1

Dhaka University of Engineering & Technology,

Gazipur
Faculty of Science and Engineering
Department of Humanities and Social Sciences
Section: ()
Trimester: Summer 2017
Lecture Materials
Course Code: HUM 1203; Course Title: Economics
Course Teacher:)

Dept. of Humanities and Social Sciences (HSS)

Dhaka University of Engineering and Technology (DUET)

BASIC CONCEPTS
Definition:
Economics is the study of how societies use scarce resources to produce valuable commodities
and distribute them among different people.

Economics is the study of the production and consumption of goods and the transfer of wealth to
produce and obtain those goods. Economics explains how people interact within markets to get
what they want or accomplish certain goals. Since economics is a driving force of human
interaction, studying it often reveals why people and governments behave in particular ways.ices
to satisfy unlimited human wants.

Economics deals with how the numerous human wants are to be satisfied with limited
resources. Thus, the science of economics centers on want -effort -satisfaction.

Economics
 Analyzes how a society’s institutions and technology affect prices and the allocation of
resources among different uses.
Explores the behavior of the financial markets, including interest rates and stock prices.
 Examines the distribution of income and suggests ways that the poor can be helped without
harming the performance of the economy.
Studies the business cycle and examines how monetary policy can be used to moderate the
swings in unemployment and inflation.
 Studies the patterns of trade among nations and analyzes the impact of trade barriers.
 Looks at growth in developing countries and proposes ways of encourage the efficient use of
resources.
 Asks how government policies can be used to pursue important goals such as rapid economic
growth, efficient use of resources, full employment, price stability and fair distribution of
income.

Macroeconomics:
Is the study of very large, economy-wide aggregate variables such as various indicators
of the levels of total economic activity. Thus macroeconomic analysis is concerned with our
banking and monetary systems and how the levels of gross national product, unemployment,
inflation and economic growth are determined in a society.
Commonly agreed upon goals of macroeconomic policy include.
1) Full Employment
2) Price-Level stability
3) Economic Growth.
Microeconomics:
Microeconomics is concerned with the individual parts of the economy. The allocation of
resources; and how prices, production, and the distribution of income are determined. It is
 2
concerned with the demand and supply of particular goods and services and resources cars,
butter, clothes and haircuts; etc.
Macroeconomics is concerned with the economy as a whole. It is thus concerned with
aggregate demand and aggregate supply. By aggregate demand we mean the total amount of
spending in the economy,
- Where by consumers
- By overseas customers for our exports
- By the government
- Or by firms when they buy capital equipment
- Or stock up on raw materials.
By aggregate supply we mean the total national output of goods and services.

Aneed is something you have to have, something you can't do without. A good example is food.
If you don't eat, you won't survive for long. Many people have gone days without eating, but
they eventually ate a lot of food. You might not need a whole lot of food, but you do need to eat.

Awant is something you would like to have. It is not absolutely necessary, but it would be a good
thing to have. A good example is music. Now, some people might argue that music is a need
because they think they can't do without it. But you don't need music to survive. You do need to
eat.

1) Need is a necessity without which a person cannot exist. E.g; food, water and etc.
2) Want is something that you decide to get but without which you can survive and exist.As car,
Cell phone
3) Demand is a state of mind which drives you towards fulfillment of your need or want.

Wealth: Total of all assets of an economic unit that generate currentincome or have the potential
to generate future income. It includes natural resources and human capital but generally excludes
money and securities because therepresent only claims to wealth. Two commontypes of
economic wealth are (1) Monetary wealth: anything that can be bought and sold, for which there
is market and hence a price. The market price, however, reflects only the commodity price and
not necessarily its value. For example, water is essential for human existence but is usually very
cheap. (2) Non-monetary wealth: things which depend on scarce resources, and for which there
is demand, but are not bought and sold in a market and hence have no price. Examples are
education, health, and defense.
Goods: A consumable item that is useful to people but scarce in relation to its demand, so that
human effort is required to obtain it. In contrast, free goods (such as air) are naturally in
abundant supply and need no conscious effort to obtain them. Economic goods and free goods

Free goods are goods that exist in quantities that are more than sufficient to meet demand at a
zero price. In other words, for a free good, at a zero price, the quantity supplied is larger than the
quantity demanded. The opportunity cost of producing a free good is zero. Examples of free
goods are desert sand and sea water.

Economic goods are goods that exist in quantities that are less than sufficient to meet demand at
a zero price. Thus, economic goods have a positive price. The opportunity cost of producing an
economic good is positive. Examples of economic goods are shoes and computers.

Value:The worth of all the benefits and rights arising from ownership. Two types of economic
value are (1) the utility of a good or service, and (2) power of a good or service to command
other goods, services, or money, in voluntary exchange.

Marketing:The management process through which goods and services move from Producer to
the Customer. It includes the coordination of four elements called the 4 P's of marketing:
(1) identification, selection and development of a product,
(2) determination of its price,
(3) selection of a distribution channel to reach the customer's place, and
(4) development and implementation of a promotional
 3

Price: price is determined by what (1) a buyer is willing to pay, (2) a seller is willing to accept,
and (3) the competition is allowing to be charged. Price is the sum or amount of money or its
equivalent for which anything is bought, sold, or offered for sale

Utility:Ability of a good or service to satisfy one or more needs or wants of a consumer. It

is an abstract concept rather than a concrete, observable quantity. The units to which we assign
an "amount" of utility, therefore, are arbitrary, representing a relative value. Total utility is the
aggregate sum of satisfaction or benefit that an individual gains from consuming a given amount
of goods or services in an economy. Marginal utility is the additional satisfaction, or amount of
utility, gained from each extra unit of consumption.

Production: The processes and methods used to transform tangible inputs (raw materials, semi-
finished goods, subassemblies) and intangible inputs (ideas, information, knowledge) into goods
or services. Resources are used in this process to create an output that is suitable for use or has
exchange value.
Production is a process of combining various material inputs and immaterial inputs (plans, know-
how) 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.
Budget
A budget is a description of a financial plan. It is a list of estimates of revenues to and
expenditures by an agent for a stated period of time. Normally a budget describes a period in the
future not the past.One of the most important administrativetools, a budget serves also as a (1)
plan of action for achieving quantified objectives, (2) standard for measuring performance, and
(3) device for coping with foreseeable adverse situations.
Investment:
Economists mean the production of goods that will be used to produce other goods. This
definition differs from the popular usage, wherein decisions to purchase stocks or BONDS are
thought of as investment. Money committed or property acquired for future income.
Two main classes of investment are (1) Fixed income investment such as bonds, fixed deposits,
preference shares, and (2) Variable income investment such as businessownership (equities), or
property ownership. In economics, investment means creation of capital or goods capable of
producing other goods or services.
Wants and Needs:
Economics, both macro and microeconomics, is about the satisfaction of material wants.
It is necessary to be quite clear about this; it is people’s wants rather than their need which
provide the motive for economic activity. We go to work in order to obtain an income which will
buy us the things we want rather than the things we need. It is not possible to define ‘need’ in
terms of any particular quantity of a commodity, because this would imply that a certain level of
consumption is right for an individual.
It is assumed that individuals wish to enjoy as much well-being as possible and if their
consumption of food, clothing entertainment and other goods and reveries is less than the amount
required to give them complete satisfaction they will want to have more of them.

Scarcity:
Resources are scarce when they are insufficient to satisfy peoples wants. Scarcity is a
relative concept. It relates the extent of peoples wants to their ability to satisfy those wants.

Resources:
The resources of a society consist not only of the free gifts of nature such as land, forests
and minerals, but also human capacity, both mental and physical, and of all sorts of man-made
aids to further production, such as tools, machinery, and buildings.
Resources are divided into three main groups.
(1) all those free gifts of nature, such as land, forests and minerals etc commonly called
natural resources and known to economist as land.
(2) all human resources, mental and physical, both inherited and acquired, which
economist call labour.
 4
(3) all those man-made aids to further production, such as tools, machinery, and factories,
which are used up in the process of making other goods and services rather than being consumed
for their own shake, which economist call capital.
Often a fourth resource is distinguished. This is entrepreneur ship from the French word
entrepreneur meaning who undertakes task.
Entrepreneurs take risks by introducing both new products and new ways of making old
products. They organize the other factors of production and direct them along new lines.

Collectively these resources are called factors of production.

Consumption: The act of using these goods and service to satisfy wants is called consumption.
This will normally involve purchasing the goods and services.

Positive economics and normative economics:

Positive economics describes the facts of an economy while normative economics
involves value judgments.
Positive economics deals with the questions such as: why do doctors earn more than
rickshaw puller? Does free trade raise or lower the wages of most Americans? What is the
impact of computers on productivity?
Normative economics involves ethical precepts and norms of fairness. Should poor
people be required to work if they are to get government assistance? Should unemployment be
raised to ensure that price inflation does not become too rapid? Should United states breakup
Microsoft because it has violated the antitrust laws? There are no right or wrong answers to these
questions because they involve ethics and values rather than facts. They can be resolved only by
political debate and decisions not by economic analysis alone.

THE THREE PROBLEMS OF ECONOMIC ORGANIZATION:

Choice:
Because resources are scarce, choices have to be made. There are three main categories
of choices that must be made in the society.

What commodities are produced and in what quantities? A society must determine how
much of each of the many possible goods and services it will make and when they will be
produced. How many curs, how much wheat, how much insurance, how many coats etc. will be
produced? Will we use scarce resources to produce many consumption goods (like pizza)? Or
will we produce fewer consumption goods and more investment goods (like pizza-making
machines). Which will boost production and consumption tomorrow.

How are things going to be produced, given that there is normally more than one way of
producing things? What resources are going to be used and in what quantities? What techniques
of production are going to be adopted? Will cars be produced by robots or by assembly line
workers? Will electricity be produced from coal, oil, gas, nuclear fission, renewable resources or
a mixture of these.

For whom are things going to be produced? In other word, how is the nation’s income going
to be distributed? Are many people poor and few rich? Is the distribution of income and wealth
fair and equitable? All societies have to make these choices, whether they be made by
individuals, by groups or by government.

Choice and opportunity cost:

Choice involves sacrifice. The more food you choose to buy, the less money you will
have to spend on other goods. The more food a nation produces, the fewer resources will there be
for producing other goods. In other words the production or consumption of one thing involves
the sacrifice of alternatives. This sacrifice of alternative in the production or consumption of a
good is known as its opportunity cost.
If the workers on a firm can produce either 1000 tones of wheat or 2000 tones of barley,
then the opportunity cost of producing 1 tone of wheat is the 2 tones of barley forgone. The
opportunity cost of buying a textbook is the new pair of jeans you also wanted that you have had
 5
to go without. The opportunity cost of working overtime is the leisure you have sacrificed. So we
can define Opportunity Cost as The cost of any activity measured in terms of the best
alternative forgone.

SCARCITY, CHOICE AND OPPORTUNITY COST

Although resources are limited, human wants are unlimited. Scarcity is the situation where
limited resources are insufficient to produce goods and services to satisfy unlimited human
wants. Scarcity necessitates choice. In other words, due to scarcity, society must choose what
goods and services to produce. The opportunity cost of a course of action is the benefit forgone
by not choosing its next best alternative. When a choice is made, an opportunity cost is incurred.
In other words, when society chooses what goods and services to produce, it is choosing what
goods and services not to produce

Production possibility curve:

A curve showing all the possible combination of two goods that a country can produce
within a specified time period with all its resources fully and efficiently employed.
The production possibility frontier is one of the simplest models of an economy. Three critical
assumption underlie this graphical model:
1. The amounts of the various factors of production are fixed.
2. Technology is assumed constant.
3. All resources are fully and efficiently employed.
Economics is the study of scarcity the study of the allocation of scarce resources to satisfy
human wants. Scarcity is a fundamental problem for every society. Decision must be made
regarding
What to produce?
How to produce and
For whom to produce.
What to produce involves decisions about the kinds and quantities of goods and services to
produce. How to produce requires decisions about what techniques to use and how the economic
resources are to be combined in producing output. And for whom to produce involves decisions
on the distribution of output.
Decisions on what to produce and how to produce involve opportunity costs. An opportunity cost
is what is sacrificed to implement an alternative action i.e. what is given up to produce or obtain
a particular good or service.
The production possibility frontier:
A production possibility frontier shoes the maximum amount of alternative combinations
of goods and services that a society can produce at a given time when there is full utilization of
economic resources and technology.

The Guns Butter

following table (thousand (million
present alternative units) units)
combination of guns P
GUNS (Thousands of units)

and butter output for 1

0
a hypothetical
economy.Alternative
output C
A 0 20 5
B 2 18
C 5 14
D 9 6
E 10 0 P
0
1 2
4 0
Butter (millions of
units)
 6
The curve labeled pp© is called the production possibility frontier. Point C on the
production possibility curve represents a position of full emolument of the economy’s resources
and full use of its technology; A at point C, 5000 guns and 14 million units of butter are
produced.
The production possibility frontier depicts not only limited productive capacity but also
the concept of opportunity cost. When an economy is on the production possibility curve such as
at point C, gun production can be increased only by decreasing butter output. Thus to move from
alternative C to alternative D, 8 million fewer units of butter are produced in order to increase
gun production 4000 units. The opportunity cost of the additional 4000 units of gun production is
8 million units of butter.
Points on a production possibility frontier are efficient because all the available resources
are utilized and there is full use of existing technology. Points within a production possibility
frontier are inefficient because some resources are either unemployed or underemployed. Points
outside the production possibility frontier are unattainable since the production possibility
frontier defines the maximum output that can be produced at a given time.

Shift in production possibility curves:

The production possibility frontier shifts outward over time as more resources become
available and/or technology is improved. The growth in the economy’s productive capability is
depicted in the figure below by an outward shift of the production possibility frontier from ppto
p© p©.

p
©
Guns

O p
p© But
A country’s ability to produce more goods and services
ter of all types depends upon
changes such as an increase in the labour force, an increase in the stock of capital goods
(factories, power, stations, transport networks, machinery etc.) and or an increase in technical
knowledge.
The production possibility curve can also shift inwards to the left if a country’s
production potential declines. This could occur due to war or a natural disaster which reduces a
country’s resources. This is shown in figure below by a downward shift of the production
possibility frontier from ppto p© p©.

p©
Guns

P
O p
Butter

Production possibility schedule:

A production possibility schedule present the alternative combinations of two goods that
society can produce, assuming that all its resources and the best technology available are used.
 7
The following table presents a production possibility schedule for a hypothetical economy which
produces only food and clothing.
Production possibility schedule:

Alternative or Point Units of Food (millions) Units of clothing (thousand)

A 0 8
B 1 7.5
C 2 6.5
D 3 5.0
E 4 3.0
F 5 0.0
The above table shows that this economy can produce either no food and 8 thousand units of
clothing 1 million units of food and 7.5 thousand units of clothing, 2 million units of food and
6.5 thousand units of clothing, 3 million units of food and 5 thousand units of clothing, 4 million
units of food and 3 thousand units of clothing or 5 million units of food and no clothing. Since
we assume that society is utilizing all its resource and the best technology, this society can
produce more units of food only by releasing economic resource from clothing production and
thereby production less clothing.

Characteristics of Economics
Free Markets
Markets are allowed to operate without a lot of interference, or meddling, from the government
Private Property
Individuals and businesses have the right to own personal property as well as the means of
production without a lot of government interference.
Profit
Earnings (money) after all expenses are paid.
Competition
Rivalry between producers of a good or service, results in higher quality goods and lower prices.
Capitalist Economy:
The main features of a capitalist economy are as follows:
(a) Factors of production are owned by the individuals.
(b) Every individual has freedom to start business of his own choice.
(c) All economic activities are guided by the motive of profit.
(d) Individuals are the owners and acquire property and pass it on to next heir after death.
(e) Government has little role to play in the functioning of the economy. (/) Prices of goods and
services are determined by the market forces of demand and supply.
Mixed Economy
Mixed economy is a combination of market economy as well as government planning. It has
both private sector and public sector. Some businesses are owned by private individuals while
some businesses are owned by the government. India, Indonesia is examples of mixed
economies. Mixed economy attempts to overcome the disadvantages of a market economic
system by using government intervention to control or regulate different markets.
Characteristics of a mixed economy are:
 to possess means of production (farms, factories, stores, etc.)
 to participate in managerial decisions (cooperative and participatory economics)
 to travel (needed to transport all the items in commerce, to make deals in person, for
workers and owners to go to where needed)
 to buy (items for personal use, for resale; buy whole enterprises to make the organization
that creates wealth a form of wealth itself)
 to sell (same as buy)
 to hire (to create organizations that create wealth)
 to fire (to maintain organizations that create wealth)
 to organize (private enterprise for profit, labor unions, workers' and professional
associations, non-profit groups, religions, etc.)
 8
 to [communicate (free speech, newspapers, books, advertisements, make deals, create
business partners, create markets)
 to protest peacefully (marches, petitions, sue the government, make laws friendly to
profit making and workers alike, remove pointless inefficiencies to maximize wealth
creation)
 private sector business activity encouraged.
 state control resources in supply of certain goods and services.
 taxes used to collect revenue to pay for state goods and services.
Market Economy/Free Market Economy
Features
 All the resources in a market economy are privately owned by people and firms.
 Every business will aim to make as much profit as possible i.e. profit is the main motive.
 There is consumer sovereignty.
 Firms will only produce those goods which consumers want and are willing to pay for.
 Price is determined through the price mechanism
Advantages
 Market economies responds quickly to people’s wants
 Factors of production which are profitable will only be employed.
 There is wide variety of goods and services in the market.
 New and better methods of production are encouraged thus leading to lower cost of goods
and services.
Disadvantages
 Public goods may not be provided for in Market economy, thus the government will have
to interfere to provide these types of goods.
 Market economies encourage consumption of harmful goods
 Prices are determined by the demand and supply of goods.
 Social cost may not be considered while producing goods and services.It may lead to
unemployment because machines will be more productive than men.
Planned Economy/ Command Economy
Features
 Government decides how all scarce resources were to be used.
 Government will decide what is to be produced, how much to be produced and how much
should be charged for goods and services.
 The economy only has Public Sector.
Advantages
 There is no competition between firms thus resulting in less wastage.
 Government ensures that everybody is employed.
 Less gap between poor and rich
Disadvantages
 No incentives for businesses to produce.
 Production of goods is decided by government thus there is no consumer sovereignty.
 Businesses usually are less efficient because of lack of profit motive.

DEMAND

The demand for a commodity is its quantity which consumers are able and willing to buy at
various prices during a given period of time. So, for a commodity t have demand
the consume must possess willingness to buy it.
the ability or means to buy it
and it must be related to per unit of time i.e, per day, per week, per month or per year.
The amount of a product that consumers wish to purchase is called the quantity
demanded. Quantity demanded is a desired quantity. It is how much consumer’s wish to
purchase, not necessarily how much they actually succeed in purchasing.

Types of Demand Economics

 9
Composite
Composite demand refers to a good that has multiple purposes and satisfies different needs. It
influences how the market allocates a good with numerous uses. For example, cattle provide
leather, milk and meat. If the demand for milk increases, the production of leather and meat will
decrease.
Derived
Derived demand refers to the relationship between the resources used to produce a good or
service, called factors of production, and the finished product or service sold on the market. The
factors of production include land, labor and capital. As demand for the finished product
increases, demand for the resources used to produce that good increases. However, decreased
demand for the final product reduces demand for the factors of production. For example, an
increase in the demand for cars increases automobile manufacturers' demand for labor in
assembly plants.
Competitive
Competitive demand is the demand for products that are competing for sales. People can
substitute one competing product for another. If the demand for one product increases, the
demand for its competitor will decrease. For example, Coke and Pepsi are competing soft drinks.
If the price of Pepsi drops below that of Coke, consumer demand for Pepsi will increase while
the demand for Coke decreases.
Complementary
Complementary demand, also called joint demand, occurs when two products are necessary to
meet one demand. A change in the demand for one of these goods causes a similar change in
demand for the other product. For example, cars need gasoline or diesel fuel. An increase in the
demand for automobiles leads to an increase in the demand for fuel.
Demand function:
An equation which shows the mathematical relationship between the quantity demanded of a
good and the values of the various determinants of demand. Demand function is an algebraic
expression of the demand schedule expressed either in general terms or with specific numerical
values expressed for the various parameters, and usually including all factors affecting demand.
In other words demand function shows the functional relationship between quantity demanded of
a commodity and the factors influence the demand for that commodity. The demand function can
be expressed as : Q XD  ( Px, P1 ------Pn, Y, T, S)
Where
Q XD  Quantity demanded X (X=any commodity)
Px = Price of X
P1----Pn= Prices of related commodities
Y = Consumer’s income and wealth.
T = Consumer’s taste
S = Various sociological factors.
Demand schedule and demand curve:
A demand schedule is one way of showing the relationship between quantity demanded
and price. It is a numerical tabulation that lists some selected prices and shows the quantity that
will be demanded at each.
The following table is an individuals hypothetical demand schedule for carrots. It shows
the quantity of carrots that the individual would demand at six selected prices.
An individual consumer’s demand schedule for carrots:
Reference letter Price (Tk per kg) Quantity demanded (Kg per
month)
A 1 80
B 2 60
C 3 40
D 4 30
E 5 20
F 6 10
For example, at price Tk 4 per kg, the quantity demanded is 30 kg per month. Each of the price-
quantity combination in the table is given a letter for easy references.
Demand curve: A graph showing the relationship between the price of a good and the quantity
of the good demanded over a given time period. Price is measured on the vertical axis; quantity
 10
demanded is measured on the horizontal axis. On the other hand, a demand curve is the graphical
representation of the demand schedule.

6 F
5 E
4 D
Pric
e
C
3
B
2
A
1
0
10 20 30 40 50 60 70 80
Quantity Demanded
The above curve shows the quantity of carrots that the consumer would like to buy at every
possible price; Its negative slope indicates that the quantity demanded increases as the price falls.
A single point on the demand curve indicates a single price-quantity relation. The whole
demand curve shows the complete relation between quantity demanded and price.
Law of demand:
A basic economic hypothesis is that the lower the price of a product, the larger the
quantity that will be demanded, other things being equal.
The quantity of a good demanded per period of time will fall as price rises and will rise as
price falls, other things being equal. (ceteris paribus)
Determinations of demand:
Factors which determine the level of demand for any commodity are as follows:
1. Price: The higher the price of a commodity the lower the quantity demanded. The lower
the price the higher the quantity demanded.
2. Taste: The more desirable people find the good, the more they will demand. Tastes are
affected by advertising, by fashion, by observing other consumers, by considerations of
health and by the experience from consuming the good on previous occasions.
3. The number and price of substitute goods: The higher the price of substitute goods. the
higher will be the demand for this good, as people switch from the substitutes. For
example the demand for tea will depend upon the price of coffer. If the price of coffee
goes up the demand for tea will rise.
Substitute Goods are 1. Tea and Coffee 2.Coke and Pepsi 3. Pen and Pencil
ComplementaryGoods: Vitamin C and Amloke, Water and Juice
4. The number and price of complementary goods: Complementary goods are those that
are consumed together: Cars and petrol, shoes and polish, fish and chips. The higher the
price of complementary goods, the fewer of them will be bought and hence the less will
be the demand for these goods. For example, the demand for matches will depend on the
price of cigarettes. If the price of cigarettes goes up, so that fewer are bought, the demand
for matches will fall.
5. Income: As people’s income rise, their demand for most goods will rise. Such goods are
called normal goods. As people get richer, they spend less on inferior goods, such as
cheap margarine, and switch to better quality goods.
A rise in consumer’s income shifts the demand curve for normal products to the right and
for inferior goods to the lift.
6. Distribution of income: If national income were redistributed from the poor to the rich,
the demand for luxury goods will rise. At the same time, as the poor got poorer, they
might have to turn to buying inferior goods, whose demand would thus rise too.
7. Expectation of future price change: If people think that prices are going to rise in the
future, they are likely to buy more now before the price does go up.
8. Advertising: Advertising is a powerful instrument affecting demand in many markets. In
highly competitive markets, a successful advertising campaign will move the products
demand curve to the right.
 11
9. The availability of credit: If developed countries the demand for many durable
consumer goods depend very much on the provision of credit facilities. Any changes in
the terms on which this type of finance can be obtained will have a marked effect on the
demand for such things as motor cars, electrical appliances, furniture, and other types of
household equipment. A similar situation applies in the housing market since the
overwhelming majority of houses purchased with borrowed funds.
10. Changes in population: The influence of this factor is of a longer term nature unless the
change comes about by large-scale migration. Changes in the total population and
changes in the age distribution will affect both the total demand for goods and services
and the composition of that demand. For instance, a fall in the death rate will increase
demand for residential homes, for greater health care for the elderly, etc.
11. Sociological variables: Changes in the many sociological variables that influence
demand will cause demand curve to shift. For example, a reduction in the typical number
of children per consumer, as happened in this century, will reduce the demands for many
of the things used by children. If the typical age of retirement falls significantly, there
will be a rise in the demands for goods consumed during leisure time and a fall in the
demands for goods required while working.
Shifts in the demand curve:
An increase in demand means that the whole demand curve has shifted to the right; A
decrease in demand means that the whole demand curve has shifted to the left.

D
D
1
D o
2
Price

O
Quantity
A shift in the demand curve from Do to D1 indicates an increase in demand, a shift from Do to D2
indicates a decrease in demand.
An increase in demand means that more is demanded at each price. Such a rightward shift can
be cause by
1. a rise in the price of a substitute
2. a fall in the price of a complement
3. i) a rise in income, for normal goods
ii) income declines, for inferior goods,
4. a redistribution of income toward groups who favor the commodity.
5. a change in taste that favors the commodity.
6. The number of buyers increases.
7. Income or price expectation decreases.
A decrease in demand means that less is demanded at each price. Such a leftward shift can be
caused by
(1) a fall in the price of a substitute
(2) a rise in the price of a complement.
(3) i) a fall in income, for normal goods
ii) a rise in income for inferior goods
(4) a distribution of income away from groups who favor the commodity.
(5) a change in taste that disfavors the commodity.
(6) the number of buyers decreases.
(7) income or price expectations increases.
Change in quantity demanded:
Movements along a demand curve can be referred to as extensions and contractions in demand or
changes in quantity demanded.
In the above figure an extension in demand from OQ to OQ1, results from a decrease in price
from OP to OP1. This can also be referred to as an increase in the quantity demanded.
Price
 12

The above figure shows a contraction in demand from OQ to OQ1 due to rise in price from OP to
OP1.
A movement down a demand curve is called an increase in the quantity demanded. a
movement up the demand curve is called a decrease in the quantity demanded.
Movements along demand curves versus shifts:

P3
Price

Price

P2 C
A B
Po
B
D1
Do
P
O 1 q3 qo q2 q1
A
Quantity

A rise in demand means that more will be bought at each price, but it does not mean that more
will be bought under all circumstance.
O The demand curve is originally Do and price is Po, at
Q
which qo is bought (Point A). Demand then
1 Q increase to D1. At the old price of Po, the quantity
demanded in now q1 (Point B). Assume that, the priceQuantity
rises to above Po. This causes the quantity
Demanded
demanded to be reduced to below q1. The net effect of these two shifts can be either an increase
or decrease in the quantity demanded. If the price rises to P2, the quantity demanded of q2 still
exceeds the original quantity qo (point C); while a rise in price to P3 leaves the final quantity of
q3 (Point D) below the original quantity of qo.

Causes of Downward Sloping Demand Curve:

Why does a demand curve slope downward from left to right? The reasons for this also
clarify the working of the law of demand. The following are the main
Reasons for the downward sloping demand curve:
(1) The law of demand is based on the law of Diminishing Marginal Utility. According to
this law, when a consumer buys more units of a commodity, the marginal utility of that
commodity continues to decline. Therefore, the consumer willbuy more units of that commodity
only when its price falls. When less units are available, utility will be high and the consumer will
be prepared to pay more for the commodity. This proves that the demand will be more at a lower
price and it will be less at a higher price. That is why the demand curve is downward sloping.
(2) Every commodity has certain consumers but when its price falls, new consumers start
consuming it, as a result demand increases. On the contrary, with the increase in the price of the
product, many consumers will either reduce or stop its consumption and the demand will be
reduced. Thus, due to the price effect when consumers consume more or less of the commodity,
the demand curve slopes downward.
(3) When the price of a commodity falls, the real income of the consumer increases because
he has to spend less in order to buy the same quantity On the contrary, with the rise in the price
 13
of the commodity, the real income of the consumer falls. This is called the income effect. For
instance, with the fall in the price of milk, he will buy more of it but at the same time. He will
increase the demand for other commodities. On the other hand, with the increase in the price of
milk he will reduce its demand. The income effect of a change in the price of an ordinary
commodity being positive, the demand curve slopes downward.
(4) The other effect of change in the price of the commodity is the substitution effect. With
the fall in the price of a commodity; the prices of its substitutes remaining the same, consumers
will buy more of this commodity rather than the substitutes. As a result, its demand will increase.
On the contrary, with the rise in the price of the commodity (under consideration) its demand
will fall, given the prices of thesubstitutes. For instance, with the fall in the price of tea, the price
of coffee being unchanged, the demand for tea will rise, and contrariwise, with the increase in
the price of tea, its demand will fall.
(5) There are persons in different income groups in every society hut the majority is in low
income group. The downward sloping demand curve depends upon this group. Ordinary people
buy more when price falls and less when price rises. The rich do not have any effect on the
demand curve because they are capable of buying the same quantity even at a higher price.
(6)There are different uses of certain commodities and services that are responsible for the
negative slope of the demand curve. With the increase in the price of such products, they will be
used only for more important uses and their demand will fall. On the contrary, with the fall in
price, they will be put to various uses and their demand will rise. For instance, with the increase in
the electricity charges, power will be used primarily for domestic people will use power for
cooking, fans, lighting, but if the charges are reduced, people will use power cooking, fans,
heaters, etc.
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
lesswhen price falls.
Many causes are attributed to an upward sloping demand curve.
(i)War:If shortage is feared in anticipation of war, people may start buying for building
stocks or for hoarding even when the price rises.
ii)Depression:During a depression, the prices of commodities are very low and the demand
for them is also less. This is because of the lack of purchasing power with consumers.
(iii) Habit:if someone is habituated in consuming any commodity and the price of that
product goes up, he doesn’t reduce the consumption.
(iv) Gffen Paradox. If a commodity happens to be a necessity of life like wheat and its
price goes up, consumers are forced to curtail the consumption of more expensive foods like
meat and fish, and wheat being still the cheapest food they will consume more of it. The
Marshallian example is applicable to developed economies. It the case of an underdeveloped
economy, with the fall in the price of an inferior commodity like maize, consumers will start
consuming more of the superior commodity like wheat. As a result, the demand for maize will
fall. This is what Marshall called the Gffen Paradox which makes the demand curve to have a
positive slope.
(v) Demonstration Effect.If consumers are affected by the principle of conspicuous
consumption or demonstration effect, they will like to buy more of those commodities which
confer distinction on the possessor, when their prices rise. On the other hand, with the fall in the
prices of such articles, their demand falls, as is the case with diamonds.
(vi) Ignorance Effect. Consumers buy more at a higher price under the influence of the
“ignorance effect”, where a commodity may be mistaken for some other commodity, due to
deceptive packing, label, etc.
(vii) Speculation.Marshall mentions speculation as one of the important exceptions to the
downward sloping demand curve. According to him, the law of demand does not apply to the
demand in a campaign between groups of speculators. When a group unloads a great quantity of
a thing on to the market, the price falls and the other group begins buying it. When it has raised
the price of the thing, it arranges to sell a great deal quietly. Thus when price rises, demand also
increases.
(viii) Very rich people: Law of demand does not work for the very rich people because he
can purchase whatever he wants. A millionaire doesn’t have any effect on the increase in the
 14
price rice or any commodity
Market demand:The market demand for a commodity gives the alternative amounts of the
commodity demanded per time period, at various alternative prices, by all the individuals in the
market. The market demand for a commodity thus depends on all the factors that determine the
individuals demand and in addition, on the number of buyers of the commodity in the market.
Geometrically the market demand curve for a commodity is obtained by the horizontal
summation of all the individuals demand curves for the commodity. Suppose there are three
individuals A, B and C in a market who purchase the commodity. The demand schedule for the
commodity in depicted in the following table.
Market demand schedule:
Prices perkg (Tk)(1) Quantity demanded (Per unit of time)
Individual A(2) Individual B(3) Individual C (4) Total
Demand(5)
6 9 18 30 57
5 10 20 32 62
4 12 24 36 72
3 16 30 45 91
2 22 40 60 122
1 30 60 110 200
The last column (5) of the table represents the market demand of the commodity at various
prices. It is arrived at by adding columns (2), (3) and (4) representing the demand of consumer
A, B and C respectively. The relation between column (1) and (5) shows the market demand
schedules. When the price is 6tk per kg then the market demand for the commodity is 57 kgs. As
price falls demand increases. When the price is 1 Tk per kg the market demand is 200 kgs. This
is shown in figure below.

6 . . . .
5
. . . .
4 . . . .
3 . . . .
2 . . . .
1 . DA . DB . DC .D X =DA+ DB +DC

0
. . . . . . . .
20 40 60 80 100 120 140 160
. .
180 200

Demand equations:
We can represent the market demand for a good and the determinants of demand in the
form of an equation. This is called a demand function.
Demand equations are often used to relate quantity demanded to just one determinant.
Thus an equation relating quantity demanded to price could be in the form: Qd = a – bP
For example, the actual equation might be for commodity X is –
Q XD  8  PX , (ceteris paribus.)
By substituting various prices of X into this demand function we get individuals demand
schedule shown in table below
PX 8 7 6 5 4 3 2 1 0
Q XD 0 1 2 3 4 5 6 7 8
Plotting each pair of values as a point on a graph and joining the resulting points, we get the
individuals demand curve for commodity X. as shown in figure below.
 15
PX

0 8 QX
If there are 1000 identical individuals in the market each with the demand for commodity x given
by Q dX  8  PX ceteris paribus, the market demand schedule and the market demand curve for
commodity X are obtained as follows.
Q dX  8  PX cet. par. (individual’s dx)
QDx = 1000 ( QDX ) cet. par. (Market DX)
QDx= 8000-1000 Px
PX 8 7 6 5 4 3 2 1 0
Q XD 0 1000 2000 3000 4000 5000 6000 7000 8000

PX

0 400 800 Q XD
Estimated demand equations:
Using statistical techniques called regression analysis, a demand equation can be
estimated. Assume that the demand for butter (measured in 250g units) depended on its price
(Pb), the price of margarine (Pm) and total annual consumer income (Y). The estimated weekly
demand equation may than be something like.
Qd  2000000  50000 Pb  20,000 Pm 0.01 Y
If price of butter were 50 p, the price of margarine were 35 p and consumer income were α 200
million and Pband Pm were measured in pence and Y were measured in pounds. then the demand
for butter would be
Qd  2000000  (50000  50)  (20,000  35)  0.01 20000000
 2000000  2500000  700000  2000000
= 2200000
Demand for butter:
Let us look at how the demand for butter is affected by the other factors –
 Taste: if it is heavily advertised, demand is likely to rise, on the other hand, if there is a
cholesterol scarce people may demand less for health reason.
 Substitute: If the price of margarine goes up, the demand fro butter is likely to rise as people
switch from one to other.
 Complement: If the price of bread goes up, people will buy less bread and hence less butter to
spread on it.
 Income: if peoples income rises, they may well turn to consuming butter rather than
margarine or feel that they can afford to spread butter more thickly on bread.
 Income distribution: If income is redistributed away from the poor, they may have to give up
consuming butter and buy cheaper margarine instead, or simply buy less butter and be more
economical with the amount they use.
 16
 Expectation: if it is announced in the news that butter prices are expected to rise in the near
future, people are likely to buy more now and stock up their freezer while current prices last.
A real-world demand function:
The following is an estimate of the UK’s market demand curve for butter. It has been
estimated from actual data for the years 1969-91.
Qd = 283.8 – 35.4 Pb+ 89.1 Pm – 1.96 Y
Where
Qd = quantity of butter sold in grams per person per week
Pb = real price of butter i.e. the price of butter in pence per kg, divided by the real
price index (RPI) (1980 = 100)
Y = real personal disposable income of household that other determinants of demand
have not changed. But one of the other factor did change. This was taste – during 1970s and
1980s there was a massive shift in demand from butter to margarine,
- perhaps for health reason
- perhaps because of the advent of ‘easy to spread’ margarines.
- perhaps because of an improvement in the flavour of margarines
The following table shows this shift.
Consumption of butter, margarine and spreads.
(grams per person per week)
Butter Margarine Low-fat spreads
1969 174 79 --
1987 61 113 31
1994 39 43 74
Assuming that this shift in taste took place steadily over time, a new demand equation was
estimated for the same years.
Qd = 321.4 – 38.5 Pb + 16.1 Pm – 0.38 Y – 5.21 TIME
Where the TIME term is as follows: 1969 = 1, 1970 = 2, 1971 = 3 etc.
It mid 1980s a new substitute entered the market: low-fat spreads. These have not been on the
market long enough to estimate a new demand equation, but clearly they have shifted the
demand curve for butter.
* Here they assume that
SUPPLY
Supply refers to the amounts of product that producers are willing to sell under various
conditions during a given period. The amount of a product that firms are able and willing to offer
for sale is called the quantity supplied. Supply is a desired flow: how much firms are willing to
sell per period firms are willing to sell per period of time, not how much they actually sell.
Supply schedule and supply curve:
Supply schedule is a table showing the different quantity of a good that producers are
willing and able to supply at various prices over a given time period. A supply schedule can be
for an individual producer or group of produces, or for all producers.
Supply function:
An equation which shoes the mathematical relationship between the quantity supplied of
commodity and the values of the various determinants of supply. The quantity of a commodity
that a single producer is willing to sell over a specific time period is a function of price and is
expressed as
QSX   (PX ) (Ceteris paribus)
Where
QSX  Quantity supplied X (X = any commodity)
PX  Price of X
This is the simplest form of representing the supply function. Here other factors that influence
supply are kept constant. We can write the supply function in a complex way by considering
other factors that influence supply. i.e
QSX   ( PX , P1 ........Pn , T, W, Tax , P1 .........Pn )
Here
Pi1.............Pin  Price of inputs
 17
P1 .............Pn  Price of othercommo dities
T = Technology
Tax = Taxation and Subsidy
In order to get a producers supply schedule and supply curve of a but price
commodity, we Keep all the factors constants while varying the price of the commodity. We get
individual producer’s supply schedule and supply curve.
Suppose that a single producer’s supply function for commodity X is
Q sx   40  20 Px (Ceteris Paribus)
By substituting various relevant price of X into this supply function we get producers supply
schedule. as shown in table below.
Supply Schedule:
Px 6 5 4 3 2
Qx 80 60 40 20 0
plotting each point of values from the Supply Schedule on graph and joining the resulting points
we get the producers supply carve on shown below:

Px($)

. . Sx

6
5

. .
.
4
3
2
1
0
20 40 60 80 QSx

The higher the price, the greater will be the quantity of a commodity that will be supplied a
producer and vice versa . The relationship between price and quantity Supplied is direct and
positive.
Law of supply:
The general relationship between price and supply is, when the price of a good rises, the
quantity supplied will also rises. There are three reasons for this
1. As firms supply more, they are likely to find that beyond a certain level of output, cost
rise more and more rapidly. That is why they are interested to supply more at higher
prices.
2. The higher the price of the good, the more profitable it becomes to produce, Firms will
thus be encouraged to produce more of it by switching from producing less profitable
goods.
3. Given time, if the price of a good remains high, new producers will be encouraged to set
up in production. Total market supply thus rises.
The law of supply states that, other things being equal, the quantity supplied varies directly
with the price of the commodity. When price rises, the quantity supplied rises, the quantity
supplied rises and when the price falls the quantity supplied also falls. Other things being equal
refer to the factors that influence the market supply of a commodity. All these factors are
assumed to be constant.
The law of supply is explained with the help of a schedule and a curve. A supply
schedule is a statement of the various quantities of a given commodity offered for sale at various
prices per unit of time. The following table shows a hypothetical supply schedule for apples.
 18
Supply schedule for apples:
Reference letter Price in Tk per Kg Quantity supplied in kg per month
A 50 400
B 40 300
C 30 200
D 20 100
E 10 50
If we depict this schedule on a diagram we have a supply curve as shown in figure below.
The supply curve has a positive slope. It moves upward to the right price is measured on the
vertical axis and quantity supplied on the horizontal axis. At price 30 Tk per kg quantity supplied
is 200 kg per month.

Supply curve

60
40
Price

Px
20
0
0 200 400 600
Quantity

Determinants of supply:
FACTORS INFLUENCING SUPPLY:
(i) The supply of a commodity depends upon the goals of firms: If producers of
some commodity want to sell as much as possible, even if it costs them some
profits to do so more will be sold of that commodity than if they wanted to make
maximum profits. If producers are reluctant to take risks we expect small
production of any good the production of which is risky. In elementary economic
theory we assume the goal of the firm is to make as much profit as is possible.

(ii) The supply of a commodity depends upon the price of that commodity: Ceteris
paribus, the higher the price of the commodity the more profitable will it be to make the
commodity. We expect, therefore, that the higher the price, the greater will be the quantity
supplied.
(iii) The supply of a commodity depends upon the prices of all other commodities:
Generally, an increase in the price of other commodities will make production of the commodity
whose price does not rise relatively, less attractive than it was previously. We thus expect that,
ceteris paribus, the supply of one commodity will fall as the prices of other commodities rise.
(iv) The Supply of a commodity depends upon the prices of factors or production: A
rise in the price of one factor of production will cause a large increase in the costs of making
those goods that use a great deal of that factor, and only small increase in the costs of producing
those commodities that use a small amount of the factor. For example, a rise in the price of land
will have a large effect on the costs of producing wheat and only a very small effect on
producing motor vehicles. Thus a change in the price of one factor of production will cause
changes in the relative profitability of different lines of production and this will cause change in
the supplies of different commodities.
(v) The supply of a commodity depends upon the state of technology: The enormous
increase in production per worker that has been going on in industrial societies for about 200
years is very largely due to improved methods of production. Those in turn have been heavily
influenced by the advance of science. Discoveries in chemistry have led to lower costs of
production of well-established products, like paints, and to a large variety of a new products
made of plasticity’s and synthetic fibers. The new electronics industry rests upon transistors and
other tiny devices that are revolutionizing production in television, high-fidelity equipment,
computers and guidance control systems.

vi) Transport and communication:Every manufacturing industry requires cheap and efficient
means of transportation for the movement of both raw materials from the source of supply to the
 19
factory and finished products from the factory to the markets or the centres of consumption. The
location of the plant, should therefore, be at a place where adequate transport facilities are
available at cheaper rate.

vii) Tax and Subsidy:The policy and aids of government denotes the supply of producers
which is influenced by tax policy and financial regulations.

VIII)Weather:Certain industries for their successful working require a special type of climate.
For example, cotton textile industry requires humid climate while the photographic goods
industry flourishes best in regions of dry climate. Climate also affects the efficiency of labour.

SHIFTS IN THE SINGLE PRODUCER’S SUPPLY CURVE

When the factors that we kept constant in defining a supply schedule and a supply curve
(cet. par.) change, the entire supply curve shifts. This is referred to as a change or shift in supply
and must be clearly distinguished from a change in the quantity supplied (which is a movement
along the same supply curve).
Table 1.2 gives two supply schedules of a producer of commodity X. The first of these two
supply schedules (QSx)is a normal supply schedule. The second (QSx©)resulted from an increase
in the prices of the inputs necessary to produce commodity X (cet. par.).
(a) Now we plot the points of the two supply schedules on the same set of axes and get the two
supply curves.
(b) What would happen if the price of X rose from $3 to $5before the shift in supply?
(c) What quantity of commodity X will the producer place on the market at the price of
$3before and after the supply curve shifted up?
(d) What happens if at the same time the producer’s supply of X decreases, the price of X rises
from $3 to $5?
Table 1.2

Px($) 6 5 4 3 2 1
QSx 42 40 36 30 20 0
QSx© 22 20 16 10 0 0
(a)
Px($)

.. ...
Sx© Sx
6 B
5
4
3
2
1
.. . .. .
C
10
D

20
A
30 40 50
0

Qx

Fig. 1.2

b) When the price of X rises from $3 to $5, the quantity of X supplied by the producer
increases from 30 to 40 units per time period. (This is a movement along S x in an upward
direction, from point A to point B in the figure.)
c) The upward shift in the entire supply curve from Sx to Sx© is referred to as a decrease
in supply. At the unchanged price of $3, the producer will now (i.e., after the shift) supply 10
units of X rather than 30 (i.e., the producer goes from point A to Point C).
d) When both the producer’s supply of X decreases and the price of X rises form $3 to
$5, the producer will place on the market 10 units less than before these changes occurred (i.e.,
the producer goes from point A to point D).
If there is an improvement in technology: (so that the producer’s costs of production fall),
the supply curve shifts downward. This downward shift is referred to as an increase in supply. It
means that at the same price for the commodity, the producer offers more of it for sale per time
 20
period. It will be clear from the following analysis.
Suppose that as a result of an improvement in technology, the producer’s supply function
becomes QSx© = -10 +20Px (as opposed to QSx = - 40 + 20Px in previous example ).
(a) Now we derive this producer’s new supply schedule.
(b) On one set of axes, draw this producer’s supply curves before and after the
improvement in technology.
(c) How much of commodity X does this producer supply at the price of $4 before and
after the improvement in technology?
(a) Table 1.3
Px($) 6 4 2 .5
QSx© 110 70 30 0

(b)

Px(
$)

. .
Sx
Sx
6
5

. .... . ©
Fig.1.18
4
3
2
1
.. . QSx
0 40 70
110
(C) Before the supply curve increased (Shifted down), the producer offered for sale 40 units of X
at the price of $4. After the improvement in technology, the producer is willing to offer 70 units
of X at the same commodity price of $4.

Assumption, reasons and exceptions to law of supply!

Economists have studied the behavior of sellers, just as they have studied the behaviour of
buyers. As a result of their observations, they have arrived at the law of supply. Law of supply
states the direct relationship between price and quantity supplied, keeping other factors constant
(ceteris paribus).

We know, price is the dominant factor in determining supply of a commodity. As price of the
commodity increases, there is more supply of that commodity in the market and vice-versa. This
behaviour of producers is studied under the law of supply.

Assumptions of Law of Supply:

While stating law of supply the phrase ‘keeping other factors constant or ceteris paribus’ are
used. This phrase is used to cover the following assumptions on which the law is based:

 Price of other goods is constant;

 There is no change in the state of technology;
 Prices of factors of production remain the same;
 There is no change in the taxation policy;
 Goals of the producer remain the same.
 21
Table 9.3: Supply Schedule:

Price (in Rs.) Quantity (in units)

1 10
2 20
3 30
4 40
5 50

Important Points about Law of Supply:

 It states the positive relationship between price and quantity supplied, assuming no
changes in other factors.
 It is a qualitative statement, as it indicates the direction of change in the quantity
supplied, but it does not indicate the magnitude of change.
 It does not establish any proportional relationship between change in price and the
resultant change in quantity supplied.
 Law is one sided as it explains only the effect of change in price on the supply, and not
the effect of change in supply on the price.

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 into the 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:
 22
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 of resources.
The scale of production

When an increase in the scale of production yields a more than proportionate increase in
output, the enterprise is said to be experiencing economics of scale. These economies might be
defined as those aspects of increasing size which lead to falling long-run average costs.
Economies of scale are conveniently classified as internal and external economies.
Internal economies of scaleare those which arise from the growth of the firm independently of
what is happening to other firms. They are not due to any increase in monopoly power or to any
technological innovation: they arise quite simply from an increase in the scale of production in
the firm itself A firm may grow as a result of increasing the size of its workplaces or increasing
their number.
External economics of scaleare those advantages in the form of lower average costs which a
firm gains from the growth of the industry. These economies accrue to all firms in the industry
independently of changes in the scales of individual outputs.
Internal economies of scale can be divided into plant economies of scale and firm economies of
scale.
Plant economies
These arise not only from the growth of individual workplaces, including individual factories and
offices but also technical economies.
Increased specialization
The larger the establishment the greater the opportunities for the specialisation of men and
machines. In the larger firm the process can be broken down into many more separate operations,
workers can be employed on more specialised tasks, and the continuous use of highly specialised
equipment becomes possible. For example a large supermarket can employ electronic fund
transfer at point of sale.
Indivisibility
Some types of capital equipment can only be employed efficiently in units of a minimum size,
and this minimum may well be too large for the small firm. There is a lower limit to the size of a
blast furnace, a nuclear power station, a car assembly line, and a power press. This lower limit
may be a technical limit; a smaller version of the equipment is impracticable. In a small firm this
type of capital equipment would be standing idle for a large part of the time, the heavy fixed
costs would be spread over small outputs, and average cost would be disproportionately high.
Increased dimensions
If one doubles the length, breadth, and height of a cube, the surface area is four times as great,
and the volume eight times as great as the original. A modern oil tanker of 240000 tonnes is only
twice the size of a 30 000 tonne tanker in terms of length. width, and height, and only four times
as large in terms of surface area. It will require very few, if any, more people to operate her and
she will certainly not require eight times the power to propel her through the water.

The principle of multiples

Most industries make use of a variety of machines. each machine carrying out a different
operation. Each of these different machines is likely to have a different capacity. The machine
which moulds the blocks of chocolate will operate at a much slower speed than the machine
which wraps the blocks in silver paper.
Assume that a particular process requires a team of four machines. A, B. C. and D, the
productive capacities of which are 50.60, 20.and 30 units per hour. If the team comprises only
one machine of each type, the maximum output per hour will he 20 units and machines A. B. and
D will he working below capacity. This would he the kind of problem facing the small firm
producing a small output. For small outputs it is not possible to obtain a balanced team of
machines such that each machine
being fully utilised.
 23
The lowest common multiple of 50. 60. 20. and 30 is 300. This is the smallest output per hour
which will enable a sequence of machines of this type to work at full capacity. Such a balanced
team of machines would be:
Machine A Machine B Machine C Machine D
6 5 15 10
This assembly of machines would provide an output of 300 units per hour and all machines
would be working at full capacity. If output is to be increased it will only be possible to maintain
100 per cent utilisation if production is increased by multiples of 300 units (i.e. 600, 900, 1200,
etc.). The reader can test this statement by trying to work out the most economic way of
producing intermediate outputs of say 450 or 700 units.

By-product economies
A large plant may be able to sell or convert its by-products. For instance, a large stable may be
able to sell the manure from its horses on a commercial basis. A large petroleum refinery plant
may process chemicals extracted from oil and sell them. One of the most famous by-products is
Tupperware which has become a very profitable concern.

Economies of linked processes

A large plant may enable more than one product to be produced. For instance, iron and steel may
be produced together in a large factory. A large bank branch, in addition to carrying out standard
banking services, may also operate an estate agency department.

Stock economies
A large plant can operate with smaller stocks in proportion to sales than the smaller firm. This is
because variations in orders from individual customers and unexpected changes in customers’
demands will tend to offset each other when total sales are very large.

Firm economies
There are a number of advantages which can be gained if a business unit such as a building
society grows in size. This could be achieved by the building society opening more branches; the
individual branches do not have to be larger.

Marketing economies
A large firm is able to buy its material requirements in large quantities. Bulk buying enables the
large enterprise to obtain preferential terms. It will be able to obtain goods at lower prices and be
able to dictate its requirements with regard to quality and delivery much more effectively than
the smaller firm. By placing large orders for particular lines bulk buyers enable suppliers to take
advantage of ‘long runs’ .- a much more economical proposition than trying to meet a large
number of small orders from small firms each requiring a different colour, or quality, or design.
The large firm will be able to employ specialist buyers, whereas in the small firm, buying will
be a function of an employee who will have several other responsibilities. Expert buyers have the
knowledge and skill which enables them to buy ‘the right materials, at the right time, at the right
price’. Expert buying can be a great economy; unwise buying can be very costly.
The selling costs of the larger firm will be much greater than those of the small firm, but the
selling costs per unit will generally be much lower. Packaging costs per unit will be lower. A
package containing 100 articles is much easier to pack than 10 separate packages each containing
10 articles. The clerical and administrative costs of dealing with an order for 1000 articles
involves no more work than that involved in an order for 100, and, as we have just seen,
transport costs do not increase proportionately with volume.
Financial economies
The large firm has several financial advantages. The fact that it is large and well known makes it
a more credit-worthy borrower. Its greater selling potential and larger assets provide the lenders
with greater security’ and make it possible for them to provide loans at lower rates of interest
than would be charged to the smaller firm.
The larger firm has access to far more sources of finance. In addition to borrowing from the
banks, it may’ approach a wide variety of other financial institutions as well as taking advantage
of the highly developed market in the issuing of new shares and debentures. Most of the larger
financial institutions and the new issue market are not structured to meet the needs of the smaller
firm.
 24
Research and Developmenteconomies
A research department must be of a certain size in order to work effectively. To the small firm
this minimum effective size may represent a level of expenditure too large to justify any possible
returns.
Managerial economies

Large firms can employ specialist accountants. lawyers. personnel officers. etc. In large firms
they could he fully utilised but it is doubtful if the smaller firm could find enough specialised
work to keep them fully occupied.

Rick-hearing economies
Large firms are usually better equipped than small firms tocope with the risksof trading.They
can benefit from the law of averagesor the law of large numbers.area.Many large firm are able to
reduce the risks of trading bymeans of a policy ofdiversification. They manufacture either a
variety of models of a particularproduct, or. more likely nowadays, a variety of products. A fall
in the demand for any one of its products may not mean serious trouble for the firm; it may well
be cancelled out by a rise in the demand for one or more of the other products.
Plant specialization economies

A firm may be large enough for its individual plants to specialise. For instance, a large motor
vehicle company may have plants producing buses, plants producing cars and plants producing
lorries.

Staff facilities economies

A large firm may be able to offer, among other things, staff canteens, sports grounds and medical
care. With a large number of staff the cost of providing these facilities per member of staff may
be relatively low. The large retailer Marks and Spencer provides a range of facilities for its staff.

Diseconomies of scale
Increasing size brings many advantages, but it can also bring disadvantages.
For each particular industry there will be some optimum size of firm in which average cost
reaches a minimum. This optimum size will vary over time as technical progress changes the
techniques of production. As firms grow beyond this optimum size, efficiency declines and
average costs begin to increase.There seems to be no good reason why such diseconomies of
scale should arise from purely technical causes
Management problems
There is no doubt that as the size of the firm increases, management problems become mote
complex. It becomes increasingly difficult to carry out the management functions of
coordination, control, communication and the maintenance of morale in the labour force
Coordination
Large organisations must be subdivided into many specialised departments (production planning,
sales, purchasing, personnel, accounts etc.). As these departments multiply and grow in size, the
task of coordinating their activities becomes more and more difficult.
Control
Essentially, management consists of two basic activities~ the taking of decisions and seeing that
these decisions are carried out. This latter function is that of control. The large firm usually has
an impressive hierarchy of authority (managing director, director, head of division, head of
department, foreman, and so on), but, in practice, the problem of seeing that ‘everyone is doing
what they are supposed to be doing, and doing it well’, is a very difficult task.
Communication
The transfer of information in industry and commerce is a two-way process. It is not simply a
matter of passing orders down the line~ subordinates must be able to feed back their difficulties
and problems. There must not only be a vertical line of communication, information must also
move laterally, because one section of the firm must know what the other sections are doing.
Morale
Probably the most difficult problem for organisations with large numbers of employees is the
maintenance of morale. The attitude of workers to management is of critical importance to the
efficient operation of the enterprise, and the cultivation of a spirit of willing cooperation appears
 25
to become more and more difficult as the firm becomes larger. Indeed, industrial relations tend to
be worse in large plants than in small plants.
The main internal economies of scale are shown in Figure below.

Prices of inputs
A further possible reason why growth in the size of the firm may lead to rising average costs may
be increases in the prices of the factors of production. As the scale of production increases, the
firm will increase its demands for materials, labour, energy, transport and so on. It may,
however, be difficult to obtain increased supplies of some of these factors, for example, skilled
labour, or minerals from mines which are already working at full capacity. In such cases a firm
attempting to increase the scale of its production may find itself bidding up the prices of some of
its inputs.
External economies of scale
External economies are the adventages which accrue to a firm from the growth in the size of the
industry. These advantages may he gained by firms of any size. Indeed, a collection of relatively
small independent firms can specialise on quite a large scale so that collectively they can achieve
many of the economies of scale outlined earlier. External economies are especially significant
when that industry is heavily localized. In this particular case they are often referred to as
economies of concentration. Principles of Multiples
By-product economies
Increased dimensions

Stock economies
Indivisibility of capital Plant economies

Economies of linked process

Increased Specialisation

INTERNAL ECONOMIES OF SCALE

Marketing economies Staff facilities economies

Firm economies

Financial economies Plant specialisation economies

Research and development Managerial Risk bearing economies

economies economies
 26

Labour
The concentration of similar firms in any one area leads to the creation of a local labour force
skilled in the various techniques used in the industry. Local colleges develop special courses of
training geared to the particular needs of the industry. The further-education colleges in Cornwall
and Devon have important travel and tourism departments and the further-education college in
Witney has a stud and stable course attracting students from throughout the UK and abroad.
Ancillary services
In areas where there is a high degree of industrial concentration, subsidiary industries catering
for the special needs of the major industry establish themselves. Thus we find many participants
of the horse racing industry being based in Newmarket. Here too we find firms specializing in
the provision of horse feed, vets speeialising in the treatment of horses and blacksmiths to shoe
horses.
Even when an industry is dispersed, if it is large enough ancillary industries will develop. For
example, the fertilizer industry supplies farmers throughout the country.
Disintegration
Where an industry is heavily localised there is a tendency for individual firms to specialize in a
single process or in the manufacture of a single component. The classic example is to be found in
Lancashire. where the production of cotton cloth is broken down into many processes each
carried out by a specialist firm (spinning, weaving, dyeing, finishing, etc.).
Cooperation
Regional specialization encourages cooperation among the firms. A good example is provided by
the research centers established as joint ventures by the firms in heavily localized industries. The
pottery firms in Stoke-on-Trent, the footwear firms in the East Midlands, and the cotton firms in
Lancashire have all set up research centers for their particular industries. The opportunities for
formal and informal contacts between members of the firms are much greater where the firms
themselves are all in one locality. The formation of trade societies, the publication of a trade
journal and other such cooperative ventures are more easily stimulated in localised industry.
Commercial facilities
External economies also arise from the fact that the service industries in the area develop a
special knowledge of the needs of the industry and this often leads to the provision of specialised
facilities. Banking and insurance firms become acquainted with the particular requirements of
the industry arid find it worthwhile to provide special facilities. Transport firms may find it
economical to develop special equipment (e.g. containers and vehicles) to deal with the
industry’s requirements. Improved infrastructure in the form of better roads and airports may be
provided. Again, each firm is a beneficiary, not because the firm itself is large, but because the
industry as a whole provides a large demand fur these services.
Specialized markets
When an industry is large enough specialised places and facilities to bring buyers and sellers into
contact may be developed. An example is Lloyds of London.

External diseconomies
A firm may also experience external diseconomies of scale as the industry to which it belongs
becomes larger. A shortage of labour with the appropriate skills may develop so that firms in this
industry may find themselves bidding up wages as they try to attract more labour (or hold on to
their existing supplies).
Increasing demands for raw materials may also bid up prices and cause costs to rise. If the
industry is heavily localised, land for expansion will become increasingly scarce and hence more
expensive both to purchase and to rent. Transport costs may also rise because of increased
congestion.
 27
Factors of production
At any one point in time, the economy can produce only a certain amount of goods and services
because the amount of resources is limited. These resources fall into four categories known as
the four factors of production: land, labour, capital and enterprise.

Land Land refers to the gifts of nature that are used to produce goods and services. It includes
plots of land, natural resources, fishes in the sea and trees in the forests.

LabourLabour refers to the physical and mental effort that people devote to the production of
goods and services.

Capital Capital refers to the goods that are produced for use in the production of other goods. It
includes factories and machinery.

Enterprise Enterprise refers to the ability and the willingness to take risk.

The following table shows the different factor incomes received by owners of the different
factors of production.

Factor of production Factor income

Land/Space Rent
Labour/HR Wages/Salary
Capital Interest
Enterprise Profits/Wealth

Note: Students should not mix up capital in economics, which is known as physical capital, and
capital in business, which is known as financial capital. Although financial capital refers to the
money needed to start a business, physical capital refers to factories and machinery.

Cost of production
The costs related to making or acquiringgoods and services that directly generates revenue for a
firm. It comprises of direct costs and indirect costs. Direct costs are those that are traceable to the
creation of a product and include costs for materials and labor whereas indirect costs refer to
those costs that cannot be traced to the product such as overhead.
Costs of production
By "Cost of Production" is meant the total sum of money required for the production of a
specific quantity of output. In the word of Gulhrie and Wallace:
"In Economics, cost of productionhas a special meaning. It is all of the payments or expenditures
necessary to obtain the factors of production of land, labor, capital and management required to
produce a commodity. It represents money costs which we want to incur in order to acquire the
factors of production".

In the words of Campbell:

"Production costs are those which must be received by resource owners in order to assume that
they will continue to supply them in a particular time of production".

Formula for computing Production Costs

The general formula used for computing production cost is:

Production cost per item = Fixed Cost (FC) + Variable cost (VC) / No. of units produced

Elements of Cost of Production:

The following are the important elements of production cost under process costing :
(i) Material
(ii) Labour
(iii) Production overhead.
 28
(1) Material
The material required for production is issued to the first process, then offer processing. Then it
can be transferred to next process and so on. In some situations, material may pass from the first
process to the next process where an additional material is to be added; it may continue until
completion. Normally, material requisitioned in the prescribed form only may be issued. Cost
incurred for this operation is treated as material cost.
(ii) Labour
Some of the Labour Forces are directly engaged in manufacturing of a product. But generally
employees are utilised continuously on one process and time spent by them is debited to the
process account. Amount paid for the utilisation of Labour force is treated as labour cost.
Normally the cost of direct labour constitutes a very small part of the cost of production in
industries. Because more number of automatic machineries are installed in the industry.
(iii) Production Overhead
Any expenses incurred for the production other than the material and labour come under the head
of production overhead. Normally the overhead element of total constitutes generally a very huge
portion in the process costing. So appropriate decision is required to ensure that reasonable share
of production is charged to each process.
Material cost, Labour cost, and Production Overhead cost, these three elements taken together
are called the cost of production of the product.
Types/Classifications of Cost of Production:
Prof, Mead in his book, "Economic Analysis and Policy" has classified these costs into three
main sections:
(1) Production Costs: It includes material costs, rent cost, wage cost, interest cost and normal
profit of the entrepreneur.
(2) Selling Costs:It includes transportation, marketing and selling costs.
(3) Sundry Costs:It includes other costs such as insurance charges, payment of taxes and rate,
etc., etc

Fixed and variable costs

Fixed Cost: Costs that remain the same in total regardless of changes in the activity level. It is
fixed for total units , vary for per units, implies for total production 10000 units & fixed cost
100000 tk, if production is 5000 units then per unit fixed cost vary & vice versa. a) Rent and
rates of the factory building;
(b) Salary of Works Manager, Administration Manager, Sales Manager, etc.; (in India, labor cost
is fixed cost);
(c) Depreciation of buildings;
(d) Insurance;
(e) Interest on capital (if included in costs).
Variable costs: Costs that vary in total directly & proportionately with changes in the activity
level. It remains the same per unit at every level of activity such as @50 tk per unit. a) Direct
materials;
(b) Direct labor, if any;
(c) Direct expense;
(d) Variable overhead, e.g., consumable stores, power, fuel, etc.
3. Semi-variable Cost ; These costs contain partly fixed and partly variable elements. These
costs are thus partly affected by fluctuations in the level of activity. Semi-variable costs are also
known as semi-fixed costs. Examples of semi-variable or semi-fixed costs are:-
(a) Normal maintenance of buildings and plant;
(b) Salary of supervisors;
(c) Depreciation of plant and machinery;
(d) Service department wages. .

Fixed costs are those that do not vary with output and typically include rents, insurance,
depreciation, set-up costs, and normal profit. They are also called overheads.

Variable costs are costs that do vary with output, and they are also called direct costs. Examples
of typical variable costs include fuel, raw materials, and some labour costs.

The following elements are included in the cost of production:

(a) Purchase of raw machinery, (b) Installation of plant and machinery, (c) Wages of labor, (d)
Rent of Building, (e) Interest on capital, (f) Wear and tear of the machinery and building, (g)
 29
Advertisement expenses, (h) Insurance charges, (i) Payment of taxes, (j) In the cost of
production, the imputed value of the factor of production owned by the firm itself is also added,
(k) The normal profit of the entrepreneur is also included In the cost of production.

Normal Profit:
By normal profit of the entrepreneur is meant in economics the sum of money which is
necessary to keep an entrepreneur employed in a business. This remuneration should be equal to
the amount which he can earn in some other alternative occupation. If this alternative return is
not met, he will leave the enterprise and join alternative line of production.

Marginal costs

Marginal cost is the cost of producing one extra unit of output. It can be found by
calculating the change in total cost when output is increased by one unit.

OUTPUT TOTAL COST MARGINAL COST

1 150
2 180 30
3 200 20
4 210 10

It is important to note that marginal cost is derived solely from variable costs, and not fixed
costs.

The marginal cost curve falls briefly at first, then rises. Marginal costs are derived from variable
costs and are subject to the principle of variable proportions.

The significance of marginal cost

The marginal cost curve is significant in the theory of the firm for two reasons:

1. It is the leading cost curve, because changes in total and average costs are derived from
changes in marginal cost.
2. The lowest price a firm is prepared to supply at is the price that just covers marginal cost.

ATC and MC

Average total cost and marginal cost are connected because they are derived from the same basic
numerical cost data. The general rules governing the relationship are:

1. Marginal cost will always cut average total cost from below.
2. When marginal cost is below average total cost, average total cost will be falling, and
when marginal cost is above average total cost, average total cost will be rising.
3. A firm is most productively efficient at the lowest average total cost, which is also where
average total cost (ATC) = marginal cost (MC).

Average fixed costs

Average fixed costs are found by dividing total fixed costs by output. As fixed cost is divided by
an increasing output, average fixed costs will continue to fall.

OUTPUT TOTAL FIXED COST (£000) AVERAGE FIXED COST (£000)

1 100 100
2 100 50
3 100 33.3
4 100 25
 30
Average variable costs
Average variable costs are found by dividing total fixed variable costs by output.

OUTPUT TOTAL VARIABLE COST (£000) AVERAGE VARIABLE COST (£000)

1 50 50
2 80 40
3 100 33.3
4 110 27.5

Average total cost

Average total cost (ATC) is also called average cost or unit cost. Average total costs are a key
cost in the theory of the firm because they indicate how efficiently scarce resources are being
used. Average variable costs are found by dividing total fixed variable costs by output.

AVERAGE FIXED COST AVERAGE VARIABLE COST AVERAGE TOTAL COSTS

OUTPUT
(£000) (£000) (£000)
1 100 50 150
2 50 40 90
3 33.3 33.3 67
4 25 27.5 52.5

Marginal costs

Marginal cost is the cost of producing one extra unit of output. It can be found by calculating
the change in total cost when output is increased by one unit.

OUTPUT TOTAL COST MARGINAL COST

1 150
2 180 30
3 200 20
4 210 10

It is important to note that marginal cost is derived solely from variable costs, and not fixed
costs.

The significance of marginal cost

The marginal cost curve is significant in the theory of the firm for two reasons:

1. It is the leading cost curve, because changes in total and average costs are derived from
changes in marginal cost.
2. The lowest price a firm is prepared to supply at is the price that just covers marginal cost.

ATC and MC

Average total cost and marginal cost are connected because they are derived from the same basic
numerical cost data. The general rules governing the relationship are:

1. Marginal cost will always cut average total cost from below.
2. When marginal cost is below average total cost, average total cost will be falling, and
when marginal cost is above average total cost, average total cost will be rising.
3. A firm is most productively efficient at the lowest average total cost, which is also where
average total cost (ATC) = marginal cost (MC).
 31
Sunk costs

Sunk costs are those that cannot be recovered if a firm goes out of business. Examples of sunk
costs include spending on advertising and marketing, specialist machines that have no scrap
value, and stocks which cannot be sold off. Sunk costs are a considerable barrier to entry and
exit.

Factors that Influence the Cost of Production

Types of factors which influence the cost of production are as follows:

An entrepreneur has to take some very important decisions before setting up a new venture.
These decisions have close bearing on the cost of production of the product in the long run. He
has to decide the site of the works, the nature of production, scope and size of the market that
will be served and the size of the plant.

All these decisions are of such nature that once taken cannot be altered time and again. All these
decisions affect the cost of production in the long run.

The entrepreneur, therefore, should study the various forces (factors) which may affect the cost
behaviour in the long run. Generally there are three types of factors which influence the cost of
production e.g. I. Location, II. Scope, and III. Size A complete analysis of these factors, will
certainly help the entrepreneur to earn maximum profits by reducing the costs.

I.Location:

These are money, material, men, market, machinery, motive power, management, means of
transport and momentum of early start.

The success of the new enterprise very much rests on the selection of suitable site. In the
selection of the site the following factors should be kept in view.

1.Availability of raw materials:

The place selected should be such where the raw materials are available easily. There should be
an easy approach to the place of raw materials. Iron and Steel industry in Bihar textile factories
in Gujarat and Maharashtra, Jute works in Bengal owe their success on account of easy
availability of raw materials. It reduces the cost of transportation.

2.Nearness to the market:

Manufacturing a thing successfully is not sufficient. It is also necessary that the output should
find ready market and that the product is sold at a price to yield reasonable profit. This is
possible only when the market is not far away. Nearness of the market ensures transportation
cost less and minimum wastage.
3.Nearness to source of operating power:
Every industry requires fuel for working the machinery and unless the region has rich fuel
resources it cannot develop an industrial area. Various sources of power now available are coal,
hydro-electricity and oil etc. Coal is the cheapest source of power, but it is very bulky and
involves high transportation costs.
4.Labour supplies:
For the successful and uninterrupted working of a factory, availability of adequate supply of
labour of the right type at reasonable wages is also very essential. There are some industries in
which the inherited skill of the workers is an important factor in the process of manufacturing.
The development of the dying and printing industry in Farukhabad and the glass industry in
Ferozabad I have been mainly located there due to the availability of skilled labour in these
towns.
5.Transportation:
Every manufacturing industry requires cheap and efficient means of transportation for the
movement of both raw materials from the source of supply to the factory and finished products
 32
from the factory to the markets or the centres of consumption. The location of the plant, should
therefore, be at a place where adequate transport facilities are available at cheaper rate.
6.Finance:
No productive activity is possible without the availability of adequate capital. Banks, Stock
Exchanges and other similar institutions help in capital formation and expansion of industry by
providing financial help to it from time to time.
7.Climate:
Certain industries for their successful working require a special type of climate. For example,
cotton textile industry requires humid climate while the photographic goods industry flourishes
best in regions of dry climate. Climate also affects the efficiency of labour.
8. Industrial inertia or momentum of early start:
There is tendency for an established industry to remain localized in a particular area in which it
arose even after some of the original advantages possessed by that area for such work have lost
their previous importance. If, however, the entrepreneur acts rationally and has necessary
knowledge, he will choose the location which offers the lowest cost per unit of output.
9. Personal preferences:
Location of any industry may sometimes be decided according to the personal preferences and
prejudices of the industrial enterprises.
10. Government policy:
These days the government plays an important role in determining the location of new industries.
In addition to the factors discussed above, cost of land and building for setting up the factory,
topography of the area, the possibilities of future expansion etc. are some other factors which
influence the decision making regarding location of industry.

II. Scope:

It is advisable to plan before hand the scope of activities of the firm beforehand. On the basis of
further experience the plan may be revised from time to time in deciding about the scope. The
following points should be taken into consideration in this regard-

(i) What techniques have to be followed in production? What parts have to be manufactured in
the factory itself and for what parts should depend on other firm?

(ii) Should all the processes involved in the production be carried in the factory or some have to
depend upon contracts?

(iii) Has the firm to produce the raw materials itself or should it depend upon other firms?

(iv) How far the firm should specialize in production or should it depend upon other firms?

(v) Should all the connected goods with the main product be manufactured by the firm itself and
the business scope be expanded?

(vi) Should the marketing of the product be organized by the firm itself or should it depend upon
other agencies for marketing?

(vii) Should the after-sale service to the consumers be undertaken by the firm itself or should
firm enter into some agreement with other firm for this important responsibility?

III. Size:

The success and efficiency of the firm also depends on its suitable size. The size of the firm
should be optimum as to ensure maximum profitability.

The optimum size of the firm is that point which results in the lowest production cost and
maximum efficiency.

At this optimum point of output all the technical, managerial marketing factors are well
balanced.
 33
It should be noted that optimum size of the firm is not fixed but goes on altering with the
improved techniques of production and managerial experience.

Money
BARTER TRADE

Before there was money, there was barter trade. In other words, people exchanged goods directly
for other goods. However, barter trade suffers from many disadvantages.

Lack of double coincidence of wants

A double coincidence of wants occurs when the two parties involved in a barter trade have the
goods that each other desires. Such exchange was possible in a primitive society which produced
a small range of goods. However, in today’s society, it is virtually impossible to carry out a
direct exchange of goods and services using barter system since our wants are numerous and
diverse.

Lack of a common measure of value

The value of a good is the quantities of other goods it can command in the market. Therefore, the
value of a good is difficult to measure since it has to be stated in terms of the quantities of many
other goods. For this reason, it will be difficult for firms to draw up and interpret profit and loss
statements.

Indivisibility of certain goods

Barter trade is undesirable if the goods that are to be exchanged cannot be divided without
incurring any loss of value. This is a problem when large goods are to be exchanged for small
ones.

Inability to specialise
In today’s society, many people produce only parts of goods. This is a process known as
specialisation. However, exchanging parts of goods for other parts of goods is much more
difficult than exchanging a whole good for another whole good.

2 MONEY AND THE MONEY SUPPLY

A current medium of exchange in the form of coins and banknotes; coins and banknotes
collectively. Money is a token or item which acts as a medium of exchange that has both legal
and social acceptance with regards to making payment for buying commodities or receiving
services, as well as repayment of loans.
In addition, money also functions as a standard of value and a store of value because with the
help of money, the value of various goods and services can be measured. According to a small
number of economists, money is a standard of deferred payment. There are various types of
money and different definitions are applied for them

Factors that can influence money behaviors include:

 Culture or gender - groups may define what is acceptable or what is emphasized such as
talking about money, importance of sharing resources, who makes "big" money
decisions.
 Stage in the life cycle - young parents spending may focus on needs of the child;
whereas, a couple with adult children may focus on leisure activities.
 Concept of roles and responsibilities - whose job is it to spend money, take care of day-
to-day finances, or make decisions about major purchases like a car, etc.
 Planning and organizational skills - is someone more skilled in organizing and handling
details?

Functions of money

Money is anything that is accepted as a medium of exchange. However, in addition to the

function as of a medium of exchange, good money must serve three other functions.

Medium of exchange
Money is a medium of exchange as it is accepted in payment for goods and services. Therefore,
 34
the use of money does away with the need for a double coincidence of wants for a transaction to
take place and hence facilitates specialisation and exchange.

Store of value
Money is a store of value as it allows us to store our purchasing power for future use. Therefore,
not every sale is a purchase. A person can be a seller but only become a buyer tomorrow.
However, in times of inflation, money becomes a poor store of value.

Unit of account
Money is a unit of account which provides a common measure of value. Therefore, money
allows us to make comparison between the values of different goods and services. In addition,
money allows firms to draw up and interpret profit and loss statements.

Standard of deferred payment

Since money is a unit of account, it is also a standard of deferred of payment, or simply a unit of
account over time. People often want to agree today the values of some future payments. For
instance, some firms sign contracts with their suppliers specifying the prices of raw materials and
other supplies. Money provides a convenient means of measuring future payments.

Attributes of money

To function properly, money must be durable, portable, divisible, difficult to counterfeit and
controllable. These attributes combine to give money its key characteristic. That characteristic is
acceptability.

Historically, different things have been used as money. Forms of money have changed over time
and are constantly evolving. The following is an outline of the origin and the historical
development of the today’s money.

First, there was commodity money (e.g. cattle, salt, silver, gold, etc). Next, there was paper
money (receipts given by goldsmiths, evolved into banknotes, fractionally backed by gold,
inconvertible paper money declared by the government to be legal tender which is also known as
fiat money where fiat means ‘let there be’ in Latin). Finally, there are bank deposits (i.e.
demand/sight/current account deposits).

Official definitions of money in Singapore (Institutions-based approach)

Narrow money (M1)

The narrow definition of money measures the immediate purchasing power in the economy. It
looks at money primarily as a medium of exchange.

M1 = Currency in Active Circulation + Demand Deposits with Banks

Broad money (M3)

The broad definition of money measures the potential purchasing power of money in the
economy. It looks at money primarily as store of value.

Quasi-money Quasi-money is any asset that is not money but can readily be converted into
money. Items commonly regarded as quasi-money are savings deposits, fixed deposits, unit
trusts, etc. None of these deposits serves as a medium of exchange and thus they are not included
in narrow money (M1). However, many banks now allow depositors to transfer savings deposits
to demand deposits through phone calls or ATMs and this blurred the distinction between narrow
money (M1) and broad money (M3).

M2 = M1 + Quasi-money with Banks (i.e. Fixed Deposits, Savings Deposits, Unit Trust
Funds, etc)

M3 = M2 + Net Deposits with Non-bank Financial Institutions (i.e. Finance Companies)

Note: In some countries such as the US, the monetary characteristics of instruments approach is
used. In economics, unless otherwise stated, the money supply refers to broad money.

The main functions of money are :

It is a medium of exchange.
It gives purchasing power to consumer to pay for goods and services.
It is a unit of account.
 35
It is a unit measure of value.
It is a standard of deferred payment.

There are several kinds of money varying in liability and strength. The society has modified the
money at different times and in this way several types of money are introduced. When there was
ample availability of metals, metal money came into existence later it was substituted by the
paper money. At different times, several commodities were used as the medium of exchange. So,
it can be said that according to the needs and availability of means, the kinds of money has
changed.

There are 4 major types of money :

There are four different types of money as mention below:

 Commodity Money,
Fiat Money
Fiduciary Money
Commercial Bank Money

Commodity Money
It is the simplest kind of money which is used in barter system where the valuable resources
fulfill the functions of money. The value of this kind of money comes from the value of resource
used for the purpose. It is only limited by the scarcity of the resources. Value of this kind of
money involves the parties associated with the exchange process. These money have intrinsic
value.
Whenever any commodity is used for the exchange purpose, the commodity becomes equivalent
to the money and is called commodity money. There are certain types of commodity, which are
used as the commodity money. Among these, there are several precious metals like gold, silver,
copper and many more. Again, in many parts of the world, seashells (also known as cowrie
shells), tobacco and many other items were in use as a type of money & medium of exchange.
Ex : gold coins , beads , shells, pearls, stones, tea, sugar, metal

Fiat Money
The word fiat means the”command of the sovereign”. Fiat currency is the kind of money which
don’t have any intrinsic value and it can’t converted into valuable resource. The value of fiat
money is determined by government order which makes it a legal instrument for all transaction
purposes. The fiat money need to be controlled as it may affect entire economy of a country if it
is misused. Today Fiat money is the basis of all the modern money system. The real value of fiat
money is determined by the market forces of demand and supply.
Ex :Paper money, Coins

Fiduciary Money
Today’s monetary system is highly fiduciary. Whenever, any bank assures the customers to pay
in different types of money and when the customer can sell the promise or transfer it to
somebody else, it is called the fiduciary money. Fiduciary money is generally paid in gold, silver
or paper money. There are cheques and bank notes, which are the examples of fiduciary money
because both are some kind of token which are used as money and carry the same value.

Commercial Bank Money

Commercial Bank money or demand deposits are claims against financial institutions that can be
used for the purchase of goods and services. A demand deposit account is an account from which
funds can be withdrawn at any time by cheque or cash withdrawal without giving the bank or
financial institution any prior notice. Banks have the legal obligation to return funds held in
demand deposits immediately upon demand (or ‘at call’). Demand deposit withdrawals can be
performed in person, via cheques or bank drafts, using automatic teller machines (ATMs), or
through online banking.

There are also various other types of money like the credit money, electronic money, coin and
paper money, Fractional money and Representative money as discussed below :

Fractional Money
It is a hybrid type of money which is partly backed by a commodity and has a fiat money
transaction purpose. If the commodity loses its value then Fractional money converts into Fiat
money.
 36
REPRESENTATIVE MONEY
It represents a claim on commodity and it can be redeemed for that commodity at a bank . It is a
token or paper money that can be exchanged for a fixed quantity of commodity. Its value
depends on the commodity it backs.

Coins
Metals of particular weight are stamped into coins. There are various precious metals like gold,
silver, bronze , copper whose coins are already used in human history. The mintingg of coins is
controlled by the state.

Paper Money
Paper money don’t have any intrinsic value , as a fiat money it is approved by government order
to be treated as legal tender through which value exchange can happen. Governments print the
paper money according to the requirements which is tightly controlled as it can affect the
economy of the country.

Sources of Finance
Companies need funds to bridge the gap between paying for the production of finished goods
and receiving money from their customers (working capital). They also need money to buy their
fixed assets with which they operate, such as machinery, land and building (fixed capital)
The major source of finance for companies is retained earnings, which can be used for both
working capital and fixed capital

Short or medium

Short or medium term finance is obtained from the money market and long term finance is from
the capital market
Short term = up to 1 year- e.g. Trade credit, overdraft
Medium term = up to 7 years- e.g. Leasing, Hire purchase
Long term = 7 years or more – e.g. Debentures, preference shares

Internal source of finance

The main type of internal source of finance is

Internally generated funds and this comprises of retained earnings plus non -cash charges
against profit (e.g. depreciation)

External source of finance

This is mainly made up of long term finance. Long term finance can be defined as those that are
due for payment after one year. The main forms of long term finance are the following
Equity finance- Equity relates o ordinary shares only and it is the investment in a company by
ordinary share holders.
Equity capital is raised through the sale of shares to individuals or groups. Ordinary shares in the
equity of a business entitled the holders to all distributed profits.
Share holders expect to be rewarded for their investment in two ways these are
Receive a dividend after holders of debentures and preference shares have been paid
They may be able to make capital gain on their investment by selling their share holding
at a later date when the price increases.
Preference shares- These are designed for investors who do not wish to take the degree of risk
associated with being an ordinary share holder.
Ordinary share
This is the most valuable form of finance and forms the backbone of the financial structures of
businesses. It also represents a risky finance and it also gives shareholders control over the
business.Issuing of share
New shares can be issue by any of the following
Private negotiation
Placing or offer for sale
Right issues
Loans
Many businesses rely on loan capital to finance their operations. Lenders would enter into a
contract with the company in which the rate of interest dates of interest payment and capital
payment and the security of the loan are clearly stated.
Types of loan
 37
Debentures- These are written acknowledgement of a debt by a company. It usually contains a
provision of payment of interest and also terms for the repayment of the principal. Debentures
are often referred to as bonds or loan stocks
Debentures are traded on stock markets just like shares. They may be secured or
unsecured, redeemable or irredeemable
Characteristics of debentures
Debts are regarded as low risk
Debts holders do not have voting rights, only when interest is not paid will the holders
take control of the company
They are cheap because it is less risky for investors. Debentures holders would accept a
lower rate of return than share holders
Convertible loans
This is a traded debt which gives the holder the right to convert to other securities usually
ordinary shares at a given future price date at a given price.
The investor remains a lender to the business and would be paid an interest. The investor is not
obliged to convert the loan into ordinary shares.
Mortgages
This is form of a loan that is secured on a freehold property and could be over a period of 20
years
Loan covenants
Accounts- Lender may require access to the financial accounts of the business
Other loans- business may have to ask permission from lender before taking other loans
Dividend payment- lenders may require dividend to be limited during the period of the loan
Liquidity – lender may require business to maintain certain level of liquidity during the period of
the loan
Sources of short term loans
 Overdraft
 Trade creditors
 Debt factoring
 Invoice discounting
 Debt factoring
This is service provided by financial institutions known as factors. The factor takes over the debt
collection of the business. It also makes advance payment to the business to the maximum of
85% of the approved trade debtors and also charges between 2-3% of the business turnover

Any advance made to the company attracts an interest rate similar to bank overdraft
The capital market
Capital markets deal in long term finance through the stock exchange. The major types of
securities dealt on the capital markets are as follows:
Public sector stocks
Foreign stocks
Company securities
Eurobonds
The capital market provides the following sources of long term finance
Equity – ordinary shares, preference shares
Debentures
Euro bonds
Eurobonds are bonds dominated in a currency other than that of the national currency of
the issuing company. It has nothing to do with Europe. They are also called international bonds.
The money markets
Money markets deals in shorter –term funds which are in the forms of bank bill, trade bills,
certificate of deposits, unsecured loans etc. No physical location exists, transactions are conduct
by the phone, internet etc.
The money market is not one single market but a number of different markets are closely inter-
connected with each other.
The main participants in the money markets are central banks and the commercial banks. Other
participants include the financial houses, building society, investment trusts, unit trusts, local
authorities, large companies and some private individuals
The money market provides the following source of short and medium term finance
Leasing
High purchasing
Trade credit
Overdraft
Special (government grants)

Stock market
 38
The stock market is a market which issued securities of public companies. Government bonds,
loans issued by local authorities and other public owned by institutions and some overseas
stocks.
The stock market assists the location of capital to industry. If the market thinks highly of a
company, the shares of that company will rise in value and it would be able to raise fresh capital
through the new issue market at a very low cost.

What is Fiscal Policy?

Fiscal policy involves the decisions that a government makes regarding collection of revenue,
through taxation and about spending that revenue. It is often contrasted with monetary policy, in
which a central bank sets interest rates and determines the level of money supply.
Fiscal policy can be defined as governments actions to influence an economy through the use of
taxation and spending. This type of policy is used when policy-makers believe the economy
needs outside help in order to adjust to a desired point. Typically a government has a desire to
maintain steady prices, an employment level, and a growing economy. If any of these areas are
out of sorts, some type of fiscal policy may be in order.

What is the difference between monetary policy and fiscal policy,

and how are they related?
Monetary policy is a term used to refer to the actions of central banks to achieve macroeconomic
policy objectives such as price stability, full employment, and stable economic growth. Fiscal
policy is a broad term used to refer to the tax and spending policies of the government. Fiscal
policy decisions are determined by the central bank; the bank plays no role in determining fiscal
policy.

The central bank uses a variety of policy tools to foster its statutory objectives of maximum
employment and price stability. One of its main policy tools is the target for the short-term
interest rate. By adjusting the level of short-term interest rates in response to changes in the
economic outlook, central bank can influence longer-term interest rates and key asset prices.
These changes in financial conditions then affect the spending decisions of households and
businesses.

The monetary policymaking body within the Reserve System is the government that reviews
economic and financial developments and determines the appropriate stance of monetary policy.
In reviewing the economic outlook, considers how the current and projected paths for fiscal
policy might affect key macroeconomic variables such as gross domestic product growth,
employment, and inflation. In this way, fiscal policy has an indirect effect on the conduct of
monetary policy through its influence on the aggregate economy and the economic outlook. For
example, if tax and spending programs are projected to boost economic growth, central bank
would assess how those programs would affect its key macroeconomic objectives--maximum
employment and price stability--and make appropriate adjustments to its monetary policy tools.

What are the goals of monetary policy?

The goals of monetary policy are to promote maximum employment, stable prices and moderate
long-term interest rates. By implementing effective monetary policy, the Fed can maintain stable
prices, thereby supporting conditions for long-term economic growth and maximum
employment.

What are the tools of monetary policy?

The central bank’s use three instruments of monetary policy are (i) open market
operations,(ii)the discount rate and (iii) reserve requirements.

Open market operations

Open market operations involve the buying and selling of government securities. The term “open
market” means that the central bank doesn’t decide on its own which securities dealers it will do
business with on a particular day. Rather, the choice emerges from an “open market” in which
the various securities dealers that the central bank does business with – the primary dealers –
 39
compete on the basis of price. Open market operations are flexible, and thus, the most frequently
used tool of monetary policy.

When the central bank wants to increase reserves, it buys securities and pays for them by making
a deposit to the account maintained at the central bank by the primary dealer’s bank. When the
central bank wants to reduce reserves, it sells securities and collects from those accounts.

The funds rate is sensitive to changes in the demand for and supply of reserves in the banking
system, and thus provides a good indication of the availability of credit in the economy.

The discount rate

The discount rate is the interest rate charged by central bank banks to depository institutions on
short-term loans.

The discount rate is the interest rate central bank charge commercial banks for short-term loans.
central bank lending at the discount rate complements open market operations in achieving the
target funds rate and serves as a backup source of liquidity for commercial banks. Lowering the
discount rate is expansionary because the discount rate influences other interest rates. Lower
rates encourage lending and spending by consumers and businesses. Likewise, raising the
discount rate is contractionary because the discount rate influences other interest rates. Higher
rates discourage lending and spending by consumers and businesses.

Reserve requirements

Reserve requirements are the portions of deposits that banks must maintain either in their vaults
or on deposit at a central bank.

Reserve requirements are the portions of deposits that banks must hold in cash, either in their
vaults or on deposit at a central bank. A decrease in reserve requirements is expansionary
because it increases the funds available in the banking system to lend to consumers and
businesses. An increase in reserve requirements is contractionary because it reduces the funds
available in the banking system to lend to consumers and businesses.
INFLATION
MEANING

To the neo-classical and their followers at the University of Chicago, inflation is fundamentally a
monetary phenomenon. In the words of Friedman, "Inflation is always and everywhere a
monetary phenomenon . . . and can be produced only by a more rapid increase in the
quantity of money than output." But economists do not agree that money supply alone is the
cause of inflation.

As pointed out by Hicks, "Our present troubles are not of a monetary character."
Economists, therefore, define inflation in terms of a continuous rise in prices. Johnson defines
"inflation as a sustained rise in prices.

Demand-pull inflation

Demand-pull inflation occurs when the general price level rises due to an increase in aggregate
demand. Aggregate demand is the total demand for the goods and services produced in the
economy over a period of time and is comprised of consumption expenditure, investment
expenditure, government expenditure on goods and services and net exports. When aggregate
demand rises, the demand for factor inputs in the economy and hence the prices will rise. When
this happens, the cost of production in the economy will rise which will induce firms to increase
prices to maintain profitability resulting in a rise in the general price level. Given any increase in
aggregate demand, the extent of the rise in the general price level will depend on the state of the
economy. The nearer the economy is to the full-employment equilibrium, the larger will be the
rise in the general price level.

Cost-push inflation
 40
Cost-push inflation occurs when the general price level rises due to a rise in the cost of
production in the economy, independent of demand. Aggregate supply is the total supply of
goods and services in the economy over a period of time. When the cost of production in the
economy rises independently of demand, firms will increase prices at the same output levels to
maintain profitability. In other words, they will reduce output at the same prices which will lead
to a decrease in aggregate supply resulting in a rise in the general price level.

However, it is essential to understand that a sustained rise in prices may be of various

magnitudes. Accordingly, different names have been given to inflation depending upon the rate
of rise in prices.
1. Creeping Inflation.When the rise in prices is very slow like that of a snail or creeper, it is
called creeping inflation. In terms of speed, a sustained rise in prices of annual increase of less
than 3 per cent per annum is characterized as creeping inflation. Such an increase in prices is
regarded safe and essential for economic growth.
2. Walking or Trotting Inflation: The rate of rise in prices is in the intermediate range of 3
to 7 per cent per annum or less than 10 per cent. Inflation at this rate is a warning signal for the
government to control it before it turns into running inflation.
3. Running Inflation:When prices rise rapidly like the running of a horse at a rate of speed of
10 to 20 per cent per annum, it is called running inflation. Such Inflation affects the poor and
middle classes adversely. Its control requires strong monetary and fiscal measures, otherwise it
leads to hyperinflation.
4. Hyperinflation. When prices rise very fast at double or triple digit rates from more than 20
to 100 per cent per annum or more, it is usually called runaway or galloping inflation. It is also
characterized as hyperinflation by certain economists. In reality, hyperinflation is a situation
when the rate of inflation becomes immeasurable and absolutely uncontrollable.

CAUSES OF INFLATION
Inflation is caused when the aggregate demand exceeds the aggregate supply of goods
and services. We analyze the factors which lead to increase in demand and the shortage of
supply.

Factors Affecting Demand

Both Keynesians and monetarists believe that inflation is caused by increase in the
aggregate demand. They point towards the following factors which raise it.
1. Increase in Money Supply.Inflation is caused by an increase in the supply of money
which leads to increase in aggregate demand. The higher the growth rate of the nominal
money supply, the higher is the rate of inflation. Modern quantity theorists do not believe
that. true inflation starts after the full employment level..
2. Increase in Disposable Income.When the disposable income of the people increases, it
raises their demand for goods and services. Disposable income may increase with the rise in
national income or reduction in taxes or reduction in the saving of the people.
3. Increase in Public Expenditure.Government activities have been expanding much with
the result that government expenditure has also been increasing at a phenomenal rate, thereby
raising aggregate demand for goods and services. Governments of both developed and
developing countries are providing more facilities under public utilities and social services,
and also nationalizing industries and starting public enterprises with the result that they help
in increasing aggregate demand.
4. Increase in Consumer Spending. The demand for goods and services increases when
consumer expenditure increases. Consumers may spend more due to conspicuous
consumption or demonstration effect. They may also spend more when they are given credit
facilities to buy goods on hire-purchase and installment basis.
5. Cheap Monetary Policy. Cheap monetary policy or the policy of credit expansion also
leads to increase in the money supply which raises the demand for goods and services in the
economy. When credit expands, it raises the money income of the borrowers which, in turn,
 41
raises aggregate demand relative to supply, thereby leading to inflation. This is also known
as credit-induced inflation.
6. Deficit Financing.In order to meet its mounting expenses, the government resorts to
deficit financing by borrowing from the public and even by printing more notes. This raises
aggregate demand in relation to aggregate supply, thereby leading to inflationary rise in
prices. This is also known as deficit-induced inflation.
7. Expansion of the Private Sector.The expansion of the private sector also tends to raise
the aggregate demand. For huge investments increase employment arid income, thereby
creating more demand for goods and services. But it takes time for the output to enter the
market.
8. Black Money.The existence of black money in all countries due to corruption, tax
evasion etc. increases the aggregate demand. People spend such unearned money
extravagantly, thereby creating unnecessary demand for commodities. This tends to raise the
price level further.
9. Repayment of Public Debt. Whenever the government repays its past internal debt to the
public, it leads to increase in the money supply with the public. This tends to raise the aggregate
demand for goods and services.
10. Increase in Exports. When the demand for domestically produced goods increases in
foreign countries, this raises the earnings of industries producing export commodities. These,
in turn, create more demand for goods and services within the economy.

Factors Affecting Supply

There are also certain factors which operate on the opposite side and tend to reduce the aggregate
supply. Some of the factors are as follows:
1. Shortage of Factors of Production. One of the important causes affecting the supplies of
goods is the shortage of such factors as labour, raw materials, power supply, capital etc. They
lead to excess capacity and reduction in industrial production.
2. Industrial Dispute. In countries where trade unions are powerful, they also help in curtailing
production. Trade unions resort to strikes and if they happen to be unreasonable from the
employers' viewpoint and are prolonged, they force the employers to declare lock-outs. In both
cases, industrial production falls, thereby reducing supplies of goods. If the unions succeed in
raising money wages of their members to a very high level than the productivity of labour, this
also tends to reduce production and supplies of goods.
3. Natural Calamities. Drought or floods is a factor which adversely affects the supplies of
agricultural products. The latter, in turn, create shortages of food products and raw materials,
thereby helping inflationary pressures.
4. Artificial Scarcities. Artificial scarcities are created by hoarders and speculators who indulge
in black marketing. Thus they are instrumental in reducing supplies of goods and raising their
prices.
5. Increase in Exports. When the country produces more goods for export than for domestic
consumption, this creates shortages of goods in the domestic market. This leads to inflation in
the economy.
6. Lop-sided Production. If the stress is on the production of comfort, luxuries, or basic
products to the neglect of essential consumer goods in the country, this creates shortages of
consumer goods. This again causes inflation.
7. Law of Diminishing Returns. If industries in the country are using old machines and
outmoded methods of production, the law of diminishing returns operates. This raises cost per
unit of production, thereby raising the prices of products.
8. International Factors. In modern times, inflation is a worldwide phenomenon. When prices
rise in major industrial countries, their effects spread to almost all countries with which they
have trade relations. Often the rise in the price of a basic raw material like petrol in the
international market leads to rise in the price of all related commodities in a country.

MEASURES TO CONTROL INFLATION

We have studied above that inflation is caused by the failure of aggregate supply
to equal the increase in aggregate demand. Inflation can, therefore, be controlled by increasing
the supplies and reducing money incomes in order to control aggregate demand. The various
methods are usually grouped under three heads: Monetary measures, fiscal measures and other
measures.
1. Monetary Measures
Monetary measures aim at reducing money incomes.
 42
(a) Credit Control. One of the important monetary measures is monetary policy. The central bank
of the country adopts a number of methods to control the quantity and quality of credit. For this
purpose, it raises the bank rates, sells securities in the open market, raises the reserve ratio, and
adopts a number of selective credit control measures, such as raising margin requirements and
regulating consumer credit.

Monetary policy may not be effective in controlling inflation, if inflation is due to cost-push
factors. Monetary policy can only be helpful in controlling inflation due to demand-pull factors.
(b) Demonetization of Currency. However, one of the monetary measures is to demonetize
currency of higher denominations. Such a measure is usually adopted when there is abundance of
black money in the country.
(c) Issue of New Currency. The most extreme monetary measure is the issue of new currency in
place of the old currency. Under this system, one new note is exchanged for a number of notes of
the old currency. The value of bank deposits is also fixed accordingly. Such a measure is adopted
when there is an excessive issue of notes and there is hyperinflation in the country. It is very
effective measure.
2. Fiscal Measures
Monetary policy alone is incapable of controlling inflation. It should, therefore, be supplemented
by fiscal measures. Fiscal measures are highly effective for controlling government expenditure,
personal consumption expenditure, and private and public investment. The principal fiscal
measures are the following:

(a) Reduction in Unnecessary Expenditure. The government should reduce unnecessary

expenditure on non-development activities in order to curb inflation. This will also put a check
on private expenditure which is dependent upon government demand for goods and services. But
it is not easy to cut government expenditure. Though economy measures are always welcome but
it becomes difficult to distinguish between essential and non-essential expenditure. Therefore,
this measure should be supplemented by taxation.

(b) Increase in Taxes. To cut personal consumption expenditure, the rates of personal, corporate
and commodity taxes should be raised and even new taxes should be levied, but the rates of taxes
should not be so high as to discourage saving, investment and production. To increase the supply
of goods within the country, the government should reduce import duties and increase export
duties.
(c) Increase in Savings. Another measure is to increase savings on the part of the people. This
will tend to reduce disposable income with the people, and hence personal consumption
expenditure. But due to the rising cost of living, people are not in a position to save much
voluntarily.For this purpose, the government should float public loans carrying high rates of
interest, start saving schemes with prize money, or lottery for long periods, etc. It should also
introduce compulsory provident fund, provident fund-cum-pension schemes, etc. compulsorily.
All such measures to increase savings are likely to be effective in controlling inflation.
(d) Surplus Budgets. An important measure is to adopt anti-inflationary budgetary policy. For
this purpose, the government should give up deficit financing and instead have surplus budgets.
It means collecting more in revenues and spending less.
(e) Public Debt. At the same time, it should stop repayment of public debt and postpone it to
some future date till inflationary pressures are controlled within the economy. Instead, the
government should borrow more to reduce money supply with the public.
Like the monetary measures, fiscal measures alone cannot help in controlling inflation. They
should be supplemented by monetary, non-monetary and non fiscal measures.

3. Other Measures
The other types of measures are those which aim at increasing aggregate supply and reducing
aggregate demand directly.

(a) To Increase Production. The following measures should be adopted to increase production:
(i) One of the foremost measures to control inflation is to increase the production of essential
consumer goods like food, clothing, kerosene oil, sugar, vegetable oils, etc.
(ii) If there is need, raw materials for such products may be imported on preferential basis to
increase the production of essential commodities.
(iii) Efforts should also be made to increase productivity. For this purpose, industrial peace
should be maintained through agreements with trade unions, binding them not to resort to strikes
for some time.
 43
(iv) The policy of rationalization of industries should be adopted as a long-term measure.
Rationalization increases productivity and production of industries through the use of brain,
brawn and bullion.
(v) All possible help in the form of latest technology, raw materials, financial help, subsidies, etc.
should be provided to different consumer goods sectors to increase production.

(b) Rational Wage Policy. Another important measure is to adopt a rational wage and income
policy. Under hyperinflation, there is a wage-price spiral. To control this, the government should
freeze wages, incomes, profits, dividends, bonus, etc. But such a drastic measure can only be
adopted for a short period and by antagonizing both workers and industrialists. Therefore, the
best course is to link increase in wages to increase in productivity. This will have a dual effect. It
will control wage and at the same time increase productivity, and hence production of goods in
the economy.

(c) Price Control. Price control and rationing is another measure of direct control to check
inflation. Price control means fixing an upper limit for the prices of essential consumer goods.
They are the maximum prices fixed by law and anybody charging more than these prices is
punished by law. But it is difficult to administer price control.

(d) Rationing. Rationing aims at distributing consumption of scarce goods so as to make them
available to a large number of consumers. It is applied to essential consumer goods such as
wheat, rice, sugar, kerosene oil, etc. It is meant to stabilize the prices of necessaries and assure
distributive justice. But it is very inconvenient for consumers because it leads to queues, artificial
shortages, corruption and black marketing. Keynes did not favour rationing for it "involves a
great deal of waste, both of resources and of employment."

Conclusion: From the various monetary, fiscal and other measures discussed above, it becomes
clear that to control inflation, the government should adopt all measures simultaneously.
Inflation is like a hydra-headed monster which should be fought by using all the weapons at the
command of the government.

EFFECTS OF INFLATION

Fall in the real value of savings

High inflation will reduce the real value of savings. When inflation is high, nominal interest rates
will not fully compensate for the rise in the general price level which will reduce the amount of
goods and services that can be purchased with any given amount of savings.

Fall in investment expenditure

High inflation may lead to a decrease in investment expenditure. Since high inflation tends to be
less stable, firms will find it harder to estimate the costs and revenues of investments when
inflation is high which will lead to a decrease in investment expenditure.

Deterioration in the balance of payments

If net exports fall, the current account and hence the balance of payments will deteriorate. A
deterioration in the balance of payments may lead to a persistent balance of payments deficit
resulting in adverse consequences such as high imported inflation, lower national income, higher
unemployment and rising foreign debt.

Fall in national income

A decrease in net exports and investment expenditure will lead to a decrease in aggregate
demand resulting in a decrease in national income.

Rise in unemployment
Since national income is equal to national output, the decrease in national income will lead to a
fall in the demand for labour in the economy resulting in a rise in unemployment.

High shoe-leather cost of inflation

High inflation will lead to a high shoe-leather cost of inflation. High inflation will lead to high
interest rates. Metaphorically, when interest rates are high, the transactions demand for money
will be low. Therefore, people will make frequent trips to the bank to withdraw small amounts of
money which will cause their shoes to wear out rapidly resulting in a high shoe-leather cost of
inflation.

High menu cost of inflation

High inflation will lead to a high menu cost of inflation. When prices of goods and services rise,
 44
firms have to reprint price labels. For example, restaurants have to reprint menus to reflect the
higher prices of meals. When inflation is high, prices of goods and services will rise frequently
which will lead to a high menu cost of inflation.

Haphazard redistribution of real income and wealth (unanticipated inflation)

Unanticipated inflation will lead to a haphazard redistribution of real income and wealth.
Consider a wage contract that specifies a wage increase of 3 per cent on the assumption that the
general price level will remain unchanged. If inflation unexpectedly turns out to be 10 per cent,
the 3 per cent increase in nominal wages will mean a 7 per cent decrease in real wages. In this
instance, real income will be haphazardly redistributed from workers to firms. Furthermore,
unanticipated inflation will decrease the liabilities of debtors and the assets of creditors in real
terms. In other words, when there is unanticipated inflation, debtors will owe creditors less in
terms of goods and services. In this instance, wealth will be haphazardly redistributed from
creditors to debtors.

Haphazard redistribution of real income (anticipated inflation)

Anticipated inflation will also lead to a haphazard redistribution of real income. Some private
pension plans are stated in nominal terms and others compensate for up to only 5 per cent
inflation. Therefore, even if inflation had been anticipated, people who live on fixed nominal
income will see their real income erode away over time.

Although high inflation is undesirable for the economy, low inflation is desirable. Low inflation
is desirable for the economy because it injects some downward flexibility into real wages
resulting in lower unemployment. Although it is easy for firms to increase real wages by
increasing nominal wages, the converse is not true because workers are resistant to pay cuts.

Why are food costs rising?

The cost of producing additional food rises because resources are not homogeneous. That
is economic resources of a nation are not equally efficient in the production of food and clothing.
On producing the first 1 million units of food. The economy uses those resources which are most
efficient in food production and least efficient in clothing production. Thus, the amount in
clothing given up to produce the first 1 million units of food is very little. But as we continue to
expand food production by decreasing clothing production, the economic resources that must be
utilized to produce food are less and less productive in food production and more and more
productive in clothing production. As a result, the cost of expanding food production in terms of
reduced clothing production increases.

Note: A nominal value is measured in terms of money. A real value is measured in terms of
goods and services. Suppose that a firm pays a worker an income of $1000. Further suppose that
the only good in the economy is lipstick which costs $20 each. In this case, the nominal income
of the worker is $1000 and the real income is 20 lipsticks. It is important for students to note that
firms and workers are concerned with real income. Similarly, lenders and borrowers are
concerned with real interest rate. Suppose that a lender charges a borrower an interest rate of 7
per cent. Further suppose that inflation is 3 per cent. In this case, the real interest rate is 4 per
cent. This means that although the borrower will pay back 7 per cent more to the lender in terms
of money, the lender will only receive 4 per cent more from the borrower in terms of goods and
services.

NATIONAL INCOME AND ECONOMIC ACCOUNTING

National Income
National income is the total value a country’s final output of all new goods and services
produced in one year. Understanding how national income is created is the starting point for
macroeconomics.
There are three methods of calculating national income:
 The income method, which adds up all incomes received by the factors of production
generated in the economy during a year. This includes wages from employment and self-
employment, profits to firms, interest to lenders of capital and rents to owners of land.
 The output method, which is the combined value of the new and final output produced in
all sectors of the economy, including manufacturing, financial services, transport, leisure
and agriculture.
 45
 The expenditure method, which adds up all spending in the economy by households and
firms on new and final goods and services by households and firms.

Value Added Method. Another method of measuring national income is the value added
by industries. The difference between the value of material outputs and inputs at each
stage of production is the value added. If all such differences are added up for all
industries in the economy, we arrive at the gross domestic product.

In common parlance, national income means the total value of goods and services produced
annually in a 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.

CONCEPTS OF NATIONAL INCOME

There are a number of concepts pertaining to national income. For instance, Gross National
Product, Net National Product, Net National Income at Factor Cost, Net Domestic Product at
Factor Cost, Personal Income, Disposable Income, and Real Income. One by one, these concepts
are discussed below.
Gross National Product (GNP)
GNP is the total measure of the flow of goods and services at market value resulting from
current production during a year in a country, including net income from abroad. GNP includes
four types of final goods and services:
(1) Consumers’ goods and services to satisfy the immediate wants of the people;
(2)Gross private domestic investment in capital goods consisting of fixed capital
formation, residential construction and inventories of finished and unfinished goods;
(3) Goods and services produced by the government; and
(4) Net exports of goods and services, i.e., the difference between value of exports and
imports of goods and services, known as net income from abroad.
In this concept of GNP there are certain factors that have to be taken into consideration.
First, GNP is the measure of money, in which all kinds of goods and services produced
in a country during one year are measured in terms of money at current prices and then added
together.
Second, in estimating GNP of the economy, the market price of only the final products
should be taken into account. Many of the products pass through a number of stages therefore
they are ultimately purchased by consumers. If those products were counted at every stage, they
would be included many a time in the national product and consequently the GNP would
increase too much. To avoid double counting, therefore, only the final products, and not the
intermediary goods should be taken into account.
Third.goods and services rendered free of charge are not included in GNP., because it is not
possible to have a correct estimate of their market prices. For example, the bringing up of a child
by the mother, imparting instructions to his son by a teacher, recitals to his friends by a musician,
sculpturing as a hobby by a sculptor, etc.
Fourth, the transactions which do not arise from the produce of current year or which do
not contribute in any way to production, are not included in GNP. The sale and purchase of old
goods, and of shares, bonds and assets of existing companies are not included in GNP.
Fifth, the profits earned or losses incurred on account of changes in capital assets as a
result of fluctuations in market prices, are not included in the GNP if they are not responsible for
current production or economic activity.
Last, the income earned through illegal activities is not included in the GNP. Although
the goods sold in the black-market are priced and fulfill the needs of the people, but as they are
not useful from the social point of view, the income received from their sale and purchase is
always excluded from the GNP.
Three Approaches to GNP
Three approaches are employed for estimation of GNP. One, the income method to GNP; two,
the expenditure method to GNP; and three, value added method to GNP. Since the gross income
equals the gross expenditure, GNP estimated by all these methods would be the same with
appropriate adjustments.
 46
Income Approaches to GNP
The income approach to GNP consists of the remuneration paid in terms of money to the
factors of production annually in a country. Thus GNP is the sum total of the following items:
(i) Wages and salaries. Under this head fall all forms of wages and salaries earned through
productive activities by workers and entrepreneurs. It includes all sums received or deposited
during a year by way of all types of contributions like overtime, commission, provident fund,
insurance etc.
(ii) Rents. Total rent includes the rents of land, shop, house, factory, etc. and the estimated
rents of all such assets as are used by
the owners themselves.
(iii) Interest. Under interest comes the income by way of interest received by the individual of
a country from different sources. To this is added the estimated interest on that private capital
which is invested and not borrowed by the businessman in his personal business. But the interest
received on governmental loans has to be excluded, because it is a mere transfer of national
income.
(iv) Dividends. Dividends earned by the shareholders from
companies are included in the GNP.
(v) Undistributed corporate profits. Profits which are not distributed by companies and are
retained by them are included in the GNP.
(vi) Mixed incomes. These include profits of unincorporated businesses, self-employed
persons and partnerships. They form part of GNP.
(vii) Direct taxes. Taxes levied on individuals, corporations and other businesses are included
in the GNP.
(viii) Indirect taxes. The government levies a number of indirect taxes, like excise duties and
sales tax. These taxes are included in the prices of commodities. But revenue from these goes to
the government treasury and not to the factors of production. Therefore, the income due to such
taxes is added to the national income.
(ix) Depreciation. Every corporation makes allowance for expenditure on wearing out and
depreciation of machines, plants and other capital equipment. Since this sum also is not a part of
the income received by the factors of production, it is, therefore, also included in
GNP.
(x) Net income earned from abroad. This is the difference between the value of exports of
goods and services and the value of imports of goods and services. If this difference is positive,
then it is added to GNP and if it is negative it is deducted from GNP.

Thus GNP according to Income Method = Wages and Salaries +Rents + Interest +
Dividends + Undistributed Corporate Profits + Mixed Incomes + Direct Taxes + Indirect
Taxes + Depreciation + Net Income from abroad.
Expenditure Approach to GNP
From the expenditure viewpoint, GNP is the sum total of expenditure incurred on goods and
services during one year in a country. It includes the following items:

(i) Private consumption expenditure. It includes all types of expenditure on personal

consumption by the individuals of a country. It comprises expenses on durable goods like watch,
bicycle, radio etc., expenditure on single-used consumers’ goods like milk, bread, ghee, clothes
etc., as also the expenditure incurred on services of all kinds like fees for school, doctor, lawyer
and transport. All these are taken as final goods.

(ii)Gross domestic private investment. Under this comes the expenditure incurred by private
enterprise on new investment and on replacement of old capital. It includes expenditure on
house-construction, factory-buildings, all types of machinery, plants and capital equipment.

(iii) )Net foreign investment. It means the difference between exports and imports or export
surplus. Every country exports to or imports from certain foreign countries. The imported goods
are not produced ‘within the country and hence cannot be included in national income, but the
exported goods are manufactured within the country. Therefore, the difference of value between
exports (X) and imports (M), whether positive or negative, is included in the GNP
 47

(iv) Government expenditure on goods and services. The expenditure incurred by the
government on goods and services is a part of GNP. Central, State or Local governments spend a
lot on their employees, police and army. To run the offices the governments have also to spend
on contingencies which include paper, pen, pencil and various types of stationery, cloth,
furniture, cars etc. It also includes the expenditure on government enterprises. But expenditure
on transfer payments is not added, because these payments are not in exchange for goods and
services produced during the current year.

Thus GNP according to Expenditure Method = Private Consumption Expenditure

(C)+Gross Domestic Private Investment (I)+Net Foreign Investment (X—M)+Government
Expenditure on Goods and Services (G) = C+I+(X—M)+ G.
As already pointed out above, GNP estimated by either the income or the expenditure method
would work out to be the same, if all the items are correctly calculated.
Value Added Approach to GNP
Another method of measuring GNP is by value added. In calculating GNP the money value of
final goods and services produced at current prices during a year is taken into account. This is
one of the ways to avoid double counting. But it is difficult to distinguish properly between a
final product and an intermediate product. For instance, raw materials, semi-finished products,
fuels and services, etc. are sold as inputs by one industry to the other. They may be final goods
for one industry and intermediate for others. So, to avoid duplication, the value of intermediate
products used in manufacturing final products must be subtracted from the value of total output
of each industry in the economy.

GNP at Market Prices

When we multiply the total output produced in one year by their market prices prevalent
during that year in a country, we get the Gross National Product at market prices. Thus GNP at
market prices means the gross value of final goods and services produced annually in a country
plus net income from abroad.

GNP at Factor Cost

GNP at factor cost is the sum of the money value of the income produced by and accruing to the
various factors of production in one year in a country. It includes all items mentioned above
under Income Approach to GNP less indirect taxes. GNP at market prices always includes
indirect taxes levied by the government on goods which raise their prices. But GNP at factor cost
is the income which the factors of production receive in return for their services alone. It is the
cost of production. Thus GNP at market prices is always higher than GNP at factor cost.
Therefore, in order to arrive at GNP at factor cost, we deduct indirect taxes from
GNP at Factor cost = GNP at Market Prices—Indirect Taxes+ Subsidies.
Net National Product (NNP)

GNPincludes the value of total output of consumption goods and Investment goods. But the
process of production uses up a certain amount of fixed capital. Some fixed equipment wears
out, its other components are damaged or destroyed, and still others are rendered obsolete
through technological changes. All this process is termed depreciation or capital consumption
allowance. In order to arrive at NNP, we deduct depreciation from GNP. The word ‘net’ refers to
the exclusion of that part of total output which represents depreciation. So NNP = GNP—
Depreciation.

NNP at Market Prices

Net National Product at market prices is the net value of final goods and services evaluated at
market prices in the course of one year in a country. If we deduct depreciation from GNP at
market prices, we get NNP at market prices.
So NNP at Market Prices = GNP at Market Prices—Depreciation.
NNP at Factor Cost
Net National Product at factor cost is the net output evaluated at factor prices. It includes
income earned by factors of production through participation in the production process such as
wages and salaries, rents, profits, etc. It is also called National Income. This measure differs
 48
from NNP at market prices in that indirect taxes are deducted and subsidies are added to NNP at
market prices in order to arrive at NNP at factor cost.
Thus NNP at Factor Cost = NNP at Market Prices—Indirect taxes + Subsidies.
= GNP at Market Prices— Depreciation—Indirect taxes + Subsidies.
=National Income.
Normally, NNP at market prices is higher than NNP at factor cost because indirect taxes
exceed government subsidies. However, NNP at market prices can be less than NNP at factor
cost when government subsidies exceed indirect taxes.

Per Capita Income

The average income of the people of a country in a particular year is called Per Capita
Income for that year. This concept also refers to the measurement of income at current prices,
and at constant prices. For instance, in order to find out the per capita income for 2015, at
current prices, the national income of a country is divided by the population of the country in
that year

Per Capita Income for 2015 = National income for 2015

Population in 2015

DIFFICULTIES IN THE MEASUREMENT OF NATIONAL INCOME

To calculate the national income of a country is a complicated problem and is beset with the
following difficulties:
(1) First there is the difficulty of defining `nation' in national income. Every nation has its
political boundaries, but in the national income is also included the income earned by the
nationals of a country in a foreign country beyond the territorial boundaries of that country.
(2) National income is always measured in money, but there are a number of goadsand
services which are difficult to be assessed in terms of money, e.g., painting as a hobby by an
individual, the bringing up of children by the mother. Similarly, when the owner of a firm gets
married to his lady secretary, her services, though a part of national income, are not included in
it. By excluding all such services from it the national income will work out to be less than what it
actually is.
(3) The greatest difficulty in calculating the national income is of double counting, which
arises from the failure to distinguish properly between a final and an intermediate product. There
always exists the fear of a good or a service being included more than once. If it so happens, the
national income would work out to be many times the actual. Flour used by a bakery is an
intermediate product and that by a household the final product. To solve this difficulty, only the
final goods and services are taken into account, and that is not so easy a task.
(4) Income earned through illegal activities such as gambling, or illicit extraction of wine,
etc is not included in national income. Such goods and services do have value and meet the needs
of the consumers. But by leaving them out, the national income works out to less than the actual.
(5) Then there arises the difficulty of including transfer payments in the national income.
Individuals get pension, unemployment allowance and interest on public loans, but whether these
should be included in national income is a difficult problem. On the one hand, these earnings are
a part of individual income and on the other, they are government expenditure. To avoid this
difficulty, these are deducted from national income.
(6) Capital gains or losses which accrue to property owners by increases or decreases in
the market value of their capital assets or changes in demand are excluded from the GNP because
such changes do not result from current economic activities. It is only when capital gains or
losses are the result of the current flow or non-flow of productive activities that they are included
in the GNP.
(7)All inventory changes whether negative or positive are included in the GNP. The
procedure is to take positive or negative changes in physical units of inventories and multiply
them by current prices. But the problem is that firms record inventories at their original costs
rather than at replacement costs. When prices rise there are gains in the book value of
inventories. Contrariwise, there are losses when prices fall. So the book value of inventories
overstates or understates the actual inventories.
(8) When we deduct capital depredation from GNP, the resulting measure is NNP.
 49
Depreciation is a charge on profits which lowers national income. But the problem of estimating
the current depreciated value of a piece of capital whose expected life is fifty years is very
difficult.
(9)Another difficulty in calculating national income is that of price-changes which fail to
keep stable the measuring rod of money for national income. When the price level in the country
rises, the national income also shows an increase even though the production might have fallen.
On the contrary, with a fall in price level, the national income shows a decline even though the
production might have gone up.
(10) Moreover, the calculation of national income in terms of money is under-
estimation of real national income. It does not include the leisure foregone in the process of
production of a commodity. The income earned by two individuals may be equal, but if one of
them works for longer hours than the other, would it be correct to some extent to say that the real
income of the former has been understated.
(11) In calculating national income, a good number of public services are also taken
which cannot be estimated correctly. How should the police and military services be estimated?
In the days of war, the forces are active, but during peace they rest in cantonments. Similarly, to
estimate the contribution made to national income by profits earned on irrigation and power
projects in terms of money is also a difficult problem.
Problems of Measurement in a Developing Economy
In a developing economy, complete and reliable information relating to the various methods of
estimating national income are not available due to the following problems:
1. Non-monetized Sector. There is a large non-monetized sector in a developing
economy. This is the subsistence sector in rural areas in which a large portion of production is
partly exchanged for the other goods and is partly kept for personal consumption. Such
production and consumption cannot be calculated in national income.
2.Lack of Occupational Specialization. There is the lack of occupational specialization in
such a country which makes the calculation of national income by product method difficult.
Besides the crop, farmers in a developing country are engaged in supplementary occupations like
dairying, poultry, cloth making, etc. But income from such productive activities is not included
in the national income estimates.
3.Non-market Transactions. People living in rural areas in adeveloping country are able
to avoid expenses by building their own huts, tools, implements, garments and other essential
commodities. Similarly, people in urban areas having kitchen gardens produce vegetables which
they consume themselves. All such productive activities do not enter the market transactions and
hence are not included in the national income estimates.
4. Illiteracy. The majority of people in such a country are illiterate and they do not keep
any accounts about the production and sales of their products. Under the circumstances, the
estimates of production and earned incomes are simply guesses.
4.Non-availability of Data. Adequate and correct production and Cost data are not available
in a developing country. Such data relate to crops, forestry, fisheries, animal husbandry,
and the activities of petty shopkeepers, small enterprises, construction workers, etc. For
estimating national income by the income method, data on unearned incomes and on
persons employed in the service sector are not available. Moreover, data on consumption
and investment expenditures of the rural and urban population are not available for the
estimation of national income by the expenditure method. Moreover, there is no
machinery for the collection of data in such countries.

NATIONAL INCOME AND THE STANDARD OF LIVING

The standard of living refers to the material and non-material welfare of the people.

Since national income is equal to national output, an increase in national income may lead to an
increase in the amount of goods and services available for consumption. If this happens, the
material standard of living will rise. In addition to a rise in the material standard of living, an
increase in national income may lead to a rise in the non-material standard of living. When
national income rises, the demand for labour in the economy will increase which will lead to a
fall in unemployment. When this happens, the mental health of workers in the economy will
 50
improve, and this is true particularly if the workers with a new found job were jobless for a
prolonged period of time.

However, due to several reasons, this is not necessarily true. Therefore, problems arise when
national income is used to compare the standard of living over time and across space.

Comparison of the standard of living over time

An increase in national income may not lead to a rise in the standard of living because it may not
lead to an increase in the amount of goods and services available for consumption due to several
reasons.

First, the amount of goods and services available for consumption may not increase because the
amount of non-marketed goods and services may decrease. The value of non-marketed goods
and services is not included in national income. For instance, when a baker bakes a pie, the value
of the pie is included in national income. However, when a housewife bakes a pie, it is not.
When unemployment falls, less people will have time to engage in household production which
will lead to a decrease in the amount of non-marketed goods and services.

More examples in developing economies, many of the households engage in subsistence farming
where they produce food to feed themselves. However, the value of food that these households
produce is not included in national income. In this case, the omission of the value of non-
marketed goods and services from national income understates the standard of living as
measured by national income.

Second, the amount of goods and services available for consumption may not increase because
the amount of undeclared goods and services in the underground economy may decrease. The
value of undeclared goods and services in the underground is not included in national income.
These goods and services are not declared because they may be illegal, such as drugs and
prostitution, or for the purpose of tax evasion. For instance, people smuggle tobacco and alcohol
to evade tax. When unemployment falls, less people will be compelled to engage in production
in the underground economy which will lead to a decrease in the amount of undeclared goods
and services.

First, the amount of goods and services available to domestic residents for consumption may not
increase because an increase in national income may be due to an increase in exports.

Second, the amount of goods and services available to the average person for consumption may
not increase because the population may increase.

Third, an increase in national income may worsen income inequity. When national income rises,
high income workers may receive larger wage raises than low income workers. If this worsens
income inequity, low income workers may feel relatively worsen off resulting in a fall in their
non-material standard of living.

Fourth, an increase in national income may lead to more negative externalities such as carbon
emissions resulting in a fall in the non-material standard of living.

Fifth, an increase in national income may lead to people working longer hours resulting in less
leisure time and hence a fall in the non-material standard of living.

Contrary to what is discussed above, an increase in national income may lead to a larger increase
in the standard of living. First, the quality of goods and services produced may improve. Second,
the variety of goods and services produced may increase.

Comparison of the standard of living across space

If the national income of economy A is higher than that of economy B, the standard of living
may not be higher because the amount of goods and services available for consumption may not
be larger due to several reasons.
 51
First, the amount of goods and services available to domestic residents for consumption in
economy A may not be larger because the higher national income may be due to higher exports.

Second, the amount of goods and services available to the average person for consumption in
economy A may not be larger because the population may be larger.

Third, the distribution of income in economy A may be less equitable than that in economy B.

Fourth, the amount of negative externalities such as carbon emissions produced in economy A
may be larger than that is produced in economy B resulting in a lower non-material standard of
living.

Fifth, the people in economy A may be working longer hours than those in economy B which
means that the people in economy A may have less leisure time and hence a lower non-material
standard of living.

Contrary to what is discussed above, a higher national income in economy A than in economy B
may lead to an even higher standard of living. First, the quality of goods and services produced
in economy A may be lower than that in economy B. Second, the variety of goods and services
produced in economy A may be smaller than that in economy B.

GNP and GDP both reflect the national output and income of an economy. The main difference
is that GNP (Gross National Product) takes into account net income receipts from abroad.

Gross Domestic Product Gross National Product

What is it? A measure of the total economy of a GNP is the measure of money, in
nation within the country. which all kinds of goods and
services produced in a country
during one year are measured in
terms of money at current prices
and then added together.
How it’s calculated Measuring all income earned within a GDP, plus income from foreign
country, or by measuring all sources, less income paid to
expenditures within the country, which foreign citizens and entities
should approximately match
Why is it important? It measures both the size and direction Same as GDP
of economic activity (growth,
stagnation or contraction) – expansions
and recessions are based on changes in
GDP
Who uses it? Politicians, economists, large Same as GDP
companies (especially multi-nationals)

GNP and GDP both reflect the national output and income of an economy. The main difference
is that GNP (Gross National Product) takes into account net income receipts from abroad.

GDP (Gross Domestic Product) is a measure of national income / national output and
national expenditure produce in a particular country.

GNP = GDP + Net property income from abroad. This net income from abroad includes,
dividends , interest and profit.
GNP includes the value of all goods and services produced by nationals whether in the
country or not.

Both GDP and GNP are complicated, and best summarized in a side-by-side comparison.

The Balance of Payments

A. A nation’s balance of payments is the sum of all transactions that take place between
its residents and the residents of all foreign nations. These transactions include
merchandise exports and imports, tourist expenditures, and interest plus dividends
 52
from the sale and purchases of financial assets abroad. The balance of payments
account is subdivided into three components: the current account, the capital account,
and the official reserves account.
B. Current Accounts is shown:
1. The current account summarizes BD. trade in currently produced goods and
services.
2. The merchandise trade balance is the difference between its exports and imports
of goods.
3. The balance on goods and services, shown the difference between BD. exports of
goods and services and BD. imports of goods and services
4. Balance on the current account is found by adding all transactions in the current
account (item 10, Table 38.1).
5. Global Perspective gives trade balance for other nations.
C. Capital Account:
1. The capital account summarizes the flows of payments (money “capital”) from
the purchase or sale of real or financial assets.
2. For example, a foreign firm may buy a real asset, say an office tower in the BD.,
or a BD. government bond. Both kinds of transactions involve the “export” of the
ownership of BD. assets from the United States in return for payments of foreign
currency (money “capital”) inflows.
3. The balance in the capital account was $2122 billion in 2014.
D. Official Reserves Account:
The third account in the overall balance of payments is the official reserves
account. The central banks of nations hold quantities of foreign currencies called
official reserves. These reserves can be drawn on to make up any net deficit in
the combined current and capital accounts (much as you would draw on your
savings to pay for a special purchase). In 2014 this was $599 billion
E. Payments Deficits and Surpluses:
1. A drawing down of official reserves measures a nation’s balance of payments
deficit; a building up of official reserves measures its balance of payments
surpluses. Adding to foreign reserves would occur if there is a surplus.
2. A balance of payments deficit is not necessarily bad, nor is a balance of payments
surplus necessarily good. However, persistent payments deficits would ultimately
deplete the foreign exchange reserves.
3. To correct its balance of payments deficit, a nation might implement a major
depreciation of its currency or other policies to encourage exports.
The balance of payments has three components:
 the current account: records exports and imports of goods and services and international
receipts or payments of income
 the _nancial account: record of sales of assets to foreigners and purchases of assets
located
abroad (foreign assets).
 the capital account: debt forgiveness and entering-departing migrants' transfers
Current Account Balance + Financial Account Balance +Capital Account Balance= 0
This distinction between the _nancial and capital account is made by the IMF and other
inter-
national organizations. Most practitioners include the _nancial account in the capital
account.

Basis of
Balance of Trade (BOT) Balance of Payment (BOP)
Difference
Balance of trade may be defined
1. Definition Balance of payment is flow of cash between domestic
as difference between export
country and all other foreign countries. It includes not
and import of goods and
only import and export of goods and services but also
services.
includes financial capital transfer.
2. Formula BOT = Net Earning on BOP = BOT + (Net Earning
Export - Net payment on foreign investment - payment made to foreign
forimports investors) + Cash
Transfer + Capital Account +or - Balancing Item
 53
or
BOP = Current Account + Capital Account + or -
Balancing item ( Errors and omissions)

3. Favourable
or Balance of Payment will be favourable, if you have
Unfavourable If export is more than surplus incurrent account for paying your all past loans
import, at that time, BOT will in your capital account.
be favourable. If import is more Balance of payment will be unfavourable, if you
than export, at that time, BOT have current account deficit and you took more loan
will be unfavourable. from foreigners. After this, you have to pay
high interest on extra loan and this will make your
BOP unfavorable.

4. Solution of
To Buy goods and services To stop taking of loan
Unfavourable
from domestic country. from foreign countries.
Problem
Following are main factors
5. Factors Following are main factors
which affect BOT
which affect BOP
a) cost of production
a) Conditions of foreign lenders.
b) availability of raw materials
b) Economic policy of Govt.
c) Exchange rate
c) all the factors of BOT
d) Prices of goods manufactured
at home
If you see RBI' Overall
6. Meaning of
balance of payment report, it
Debit and Credit means to receipt and earning both current and
shows debit and credit ofcurrent
Credit capital account and debit means total outflow of cash
account.
both current and capital account and difference
Credit means total export of
between debit and credit will be net balance of
different goods and services and
payment.
debit means total import of
goods and services in current
account.

Bank and Banking in Bangladesh

Bangladesh Bank
Bangladesh Bank is the central bank and monetary authority of the country. It cameinto
existence under the Bangladesh Bank Order 1972 (Presidential Order No. 127of 1972) which
took effect on 16 December 1971. Through this order, the entireoperation of the former State
Bank of Pakistan in the eastern wing was transferredto Bangladesh Bank.
The powers and functions of Bangladesh Bank are governed by various laws and acts including
the Banker's Books Evidence Act 1891, Insolvency Act 1920, Banking Companies Ordinance
1962, Bangladesh Bank Order 1972, Foreign Exchange (Regulation) Act 1986, Money Loan
Court Act1990, Banking Companies Act 1991, Financial Institutions Act 1993 and Rules1994,
Companies Act 1994 and Bankruptcy Act 1997.
History of Bangladesh Bank
After theliberation war , and the eventual independence of Bangladesh, theGovernment of
Bangladesh reorganized theDhakabranch of theState Bank of Pakistanas thecentral bank of the
country, and named it Bangladesh Bank.
Thisreorganization was done pursuant to Bangladesh Bank Order, 1972, and theBangladesh Ban
k came into existence with retrospective effect from16th December ,1971.The highest official in
the bank is the Governor.The Governor chairs the Board of Director. The Executive Staff, also
headed bythe Governor, are responsible for the day to day affairs.
Objectives of Bangladesh Bank
As the central Bank of Bangladesh, the broad objectives of the Bank are:
a) To regulate currency issuance and to keep foreign exchange reserves;
b) To manage the monetary and credit system of Bangladesh with a view tostabilizing domestic
monetary value;
c) To preserve the par value of the Bangladesh Taka;
 54
d) To promote and maintain a high level of production, employment and realincome in
Bangladesh; and to foster growth and development of the country's productive resources

Missions of Bangladesh Bank

To uphold the vision and in pursuant with the Bangladesh Bank Order of 1972,Bangladesh
Bank’s mission is to promote and maintain macroeconomic and pricestability through:
#Formulating and implementing appropriate monetary policy consistent with the country’s
national development goals;
#Pursuing prudent policies to ensure stable internal and external value of Taka;
#Identifying policy priorities for implementation by the Governmentthrough assessing the transm
ission channels and the interactions of monetary policy with fiscal, exchange rate, and other
acroeconomic policies and their impact on the economy;
#Proposing necessary legislative measures to attain the central bank’sobjectives and perform its
functions including strategies and regulationsfor and supervision of banking companies and
financial institutions withthe aim to providing efficient financial intermediation and
financialservices to large, medium, small, and micro enterprises and to pro-poor activities
#Promoting, regulating and ensuring a secure and efficient payment system, including the issue
of Bank

1: Define Bank / Commercial Bank and Discuss the functions of

Commercial Banks.
A) MEANING AND DEFINATION OF COMMERCIAL BANK :
In modern economy commercial Banks play an important role in the financial sector. A
Bank is an institution dealing in money and credit. Credit money is the major component of
money supply in a modern economy. Commercial banks are the creators of credit. The strength
of economy of any country basically depends on a sound and solvent banking system.
A Commercial bank is a profit seeking business firms dealing in money or rather claims to
money. It safeguards the savings of the public and give loans and advances.
The Banking Companies Act of 1949, defines banking company as “accepting for the
purpose of lending or investment of deposit money from the public, repayable on demand or
otherwise and withdrawable by cheque, drafts, order or otherwise”.

B) FUNCTIONS OF COMMERCIAL BANKS :-

Modern commercial banks perform a variety of functions. They keep the wheels of
commerce, trade and industry always revolving. Major functions of a commercial bank are: -
Primary or Banking functions and Secondary or Non-Banking functions.

FUNCTIONS OF COMMERCIAL BANKS

Primary Secondary Subsidiary

Activities

Deposits Loans Agency Utility

& Services Services
Advances

I. Primary / Banking Functions :-

Commercial banks have two important banking functions. One is accepting deposits and
other is advancing loans.
1) Deposits :-
One of the main function of a bank is to accept deposits from the public. Deposits are
accepted by the banks in various forms.
a) Current Account Deposits :-
Current Accounts are usually opened by businessmen who have a number of regular
transactions with the bank, both deposits and withdrawls. There is no restriction on number and
amount of deposits. There is also no restriction on withdrawls. No interest is paid on current
 55
deposits. Banks may even charge interest for providing this facility. These accounts are also
known as demand deposits as amount can be withdrawn on demand.
b) Saving Account Deposits :-
Saving Accounts are opened by salaried and other less income people. There is no restriction
on number and amount of deposits. Withdrawls are subject to certain restrictions. It earns Interest
but less than fixed deposits. It encourages saving habit among salary earners and others. Saving
deposits are an important source of funds for banks.
c) Fixed Account Deposits :-
Deposits in fixed account are time deposits. Money under this account is deposited for a
certain fixed period of time varying from 15 days to several years. A high rate of interest is paid.
If money is withdrawn before expiry date, the depositor receives lower rate of interest. Deposits
can be renewed for further period. Many banks sanction loans against security of fixed deposits.
d) Recurring Account Deposits :-
In Recurring deposit, a specified amount is regularly deposited by account holder, at an
internal of usually a month. This is to form the habit of small savings among the people. At the
end of maturity period, the account holder gets a substantial amount. Interest on this type of
deposit is almost equal to fixed deposits.
Thus by creating variety of deposits, banks motivate people in a variety of ways and
encourage savings in the economy.
2) Loans And Advances :-
Banks not only mobilize money but also lend to its credit worthy customers for maximizing
profits. Loans and Advances are granted To :-
a) Business And Trade :-
Commercial banks grant short-term loans to business and trade activities in following forms:-

i) Overdraft :-
Commercial banks grant overdraft facility to current account holders Under this system a
borrower is allowed to draw more than what is deposited in his account. The borrower is granted
to a fixed additional amount against collateral security. Interest is charged for actual amount
drawn.
ii) Cash Credit :
Cash credit is given by the bank to any businessman to meet regular working capital needs,
against the security of goods or personal security. Interest is charged on actual amount drawn by
the customer.
iii) Discounting Of Bills :
When the holder of the bill is not in a position to wait till the maturity of the bill and requires
cash urgently, he sells the bill of exchange to bank. Bank advance credit by discounting bills of
exchange, government securities or any other approved financial instruments. The bank
purchases the instruments at a discount.

iv) Money At Call :

Banks also grant loans for a very short period, generally not exceeding 7 days. Such advances
are repayable immediately at a short notice hence they are called as Money at Call or Call
money. These loans are given to dealers or brokers in stock market against Collateral Securities.
v) Direct Loans :
Loans are given to customers against the security of moveable properties. Their maturity
varies from 1 to 10 years. Interest has to be paid on entire loan amount sanctioned. Loans are of
many types like :- personal loans, term loans, call loans, participative loans, collateral loans etc.
b) Loans to Agriculture :
Banks grant short-term credit to agriculture at a lower rate of interest. Loans are granted for
irrigation, purchase of equipments, inputs, cattle etc.
c) Loans To Industries :
Banks grant secured loans to small and medium scale industries to meet their working capital
needs. The time period may be from one to five years. It may be in the form of Overdraft, cash
credit or direct loan.
d) Loans To Foreign Trade :
Loans are granted to export and import in the form of direct loans, discounting of bills,
guarantee for deferred payments etc. Here the rate of interest is low.
 56
e) Consumer Credit / Personal loans :
Banks also grant credit to household in a limited amount to buy some durable consumer goods
like television sets, refrigerators, washing machine etc. Such consumer credit is repayable in
installments. Under 20-point programme, the scope of consumer credit has been extended to
cover expenses on marriage, funeral etc., as well.

f) Miscellaneous Advances :
Banks also gives advances like packing credits to exporters, export bill purchased or
discounted, import finance, finance to self-employed, credit to weaker sections of society at
concessional rates etc.
II. Secondary / Non-banking Functions :
Banks gives various forms of services to public. Such services are termed as non- banking or
secondary functions:

1. Agency Services:
Banks perform certain functions on behalf of their customers. While performing these services,
banks act as agents to their customers, hence these are called as agency services. Important
agency functions are :
a) Collection :
Commercial banks collect cheques, drafts, bills, promissory notes, dividends,
subscriptions, rents and any other receipts which are to be received by the customer. For these
services banks charge a nominal amount.
b) payment :
Banks also makes payments on behalf of their customers like paying insurance
premium, rent, taxes, electricity and telephone bills etc for such services commission is charged.
c) Income – Tax Consultant :
Commercial banks act as income-tax consultants. They prepare and finalize the
income tax returns of their clients.
d) Sale And Purchase Of Financial Assets :
As per the customers instruction banks undertake sale and purchase of securities,
shares and any other financial assets. Nominal charges are charged by a bank.
e) Trustee, Executor And Attorney :
As a trustee, banks become the custodian and manager of customer funds. Bank also
acts as executor of deceased customer’s will. As an Attorney the banks sign the documents on
behalf of customer.
f) E- Banking :
Through Electronic Banking, a customer can operate his bank account through internet.
He can make payments of various bills. He can even transfer money from one place to another.
2. Utility Services :
Modern Commercial banks also performs certain general utility services for the community,
such as :
a) Letter Of Credit :
Banks also deal in foreign trade. They issue letter of credit and provide guarantee to
foreign traders for the soundness of their customers.
b) Transfer Of Funds :
Banks arrange transfer of funds cheaply and safely from one place to another. Transfer
can be in the form of Demand draft, Mail transfer Travellers cheques etc.
c) Guarantor :
Banks offer a guarantee of payment on behalf of importer to facilitate imports with
deferred payments.
d) Underwriting :
This facility is provided to Joint Stock Companies and to government to enable them to
raise funds. Banks guarantee the purchase of certain proportion of shares, if not sold in the
market.
e) Locker Facility :
Safe Lockers are provided to the customers. So that they can deposit their valuables
like Jewellary, Securities, Shares and otherdocuments.
f) Referee :
 57
Banks may act as referee with respect to financial standing, business reputation and
respectability of customers.
g) Credit Cards :
Credit card facility have been introduced by commercial banks. It enables the holder to
minimize the use of hard cash. Credit card is a convenient medium of exchange which enables its
holder to buy goods and services from member – establishment without using money.
III. Subsidiary Activities :
Many commercial banks also undertakes subsidiary activities such as :-

1) Housing Finance :
Housing finance is provided against the security of immoveable property of land and
buildings. Many banks such as SBI, Bank of India etc. have set up housing finance subsidiaries.
2) Mutual Funds :
A Mutual fund is a financial intermediary that pools the savings of investors for collective
investment in diversified portfolio securities Many banks like SBI, Indian Bank etc. have set up
mutual fund subsidiaries.
3) Merchant Banking :
A variety of services are offered by merchant banking like :-
Management, Marketing and Underwriting of new issues, project promotion, corporate advisory
services, investment advisory services etc.
4) Venture Capital Fund :
Venture capital fund provides start-up share capital to new ventures of little known,
unregistered, risky, young and small private business, especially in technology oriented and
knowledge intensive business. Many commercial banks like SBI, Canara Bank etc. have set up
venture Capital Fund Subsidiaries.
5) Factoring :
Factoring is a continuing arrangement between a financial intermediary (factor) and a
business concern (client) where by the factor purchases the clients accounts recieveable. Banks
like SBI and Canara Bank have established subsidiaries to provide factoring services.
Thus various services are provided by commercial Banks.

The Role of Central Bank in a Developing Economy of a

Country
Role of Central Bank in Economic Development:

The central bank in a developing country aims at the promotion and maintenance of a rising level
of production, employment and real income in the country. The central banks in the majority of
underdeveloped countries have been given wide powers to promote the growth of such
economies. They, therefore, perform the following functions towards this end.

Creation and Expansion of Financial Institutions:

One of the aims of a central bank in an underdeveloped country is to improve its currency and
credit system. More banks and financial institutions are required to be set up to provide larger
credit facilities and to divert voluntary savings into productive channels. Financial institutions
are localised in big cities in underdeveloped countries and provide credit facilities to estates,
plantations, big industrial and commercial houses.

Proper Adjustment between Demand for and Supply of Money:

The central bank plays an important role in bringing about a proper adjustment between demand
for and supply of money. An imbalance between the two is reflected in the price level. A
shortage of money supply will inhibit growth while an excess of it will lead to inflation. As the
economy develops, the demand for money is likely to go up due to gradual monetization of the
non-monetized sector and the increase in agricultural and industrial production and prices.
 58
A Suitable Interest Rate Policy:

In an underdeveloped country the interest rate structure stands at a very high level. There are also
vast disparities between long-term and short-term interest rates and between interest rates in
different sectors of the economy. The existence of high interest rates acts as an obstacle to the
growth of both private and public investment, in an underdeveloped economy.

A low interest rate is, therefore, essential for encouraging private investment in agriculture and
industry. A low interest rate policy is also essential for encouraging public investment. A low
interest rate policy is a cheap money policy. It makes public borrowing cheap, keeps the cost of
servicing public debt low and thus helps in financing economic development.

Debt Management:

Debt management should aim at proper timing and issuing of government bonds, stabilizing their
prices and minimizing the cost of servicing public debt. It is the central bank which undertakes
the selling and buying of government bonds and making timely changes in the structure and
composition of public debt.

Credit Control:

Central Bank should also aim at controlling credit in order to influence the patterns of investment
and production in a developing economy. Its main objective is to control inflationary pressures
arising in the process of development. This requires the use of both quantitative and qualitative
methods of credit control.

Open market operations are not successful in controlling inflation in underdeveloped countries
because the bill market is small and undeveloped. Commercial banks keep an elastic cash-
deposit ratio because the central bank’s control over them is not complete. They are also
reluctant to invest in government securities due to their relatively low interest rates.

Solving the Balance of Payments Problem:

The central bank manages and controls the foreign exchange of the country and also acts as the
technical adviser to the government on foreign exchange policy. It is the function of the central
bank to avoid fluctuations in the foreign exchange rates and to maintain stability. It does so
through exchange controls and variations in the bank rate.

What is the meaning of 'vicious circle of poverty’?

Vicious circle of poverty

In economics, the cycle of poverty is the "set of factors or events by which poverty, once started,
is likely to continue unless there is outside intervention." The cycle of poverty has been defined
as a phenomenon where poor families become trapped in poverty for at least three generations.

Dr. Ruby K. Payne distinguishes between situational poverty, which can generally be traced to a
specific incident within the lifetimes of the person or family members in poverty, and
generational poverty, which is a cycle that passes from generation to generation, and goes on to
argue that generational poverty has its own distinct culture and belief patterns.

Overcoming the barriers of poverty often requires a concentrated effort on many fronts and a
'big-push' is required to break the 'vicious cycle' into 'virtuous circle'.

If the country has stepped to invest more, improve health and education, develop labour skills,
and curb population growth, she can break vicious cycle of poverty and stimulate a virtuous
circle of rapid economic growth.

Localization of Industries
 59
Localization means the concentration of a certain industry in a particular area locality or region.
Localization is related to the territorial division of labor, that is specialization by areas or
regions. A certain town or region tends to specialize in the production of a particular commodity.
Switzerland specializes in watches. Brazil in coffee and India in tea.

CAUSES OF LOCALISATION

When a firm chooses its location it may be influenced by a wide range of factors from the
relative costs of alternative sites to the irrational whims of the businessman. All factors are
influenced by low costs of production, and minimum transport costs. These causes may be
enumerated as under:

(1) Climatic Conditions: Climatic or soil conditions in certain areas are suited for the production
of a particular product. Such an area has got an overwhelming advantage over other areas. If
efforts are made to develop other areas by artificial means, the cost of manufacture would be
very high. This is the reason for the concentration of tea industry in Sylhet in Bangladesh.

(2) Nearness to raw Materials: Nearness to raw materials is a dominant factor in the location of
an industry, especially that industry which uses bulky raw material that is expensive to transport
and looses weight in the manufacturing process. The concentration of iron and steel industry in
Bihar is due to the availability of iron ore and other smelting materials there.

(3) Nearness to Sources of power: Nearness to the sources of power is another important cause of
localization of industries. This explains the concentration of iron and steel industry near the coal-
fields. The farther coal is carried away from the coal mines, the higher become the costs of
transportation. But with the development of hydro-power and atomic-power, coal as a source of
power has become less important because the former can be carried to hundreds of kilometers
with comparatively less cost.

(4) Nearness to Markets: Before starting an industry, an entrepreneur has to take into
consideration the market potentialities of his product. If the market is quite away from the place
of manufacture, transport costs will be high which will raise the selling price of the product in
comparison with other similar products which are manufactured near the market.

(5) Adequate and Trained Labour: Industries tend to be concentrated in those areas where
adequate supplies of trained labour are available. New industries are also attracted to such areas.
(6) Availability of Finance: Finance is the life of every industry. Industries are located in those
areas where banking and financial facilities are easily available. As a matter of fact, capital is
attracted to those areas where industries are localised which, in turn, attract more industries.

(7)Momentum of an early start: Sometimes an industry is concentrated at a particular place

simply by chance, or due to the whims of the entrepreneur, or due to his attachment to that place.
The setting up of the motor car industry at Detroit in America by Henry Ford, and at Oxford in
England by William Morris was due to their attachment to these places as their birth places
respectively.

8) Political patronage: Political causes have the greatest influence in the concentration of
industries. The patronage given by the Hindu and Muslim rulers led to the concentration of silk
industry in Varanasi and ivory work in Delhi.

Localization has both advantages and disadvantages.

Advantages

When an industry is localized in a particular locality, it enjoys a number o1 advantages which are
enumerated below.

(1) Reputation. The place where an industry is localized gains reputation., and so do the products
manufactured there. As a result, products bearing the name of that place find wide markets, such
as Sheffield cutlery, Swiss watches, Ludhiana hosiery, etc.

(2) Skilled Labour. Localization leads to specialization in particular trades, As a result, workers
skilled in those trades are attracted to that place. The localised industry is continuously fed by a
regular supply of skilled labour that also attracts new firms into the industry. Besides, there is the
local supply of skilled labour which children of the workers inherit from them. The development
 60
of the watch industry in Switzerland, of the shawl industry in Kashmir- and of the brassware
industry in Moradabad are primarily due to this factor.

(3) Growth of Facilities. Concentration of an industry in particular locality leads to the growth of
certain facilities there. To cater to the needs of the industry, banks and financial institutions open
their branches. Railway and transport companies provide special transport facilities which the
firms utilise for bringing inputs and transporting outputs. Similarly.insurance companies provide
insurance facilities and thus cove] risks of fire, accidents, etc.

(4) subsidiary Industries. Where industries are localised, subsidiary industries grow up to supply
machines, tools, implements and other materials, and to utilise their by-products. For
example.where the sugar industry is localised plants to manufacture sugar machinery, tools and
implements are set up, and subsidiary industries crop up for the manufacture of spirit from
molasses and for rearing poultry which utilise molasses in feed.

(5) Employment Opportunities. As a corollary to the above, with the localisation of an industry
in a particular locality and the establishment of subsidiary industries, employment opportunities
considerably increase in that locality.

(6) Common Problems. All firms form an association to solve their common problems. This
association secures various types of facilities from the goverment and other agencies for
expanding business, establishes research laboratory publishes technical and trade journals, and
opens training centers for technical personnel. As a result, all firms benefit.

(7) Economy Gains. Localization leads to the lowering of production costs and improvement in
the quality of the products when the firms benefit from the availability of skilled labour, timely
credit, quality materials, research facilities, market intelligence transport facilities, etc. Besides,
the trade gains through the reputation of the place, the people gain through larger employment
opportunities, the government gain through larger tax revenue, and thus the economy gains on
the whole.

Disadvantages

But localization is not an unmixed blessing. It has its disadvantages.

(l) Dependence. When an industry is localized in a particular locality, it makes the economy
dependent for its requirements of the products manufactured there. Such dependence is
dangerous in the event of a war a depression or a natural calamity because the supplies of the
products will be disrupted and the entire economy will suffer.

(2) Social problems localization of industries in a particular locality creates many social
problems such as congestion, emergence of slums, accidents, strikes, etc. These adversely affect
the efficiency of labor and the productive capacity of the industry.

(3) Limited employment where an industry is localized, employment opportunities are limited to
a particular type of labour. 1n the event of a recession in that industry, specialized labour fails to
get alternative employment elsewhere. Again, if such specialized labor organises itself into a
powerful trade union, it can force the employers to pay higher wages which may raise the cost of
production and adversely affect the industry.

(4) Diseconomies. With the passage of time.the concentration of industries in a particular

locality, economies of scale may give way to diseconoinics. Transport bottlenecks emerge.
There are frequent power break-downs. Financial institutionsare unable to meet the credit
requirements of the entire industry due to financial stringency. Labour asks for higher wages and
better living conditions. All these tend to raise costs of production and reduce production.

(5) Regional imbalances Concentration of industries in one region or area leads to the lop-sided
development of the economy. When one industry is localised in a region, it attracts more
entrepreneurs who establish other industries there because of the availability of infrastructure
facilities like power, transport, finance, labour, etc. Thus such regions develop more while the
other regions remain backward. Employment opportunities, the level of income, and toe standard
of living increase at a much higher rate in these regions as compared with the other regions of the
country.

TAX
 61
Definition of tax

A fee charged ("levied") by a government on a product, income, or activity. If tax is levied

directly on personal or corporate income, then it is a direct tax. If tax is levied on the price of a
good or service, then it is called an indirect tax. The purpose of taxation is to financegovernment
expenditure. Compulsory monetarycontribution to the state'srevenue, assessed and imposed by a
government on the activities, enjoyment, expenditure, income, occupation, privilege, property,
etc., of individuals and organizations.

Types of tax
A tax is a levy imposed on goods and services, income or wealth by the government. Taxes are
often classified into direct taxes and indirect taxes:

Direct tax:Direct taxes are taxes imposed on income and wealth

Indirect tax: Indirect taxes are taxes imposed on goods and services
What are the essentials of Tax
A tax is a compulsory contribution of a person or entity to the state as per the rules.

 The tax payer does not receive direct and or special benefit in return.
 It is spent by the government for the common interest and benefit of the people.
 It is paid only by those persons and entities who earns income exceeding a certain
specified limit.

What are the Different Types of Tax with Examples

Taxes may be categorized into different as their nature as direct taxes, indirect taxes, progressive
taxes, regressive taxes etc.

Direct Tax
A direct tax is the one, which is paid by the person or entity on whom it is legally imposed. It is
collected from the persons or entities on the income they have earned exceeding a certain
specified limit. Tax is generally calculated at a certain percentage on the income. Income tax,
corporate tax, land revenue tax etc. are the examples of direct tax.

Indirect Tax
An indirect tax is the one, which is imposed to one person or entity but paid partly or fully by
others. It is transferable to others. The tax is collected from customers by including it in the price
of the goods or services they have purchased. The producers collect such a tax from wholesalers
the wholesalers from retailers and the retailers from the final consumers. Excise duty, custom
duty, VAT etc. are some of the examples of indirect tax.

Personal income Tax

Personal income tax refers to the tax imposed on individuals or families who earn income
exceeding a certain specified limit subject to change as per the provisions made in financial rules
and regulations.

Corporate Tax
Corporate tax is the tax imposed on the incomes of a business entity. It occupies the most part of
the government revenue collected from taxes. Corporate tax rates are generally applied in flat
system with high rate of large undertakings and low rates for smaller ones. The small and large
undertakings are categorizes as per the size of the activities.

Excise duty
Excise duty is the tax levied on luxurious products. It is intended to discourage the the
consumption of harmful products on one side and to collect government revenue in considerable
extent on the other side.

Custom Duty
Custom duty is the tax charged on the goods dealt in the foreign trade especially on the imported
goods to encourage and promote export and to protect national industries. Government simply
gives exemption of this tax on export trade and imposes on import trade. Custom duty may be
export duty or import duty as its nature and imposed to the trading goods.

Land revenue Tax

Land revenue tax is the one, which is imposed to the landlords on the revenue generated from
land especially while selling or purchasing land.
 62
Value Added Tax (VAT)
Value added tax is the tax levied on value added on the price of the product at each stage of
production, and or distribution activities. Value added is the difference between sales values and
purchase value or the conversion cost plus profit. Conversion cost means the expenses on rent,
depreciation, maintenance, insurance, salary etc. It is imposed on the goods at import, production
and selling stages.

What are the objectives of Tax

The concept of tax was initiated with a view to generate government revenue in its very
beginning stage. In course of time it has been utilized for various purposes.

 To raise government revenue for development and welfare programmes in the country.
 To maintain economic equalities by imposing tax to the income earners and improving
the economic condition of the general people.
 To encourage the production and distribution of the products of basic needs and
discourage the production and harmful ones.
 To discourage import trade and protect the national industries.

What are the Importance of Tax

Tax is a major source of government revenue and its contributes for the overall development and
prosperity of a country.

 Raising government revenue in terms of income tax, custom duty, excise duty,
entertainment tax, VAT, land revenue tax etc. from various sectors in order to initiate
development and welfare programmes.
 Maintaining economic stability by reducing economic inequalities by means of equitable
distribution of wealth by way of imposing tax to the income earners and improving the
economic condition of the general people.
 Regulating the economic sectors into right direction by encouraging the production and
distribution of useful goods and discouraging the harmful products by imposing high tax
rate on them.
 Building and strengthening the national economy by encouraging and protecting national
industries and promoting export trade.
 Reducing regional economic disparity by encouraging the entrepreneurs to establish
industries in remote and backward regions by giving tax exemptions, rebates and
concessions etc.

SUBSIDY

Definition of subsidy

A subsidy is a payment made by the government to a firm not in exchange for any good or
service.

1.Economic benefit (such as a taxallowance or dutyrebate) or financial aid (such as a cashgrant

or soft loan) provided by a government to (1) support a desirable activity (such as exports), (2)
keep prices of stapleslow, (3) maintain the income of the producers of critical or
strategicproducts, (4) maintain employment levels, or (5) induce investment to reduce
unemployment. The basic characteristic of all subsidies is to reduce the market price of an item
below its cost of production

Market,a means by which the exchange of goods and services takes place as a result of
buyers and sellers being in contact with one another, either directly or through mediating agents
or institutions.

Markets in the most literal and immediate sense are places in which things are bought and sold.
In the modern industrial system, however, the market is not a place; it has expanded to include
the whole geographical area in which sellers compete with each other for customers. The value,
cost and price of items traded are as per forces of supply and demand in a market. The market
may be a physical entity, or may be virtual. It may be local or global, perfect and imperfect.

Types of Market

The types of market you are in determines the type of business strategy you need to have.
Strategies for consumer markets are completely different from that of industrial markets.
 63
Industrial markets deal in bulk product selling whereas consumer products generally involve
breaking the bulk.

And last but not the least, the Government and Institutional business which are the real revenue
generators because of their huge orders. Lets discuss each of these type of markets one by one.

1) Consumer Markets – As the name suggests, the consumer market involves marketing of
consumer goods such as Television, Refrigerator, Air conditioners etc. As awareness and
knowledge of consumers rises, marketing of consumer goods gets tougher. Today a lot of focus
has shifted to consumer goods marketing because a consumer has a lot of choices. The brand
loyalty is at its lowest and the worst fear a brand can face now is a high rate of brand defection.

Along with the branding part, the costing part too needs to be considered in the consumer
market. The cost of operations is too high with various departments and specialities coming
together to form a consumer goods companies. There is inventory management, logistics,
manufacturing, promotions, strategies and whatnot.

2) Business Markets – Similar to consumer markets, nowadays even the organizational buyer
has numerous options in his kitty. Just at the number of software and hardware services providers
in the Market. For software there’s IBM, Accenture, Oracle and several other top brands. For
hardware there’s Microsoft, Dell, and others. The competition is increasing. Furthermore, the
organizational buyer will think 4–5 times before purchasing a product because of the cost
involved. An order for computers for an multinational company’s office will probably go in
crores.

Because of the cost involved, Organizational buyers make it a point to be much more
knowledgeable than any average customer. Organizational buyers have a group of dedicated
people who form the “Purchase department”. These people are responsible for buying at the
lowest possible price they can. The other characteristics of business markets is the time taken to
close the deal. Business markets involve selling of projects too.

3) Global Markets – The changes in the cost of transportation, government policies and the
overall need for expansion have given an impetus to globalization. The strategies of global
market companies may differ from each other but the core concept is the same. Most global
marketing companies work on one fundamental. “Think local, act global”. The company which
comes at the top of my mind is McDonalds and Coca Cola. Both known for their global presence
as well as for the way they customize their message based on the country they are in.

Companies may be global on the basis of both – business to business as well as business to
consumers. The challenges faced by global companies are much more than those faced by local
companies. Nonetheless, Global expansion is an excellent option for any company provided it
has deep pockets to sustain the initial expenditure required to establish yourself in another
country.

4) Government or Non profit Market – The government market mainly involves Government
offices, ordnance factories, army, navy and other government departments. The non profits on
the other hand may involve groups based on different beliefs some of which really have an
excellent brand name and are recognised by several companies. Both of these entities have a
limited purchasing budget and hence the price of products is important. Accordingly the
purchase process is organized.

Most government and non profit organizations involve the issuance of tenders and bids. The one
to bid the lowest is known as L1 and the one to bid the highest is known as H1. Naturally,
L1 wins the bid. There are several companies which have modified their products specifically for
the government markets to come L1 in these tenders and bids. The products may be a bit inferior,
nonetheless they do meet the government’s requirement and that is what matters in the end.

Each of these markets can be tapped separately by companies. In fact, some consumer durable
companies have different departments for corporate sales and government sales. Tapping each of
these markets provides an avenue for the company to expand their market share and overall
revenue generated by the company.

Types of market structure

1. Perfect competition – Many firms, freedom of entry, homogeneous product, normal

profit.
 64
2. Monopoly – One firm dominates the market, barriers to entry, possibly supernormal
profit.
1. Monopoly diagram
3. Oligopoly – An industry dominated by a few firms, e.g. 5 firm concentration ratio of >
50%. Interdependence of firms
1. Oligopoly diagram
2. Collusive behaviour – firms seek to form agreement to increase prices.
4. Monopolistic competition – Freedom of entry and exit, but firms have differentiated
products. Likelihood of normal profits in the long term.
5. Contestable markets – An industry with freedom of entry and exit, low sunk costs. The
theory of contestability suggests the number of firms is not so important, but the threat of
competition.

Characteristics of Market:
The essential features of a market are:
(1) An Area:
In economics, a market does not mean a particular place but the whole region where sellers and
buyers of a product ate spread. Modem modes of communication and transport have made the
market area for a product very wide.
(2) One Commodity:
In economics, a market is not related to a place but to a particular product.
Hence, there are separate markets for various commodities. For example, there are separate
markets for clothes, grains, jewellery, etc.
(3) Buyers and Sellers:
The presence of buyers and sellers is necessary for the sale and purchase of a product in the
market. In the modem age, the presence of buyers and sellers is not necessary in the market
because they can do transactions of goods through letters, telephones, business representatives,
internet, etc.
(4) Free Competition:
There should be free competition among buyers and sellers in the market. This competition is in
relation to the price determination of a product among buyers and sellers.
(5) One Price:
The price of a product is the same in the market because of free competition among buyers and
sellers.
On the basis of above elements of a market, its general definition may be as follows:
The market for a product refers to the whole region where buyers and sellers of that product are
spread and there is such free competition that one price for the product prevails in the entire
region.
Market Structure:
Meaning:
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.
They are:
(1) The number and nature of sellers.
(2) The number and nature of buyers.
(3) The nature of the product.
(4) The conditions of entry into and exit from the market.
(5) Economies of scale.
They are discussed as under:
1. Number and Nature of Sellers:
The market structures are influenced by the number and nature of sellers in the market. They
range from large number of sellers in perfect competition to a single seller in pure monopoly, to
two sellers in duopoly, to a few sellers in oligopoly, and to many sellers of differentiated
products.
2. Number and Nature of Buyers:
The market structures are also influenced by the number and nature of buyers in the market. If
there is a single buyer in the market, this is buyer’s monopoly and is called monopsony market.
Such markets exist for local labour employed by one large employer. There may be two buyers
who act jointly in the market. This is called duopsony market. They may also be a few organised
buyers of a product.
This is known as oligopsony. Duopsony and oligopsony markets are usually found for cash crops
such as rice, sugarcane, etc. when local factories purchase the entire crops for processing.
 65
3. Nature of Product:
It is the nature of product that determines the market structure. If there is product differentiation,
products are close substitutes and the market is characterised by monopolistic competition. On
the other hand, in case of no product differentiation, the market is characterised by perfect
competition. And if a product is completely different from other products, it has no close
substitutes and there is pure monopoly in the market.
4. Entry and Exit Conditions:
The conditions for entry and exit of firms in a market depend upon profitability or loss in a
particular market. Profits in a market will attract the entry of new firms and losses lead to the exit
of weak firms from the market. In a perfect competition market, there is freedom of entry or exit
of firms.
But in monopoly and oligopoly markets, there are barriers to entry of new firms. Usually,
governments have a monopoly in public utility services like postal, air and road transport, water
and power supply services, etc. By granting exclusive franchises, entries of new supplies are
barred. In oligopoly markets, there are barriers to entry of firms because of collusion, tacit
agreements, cartels, etc. On the other hand, there are no restrictions in entry and exit of firms in
monopolistic competition due to product differentiation.
5. Economies of Scale:
Firms that achieve large economies of scale in production grow large in comparison to others in
an industry. They tend to weed out the other firms with the result that a few firms are left to
compete with each other. This leads to the emergency of oligopoly. If only one firm attains
economies of scale to such a large extent that it is able to meet the entire market demand, there is
monopoly.
Forms of Market Structure:

On the basis of competition, a market can be classified in the following ways:

1. Perfect Competition
2. Monopoly
3. Duopoly
4. Oligopoly
5. Monopolistic Competition
1. Perfect Competition Market:
A perfectly competitive market is one in which the number of buyers and sellers is very large, all
engaged in buying and selling a homogeneous product without any artificial restrictions and
possessing perfect knowledge of market at a time. In the words of A. Koutsoyiannis, “Perfect
competition is a market structure characterised by a complete absence of rivalry among the
individual firms.” 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:
The following are the conditions for the existence of perfect competition:
(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 a fraction of the total output that he
cannot influence the price of the product by his action alone. In other words, the individual seller
is unable to influence the price of the product by increasing or decreasing its supply.
Rather, he adjusts his supply to the price of the product. He is “output adjuster”. Thus no buyer
or seller can alter 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 being sustained 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. This is only possible if units of the same product
produced by different sellers are perfect substitutes. In other words, the cross elasticity of the
products of sellers is infinite.
No seller has an independent price policy. 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 buy the product from other sellers at the ruling lower price.
(4) Absence of Artificial Restrictions:
 66
The next condition is that there is complete openness in buying and selling of goods. Sellers are
free to sell their goods to any buyers and the buyers are free to buy from any sellers. In other
words, there is no discrimination on the part of buyers or sellers.
(5) Profit Maximisation Goal:
Every firm has only one goal of maximising its profits.
(6) 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 can fetch the highest price. Factors
can also move from a low-paid to a high-paid industry.
(7) 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.
(8) Absence of Transport Costs:
Another condition is that there are no transport costs in carrying of product from one place to
another. This condition is essential for the existence of perfect competition which requires 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.
(9) Absence of Selling Costs:
Under perfect competition, the costs of advertising, sales-promotion, etc. do not arise because all
firms produce a homogeneous product.

Perfect Competition vs Pure Competition:

Perfect competition is often distinguished from pure competition, but they differ only in degree.
The first five conditions relate to pure competition while the remaining four conditions are also
required for the existence of perfect competition. According to Chamberlin, pure competition
means, competition unalloyed with monopoly elements,” whereas perfect competition involves
perfection in many other respects than in the absence of monopoly.” The practical importance of
perfect competition is not much in the present times for few markets are perfectly competitive
except those for staple food products and raw materials. That is why, Chamberlin says that
perfect competition is a rare phenomenon.”
Though the real world does not fulfill the conditions of perfect competition, yet perfect competi-
tion is studied for the simple reason that it helps us in understanding the working of an economy,
where competitive behavior leads to the best allocation of resources and the most efficient
organization of production. A hypothetical model of a perfectly competitive industry provides
the basis for appraising the actual working of economic institutions and organizations in any
economy.
2. Monopoly Market:
Monopoly is a market situation in which there is only one seller of a product with barriers to
entry of others. The product has no close substitutes. The cross elasticity of demand with every
other product is very low. This means that no other firms produce a similar product. According
to D. Salvatore, “Monopoly is the form of market organization 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.
In any situation, the ultimate aim of the monopolist is to have maximum profits.
Characteristics of Monopoly:
The main features of monopoly are as follows:
 Under monopoly, there is one producer or seller of a particular product and there is no
difference between a firm and an industry. Under monopoly a firm itself is an industry.
 A monopoly may be individual proprietorship or partnership or joint stock company or a
cooperative society or a government company.
 A monopolist has full control on the supply of a product. Hence, the elasticity of demand
for a monopolist’s product is zero.
There is no close substitute of a monopolist’s product in the market. Hence, under monopoly, the
cross elasticity of demand for a monopoly product with some other good is very low.
 There are restrictions on the entry of other firms in the area of monopoly product.
 A monopolist can influence the price of a product. He is a price-maker, not a price-taker.
 Pure monopoly is not found in the real world.
 Monopolist cannot determine both the price and quantity of a product simultaneously.
 Monopolist’s demand curve slopes downwards to the right. That is why, a monopolist
can increase his sales only by decreasing the price of his product and thereby maximise
his profit. The marginal revenue curve of a monopolist is below the average revenue
 67
curve and it falls faster than the average revenue curve. This is because a monopolist has
to cut down the price of his product to sell an additional unit.
3. Duopoly:
Duopoly is a special case of the theory of oligopoly in which there are only two sellers. Both the
sellers are completely independent and no agreement exists between them. Even though they are
independent, a change in the price and output of one will affect the other, and may set a chain of
reactions.
If, on the other hand, each seller takes into account the effect of his policy on that of his rival and
the reaction of the rival on himself again, then he considers both the direct and the indirect
influences upon the price. Moreover, a rival seller’s policy may remain unaltered either to the
amount offered for sale or to the price at which he offers his product.

4. Oligopoly:
Oligopoly is a market situation in which there are a few firms selling homogeneous or differenti-
ated products. It is difficult to pinpoint the number of firms in ‘competition among the few.’
With only a few firms in the market, the action of one firm is likely to affect the others. An
oligopoly industry produces either a homogeneous product or heterogeneous products.
The former is called pure or perfect oligopoly and the latter is called imperfect or differentiated
oligopoly. Pure oligopoly is found primarily among producers of such industrial products as
aluminium, cement, copper, steel, zinc, etc. Imperfect oligopoly is found among producers of
such consumer goods as automobiles, cigarettes, soaps and detergents, TVs, rubber tyres,
refrigerators, typewriters, etc.
Characteristics of Oligopoly:
In addition to fewness of sellers, most oligopolistic industries have several common
characteristics which are explained below:
(a) Interdependence:
There is recognised interdependence among the sellers in the oligopolistic market. Each
oligopolist firm knows that changes in its price, advertising, product characteristics, etc. may
lead to counter-moves by rivals. When the sellers are a few, each produces a considerable
fraction of the total output of the industry and can have a noticeable effect on market conditions.
(b) Advertisement:
The main reason for this mutual interdependence in decision making is that one producer’s
fortunes are dependent on the policies and fortunes of the other producers in the industry. It is for
this reason that oligopolist firms spend much on advertisement and customer services. If, on the
other hand, one oligopolist advertises his product, others have to follow him to keep up their
sales.
(c) Competition:
This leads to another feature of the oligopolistic market, the presence of competition. Since
under oligopoly, there are a few sellers, a move by one seller immediately affects the rivals. So
each seller is always on the alert and keeps a close watch over the moves of its rivals in order to
have a counter-move. This is true competition.
(d) 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 restraint
new firms from entering the industry.
They may be:
(i) Economies of scale enjoyed by a few large firms; (ii) control over essential and specialised
inputs; (iii) high capital requirements due to plant costs, advertising costs, etc. (iv) exclusive
patents and licenses; and (v) the existence of unused capacity which makes the industry
unattractive. When entry is restricted or blocked by such natural and artificial barriers, the
oligopolistic industry can earn long-run super normal profits.
(e) Lack of Uniformity:
Another feature of oligopoly market is the lack of uniformity in the size of firms. Finns differ
considerably in size. Some may be small, others very large. Such a situation is asymmetrical.
This is very common in the American economy. A symmetrical situation with firms of a uniform
size is rare.
(f) Demand Curve:
It is not easy to trace the demand curve for the product of an oligopolist. Since under oligopoly
the exact behaviour pattern of a producer cannot be ascertained with certainty, his demand curve
cannot be drawn accurately, and with definiteness. How does an individual seller s demand curve
look like in oligopoly is most uncertain because a seller’s price or output moves lead to
unpredictable reactions on price-output policies of his rivals, which may have further
repercussions on his price and output.
The chain of action reaction as a result of an initial change in price or output, is all a guess-work.
Thus a complex system of crossed conjectures emerges as a result of the interdependence among
the rival oligopolists which is the main cause of the indeterminateness of the demand curve.
 68
If the oligopolist seller does not have a definite demand curve for his product, then how does he
affect his sales. Presumably, his sales depend upon his current price and those of his rivals.
However, a number of conjectural demand curves can be imagined.
For example, in differentiated oligopoly where each seller fixes a separate price for his product, a
reduction in price by one seller may lead to an equivalent, more, less or no price reduction by
rival sellers. In each case, a demand curve can be drawn by the seller within the range of
competitive and monopoly demand curves.
(g) No Unique Pattern of Pricing Behaviour:
The rivalry arising from interdependence among the oligopolists leads to two conflicting
motives. Each wants to remain independent and to get the maximum possible profit. Towards
this end, they act and react on the price-output movements of one another in a continuous
element of uncertainty.
On the other hand, again motivated by profit maximisation each seller wishes to cooperate with
his rivals to reduce or eliminate the element of uncertainty. All rivals enter into a tacit or formal
agreement with regard to price-output changes.

5. Monopolistic Competition:
Monopolistic competition refers to a market situation where there are many firms selling a differ-
entiated product. “There is competition which is keen, though not perfect, among many firms
making very similar products.” No firm can have any perceptible influence on the price-output
policies of the other sellers nor can it be influenced much by their actions. Thus monopolistic
competition refers to competition among a large number of sellers producing close but not
perfect substitutes for each other.
It’s Features:
The following are the main features of monopolistic competition:
(a) Large Number of Sellers:
In monopolistic competition the number of sellers is large. They are “many and small enough”
but none controls a major portion of the total output. No seller by changing its price-output
policy can have any perceptible effect on the sales of others and in turn be influenced by them.
Thus there is no recognised interdependence of the price-output policies of the sellers and each
seller pursues an independent course of action.
(b) Product Differentiation:
One of the most important features of the monopolistic competition is differentiation. Product
differentiation implies that products are different in some ways from each other. They are
heterogeneous rather than homogeneous so that each firm has an absolute monopoly in the
production and sale of a differentiated product. There is, however, slight difference between one
product and other in the same category.
Products are close substitutes with a high cross-elasticity and not perfect substitutes. Product
“differentiation may be based upon certain characteristics of the products itself, such as exclusive
patented features; trade-marks; trade names; peculiarities of package or container, if any; or
singularity in quality, design, colour, or style. It may also exist with respect to the conditions
surrounding its sales.”
(c) 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.
(d) Nature of Demand Curve:
Under monopolistic competition no single firm controls more than a small portion of the total
output of a product. No doubt there is an element of differentiation nevertheless the products are
close substitutes. As a result, a reduction in its price will increase the sales of the firm but it will
have little effect on the price-output conditions of other firms, each will lose only a few of its
customers.
Likewise, an increase in its price will reduce its demand substantially but each of its rivals will
attract only a few of its customers. Therefore, the demand curve (average revenue curve) of a
firm under monopolistic competition slopes downward to the right. It is elastic but not perfectly
elastic within a relevant range of prices of which he can sell any amount.
(e) Independent Behavior:
In monopolistic competition, every firm has independent policy. Since the number of sellers is
large, none controls a major portion of the total output. No seller by changing its price-output
policy can have any perceptible effect on the sales of others and in turn be influenced by them.
(f) Product Groups:
There is no any ‘industry’ under monopolistic competition but a ‘group’ of firms producing
similar products. Each firm produces a distinct product and is itself an industry. Chamberlin
lumps together firms producing very closely related products and calls them product groups,
such as cars, cigarettes, etc.
(g) Selling Costs:
 69
Under monopolistic competition where the product is differentiated, selling costs are essential to
push up the sales. Besides, advertisement, it includes expenses on salesman, allowances to sellers
for window displays, free service, free sampling, premium coupons and gifts, etc.
(h) Non-price Competition:
Under monopolistic competition, a firm increases sales and profits of his product without a cut in
the price. The monopolistic competitor can change his product either by varying its quality,
packing, etc. or by changing promotional programmes.