Unit 1: Introduction to Economics and utility analysis

 Definition of Economics, Scarcity, opportunity cost, and the basic economic problem, Economic systems, Types of economies
 Production possibility Curve, Law of Increasing Opportunity Cost
 Utility analysis: cardinal and ordinal utility analysis, Marginal utility theory, Water-Diamond Paradox, Budget constraints
 Indifference curves and its properties, Consumer equilibrium

Unit 2 : Demand, Supply and Market Equilibrium

 Demand function, Movement along demand curve, shifts in demand, price elasticity of demand, factors affecting price elasticity of demand, Income
elasticity and cross-sectional elasticity of Demand.
 Supply and its determinants, Elasticity of supply.
 Market equilibrium and the role of demand and supply forces

Unit 3: Production, Costs and Market Structure

 Production function, Law of variable proportion, law of returns to scale, Concepts of Isoquants, Marginal rate of Technical Substitution, Producer
equilibrium by using isoquants.
 Cost concepts and its classification, short run and long run cost function, relationship between Marginal cost and average cost
 Overview of different market structure: Perfect competition, Monopoly, Monopolistic, and Oligopoly

Unit 4 : Introduction to Macroeconomics

 National Income Accounting: Definitions and Key metrics
 Approaches to Measuring GDP: Value-added, Income and Expenditure method
 Circular flow of income and diagram for the 2, 3 and 4 Sector model.
 Keynesian theory of Income determination
 Fiscal policy: Government spending, taxation, budget deficits/surpluses
 Introduction to
Economics
Economics is a social science that focuses on the production,
distribution, and consumption of goods and services.

The study of economics is primarily concerned with analyzing the

choices that individuals, businesses, governments, and nations make
to allocate limited resources.

The two branches of economics are microeconomics and

macroeconomics.

The study of microeconomics focuses on the choices of individuals and

businesses, and macroeconomics concentrates on the behavior of the
economy on an aggregate level.
Basic Economic Problem
•The fundamental economic problem is the issue of
scarcity and how best to produce and distribute
these scace resources.
•Scarcity means there is a finite supply of goods and raw
materials.
•Finite resources mean they are limited and can run out.
•Unlimited wants mean that there is no end to the
quantity of goods and services people would like to
consume.
•Because of unlimited wants – People would like to
consume more than it is possible to produce (scarcity)
Scarcity & Opportunity Cost
Economic resources are in short supply in comparison to the demand
for alternative uses. The primary economic problem is allocating
scarce resources to satisfy human desires in the most satisfying way
possible.

Scarcity occurs when demand for a good or service is greater than

availability.

Scarcity limits the choices available to consumers in an economy

Scarcity makes goods more valuable and sellers can set higher prices.
Opportunity cost represents the potential benefits that a business,
an investor, or an individual consumer misses out on when choosing
one alternative over another.

Opportunity cost is the forgone benefit that would have been derived
from an option other than the one that was chosen.
Economic Systems

Types of Economic Systems

Capitalism

Socialism

Mixed Economic System

 Economic Systems
Economic system is a pattern of co-operation among associates of an economy with its
specific institutions. It comprises the institutions that direct an economy.
Various types of economic systems can be differentiated on the basis of following
criteria
On the Basis of Ownership and Control over Means of Production or Resources

On the Basis of Trade

On the Basis of Level of Development

On the Basis of Sectoral Contribution

 Ownership of means of production also determines the form of
economic system of a nation. This would mean private, government or
joint ownership of the means of production

Capitalism: The ownership of means of production lies in the hands of

private individuals and institutions. It is wholly market based and profit is
the guiding principle of all economic activities, regulated by the forces of
demand and supply – that whatever is in demand will be produced since it
yields high profits. The consumer is the supreme factor around whose
choices the goods and services are based. It is also called a ‘Free Market
Economy’
 Capitalism
Merits of Capitalism
Economic freedom
Equal right to work
Right to accrue wealth
Rich choice of goods and services
Quality production
Demerits
Disproportionate sharing of wealth
Neglect of public welfare
Discord between the haves and have-nots.
 Socialism
The economic system is administered and regulated by the government. The
objective is to secure welfare and equality of the society.
Merits of Socialism
Social Welfare
Optimum usage of economic resources
Better way out to basic problems
Rapid, balanced economic development
Equitable distribution of income

Demerits of Socialism
End of consumer’s sovereignty
No importance to personal efficiency and productivity
Difficulties in the right implementation of the plan
Lack of freedom
 Mixed Economic System
“Mixed economy is that economy in which both government and private
individuals exercise economic control”.

Merits

Economic freedom and capital formulation

Competition and efficient production
Efficient allocation of resources
Advantages of planning
Economic equality
Freedom from exploitation
 Demerits

Unstable economy: The current trend in India shows a strong shift to

capitalist economy. Some decades ago the focus was socialist economy.
Based on the strength at a given time, one sector dominates the other
thereby tilting towards one economic system. This may destabilize the
mixed economy in the long run.

Constrained growth: in a mixed economy neither the private sector is

allowed to operate freely nor does the public sector function to its
optimum efficiency. This prevents desired growth in both the sectors.

Lack of efficiency

Corruption
 On the Basis of Trade
Open Economy: A market Economy generally free from Trade Barriers.

One can trade with any country in the world.

Almost all the economies in the world follow open economy system

Closed Economy: An Economy in which no activity is conducted with outside economies.

This is called a self sufficient economy where no imports are brought in and no exports are sent
out. Consumers are provided everything they need from within the economic borders. In practice
no economy is completely closed. E.g Brazil which is World’s most closed economy with fewest
imports
 On the basis of level of development
Economies can be classified in two categories:

(i) Developed economy

Developed countries have higher national and per-capita income, high rate
of capital formation i.e. high savings and investment. They have highly
educated human resources, better civic facilities, health and sanitation
facilities, low birth rate, low death rate, low infant mortality, developed
industrial and social infrastructures and a strong financial and capital
market. In short, developed countries have high standard of living.
(ii) Developing economy

The national and per capita income is low in these countries. They
have backward agricultural and industrial sectors with low savings,
investment and capital formation. Although these countries have
export earnings but generally they export primary agicultural
products. In short, they have low standard of living and poor health
and sanitation, high infant mortality, high birth and death rates and
poor infrastructure.
 Sectoral Contribution
The 3 main sectors of the economy are

Primary (Agrarian Economy)

Secondary (Manufacturing/Industrial Economy)
Tertiary sector (Service Economy)

Producing of agricultural/raw materials comes

under the primary sector of the economy.
Manufacturing comes under the secondary
sector, and the services industry comes in the
tertiary sector of the economy.
 Agrarian economy

An agrarian economy is an economy that is based on agriculture, where

most people are involved in farming and rely on the land for their
livelihood. Some characteristics of agrarian economies include:

•Rural-based: Agrarian economies are based in rural areas.

•Production, consumption, and sale of agricultural goods: Agrarian

economies involve the production, consumption, and sale of agricultural
goods.

•Subsistence farming: In agrarian economies, farmers often grow crops

for their own use.
 Industrial Economy
Industrial Economy is a process by which an economy
is transformed from primarily agricultural products to
one based on manufacturing goods.

An industrial economy is an economic system that's based on

manufacturing goods using advanced technology, machinery, men
and capital.

The production, distribution, and consumption of goods

resulting from all manufacturing business/processes
 Production Possibility
Curve
The Production Possibility Curve (PPC), also known as the Production
Possibility Frontier (PPF), is a fundamental concept in economics that
illustrates the trade-offs and opportunity costs associated with
producing two different goods or services.

Production possibilities frontier (PPF) shows the maximum attainable

combinations of two products that may be produced if we use our
resources efficiently.

A production possibilities curve (PPC) is a graph that

shows the maximum amount of two goods that can be
produced with a limited amount of resources.
Assumptions involved in PPC
•A company/economy produces only two products.

•Resources are limited.

•Technology and techniques remain constant.

•All resources are fully and efficiently used.

 Purpose of the Production
Possibility Frontier in Economics
•Determine if resources are being used efficiently
•A point on the graph that shows where a company or
economy is currently producing can indicate if resources are
being used efficiently.
•Help companies make decisions
•Companies can use the PPC to determine how to allocate
resources to produce the most profitable mix of products.

•Show how efficiently a country is using its resources

•A country that is producing on its PPC is producing at full
capacity, while a country that is producing inside the PPC is
not using its resources efficiently.
Why Is the Production Possibility Frontier
Called the Opportunity Cost Curve?

The PPF identifies the options when making a

decision. When a decision on one action is
made, the opportunity that the other action
provides is lost. Thus, there is an opportunity
cost; the PPF curve plots this.
Law of increasing opportunity cost

When producing goods, opportunity cost is what is given up when we

take resources from one product to produce another.

The law of increasing opportunity costs states that as the

production of one good increases, the opportunity cost to
produce an additional good will increase.

The PPF demonstrates that the production of one commodity may

increase only if the production of the other commodity decreases.
 Utility analysis

Customers are the ultimate user of any goods or services

and the producer’s only aim is to satisfy their needs and
desires. However, the level of satisfaction differs from
individual to individual and their mental position.

Utility is a physiological fact that implies the satisfaction a

person receives from consuming a good or service.

Utility analysis is a concept used to describe how people

make choices based on the satisfaction or usefulness they
get from using goods and services.
 Types of Utility Analysis

Utility analysis in economics can be understood as a concept which

stresses on knowing and quantifying the satisfaction or well-being
that people get through consumption of goods and services.

The two primary theories for utility are

Ordinal Utility Analysis

Cardinal Utility Analysis

Both concepts Ordinal utility and Cardinal utility help understand consumer
behavior and preferences
 Ordinal Utility
The function that represents utility of a product according to its
preference, but does not provide any numerical value, is known
as an Ordinal Utility.

It explains that the satisfaction level after consuming any goods

or services cannot be scaled in numbers. However, these things
can be arranged in the order of preference.
In simpler words, this theory affirms that it is relevant to ask
which item is better as compared to others instead of how good
is that product.

According to the ordinal approach, utility is a psychological

phenomenon like happiness, satisfaction, and welfare. The
ordinal theory is highly subjective and differs across individuals.
Therefore, it cannot be measured in quantifiable terms.
 Cardinal Utility
Cardinal Utility is a quantitative concept that can be
measured in terms of a number.

It explains that the satisfaction level after consuming any

goods or services can be scaled in terms of countable
numbers.

Utility is measured based in utils.

Util is not regarded as a standard unit because it varies

from person to person, place to place, and time to time
Cardinal Utility Ordinal Utility

Definition

It explains that the satisfaction level after consuming any goods or services can It explains that the satisfaction level after consuming any goods or services cannot
be scaled in terms of countable numbers. be scaled in numbers. However, these things can be arranged in the order of
preference.

Example

Pizza gives Ram 60 utils of satisfaction, whereas burger gives him only 40 utils. Ram gets more satisfaction from a pizza as compared to that of a burger.

Measurement

Utility is measured based on utils. Utility is ranked based on satisfaction.

Realistic

It is less practical. It is more practical and sensible.

 Marginal utility theory

Marginal utility theory examines the increase in

satisfaction consumers gain from consuming an extra unit
of a good.

•Utility is an idea that people get a certain level of

satisfaction/happiness/utility from consuming goods and
service.

•Marginal utility is the benefit of consuming an extra unit

Marginal utility is the additional satisfaction a consumer gets
from having one more unit of a good or service.

The concept implies that the utility or benefit to a consumer

of an additional unit of a product is inversely related to the
number of units of that product he already owns.

Marginal utility to a buyer of a product decreases as he

purchases more and more of that product, until the point is
reached at which he has no need at all of additional units. The
marginal utility is then zero.
 Paradox
The economists observed that the value of diamonds was far
greater than that of bread, even though bread, being
essential to the continuation of life, had far greater utility
than did diamonds, which were merely ornaments. This
problem, known as the paradox of value, was solved by the
application of the concept of marginal utility. Because
diamonds are scarce and the demand for them was great,
the possession of additional units was a high priority. This
meant their marginal utility was high, and consumers were
willing to pay a comparatively high price for them. Bread is
much less valuable only because it is much less scarce, and
the buyers of bread possess enough to satisfy their most
pressing need for it. Additional purchases of bread beyond
people’s appetite for it will be of decreasing benefit or utility
and will eventually lose all utility beyond the point at which
hunger is completely satisfied.
 Diamond–Water Paradox

Adam Smith emphasized the distinction between use value and exchange
value to understand the value of goods. Goods that fulfill basic needs,
such as water, have a high use value. However, due to their abundance
and easy accessibility, these goods may have a low market value.
According to Smith, use value represents the ability of a good to
effectively meet human needs.

On the other hand, rare and difficult-to-extract goods like diamonds may
involve more labor in production, leading to a high market value despite a
low use value.

In this context, the paradox of water and diamonds serves as a symbolic

example in understanding the contradiction between use value and
exchange value in economic theories.
 Indifference curve
An indifference curve is a graph that shows the different
combinations of two goods that give a consumer the
same level of satisfaction or utility. It is also known as an
iso-utility curve or equal utility curve.

Every point on the indifference curve shows that an

individual or a consumer is indifferent between the two
products as it gives him the same kind of satisfaction.

The slope of the indifference curve is known as the marginal rate of

substitution (MRS). The MRS is the rate at which the consumer is
willing to give up or substitute one good for another.
What Does an Indifference
Curve Explain?
An indifference curve is used by economists to
explain the tradeoffs that people consider when they
encounter two goods they wish to buy. People can
be constrained by limited budgets so they can't
purchase everything. Indifference curves visually
depict this tradeoff by showing which quantities of
two goods provide the same utility to a consumer.
Properties of indifference curves
The four properties of indifference curves are:

(1) indifference curves always slope downwards

(2) indifference curves are convex

(3) indifference curves can never cross each other

(4). The farther out an indifference curve lies, the higher the utility
it indicates
UNIT TWO
Demand, Supply and
Market Equilibrium
Demand : It means the individual’s desire for a good
backed by capacity to pay for it.

In other words, an individual’s desire for a good to

satisfy a particular want backed up by his/her
willingness and ability to pay gives rise to demand for
a good.
For demand to exist two conditions must be fulfilled:

i) individuals must have a desire for that good, and

ii) their desire must be supported by income or purchasing

power or means to pay, given of course the individuals
willingness to pay or spend
Factors affecting demand for a good
Price of the good under consideration
The normal behaviour that one would observe is an inverse relationship
between the quantity demanded of a good and its own price. As the
price of a good rises the quantity demanded falls. And as the price falls
the quantity demanded would tend to increase.

Substitutes and Complements

The quantity demanded of a good would vary positively with the price
of the substitute good, while it will vary negatively with the price of the
complementary good.
Income level: Another influence on the demand for a good is the individual
consumer’s income level. As an individual becomes richer, he would tend to
increase the consumption of each and every good.

However, if the increase in income results in a decrease in the demand

(consumption) for a good, that good will be classified as an inferior good. E.g
Artificial Jewellery, rice of low quality etc.

Consumer’s tastes and preferences: The demand for a good depends upon
the individual consumer’s tastes or preferences. A consumer will demand or
desire a good if and only if she has a taste for the good (or, has a definite
preference for that good). E.g NORTH/SOUTH DIVIDE
Advertising: The effect of advertising tend to increase the quantity
demanded. Advertising affects demand by providing information of the
product and its usefulness and effectiveness.

Other Factors: This includes habits, marital status etc. which also affect
the demand for a commodity
.
 Demand Curve
In any particular situation if we keep factors other than own price as
constant, we can then derive a demand schedule, a demand function,
and a demand curve.
A demand schedule lists the various quantities of a good that a potential
consumer buys from the market at different prices of the good,
observed at a given moment of time.
Price of Milk: 20 15 10 5
per litre (Rs.)

Quantity 1 1.5 3 6
Demanded
(Litre)
 Demand Function
The demand function for a good expresses a functional relationship between quantity demanded of
the good and its determinants.

Qx = f( Px, PR, Y, T, A,Z ).

Economists analyse the relationship between quantity demanded and the factors which influence
demand by studying the effect of one factor (say price or income) at a time and by assuming all
other factors remain constant

If the good is X (milk in our case), Qx is quantity demanded and Px is the price of good X, then the
general form of the demand function will be
Qx = f( Px )
it says is that quantity demanded depends on price only with everything else held constant.
Price is the cause variable and quantity demanded is the effect variable. Stated alternatively, price is
the independent variable while quantity demanded is the dependent variable.
 Demand Curve
The demand curve is a graphical representation of the demand schedule. The
graph of the demand function is plotted on a two dimensional Euclidean space
with horizontal axis (abscissa) measuring the quantity demanded of the good
and the vertical axis (ordinate) measuring the price.

A demand curve is a graph that shows the relationship between the price of a
good and the quantity demanded over a specified period of time.

The demand curve generally slopes down from left to right, due to the law of
demand , which states that as the price of a given commodity increases, the
quantity demanded decreases as long as all other factors are constant.
Movement along demand
curve
A change or movement along the same demand curve occurs when the
quantity demanded of a commodity changes due to a change in its price
only.
Thus for movement along the same demand curve, changes in the
amount that a customer is willing and able to buy occur when all other
determinants of demand stay the same and price alone changes.
These movements along a demand curve are called expansions or
contractions of demand depending on whether quantity demanded has
increased or decreased.
 Shift in Demand Curve
A shift of the demand curve is an actual physical movement of the
demand curve and occurs when the quantity demanded of a commodity
changes due to a change in any of the factors (except price) which
influences demand.

A shift in the demand curve is caused by a change in any

non-price determinant of demand.

A 'movement' in the demand curve describes a change in

the quantity demanded due to price variation, whereas a
'shift' refers to a change in the demand caused by non-
price factors.
From Fig. above, we can clearly see
that if the income changes, then a
change in price shifts the demand
curve. In this case, the shift is to the
right which indicates that there is an
increase in the desire to purchase the
commodity at all prices.
On the other hand, if the income falls, then the
demand curve will shift to the left decreasing
the desire to purchase the commodity.
Movement of the demand curve happens when all
other factors affecting the quantity demanded,
remain constant and only the price changes.
Hence, the demand moves upward or downward
along the same curve.
 Price Elasticity of
Demand
Price elasticity of demand is a numerical measure of the extent to
which quantity demanded responds to a change in price, other
determinants of demand being kept constant.

PE= % change in quantity demanded

% change in price

The price elasticity gives the percentage change in quantity

demanded when there is a one percent increase in price, holding
everything else constant.
 Factors Governing Price Elasticity of Demand
Availability of substitutes : The more and the better substitute, the greater is the price
elasticity of demand.

Time Period: In the short-run, consumers don't have much time to find substitutes, so demand
is more inelastic. The greater the time period, the greater is the price elasticity of demand

Proportion of income spent on the good: the larger proportion of income a good
constitutes, the more responsive its consumers will be to changes in price. If a good only
constitutes a small proportion of a consumer's income, the demand for the good is likely to be
price inelastic.
The elasticity of demand is typically low for high-income households, but high for low-income
households

Whether the good is a luxury or a necessity if a good is a necessity (eg. food), consumers
will continue to buy it regardless of changes in price. If a good is a luxury good, an increase in
price might cause consumers to stop buying the good. Thus, the demand for luxury goods tends
to be price elastic, while the demand for necessity goods is price inelastic.
 Income Elasticity
Income elasticity of demand measures the relationship between
the consumer’s income and the demand for a certain good.
Income elasticity of demand is a numerical measure of the extent to
which quantity demanded responds to a change in income, other
determinants of demand being kept constant.
IE= % change in quantity demanded
% change in income

Income elasticity of demand is an economic measure of how

responsive the quantity demanded for a good or service is to a
change in income
Cross-sectional elasticity of Demand
Cross elasticity of demand is a numerical measure of the degree to which
quantity demanded of good responds to changes in the price of other
commodities, the other determinants of demand being kept constant.

CE= % change in quantity demanded of Good X

% change in price of good Y

Cross elasticity of demand refers to the way that sees how

changes in the price of one good can affect the quantity
demanded of another good. This relationship can vary
depending on whether the two goods are substitutes or
complements.
Supply and its Determinants
Supply is analogous to demand

It is defined as the quantity of a commodity that a firm is willing and able to

offer for sale during a given time period at a given price.
This definition has four essential dimensions- quantity of a
commodity, willingness to sell, price of commodity and period of
time.

The supply function in economics is a mathematical formula that

depicts the relationship between quantity supplied, price of the
commodity, and other related variables.
 Law of Supply

The law of supply is a fundamental principle of economic theory

which states that, keeping other factors constant, an increase in
price results in an increase in quantity supplied.
In other words, there is a direct relationship between price and
quantity: quantities respond in the same direction as price
changes. This means that producers and manufacturers are
willing to offer more of a product for sale on the market at higher
prices, as increasing production is a way of increasing profits.
In short, the law of supply is a positive relationship between
quantity supplied and price, and is the reason for the upward
slope of the supply curve.
 Elasticity of Supply
Elasticity of supply, also known as price elasticity of supply (PES), is a
measure of degree of responsiveness of the quantity supplied to the
change in the price of a given commodity.

In other words, Price elasticity of supply, in application, is the percentage

change of the quantity supplied resulting from a 1% change in price.

PES= % change in quantity supplied

% change in price
 Determinants of
Supply
The factors on which the supply of a commodity depends
are known as the determinants of demand. These are:

•Price of the Commodity

• Prices of other Commodities
• Firm Goals
• Technology
•Government Policy
•Price of Inputs or Factors
•Natural Factors
•
Price of the Commodity
It is the main and the most important determinant of
supply. When the price of the commodity is high, the
producers or suppliers are willing to sell more
commodities. Thus, the supply of the commodity
increases.

Similarly, when the price is low the supply of the

commodity decreases owing to the direct relationship
between the price of a commodity and its supply.
 Prices of other Commodities

When the price of complementary goods increases their

supply also increases. Thus, this results in the increase in
the supply of commodity also and vice-versa.

Also, when the price of the substitutes increases, their

supply also increases. This results in a decrease in the
supply of original goods.
 Firm Goals
The supply of goods also depends on the goals of an
organization. An organization may have various goals
such as profit maximization, sales maximization,
employment maximization, etc

Where the firm’s objective is the maximization of profit, it

will sell more goods when profits are high and less
quantity of goods when the profits are low
 Technology

When a firm uses new technology it saves the

inputs and also reduces the cost of production.
Thus, firms produce more and supply more goods.
 Government Policy

The taxation policies and the subsidies given by the

government also impact the supply of goods.
When the taxes are high the producers are unwilling to
produce more goods and thus, the supply will decrease.
On the other hand, when the government grants various
subsidies and gives financial aids to the producers, they
increase the production of goods. Thus, the supply
increases.
 Price of Inputs or Factors

The price of inputs or the factors of production such as

land, labor, capital, and entrepreneurship also determine
the supply of the goods. When the price of inputs is low
the cost of production is also low.
Thus, at this point, the firms tend to supply more goods in
the market and vice-versa
 Natural Factors

The factors like weather conditions, flood, drought, pests,

etc. also affect the supply of goods. When these factors
are favorable the supply will increase, else will decrease
depending upon the factors.
 Market equilibrium and the role of
demand and supply forces
An equilibrium is a state of rest where no economic forces are being
generated to change the situation

Equilibrium is the state in which market supply and demand balance

each other, and as a result prices become stable
The balancing effect of supply and demand results in a state of
equilibrium.
 Market equilibrium

Market equilibrium is a market state

where the supply of a commodity in
the market is equal to the demand in
the market
 Production Function
Production is defined as the process of creating goods and services with
the help of factors of production or inputs for satisfaction of human
wants.
In other words, ‘transformation of inputs into output’ whereby value is
added, is broadly called production.
Definition of Production
Function
Production function refers to the physical relationship between inputs
and output under given technology.
Qx = f (L, K) Where,
Qx=Quantity of commodity X
f is the function and
L = Labour
K = Capital
Types of Production Function
The four types of production functions are

Linear
Cobb-Douglas
Leontief
CES (Constant Elasticity of Substitution)
 Types of Production Function

Production function on the basis of the time period can be

divided into two categories:

Short Run Production Function

Long Run Production Function.
Short-Run Production Function

In the short run, certain inputs (e.g., capital,

machinery, or land) are fixed due to time or
cost constraints.

Other inputs (e.g., labor, raw materials) can be

varied.
 Law of variable
proportion
The law of variable proportion is used in short-run
production functions, where one factor varies while the
others remain fixed.

Law of Variable Proportion is regarded as an important

theory in Economics. It is referred to as the law which
states that when the quantity of one factor of
production is increased, while keeping all other factors
constant, it will result in the decline of the marginal
product of that factor.
Law of Diminishing Marginal Returns

As additional units of a variable input are

added to fixed inputs, the marginal increase
in output eventually decreases.
 Production in the long
Run
•Short-Run Production Function: At least one input is fixed,
Long-Run Production Function: All inputs are variable.

A long run production function is a model that shows how

output changes when all factors of production are
changed at the same time and in the same proportion.

In the long run, firms can change the quantities of all

inputs, such as labor, capital, and raw materials, to
maximize output and optimize production.
Law of Return to Scale
The law of returns to scale is an economic theory that
describes how a firm's output changes when all factors
of production are increased in the same proportion.

It's a long-term theory because companies can only

change production scale by changing factors of
production, such as investing in new machinery or
building new facilities.
This law applies only in the long
run when no factor is fixed, and all
factors are increased in the same
proportion to boost production.
Types of returns to scale
There are three types of returns to scale

•Increasing returns to scale: When output increases at

a higher rate than the increase in inputs

•Constant returns to scale: When output increases at

the same rate as the increase in inputs

•Decreasing returns to scale: When output increases

at a lower rate than the increase in inputs
 Isoquant
An isoquant is a curve that shows all possible
combinations of inputs that can produce a given level of
output while keeping other factors constant.
The term "isoquant" comes from the words "iso" meaning
equal and "quant" meaning quantity
 Properties of isoquants
•Slopes downward: Isoquants slope downward from
left to right.

•Convex to origin: Isoquants are convex to their origin

point.

•Do not intersect: Two isoquants cannot intersect each

other.

•Higher isoquants represent higher

output: Isoquants that are higher
•and further to the right on a graph represent a higher
level of output.
Isoquants are also known as iso-product
curves or producer indifference
curves. The producer is indifferent
between all the combinations of inputs
that yield the same level of output.
Marginal rate of technical
substitution
The marginal rate of technical substitution (MRTS) is a
microeconomic theory that measures how much one input
needs to be reduced when another input is increased to
maintain the same level of output:

MRTS is a reflection of the trade-off between inputs, like

labor and capital, in the production function. It's
important for companies to understand MRTS to optimize
their input mix.
 Isocost
•An isocost show all combinations of factors that cost the
same amount.
•Isocosts and isoquants can show the optimal
combination of factors of production to produce the
maximum output at minimum cost.
Isoquants and isocost are curves that
are plotted on a graph to help producers
and manufacturers determine how to
maximize output at a minimum cost
Let’s assume that a farmer has Rs. 1,000 to spend on labour costs and
ploughs for farming. The cost of one such plough and wage per labourer is
Rs. 100. Considering his total outlay of Rs. 1,000, he can spend that money
in the following combinations:
The farmer, in this case, can either spend the entire sum of Rs. 1,000 on just
ploughs by buying 10 of them. Similarly, he can also spend it all on labour
by employing 10 labourers. He can even purchase both, labour and ploughs
using different combinations as shown above. The total outlay of Rs. 1,000
will remain the same. Hence, the isocost line will remain straight

Plough
0 100 200 300 400 500 600 700 800 900 1000
s

Labour 1000 900 800 700 600 500 400 300 200 100 0
Cost minimisation occurs when an isoquant is just
tangent to (but does not cross) an isocost line.

OR

The point of tangency between any isoquant and an isocost line

gives the lowest-cost combination of inputs that can produce the
level of output associated with that isoquant.

Equivalently, it gives the maximum level of output that can be

produced for a given total cost of inputs.
 Producers Equilibrium
Producer's equilibrium is the optimal production level for a
producer, and it can be determined using isoquant curves and
isocost lines

Isoquant curves: Show the input combinations that can be used to

achieve specific output levels

Isocost lines: Show the combinations of two factors that can be

used to produce output within a certain cost.

Producer's equilibrium: The optimal production level is found

by combining the two graphs
 Cost concepts
In economics, costs represent the expenses incurred
by a firm in the production of goods and services.
These costs are classified into various types based
on their traceability, behavior, and time period.

These concepts are very important in the decision-

making of the business enterprise. This can directly
impact the profitability of the firm.
 Types of Costs
a) Fixed Costs (FC):
•Costs that remain constant regardless of the level of
production.
•Examples: Rent, salaries of permanent staff, insurance.

b) Variable Costs (VC):

•Costs that vary directly with the level of production.
•Examples: Raw materials, wages for casual labor, electricity.

c) Total Cost (TC):

•The sum of fixed and variable costs.
•Formula: TC = FC + VC
d) Average Costs:

•Costs per unit of output.

• Average Fixed Cost (AFC): AFC=FC/Q

• Average Variable Cost (AVC): AVC=VC/Q

•
• Average Total Cost (ATC): ATC=TC/Q
e) Marginal Cost (MC):
•The additional cost incurred to produce one extra unit of
output.

• OR
•The change in total cost per unit of change in output

Formula: MC=ΔTC/ΔQ​
Classification of Costs
Costs can be classified based on:

a) Behavior:

•Fixed Costs: Unchanging with output--These costs remain

the same regardless of production or sales levels. Examples
include rent, salaries of permanent staff, insurance etc.

•Variable Costs: Change with output-- Variable costs are costs

that change with the changes in the level of production. Example--
cost of raw materials and casual labour wages

•Semi-variable Costs: Partly fixed and partly variable--These

costs have both fixed and variable components
b) Traceability
Costs can be classified as Explicit or implicit:

Explicit Cost : Direct payments made (e.g., wages, rent).

“An explicit cost is a direct expense that is paid in money to others
during the production of goods.” These are traceable in nature.
It is also referred to costs associated with various factors used in
the production of the commodity such as raw materials, labour
wages, package, transportation, etc.

Implicit Costs: Indirect Cost--Opportunity costs (e.g., owner's

time)
These are costs that a business incurs but does not pay out, such
as the opportunity cost of using resources that the business
already owns. for example, expanding a factory onto land already
owned.. They may also be intangible costs that are not easily
accounted for, including when an owner allocates time toward the
maintenance of a company, rather than using those hours
elsewhere.
The costs are not met by payments
•These costs are generally untraceable in nature
Explicit describes something that is very clear
and without vagueness or ambiguity.

Implicit functions are the opposite, referring to

something that is understood, but not described
clearly or directly, and often using implication or
assumption.
 c) Time Period:
•Short-Run Costs: At least one input is fixed such as monthly salaries for
laborers

•Long-Run Costs: All inputs are variable.

In the short run:

•Fixed Costs (FC): Do not change.
•Variable Costs (VC): Increase with output.
•Total Costs (TC): Increase as output increases.
 Long Run Cost Functions

In the long run:

•All costs are variable as firms can adjust all inputs and
achieve optimal production scale

•In order to increase the output, the firm needs to

increase the cost of all the inputs involved in the
production. (The fixed cost and variable cost both have to
be increased )
 Overview of different market
structure: Perfect competition,
Monopoly, Monopolistic, and Oligopoly
In economics, market is a place where buyers and sellers are exchanging
goods and services with the following considerations such as: • Types of
goods and services being traded • The number and size of buyers and
sellers in the market • The degree to which information can flow freely
Overview of different market structure

In economics, a market is a place where buyers and

sellers can exchange goods, services, information, or
currency.
OR
A market is a venue where buyers and sellers can meet to facilitate the
exchange or transaction of goods and services.

Markets can be physical, like a retail outlet, or virtual, like an e-retailer.

The prices of goods and services in a market are determined by supply

and demand.
 Market structure
Industry competition encourages companies to remain
innovative and provide customers with fair prices. Market
structure is a way to classify and understand businesses
based on the degree of competition they have within their
industry

Market structure, in economics, refers to how different

industries are classified and differentiated based on their
degree and nature of competition for goods and services

A market structure helps us to understand what

differentiates markets from one another.
 The four main types of market structures are

The main difference between different market structures is

the degree of competition in the market.
 Perfect Competition

• Large Number of Buyers and Sellers: Many participants, each

too small to influence market prices.
• Homogeneous Product: Products offered by all firms are
identical.
• Free Entry and Exit: Firms can easily enter or leave the market.
• Perfect Information: All buyers and sellers have complete
knowledge of market conditions.
• Price Taker: Firms are price takers. Firms accept the market-
determined price; they cannot set their own price.
•Examples:
• Agricultural markets (e.g., wheat, rice).
 Monopoly

• Single Seller: One firm dominates the market with complete

control over supply and price

• Unique Product: No close substitutes for the product.

• High Barriers to Entry: Legal, technological, or economic
obstacles prevent other firms from entering.
• Price Maker: The firm has significant control over price.

•Examples:
• Utility companies (e.g., electricity, water in some regions).
 Monopolistic Competition

• Large Number of Sellers: Many firms compete in the market.

• Differentiated Products: Products are similar but not identical

(e.g., branding, quality differences).

• Some Control Over Price: Firms can set prices within a range
due to product differentiation.

• Firms in a monopolistically competitive market have

market power due to product differentiation.

• Free Entry and Exit: Relatively low barriers to entry and exit.

•Examples:
• Restaurants, clothing brands, cosmetic products.
 Oligopoly

• Few Firms: A small number of firms dominate the market.

• Interdependence: Firms consider competitors' actions when
making decisions.
• Differentiated or Homogeneous Products: Products may be
similar (e.g., oil) or different (e.g., cars).
• Significant Barriers to Entry: High costs or other obstacles
limit new firms from entering.
• Price Rigidity: Prices tend to remain stable due to mutual
dependence among firms.
•Examples:
• Automobile industry, airline industry, telecommunications.
 Monopolistic
Feature Perfect Competition Monopoly Competition Oligopoly

Number of Firms Many One Many Few

Product Type Homogeneous Unique Differentiated Both

Price Control None (Price Taker) High (Price Maker) Some Moderate

Barriers to Entry None High Low High

Examples Agriculture Utilities Restaurants, clothing Cars, airlines

 National Income Accounting
National Income Accounting is a technique to measure the
income and production of an economy.

National income accounting refers to the set of methods and

principles that are used by the government for measuring
production and income, or in other words economic activity of a
country in a given time period.

National Income Accounting is a system used by governments,

economists, and researchers to measure and analyze the
economic performance of a country over a specific period.

This system is essential for evaluating policy decisions,

identifying economic trends, and comparing performance
across countries
National income accounting can be used to:
•Identify strengths and weaknesses in the economy

•Compare the economies of different countries

•Assess the standard of living and distribution of income

•Evaluate the effects of economic policies

•Set or modify economic policies, interest rates, and

monetary policy
 Key Metrics in National Income Accounting
The various measures of determining national income are

GDP (Gross Domestic Product),

GNP (Gross National Product),

NNP (Net National Product)

along with other measures such as national Income,

personal income and disposable income
GDP (Gross Domestic Product)
The most important metric that is determined by national income accounting is GDP
or the gross domestic product.

•Definition: The total monetary value or the market value of all final goods and
services that are produced within the geographical boundaries of a country in a
specific time period.

•Types of GDP:

• Nominal GDP: Measured at current market prices and does not account for
inflation.

• Real GDP: Adjusted for inflation to reflect the true value of goods and services.

GDP works as a scorecard that reflects the economic health of a country. It is

calculated on an annual basis. GDP helps in estimating the growth rate of a
country.
Gross National Product (GNP)
Gross national product or GNP is a measure of the total value of all
the finished goods and services that is produced by the citizens of
a country irrespective of their geographic location.
It signifies how much the citizens of a country are contributing to
the economy. It does not include income earned by foreign
nationals within the country
The total value of all goods and services produced by the residents
of a country, including income earned abroad, but excluding
income generated by foreigners within the country.

GNP=GDP + Net Factor Income from Abroad (NFIA)

 Net National Product (NNP)

Net national product or NNP is the total value of all goods

and services that are produced in a country during a
given period of time minus the depreciation.

GNP adjusted for depreciation (the wear and tear of

capital assets)
NNP=GNP−Depreciation
 National Income (NI)

National Income is the total income earned by a country's residents

(citizens and businesses) from both domestic and foreign sources in a
given period. It reflects the income earned by nationals irrespective of
where the production occurs.

Total income earned by nationals after adjustments.

 Personal Income (PI)
•Personal income refers to all income collectively received by all
individuals or households in a country.

•Sources of personal income include money earned from employment-

wages, salaries, interest, dividends and distributions paid by
investments, rents derived from property ownership, and profit
sharing from businesses.

•Personal income is generally subject to taxation.

 Disposable Personal Income (DPI)

The amount of income left with individuals after paying personal

taxes, available for consumption or savings.

Disposable personal income represents what people actually have that

they can spend.
Primary approaches to calculating GDP

GDP can be calculated by the following methods

Value-Added Method,
Income Method
Expenditure Method.
Production/Value-Added) Method
This method calculates GDP by summing the value added at each stage of
production for all goods and services in an economy.
•Steps:
• Identify the gross output (total sales) of goods and services.
• Subtract the value of intermediate goods and services used in production (to avoid
double counting).
• Sum the value added across all sectors of the economy (e.g., agriculture, industry,
and services).
•Formula:

GDP (Value Added) = Gross Output − Intermediate

Consumption
 Income Method

The income method calculates GDP by summing all the incomes

earned by factors of production (land, labor, capital, and
entrepreneurship) within an economy.
Components of Factor Incomes:
1.Wages and Salaries: Compensation to labor.
2.Rent: Income from land or property.
3.Interest: Income from capital (loans, investments).
4.Profit: Earnings of businesses after expenses.

Formula:
National Income = Wages + Rent + Interest + Profits
This is Net National income and to reach the gross income we have
to make some adjustments.
GDP = Wages + Rent + Interest + Profits + Depreciation + Net
Foreign Factor Income
 .
Expenditure Method
This method calculates GDP by summing all expenditures made in the economy.

Four types of spending:

•Components:
• Consumption (C): Spending by households on goods and services.
• Investment (I): Spending by businesses on capital goods (e.g., machinery,
buildings).
• Government Spending (G): Public sector expenditure on goods and services. The
amount of money spent by the government on goods and services, such as
salaries, healthcare, and education
• Net Exports (X - M): The difference between a country's total exports and total
imports

•Formula: GDP=C+I+G+(X−M)
 National income accounting equation

National income accounting equation is an equation that shows the

relationship between income and expense of an economy and other
categories. It is represented by the following equation:

Y = C + I + G + (X – M), where
Y = National income
C = Personal consumption expenditure
I = Private investment
G = Government spending
X = Net exports
M = Imports
Circular flow of income
The circular flow of income is an economic model that
shows how money, goods, and services flow between different
sectors of the economy.

It helps in understanding the interdependence of households, firms,

government, and the external sector in the economic system.

The model can be represented in different ways- two-

sector, three-sector, and four-sector models.
 Two-Sector Model
The simplest circular flow model involves only two
sectors:
Households
Firms

Households are consumers of goods and services and the

owners of the factors of production (land labour, capital,
and enterprise). However, the firm sector produces goods
and services and sells them to households.
 Features
Households:
•Supply factors of production (land, labor, capital, and entrepreneurship)
to firms.

•Receive income in the form of wages, rent, interest, and profit.

•Spend income on goods and services provided by firms.

 Firms
•Produce goods and services using the factors of
production supplied by households.

•Pay households for the use of their factors of production

in the form of rent, wages, interest, and profit.

•Sell goods and services to households.

 Assumptions:
No government or foreign trade.
.
Households spend all their income; there is no saving.

Firms produce only for household consumption

 Three-Sector Model
The three-sector model incorporates the Government into the circular
flow.
The government of a country acts as both a firm and a
consumer. As a firm or producer, the government
produces goods and services for the economy. However,
as a consumer, it spends money on the consumption of
goods and services produced by the firms.
 Features
Households:

•Supply factors of production.

•Pay taxes to the government.
•Receive goods, services, and transfer payments (subsidies, old age
pensions, scholarships, unemployment benefits) from the government.
Firms:
•Pay taxes to the government in the form of direct and indirect taxes.

•Provide goods and services to both households and the government.

•Receive subsidies or payments from the government for certain

activities.

Government:
•Collects taxes from households and firms.

•Provides public goods and services.

•Redistributes income through welfare programs and subsidies.

 Role of Financial Market
The financial market also plays an important role in a
three-sector economy, as the government saves a part of
their earned income and deposits the same in the
financial market. Besides, the government also borrows
money from the financial market so it can meet its
expenditures.
 Four-Sector Model
Besides households, firms, and the government, the
foreign sector also plays a crucial role in an economy.
Therefore, the circular flow in a four-sector economy
consists of households, firms, government, and the
foreign sector

Therefore, the four-sector model that adds the External Sector, capture
the open economy's interaction with global trade.
 Household Sector
The household sector of an economy provides factor services
to the firms, government, and the foreign sector for which it
received factor payments in return. Besides factor payments,
the households also receive transfer payments like old age
pensions, scholarships, etc., from the government.

The household sector spends its earned income on Payments

for goods and services purchased from firms, payments for
imports, and tax payments to the government.

1.Supply factors of production.

2.Consume both domestically produced and imported
goods.
3.Save or invest income in foreign markets.
 Firms

The firms receive revenue for the sale of goods and services from
the government, households, and foreign sectors. They also receive
subsidies from the government to produce goods and services.
Besides, the firms make payments for taxes to the government,
factor services to the households, and imports to the foreign sector.

1.Produce goods and services for domestic and international

markets.
2.Import raw materials or finished goods from abroad.
3.Export goods to foreign markets.
•Government:

•The government receives revenue for the sale of

goods and services, fees, taxes, etc., from the firms,
households, and the foreign sector. It also makes
factor payments to households and spends its revenue
on transfer payments and subsidies.

•It influences international trade through tariffs, subsidies, and

trade agreements.

•Engages in borrowing or lending with foreign entities.

 :
External Sector
•The foreign sector receives revenue for the export of goods and
services from firms, households, and the government. It also makes
payments to firms and the government for the import of goods and
services, and households for the factor services.

•Represents foreign economies.

•Imports represent a leakage from the economy.
•Exports represent an injection into the economy.
 Leakage & Injection
•Leakage
•A withdrawal of income from the flow, such as savings, taxation, and
imports is called leakage.
•Leakages reduce the flow of income.
•Injection

•An introduction of income into the flow, such as additions to

investment, government expenditure, and exports is called injection.
•Injections increase the flow of income.

•The level of injections is the sum of government spending (G),

exports (X), and investments (I).
•The level of leakage or withdrawals is the sum of taxation (T),
imports (M), and savings (S).

The circular flow of income for a nation is balanced when leakage

equals injections.
 Role of Financial
Market
The financial market also plays an important role in a
four-sector economy as the savings made by the
households, firms, and the government gets accumulated
here and this money is invested by the financial market in
the form of loans to firms, households, and the
government. The inflows of money in the financial market
in a four-sector economy are equal to the outflows of
money, which makes the circular flow of income
continuous and complete.
 Comparison of Models

Model Type Number of Sectors Key Components

Simple flow between households

Two-Sector Model 2 (Households, Firms) and firms with no government or
external trade.

Includes taxation and government

Three-Sector Model 3 (Households, Firms, Government)
spending.

4 (Households, Firms, Government, Accounts for international trade

Four-Sector Model
External Sector) and foreign investments.
Importance of the Circular Flow of Income

•Understanding the Economy: Explains the interaction between different sectors.

•Measuring Economic Activity: Helps compute national income, GDP, and other indicators.

•Analyzing Policy Impacts: Shows how government policies (e.g., taxation, subsidies)
affect the economy.

•Global Perspective: Demonstrates the role of international trade in economic growth.

 Keynesian theory of Income determination

Economy must produce goods and services and generate income for its
citizens. For this it must provide employment opportunities. In this
context 2 questions arise:
“How much output should be produced in the economy?”
What should be the level of income and employment?”
John Maynard Keynes a famous economist who pioneered the study of
macro economics in the 1930s has propounded a simple theory of
income and employment to answer these questions. It emphasizes the
role of aggregate demand in driving economic output, particularly in the
short run.
 Key Assumptions
The Keynesian theory of income determination is based on several key assumptions.

1. There exists only 2 sectors--firms and household

2. The model focuses on the short run, where prices and wages are assumed to be fixed or
limited

3. It assumes a closed economy with no international trade (no imports or exports).

4. Aggregate Supply is Perfectly Elastic: Firms are assumed to have unutilized capacity, so
they can increase output without increasing prices. The level of output is determined
solely by aggregate demand, not by supply constraints.

5. Government is assumed to be effective in influencing aggregate demand.

Key Components of Keynesian
Theory
Aggregate Demand
Aggregate demand of an economy is defined as the total demand for goods and
services at the given price level.

AD = C + I
Where, AD = aggregate demand
C = consumption
I = investment
 Aggregate Supply (AS)

•Total output of goods and services produced in an economy.

•.
•In the short run, prices and wages may not adjust fully, leading to
unemployment or inflation when AD changes.
•Assumes that firms adjust output to meet demand since resources are
underutilized in the short run.

•AS = C + S,
S=Saving
Equilibrium Condition:
In the short period, level of national income and so of
employment is determined by aggregate demand and
aggregate supply in the country.

The equilibrium of national income occurs when aggregate

demand is equal to aggregate supply. This equilibrium is also
called effective demand point".

Equilibrium also occurs when savings (S) equals investment (I)

S=I
 Effective Demand
It represents that aggregate demand matches with aggregate supply

Effective demand is the equilibrium between aggregate demand (C+I) and

aggregate supply (C+S).

This equilibrium position (effective demand) indicates that the

entrepreneurs neither have a tendency to increase production nor a
tendency to decrease production.

Keynesian theory of income and employment emphasizes that the

equilibrium level of employment would not necessarily be full employment.
It can be below or above the level of full employment
 Role of Government
•Fiscal Policy: Keynes emphasized government intervention to stabilize the economy
through:
•Increased Spending: Boosts aggregate demand.

•Tax Cuts: Increases disposable income and consumption.

•Effective fiscal policies can address unemployment and stimulate economic recovery.
Aggregate Demand (AD):
•Total demand for goods and services in an economy

AD=C+I+G, where:
• C: Consumption
• I: Investment
• G: Government spending
 Fiscal policy
Fiscal policy refers to the use of government spending and taxation to
influence the economy. It is a key tool of macroeconomic management,
used to achieve specific economic objectives such as
Growth,
Employment,
Price stability and
Equitable distribution of income.
Components of Government Budget
 Revenue Budget
•Revenue Receipts It consists of the money earned by
the government through tax (such as excise duty, income
tax, corporate tax) and non-tax sources (such as dividend
income, profits, interest receipts).

•Revenue Expenditure is the recurring expenditure by

the government which includes salaries, interest
payments, pension, subsidies and administrative
expenses.
 Taxation
•Types of Taxes:

• Direct Taxes: Levied on income or profits (e.g.,

income tax, corporate tax).

• Indirect Taxes: Levied on goods and services

(e.g., VAT, excise duty).
 Capital Budget
•Capital Receipts indicate the receipts which lead to
a decrease in assets or an increase in liabilities of the
government. It consists of: (i) the money earned by selling
assets (or disinvestment) such as shares of public enterprises,
and
•(ii) the money received in the form of borrowings or
repayment of loans by states.
•Capital expenditure is used to create assets or to reduce
liabilities. It consists of: (i) the long-term investments by the
government on creating assets such as roads, schools and
hospitals, and
•(ii) the money given by the government in the form of loans to
states or repayment of its borrowings.
 Fiscal Policy and Budget
Types of Budgets:

Surplus Budget: When a government receives more in taxes than it

spends, it has a budget surplus. OR When revenue exceeds spending
Revenues > Expenditures.

Deficit Budget: When a government spends more than it receives in

taxes, it has a budget deficit or in other words when government spending
exceeds revenue.
Expenditures > Revenues.

Balanced Budget: When a government's spending and revenue are

equal.

Revenues = Expenditures. Rarely used as a fiscal tool.

 Measures of Government Deficit
Revenue Deficit: It refers to the excess of government’s revenue
expenditure over revenue receipts.

Revenue Deficit = Revenue expenditure – Revenue receipts

Fiscal Deficit: Fiscal deficit is the difference between the total revenue
and total expenditure of a government in a financial year.

Fiscal deficit = Total Expenditure – Total revenue (Excluding the

borrowings)
This equals the money the government needs to borrow during the year.
 Goals of Fiscal Policy
•Economic Growth: Stimulate investment and consumption to promote
GDP growth.

•Employment: Reduce unemployment by funding job-creating projects.

•Price Stability: Control inflation and deflation by adjusting demand

levels.

•Redistribution of Income: Use progressive taxation and welfare

programs to reduce income inequality.