure Method
1. Value Added Method:
This is also called output method or production method. In this method the value added by each
enterprise in the production goods and services is measured. Value added by an enterprise is obtained
by deducting expenditure incurred on intermediate goods such as raw materials, unfinished goods.
Under this method, the economy is divided into different industrial sectors such as agriculture,
fishing, mining, construction, manufacturing, trade and commerce, transport, communication and
other services.
Measurement of National Income:
 Value of output produced by an enterprise is equal to physical output (Q) produced
multiplied bythe market price (P), that is, P.Q.
 From the value added by each enterprise we subtract consumption of fixed
capital (i.e., depreciation) to obtain net value added at market prices
(NVAMP).
 Then, the net value added at factor cost (NVAFC) by each productive enterprise as well
as by each industry or sector is estimated by deducting net indirect taxes (i. e. indirect
taxes less subsidies provided by the Government).
 Summing up the net values added at factor cost (NVAFC) by all productive enterprises of
an industry or sector gives us the net value added at factor cost of each industry or sector.
 We then add up net values added at factor cost by all industries or sectors to get net
domestic product at factor cost (NDPFC).
 Lastly, to the net domestic product we add the net factor income from abroad to get
net national product at factor cost (NNPFC) which is also called national income.
Thus,
NI or NNPFC = GDPMP – Depreciation - NIT + Net factor income from abroad
Precautions for Product Method or Value Added Method: There are certain precautions

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which are to be taken to avoid miscalculation of national income using this method. These inbrief are:
(i) Problem of double counting: When we add up the value of output of various sectors, we
should be careful to avoid double counting. This pitfall can be avoided by either counting (he
final value of the output or by including the extra value that each firm adds to an item.
(ii) Value addition in particular year: While calculating national income, the values of goods
added in the particular year in question are added up. The values which had previously been
added to the stocks of raw material and goods have to be ignored. GDP thus includes only those
goods, and services that are newly produced within the current period.
(iii) Stock appreciation: Stock appreciation, if any, must be deducted from value
added. This is necessary as there is no real increase in output.
(iv) Production for self-consumption: The production of goods for self-consumption should
be counted while measuring national income. In this method, the production of goods for self-
consumption should be valued at the prevailing market prices.
2. Income Method: This method approaches national income from distribution side. In other
words, this method measures national income at the phase of distribution and appears as income
paid and or received by individuals of the country. Thus, under this method, national income is
obtained by summing up of the incomes of all individuals of a country. Individuals earn incomes
by contributing their own services and the services of their property such as land and capital to
the national production.
Therefore, national income is calculated by adding up the rent of land, wages and salaries of
employees, interest on capital, profits of entrepreneurs (including undistributed corporate profits) and
incomes of self-employed people. This method of estimating national income has the great advantage
of indicating the distribution of national income among different income groups such as landlords,
owners of capital, workers, entrepreneurs.
Measurement of national income through income method involves the following main steps:
1. Like the value added method, the first step in income method is also to identify the productive
enterprises and then classify them into various industrial sectors such as agriculture, fishing,
forestry, manufacturing, transport, trade and commerce, banking, etc.
2. The second step is to classify the factor payments. The factor payments are classified
intothe following groups:
i. Compensation of employees which includes wages and salaries, both in cash and kind, as
well as employers’ contribution to social security schemes.
ii. Operating Surplus which includes rent, royalty, interest, profits, dividends etc.
iii. Mixed income of the self-employed: In India a good number of people are engaged in household
industries, in family farms and other unorganised enterprises. Because of self-employment nature
of the business it is difficult to separate wages for the work done by the self-employed from the
surplus or profits made by them. Therefore, the incomes earned by them are mix of wages, rent,
interest and profit and are, therefore, called mixed income of the self-employed.
3. The third step is to measure factor payments and adding it. Income paid out by each enterprise
can be estimated by gathering information about the number of units of each factor employed
and the income paid out to each unit of every factor.
4. By summing up the incomes paid out by all industrial sectors we will obtaindomestic factor
income which is also called net domestic product at factor cost (NDPFC).
5. Finally, by adding net factor income earned from abroad to domestic factor income or NDPFC
we get net national product at factor cost (NNPFC) which is also called national income.
Precautions: While estimating national income through income method the following precautions
should be taken:
1. Transfer payments are not included in estimating national income through this method.
2. Illegal money such as hawala money, money earned through smuggling etc. are not included
as they cannot be easily estimated.
3. Windfall gains such as prizes won, lotteries are also not included.
4. The receipts from the sale of second-hand goods should not be treated as a part of national
income. This is because the sale of second-hand goods does not create new flows goods and
services in the current year.
3. Expenditure Method:

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The expenditure approach measures national income as total spending on final goods and services
produced within nation during a year. The expenditure approach to measuring national income is to add
up all expenditures made for final goods and services at current market prices by households, firms and
government during a year. Total aggregate final expenditure on final output thus is the sum of four
broad categories of expenditures:
(i) Consumption (ii) investment (iii) government and (iv) Net export.
(i) Consumption expenditure (C): Consumption expenditure is the largest component of
national income. It includes expenditure on all goods and services produced and sold to the final
consumer during the year.
(ii) Investment expenditure (I): Investment expenditure is expenditure incurred on by business firms
on
(a) new plants, (b) adding to the stock of inventories and (c) on newly constructed houses.
(iii) Government expenditure (G): It is the second largest component of national income. It
includes all government expenditure on currently produced goods and services but excludes
transfer payments while computing national income.
(iv) Net exports (X - M): Net exports are defined as total exports minus total imports.
Measurement of national Income-
1. National income calculated from the expenditure side is the sumof final consumption
expenditure, expenditure by business on plants, government spending and net exports.
Thus, we add up the above four types of expenditure to get final expenditure on gross domestic
product at market prices (GDPMP). Thus,
GDPMP = Private final consumption expenditure + Government’s final consumption
expenditure + Gross domestic capital formation + Exports — Imports or
GDPMP = C+G + I+ (X — M)
= C + G + I + NX
2. On deducting consumption of fixed capital (i.e., depreciation) from gross domestic product
at market prices (GDPMP) we get net domestic product at market prices (NDPMP).
3. In this method, we then subtract net indirect taxes (that is, indirect taxes – subsidies) to
arrive at net domestic product at factor cost (NDPFC),
4. Lastly, we add ‘net factor income from abroad’ to obtain net national product at
factor cost (NNPFC), which is called national income. Thus,
NNPFC = GDPMP – Consumption of Fixed capital – Net Indirect taxes + Net Factor Income
from Abroad.
Precautions: While estimating final expenditure on Gross National Product, the following
precautions should be taken:
1. Second-hand goods: The expenditure made on second-hand goods should not be included
because this does not contribute to the current year production of goods and services.
2. Purchase of shares and bonds: Expenditure on purchase of old shares and bonds from other
people and from business enterprises should not be included while estimating Gross Domestic
Product through expenditure method. This is because bonds and shares are mere financial claims
and do not represent expenditure on currently produced goods and services.
3. Expenditure on transfer payments by government such as unemployment benefits, old-age pension
should also not be included because no goods or productive services are produced in exchange by
the recipients of these payments.
4. Expenditure on intermediate goods such as fertilisers and seeds by the farmers and wool, cotton and
yarn by manufacturers of garments should also be excluded. This is because we have to avoid
double counting. Therefore, for estimating Gross Domestic Product we have to include only
expenditure on final goods and services.
Difficulties In Measuring National Income A Developing Country Like India
(1) Difficulty of defining the nation —National income does not only include income
produced within the country, but also income earned in other countries by way of shipping
charges, interest, insurance and banking, minus any payments made to foreign countries.
Therefore, the definition of nation goes beyond the political boundaries of a nation.
(2) Non-marketed services.—Commodities and services, having money value are included in the
national item, but there are goods and services which may have no corresponding flow of money
payments. A paid maid servant's services are included in the national income but later when she

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marries the master, she is not paid any more though she continues to perform the services and this
service in not included in the national income.
(3) Inapplicability of any one method.—Some sectors are not applicable to the methods of national
income estimation. It is, however, preferred to use these methods simultaneously depending upon
the availability of statistics.
(4) Stage of economic activity.-There are different stages in economic activities such as production,
consumption, exchange and distribution. The problem of the selection of stage has to be found in
the calculation of national income.
(5) Non Availability of statistics - Non-availability of statistical material is one of the difficulties in
estimating the national income.
(6) Double Counting.— Another difficulty is of double counting usually
associated withthe inventory method.
(7) Identification of transfer payments- Another difficulty in the calculation of national income is
that of transfer payments associated with the income method of calculating national income
calculation.
(8) Self-consumed production. — A good portion of the produce is not brought to the market to
be exchanged with money. It is either consumed directly or is exchanged for other goods and
services in the unorganised sector.
(9) Multiple occupation.-As a result of little specialisation of function an individual works some
period in one sector and some period in another sector. A precise calculation of national income is
almost impossible in the case of people who have been found engaged in a number of economic
activities simultaneously.
(10) Illiteracy.—People do not, disclose their incomes easily and correctly as they are illiterate
and donot keep proper accounts
Importance of national income
(1) Economic policy- National income figures are an important tool of macro-economic analysis and
policy.
(2) Economic planning.—National income statistics the most important tools for long-term and
shoes term economic planning.
(3) Economy's structure.—National income enables us to know the relative importance of
the various sectors of the economy.
(4) Budgetary policies.—Modern governments try to prepare their budgets within the framework of
national income data and try to formulate policies according tothe facts revealed by the national
income estimates.
(5) National expenditure.—National income statistics show how national expenditure is
divided between consumption expenditure and investment expenditure.
(6) Distribution of grants-in-aid.—National income estimates help a fair distinction of grants-in-aid
by the federal governments.
(7) Standard of living.—National income studies help us to compare the standards of living of
people in different countries through per capita income.
(8) Public sector.—National income figures enable us to know the relative roles of public
and private sectors in the economy.
(9) Inflationary and deflationary gaps.—National income and national product figures enable us to
havean idea of the inflationary and deflationary gaps.
(10) International sphere.—National income statistics are important even in the international
sphere as these estimates help us to fix burden of international payments.

Q2. ROLE OF CREDIT AND BANKING SYSTEM

Credit is the most important part of the economy. According to Ray Dalio “Credit is a transaction
between a lender and a borrower, in which the borrower promises to pay back the money in the future
along with interest.
Meaning of Credit: Credit is a contractual agreement in which a borrower receives something of
value now and agrees to repay the lender at some date in the future, generally with interest.
In Banking credit defines as the purchasing power created by banks through lending based on
fractional reserve system.
In Commerce credit defined as an agreement based largely on trust under which goods, services, or

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money is exchanged against a promise to pay later. Also called commercial credit.
1. Large Scale Production:- The less developing countries like India or Pakistan facing capital
shortage problem. Our production sources are limited. So credit instruments have provided the
money to the industrialists. Now production is on large scale and cost per unit has been reduced.
The quality and quantity has been improved.
2. Increases In Saving Rate:- Credit provides an opportunity to save the money some people
savethe money but they are not capable to do any business. So they lend it to the financial
institutions. Credit makes possible the shifting of money to those people who can use it for
productivity.
3. Shifting of Capital To Productive Purposes:- There are so many people who have surplus money
but they are not capable to do any business. So they lend it to the financial institutions. Credit makes
possible the shifting of money to those people who can use it for productivity.
4. Economy in the Use of Metal:- Credit instruments are used in place of metallic coins. So there is
a saving of precious metals also. Further use of credit instruments is more effective and
convenient.
5. Provision of Working Capital:- Sometimes an industrialist faces the finance problem to purchase
the raw material or for the payment of wages. So he avails the credit facility.
6. Sale of Bonds:- Sometime a firm can obtain credit by selling the bonds. If the firm prospects are
bright it will repay the principal amount with interest.
7. Case of Young Firm:- Credit enables the manager of a young firm to develop its resources
at arapid speed.
8. Emergency of New Businessman:- Credit makes possible the entrance of new talent in the
business enterprise. If the person has all the qualities of a good entrepreneur but having no
capital, credit provides him the chance to utilize his qualities.
9. Purchase of Goods:- Credit enables the consumer to purchase the consumption goods like T.V.
Radio, Car House etc.
10. International Payments:- Through the bills of exchange international payments can be
made very easily. There is no need to import or export the gold for the international business
transactions.
11. Useful For the State:- If the Govt. Budget is deficit, it can be met by selling the
bonds and receiving the credit. Even in case of emergency, war, credit is very
beneficial for the state.
12. Improve Standard of Living:- Credit also results in improving the living standard of the
peoples. When money supplies total increases, income and per capita also increases, then ultimately
it leads to a good living standard
DANGERS OF CREDIT: No doubt credit is just like the blood and life for the trade and industry but
it has also some defects. If the credit weapon is not properly regulated and controlled it has serious
defects, which are following:
1. Over Issue of Credit:- The expansion of credit beyond the safe limit usually results
in over investment, over production and raising price. While the contraction of
credit.
2. Bad Debts:- If any consumer or nation misuses the credit then the loan will not repaid and it
will create panic in the monetary circles.
3. Inefficient Business Concerns:- Financially weak businessman who is running uneconomic
concernsand he is receiving the credit, all the firms which had trade relations with it all suffer. It
will also create panic in the business circle.
4. Monopolistic Explosion:- If a large amount of credit is at the disposal any individual or
corporation, then there is a danger of monopolistic exploitation and a monopolist can adopt any
unfair method in the business dealings.
5. Borrowing by Govt.:- If the Govt. spends the borrowed money lavishly the citizen
will loose confidence on the credit-ability of the state.

Q3. Banking System In India

Origin Of Word Bank
 BANCK – (From German Language ) : JOINT STOCK FUND
 BANCO – (From Italian) : HEAP OF MONEY

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 BANCUS – (From French) : A PLACE WHERE VALUABLE ASSETS KEPT

 BANK – (From English) : FINANCIAL INSTITUTION
Banking system in india can be explained briefly with the help of following classification and
working off banks –
 Central Bnak
 Commercial Bank
 Co-operative Bank
 Regional Rural Bank

CENTRAL BANK
A central bank is an independent national authority that conducts monetary policy, regulates banks,
and provides financial services including economic research. Its goals are to stabilize the nation's
currency, keep unemployment low, and prevent inflation. In simple words central bank is an apex
(most important) institution which controls, regulates, monitor the financial system of a country.
Meaning - The apex financial institution which is responsible for the financial and economic
stability of country.
It has a pivotal position in the banking system and regulates and formulates policies for the
scheduled commercial banks in the country.
Examples of Central Banks include
 Federal Reserve – US
 Bank of England – UK
 European Central Bank (ECB) – EU
 Reserve Bank of India – RBI
RBI AND ITS ORIGIN
The bank of England came into being as first ever central bank in 1694.
 RBI established as shareholder’s bank as per the Reserve Bank of India Act, 1935
 It Commenced Operations on 1 April 1935
 The World Bank (IBRD) and international monetary funds (IMF) have their full control over all central
banks.
Principles of Central Bank –
 Spirit of national welfare
 Monetary & financial stability
 Freedom from political influence
 Control the entire banking system
 Owned by Government
Functions of Central Bank - A Central Bank is an integral part of the financial and economic system.
They are usually owned by the government and given certain functions to fulfil. These include printing
money, operating monetary policy, lender of last resort and ensuring the stability of financial system.
The main functions of central bank can be explained as follows –
1. Sole authority to note-issue – Sole authority to issue currency is the main function
performed by the central bank. It implies that in any country the currency is issued by only central
bank. The right to issue notes has been granted to the central bank in all the countries of the world.
This monopoly of note-issue by the central bank results in several advantages to country.
 It ensures uniformity in the monetary system of the country which develops public
confidence in the currency.
 This also helps the central bank to exercise control on creation of credit by the commercial
banks.
 With this the central bank can maintain stability in the internal & external values of home
currency.
2. As a banker, agent and advisor to the Government – The central bank performs the
functions as a banker, agent and financial advisor to the Government.
 As the government's banker, the central bank keeps the accounts of various government
departments and institutions.
 As an agent to government, it accepts loans and manages the public debt on behalf of the
government. It receives taxes and other payments from the public on behalf of the

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government as its fiscal agent.

 As financial advisor, the central bank tenders useful advice to the government on important
economic and financial problems. The central bank is also the custodian of the nation's gold
and foreign exchange reserves and in that capacity manages the country's relations with
international financial institutions.
3. Acts as the banker's bank - The central bank acts as the banker's bank in three different
capacities. These are:—
i. It acts as the custodian of the cash reserves of the commercial banks - Every
commercial bank has to keep a certain percentage of its liability with the central
bank in the form of cash reserves. This cash reserve is kept by the commercial
banks in two forms: (a) cash reserve kept with itself; and (b) cash reserves kept
with the central bank. The commercial bank makes use of their reserves with the
central bank in times of emergencies.
ii. It acts as the lender of the last resort - This means that if the commercial
banks are not able to secure financial accommodation from other sources,
then, as a last resort, they can approach the central bank for the necessary
credit facilities. The central bank, in such a case, will be prepared to grant
accommodation to the commercial banks against eligible securities.
iii. It is the bank of central clearance, settlement & transfers - The central bank
acts as the clearing house for the commercial banks. Since it holds the cash
reserves of the commercial banks, it becomes easier & convenient for it to act as
the clearing house of the country. Consequently, the central bank can settle the
claims & counter claims of the commercial banks with the minimum use of cash.
4. The custodian of nation's gold & foreign exchange reserves – The central bank keeps
nations’ gold & foreign currency reserves in safe custody. If there are fluctuations in foreign
exchange rates, then the central bank use these reserves to attain stability by selling or purchasing
them.
5. Publish economic statistics and other useful information - In almost every country, the
central bank collects and publishes statistics about the various aspects of the functioning of the
national economy. This provides valuable information on the basis of which the government
formulates and implements its economic policies.
6. Acts as the controller of credit - Controlling of credit is the most important function of the
central bank. If the central bank is able to keep the creation of credit, within limits, it can prove a
blessing for the country. But, if credit is not effectively controlled and kept within limits, it can have
dangerous consequences for the economy. Hence, it is essential that the creation of credit is kept
within reasonable limits by the central bank. By controlling credit in an effective manner, the central
bank can also help to bring about stability not only in the internal price level but can also check
fluctuations in the foreign exchange rates. In order to control credit, the central bank uses several
weapons such as, the bank rate, open market operations, changes in the reserve ratios and selective
methods of credit control.
7. Promotes the economic growth of the country - The central bank is not merely a regulatory authority;
it is also an agency of economic growth. It takes all possible steps from time to time to stimulate
economic growth of the country. The promotional and the developmental activities of the central bank
have greatly expanded in recent years, particularly in the backward and under- developed countries. The
central banks in these countries are taking measures to set up a sound and an adequate system of
commercial banking to cater the requirements of trade, commerce, industry & agriculture.
8. Specialized Financial Institutions: The RBI has also been playing an important promotional role for
setting specialized financial institutions for meeting the long term credit needs of large and small scale
industries and other sectors. Accordingly, the RBI has promoted the development of various financial
institutions like, IDBI, ICICI, SIDBI, Exim Bank etc. which are making a significant contribution to
industry and trade of the country.
9. Providing Refinance for Exports: The Reserve Bank of India is providing refinance for export
promotion. The Export Credit and Guarantee Corporation (ECGC) and Export Import Bank were
established initially by the Reserve Bank of India to finance the foreign trade of India. They finance
foreign trade in the form of insurance cover, long-term finance and foreign currency credit. However,
they are now functioning separately.

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10. Developmental Functions: The RBI is also working as a development agency by developing various
sister organizations like Agricultural Refinance Development Corporation. Industrial Development Bank
of India etc. for rendering agricultural credit and industrial credit in the country.
COMMERCIAL BANK
A commercial bank is a financial institution which performs the functions of accepting deposits
from the general public and giving loans for investment with the aim of earning profit.
They generally finance trade and commerce with short-term loans. They charge high rate of interest
from the borrowers but pay much less rate of Interest to their depositors with the result that the
difference between the two rates of interest becomes the main source of profit of the banks.
CLASSIFICATION OF COMMERCIAL BANKS- Commercial banks are classified into two
categories i.e. scheduled commercial banks and non-scheduled commercial banks.
Scheduled commercial banks refer to the banks which are covered in the Reserve Bank of India’s
second schedule. Further, scheduled commercial banks are further classified into three types: Private
Bank: When the private individuals own more than 51% of the share capital, then that banking
company is a private one. However, these banks are publicly listed companies in a recognized
exchange.
Public Bank: When the Government holds more than 51% of the share capital of a publicly listed
banking company, then that bank is called as Public sector bank.
Foreign Bank: Banks set up in foreign countries, and operate their branches in the home country
are called as foreign banks.
Non-scheduled commercial banks refer to the banks which are not covered in the Reserve Bank of
India’s second schedule. The paid-up capital of such banks is not more than Rs. 5 lakhs.
Features:
1. It accepts deposits from the public. These deposits can be withdrawn by cheque and are repayable
on demand.
2. A commercial bank uses the deposited money for lending and for investment in securities.
3. It is a commercial institution, whose aim is to earn profit
4. It is a unique financial institution that creates demand deposits which serves as the medium of
exchange.
5. Money created by commercial banks is known as deposit money.
Functions of Commercial Banks: The fundamental functions of commercial banks are as follows-
1) Acceptance of deposits – The primary function of banks is to accept deposits. Banks accepts
three types of deposits from the public under the following accounts:—
(i) Fixed deposit account - Money in this account is accepted for a fixed period and cannot be
withdrawn before the expiry of that period. The longer the period, the higher is the rate of interest.
(ii) Current account - The depositor can withdraw money from the account whenever he requires
it. Generally, the bank grants no interest on this account. On the contrary, it levies certain
incidental charge on customer for the services rendered by it.
(iii) Saving bank account - Some restrictions are imposed on the depositor under the account. For
example, the customer can withdraw only a specified sum of money in a week. The rate of interest
allowed on this account is rather low.
(2) Advancing of loans - The deposits received are given as loans and advances by banks to the
needy borrowers after keeping certain cash reserves. The various types of loans and advances are as
follows:—
(i) Ordinary loans - The bank gives a specified sum of money to a person or a firm against some
security. The loan money is credited to the account of the borrower and he can withdraw the money
according to his requirements.
(ii) Cash credit - The bank gives loans to the borrowers against certain securities. The entire loan is
not given at one particular time. The bank charges interest only on the amount withdrawn from the
account. For example, the bank allows the debtor to withdraw the money from time to time up to a
certain limit determined by the value of the stock kept in the debtor’s safe.
(iii) Overdraft - The bank allows its respectable & reliable customers to overdraw their accounts
through cheques. The customer pay interest to the bank on the amount overdrawn by them.
(iv) Discounting to the bills of exchange – the holder of an exchange bill submits it to the bank
and gets it immediately discounted by the bank. The bank pays the present price of the bill to the

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holder after deducting its commission. When the bill matures, the bank can secure its payment from
the party which had accepted the bill.
(3) Agency functions of the bank - The banks Perform the following agency services:—
(i) Transfer of funds - The bank helps its customers in transferring funds from one place to another
through an instrument known as 'bank draft'.
(ii) Collecting customer's funds - The bank collect the funds of its customers from other banks and
credit them to their accounts.
(iii) Purchase and sale of shares and securities for the customers - The bank buys and sells
stocks and shares of private companies as well as government securities on behalf of its customers.
(iv) Collecting dividends on the shares of the customers - The bank collects dividends as well as
interest on the shares and debentures of the customers and credits them to their account.
(v) Payment of insurance premium - The bank pays premium to the insurance companies on
behalf of its customers.
(vi) Trustee and executor - The bank preserves the `wills' of the customers and executes them after
their death.
(4) Purchase and sale of foreign exchange - The bank also carries on the business of buying and
selling foreign currencies by the department of foreign exchange of the bank.
(5) Financing internal and foreign trade - The bank gives short-term loans to traders on the
security of commercial papers such as exchange bills. This provision greatly facilitates the
movement of internal and external trades.
(6) Miscellaneous functions of the bank - The bank will also attend the following functions:—
(i) Safe custody of valuable goods - The modern bank provides locker facilities to its customers for
which it charges them an annual rental.
(ii) Issuing of traveller's cheques - The bank also issues traveller's cheques or circular letters of
credit for the benefit of its customers.
(iii) Giving information about its customers - Since the bank is closely familiar with its
customers, it can pass on reliable information about their credit-worthiness to other parties of other
places.
(iv) Collection of statistics - The modern bank collects statistics about money, banking, trade and
commerce and publishes them in the form of pamphlets and handbills.
(v) Underwriting of company debentures - Private companies issue debentures for public sale.
But the public may hesitate in buying these debentures unless they have underwriting by the banks.
For underwriting these debentures, the banks charge small commission.
(vi) Accepting bills of exchange on behalf of customers - The banks accept exchange bills on
behalf of their trusted customers.
(vii) Financial advice - It gives useful advice to its customers on financial matters.
(7) Creation of credit - When the bank grants loan to its customers, it generally does not lend out
cash to the customers concerned but opens an account in the borrower's name and credits the
amount of the loan to his account. Thus, whenever a bank grants a loan, it creates a deposit or
liability against itself. As the deposits of the bank circulate as money, the creation of such deposits
leads to a net increase in the money stock. This is known as ‘creation of credit by the bank.'

Q4. RURAL MONEY MARKET

The Rural Marketing refers to the activities undertaken by the marketers to encourage the people,
living in rural areas to convert their purchasing power into an effective demand for the goods and
services and making these available in the rural areas, with the intention to improve their standard of
living and achieving the company’s objective, as a whole.
The rural market has been growing steadily over the past few years and is now even bigger than the
urban market. About 70 per cent of India’s population lives in villages. More than 800 million people
live in villages of India. ‘Go rural’ is the marketer’s new slogan. Indian marketers as well as multina-
tionals, such as Colgate-Palmolive, Godrej and Hindustan Lever have focused on rural markets.
RURAL MONEY MARKETS
The different sources of rural money markets may be into non-institutional agencies and institutional
agencies.
Non institutional agencies or private sources
1. unorganised money market consists of :—

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i) Money-lenders, landlords, merchants, etc.

ii) Indigenous bankers—it consists of traders, commission agents, etc.
iii) Nidhis—these are mutual loan associations.
iv) Chit funds—these are mobilising rural saving.
v) Family Members, Relatives and Friends.
(1) Money-lenders.—the money-lender has been the most important source of rural credit. There
are two classes of money-lenders. One is the more common professional money-lenders who
combines his business with trading in the village produce. The other non-professional money-
lender is from the ranks of landowners and well-to-do agriculturists.
Money-lenders are popular in rural areas due to many reasons
(i) There is a great dearth of institutional finance provided through co-operative
societies and commercial banks.
(ii) Money-lenders being residents of the villages, Mahajan’s have an intimate
knowledge of local conditions and people.
(iii) They can easily adapt themselves to the changing requirements of the rural people.
(iv) 'Their rules are simple and changeable to suit individual needs.
(v) They do not insist upon any particular type of security for grant of loans.
(vi) They are ready to advance loans for anybody for any purpose.
For such reasons money-lenders have dominated the rural money market. Interest charges have been too
harsh. Some money-lenders have indulged in malpractices like manipulation of accounts and other terms
of loans, forcing debtors to sell their produce and property at a very low price. Unless the government
controls their activities, it would be difficult to improve the conditions of rural people.
(2) Indigenous Bankers.—It consists of traders and commission agents. This institution holds a
unique position in regard to the magnitude of their operations and the significant role which it
has been playing in the economy of the country.
(i) The indigenous banker may also combine banking business but in his case banking
is primary occupation.
(ii) Indigenous banker accepts deposits and deals in hundies.
(iii) Indigenous bankers mostly finance trade and commerce.
(iv) The financial transactions of an indigenous banker a, mostly based on short-
term credit instruments.
(v) Indigenous bankers may open branches at other.
(3) Nidhis.—Nidhis have developed into a sort of semi-banking institutions with great amount
of respectability among the rural folk for whom ordinary banking facilities are not available.
Nidhis receive deposits from members. Another way of receiving funds is to receive from
members with drawableshare capital in monthly instalments. The important functions of
Nidhis are:
(i) They promote saving among members and mobilise them for being used for loan purposes.
(ii) Nidhis give loans to members for all purposes on good security.
(iii) This helps members to avoid usurious money lenders.
(iv) The rate of interest charged by Nidhis are generally lower than those charged by money-
lenders in the area.
(4) Chit Funds- Chit funds can be designed as loose voluntary associations for mobilising rural
savings and to provide loans to members. Generally an entrepreneur starts a chit fund from the
persons who are known as the members. The members agree to make periodical contribution
to the promoters.
II. Organised Rural Money Market: It consists of the following
(1) Government.—In present times, the government has and long term been an important source
of rural credit both for short and long term periods the Government provides both direct and
indirect help. Indirect credit is provided through the co-operative societies. The government
provides crop loans to agriculturists directly with a nominal interest rate.
(2) Central Bank.—The Reserve Bank Central Bank of India. It plays an indirect role in field of
rural credit. A separate department, viz., the Agriculture credit department provides funds to the
financing of agriculture from the National Agricultural Credit (Stabilisation) Fund. The Reserve
Bank of India lends to the State governments and to State co-operative banks which in turn use the
funds to lend to the cultivators through co- operative societies.
(3) Commercial Banks.—The commercial banks provide the credit to the rural people under

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Village Adoption Scheme, Integrated Rural Development Schemes, Warehousing Scheme, and financial
assistance to marketing and processing societies. The present day white revolution (dairydevelopment) and
bluerevolution (fisheries development) are due to the assistance of commercial banks.
(4) Regional Rural Banks.—The Regional Rural Banks are providing credit to the farm
sector. Each rural bank covers an area consisting of district or some districts. These banks pay
attention tothe credit needs of the small and marginal farmers, agricultural labourers, etc.
(5) Co-operative credit societies.—A co-operative credit society consists of borrowers
and non- borrowers as their members living at the same place: The society extends credit
facilities for short periods,. Normally for one harvest season for carrying on agricultural
operations. The loan is advanced for productive purposes only primary credit society is the
base of cooperative movement and constitutes the primary source of credit to the farmers.
The resources of the society constitute the funds raised from the members and the deposits
attracted from the affluent people of their own funds coming in the form of savings from the
members. It gives loans and advances to needy members mainly out of these funds. Central Co-
operative Banks provide means of funds to the credit societies and exercise effective control over
their working. These banks have definite areas of operations and control. The central co-operative
Banks are also undertaking commercial banking business. They constitute an important link
between the credit societies and State co-operative banks. A State co-operative bank constitutes an
apex body institutional co-operative credit in each State. They cooperate and control the working of
the central co-operative banks in the State.
They are the major source of finance to the co-operative banks. These banks have links with the
moneymarket and the Reserve Bank of India from where the draw funds to provide them to central
co- operative banks and the co-operative societies. These banks undertake commercial banking
business also.
(6) Land Development Banks or Land Mortgage Banks.-Land development banks, formerly
knownas land mortgage banks provide long-term credit to farmers. They help the farmers on
making structure changes in their agricultural system. These banks cater to the long term credit
requirements, e.g., provision of pump sets, tractors and machinery and land improvements in
the form of levelling, building reclamation of land, fencing, digging up new wells and repairs of
old wells is given priority. The major source of the funds of these banks include their own share
capitaland resources of deposits and issue of bonds or debentures. In addition to it other banks
and the central bank also subscribe to the funds of land development banks. The funds are used
for granting long term loans against the security of agricultural properties.
(7) Agricultural Refinance and Development Corporation (ARDC).—This Corporation
aims at providing finance (medium term and long term) for major agricultural development
projects whichcannot be satisfactorily financed by the existing institutional agencies like the
land development banks and the scheduled banks. Before accepting the projects, the
corporation conducts thorough economic feasibility and technical feasibility studies, as also
cost benefit analysis.
(8) National Bank for Agriculture and Rural Development (NABARD).—The NABARD wasset
-up and started functioning from July 12, 1982. It 1s expected that the rural poor can now enjoy
credit facilities at one window in a single package and will be able to be independent of the local
money- lenders.

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