....

CONTINUED FROM THE NOTES

Economics 30th October

Explanation of diagram

Suppose our consumer has indiffernce map shown in the above diagram, further assume that the
priceline facing the consumer is AM. Given a ceratin amount of money he has to spend on A and B
and the prices of these goods prevailing in the market. Since his income and relative prices of the
two goods to be purchased are shown by the price line AM. This equilibrium must be on some point
on this line. This line contains all the possible opportunities of combining two goods that are open to
out hypothetical consumer.

Actually the consumer will be in equilibrium at the point P. Ie he will be buying OR units of
commodity B and OH units of Commodity A. The consumer will maximise his satisfaction and be in
equilibrium at a point where the price line touches (or is tangent to) an indifference curve. In the
diagram, such point is P, which lies on indifference curve IC3, there can only be one point such as P
with a given Priceline. Any combination other than P will give less satisfaction to the consumer.

If our consumer chooses a combination S, he will be on a lower indifference curve IC1 and will get
less satisfaction than P. The combination of N will also give him less satisfaction because it lies on
IC2. Similarly, all other combinations i.e., A, M, K and L will give less satisfaction to the consumer
compared to the combination P.

At equilibrium point P, the marginal rate of substitution of A and B is eual to the price ratio between
these two goods, since both the indifference curve IC3 and Priceline AM have the same slope at the
point P

Law of diminishing returns

STATEMENT OF THE LAW

Every farmer knows by experience that, if a particular piece of land is cultivated over and over again,
it generally gives less than proportionate returns. If every year more and still more, units of capital
and labour are put into it, the successive return per unit doesn’t increases but actually decreases.

Alfred Marshall states the law thus, “an increase in the capital and labour applied in the cultivation
of land causes in general, a less than proportionate increase in the amount of produce raise, unless it
happens to coincide with an improvement in the art of agriculture.
Explanation

Suppose there is a farmer who cultivates a small farm, he applies some capital and labour to his farm
in certain fixed quantities which he calls doses. Suppose each dose of capital and labour costs Rs
500, and the return to each dose is as follows

DOSE APPLIED TOTAL RETURNS MARGINAL RETURNS

1. 12 12
2. 22 10
3. 30 8
4. 35 5
5. 40 5
6. 40 0
7. 35 -5

The 3rd 8, the 4th 5 and so on. The total return no doubt goes on increasing but it should be careful
noted that it doesn’t increase proportionately. For example, when the first does is applied, the yield
is 12 and when 2 doses are applied, the total return is 22 and not 24.

I.e. it doesn’t become double, because the yield if the second dose is not equal to that of the first
dose. So we can say that the total return increases but at a diminishing rate. We may also notice that
even the total returns begin to decrease after certain doses. The stages of diminishing returns in the
case of total returns, however comes much later and if the farmer is prudent it may never happen.

The sixth dose no addition to the total and the seventh even decreases.

LIMITATIONS to the law

In Marshall’s statement of the law the phrase in ‘general’ is significant. It means that the law applied
generally but may not apply always..........................
.......

If improved methods of cultivation are applied, then to the marginal return will increase instead of
diminishing. Sometimes the capital applied to land may have been insufficient for sometime the
increased applications of capital may bring in more than proportionate returns.

Why this law operates in agriculture.

Agriculture is largely under natural influences like climate, rainfall, and weather conditions. The best
human efforts neutralised by adverse influences

There is a very limited scope for the use of machinery in agriculture sector. Thus economies which
result from the use of specialized machinery cannot be squired in agriculture. The scope of division
of labour is also limited. Hence the advantages of division of labour are lost and diminishing returns
set it.
Agricultural operations are spread over a very large area and supervision is very difficult. This
reduces the yield

All lands are not equally fertile. If cultivation is extended to inferior lands the returns per acre
diminishes

1st November 2009

Law of increasing returns

The law states that “an increase in the capital and labour applied in the production leads to a more
than proportionate increase in the amount of the product. The law of increasing returns refers to the
cases in which extra investment brings in a more than proportionate increase in output. It makes
clear that the total output goes on increasing at an increasing rate when additional losses of the
precaiolinf factors are combined with a fixed factor in the process of production. I.e., as investment
of labour and capital is increased, the output from such investments increases more than
proportionately.

The law can be explained in terms of cost also. Increasing returns means diminishing cost. When
more and more units of capital and labour are applied in the process of production, the cost per unit
of marginal output will fall continuously. This fall in marginal cost will continue till the industry
reaches optimum level. Beyond that, diminishing return will operate.

The following table explains the law

Units of Labour and Capital Total Returns Marginal returns

1 10 10
2 25 15
3 45 20
4 70 25
5 100 30

The table reveals that when more and more unit of labour and capital are applied in the production
process, the total return increases more than proportionately. As a result marginal return increases
from 10 to 15, 15 to 20 and so on.

The law of increasing returns operates in earlier stages of production till the business reaches
optimum level. The law operates because of

1. Indivisibility of certain factors of production- some factors are divisible and some factors are
indivisible.
2. Division of labour
3. Proper combination of factors of production.

INTERNATION TRADE

The exchange of goods between citizens of different countries is called international trade. The
distinction between international trade and internal trade are,
 1. Immobility of factors of production – labour and capital don’t move as freely from one
country to another as they do within the same country. But within the same political
boundaries, people distribute themselves more or less according to opportunities.
2. Different Currencies – each country has a different currency so in the case of international
trade, different currencies leads to complication during trade. But in the case of internal
trade this complication is not seen.
3. Restriction on trade – trade between different countries is not free. There are certain
restrictions imposed by the countries on trade such as customs duties, tariffs, exchange
restrictions, fixed quota and other trade barriers.
4. Ignorance – knowledge of other countries cannot be exact and full as of one’s own country.
Difference in culture, language, religion etc stand in the way of free communication between
countries. On the other hand, within the borders of a country, labour and capital moves
freely.
5. Transport and insurance cost – the cost of transportation and insurance also check free
international trade. The greater the distance between two nations, the greater are these
costs.

The theory of comparative cost

The comparative cost is the basis of international trade. It explains that “it pays countries to
specialize in the production of those goods in which they posses greater comparative advantage or
the least comparative disadvantage. For E.g. country A produces 20 brushes and 20 kg of sugar and
country B produces 15 brushes and 10 kg of sugar. Country A has an advantage over country B in the
production of both Brushes and Sugar but county A has a greater comparative advantage in sugar.
Country B has disadvantage in both the commodities. But the comparative disadvantage is less in the
case of toothbrushes and thus country A will specialize in Sugar.

It is not the cost of commodity in country A and B but the ratio between the costs of commodities in
two countries.

6th November 2009

Barter System

Barter system means to acquire goods with other goods. The inconveniences of the barter system
are;

1. Need for double - When goods have to be directly exchanged for goods are it’s essential that
both the parties must stand in need of each other’s possessions. For example a shoemaker
may need a hat. In that case a lot of time and energy has to be spent in finding out a person
who not only has a hat but is also prepared to buy a shoe. No exchange can take place unless
one party precisely wants what the other can spare, what the other wants.
 2. Difficulty of subdivision – barter system needs the sale to be adjusted. After the rate of
exchange between two parties is settled, there is another difficulty to be got over. For e.g. if
X has a cow, and wants some salt. Therefore he is prepared to accept salt for his cow

3. Absence of common measure of value – let us suppose that a person has been found who
has in possession what X needs and is also prepared to part with it, here the difficulty arises
is that at what rate, should the two commodities exchange. Much time and energy is lost, in
striking a bargain, especially over goods which don’t’ confer to any common measure of
value.

4. No store of value – Goods cannot be stored for a long time period and a loss in value if you
keep the commodity for a long time. Some of them wholly perish after some time. Let us
imagine a situation, if the students brought a little cow, pig etc to pay the college fees. If a
plague came, the whole stock would be lost in no time.

MONEY

Money is anything which is generally accepted in exchange of other things an which can discharge all
obligations, past and present; for money, general acceptability is essential. Thus we can sya currency
notes are money but not cheques

Money solves all the difficulties of barter system. There is no necessity of double coincidence of
wants. For example, a man who has a cow, wants to purchaser a horse, he can sell his cow in them
market for money and then purchase a horse with the money he obtained. Money units are of all
denominations and it is easy to make a fractional purchase which is not possible under barter
system.

Money is used as a store of value. In modern terminology it is known as which helps to keep
resources liquid. The money serves as a store of value function. More correctly it enables a person
to keep a portion of his assets liquid. Liquid assets mean the assets that can be used for an purpose
at any time one likes. It is standard for measuring values. Money removes the difficulty of lack of
common measure of value in terms of which other values could be exchanged. In a money economy,
it is easy to compare their oectucve values of commodities and services. In a matter of exchange, the
common standard of value makes the transaction easy and fair.

Standard of differed payments – It serves as a standard a payments which are to be made after a
lapse of time. Lending a borrowing must take place in terms of a commodity which will keep its
values stable over a time period.

Functions of money can be summed up in couplet. “Money is a matter of functions for a stock, a
measure, a standard, and a medium of exchange.

Quantity theory of money

The general price level in community is influenced by

1. Volume of trade
 2. Quantity of currency
3. Volume of credit
4. Velocity of circulation of money

The greater the volume of exchange required to be made; the grater is the demand for money. So,
the value of one unit of currency is also greater, therefore the value of money varies greatly wit the
volume of trade.

The value of anything depends also on its supply

There is an inverse relationship between the value of one unit of money and its quantity. The credit
instruments also had been taken into consideration when we are trying to find the total quantity of
money. The velocity of circulation means the number of time the rupee changes hands in.

Equation of exchange – Fisher Equation

Irwin Fisher who developed the quantity theory puts it in the form of an equation,

P = M/T where P = price level, M = money and T = Trade or goods exchanged

This simple equation is proved only in a small isolated community;

1. Where number of transactions is small,

In modern community, a coin changes hands number of times. This is called the velocity if
circulation. To find out the effective amount of money in a country, we have to multiply the total
number of coins by their velocity. So the equation changes to P = M/T.

Nut in addition to money, other forms of money also helps in the exchange of goods. Instruments of
credit like cheques and drafts also serve the same purpose. There velocity of circulation is also take
in to consideration.

The equation again changes to P=M*V+ M’V’/T

Where M’ is credit money and V’ is circulation,

This equation signifies that P changes when quantity of money (M) or the quantity of credit money,
(M’) changes or the velocity changes (P and P’). P also changes if the quantity if goods (T), required
to be exchanged changes.