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AS Level
Chapter 1: Basic Economic Ideas and Resource Allocation

 Introduction to Economics

 Economics emerged as a separate subject in 1776 after the publication of a famous book named
An Inquiry into the Nature and the Causes of Wealth of Nations known as wealth of nations in
short. This book was published by the father of economics and the leader of classical
economists Adam Smith. In this book he defined economics for the first time. According to him
economics is a science of wealth. This definition was supported by other classical economists
and they also defined economics making wealth as the base of their definitions.

Classical period in economics: 1776 to 1880

Prominent Classical economists are Adam Smith, David Ricardo, T.R. Malthus, J.B. Say and
J.S. Mill……..so on

 In the year 1880, Alfred Marshall-the leader of Neo-Classical economists defined economics
making welfare as the base of his definition. According to him, “economics is a study of
mankind in the ordinary business of life; it examines that part of individual and social action
which is most closely connected with the attainment and with the use of the material
requisites of well-being.”

Neoclassical period in economics: 1880 to 1932

Prominent Neoclassical economists: Alfred Marshall, William Stanley Jevons, Carl Menger, Leon
Walras…so on

 The modern period of economics begins in the year 1932. Some of the prominent modern
economists are Lionel Robbins, Amartya sen, Arthur Laffer, Abhijit Banarjee and so on. A
prominent modern economist Lionel Robbins defined economics as,” a study of human
behavior as a relationship between ends (wants/needs) and scarce means(resources) which
have alternative uses”. So, according to this definition, economics is a study of how the human
beings manage/use the scarce resources to satisfy their unlimited/infinite wants.
The following propositions can be deduced from this definition:

 Wants---- desire/wish to possess or to do something

 Resources----means to satisfy the human wants
 Scarce resources have alternative uses

1.1 Scarcity, choice and opportunity cost

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Human wants are unlimited/ infinite while the resources to satisfy the human wants are scarce or
limited. This limitedness of resources in relation to unlimited human wants is refered to as the
“fundamental economic problem of scarcity.”

The problem of scarcity necessitates making choices. Choice is inevitable at all levels such as individuals,
firms and governments. Making choices gives rise to opportunity cost. It is the second/next best option
that is given up or sacrificed.

Example: 1
Using all the available resources an economy can produce 500 units of good x or 250 units of good y. In
such a case, if the economy decides to produce 500 units of good x it must give up 250 units of good y
and if it decides to produce 250 units of good Y, it must give up 500 units of good X. So, the opportunity
cost of producing 500 units of good x is 250 units of good y that is given up while the opportunity cost of
producing 250 units of good Y is 500 units of good X. That is,
500x = 250y
1X =0.5y

0r, 250y = 500x

1y = 2x

Example: 2
You have a sum of $50 which you wish to spend on a pair of shoes and a book. The price of book is $50
and the price of the pair of shoes is $45. If you decide to buy a book you must give up the pair of shoes.
So, the opportunity cost of the book you buy is the pair of shoes that you give up.

Example: 3

 Basic questions that arise due to the problem of scarcity

The existence of fundamental economic problem gives rise to three interrelated questions that the
society needs to confront. These questions are concerned with the use scarce resources between
alternative uses to achieve the best outcome. That is, answering these questions ensures the best use of
scarce resources. The questions are: What to produce, how to produce and for whom to produce.

 What to produce?
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Since the resources are scarce we cannot produce everything so as to satisfy all our wants. We need to
decide what to produce and in what quantities. For example, we have to choose whether to produce
lots of consumer goods such as food, clothing and vehicles to improve our living standard or to produce
lots of military hardware to improve our defense. In this context, the economists are of the view that
the goods that satisfy the most urgent wants of the people should be prioritized and the production of
the goods that satisfy the less urgent wants of the people should be postponed.

 How to produce?
Since the resources are scarce in relation to unlimited human wants, decision has to be made as how
the resources are used so that the best outcome arises. We need to consider how we can get the best
use out of the resources available to us. There may be various alternative production techniques
available to us to produce the given/chosen goods and services. The best production technique is the
one that produces the given output at the lowest possible cost. That is, maximum possible quantities of
the given goods and services should be produced using the minimum quantity of scarce resources.

 For whom to produce?

Because we cannot satisfy all the wants of the population, decision has to be made about how many of
each person’s wants are to be satisfied. On a broader level we need to decide whether everyone is going
to have a more or less equal share of what is being produced or whether some will have more than
others.
In some economies there are deliberate attempts to create a more egalitarian (equitable) society
through policies that redistribute wealth and income from the rich to the poor. This could be achieved
through progressive tax system. In other economies there are no such policies and inequalities of
income and wealth remain extreme.

Exercise
Explain the three basic questions that arise due to the problem of scarcity.

1.2 Economic methodology

Economics as a social science

Economics is a social science. The ‘social’ aspect is because economics studies the human behavior,
particularly in relation to satisfying human needs and wants using the available resources.

Economics is also a ‘science’. This is because the economists put forward and investigate the theories in
the same way as the scientists do. Like scientists, economists put forward new ideas that explain the
ever changing global economy in which we all live and work. The theories put forward by the economists
are often referred to as economic models.
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 Positive and Normative Economics

Positive economics and normative economics are two standard branches of modern economics. Positive
economics describes and explains various economic phenomena or the "what is" scenario. While
normative economics focuses on the value of economic fairness or what the economy should be.

To put it simply, positive economics is called the "what is" branch of economics. Normative economics,
on the other hand, is that branch of economics that tries to determine people's desirability to different
economic programs and conditions by asking what "should" be or what "ought" to be.

Positive economics is based on facts and cannot be approved or disapproved while normative
economics is based on value judgments.

An example of a positive economic statement is: "Government-provided healthcare increases public

expenditures." This statement is fact-based and has no value judgment attached to it. Its validity can be
proven (or disproven) by studying healthcare spending where governments provide healthcare.

An example of a normative economic statement is: "The government should provide basic healthcare
to all citizens." As you can deduce from this statement, it is value-based, rooted in personal perspective,
and satisfies the requirement of what "should" be.

Important: Both positive and normative economic statements are required in order to create the
policies of a country, region, industrial sector, institution, or business.

 Meaning of the term ‘ceteris paribus’

Ceteris paribus is a Latin term which means “other things remain equal /unchanged”. It is an
assumption used by the economists to model one change at a time. Under this assumption, the
effect of only one factor affecting an economic phenomenon is studied in isolation. That is, it studies
the effect of only one factor affecting an economic phenomenon at a time, keeping all other factors
fixed/ unchanged.

Example: The market demand for a good (good x) is affected by various factors such as the price of
the good itself, prices of related goods, income of consumers, tastes of consumers…etc. Under
ceteris paribus assumption, the effect of change in these factors on demand is studied in isolation.
For instance, if we study the effect of the change in the price of the good on its demand, we hold all
other factors fixed or unchanged.

 Time periods/dimensions in economics

Time periods are used in economics to understand the key concept of change. Economists take change
into account in the analysis of economic situations. It is used to assess how, over time, change can
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influence the concept that the economists seek to explain. The time periods used to analyze the
economic situations are:

 Short run
Short run is a time period where at least one factor affecting an economic phenomenon remains
constant/ fixed.
Example: The quantity of a good produced is the result of the factor inputs (labor and capital) used
inthe production process. If we want to increase the quantity of good produced, we have to increase
the factor inputs used. In the short run we cannot increase all the factor inputs. If we increase one
factor input, others will remain constant/fixed.

 Long run
In the long run, all the factors affecting an economic phenomenon are variable.
Example: If a producer wants to increase the quantity of the good produced then, in the long run he
can change all the factor inputs used in the production process.

 Very long run

In the very long run along with all the factors affecting an economic phenomenon, the structure of
the economy changes. Change in the economic structure may involve change in government, change
in tax system, Change in technology…etc.

 The margin
Like ceteris paribus, the margin is another tool that is used by economists to simplify a situation. Many
aspects of microeconomics involve analyzing decisions at the margin.

Marginal in economics, means having a little more or a little less of something. It refers to the effects of
consuming and/or producing one extra unit of a good or service. That is, looking into the effect of
adding to or subtracting from the current level of activity. For example, if a producer is currently
producing 10 units of good x then making decision at the margin means looking at the effect of
producing 11th unit of good x and deciding whether to produce the 11th unit or not.

Rational consumers and producers are assumed to calculate the marginal cost and benefit of each
decision. Nearly all choices are made at the margin. That means they almost always involve additions
to, or subtractions from current conditions, rather than all or nothing decisions. We don’t make all-or-
nothing decisions, such as choosing between eating or wearing clothes. Instead we choose between
having a little more food at the cost of a little less clothing.

 Microeconomics and Macroeconomics

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Microeconomics is the study of individuals, households and firms' behavior in decision making and
allocation of resources. It generally applies to markets of goods and services and deals with individual
and economic issues.
Microeconomic study deals with what choices people make, what factors influence their choices and
how their decisions affect the markets for goods by affecting the price, the supply and demand.
For example, microeconomics examines how a company could maximize its production and minimize
costs so that it could lower prices and better compete in its industry.

Macroeconomics is the branch of economics that studies the behavior and performance of an economy
as a whole. It focuses on the aggregate changes in the economy such as unemployment, growth rate,
gross domestic product and inflation.
Macroeconomics analyzes all aggregate indicators and the microeconomic factors that influence the
economy. Government and corporations use macroeconomic models to help in formulating of economic
policies and strategies.
For example, Unemployment, interest rates, inflation, GDP, all fall into macroeconomics. Government
raising taxes and cutting spending to reduce aggregate demand is macroeconomics.

1.3 Resource allocation in different economic systems and the issue of transition

 Market economy

It is an economic system where the property resources are owned by the private individuals and
organisations and the allocation of resources relies on the price mechanism or market mechanism. That
is, in a market economy the decisions regarding what, how and for whom to produce are made on the
basis of the price mechanism. Price mechanism or market mechanism is the interaction of demand and
supply (market forces also called invisible hands) to determine the prices and the quantities of the goods
produced and consumed in the market. The market economy is also known as free market economy,
free enterprise economy, capitalist economy or “laissez-faire” capitalism. Some examples of market
economy include UK, USA, Japan, and Singapore and so on.

 Characteristics of market economy.

Advantages:
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 Consumer sovereignty
 Freedom of choice and enterprise
 Quick response to consumer demand
 Financial incentives encourages enterprise and efforts
 Competition and efficiency

Disadvantages:
 Risk of unemployment of resources
 Externalities (spillover effects of production or consumption decision) are not taken into account
 Merit goods are under produced and under consumed
 Demerit goods are overproduced and over consumed
 Public goods are not produced
 Too high concentration on consumer goods and services
 Abuse of market power
 Economic inequality

 Allocation of scarce resources in the market economy

In a market economy, allocation of resources relies in the price mechanism or market mechanism. It is
the process where the market forces of demand and supply interact to determine the prices of the
goods and the quantities of the goods produced and consumed in the market.

Fig: Market mechanism or price mechanism

Allocation of scarce resources is concerned with deciding what to produce, how to produce and for
whom to produce.

 What to produce?
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The private enterprises are guided by profit motive. So they allocate the scarce resources for the
production of those goods that yield the highest profit. The amount of profit generated from the
production of a good depends upon its market price. All other things being unchanged, higher
the price of the good higher will be the profit and vice versa.

 How to produce?
Since the private enterprises / firms are guided by profit motive, they produce the chosen goods
using such a production method that yields the lowest cost of production. Producing the goods
at the lowest possible costs makes the goods efficient, competitive and profitable.

 For whom to produce?

In a market economy goods/services are produced for those who have the ability to pay for
them. Those who lack the ability to pay cannot enjoy the benefits of the goods/ services that are
being produced in the market economy.

Exercise
Explain how the scarce resources are allocated in the market economic system.

 Planned economy / Command economy

It is an economic system where the property resources are owned by the government/public
authorities. In this economic system, the allocation of scarce resources relies on government directives
or state planning. That is, the decisions regarding what, how and for whom to produce is taken by the
government/public authorities. Some examples of planned economy include Belarus, Myanmar, Iran,
Libya, Cuba, Albania, North Korea and Vietnam.

 Characteristics of Planned economy

Advantages:

 Full employment of resources

 Economic equality
 Avoids wasteful duplication
 Externalities are taken into account
 Encourages the production of merit goods
 Discourages the production of demerit goods
 Provides public goods

Disadvantages
 Slow response to consumer demand
 Lack of incentives discourages enterprise and efforts
 Lack of freedom of choice and enterprise
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 Lack of competition results in economic inefficiency

 Bureaucracy - makes the decision making process complex
 Disproportionate concentration of capital goods

 Allocation of resources in a planned economy.

In a planned economy, allocation of resources relies on government directives or state planning. The
government instructs the public enterprises on which goods to produce and in what quantities. The
scarce resources are allocated to the production of goods or services considering the perceived need of
the citizens.

The government instructs the public enterprises on which method of production to be used to produce
the chosen goods. Such production methods are used to produce the goods that ensure sustainability in
producing the goods and satisfying the wants of the people.

In a planned economy, through various policies government ensures equality in the distribution of goods
or services that are being produced in the economy. That is, the citizens are able to enjoy equal share of
the goods or services that are being produced in an economy.

 Mixed economy
It is an economic system where there is a co-existence private and public sector. The private sector
represents market economy while the public sector represents planned /command economy. The
property resources are owned by the private individuals and organizations as well as the public
authorities. The allocation of resources relies on both price mechanism and the state planning.
Examples of mixed economy include Nepal, India, Pakistan, Bangladesh etc.

 Characteristics of mixed economy

Advantages
A mixed economy aims to gain the advantages of both market economy and planned economy. Some of
them are:
 Competition and efficiency
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 Quick response to change in consumer demand

 Freedom of choice and enterprise
 Financial incentives encourage enterprise and efforts
 Avoids wasteful duplication
 Economic equality
 Full employment of resources
 Externalities taken into account ( Government imposes indirect taxes on the activities that
generate externalities)

Disadvantages
A mixed economy may experience the disadvantages of both market economy and planned economy.
Some of them are:
 Lack of consumer sovereignty
 Slow response to consumer demand
 Abuse of market power
 Demerit goods are overproduced and over consumed
 Merit goods are under produced and under consumed
 Risk of unemployment of resources
 Disproportionate concentration on capital goods
 Bureaucracy- may result in bureaucratic corruption and make the decision making process
complex.

Exercise
Explain the differences in the features of market economy and planned economy. [8/12]

 Allocation of resources in a mixed economy

In a mixed economy, allocation of resources relies on both the price mechanism and the state
planning. In the private sector, allocation of resources relies on the price mechanism or market
mechanism. The private enterprises allocate the resources for the production of those goods that yield
higher profit. They use the most efficient production methods to produce the chosen goods. This
enables them to minimize the cost and thus they can make higher profit. The private enterprises
produce the goods for those who have the ability to pay for the goods. Those without the ability to pay
cannot enjoy the benefits of the goods produced by the private enterprises.

On the other hand, allocation of resources in the public sector depends on the government directives or
state planning. The government instructs the public enterprises on which goods to produce and in what
quantities. The method of production to use also depends on the government directives.
However, on deciding for whom to produce, the government uses polices that ensure equality in the
distribution of goods or services that are being produced by the public enterprises.
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 Issue of transition from planned economy to market economy.

Transition economies are those economies that are involved in moving from planned economy to
market economy or mixed economy.

 Key aspects or requirements of transition process

 Liberalization of markets to give the price mechanism a bigger role in the allocation of resources
between alternative uses.
 Privatization of public assets
 Removal of government subsidies to loss making public industries
 Removal of tax on imports and exports to make the economy open to the world
 Legal reform to protect the right to private property
 Banking reforms and interest rate liberalization

 Problems of transition from planned to market or mixed economy

 Risk of unemployment of resources
 Brain drain
 Economic inequality
 Trade deficit
 Rise in prices (inflation)
 Corruption and consumer abuse

Exercise
Define transition economy. Discuss the problems that arise during the transition from planned
economy to market economy.

1.4 Factors of production

There are hundreds and thousands of things that are used to produce the finished products that satisfy
the human wants. They are collectively called factors of production or factor inputs and are classified
into the following four groups:
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 Land---all the natural resources

 Labor----physical or mental work done with the expectation of monetary rewards.

Work done without the expectation of monetary reward is not labor.

 Capital---all the man-made aids of production such as machines, tools, equipments,

factories, offices, delivery vehicles etc. Money is a means to buy/hire capital goods.
Spending on capital goods is called investment.

 Enterprise-----organisations / companies. This factor of production performs two

important functions. Firstly, it organizes other factors (land, labour and capital) to carry
out the production process. Secondly, it takes the risk involved in business.

Rewards to the factors of production

Factors of Sources/ supplier/where Factor payments

production they come from
Land Landlords Rent
Labor Laborers Wages
Capital Capitalists Interest
Enterprise Entrepreneurs Profit

 Economic activities
 Production:
It is the creation of utility. In the process of production, factor inputs are converted into finished
products. That is,
Land+ Labor+ capital +Enterprise = Finished products

 Consumption:
It means using the finished products to satisfy the human wants. The utility possessed by finished
products is destroyed in the act of consumption.

 Exchange:
It means giving what one has and taking in return what one wants. In the primitive society, exchange
occurred in the form of barter where people used to exchange goods for goods. In the modern
economic system, goods are exchanged with money.

 Distribution:
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It means paying remuneration to the factors of production for their contribution to the production of
the finished products. The value of output/finished products produced is distributed among the factors
of production in the form of rent, wages, interest and profit.
That is,
Value of finished products = Rent + wages + interest + profit

 Public Finance:
It is the study of income and expenditure of the public authorities/government.

 Division of labour or enterprise and specialisation

Division of Labour is where the main process of production is split up into many simple parts and each
part is carried out by different workers who are specialised in performing that specific part.

Different workers perform different parts of production on the basis of their specialisation. The result is
that goods come to the final shape with the co-operation of many workers.

For example – In a large scale readymade garment factory, a man does cutting of cloth, the second man
stiches clothes with machines, the third buttons, the fourth makes folding and packing etc.

The main motive of practicing division of labour is to make the best use of resources and increase the
scale of production so that the maximum level of infinite human wants are satisfied.

 Essential conditions or pre-requisites of division of labour

Complete success of division of labour depends on the following factors:

 Wide Market
Division of Labour will function well and its success depends on wide market. If there is small market
Division of Labour will not develop much. Division of Labour is mostly found in big factories, where
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commodities are produced on a large scale. It is possible to split up the job into different processes only
in large scale industries.

 Large Scale Production

For the complete success of Division of Labour the goods must be produced on large scale. When there
is large scale production more labourers will be employed and then Division of Labour will be possible in
a nice way.
 The Quantity of capital goods available
Sufficient capital is needed for a successful and better Division of Labour. Shortage of capital and money
not available on time may help the company not to go for Division of Labour.

 Nature of Demand
Some industries are of such nature that it is not possible to split up the work into distinct and separate
processes. Here also the scope of Division of Labour is limited. Possibility of splitting up production is
essential for Division of Labour.

 Organising Ability
Division of Labour involves the employment of a large number of workers in one factory. To handle
them properly and to assign to each worker a suitable job requires judgment of human nature of a high
order. Hence, the entrepreneur must have the necessary ability to organise production on a large scale.

 Spirit of Co-operation
If the workers are not co-operative, quarrelsome and cannot work together amicably, Division of Labour
is out of question. There must be a spirit of co-operation, a spirit of compromise and a team spirit
should exist. Without the spirit of give and take, Division of Labour cannot be introduced.

 There should be proper development of means of transport and communication

For the success of Division of Labour means of transport and communication must be developed. If
there is development of means of transport raw-materials can be easily available and finished goods can
be sent outside for sale.

 Advantages of division of labour

Following are the advantages of division of Labour:

1. Availability of goods at a Cheaper Price

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Division of Labour helps in mass production. Thus, production becomes less expensive and more
economical. Therefore, cheaper goods are produced by manufacturers. Availability of cheaper goods for
consumers improves the standard of living of the consumers and the people.

2. Better Quality of goods

Division of Labour implies splitting up of production into a number of processes. Each person is given the
job for which he is best suited. In this way, a right man is placed at the right job which helps in getting
better quality of commodities.

3. Increase in Efficiency of Labour

With the Division of Labour a worker has to do the same work time and again, and he gets specialisation
in it. In this way, the Division of Labour leads to a great increase in efficiency.

4. Best Use of Tools

In this system, it is not necessary to provide each worker with a complete set of tools. He needs a few
tools only for the job in which he can make their best use. Therefore, the continuous use of tools is
possible which are used at different stage.

5. Right man at right work

Division of labour ensures that the workers are assigned the tasks on the basis of their education
training and experience. It also ensures that every person can find work according to his taste and
interest.

6. Saving of Time and Expenses in Training

Under Division of Labour a worker has to train himself in a small part of production. There is no need to
learn the complete process of production. It ensures saving of time as well as expenses in training.

7. Development of international trade

Division of Labour increases the tendency of specialisation not only in the workers or industries, but in
different countries also. On the basis of specialisation, every country produces only those goods in
which it has a comparative advantage and imports such goods from those countries which have also
greater comparative advantage. Therefore, Division of Labour is beneficial for the development of
international trade also.

 Disadvantages of division of labour

Following are the demerits or dis-advantages from Division of Labour:

1. Danger of Over-production
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Over-production means that the supply of production is comparatively more than its demand in the
market. Because of the Division of Labour when production is done on a large scale, the demand for
production lags much behind its increased supply. Such conditions create over-production which is very
harmful for the producers as well as for the workers when they become unemployed.

2. Loss of Responsibility
Many workers join hands to produce a commodity. If the production is not good and adequate none can
be held responsible for it. It is generally said that “every man’s responsibility is no man’s responsibility.”
Therefore, the Division of Labour has the dis-advantage of loss of responsibility.

3. Increased Dependency
When the production is divided into a number of processes and each part is performed by different
workers, it may lead to over-dependence. For example – In the case of a readymade garments factory, if
the man cutting cloth is lazy, the work of stitching, buttoning etc. will suffer. Therefore, increased
dependence is the result of Division of Labour.

4. Increased dependence on machines

As Division of Labour increases there will be an increased use of machines. Almost all the workers work
on different types of machines. It is very difficult for them to work without machines. Thus, Division of
Labour increases the dependence on machines.

5. Monotony of Work:
Under Division of Labour a worker has to do the same job time and again for years together. Therefore,
after sometime, the worker feels bored or the work becomes irksome and monotonous. There remains
no happiness or pleasure in the job for him. It has an adverse effect on the production.

6. Fear of Unemployment
When the worker produces a small part of goods he gets specialised in it and he does not have complete
knowledge of the production of goods. For example – If a man is expert in buttoning the clothes and if
he is removed or dismissed from the job, it becomes difficult for him to find the job of building. Thus,
Division of Labour has a fear of unemployment.

7. Reduction in mobility of labour:

It has been observed that the mobility of labour is reduced on account of Division of Labour. The worker
performs only a part of the whole task. He is trained to do that much part only. So, it may not be easy
for him to find out exactly the same job where else, if he wants to change the place. In this situation the
mobility of labour gets retarded.
8. Maximum production leads to depression/recession in the country
In Division of Labour if maximum production is done then depression/recession the country takes place
and the bad effect of depression directly falls on social and economic situation of the county.

Conclusion:
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Division of Labour no doubt has a number of drawbacks. But the advantages outweigh the
disadvantages. The problems can be minimised by shortening the hours of work and providing more
leisure to the worker. It is no longer possible nor it is desirable, to do away with this system. Remember
Division of Labour is beneficial to the workers, to the producers and to the society as a whole

Exercise
Discuss whether division of labour brings only benefits to an economy.

1.5 Production possibility curves (PPCs)

Production possibility means the maximum possible quantities of the goods that an economy can
produce using all the available resources.
Production possibility curve (PPC) is a graphical representation of the maximum possible quantities of
the goods that an economy can produce using all the available resources. It is also used to explain the
link between the problem of scarcity and opportunity cost. It is also called production Possibility frontier
or production possibility boundary.
Table: Production possibility schedule

Consumer goods Military goods

50 0
40 10
30 20
20 30
10 40
0 50

Fig: PPC with constant opportunity cost

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In the above diagram:

 AF is the economy’s production possibility curve (PPC) that shows the maximum quantities
of two goods (consumer goods and capital goods) that the economy can produce using all
the available resources.

 In this example, using all the available resources the economy can produce 50 units of
consumer goods or 50 units of military goods. If it produces 50 consumer goods it must give
up 50 military goods and if it produces 50 military goods, it must give up 50 consumer
goods. So, the opportunity cost of 50 consumer goods is 50 military goods and that of 50
military goods is 50 consumer goods. That is,
50C = 50m
IC = 1m, and
50m = 50c
1m = 1C

 All the points on the PPC (A,B,C,D,E,F) denote full employment of resources and the output
produced at all these points is the potential/ full employment level of output. An economy
will produce at any of these points if there is full employment of resources and the scarce
resources are used in the most efficient manner.

 Movement from one point to another on the PPC shows the reallocation of resources and it
gives rise to opportunity cost. Let us assume that the economy is currently producing at
point ‘C’ .At this point the economy produces 30 units of consumer goods and 20 units of
military goods which is the potential level of output. Now if the economy decides to
increase the production of military goods from 20 units to 30 units, it must give up 10 units
of consumer goods. So, the opportunity cost of producing 10 units of military goods is 10
units of consumer goods that are given up. This is shown by the movement from point ‘C’ to
‘D’ on the PPC.
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 The opportunity cost arises because a fully employed economy cannot increase the
production of one good without giving up something of another good. In order to increase
the production of one good, the resources have to be switched from the production of
another good.

 Moving from point ‘A’ to ‘F’ along the PPC it is seen that the economy is giving up 1 unit of
consumer good for every additional (1 unit) of military good. This is law of constant
opportunity cost. That is the resources are equally efficient in producing consumer goods
and military goods. This law of constant opportunity cost makes the ppc a straight line.

 Any point inside the PPC shows inefficiency in the allocation of resources. The problem with
this point is that the scarce resources are either not fully employed or the resources are not
used efficiently. So, more of one or both the goods can be produced without giving up
anything of another. This shows that opportunity cost doesn’t arise if the scarce resources
are not fully employed. Movement from a point inside the PPC to a point on the PPC shows
an increase in the employment of resources while movement from a point on the PPC to a
point inside the PPC shows an increase in the unemployment of resources.

 Any point outside the PPC is unattainable. The scarcity of resources doesn’t allow the
country to produce outside its PPC.

Table: Production possibility schedule with increasing opportunity cost

Good X Good y
10 0
9 1
7 2
4 3
0 4

Fig: PPC with increasing opportunity cost

20 | P a g e

Note: The law of increasing opportunity costs is driven by the fact that economic resources are not
completely adaptable to alternative uses. That is, the resources are not equally efficient in producing
all the goods. To get more of one product, resources whose productivity in another product is
relatively greater will be needed.

Exercise
Using PPC, explain the link between the problem of scarcity and opportunity cost.

 Resource endowments and countries’ PPCs

A country’s production possibility depends on the availability of resources. A country with higher
resource endowments has higher production possibility than a country with lower resource
endowments. Hence, the PPC of a country with higher resource endowments lies to the right of the PPC
of a country with lower resource endowments.

Fig: Resource endowments and the countries’ PPCs

In the above diagram, the PPC of country Y lies to the right of country X’s PPC. This shows that country Y
has higher resource endowments than country X and hence the production possibility of country Y is
higher than that of country X. That is, the full employment level of output is higher in country Y than in
country X.

Exercise
Explain how the production possibility of a country is determined by the availability of resources.

 Shifts in PPC

Shift in PPC shows a change in country’s production possibility caused by any change in the quantity
and quality of resources available. An increase in the quantity and quality of resources increases the
country’s production possibility and causes the PPC to shift rightward or outward. While a decrease in
the quantity and quality of resources reduces the country’s production possibility and causes the PPC to
shift leftward or inward.
21 | P a g e

Fig: Effect of change in production possibility on country’s PPC

A country’s production possibility increases due to an increase in the quantity and quality of resources
caused by:

Increased spending by the government on education and training of workers

Discovery of new resources
Technological advancement
Increased Immigration of workers
Land reclamation
Increase in the retirement age….etc

A country’s production possibility decreases due to a decline in the quantity and quality of resources
caused by:

Wars
Natural disasters
Pandemics
Increased emigration of workers, etc
22 | P a g e

• Change in country’s production possibility in terms of only one good cause the PPC to rotate from a
point on the axis (pivot point).

Fig: Effect of change in country’s production possibility in terms of only one good

 Making use of PPC

Production possibility curves (PPCs) can be used to illustrate the economic issues faced by the economic
decision makers in the real world. Some such issues that can be illustrated using the PPC are:

 Issue of choice between consumer and capital goods: an issue of “Jam today or more jam
tomorrow”
 Issue of hard choice for developing economies
 Issue of economic growth
 Issue of employment and unemployment
 Issue of economic efficiency and inefficiency

•Choice between consumer and capital goods: an issue of “Jam today or more jam tomorrow”

If an economy allocates more resources to produce consumer goods, its current consumption will
increase but the future growth prospect will decline. This is because if more consumer goods are
produced, production of capital goods will be low and capital consumption (depreciation) will be high.
On the other hand, if more capital goods are produced, current consumption will fall and current living
standard will decline. However, this will only be a short-term effect as the increased production of
capital goods will enable the country to produce more of both consumer goods and capital goods in the
future.

Fig: Choice between consumer goods and capital goods

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 Hard choice for developing countries

Developing economies are characterized by low economic growth rate and high population growth
rate. One of the main objectives of these economies is to achieve high economic growth rate. In order
to achieve higher economic growth rate, they must allocate more of the scarce resources to the
production of capital goods. But they can’t do so because they have to allocate most of their scarce
resources to the production of consumer goods for the subsistence of their ever increasing population.
Hence, the economic growth rate continues to be low in the developing economies.

Fig: Capital consumption/depreciation in the developing economies.

 Issue of actual and potential economic growth

If an economy is operating inside its PPC and produces more as a result of using previously unemployed
resources, or using resources more efficiently, this is referred to as actual growth. This is illustrated by a
movement from a point within the PPC to a point towards or on the PPC.

The productive potential of an economy may be increased by an increase in the quality and/or quantity
of resources and, when this occurs, this is known as potential growth. This is shown by a rightward or
outward shift in the PPC.

Fig: Actual and potential economic growth

24 | P a g e

 PPCs can also be used to illustrate the issue of unemployment of resources in an economy. If
unemployment in an economy increases, movement occurs from a point on the PPC to a point
inside the PPC. While if employment increases, movement occurs from a point inside the PPC to
a point on the PPC.

 PPCs can also be used to show how efficient an economy is. An economy producing inside the
PPC shows economic inefficiency while producing on the PPC shows an efficient use of
resources.

Exercise
Explain any three economic issues that can be illustrated using PPCs

1.6 Classification of goods and services

 Free goods and economic goods

Free goods are freely available in nature. They don’t involve cost of production. They can be consumed
at zero prices/charges. That is, the free goods do not have market prices. Their consumption doesn’t
give rise to opportunity costs. Some examples of free goods include air, natural water, sunlight etc.

Economic goods involve costs of production and hence they command some prices/charges. Their
production and consumption gives rise to opportunity costs. Some examples of economic goods are
food, clothing, housing, electronics, motor cars, furniture etc.

 Private goods, public goods and quasi-public goods

Private goods are privately owned by the private individuals or organizations on paying the prices. They
possess two important characteristics of excludability and rivalry. They are excludable in the sense that
those who cannot pay for the goods cannot enjoy the benefits of these goods. They are rival in use in
25 | P a g e

the sense that once the goods are bought by one/some consumers; they may not become available to
others. Their production yields profit as the consumers have to pay the prices to own or enjoy the
benefits of these goods.

Public goods are those goods that possess the characteristics of non-excludability and non-rivalry. They
are non-excludable in the sense that no one can be stopped/ excluded from enjoying the benefits of
these goods once they are made available by one producer or consumer. They are non-rival in the sense
that the benefits enjoyed by the consumers already using the goods doesn’t diminish with an increase in
the number of users of the goods. Profit cannot be made from the production of public goods as they
are non-excludable and hence the consumers can enjoy the benefits of these goods without paying for
them.

Examples include roads, public parks, street lights, light houses, security services provided by local
police, national defense etc.

Quasi-public goods have characteristics of both private and public goods. They may be excludable but
non-rival. Example: education, zoo, museums, public libraries, public transportation, cinema halls etc.

 Problem caused by public goods in the allocation of resources

The problem caused by the presence of public goods is that the free market (market economy or the
private enterprises/private sector economy) doesn’t allocate any resources for the production of public
goods. This problem can be explained in terms of the ‘free rider’ issue. Since the public goods are non-
excludable, no consumers can be excluded from enjoying the benefit of a good once it is provided by
someone. Due to this reason, all the consumers wait for someone else to pay for the goods so that they
can enjoy the benefit of the good without paying for them. That is, the consumers expect to have a free
ride at the back of other consumers’ purchase of the goods. It is quite reasonable for them to do so as
the public goods bear the characteristic of non-excludability. Due to this reason, profit cannot be made
from the production and distribution of public goods. Hence the free market or the private enterprises
do not allocate any resources for the production of public goods as they are guided by profit motive.
Hence, the free market fails.

Exercise
Explain the problem caused by public goods in the allocation of resources.

 Merit goods, demerit goods and information failure

A merit good is defined as a good that is better for a person than the person who consumes the good
realizes. This means that merit goods possess higher value than the value assigned to them by the
consumers. These goods are valued less than their actual value by the consumers due to the problem of
information failure. The consumers of these goods do not have the right information or they simply lack
the relevant information. Production and consumption of merit goods gives rise to positive
26 | P a g e

externalities or positive spillover effects. That is, production or consumption of merit goods not only
benefits the private producers and consumers but the benefits are also extended to the third party (one
who is not directly involved in the production or consumption decision). Examples include education,
healthcare services etc.

A demerit good is defined as a good that is more harmful for the individual consumers than they realize.
This means that the demerit goods possess lower value than the value assigned to them by the
consumers. These goods are valued more than their actual value by the consumers due to the problem
of information failure. The consumers are not informed about the actual harmfulness of these goods.
Production and consumption of demerit goods gives rise to negative externalities or negative spillover
effects. That is, production or consumption of demerit goods not only harms the private producers and
consumers but the negative impacts are also extended to the third party (one who is not directly
involved in the production or consumption decision). Examples include cigarettes, alcohol, tobacco, junk
food etc.

The definition of merit and demerit goods has to do with the problem of information failure. The
consumers of these goods don’t know how good or bad these goods are actually for them. They either
do not have the right information or they simply lack the relevant information. Due to this problem of
information failure, these goods are produced and consumed in the quantities more or less than the
optimum quantity.

Exercise
Explain with examples, the difference between merit and demerit goods. [8]

 Problem caused by merit and demerit goods in the allocation of resources.

The problem caused by the presence of merit goods is that they are under produced and under
consumed in the free market. These goods are undervalued by the consumers due to the problem of
information failure. Due to this reason, they register too low demand for the merit goods. As a result,
the free market (market economy or the private enterprise) allocates too little resources for the
production of these goods. Thus the merit goods are produced and consumed in the quantities less than
the optimum quantity and the free market fails to allocate the scarce resources efficiently.

On the other hand, the problem caused by the presence of demerit goods is that they are over produced
and over consumed in the free market. These goods are overvalued by the consumers due to the
problem of information failure. Due to this reason, they register too high demand for the demerit goods.
As a result, the free market (market economy or the private enterprise) allocates too much of scarce
resources for the production of these goods. Thus the demerit goods are produced and consumed in the
quantities more than the optimum quantity and the free market fails to allocate the scarce resources
efficiently.
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Exercise
Explain the problems caused by merit and demerit goods in the allocation of resources [8]

xxxxxxxxxxxxxxxxxxxxxxxxx
1|Page

AS Chapter 2: The price system and the micro economy

 Market:
It is the exchange of goods/services or the factors of production (resources). The exchange of
goods/services is called the product market while the exchange of factors of production is
called the factor market.

 Free market
The market for a good/service is said to be a free market if its price and quantity traded is
determined by the free interaction of the forces of market demand and supply. In a free market
the government has no role in determining the prices and quantities of the goods/services.
The free market forces are market demand and market supply which are also referred to as
the invisible hands.

 Demand
It is the quantity of any good/commodity that the buyers are able and willing to buy at the
given prices over a period of time, ceteris paribus.

Example: When the price of good x is $10 per unit, its quantity bought by the consumers is 50
units per week. So, demand for good x is 50 units per week.

Demand for a good arises only when the consumers have the ability and willingness to pay for
the good. A consumer’s want to have something without the ability and willingness to pay for it
is not demand; it is a mere wish or desire. A consumer’s wish/desire to have something
becomes his demand if he has the ability and willingness to pay for it. So, an effective demand
is a consumer’s desire to have something that is supported by his ability and willingness to pay
for it.

Table: Demand Schedule

Price of Good X Quantity demanded
($ per unit) (Units per week)
10 2
9 3
8 4
7 5
6 6
5 7
4 8
2|Page

Fig: Demand curve

 Individual and market demand:

 Individual demand is the quantity of a good bought/demanded by an individual buyer at

various prices over a period of time.

Example: If at the price of $10 per unit, the market demand for good x is 50 units/ week and
the quantity demanded by buyer A is 20% of the total market demand then, individual demand
for good x is 10 units/ week.

 Market demand
Market demand is the sum of the quantities of a good demanded by all the individual buyers of
the good at various prices over a period of time. It is derived by horizontally adding up or
aggregating the individual demand.

Table: Individual and market demand schedule

Price of good x Quantity Demanded (units per week)
($ per unit) Buyer A Buyer B Buyer C Market Demand
10 1 2 3 6
9 2 3 4 9
8 3 4 5 12
7 4 5 6 15
6 5 6 7 18
5 6 7 8 21
3|Page

Fig: Individual demand curve

In the above diagram,

DD is an individual
demand curve. It is
negatively sloped (sloping
downward from left to
right). This shows that
there exists an inverse
relationship between the
price of a good and its
quantity demanded by an individual buyer. That is, all other things being unchanged, when the
price of a good rises, its quantity demanded by an individual buyer decreases and vice versa.

Fig: Derivation of market demand curve

4|Page

 Factors affecting demand: Determinants of demand

 Price of the given good

 Taste of the consumers

 Prices of related goods (substitutes and complements)
 Income of consumers
 Number of buyers/ users of the good
 Expectation of price and income change
 Seasonal change
 Government policy
 Culture and tradition
 Advertisement

 Price of the given good [dx= f (Px)]

All other factors being unchanged, when the price of a good rises, its quantity demanded decreases and
vice versa.
Fig: the demand curve

Total Expenditure (TE) = Price x Qty. demanded

Example, when price=OP, Quantity demanded=OQ

So, TE =OP x OQ
=OPaQ
If P=8 and Qd=12 then,
TE = 8 X12=96
5|Page

 Non-price factors/ determinants of demand

 Taste of consumers/fashion
Demand for a good rises if it is in fashion or preferred by the consumers over other goods while its
demand decreases if it goes out of fashion.

 Income of consumers
To analyse the effect of change in consumer’s income on the demand for the good, we classify the
goods as superior or normal goods and inferior goods.

In case of superior or normal goods, as consumers’ income increases, their demand increases and vice
versa.
Fig: Demand for superior/normal goods

In case of inferior goods, an increase in consumers’ income reduces their demand and vice versa.
Fig: Demand for inferior goods

 Prices of related goods [dx= f(py)]

To analyse the effect of change in price of related goods on the demand for a good, we
classify the goods as substitutes and complements.
6|Page

In case of substitutes, demand for a good increases if the price of its substitute increases and
vice versa. For example, demand for coke will increase if the price of Pepsi rises and vice versa.
Fig: Alternative demand

In case of complements, demand for a good decreases if the price of its complement increases
and vice versa. For example, an increase in price of petrol reduces the demand/use of cars and
vice versa.
Fig: Joint demand

 Number of buyers/ users of the good

An increase in the number of buyers or users of the good increases the demand for the good
and vice versa. For example, an increase in the number of students studying A Level economics
will increase the demand for economics text book and vice versa.

 Expectation of price and income change

If the consumers expect the price of a good to rise in the near future its demand will increase as
the consumers will rush to buy the good and hold in stock before the price rises. While if the
consumers expect the price of the good to fall in the near future, its demand will decrease as
the consumer will postpone their purchase and wait for the price to fall.
7|Page

Similarly, expectation of income change also affects the demand for the goods. If an economy is
experiencing economic growth, consumers can expect a rise in employment and income. This
will increase the consumer confidence and hence they will consume more. On the other hand,
if the economy is experiencing recession, there will be an atmosphere of pessimism as
employment and income is expected to fall. Thus, there will be lack of consumer confidence
and the demand for goods decreases.

 Seasonal change
Demand for the goods changes with the change in season/weather. For example, demand for
cold drinks increases in the summer season while their demand decreases in the winter season.

 Culture and tradition

Demand for the goods is also affected by the culture and tradition followed by the people.
For example, demand for fruits, flowers, sweets, dairy products etc. increases during the festive
season.

 Government policy
Demand for a good is also affected by government policy. For example, government policy of
increase in direct taxes (income tax) reduces the disposable income of the consumers which in
turn, reduces the demand for the good. On the other hand, cut in income tax raises the
demand for the good.

 Advertisement
An effective advertisement provides information to the consumers about the good and attracts
the consumers towards the good. This increases the demand for the good.

 ‘Change in quantity demanded’ and ‘change in demand’: movement along

and shift in demand curve
8|Page

Change in quantity demanded is caused by a change in the price of the good itself, all other
factors remaining unchanged. Change in quantity demanded causes a movement along the
demand curve. An increase in the price of the good reduces the quantity demanded and causes
a leftward movement along the demand curve. This is technically referred to as “contraction of
demand”. On the other hand, a fall in the price of good increases its quantity demanded and
causes a rightward movement along the demand curve. This is referred to as an “expansion of
demand”.

Fig: Change in quantity demanded: movement along the demand curve

Change in demand is caused by the change in one or all the non-price determinants of demand,
price of the good being unchanged. Change in demand causes a shift in the demand curve. An
increase in demand causes the rightward shift while a decrease in demand causes a leftward
shift in the demand curve. For example, price of economics textbook being unchanged, if there
is an increase in the number of students studying economics; demand for economics textbook
will increase. This will cause the demand curve to shift rightward.
Fig: Change in demand: shift in demand curve

 Law of demand
9|Page

The law of demand states that all other things being unchanged; there exist an inverse
relationship between the price of good and its quantity demanded. That is when the price of a
good rises, its quantity demanded decreases and vice versa.
Fig: the demand curve

 Exceptions of law of demand

 Giffen Goods
Giffen Goods is a concept that was introduced by Sir Robert Giffen. These goods are goods that
are inferior in comparison to luxury goods. However, the unique characteristic of Giffen goods
is that as its price increases, the demand also increases. And this feature is what makes it an
exception to the law of demand.

 Veblen Goods
Veblen Goods is a concept that is named after the economist Thorstein Veblen, who introduced
the theory of “conspicuous consumption“. According to Veblen, there are certain goods that
become more valuable as their price increases. If a product is expensive, then its value and
utility are perceived to be more, and hence the demand for that product increases.
And this happens mostly with precious metals and stones such as gold and diamonds and luxury
cars such as Rolls-Royce. As the price of these goods increases, their demand also increases
because these products then become a status symbol.

 The expectation of Price Change

There are times when the price of a product increases and market conditions are such that the
product may get even more expensive. In such cases, consumers may buy more of these
products before the price increases any further. Consequently, when the price drops or may be
expected to drop further, consumers might postpone the purchase to avail the benefits of a
lower price. There are also times when consumers may buy and store commodities due to a
fear of shortage. Therefore, even if the price of a product increases, its associated demand may
also increase as the product may be taken off the shelf or it might cease to exist in the market.
10 | P a g e

 Necessary Goods and Services

Another exception to the law of demand is necessary or basic goods. People will continue to
buy necessities such as medicines or basic staples such as sugar or salt even if the price
increases. The prices of these products do not affect their associated demand.

 Change in Income
Sometimes the demand for a product may change according to the change in income. If a
household’s income increases, they may purchase more products irrespective of the increase in
their price, thereby increasing the demand for the product. Similarly, they might postpone
buying a product even if its price reduces if their income has reduced. Hence, change in a
consumer’s income pattern may also be an exception to the law of demand.
 Reasons for an inverse relationship between the price of a good and its
quantity demanded

 Income effect of price change:

Consumer’s money income being unchanged when there is an increase in the price of a good, real
income (purchasing power) of the consumer decreases. That is, the consumer can buy lower quantity of
the good using the given money income when the price of the good rises. Hence the quantity demanded
of a good falls when its price rises and vice versa.
Let, M= $100
Px= $10/ unit
So, $100/$10= 10 units

Now, M1=$100
Px1=$20/ unit
So, M1/Px1= $100/$20= 5 units

 Substitution effect of price change:

When the price of a good rises, it becomes relatively expensive. So the consumers substitute the
expensive good with the cheaper ones. Hence, the quantity demanded of a good falls when its price
rises and vice versa. For example when the price of Pepsi increases its quantity demanded decreases
because the consumers switch to coke which is now relatively cheaper. It is always the case that the
consumers substitute towards the cheaper products.

 Law of diminishing marginal utility:

According to this law, as the quantity of a good consumed by a consumer increases, the utility
(satisfaction) derived from the successive units (marginal utility) decreases. So, a rational consumer will
not consume the successive units of the good at the same price. He will consume the successive units of
the good only if the price decreases. Hence, the quantity consumed/demanded of a good increases only
when its price decreases.
11 | P a g e

Table: Marginal utility derived from a good and the price paid by a consumer
Quantity of good x Marginal utility Price paid / value assigned
consumed ( utils/units) by consumers (in $)
1 8 10
2 6 8
3 4 6
4 2 4  Types
of demand

 Direct demand
Demand for the finished products that directly satisfy the human wants is called direct demand.

 Indirect or derived demand

Demand for factors of production / resources such as land, labour, capital etc. is called derived demand
as they are demanded for the production of finished goods or services.

 Alternative demand
Demand for substitutes is called alternative demand.

 Joint demand
Demand for two or more goods to satisfy a single want is called joint demand. For example, demand for
pen, ink and paper to write something.

 Composite demand
Demand for a single good to satisfy multiple wants is called composite demand. For example, demand
for electricity for cooking, heating, lighting, cleaning etc.

 Supply
Supply is the quantity of a good/ commodity that the sellers are able and willing to offer for sale at
various prices over a period of time, ceteris paribus.

Example: When the price of good x is $10 per unit, the sellers are able and willing to sell 50 units per
week. So, supply of good x is 50 units per week.

Table: Supply schedule

Price of good X Quantity supplied
($ per unit) (Units per week)
2 6
12 | P a g e

4 7
6 8
8 9
10 10

Fig: Supply curve

 Individual and market supply

Individual supply is the quantity of a good that an individual seller of the good is able and willing to sell
at various prices over a period of time, ceteris paribus.

Example: If at the price of $10 per unit, the market supply of good x is 100 units/ week and the quantity
supplied by seller A is 20% of the total market supply then, quantity of good x supplied by seller A is 20
units/ week.

 Market supply
Market supply is the sum of the quantities of a good supplied by all the individual sellers of the good at
various prices over a period of time. It is derived by horizontally adding up or aggregating the individual
supply.
Table: Individual and market supply schedule
Price of good x Quantity Supplied (units per week)
($ per unit) Seller A Seller B Seller C Market Supply
2 1 2 3 6
4 2 3 4 9
6 3 4 5 12
8 4 5 6 15
10 5 6 7 18
12 6 7 8 21
Fig: Individual supply curve
13 | P a g e

Fig: Derivation of market supply curve

 Factors affecting / determinants of supply

 Price of the given good

 Prices of resources (factors of production)

 Prices of related goods
 Technology
 Government policy (taxes and subsidies)
 Expectation of price change
 Number of sellers

 Price of the given good [Sx = f(Px)]

14 | P a g e

All other things being unchanged, an increase in the price of the given good raises the quantity supplied
of the good and vice versa.
Fig: the supply curve

 Non- price determinants of supply

 Prices of resources (factors of production)
An increase in the prices of resources (FoP) increases the costs of production and reduces the supply of
the goods and vice versa.

 Prices of related goods

In case the goods are in joint supply, an increase in the price of one good raises the supply of another
good and vice versa. For example, an increase in price of goose meat increases the supply of feathers
and vice versa.

 Technology
An improvement in the state of technology increases the supply of the good as the improved technology
enables the firms to produce higher quantity of the goods at lower costs.

 Government policy
An imposition of indirect taxes on the production of goods increases the costs of production and
reduces the supply of the goods and vice versa.

On the other hand, if the government provides subsidies to the producers, the costs of producing the
goods decreases and hence supply increases.

 Expectation of price change

If the sellers expect the prices of the goods to rise in the near future supply will decrease as the sellers
will hold the goods in stock to sell them at higher prices in the future. On the other hand, if the sellers
expect the prices to fall in the near future, supply will increase as the sellers will rush to sell the goods at
the current prices.

 Number of sellers [Sx=f(Ns)]

If the number or sellers of the good increases, supply of the goods will increase and vice versa.
15 | P a g e

 Change in quantity supplied and change in supply: Movement along and

shift in supply curve

‘Change in quantity supplied’ is caused by the change in the price of the good itself, all other
factors/determinants remaining unchanged. An increase in the price of a good raises its quantity
supplied and causes a rightward movement along the supply curve. This is technically referred to as
‘expansion of supply’. While a fall in the price of the good reduces its quantity supplied and causes a
leftward movement along the supply curve. This is technically referred to as ‘contraction of supply’.
Fig: Change in quantity supplied

‘Change in supply’ is caused by the change in the non-price determinants of supply, price of the good
being unchanged. For example, price of the good being unchanged, if the number of sellers of the good
increases, its supply will increase. Change in supply causes a shift in supply curve. An increase in supply
causes a rightward shift while a decrease in supply causes a leftward shift in the supply curve.
Fig: Change in supply
16 | P a g e

 The law of supply

The law of supply states that, all other factors being unchanged there exists a direct relationship
between the price of a good and its quantity supplied. That is, when the price of a good rises, its
quantity supplied increases and vice versa.
Fig: the supply curve

In the above figure,

When price is ‘OP’, quantity supplied is ‘OQ’. So,
Total Revenue (TR) = Price x quantity sold
= OP x OQ
= OPa Q

 Reasons for a direct relationship between the price of a good

and its quantity supplied
17 | P a g e

 The cost effect

In the short run, keeping one factor input fixed if other factor inputs are increased continuously, the law
of diminishing returns occur after a level of output. That is, output increases by a smaller proportion
than the increase in variable input. Due to this reason, the cost of producing the additional units of
output goes on increasing. Hence, the producers/sellers will not supply the additional units of the good
at the same price. They will supply the additional units of the good only if the price rises.
Table: Law of diminishing returns

 Incentive of higher profit

If the production cost is given, a higher price means greater profits and thus an incentive to
increase the quantity supplied. Hence, price and quantity supplied are directly related.

 Putting demand and supply altogether: Market in equilibrium and

disequilibrium

Equilibrium is a situation of balance where at least under present circumstances there is no tendency for
change to occur. The market for a product reaches a state of equilibrium when the market demand for
the product becomes equal to the market supply and the demand curve intersects the supply curve. The
price established at the state of market equilibrium is called the equilibrium price (market clearing price)
and the quantity traded (demanded and supplied) at the equilibrium price is called the equilibrium
quantity.

Table: Equilibrium in a free market

Price of PCs($) Quantity demanded of PCs per Quantity supplied of PCs per
day day
2000 1000 7000
1800 2000 6000
1600 3000 5000
1400 4000 4000
1200 5000 3000
1000 6000 2000
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800 7000 1000

Fig: Equilibrium in a free market

Exercise
What is equilibrium price? Explain how the equilibrium price of a good is established in a free market.
[8/12]

 Change in market equilibrium

The market equilibrium changes if there is any change in the market forces of demand and
supply of a good. For example, supply of the good being unchanged if the demand for the good
increases, then the excess demand will cause the equilibrium price and quantity to rise.
19 | P a g e

Fig: Effect of increase in demand on market equilibrium

Fig: Effect of decrease in demand on market equilibrium

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Fig: Effect of change (increase or decrease) in demand on market equilibrium

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Fig: Effect of increase in supply on market equilibrium

Fig: Effect of decrease in supply on market equilibrium

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Fig: Effect of change in supply on market equilibrium

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Fig: Effect of change in demand and supply on market equilibrium

24 | P a g e

Note: If the market demand and market supply of the good falls by the same proportion, the
equilibrium price will remain unchanged while the equilibrium quantity decreases.

Fig: Effect of change in demand and supply on market equilibrium

25 | P a g e

Note: If the supply of the good decreases by an equal proportion as an increase in demand then the
equilibrium quantity will remain unchanged while the equilibrium price increases.

Fig: Effect of change in demand and supply on market equilibrium

26 | P a g e

Note: If the demand for a good increases by a higher proportion than an increase in supply then the
excess demand will cause the equilibrium price as well as the equilibrium quantity to rise.

Exercise
Using appropriate diagram, explain how the market for a good reaches a new equilibrium following a
change in its supply.

 Typical demand function/ Linear demand curve equation

A typical demand function is given by:
Qd = a – bP

Where,
Qd =Quantity demanded
a = autonomous demand or the quantity demanded if the price were zero (demand
independent of price)
27 | P a g e

b = change in quantity demanded resulting from a change in price or the inverse of slope of the
demand curve (. The value of b is always negative because of an inverse relationship
between the price of a good and its quantity demanded.
P= price of the good.

Exercise 1: Using the demand schedule given below, answer the following questions:
Price of good X Quantity demanded of
good X/
per week
2000 1000
1800 2000
1600 3000
1400 4000
1200 5000
1000 6000
800 7000

1. How many units of good X per week are people willing and able to buy if the price is
$1100?
2. What price will persuade people to buy 1350 units of good X per week?

Soln-1:
Finding ‘a’ variable in the demand equation

Taking the price range $1800 to $1600

b= = = 5

Qd= a – bp

2000= a – 5(1800)

a=11000

So, at price of $1100, the quantity of good x that the people are able and willing to buy per
week is,
Qd = 11000 – 5 (1100)
Qd= 5500
28 | P a g e

 Typical supply function/ linear supply curve equation

A typical supply function is given by

Qs= C + dP

Where,
QS= Quantity supplied
C = autonomous supply or quantity supplied when price is zero
d= change in quantity supplied caused by the change in the price of the good or inverse of the
slope of supply curve (. The value of d is always positive because of a direct relationship
between the price of a good and its quantity supplied.
P = price of the good

Exercise: Using the supply schedule given below, answer the following questions:
Price of good X Quantity of good X supplied
per week
800 1000 1. How many units of good X per week are
1000 2000 companies planning to supply if the price is
1200 3000
$1100?
1400 4000
2. What price would persuade companies to
1600 5000
1800 6000 supply 1350 good X?
2000 7000
Soln 1:
d= = 5

Qs= C + dp
2000 = C +5(1000)
2000-5000=c
C = -3000

So, qty. of of good X that the companies are planning to supply at $1100 is,
Qs= -3000 + 5(1100)
29 | P a g e

=2500

Soln. 2:
1350 = -3000 + 5(P)
P = 870

 Equation of market equilibrium

Qd = Qs
11000 -5P = -3000 +5P
P = 1400

Qd= 11000 – 5(1400)

= 4000
Qs = - 3 + 5(1400)
= 4000

 Elasticity of demand

It is the responsiveness of consumers/demand to the change in the factors affecting demand

like price of the good, income of consumers, change in prices of related goods etc. It measures
to what extent the demand for the goods changes when there is any change in these factors.

Types of elasticity of demand

 Price elasticity of demand(PED)
 Income elasticity of demand(YED)
 Cross elasticity of demand(XED)
30 | P a g e

 Price elasticity of demand (PED)

It is the measure of change in the quantity demanded of a good in response to any percentage
change in the price of the given good.

Mathematically,

PED =

= ÷

= x

= x

Example: 1
Px Qdx
10(P1) 50(Q1)
20(P2) 40(Q2)

Soln:

PED =

= - 0.2 = 0.2˂ 1

Or, PED = x

= x

= - 0.2 = 0.2 ˂ 1
31 | P a g e

Note: The value of PED is always negative because of an inverse relationship between the price of a
good and its quantity demanded but by rule we ignore the negative sign.

Example: 2

Px Qdx
20(P1) 50(Q1)
25(P2) 20(Q2)

PED=

= - 2.4 = 2.4 ˃1

Interpretation: Since the value of PED is greater than 1, demand for good x is elastic. This means that
quantity demanded changes by a greater percentage than the percentage change in
the price of the good. In the given information, quantity demanded has fallen by 60% in
response to 25% rise in the price of the good.

 Types of price elasticity of demand

 Perfectly elastic demand (PED=/ Infinite elasticity

Demand for a good is said to be perfectly elastic if a small proportionate change in its price causes the
quantity demanded to change infinitely or immeasurably. That is, a small proportionate fall in price
causes the quantity demanded to increase infinitely while a small proportionate rise in price causes the
quantity demanded to fall to zero.
Example:
Px Qdx
10 0
9

Here,
PED=

Fig: Perfectly elastic demand

32 | P a g e

Note:
If the demand for a good is perfectly elastic, any percentage change in the quantity demanded causes
the total revenue or total expenditure to change by equal proportion.

 Perfectly inelastic demand / fixed demand/ zero elasticity (PED=0)

Demand for a good is said to be perfectly inelastic or fixed if any proportionate change in the price
doesn’t have any effect on the quantity demanded. That is, quantity demanded of the good remains
fixed or unchanged even if its price changes by a very high proportion.
Example:
Px Qdx
10 50
5 50

Here, PED=

=0
Fig: Perfectly inelastic demand

Note:
33 | P a g e

If the demand for a good is perfectly inelastic, any percentage change in price causes the total
revenue or total expenditure to change by equal proportion.

 Unitary elastic demand (PED=1)

Demand for a good is said to be unitary elastic if any proportionate change in its prices causes the
quantity demanded to change by equal proportion. For example, a 10% increase in the price of the good
causes the quantity demanded to fall by 10% and vice versa.
Example:
Px Qdx
10 100
15 50

Here, PED =
=1
Fig: Unitary elastic demand (PED =1)

 Relatively elastic or elastic demand (PED ˃1)

Demand for a good is said to be relatively elastic or elastic if any proportionate change in its price causes
the quantity demanded to change by a relatively greater proportion. For example, demand for a good is
elastic if a 10% rise in its price causes the quantity demanded to fall by more than 10%.

Example:
Px Qdx
10 100
12 50

Here, PED =

=2.5 ˃1

Fig: Relatively elastic demand (PED˃1)

34 | P a g e

 Relatively inelastic or inelastic demand (PED ˂1)

Demand for a good is said to be relatively inelastic or inelastic if any proportionate change in its price
causes the quantity demanded to change by a relatively smaller proportion. For example, demand for a
good is inelastic if a 10% rise in its price causes the quantity demanded to fall by less than 10%.

Example:
Px Qdx
10 100
20 50

Here, PED =

=0.5˂1
Fig: Relatively inelastic demand (PED˂1)

Exercise: Calculate and interpret the value of PED from the given information
35 | P a g e

Px Qdx
10 100
8 150

PED=

=2.5˃1

Interpretation:
Since the coefficient of PED is greater than 1, demand for good x is elastic. In the given information
quantity demanded increases by 50% in response to 20% fall in price.

Exercise 2: Calculate and interpret the value of PED from the given information
Px Qdx
10 100
20 80

PED =???

Fig: Types of PED and the demand curves

Worked example:
36 | P a g e

Using the following diagram, D1 represents the demand for cigarettes, D2 represents the demand for
movie tickets and D3 represents the demand for ice-cream. Find out which good has the most elastic
and which good has the most inelastic demand.

Soln:
PED for cigarettes=0.21
PED for movie tickets= 1.14
PED for ice cream=3
Demand for cigarettes is most inelastic (least elastic) while demand for ice cream is most elastic.

 Factors affecting price elasticity of demand

 Number of substitutes of a good

Demand for a good with large number of substitutes is elastic while the demand for a good with few or
no substitutes is inelastic.

 Nature of the good

Demand for the goods of basic necessity such as staple food, fuel, salt etc. and habit forming goods such
as cigarettes, tobacco, alcohol etc. is inelastic while the demand for luxuries and comforts is elastic.

 Proportion of consumer’s income spent on the good

Demand for a good will be elastic if the consumers have to spend a large proportion of their income on
the good while demand will be inelastic if the consumers have to spend only a small proportion of their
income on the good.

 Postponement of consumption
37 | P a g e

Demand for a good will be inelastic if the consumption of the good cannot be postponed. For example,
demand for food, medicine etc. is inelastic as their consumption cannot be postponed. While demand
will be elastic if the consumption of the good can be postponed.

 Number of uses of a good

Demand for a good with large number of uses is elastic while demand for a good with a single use is
inelastic.

 Time
Demand for a good is inelastic in the short run as the consumers cannot immediately respond to the
change in the price of the good. While demand is elastic in the long run as the consumers can change
their taste and consumption pattern in the long run.

Exercise
Explain what factors influence the price elasticity of demand for a good.

 Measuring PED using total outlay (Total Expenditure) method

Total outlay or total expenditure is the total amount of money spent by the consumers on the good at
different prices.

Mathematically,
Total outlay or total expenditure = price x quantity demanded

This method measures the PED by comparing the price of the good with the total expenditure made by
the consumers on the good. This method measures the following three types of PED:

 PED equal to unity / Unitary elastic demand (PED=1)

According to the total outlay method, PED is equal to unity if any change in the price of the good
doesn’t have any effect on the total expenditure. That is, total expenditure doesn’t change with the
change in the price of the good.
Example:
Price of Quantity Total expenditure
good x demanded (P x Q)
3 4 12
4 3 12

Here, PED= x
38 | P a g e

=x

= 0.75 = 1
Fig: PED equal to unity

Note: If the value of total expenditure is the same at all the prices of the good, then the demand curve is
said to be a rectangular hyperbola. This means that the areas of the rectangles below the demand curve
will be the same.
Fig: Rectangular hyperbola demand curve

In the above diagram,

When P= $4, Qd= 3 units
So, TR= $4 x 3
=$12(OP1aQ1)

When price falls to $3 per unit, quantity demanded increases to 4 units.

So, TR =$3 x 4
39 | P a g e

= $12(OPbQ)

 PED greater than unity / elastic demand (PED˃1)

PED is greater than unity if a fall in the price of the good raises the total expenditure and vice versa.
Example:

Price of good x Quantity Total expenditure

demanded (P x Q)
10 5 50
8 10 80

Here, PED = x = x = 5 ˃1

Fig: PED greater than unity/ elastic demand

 PED less than unity / inelastic demand (PED˂1)

PED is less than unity if a fall in the price of the good reduces the total expenditure and vice versa.

Example:

Price of good x Quantity Total expenditure

demanded (P x Q)
10 5 50
40 | P a g e

5 7 35

Here, PED = x = x = 0.8 ˂ 1

Fig: PED less than unity/ inelastic demand

 Linear demand curve and the coefficient of PED

Price of Quantity TR=TE
good x demanded
1 10
2 9
3 8
4 7
5 6
6 5
7 4
8 3
9 2
10 1
41 | P a g e

 Business relevance of PED: usefulness of PED in business decision making

 An understanding of the concept of PED helps us to understand the likely price volatility (how
the price changes) following any change in the supply of the goods. This is important for the
producers of the good who may suffer big price movements from time to time. For example,
demand for a good being unchanged, if its supply decreases its price will rise; but the extent to
which the price rises depends on the price elasticity of demand for the good.

Fig: Price volatility following a fall in supply

42 | P a g e

 An understanding of the concept of PED helps the businesses to understand how their total
revenue (TR) changes if there is any change in the price of the given good.

Fig: Effect of change in price on firm’s total revenue

In the above diagram, at initial market equilibrium,

Price= $10/unit and quantity demanded=10 units. So,
TR=TE= $10 x 10 =$100
Now, when price rises to $11 /unit,
In case of elastic demand,
TR=TE= $11 x 8= $88
In case of inelastic demand,
TR=TE=$11x 9.5 =$104.5

This shows that if the demand for a good is inelastic the businesses can increase their total revenue (TR)
by raising the price of their product while if demand is elastic, raising the price of their products will
reduce their TR.
Hence the businesses want to make the demand for their goods inelastic. They can do so by:
43 | P a g e

Creating a strong brand image of their products

The businesses can make the consumers loyal to the brand by creating a strong brand image of their
products. They can invest on advertisement and promotion of their products to create a strong brand
image of their products. The loyal consumers will not switch to the rival products even when the price of
the product rises. Hence, the businesses can increase their revenue by raising the price of their
products.

Eliminating competitors
The firms can make the demand for their products by eliminating competitors from the market. The
firms can eliminate competitors through innovation, consumer loyalty, acquisition, etc.

 Information on the PED can be used by a business as part of a policy of price discrimination. This
is where a business decides to charge different prices for the same product to different
segments of the market e.g. peak and off peak rail travel or prices charged by many of our
domestic and international airlines.

 An understanding of the concept of PED helps us to understand the effect of imposition of

indirect taxes on the government’s tax revenue. For example, imposition of indirect taxes
generates tax revenue for the government but the amount of tax revenue received by the
government depends on the price elasticity of demand.

Fig: Effect of imposition of indirect taxes on government’s tax revenue

As seen in the diagram,

44 | P a g e

Tax revenue received by imposing indirect taxes on the good that has inelastic demand (Di) = 15 x 90
=1350 (P4abP2)
Tax revenue received by imposing indirect taxes on the good that has elastic demand (De) =15x80=1200
(P3cdP1)

Thus, a government receives higher tax revenue by imposing indirect taxes on the good that has
inelastic demand than the good that has elastic demand.

 Income elasticity of demand (YED)

It is the measure of change in demand for a good caused by any change in the income of consumers. In
other words, it is the measure of responsiveness of demand for a good to any change in the income of
consumers.

Mathematically,

YED =

= ÷

= x

= x

Example:
Income Demand for Demand for
(in ‘000) good x good Z
$20 50 50
$25 60 80

YED = x
45 | P a g e

= x

= 0.8 ˃ 0

Interpretation: Since the value of YED is greater than 0, good x has positive YED. That is, an increase in
consumer’s income causes the demand for the good x to rise and vice versa. So, good x is a superior
normal good.

 Types of YED

 Positive YED (YED˃0)

 Negative YED (YED˂0)
 Zero YED (YED=0)

 Positive YED
YED is positive if an increase in consumer’s income raises the demand for the good and vice versa.
YED is positive in case of superior or normal goods.

Example:
Income Demand for
(in ‘000) good x
$20 50
$10 30

YED= x

= x

=0.8 ˃ 0

Fig: Positive YED

46 | P a g e

 Negative YED
YED is negative if an increase in consumer’s income reduces the demand for the good and vice versa.
YED is negative in case of inferior goods.

Example:
Income Demand for
(in ‘000) good x
$20 50
$10 70

YED= x

= x

= - 1.25 ˂ 0
Fig: Negative YED
47 | P a g e

 Zero YED
YED is zero if any change in consumer’s income does not affect the demand for the good. YED may be
zero in case of the goods of basic necessity such as rice, salt etc.
Example:
Income Demand for
(in ‘000) good x
$20 50
$10 50

YED=0
Fig: Zero YED

Note: Higher the value of YED, higher will be the responsiveness of demand to the change in
consumer’s income.

Worked example:
Income (in thousand) Demand for good x Demand for good y
20 50 50
30 40 20

YED for good x = x = - 0.4

YED for good y= x = - 1.2

48 | P a g e

Interpretation: Since the coefficient of YED for good y is greater than the coefficient of YED for good x
(regardless of positive or negative signs) good Y is more responsive to the change in consumers’ income
than good Y.

Exercise: Calculate and interpret the value of YED from the following information.
Income($) Demand for good X
$200 70
$150 90

 Business relevance of YED: Usefulness of YED in making business decision

The concept of YED is of significant use in making business decisions. YED may be positive or negative
depending on the types of goods. YED is positive in case of superior or normal goods. This means that
the demand for superior or normal goods increases when there is an increase in consumer’s income and
vice versa. So, the firms should increase the production of normal goods during the period of normal
economic growth. This is because during the period of normal economic growth employment and
income increases causing the demand for superior/normal goods to increase. On the other hand, the
firms should reduce the production of normal goods during the period of recession. This is because
during recession employment and income decreases causing the demand for normal goods to fall.

YED is negative in case of inferior goods. This means that the demand for inferior goods falls during the
period of normal economic growth while their demand increases during the period of recession. So, the
firms should reduce the production of inferior goods during the period of economic growth and increase
their production during the period of recession.

 Cross elasticity of demand (XED)

XED is the measure of change in demand for a good caused by any change in the price of its related
goods (substitutes or complements). In other words, it is the measure of responsiveness of demand for a
good to the change in the prices of its related goods.
Mathematically,

XEDXY =

= ÷
49 | P a g e

= x
= x

Example:
Price of good y Demand for good x
$20 50
$10 70

XEDXY = x

= x

= - 0.8˂ 0

Interpretation: Since the XEDxy is negative, good x and y are complements.

 Types of XED:
 Positive XED (XED ˃ 0)
 Negative XED (XED ˂ 0)
 Zero XED (XED = 0)

Positive XED (XED ˃ 0)

XED between two goods is positive if an increase in the price of one good raises the demand for another
good and vice versa. XED is positive in case of substitutes like Pepsi and coke, tea and coffee, bus
travel and rail travel etc.

Example:
Price of good y Demand for good x
$20 50
$10 30

XEDxy = x

= x

= 0.8 ˃ 0
Fig: Positive XED
50 | P a g e

 Negative XED (XED˂0)

XED between two good is negative if an increase in the price of one good reduces the demand for
another good and vice versa. XED is negative in case of complements like car and petrol, steel and motor
bike etc.

Example:
Price of good y Demand for good x
$20 50
$10 60

XEDxy = - 0.4 ˂ 0

Fig: Negative XED

 Zero XED (XED=0)

XED between the two goods is zero if the change in price of one good doesn’t affect the demand for
another good. XED is zero in case of unrelated goods like Pepsi and pen.

Example:
51 | P a g e

Price of good y Demand for good x

$20 50
$10 50

XED XY = 0

Fig: Zero XED

Note: Higher value of XED shows higher degree of relationship between the goods. That is, higher the
value of XED, more closely the goods is related to each other.

Example:
Price of good X Demand for good Y Demand for good Z
$10 50 50
$15 60 100

XEDYX = 0.4

XEDZX = 2.0

Interpretation: Since XEDZX ˃ XEDYX, goods X and Z are more closely related than goods X and Y.
52 | P a g e

 Business relevance of XED: Usefulness of XED in business decision making

The concept of XED is of significant use in making business decisions. XED may be positive or negative
depending on the types of relationship between the goods. XED is positive in case of substitutes like
Pepsi and coke. That is, a fall in price of Pepsi reduces the demand for coke and vice versa.
In such a situation, the firms are highly concerned with the pricing strategy of the rival firms. If a rival
firm cuts the price of its product, a firm must respond by cutting the price of its own product. If a firm
fails to respond to the cut in price by the rival firm, its total revenue and profit will fall as the consumers
will switch to the rival product which has now become relatively cheaper. For example, if Pepsi cuts its
price, coke must respond by cutting its price to prevent the fall in its revenue and profit.
In case of complements,the firms are concerned with selling a wide range of complements rather than
selling just a single product. An understanding of the concept of XED helps the firms to identify the
relationship between the goods and formulate such a pricing strategy that increases the firm’s total
revenue and profit. For example, if the firms offer discount prices on movie tickets then, the sale of
movie tickets will increase and at the same time the revenue received from parking charges and the sale
of snacks will increase. This will increase the firm’s total revenue and profit.

Exercise:
Calculate and interpret the value of XED between the goods from the given information.
Price of good X Demand for good y
20 50
25 30

XEDYX = x

=-1. 6 ˂ 0

Interpretation: Since the value of XEDYX is negative, good x and y are complements. That is, demand for
good Y has decreased in response to an increase in price of good x.

 Price elasticity of supply (PES)

It is the measure of responsiveness of quantity supplied of a good to any % change in the price
of the good.

Mathematically,

PES =
53 | P a g e

= ÷

= x

= x
Example: 1

Px QSx
10(P1) 50(Q1)
20(P2) 60(Q2)

Soln:

PES =

=
= 0.2˂1

Or, PES = x

=x

= 0.2 ˂ 1

Note: The value of PES is always positive because of a direct relationship between the price of a good
and its quantity supplied.

Example: 2
Px Qsx
20(P1) 50(Q1)
25(P2) 80(Q2)

PES= x

= x

=2.4 ˃1
54 | P a g e

Interpretation:
Since the value of PES is greater than 1, supply of good X is elastic. That is, any % change in price causes
the quantity supplied to change by a relatively higher %. In the given information quantity supplied of
good X increases by 60% in response to 25% increase in price. So, supply of good X is elastic (or 1%
increase in price causes the quantity supplied to increase by 2.4%).

 Types of price elasticity of supply

 Perfectly elastic supply (PES=

Supply of a good is said to be perfectly elastic if a small percentage change in its price causes the
quantity supplied to change infinitely or immeasurably. That is, a small proportionate rise in price causes
the quantity supplied to increase infinitely while a small proportionate fall in price causes the quantity
supplied to fall to zero.

Example:
Px QSx
10 0
11

Here,
PES =

Fig: Perfectly elastic supply

When P=11 and Qs=10

TR1=110
Now, Qs = 20
55 | P a g e

TR2 =220

Note: If the supply of a good is perfectly elastic any % change in quantity supplied will cause the firm’s
total revenue to change by equal %.

 Perfectly inelastic supply / fixed supply / zero elasticity (PES=0)

Supply of a good is said to be perfectly inelastic or fixed if any proportionate change in the price doesn’t
have any effect on the quantity supplied. That is, quantity supplied of the good remains fixed or
unchanged even if its price changes by a very high proportion.

Example:
Px QSx
10 50
5 50

Here, PES = 0

Fig: Perfectly inelastic supply

When P =10, let Qs= 50

TR1 = P x Q = 500
When ‘p’ increases to 15,
TR2=15 x 50 =750

Note: If supply of a good is perfectly inelastic, any % change in the price of the good will cause the firm’s
TR revenue to change by equal %.

 Unitary elastic supply (PES=1)

Supply of a good is said to be unitary elastic if any proportionate change in its prices causes the quantity
supplied to change by equal proportion. For example, a 10% increase in the price of the good causes the
quantity supplied to rise by 10% and vice versa.
56 | P a g e

Example:
Px Qsx
10 100
15 150

Here, PES =

=1
Fig: Unitary elastic supply (PES =1)

 Relatively elastic or elastic supply (PES ˃1)

Supply of a good is said to be relatively elastic or elastic if any proportionate change in its price causes
the quantity supplied to change by a relatively greater proportion. For example, supply of a good is
elastic if a 10% rise in its price causes the quantity supplied to rise by more than 10%.

Example:
Px QSx
10 100
12 150

Here, PES =

=2.5 ˃ 1
Fig: Relatively elastic supply (PES˃1)
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 Relatively inelastic or inelastic supply (PES ˂1)

Supply of a good is said to be relatively inelastic or inelastic if any proportionate change in its price
causes the quantity supplied to change by a relatively smaller proportion. For example, supply of a good
is inelastic if a 10% rise in its price causes the quantity supplied to rise by less than 10%.

Example:
Px QSx
10 100
20 120

Here, PES =

=0.2 ˂ 1

Fig: Relatively inelastic supply (PES˂1)

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Exercise 1: Calculate and interpret the value of PES from the given information and draw a supply curve
to illustrate the type of PES.

Px QSx
10 100
15 120

PES= = 0.4

Interpretation: Since the coefficient of PES is less than 1, supply of good x is inelastic. This means that
quantity supplied changes by a relatively smaller % in response to any % change in price. In the given
information, quantity supplied increases by only 20% in response to 50% increase in price.

Exercise 2: Calculate and interpret the value of PES from the given information and draw a supply curve
to illustrate the type of PES.

Px QSx
10 100
6 80

 Difference between elastic, inelastic and fixed supply

 Factors affecting price elasticity of supply

 Firm’s ability to store the goods

Supply of the goods is elastic if the firms can store the goods for a long time and vice versa.
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For example the supply of manufactured goods is elastic as they are durable in nature and hence can be
stored for a long time. When their prices fall, the firms hold them in stock and wait for the prices to rise.
On the other hand, supply of the goods that are perishable in nature is inelastic as they can’t be stored
for a long time. For example, supply of agricultural products, dairy products, meat, fish etc. is inelastic as
they are perishable in nature and cannot be stored for a long time.

 Firm’s ability to increase production/ availability of spare capacity

Supply of the goods is elastic if the firms can easily increase the production of goods in response to an
increase in prices. Firm’s ability to increase production depends on the spare/excess capacity available
with the firms. If the firms have spare/excess capacity, they can easily increase production in response
to increased prices of the goods. On the other hand supply is inelastic if the firm’s don’t have spare
capacity and hence cannot increase production in response to the increased prices.

 Factor mobility
Supply is elastic if the factors of production (labor and capital) are mobile and move freely between
uses. In such a case, if the price of good x increases, the firms can switch the resources from the
production of good y to the production of good x and increase its production in response to the
increased price. On the other hand, supply is inelastic if the factors of production are immobile.

 Time
Supply is elastic if the price of a good rises and remains high for a long time. This is because given a long
time; the firms can manage to increase their productive capacity and increase the production of goods
in response to their increased prices. On the other hand, supply is inelastic if the price of a good rises
and falls back to the original within a short period of time.

 Business relevance of PES: Usefulness of PES in making business decisions

An understanding of the concept of PES helps the businesses/firms to understand the price volatility
following the change in the demand for the good and how the firms can respond to the change in the
price. For example, supply of the good being unchanged an increase in demand for the good causes its
price to rise. The extent to which the firms can respond to this increased price depends on the price
elasticity of supply.

Fig: Price volatility following an increase in demand for the good

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This shows that if supply is elastic, the sellers can easily or quickly increase the supply of the goods in
response to the increase in price caused by an increase in demand.
So, the firms try to make the supply more elastic. To make the supply of the goods elastic, the firms have
to consider the following:

 Invest in spare capacity which can be used if demand rises.

 Paying workers overtime to increase production
 Using agencies to hire more workers at busy times.
 To outsource production to other firms who can meet supply
 Improve efficiency and time management techniques to increase supply.
 Consumer and producer surplus
Consumer surplus is the benefit consumers receive when they pay a price below what they are willing to
pay. In other words, it is the difference between the maximum amount the consumers are willing to pay
and the actual amount they pay for the given quantity of a good (market price).

Consumer surplus = Maximum willingness to pay – actual amount paid / market price

Example:
A consumer is willing to pay $50 for a unit of good x but the market price of the good is $40 per unit. So,
Consumer Surplus= $50 -$40 = $10
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In the above diagram,

Consumer’s willingness to pay for OQ quantity of good x= OMEQ
Actual amount paid = OPEQ
So, CS = OMEQ – OPEQ
= PME

Numerically,
CS = area of triangle PME
=0.5 X (15 x 20)
=150

Any change in the price of the good causes the consumer surplus to change. An increase in
price reduces the consumer surplus while a fall in price increases the consumer surplus.

In the above diagram, as the price rises from $15 to $ 20, consumer surplus falls to P1ME1 (75)
while if the price falls to $10, consumer surplus increases to 250.

 Producer surplus
It is the benefit that arises to the producers in the competitive markets. Producer surplus is the
benefit producers receive when they receive a price above the one at which they were willing
to supply the good. In other words, it is the difference between the actual market price and
the minimum price at which the producers are willing to sell the product.
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Mathematically,

Producer surplus = Actual market price – minimum acceptable price

Example:

A producer is willing to sell a unit of good x at $100 but the market price of the good is $120.
So,

Producer surplus= $120- $100= $20

Fig: Producer Surplus

Community Surplus

Consumer surplus + producer surplus = community surplus

In this example, community surplus is $300 million. It is shown in the following diagram:
Fig: community surplus
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Exercise:
Using demand and supply diagram, explain how producer and consumer surplus arises.

 Function / role of price in a market economy

In a market economy price acts as an allocative, rationing and signaling mechanism.

As an allocative mechanism, the function of price is to guide the allocation of resources

between alternative uses. In a market economy, the private enterprises are guided by profit
motive. They allocate the scarce resources to produce those goods that yield the maximum
profit. The amount of profit generated form the production of any product depends on the
market price of the product. All other things being unchanged, higher the price of the product,
higher will be the profit and vice versa.

As a rationing mechanism the function of price is to restrict/ reduce quantity demanded of

some goods by some consumers. Price may act as a rationing mechanism with or without the
government intervention in the market. For example, if the firms have limited production
capacity, they may restrict the quantity demanded of their products by keeping their prices
high. At higher prices the quantity demanded of the goods by some consumers is reduced and
thus rationing occurs. This is the reason why the producers of luxurious cars, designer clothes,
exclusive furniture etc. keep the prices of their products high.
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The governments may also use the price to ration the quantity demanded of some goods by the
consumers. For example, government imposes indirect taxes on demerit goods like cigarettes,
tobacco, alcohol etc. to restrict the quantity demanded of these products. Imposition of
indirect taxes raises the price of these products and their quantity consumed is reduced. Thus
rationing occurs.

Government may also use minimum pricing (price floor) to reduce the quantity demanded of
some goods. The effective minimum price is set above the equilibrium price. This setting of
minimum price reduces the quantity demanded, although the quantity supplied of the good
increases.
Fig: Effect of minimum price

As a signaling mechanism, the function of price is to provide signals / information to consumers and
producers to adjust consumption and production with the change in market conditions. For example,
supply of a good being unchanged if its demand increases, the excess demand will put pressure on the
price to rise. This rise in price provides signals to consumers to reduce consumption and to the
producers to increase production.

Fig: role of price as a signaling mechanism

Fig: Role of price as a signaling mechanism in the resource market

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Exercise:
Explain the functions of price in a market economic system.
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AS Level
Chapter 3: Government microeconomic intervention

 Market failure

Market failure occurs when the price mechanism or market mechanism fails to allocate the scarce
resources efficiently. A free market is said to have failed if the functioning of the price system fails to
deliver what is expected by the society. In other words, a free market fails if the goods involved are
produced and consumed in the quantities lower or higher than the socially desirable quantity or the
optimum quantity.

Some of the sources/reasons of market failure are:

 Presence of externalities in an economy

 Problem of information failure associated with merit and demerit goods
 Public goods and the problem of free rider issue
 Abuse of monopoly power

Government intervention in the functioning of the price system/ free market occurs with the objective
of achieving efficiency in the allocation of resources (correcting market failure) and reducing
inequalities in the distribution of income and wealth. A government uses the following methods of
intervention to achieve these objectives:
 Regulation (use of legal methods)
 Financial intervention (use of indirect taxes and subsidies)
 Government or state provision
 Maximum and minimum price control
 Provision of information

 Transfer payments/monetary benefits

 Direct provision of goods and services
 Minimum wage
 The tax system
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 Methods of intervention used to achieve efficiency in the allocation of resources

 Regulation
It is the use of legal methods to control the quantity and quality of goods/ services produced and
consumed in the free market. It forces the producers and consumers to behave in certain ways so that
efficiency is achieved in the allocation of resources.

Some examples of regulation used to control the quantity and quality of goods produced and consumed
in the economy are:
 Ban on smoking in public places
 Setting of minimum legal age at which a person can buy certain things like cigarettes, tobacco,
alcohol, etc.
 Making certain drugs available only at the prescription of a qualified doctor.
 Hygiene laws that guarantee the quality of goods produced and consumed.
 Setting standards that restrict the amount of pollution that can be legally dumped.
 Making government-funded education compulsory up to certain age.

Government may also use regulation to control the prices of goods /services produced and consumed in
an economy. Some examples of price control used by the government are rent control, minimum wage,
maximum and minimum price control etc.

 Financial intervention (Indirect taxes and subsidies)

 Indirect taxes
A government imposes indirect taxes when the goods involved are overproduced and over consumed in
an economy, may be due to the presence of negative externalities or the problem of information
failure. For example, government imposes indirect taxes on demerit goods to discourage their
production and consumption.
Imposition of indirect taxes raises the costs of production and supply decreases causing the prices of
the goods to rise. This rise in costs and prices reduces the production and consumption of the goods to
the optimum level. Thus the problem of market failure (over production and over consumption) is
corrected and efficiency is achieved in the allocation of resources.
Fig: Use of indirect taxes to correct the problem of overproduction
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In the above diagram,

Tax per unit = vertical distance between two supply curves=
Qty. traded after tax=
Total tax revenue received by government = per unit indirect tax x qty. traded after tax=
Consumers’ tax burden = rise in unit price after tax x quantity traded after tax=
Producers, tax burden=
Producer’s sales revenue after tax=
Deadweight loss= loss of producer and consumer surplus= shaded triangle “ace”=

 Other tax issues

 Tax incidence
Tax incidence refers to how the burden of a tax is distributed between producers and consumers. The
tax incidence depends upon the relative price elasticity of demand.
 The consumer burden of a tax is reflected by the amount by which the market price rises.
 The producer burden is the decline in revenue firms face after paying the tax.

Fig: Perfectly elastic demand and incidence of tax

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Note: If the demand for a product is perfectly elastic, the entire incidence of tax (tax burden) falls on the
producers.

Fig: Perfectly inelastic demand and incidence of tax

Note: If the demand for a product is perfectly inelastic, the entire incidence of tax falls on the
consumers.

Fig: Unitary elastic demand and the incidence of tax

Note: If the demand for a product is unitary elastic, the incidence of tax is distributed equally between
producers and consumers.

Fig: Inelastic demand and the incidence of tax

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Fig: Elastic demand and the incidence of tax

 Direct and indirect taxes

Direct taxes are those whose burden cannot be shifted from one person to another. The impact (initial
burden) and incidence (ultimate burden) of direct taxes fall on the same person. Some examples of
direct taxes are income tax, wealth tax, inheritance tax, gift tax, road tax, capital gain tax etc.

Indirect taxes are those whose burden can be shifted from one person to another. These are the taxes
imposed on the producers which are shifted to the consumers by adding them to the prices of the
products. That is, the impact (initial burden) of indirect taxes is borne by the producers while the
incidence (ultimate burden) is borne by the consumers. Some examples of indirect taxes are VAT, GST,
tariff, excise tax, custom tax etc.

 Types of Indirect taxes

Indirect taxes are of two types- specific and ad valorem.
Specific tax is imposed per unit of any good produced or consumed in an economy. For example, $2 per
unit of good x produced or consumed. Specific tax causes a parallel shift in the supply curve to the left.

Fig: Effect of specific tax

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Ad valorem tax is imposed as a percentage of prices of the goods produced and consumed. For
example, 20% of the price of any good produced or consumed. Ad valorem tax causes a pivotal (non-
parallel) shift of the supply curve towards the left.

Fig: Effect of specific and ad valorem tax

 Types of tax system

Progressive tax system
It is where the tax rate (% of income and wealth paid in tax) increases with an increase in income and
wealth vice versa.
Example:
Individual A’S taxable Income Marginal rate of Calculation Tax paid
($80,000) taxation
Up to $10,000 0% 10, 00 x 0% 0
Income between $10,000 and 30% 15,000 x 30% 4500
$25,000
Income between $25,000 and 40% 25000 x 40% 10,000
$50,000
Income above $50,000 ($30,000) 50% 30,000 x 50% 15000
Total income $80,000

 Proportional tax system

It is where the same tax rate is imposed on all levels of income and wealth.

 Regressive tax system

It is where the tax rate decreases with an increase in income and vice versa. That is, those on lower
incomes pay higher proportion of their income in tax to the government than those on higher incomes.
For example, the indirect taxes imposed on goods / services are regressive in nature

Example:
Individual A’s income=$100
Individual B’s income =$200
Tax paid on purchase of good x = $5
% of income paid in tax by A = 5%
% income paid in tax by B =2.5%
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Fig: Progressive, proportional and regressive tax system

 Canons of taxation

It means the quality of a good tax system. As described by Adam Smith, a good tax system should
possess the following features:

 Canon of equity
Those on higher incomes should pay higher % of their income in tax than those on lower income.

 Canon of economy
The revenue received from taxes should be higher than the costs incurred in collecting taxes.

 Canon of transparency
The tax payers should know how, when and how much they should pay in taxes.

 Canon of convenience
The tax payers should find it easy to pay taxes.

 Subsidies

A government provides subsidies to the producers when the goods involved are under produced and
under consumed in the free market may be due to the presence of positive externality or the problem
of imperfect information. For example, subsidies are provided to the producers of merit goods as they
are under produced and under consumed in the free market due to the presence of positive externality
and the problem of imperfect information.
8|Page

Provision of subsidies to the producers reduces the costs of producing the goods and hence the prices
of the goods fall. Thus the production and consumption of the goods involved is encouraged and the
problem of under production and under consumption is corrected and efficiency is achieved in the
allocation of scarce resources.

Fig (a): Effect of providing subsidies to producers

Fig (b): Effect of providing subsidies on producers and consumers

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In the above diagram,

Subsidy per unit= Vertical distance between old and new supply curves=
Qty. Produced and consumed after subsidy=
Total government spending on subsidy=
Benefit of subsidy enjoyed by the consumers=
Benefit of subsidy enjoyed by producers=
Deadweight loss=

 Government or state Provision

A government may take over the production of some goods or services fully or partially. In many
countries the activities such as electricity generation, coal mining, railways and drinking water are
entirely owned and managed by the government. They are often called the state owned enterprises or
nationalized industries. It is also commonly found that some goods and services are provided both by
the state and private sector. For example in many countries education and health care services are
provided both by the government and the private sector. In case of market failure caused by public
goods, government provision is the only solution as the private producers don’t allocate any resources
for the production of public goods.

 Maximum and minimum price control

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A maximum price (price ceiling) is the mandated maximum amount a seller is allowed to charge for a
product or service.
In case of market failure, maximum pricing (price ceiling) is used by the government to increase/
encourage the consumption of the goods when the free market prices are too high for the consumers to
afford. It is usually set on the goods of basic necessities such as staple food, fuel, housing, transportation
etc. The setting of maximum price raises the purchasing power of consumers and the consumption
increases. The effective maximum price is set below the free market price. As a result, the quantity
consumed/demanded increases while the quantity supplied decreases. Thus, there occurs a shortage of
the good in the market.
Fig: Effect of maximum price

As seen in the diagram, the setting of maximum price causes a shortage of the good in the market. The
shortage of Q3-Q2 created due to the setting of maximum price may put pressure on the price to rise to
P1 and the quantity demanded and supplied will move back to Q1 which is the free market equilibrium
quantity. In order to stabilize the price at ‘max price’ the government should eliminate the shortage
created in the market. The government can eliminate this shortage by selling the good from the buffer
stock or providing subsidies to producers of the good to increase production.

 Minimum price control (price floor)

A minimum price or price floor is the lowest legal price that can be paid in a market for goods and
services
In the context of market failure, minimum price can be used to encourage production or discourage
consumption of the goods involved. Minimum pricing (price floor) is usually used by the government to
protect the real income of the producers and thus encourages production. It is set when the market
price is too low to cover up the costs of production. The setting of minimum price encourages the
producers to increase production as they receive a reasonable price for their products. The effective
minimum price is set above the equilibrium price. This setting of minimum price increases the quantity
supplied of the good while the quantity demanded decreases. Thus, there occurs an excess supply of
the good in the market.
Fig: Effect of minimum price
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In the above diagram, the minimum price set by the government is Pmin. which is above the free market
price Pe. This setting of minimum price results in an excess supply of Q2 - Q1. If not eliminated, this
excess supply will make the minimum price ineffective and put pressure on the price to fall to Pe. In
order to stabilize the price at the minimum of Pmin, the government should eliminate the excess supply
from the market. If the objective of the government is to encourage production, the government should
buy the surplus quantity of the good and maintain a buffer stock if the good can be stored. While if the
objective of the government is to discourage consumption, the government should impose indirect tax
on producers to reduce production.

 Effect of price controls on consumer and producer surplus

Fig: Effect of maximum price (price ceiling)

Before setting the maximum price (price ceiling)

Consumer Surplus = ½($8 x 40) = 160
Producer Surplus= ½($8 x 40) = $160
Total Surplus = $320
After price ceiling
Consumer Surplus = ½($ 4 x 20) + ($8 x 20) =$200 (Red area)
Producer Surplus =1/2 ($4 x 20) = $40
Total Surplus = $240

Deadweight Loss = Area of green triangle

=1/2($8 x 20) =$80
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Fig: Effect of minimum price (price floor)

Before setting the minimum price (price floor)

Consumer Surplus = ½($8 x 40) = 160
Producer Surplus= ½($8 x 40) = $160
Total Surplus = $320

After price floor

Consumer Surplus =1/2 ($4 x20) = $40
Producer Surplus =1/2($4 x20) + ($8 x20) =$200
Total Surplus = $240

Deadweight Loss = Area of green triangle

= ½($8 x 20)
=$80

 provision of information
In case of market failure caused by the problem of imperfect information or information failure, a
government may correct the problem by providing information to the consumers about the actual value
(harmfulness or goodness) of the goods produced and consumed in an economy. A government may
launch education campaign, awareness program and various other measures to provide information to
the consumers. This provision of information helps the consumers realize the actual value of the goods
involved and thus the optimum level of production and consumption is achieved.
For example, provision of information helps the consumers realize the actual harmfulness of consuming
the demerit goods like cigarettes, alcohol, tobacco etc. This discourages the consumption of such goods
and hence the optimum level of production and consumption is achieved.
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 Government intervention (policies) to reduce income and wealth

inequalities

 Transfer payments or monetary benefits

They are the payments made from the tax revenue to those who are on low income and are in need of
financial assistance. The transfer payments are designed to increase the purchasing power of the low
income individuals and families. These payments are not made through the market as production and
exchange of goods and services don’t take place against these payments. Such payments tend to
transfer the income from those able to work and pay taxes to those unable to work and need assistance.
Some examples include unemployment benefits, state pensions, housing allowances, food coupons, old
age allowances, etc.

 Direct provision of goods and services

Inequalities in the society can also be reduced by providing certain important services free of charge to
the users. Such services are financed through the tax system. If such services are used equally by all the
citizens then, those on low income gain the most as a percentage of their income. Thus inequality is
reduced. For example, in many countries education and health care services are provided free of charge
to the citizens.

 The tax system

Use of progressive tax system helps to reduce income inequalities. In a progressive tax system, those on
higher income pay higher proportion of their income in tax than those on low income. Tax can also be
used to reduce wealth inequalities. Inheritance tax is a tax used to reduce wealth inequalities.

 Minimum wage
A government sets minimum wage with the objective of reducing poverty and inequality. The effective
minimum wage is set above the equilibrium wage that occurs in the competitive labor market. Setting
of minimum wage raises the income of low-wage workers and therefore lowers income inequality.
Workers in low-wage jobs and their families benefit the most from these income increases and thus
poverty and income inequality is reduced.

Fig: Effect of minimum wage

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In the diagram, the labour market is in equilibrium with the equilibrium wage rate W and the
equilibrium employment is Q. The minimum wage set by the government is W1 which is above the free
market wage W. The higher wage (Wm) increases the quantity of workers willing to work from Q to Q2,
but the decreases the quantity of workers that firms wish to employ from Q to Q1. The result is a surplus
of workers (Surplus in the diagram), where more workers seek employment than there are jobs
available at the mandated minimum wage—and the workers who fail to find employment are
unemployed.

In many cases, economists who support a higher minimum wage acknowledge that the policy might
reduce employment, but they argue that the employment effects are likely to be very small and the
benefits to wage earners are certainly large. So, many workers would have higher wages, which would
boost their family income, and a smaller group would be jobless, which would reduce their family
income. In short, the benefits of the higher wage outweigh the costs in terms of lost jobs.

 Relationship between equality and equity

Equality means each individual or group of people is given the same resources or opportunities. Equity
recognizes that each person has different circumstances and allocates the resources and opportunities
according to the need of the people.

Although both promote fairness, equality achieves fairness by treating everyone the same regardless of
need, while equity achieves fairness by treating people differently dependent on need. However, this
different treatment may be the key to reaching equality. So, if equality is the end goal, equity is the
means to get there.

 The meaning of economic inequality

• Unequal distribution of income

Income inequality is how unevenly income is distributed throughout a population. Higher income
inequality means less equal distribution of income.
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• Unequal distribution of wealth

Wealth refers to the total amount of assets of an individual or household. This may include financial
assets, such as bonds and stocks, property and private pension rights. Wealth inequality therefore refers
to the unequal distribution of assets in a group of people.

 Measuring economic inequality

• Lorenz curve and Gini coefficient (index)

A Lorenz curve is a graphical representation of inequality in the distribution of income or wealth within a
population. It takes data about household income gathered in national surveys and presents them
graphically.

Let us consider the following data:

Countries Survey Lowest Second Third Fourth Highest GNI Index

Year 20% 20% 20% 20% 20% (2002-2007)
Bolivia 2007 2.7 6.5 11.0 18.6 61.2 58.2
Brazil 2007 3.0 6.9 11.8 19.6 58.7 55.0
Croatia 2005 8.8 13.3 17.3 22.7 37.9 29.0
Madagascar 2005 6.2 9.6 13.1 17.7 53.5 47.2

Here, households are ranked in ascending order of income levels and the share of total income going to
groups of households is calculated. For example, if we look at Brazil, we see that the poorest 20%
households receive only 3.0% of the total household income while the richest 20% of the households
receive 58.7%. This contrasts with Croatia, where the data suggests more equality in distribution, with
the poorest 20% receiving 8.8% of the total household income and the richest 20% receiving 37.9%. This
information can be graphed using Lorenz curves.

Fig: Lorenz curves for Brazil and Croatia

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In the above diagram, the X- axis measures the cumulative percentage of the total population divided up
in the quintiles and the Y- axis measures the cumulative percentage of total income earned by the
quintiles. The line of absolute equality indicates a perfectly equal distribution of income where, for
example, 10 % of population earns 10% of the income and 90%of the population earns 90%of the
income. Each country has its own Lorenz curve based on the income data. The farther away a country’s
curve is from the line of absolute equality, the more unequal is the distribution of income. In the above
diagram, the curve drawn for Brazil is farther away from that of Croatia. This shows that income is less
equally distributed in Brazil than in Croatia.

The Lorenz curve model is useful to compare two or more countries in terms of income distribution or to
compare the change in income distribution for a single country over time.

The Gini index (also called Gini coefficient or Gini ratio) is the numerical measure of inequality in the
distribution of income and wealth in an economy. It is derived from the Lorenz curve and is the ratio of
the area between the line of equality and a country’s Lorenz curve (area ‘a’) to the total area under the
line of absolute equality (area ‘a’ + area ‘b’).

Mathematically,

Gini Index =

The value of Gini coefficient ranges from 0 to 1 where 0 represents complete equality and 1 represents
complete inequality. As inequality increases, the Gini index moves away from 0 and close to 1.

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AS Level
Unit 3: Government microeconomic intervention
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Assignment
Submission deadline: December 6, 2024

1. Explain the use of taxation and subsidies to correct the problem of market failure.
2. Explain any two methods of government intervention used to encourage the production and
consumption of merit goods.
3. Explain any two methods of government intervention to discourage the production and
consumption of demerit goods.
4. Discuss whether the imposition of indirect taxes is the best way to reduce cigarette
consumption.
5. Discuss whether the imposition of maximum prices can improve the allocation of scarce
resources.
6. Discuss whether indirect taxes and subsidies could be used to improve the consumption of merit
and demerit goods if the demand for both of these goods is price inelastic.
7. Explain the methods of intervention a government uses to reducde income and wealth
inequalities in an economy.
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Unit 4: The macro economy (AS Level)

4.1 National income statistics

A government measures a country’s total output to assess the economic performance of the
country/economy. An economy is usually considered to be doing well if its output is growing at a
sustainable rate. If an economy is growing at a slower rate then, the government should introduce policy
measures to achieve high and sustainable economic growth. A government uses a wide range of
measures (statistics) to measure its output. They are collectively called national income statistics.

4.1.1 Meaning of national income

National Income of any country means the total value of the goods and services produced by any
country in a year. It is thus the consequence of all economic activities that are running in any country
during the period of one year. It is valued in terms of money. In short, one can say that the national
income of any country is the total amount of income that arises through various economic activities in a
year.

4.1.2 Measurement of national income

Some of the important measures of country’s output/national income include:

 Gross Domestic Product (GDP)

Gross Domestic Product (GDP) is the most widely used measure of a country’s output. It is the money
value of all the finished products produced in a fiscal year within the national boundary of a country.
The output may be produced by the domestically owned or the foreign owned factors of production but
they must be produced within the national boundary of the country. For example, GDP of UK includes
the money value of all the finished products produced in UK by the domestically owned factors of
production as well as the foreign factors located in the UK.

Methods of measuring GDP

 Output method
 Income method
 Expenditure method

 Output method
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This method measures the GDP by adding up the money value of all the finished products (goods and
services) produced by all the economic sectors of a country in a year.
The economic sectors of a country are primary, secondary and tertiary sector. So, according to this
method, GDP is the sum of the money value of all the finished products produced by these three
economic sectors in a year.

GDP= Money value of finished products produced by primary sector + Money value of finished
products produced by the secondary sector + money value of services produced by the tertiary sector.

The output method includes the value of only the finished products while measuring the GDP. It does
not include the value of intermediate products. If the value of intermediate products (semi-finished
products or inputs) is included, the problem of double counting will occur. So, to avoid the problem of
double counting, only the value of finished products or the value added to the intermediate products
are taken into account.
For example, if a furniture manufacturer buys wood worth $20,000 and it manufactures furniture worth
$30,000 then, the value added to wood is $10,000.
In this case, to avoid the problem of double counting only the value of furniture ($30,000) or the value
added to wood ($20,000 +$10,000) is taken into account. If the value of both wood and furniture is
included then, there will be a problem of double counting and the value of GDP will be greater than the
actual value.

 Income method
This method measures the GDP by adding up the income received by all the factors of production that
contribute to the production of finished products.
The output produced is the combined efforts of land, labour, capital and enterprise. So, the value of
output produced is eventually distributed among the factors of production in the form of rent, wages,
interest and profit. According to the income method,
GDP= Rent + wages +Interest + Profit

The income method does not include the transfer payments like unemployment benefits, old age
allowances, state pensions etc. in the value of GDP. This is because they are not the payments received
for the production and exchange of goods and services rather they are just the transfer of income from
one group to another.

 Expenditure Method
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This method measures the GDP by adding up all the expenditures that occur in the country in a fiscal
year. All the expenditures that occur in a country in a year are broadly classified into the following four
types:
Private consumption expenditure (C)
Private investment expenditure (I)
Government spending on consumption and investment (G)
Net exports (X-M)

So according to the expenditure method,

GDP= C+I+G+(X-M)

Note: GDP=AD=AE= C+I+G+(X-M)

All the above three methods should give the same value as all of them measure the value of output
produced in an economy. The amount of income generated in an economy is the result of the output
produced. So,
Output = Income
If it is assumed that all the income is spent then,
Income = expenditure
So by rule,
Output = Income = expenditure

Exercise
What is GDP? Explain the different methods of measuring GDP.

Gross National Product (GNP/GNI)

GNP is the money value of all the finished products produced in a year by the domestically owned
factors of production. The output may be produced within or outside the national boundary of a country
but they must be produced by the domestically owned factors of production. For example, GNP of UK
includes the money value of all the finished products produced in a year by the domestically owned
factors of production located within or outside the national boundary of UK.
Mathematically,

GNP = GDP + Net factor income from abroad

GDP = GNP – Net factor income from abroad

Net factor income from abroad= Factor income received by the domestically owned factors located
abroad – factor payments made to the foreign factors located in the country.

 Net Domestic Product (NDP)

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NDP is the money value of all the finished products produced in a year within the national boundary of a
country after deducting the depreciation charges or capital consumption. So,
NDP = GDP - Depreciation / capital consumption
GDP= NDP + depreciation

 Net National Product (NNP) or Net National Income (NNI)

NNP is the money value of all the finished products produced in a year by the domestically owned
factors of production after deducting depreciation charges or capital consumption. So,

NNP/NNI = GNP- Depreciation/ capital consumption

GNP= NNP + depreciation

NNP is also called the national income and can be considered the best measure of country’s output. This
is because it includes the value of output produced abroad by the domestically owned factors, excludes
the value of output produced in the country by the foreign factors and deducts the depreciation of
capital goods that occur while producing the finished products.

Exercise
Define NNI. Explain why it can be considered the best measure of country’s output or income.

4.1.3 Adjustment of measures from market prices to basic prices/cost price

 GDP at market price and GDP at factor cost

GDP at market price is the GDP measured in terms of the prices of the goods in the shops or other retail
outlets.

GDP at market price = C+I+G+(X-M)

GDP at factor cost is the GDP measured in terms of the costs of producing the finished products. It is
obtained by deducting the indirect taxes and adding subsidies to the GDP at market price. Indirect taxes
are deducted as they increase the market price of the products and subsidies are added as they reduce
the market price of the products. So,

GDP at factor cost = GDP at market price – indirect taxes + subsidies

4.1.4 Adjustment of measures from gross values to net values

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Gross value of a country’s income / output can be converted to net values by deducting the depreciation
charges or capital consumption. For example GDP is converted into NDP by deducting the depreciation
charges or capital consumption. Similarly, deducting the depreciation charges or capital consumption
from the GNP gives the NNP/NNI. So,

NDP = GDP – depreciation or capital consumption.

NNP = GNP – depreciation or capital consumption

 Money GDP and real GDP

Money GDP or Nominal GDP is the GDP measured in terms of the prices of the goods in the year in
which they are produced. It is also called the GDP at current prices and is the measure that has not been
adjusted to inflation.
Example:
Total output produced in 2010= 200,000 units
General Price level = $5
So, Money GDP in 2010 = $1000, 000

Total output in 2012 = 200,000 units

Price level = $8
So, Money GDP in 2012 = $1600, 000

Money GDP may give a misleading picture about the country’s economic performance. It may increase
not because of an increase in the output but simply because of an increase in the price level. So, to get a
true picture of the country’s economic performance the money GDP has to be converted into real GDP.
It is the GDP measured in constant prices and is the measure that has been adjusted to inflation. By
converting the money GDP into real GDP, the effect of inflation is removed. Money GDP is converted
into real GDP using the price index. The price index used to convert the money GDP into real GDP is
called the GDP deflator. It measures the value of output produced and not the value of output
consumed.

Mathematically,
Real GDP = Money GDP (Year 1) x

Note:
Base year price is always 100

Current year price index = x 100

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Example: 1
Total output produced in 2010 = 200,000 units
Price level = $5
So, Money GDP in 2010 = $1000, 000

Total output in 2012 = 200,000 units

Price level = $8
So, Money GDP in 2012 = $1600, 000

Real GDP = $1600, 000 x [Price Index= $8/$5 x 100 =160]

= $1000, 000

Here, the real GDP is equal to money GDP in the base year. This shows that the country’s economic
performance has not improved. The money GDP between 2010 and 2012 has increased not because of
the increase in output but simply because of the increase in price level.

Example: 2
Total output produced in 2010= 200,000 units
Price level = $5
So, Money GDP in 2010 = $1000, 000

Total output in 2012 = 300,000 units

Price level = $8
So, Money GDP in 2012 = $2400, 000

Real GDP = $2400, 000 x

= $1500, 000

% increase in money GDP =140 %

% increase in real GDP = 50%

Here, the money GDP has increased by a higher % than an increase in real GDP because the price level
has increased by a higher % than an increase in output produced.

Exercise:
In 2016 a country’s GDP is $1000. In 2017 nominal/ money GDP rises to $1092 and the price index
increases by 4%. Calculate:
 Real GDP
 % increase in Money GDP
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 % increase in real GDP

Real GDP = Money GDP (Year 1) x

=$1092 x 100/104
=1050

% increase in money GDP = 9.2%

% increase in real GDP = 5%

Here, % increase in money GDP is higher than the % increase in real GDP. This shows that the output
has increased by a smaller % than the increase in price level

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4.2 Introduction to the circular flow of income

 The circular flow of income

The circular flow of income (GDP) or circular flow is a model that represents the flows of money and
goods and services between economic agents/sectors. The flows of money and goods match in value,
but run in the opposite direction.

 Two-sector model
Two- sector economy consists of two economic sectors: households and firms. In this model, all
household expenditures on consumer goods and services become income for firms. The firms then
spend all of this income on factors of production such as labor, capital and raw materials, "transferring"
all of their income to the factor owners / households. The factor owners (households), in turn, spend all
of their income on goods, which leads to a circular flow of income.
Fig: Circular flow of income in a two-sector economy

GDP = Rent + wages + interest+ profit

$1000m = 300 +250+ 300+250
Or,
GDP = AD= C+I+G+(X-M)
1000=300+200+300+200

The above diagram shows the circular flow of income in a two sector/closed economy. The inner circle
shows the real flow of products and factor services and the outer circle the flow of spending and
income. Here, it is assumed that all the income is spent.

 Three-sector model / closed economy

The three-sector model adds the government sector to the two-sector model. Thus, the three-sector
model includes households, firms, and government. The government sector consists of the economic
activities of local, state and federal governments. Flows from households and firms to government are
in the form of taxes. The income the government receives flows to firms and households in the form of
subsidies, transfers, and purchases of goods and services (government spending). Every payment has a
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corresponding receipt; that is, every flow of money has a corresponding flow of goods in the opposite
direction. As a result, the aggregate expenditure of the economy is identical to its aggregate income,
making a circular flow.
 Four-sector model (open economy)
The four-sector model adds the foreign sector (external sector or overseas sector) to the three-sector
model. Thus, the four-sector model includes households, firms, government, and the foreign sector.
The foreign sector comprises of foreign trade (imports and exports of goods and services) and inflow
and outflow of capital (foreign exchange). Again, each flow of money has a corresponding flow of goods
(or services) in the opposite direction. Each of the four sectors receives some payments from the other
in exchange of goods and services which makes a regular flow of goods and physical services. The
addition of the foreign sector transforms the model from a closed economy to an open economy.

 Injections and withdrawals (or leakages)

The circular flow model assumes that all the income is spent. However, in practice, all the income is not
spent. Some income is leaked out from the circular flow in the form of savings (S), taxation (T) and
import spending (m).
Some additional spending is also injected into the circular flow in the form of Investment by firms (I),
government spending (G) and export earnings (X). All these additional spending are called injections
and come from the incomes generated by domestic output.

Fig: Circular flow of income in a four-sector (Open) economy.

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Example:
Let, GNI/national income (income in the circular flow) = $400m

Saving=$10m Taxes=$20m Imports=$40m Investments= $20m

Govt. spending=$50m Exports=$30m

Injection= $100m
Withdrawals / leakages=$70m

Now, GNI=$400m- $70m + $100m= $430m

= $430m

 Equilibrium and disequilibrium

For income/GDP or GNI to be in equilibrium it is necessary for injections of extra spending into the
circular flow of income to equal withdrawals from the circular flow. If injections are greater than
withdrawals/leakages, there would be extra spending in the economy, causing the income to increase.
In contrast, if withdrawals exceed injections, income will decrease.

 Equilibrium income in two, three and four- sector economic models

 Two sector economy

In a two sector economy, the economic sectors are households and firms. So, there is only one
injection and one withdrawal. The injection is investment (I) by firms and the withdrawal is
savings (S) by households.

So, the equation of equilibrium income is:

Injections = withdrawals

Investment (I) = Savings(S)

Fig: Equilibrium income in a two-sector economy

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In the above diagram, ‘I’ represents autonomous investment, that is, the investment independent of
income/GDP. It remains constant irrespective of the level of income in the economy. Due to this reason,
it is a horizontal straight line. ‘S’ represents saving. It originates from the negative quadrant because
when income is zero, saving is negative as consumption spending is done from borrowing or using the
past saving. As income/GDP increases, saving in an economy also increases. Hence, the saving line ‘S’
slopes upward showing an increase in saving with an increase in income/GDP. The equilibrium income is
‘Y’ which is established when injection becomes equal to withdrawals or investment becomes equal to
savings (I=S).

If income/GDP is below ‘Y’, injection (investment) will be above withdrawals (savings) and the economy
will be in a state of disequilibrium. The excess of injection over withdrawals will cause the income/GDP
to rise until the equilibrium income of ‘Y’ is achieved.

On the other hand, if income/GDP is above ‘Y’, injection (investment) will be less than withdrawals
(savings) and the economy will be in a state of disequilibrium. The excess of withdrawals over injections
will cause the income/GDP to fall until the equilibrium income of ‘Y’ is achieved.

Fig: Effect of change in investment on equilibrium income

 Three-sector economy

In a three- sector economy, the economic sectors are households, firms and the government sector. So,
there are two injections and two withdrawals. The injections are investment (I) by firms and government
spending (G).The withdrawal are savings (S) by households and taxation (T).

So, the equation of equilibrium income is,

Injections = withdrawals

I+G=S+T
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Fig: Equilibrium income in a three-sector economy

 Algebraic Analysis
Given,
Consumption (C) = 200 + 0.75Yd [Y= C + S]
Investment (I) =100
Government spending (G) = 50
Taxation (T) =100

Solution,
For income to be in equilibrium,
Injections = Withdrawals
I+G=S+T
100 + 50 = - 200 + 0.25Yd + 100
Note: Since, Consumption (C) = 200 + 0.75Yd, Saving (S) = - 200 + 0.25Yd
150 = -200 + 0.25(Y-T) +100
150=-200 + 0.25 (Y-100) + 100
150= -200 +0.25Y – 25 +100

Y=1100

Note: Yd is disposable income which is derived by deducting direct taxes from income. So, Yd = Y – T

 Four-sector economy

In a four- sector economy, the economic sectors are households, firms, government sector and the
foreign sector. So, there are three injections and three withdrawals. The injections are investment (I) by
firms, government spending (G) and exports (x). The withdrawals are savings (S) by households, taxation
(T) and imports (m).

So, the equation of equilibrium is,

Injections = withdrawals
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I + G+X = S + T + M

Fig: Equilibrium income in a four sector economy

Fig: Effect of increase in taxation on equilibrium income

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4.3: Aggregate demand (AD) and aggregate supply (AS)

 Aggregate demand (AD)

Aggregate demand (AD) is the total spending on the economy’s goods and services at
different price levels over a given period of time. It is composed of the following four
components:
 Private consumption expenditure (C)
 Private investment expenditure (I)
 Government consumption and investment expenditure (G)
 Net exports (X-M)

So, AD = C+I+G+(X-M)

Note: Net export is the difference between the value of exports of goods and services and
the value of import of goods and services.

Example: 1
Let,
C=$25 I=$40 G=$25 X=$50 M=$25

AD =$25 + $40 + $25 + ($50 - $25)

=$115

Example: 2
Let, AD= $1000m
C =$200m I=$300m G=$400m X=$200m
Find M.

AD = C+I+G+(X-M)
$1000m = $200m + $300m+ $400m+ ($200-M)

M=$100m
2|Page

 The aggregate demand (AD) curve

The AD curve shows the different quantities of total demand for the economy’s products (goods and
services) at different price levels. A rise in the price level will cause the AD to fall while a fall in price level
causes the AD to rise. Due to this inverse relationship between the price level and AD, the AD curve
slopes downward from left to right.
Fig: The AD curve

 Reasons for an inverse relationship between the price level and AD

 Real balance effect

An increase in the price level reduces the value of money balance held by the people in the banks and
other financial institutions. This fall in the value of money balance reduces the purchasing power of the
people. Thus, the AD decreases and vice versa.
Example:
Let, money balance=$100
Price level= $5
Maximum quantity of goods that can be bought using the given money balance of $100= = 20 units

Now, money balance being unchanged; price level increases to $10. So, the maximum quantity of
goods that can be bought = = 10 units

 Interest rate effect

An increase in price level causes the interest rate to increase. This increase in the rate of interest
encourages the people to save more and spend less. In addition, an increase in interest rate raises the
cost of borrowing which, in turn, reduces the consumption spending and investment by borrowing.
Thus, the AD decreases when the price level increases and vice versa.

Note: Price level and interest rate are directly related

 Foreign purchase effect

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An increase in price level in an economy causes the domestic producers to switch to the cheaper foreign
products as well as the foreign buyers will buy less of the country’s products. Thus, the export earning
decreases and the import spending increases causing the net exports (x-m) to decrease which, in turn,
reduces the AD and vice versa.

 Factors affecting AD

Change in government spending

Government spending↑ income of households and firms↑ spending on goods and services↑ AD↑ and
vice versa

Change in money supply

Commercial bank lending↑ money supply↑ consumers’ purchasing power↑ spending on goods and
services↑ AD↑ and vice versa

Change in direct taxes

Tax rate↑ disposable income↓ spending on goods and services↓ AD↓ and vice versa

Note: Disposable income = Income –direct taxes + state benefits (if any)

Change in interest rate

Interest rate↑ savings↑ spending on goods and services↓ AD↓ and vice versa
Interest rate↑ cost of borrowing↑ consumer spending and investment by borrowing↓ AD ↓ and vice
versa

Change in exchange rate

Exchange rate↑ export prices↑ import prices↓ export earning↓ import spending↑
Net- exports(x-m) ↓ AD↓ and vice versa.

Change in the quality of domestic products

Quality of domestic products↑ imports↓ exports↑ net exports (x-m) ↑ AD↑ and vice versa

 Movement along and shift in the AD curve

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Movement along the AD curve is caused by the change in price level, all other factors affecting AD being
unchanged. An increase in the price level reduces the AD and causes a leftward movement along the AD
curve. This is called a contraction of AD. On the other hand, a fall in price level raises the AD and causes
a rightward movement along the AD curve. This is called an expansion of AD.
Fig: movement along the AD curve

Shift in AD curve shows the change in AD. It is caused by the change in one or all the factors affecting
AD, price level being unchanged.
Fig: Shift in AD curve

 Aggregate Supply (AS)

Aggregate supply (AS) is the total quantity of goods and services that the firms are able and willing to
produce at different price levels over a period of time (a fiscal year).

Short run aggregate supply (SRAS)

Short Run Aggregate Supply (SRAS) is the total supply of goods and services currently being achieved in
the economy. That is, SRAS is the total output that an economy can produce under the current situation
with the current state of technology, current government policy, current prices of materials and
components, etc.

There exists a direct relationship between the price level and SRAS. That is, when the price level rises,
SRAS increases and vice versa. Due to this reason the SRAS curve slopes upward from left to right.
5|Page

Fig: Short run AS curve

 Reasons for a direct relationship between SRAS and price level

 Profit effect
Other factors including the costs of production being unchanged, an increase in price level raises the
firms’ profit. This increased profit encourages the firms to increase production as the price level rises.

 Cost effect
As the firms increase production, the cost of producing additional output increases. The increased costs
of production can be covered up only if the price level rises. Hence, the firms produce more output only
if the price level rises.

 Misinterpretation effect
The producers/ firms often confuse the increase in price level with an increase in the relative prices. The
prices of their goods may increase because of inflation occurring in the economy but they may think that
the prices of their goods have increased as they have become more popular among the consumers. This
may encourage them to produce more when the price level rises.

 Factors affecting SRAS

Factor Productivity
Higher level of productivity means goods and services are being produced more efficiently, decreasing
unit costs of production, increasing aggregate supply.

Labor Wage Costs

Higher wage costs means that an economy produces less goods and services due to higher costs of
production
Government policy
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Imposition of regulation and taxation can place a burden on the unit costs of production, lowering the
aggregate supply of an economy. On the other hand, provision of subsidies to private producers reduces
the unit costs of production, increasing the aggregate supply in an economy.

Raw -material Prices

Higher material prices and other inputs will increase the unit costs of production and lower aggregate
supply.

Quantity of resources
Decrease in the quantity of resources due to supply side shocks will reduce the SRAS while an increase in
the quantity of resources due to say increase in the labor force participation rate will cause the SRAS to
increase.
Fig: Shifts in SRAS curve

Long-run aggregate supply (LRAS)

Long Run Aggregate Supply (LRAS) is the maximum quantity of goods and services that can be achieved
with full employment of resources.

Keynesian Approach
Note: Keynesians are the economists whose ideas are based on the work of the British economist John
Maynard Keynes. The terminology of demand-side economics is synonymous with Keynesian
economics. They believe the economy is best controlled by manipulating the demand for goods and
services (AD)

They believe that if left to free market forces there is no guarantee that the economy will achieve a full
employment level of GDP/output. Indeed they think that the level of GDP can deviate from the full
employment level by a large amount and for long period of time. In such cases, they favor government
intervention to influence the level of economic activities. They argue that if there is high unemployment,
the government should use a deficit budget (increasing government spending) to increase the aggregate
demand (AD). They believe that a government can assesses the appropriate amount of extra spending to
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inject into the economy in such a situation. For most Keynesians, the avoidance of unemployment is a
key priority.

The LRAS curve developed by the Keynesians has three segments on it. It is perfectly elastic (horizontal)
at low level of output, upward sloping over a range of output and perfectly inelastic (vertical) at the
full employment/ potential level of output.

Fig: Keynesian LRAS curve

The diagram above shows the long-run aggregate supply curve that was created by John Maynard
Keynes. Keynes believed that the long-run aggregate supply curve (LRAS) has three main segments
through which a market will go through over a period of time. Keynes believed that at the beginning, the
market will start out with an increased level of output with no increase in prices since there is lots of
spare capacity in the economy. Once the market moves through the early parts of the LRAS, the spare
capacity will then be used up and output will go up at the same time. As a consequence, the costs of the
factors of production will rise. After the middle section in the LRAS, employment will be full and output
cannot be increased further as all the factors of production are being utilized.

Monetarist’s LRAS curve

Note: Monetarists are the economists whose ideas are based on the work of the American economist
Milton Friedman. They are certain that the money supply is what controls the economy, as their name
implies.

In contrast to the Keynesians, for monetarists, the control of inflation should be the top priority of a
government. They argue that inflation is the result of excessive growth of money supply. So, they
believe that the main role of a government is to control inflation. They also maintain that attempts to
reduce unemployment by increasing government spending will only succeed in raising inflation in the
long run (conflicts between policy objectives). They believe that the economy is inherently stable unless
disturbed by erratic changes in the growth of money supply.

Monetarists believe that in the long run the economy is in full employment and the output produced is
at the potential/ full employment level. Hence, the LRAS curve illustrated by the monetarists is a vertical
straight line at the potential level of output.
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Fig: Vertical LRAS curve

However both the Keynesians and monetarists agree on that the LRAS curve shifts rightward if there is
an increase in the quantity and quality of resources. Increase in the quantity and quality of resources
will increase the production possibility of an economy and causes the LRAS curve to shift rightward .The
causes of increase in the quantity and quality of resources are:
• Increase in size of labor force
• Increase in stock of capital goods /net investment
• Increase in productivity of resources
• Advances in technology
• Discovery of new resources
• Increase in retirement age
• More women entering the labor force
• Increase in net immigration
• Improved education and training of workers
• Land reclamation
Fig: Rightward shift in the LRAS curve
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 Interaction of AD and AS: Macroeconomic equilibrium and disequilibrium

• Short-run equilibrium
Short-run macroeconomic equilibrium is achieved when aggregate demand (AD) and the short-
run aggregate supply (SRAS) are equal in the short term. In graphical form, this is the point
where the aggregate demand curve meets (or intersects) the short-run aggregate supply (SRAS)
curve. At the state of short-run macroeconomic equilibrium, the equilibrium price level and
equilibrium GDP/output is established. The equilibrium GDP established at the state of short-
run equilibrium may be less than, greater than or equal to potential or full-employment GDP.

Fig: Macroeconomic equilibrium in the short-run

10 | P a g e

In the above diagram,

Let,
Price level (P) = $10
Output/income/ GDP (Y) =$400m

Y/AD/output/GDP= C+ I+ G+(X-M)
$400m =C+ I+ G+(X-M)
If, C=$100m, G=$50m, X=$200m, M=$100m find I

$400m = $100m +$150m +$50m + ($200m-$100m)

The above figure illustrates the macroeconomic equilibrium in the short-run. The economy is in
equilibrium where the AD curve interacts the SRAS curve. The equilibrium price level is ‘P’ and the
equilibrium level of output is ‘Y’.
11 | P a g e

If the price level was initially below P, the excess demand would push the price level torise to the
equilibrium level.

If the price level was above P, the excess supply would put pressure on the price level to fall to the
equilibrium level.

 Change in equilibrium price level and GDP

Any change in the AD and/or SRAS will move the economy to a new position of equilibrium with new
equilibrium price level and GDP/output. For example, SRAS being unchanged an increase in AD will move
the economy to a new equilibrium position with a higher price level and a higher level of output.

Fig: Effect of change in AD on macroeconomic equilibrium

Fig: Effect of change in SRAS on macroeconomic equilibrium

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 Long – run macroeconomic equilibrium [Equilibrium in the

monetarist/new classical model]
In the monetarists (or new classical) model, long-run macroeconomic equilibrium requires that
equilibrium GDP is equal to potential GDP or full-employment GDP. That is, long-run
macroeconomic equilibrium requires the economy being on its vertical long-run aggregate
supply curve. This is full-employment equilibrium, and is the only case where we have long-run
equilibrium as well as short-run equilibrium. This contrasts with the short-run equilibrium
situation, in which the equilibrium GDP may be less than or greater than or equal to potential
GDP.

Fig: Macroeconomic equilibrium in the long-run

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Exercise

1. Using appropriate diagram, explain the difference between movement along and shift in AD
curve.[8/12]
2. Using AD/AS model, explain how an economy reaches a state of equilibrium in the short and
long-run. [8/12]
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4.4: Economic growth

Economic growth is an increase in the quantity of goods and services produced
by an economy over a period of time.
Economic growth rate is the annual percent change in the output produced by an
economy over a period of time.

Mathematically,

Economic growth rate = x 100

For people to enjoy more goods and services, output has to increase by more
than any growth in population. In such a case, GDP per head (per capita) would
increase.

On the other hand, Economic development means an improvement in the quality

of life and living standards of the people. We would expect economic growth to
enable more economic development. Higher real GDP enables more to be spent
on health care and education. However, the link is not guaranteed. The proceeds
of economic growth could be wasted or retained by small wealthy elite.

Economic development looks at a wider range of statistics than just GDP per
capita. Development is concerned with how people are actually affected. It looks
at their actual living standards and the freedom they have to enjoy a good
standard of living.

Measures of economic development will look at:

 Real income per head – GDP per capita

 Levels of literacy and education standards
 Levels of healthcare e.g. number of doctors per 1000 population
 Quality and availability of housing
 Levels of environmental standards
2|Page

 Life expectancy
 Equality in opportunities
 Freedom of culture and religion… etc.

Exercise:
Explain the difference between economic growth and economic development.

 Actual and potential economic growth

Actual economic growth occurs when output increases. It can be achieved as the
result of using the idle/ unused resources or by improving the use of resources.

On the other hand, potential economic growth is an increase in the productive

capacity of an economy. It is achieved when there is an increase in the quantity
and quality of resources.

Fig: Actual and potential economic growth shown on the PPC

3|Page

Fig: Actual and potential economic growth shown on the AD/AS diagram

Exercise
Using appropriate diagram, explain the difference between actual and potential
economic growth.

 Output gaps: positive and negative gaps (inflationary and deflationary

gaps)

The difference between equilibrium output and potential output is known as the output gap.

Negative output gap (recessionary or deflationary gap) is a situation where equilibrium output
is below the potential output. It occurs when there is a lack of aggregate demand and there is
unemployment of resources.
Fig: Negative output gap/ deflationary or recessionary gap
4|Page

Positive output gap (or inflationary gap) is a situation where the equilibrium
output is above the potential output. This occurs when the economy is producing
more than its maximum potential. Output may be above potential for a while
because, in response to high aggregate demand, machinery may be worked flat
out and workers may be persuaded to work long hours of overtime. However,
this cannot be sustained since a time will come when machines have to be
serviced or repaired and when workers will want to reduce the number of hours
of overtime they work.
Fig: Positive output gap/inflationary gap
5|Page

Exercise
Using AD/AS diagram, explain the difference between positive and negative
output gaps.

 Money GDP and real GDP

Money GDP or Nominal GDP is the GDP measured in terms of the prices of the
goods in the year in which they are produced. It is also called the GDP at current
prices and is the measure that has not been adjusted to inflation.
Example:
Total output produced in 2010= 200,000 units
Price level = $5
So, Money GDP in 2010 = $1000, 000

Total output in 2012 = 200,000 units

Price level = $8
So, Money GDP in 2012 = $1600, 000
Money GDP may give a misleading picture about the country’s performance. It
may increase not because of an increase in the output but simply because of an
increase in the price level. So, to get a true picture of the country’s performance
the money GDP has to be converted into real GDP. It is the GDP measured in
constant prices and is the measure that has been adjusted to inflation. By
converting the money GDP into real GDP, the effect of inflation is removed.
Money GDP is converted into real GDP using the price index. The price index used
to convert the money GDP into real GDP is called the GDP deflator. It measures
the value of output produced and not the value of output consumed.

Mathematically,
Real GDP = Money GDP (Year 1) x

Current year price index = x 100

6|Page

Example: 1
Total output produced in 2010 = 200,000 units
Price level = $5
So, Money GDP in 2010 = $1000, 000

Total output in 2012 = 200,000 units

Price level = $8
So, Money GDP in 2012 = $1600, 000

Real GDP = $1600, 000 x [Price Index= $8/$5 x 100 =160]

= $1000, 000

 Distinction between growth in nominal/money GDP and real GDP

Growth in nominal GDP is an annual percentage increase in nominal or money

GDP while growth in real GDP is an annual percentage increase in real GDP

Mathematically,

Growth in nominal GDP = x 100

Growth in real GDP = x 100

Example: 1
Total output produced in 2010= 200,000 units
Price level = $5
So, Money GDP in 2010 = $1,000, 000
Total output in 2012 = 300,000 units
Price level = $8
So, Money GDP in 2012 = $2,400, 000
7|Page

Real GDP = $2400, 000 x

= $1500, 000

% increase in money GDP =140 %

% increase in real GDP = 50%

Exercise:
In 2016 a country’s money/nominal GDP is $1000. In 2017 nominal/ money GDP
rises to $1450 and the price index increases by 6%. Calculate:
 Real GDP
 % increase in Money GDP
 % increase in real GDP

 Factors causing economic growth

The factors causing economic growth are all those factors that lead to an increase
in the quantity and quality of resources. Such factors include:
 Discovery of new natural resources
 Increased spending on human capital
 Technological advancement
 Increased spending on infrastructures
 Increased immigration of workers
 Increased investment on physical capital

 Consequences/effects of economic growth

 Costs/disadvantages of economic growth

8|Page

 Opportunity costs involved in economic growth

If an economy is operating at full capacity, there will be an opportunity cost
involved in achieving economic growth. To increase the country’s productive
capacity, more capital goods have to be produced. This requires switching the
resources from the production of consumer goods to the production of capital
goods. So the current consumption of goods and services will have to be reduced.
However this will only be a short-run cost since, in the long run, increased
investment will increase the output of both capital goods and consumer goods
and services.

 Increased stress and anxiety

A growing economy is a dynamic economy that undergoes structural changes.
Workers may have to learn new skills and may have to change their occupation
and / or where they live. Some workers may find such changes difficult to cope
with. Economic growth may also be accompanied by increased working hours and
pressure to come up with new ideas and improvements. All these may increase
stress and anxiety among the people.

 Depletion of natural resources

Economic growth may be accompanied by the depletion of natural resources and
damage to the environment. Higher output may involve using more resources,
building on green field sites and creating more pollution.

 Benefits/advantages of economic growth

 Increased consumption of goods and services

The main benefit of economic growth is the increase in goods and services that
become available for the country’s citizens to enjoy. This raises their material
living standards.

 Reduction of poverty
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Economic growth makes it easier to help the poor. Higher income and more
spending increase tax revenue of the government and some of this increased
revenue can be given to the poor in the form of monetary benefits, better
housing, better education and better health care.

 Increase in employment
Economic growth may also be accompanied by a rise in employment. A rise in
GDP caused by higher aggregate demand is likely to create extra jobs. An increase
in aggregate supply may make a country’s products more internationally
competitive and so may generate more jobs.

 Increase in investment
A stable rate of economic growth tends to increase business and consumer
confidence. This encourages investment. Indeed, economic growth can create
economic growth.

 Increases country’s prestige and power

Economic growth may increase a country’s international prestige and power. For
example, China’s rapid economic growth since the early 1990s has increased its
status as an economic and political power.

Exercise
Discuss the costs and benefits of economic growth.

xxxxxxxxxxxxxxxxxxxxxx
1|Page

4.5: Unemployment

 Influences on the size and composition of the labour force

 Labour force
Labour force in an economy is defined as the total number of population of working age available for
work (able and willing work). It therefore refers to all males and females of working age (usually 16
years and above) who can contribute to the production of goods and services. As well as those actually
in employment, it also includes those who are unemployed and are actively seeking employment.

Labour force = population of working age available for work and actually employed + population of
working age available for work but are unemployed.

 Factors affecting the size of country’s labour force

The size of a country’s labour force depends upon a wide range of demographic, economic and social
factors, such as;
 The total size of population of working age
Larger the size of population of working age larger will be the size of country’s labour force and vice
versa.

 The number of people who remain in full-time education above the school leaving age
Higher the number of people remaining in full- time education above the school leaving age, smaller will
be the size of country’s labour force and vice versa.

 The normal retirement age for males and females

Higher the normal retirement age for males and females, larger will be the size of country’s labour force
and vice versa.
 The proportion of females who join the labour force
Higher the proportion of females joining the labour force, larger will be the size of country’s labour force
and vice versa.

Exercise
Explain what factors influence the size of country’s labour force.

 Labour force participation rate

It is the percentage of total population of working age that is actually available (able and willing) for
work.

LFPR = x 100
2|Page

Example:
Total population of working age= 80,000
Population of working age available for work = 65,000

LFPR =

 Factors affecting labour force participation rate

 The number of people who remain in full-time education above the school leaving age
Higher the number of people remaining in full- time education above the school leaving age, lower will
be the labour force participation rate.

 The normal retirement age for males and females

Higher the normal retirement age for males and females, higher will be the labour force participation
rate and vice versa.

 The proportion of females who join the labour force

Higher the proportion of females joining the labour force, larger will be the labour force participation
rate and vice versa.

 Unemployment
People are unemployed when they are at the working age and able and willing to work but cannot find a
job.

 Level of unemployment
It is the total number of people of working age who are able and willing to work but are unemployed

Level of unemployment = Labour force – employed

 Rate of unemployment
It is the percentage of total population of working age that is able and willing to work but is unemployed

Rate of unemployment = x 100

Example:
Labour force = 80,000
Employed = 72,000
Find:
The level of unemployment= 80000 – 72000 = 8000
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Rate of unemployment = x 100

=10%

 Difficulties of measuring unemployment

Most governments use two main measures of unemployment. They are: Claimant count and labor force
survey

The claimant count measures unemployment by counting the number of people who receive
unemployment related benefits. This method is relatively cheap and quick to calculate as it is based on
the information that the government collects as it pays out the benefits. However the unemployment
figure obtained using this measure may not be entirely accurate. It may over or understate the true
figure as it may include some people who are not really unemployed and may omit some people who
are genuinely unemployed. Some of those receiving unemployment benefits may not be actively seeking
employment and some may be working and so claiming benefits illegally. On the other hand, there may
be a number of groups who are actively seeking employment but do not appear in the official figures.
These groups may include those above retirement age, those on government training schemes and
those who choose not to claim benefits. As this measure is based on those receiving benefits, it changes
every time there is a change in the rules on who qualifies for unemployment benefits.

The more widely used measure of unemployment involves a labour force survey using the International
Labour Organisation (ILO) definition of unemployment. According to this definition, unemployed are
those who are at the working age and available for work but are without work in a specific period of
time. This measure includes some of the groups not included in the claimant count. It also has the
advantage that as it is based on the internationally agreed concepts and definitions, it makes
international comparisons easier. However, the data are more expensive and time consuming to collect
than the claimant count measure. Also, as the data are based on sample survey, they are subject to
sampling error and to a multitude of practical problems of data collection.

Exercise
Explain why it is difficult to measure unemployment accurately.

 The causes of unemployment

Unemployment can be divided into three main types. They are frictional, structural and cyclical. Each of
these types has different causes.
4|Page

Frictional unemployment
It is the unemployment that arises when the workers are in between jobs. The forms of frictional
unemployment are:
Voluntary unemployment
Search unemployment,
Casual unemployment
Seasonal unemployment

Voluntary unemployment occurs when workers are not willing to accept the jobs at the current wage
rate and working conditions. This form of frictional unemployment may be influenced by how the level
of unemployment benefit compares to low wages. If the amount workers can earn in employment is less
than they can receive in benefits, some workers may decide to stay unemployed.

Search unemployment arises when the workers do not accept the first job or jobs on offer, but spend
some time looking for better paid jobs. Such unemployment may be reduced through the provision of
more and better-quality information.

Casual Unemployment is when the workers are employed on a day-to-day basis for a contractual job
and have to leave it once the contract terminates. Examples include actors, supply teachers and
construction workers.

Seasonal unemployment occurs when people are unemployed at particular times of the year when
demand for labor is lower than usual. For example, workers working in the tourism, hospitality,
building and farming industries may be out of work during periods of the year.

 Structural unemployment
It arises due to changes in the structure of the economy. Over time the pattern of demand and supply
may change. Some industries may expand while some may contract. If workers cannot move from one
industry to another industry, due to lack of geographical or occupational mobility, they may become
structurally unemployed. The forms of structural unemployment are:
Technological unemployment
Regional unemployment
International unemployment

Technological unemployment arises due to the introduction of labour saving production techniques. For
examples, the development of drones and robots delivering shopping is resulting in some delivery
drivers losing their jobs.
Regional unemployment arises when the declining industries are concentrated in a particular area of a
country. For example, a decrease in the demand for gold could result in a decline in the South African
gold mining industry and cause workers in the gold mining areas to lose their jobs.
5|Page

International unemployment arises when demand switches from domestic industries to more
competitive foreign industries. For example, the number of steel workers in the UK has fallen
significantly over the past 40 years as the UK steel industry has declined. In contrast, during this period,
the Chinese steel industry has expanded, creating more jobs.

 Cyclical unemployment
Cyclical unemployment or demand-deficient unemployment arises due to a lack of aggregate demand.
A lack of aggregate demand reduces the aggregate demand for labor and thus cyclical unemployment
arises. Cyclical unemployment will affect the whole economy, with job losses occurring across a range of
industries.
It usually arises during the period of economic recession when the AD is low.

Fig: Cyclical unemployment

Cyclical unemployment may also arise if the wage rate falls. A fall in wage rate reduces the demand for
goods and services as people would have less money to spend, which would cause firms to reduce their
output making the workers redundant.

Exercise
Explain the various causes of unemployment. What type of unemployment do you think exist in your
economy? Explain.

Consequences/effects of unemployment

1. Loss of income: Unemployment normally results in a loss of income. The majority of the unemployed
experience a decline in their living standards and are worse off out of work. This leads to a decline in
spending power and the risk of falling into debt problems. The unemployed for example may find it
difficult to keep up with their mortgage repayments.

2. Loss of national output: Unemployment involves a loss of potential national output (i.e. GDP
operating well below potential) and is a waste of scarce resources. If some people choose to leave the
6|Page

labour market permanently because they have lost the motivation to search for work, this can have a
negative effect on long run aggregate supply and thereby damage the economy’s growth potential.
Some economists call this the “hysteresis effect”.

3. Fiscal costs: The government loses out because of a fall in tax revenues and higher spending on
welfare payments for families with people out of work. The result can be an increase in the budget
deficit which then increases the risk that the government will have to raise taxation or scale back
(reducing expenditures) plans for public spending on public and merit goods.

4. Social costs: Rising unemployment is linked to social deprivation. For example, there is a relationship
with crime and social dislocation including increased divorce rates, worsening health and lower life
expectancy. Regions that suffer from persistently high long-term unemployment see falling real incomes
and a widening of inequality of income and wealth.

Exercise
Explain the causes and consequences of unemployment. What type of unemployment do you think
exists in your economy?
1|Page

‘4.6: Price Stability

❖ Inflation
Inflation is a sustained rise in general price level measured in terms of price indices.
When inflation occurs, the price level rises while the value of money falls. That is, too much money can
buy too few goods. That is, whenever inflation occurs, cost of living increases.

 Points to note while discussing inflation:

 An increase in the prices of just a few goods is not inflation. For inflation to occur there should
be an increase in the prices of a wide range of items so that the consumers’ total spending
increases. However, an increase in the price of fuel is an exception. Fuel being used as a
component to produce the goods, an increase in the price of fuel will cause the prices of most of
the goods to rise.

 For inflation to occur there should be a sustained rise in price level. That is, the price level
should continue to rise for a sustained period of time, say 4-5 years.

 A low and stable inflation is good for the economy as it adds competitiveness and allows the
businesses to plan ahead with confidence.

 Causes of inflation

The main causes of inflation are:

 Demand-pull inflation
 Cost- push inflation
 Monetary inflation

 Demand-pull inflation
It occurs due to an increase in aggregate demand (AD) when the economy is operating at full
employment and producing the potential output. When there is full employment of resources in an
economy, the output produced is at the potential level. In such situation, the increased demand cannot
be met due to the scarcity of resources. Thus, the excess demand drives up the price level and demand-
pull inflation occurs.
Fig: Demand-pull inflation
2|Page

 Factors causing demand-pull inflation

 Increase in commercial bank lending

 Increase in government spending
 Cut in income tax
 Fall in interest rate
 Fall in exchange rate
 Improvement in the quality of domestic products

 Cost-push inflation
It occurs when there is an increase in the costs of producing the goods and services. An increase in the
costs of production reduces the aggregate supply which, in turn, raises the price level.
Thus cost-push inflation occurs.
Fig: Cost-push inflation

 Factors causing cost-push inflation

 Wage –push inflation/ wage-price spiral
 Tax-push inflation
 Raw-material price push inflation
 Import price –push inflation
 Profit –push inflation

Exercise
Explain the difference between demand-pull inflation and cost-push inflation [8/12]

❖ Monetary inflation
According to the monetarists, the main cause of inflation is an increase in money supply in an economy.
They argue that inflation is always and everywhere a monetary phenomenon.
According to them, Money supply and price level are directly proportionate. Any increase in money
supply causes the price level to increase by equal proportion. That is, if money supply is doubled, price
level will also be doubled and vice versa.
3|Page

Fig: Effect of increase in money supply

Note: Value of money= 1/Price Level

❖ Quantity Theory of Money

The monetarists used the Quantity theory of money to explain the relationship between money supply
and the price level. According to this theory, money supply and price level are directly proportionate.
That is, any change in money supply causes the price level to change by equal proportion. That is, if
money supply is doubled, price level will also be doubled and vice versa.
This theory is based on the Fisher’s equation of exchange, which is

MV = PT (supply of money = demand for money)

Or, P= MV ÷ T

Where,
M= Quantity/supply of money
V =Velocity of circulation of money (no. of times money changes hands)
P = Price level
T = Transactions or total output of the economy

Both the sides of the above equation have to equal as both sides represent the total expenditure in the
economy. Holding ‘V’ and ‘T’ constant, if there is any increase in money supply; it will cause the price
level to increase by equal percentage.

Example
Let,
M=$1000
V= 4
P= $2 and
T= 2000
So,
4|Page

MV = PT
$1000 X 4 = $2 X 2000
$4000 = $4000

Now, let us assume that the money supply increases by 50% and it rises from $1000 to $1500,
So,
P= MV ÷ T
P= ($1500 X 4) ÷ 2000
P = $3
So, price level has increased by 50% because of 50% increases in money supply.

Now,
MV = PT
$1500 X 4 = $3 X 2000
$6000 = $ 6000

Exercise
Explain how an increase in money supply causes inflation in an economy. [8/12]

 Measuring Inflation
Inflation is measured using price index. Price index measures the change in prices of goods over a period
of time, that is, between base year and current year.
By formula,

Price index = x 100

Example: Price of good x in 2010 (base year) =$20/unit

Price of good x in 2012(current year) =$15/unit
So,
Price index (current year) = x 100 = 75 ˂ 100

Here, price of good x has decreased 25% (75-100=-25) in the current year (2012) as compared to the
base year 2010.

Note: Base year price index is always 100

By formula,
Rate of inflation = X 100

Or, Rate of inflation = Current Price index – Base year price index

❖ Price Index

 Simple price Index

5|Page

 Consumer Price Index (CPI) / weighted price Index/RPI

⮚ Measuring Inflation using Simple price index

Simple price index measures inflation by assigning equal importance/weights to all the selected
commodities.
Example: 1
Commodities Base year (2015) Current year (2018)
Price (P0) Price Index (PI0) Price (P1) Price Index
(PI1)
Rice $5 $7 x100=140
Pulses $8 $10 =
Sugar $10 $10 =
Wheat $7 $9
Milk $12 $10 =
Salt $4 $5 =
Fuel $20 $25 =
Butter $14 $16 =
Average Index= = 100 Average Index = = 117

So, rate of inflation= 117-100 =17%

The price level has increased by 17% in the current year 2018 as compared to the base year 2015.

Example: 2
Commodities Base year (2015) Current year (2018)
Price (P0) Price Index (PI0) Price (P1) Price Index (PI1)
Rice $6 100 $5 = 83.33
Pulses $10 100 $10 Average
Sugar $15 100 $12 Index
Wheat $8 100 $7 Average
Milk $12 100 $10 Index
Salt $6 100 $7 (year 0)=
Fuel $12 100 $10 100
Butter $16 100 $16 (Year 1) =
86
Meat $20 100 $15
Bread $4 100 $2
So, rate of
inflation= 86 - 100= -14%
The price level has decreased by 14% in 2018 as compared to 2015. This fall in price level is refered to as
deflation or negative inflation.

Example: 3
Goods Prices
6|Page

2016 2017 2018

Socks 4 5 4.50
Pizzas 10 13 12
Hot dogs 2 2.50 3
Total value of the 16 20.50 19.50
basket of goods

PI in 2016 (base year) = x100 = 100

PI in 2017 = x 100=128

PI in 2018 = x 100 = 122

Note: Base year consumer price index (CPI) is always 100. Current year consumer price index greater
than 100 shows an increase in average prices while the current year CPI less than 100 shows a fall in
average prices.

Calculating the rate of inflation in 2017 and 2018

By formula,

Rate of inflation = x 100

Rate of inflation in 2017 = x 100 = 28%

Therefore, the price level has increased by 28% in 2017 as compared to the base year 2016.

Rate of inflation in 2018 = x 100 = - 4.68% (deflation)

Example: 4

2016 Base year 2017 2018

Goods Prices Quantity Prices prices
Soccer balls $10 100 $15 $18
Shoes $50 40 $52 $56
Concert tickets $100 20 $104 $110
Calculating the total costs/expenditures of purchasing the given/fixed quantities of goods in each year

For 2016: ($10x100) + ($50 x 40) + ($100 x 20) = $5000

For 2017: ($15 x 100) + ($52 x 40) + ($104 x 20) = $5660
For 2018: ($18 x100) + ($56 x 40) + ($110 x 20) = $6240

Calculating Price Index (PI)

7|Page

PI in 2016 = x100

= 100

PI in 2017 = x100

=113.2

PI in 2018 = x 100

=124.8

Calculating the rate of inflation in 2016, 2017 and 2018

Rate of inflation in 2017 = x 100 = 13.2%

Therefore, the price level has increased by 13.2 % in 2017 as compared to the base year 2016

Rate of inflation in 2018 = x 100 = 10.25%

The price level has increased by 10.25% between 2017 and 2018.

Example-5

Goods Index for year x (base year) Index for year (x +1)
Housing 120 130
Foodstuffs 105 105
Travel 120 125
Clothing 120 110
Entertainment 125 130
Average Index 590/5=118 600/5=120

Rate of inflation = x 100

= 1.69%

That is, the general price level has increased by 1.69% over the given time period.

⮚ Measuring Inflation using Consumer price index (CPI) or weighted price

index or RPI
A consumer price index (CPI) is usually calculated as a weighted average of the price change of the
goods and services covered by the index. The weights are meant to reflect the relative importance of
the goods and services in the total consumption expenditure of households. A good that forms a higher
% of consumer’s total spending is assigned higher weight than other goods.
Example: 1
Commodities Weights (W) Base year (2015) Current year (2018)
8|Page

Price (P0) P0W0 Price (P1) (P1W1)

Rice $6 $8
Pulses $10 $12
Sugar $15 $20
Wheat $8 $10
Milk $12 $10
Salt $6 $7
Fuel $12 $10
Butter $16 $20
Meat $20 $22
Bread $4 $5
ΣW= ΣP0W0= ΣP1W1=

Consumer Price Index (CPI) = x 100

= x 100

=114.41
Rate of inflation =
=
So, the price level has increased by 14.41% in the current year, 2018 as compared to the base year 2015.

Example: 2
Category/items Price Index(PI) Weights(W) PIW
Food 112
Alcohol & Tobacco 105
Clothing 95
Transportation 106
Housing 104
Leisure Services 105
Household Goods 94
Other items 115
ΣW=50 ΣPIW=

Average of CPI = =

Rate of inflation =
=

Interpretation:

Example: 3
9|Page

Goods Base year Weight W0PI0 Current Weight W1 PI1

Index (PI0) (W0) Year Index (W1)
(PI1)
Housing 120 0.4 130 0.4 52
Foodstuffs 105 0.2 105 0.2 21
Travel 120 0.2 125 0.2 25
Clothing 120 0.1 110 0.1 11
Entertainment 125 0.1 130 0.1 13
Total 1.0 117.5 1.0 122

Rate of inflation = x 100 =

 Difficulties in measuring inflation

 The CPI is not fully representative

CPI used to measure inflation may be inaccurate for the ‘non-typical’ household.
The basket of goods used in constructing CPI represents the purchasing habits of a ‘typical’ household
and it is not applicable to all people. The purchasing habits of different people will clearly be different.
For example, the basket of goods of a family with children will be very different from that of an elderly
couple or a single person with no children.

 Errors in the collection of data

There may be errors in the collection of data that limits the accuracy of the final results of inflation. It is
impossible to collect the prices of all the items bought by all the households in all possible locations.
Hence, it is necessary to take sample items in a sample of selected cities and a sample of selected
outlets. The layers of sampling are likely to lead to some degree of inaccuracy. The larger the sample,
the more accurate the results will be, but this is time consuming and very costly.

 Change in prices may not sustain

Prices may change for a variety of reasons that are not sustained. For example, seasonal variations in
the prices of food and volatile oil prices may lead to unusual movements in the inflation rate and can be
misleading.

 Changes in the quality of goods

Changes in the quality of goods mean that price rises may not reflect inflation, but just the fact is an
improved quality of goods. For example, computers now have many more features than 10 years ago,
so it is difficult to compare prices because they are effectively different goods.
10 | P a g e

 Different groups can have different inflation rates.

For example, Rising electricity and gas prices may affect old people more than young people.
Therefore, old people could have a higher inflation rate than the national average.

 Basket of goods can become outdated.

In a fast-changing economy, goods people are buying are frequently changing. Trends may cause people
to be buying new technology or in different places – and the traditional basket of goods can fail to keep
up. For example, if there is a rise in internet shopping, inflation measures should give a higher weighting
to online prices, but it takes time to update the basket of goods and which prices should be counted.

Exercise
Discuss the problems / difficulties of measuring inflation.

Difference between money values and real values

Money Values or nominal values are the values expressed at the current year prices.
They are the values that have not been adjusted to inflation or they are the values obtained without
removing the effect of inflation.

In contrast, real values are the values expressed in constant prices. They are the values that have been
adjusted to inflation. By converting money value into real value, the effect of inflation is removed.
Money value is converted into real value using the price index.

By Formula,

Real Value = Money value (in year 1) x

Example:
Let, money or nominal wages in 2015=$5,000
Money or nominal wages in 2016=$6,000
Price index in 2015=100
Price index in 2016=125

So, Real wage = $6000 x

=$4800

% rise in money wage = x 100

=20%
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% increase in real wage = 4800-5000/5000 x 100

= - 4%

Here, the worker’s money wage has increased by 20% but his real wage/income has fallen by 4%. With
an inflation rate of 25%, a 20% rise in wages means that the workers will now be able to buy fewer
goods and services using the given money wage.

Degrees of inflation

% change per annum Consequences

over a period of time

˂ 4% ● Very mild inflation

● It actually aids competitiveness in the economy

4% - 10% ● Mild inflation

● It must be kept under control to avoid future difficulties

10% - 20% ● Inflationary pressure builds up in the economy

● Wage demand increases and interest rate increases
● Savings began to be affected
● Strict policies are essential if the problems are to be resolved

20%-50% ● Serious inflation

● Economic relationships are in real danger breaking down
● Confidence on money is lost

50% and above ● Hyperinflation

● Depending upon severity, the domestic economic system collapse
● Money or domestic currency becomes worthless in the domestic
economy and the foreign exchange market

Consequences of inflation
12 | P a g e

There are number of potential benefits and costs of inflation.

The potential benefits of inflation are:

⮚ Increased output
If inflation is caused due to increased AD, output will increase. In addition,a low and stable inflation rate
caused by increasing demand may make the firms feel optimistic about the future. This encourages
production. In addition, if prices rise by more than costs, profits will increase, which will provide funds
for investment.

⮚ Reduce the burden of debt

Real interest rate may fall due to inflation or may even become negative. This is because nominal
interest rates do not tend to rise in line with inflation. As a result debt burden may fall or the borrowers
may have to pay low interest in real terms. For example, those who have borrowed money to buy a
house may experience a fall in their mortgage payment in real terms.

Example:
Let,
Amount borrowed= $10,000
Interest rate=10%
Current Price level=$5
Amount paid in interest=$1000
Now,
Price level rise by 20% and the new price level=$6
Nominal interest rate rises by 5% and the new nominal interest rate =10.5%
Now, the amount paid in interest=$1050
Real interest rate =1050x 100÷120= $875

⮚ Prevents some unemployment

The declining industries have to reduce their costs to survive. For many firms, wages form a significant
proportion of the total cost. With zero inflation, the firms may have to cut their labour force to cut their
costs. But if inflation occurs, the firms can reduce their real costs either by keeping the money wages
constant or by not raising them in line with inflation. This reduction in the real costs of labour prevents
some unemployment in the economy.

The possible costs of inflation are:

⮚ Reduction in net exports

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Inflation reduces the international competitiveness of a country’s domestic products. This increases the
import spending and reduces the export earnings. This results in BOP deficit.

⮚ An unplanned redistribution of income

Some people may gain while some others may lose as a result of inflation. For example, if the rate of
interest doesn’t rise in line with inflation, borrowers will gain while lenders will lose. This is because
borrowers will pay back less in real terms and lenders will receive less.

⮚ Menu Costs
Menu costs are the costs involved in changing prices. These costs affect the firms. For example, the firms
have to change price tags, catalogues, bar codes and advertisements. This involves staff time and costs
and unpopular among the customers.

⮚ Shoe-leather costs
These are the costs (in terms of time and energy) of the efforts involved in combating the effects of
inflation. When inflation occurs, people keep less cash in hands and make more trips to banks. In times
of inflation, keeping as much money as possible in the interest bearing accounts can be a good strategy.

⮚ Fiscal drag or bracket creep

Inflation pushes wages and salaries to higher tax brackets leading to fiscal drag. The result is that the
income tax increases but the real purchasing power doesn’t increase.
E.g. let,
Money income=$20,000
Tax rate=20% on earning above a threshold of $5000
So, amount paid in tax=$15,000 x 20%
=$3000
Now, suppose that due to inflation, income rises by 5% but the government increases the tax threshold
by only 2%. So,
New income=$21000($20,000+ 5% of $20,000)
Tax threshold=$5100($5000+2% of $5000)

Now, amount on which tax is paid =$15900 and

Amount paid in tax=$3180

⮚ Discouragement of investment
An unanticipated inflation creates uncertainty and thus makes it difficult for the firms to plan ahead.
This may discourage investment which will have an adverse effect on economic growth.

⮚ Inflation causing inflation

When inflation occurs, consumers, workers and firms expect the prices to rise. As a result, they may act
in such a way that will cause further inflation. For example, the workers may demand higher wages,
14 | P a g e

firms may raise prices to cover up the expected higher costs and the consumers may seek to purchase
the products now before the prices rise.

⮚ Inflationary noise or money illusion

It arises when inflation causes producers and consumers to confuse price signals. Inflation can make it
difficult to assess what is happening to the relative prices. A rise in the price of a good may not mean
that it has become more expensive relative to other products. Indeed, the price of the product may have
risen by less than inflation and so may have become cheaper. Inflationary noise can result in consumers
and producers making wrong decisions. For example, firms seeing the prices of their products rising may
increase the output when higher prices are the result of inflation rather than the increased demand for
their goods. This may result in the misallocation of resources.

Exercise
Discuss the possible consequences of inflation.
Or,
Discuss how different groups of people in an economy are affected differently by inflation.

Factors affecting the consequences of inflation

The effects of inflation depend on the following factors:

⮚ The cause of inflation

Demand-pull inflation is likely to be less harmful than cost-push inflation. This is because demand-pull
inflation is associated with rising output while cost-push inflation is associated with falling output.

⮚ The rate of inflation

A high rate of inflation is likely to cause more damage than a low rate of inflation. This is because if the
high rate of inflation develops into hyperinflation, it can lead to households and firms losing faith in the
currency/money and may even result in the downfall of the government.

⮚ Whether the rate of inflation is accelerating or stable

An accelerating, and indeed a fluctuating inflation rate will cause uncertainty and may discourage firms
from undertaking investments. The need to devote more time and efforts to establishing future inflation
will increase costs.

⮚ Whether the rate of inflation is the one that has been expected
Unexpected inflation can also create uncertainty and so can discourage consumer expenditure and
investment. In contrast, if the households and firms correctly anticipate inflation, they can take
measures to adapt to it and so avoid some of its potentially harmful effects.
15 | P a g e

⮚ Difference in the rate of inflation between the countries

If the rate of inflation in a country is lower than its trading partners, its products will become more
internationally competitive.

Deflation and disinflation

● Deflation is a sustained fall in price level. It results in a rise in the value of money which means
each unit of money can purchase higher volume of goods. That is, when deflation occurs in an
economy, costs of living fall. Deflation involves a negative inflation rate, say -3%. While
disinflation is a fall in the rate of inflation. That is, it is a situation where inflation is positive but
the rate is decreasing. For example, inflation rate may fall from 8% to 6%. In this case, the price
level is still rising but at a slower rate.

Causes and consequences of deflation

Deflation will increase the burden of debt, may increase the real rate of interest and may result in menu
costs. The effects of deflation are however, heavily influenced by the cause of deflation. Economists
refer to the causes of deflation as good deflation and bad deflation.

Good deflation occurs as a result of increase in aggregate supply. An increase in aggregate supply
reduces the price level and raises the real GDP.

In contrast, bad deflation occurs as a result of fall in aggregate demand. A fall in aggregate demand
reduces the price level as well as the real GDP. In this case, output falls, which may result in higher
unemployment. This type of deflation runs the risk of developing into a deflationary spiral. Consumers
may delay their purchases, expecting the prices to fall further in future. Firms, seeing lower demand,
may not invest and may reduce the number of workers they employ. These measures will reduce
demand further and economic activities will decline further.

Figure a: Good deflation

Figure b: Bad deflation

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5. Government macroeconomic interventions (AS Level)

5.1 Government macroeconomic policy objectives

Government intervenes in the macro economy to achieve different macroeconomic objectives.

Government intervenes in the macro economy using different macroeconomic policies like fiscal policy,
monetary policy and supply side policies. Macroeconomic policies are the policies designed to achieve
the macroeconomic objectives.

The main objectives of government macroeconomic policies are:

• Achieving full employment
• Achieving low and stable inflation
• Correcting Balance of Payment (BOP) disequilibrium
• Avoiding fluctuations in exchange rate
• Achieving steady and sustained economic growth
• Achieving sustainable economic development

5.2 Fiscal policy

Fiscal policy is the use of Government spending and taxation to influence the Aggregate Demand (AD)
so as to achieve the macroeconomic objectives.

Expansionary fiscal policy (Reflationary fiscal policy) involves increasing the government spending and
reducing the tax rate to increase the AD. For example, if the government aims at achieving the
objective of full employment and high economic growth, it should use the expansionary fiscal policy.

Contractionary fiscal policy (Deflationary fiscal policy) involves reducing the government spending and
increasing the tax rate to reduce the AD. For example, if the government aims at achieving the
objective of low and stable inflation and equilibrium in the BOP position, it should use contractionary
fiscal policy.

If the government deliberately (intentionally) changes its spending and taxation to influence the AD, it is
referred to as discretionary fiscal policy.
A government may also allow the automatic stabilizers to work into the economy. They are the forms
of government spending and taxation (tax revenue) that change without any deliberate action taken
by the government to influence the AD. For example, during recession, government spending on
unemployment benefits automatically increases as there is large number of unemployed people while
the tax revenue from direct and indirect taxes falls automatically as income, profit and expenditure
decreases.
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Fig: Automatic stabilizers

In the figure, the economy is operating below full employment at Y with a huge gap between
government spending and taxation. As GDP rises, government spending on unemployment benefits falls
while tax revenue rises with more people in employment and so receiving more income.

 Meaning of government budget

The annual budget of a country is the statement of fiscal policy. In a budget, government outlines its
spending and taxation plans for a fiscal year.

 Distinction between a government budget deficit and a government budget surplus

A budget surplus arises when the tax revenue exceeds the government spending. That is, budget surplus
occurs when a government reduces its spending.

Balanced budget is where the government spending and tax revenue are equalized.

Budget deficit arises when the government spending exceeds the tax revenue. That is, budget deficit
occurs when a government increases its spending. The budget deficit that arises due to automatic
stabilizers is called cyclical deficit. The budget deficit that arises when the government is committed to
spend more than its tax revenue is called structural deficit.

Structural deficits will eventually pose a problem for any government. Deficits are financed by
borrowing, and continued borrowing leads to an accumulation of debt. The ability to pay off this debt is
measured by a country's debt relative to its GDP, referred to as its debt-to-GDP ratio.
3|Page

 Meaning and significance of the national debt

National debt is the total amount of money which a country's government has borrowed. It is the
financial obligations of a national government resulting from deficit spending.

The national debt level is one of the most important public policy issues. When debt is used
appropriately, it can be used to foster the long-term growth and prosperity of a country.

 Consequences of national debt

 Lower national savings and income

With the government borrowing more, a higher percentage of the savings available for investment
would go towards government securities. This, in turn, would decrease the amount invested in private
ventures such as factories and industries, making the workforce less productive. This would have a
negative effect on wages. Because wages are determined mainly by workers' productivity, the reduction
in investment would reduce wages as well, lessening people's incentive to work.

 Interest Payments Creating Pressure on Other Spending

High government debt reduces the amount of tax revenue available to spend on other governmental
services because more tax revenue will have to be paid out as interest on the national debt. Over time,
this will cause people to pay more for goods and services, resulting in inflation. As the government debt
mounts, the government will spend more of its budget on interest costs, reducing the public
investments.

 Decreased Ability to Respond to Problems

Governments often borrow to address unexpected events, like wars, financial crises, and natural
disasters. This is relatively easy to do when the national debt is small. However, with a large and growing
national debt, government has fewer options available.

 Greater Risk of a Fiscal Crisis

If the debt continues to climb, at some point investors will lose confidence in the government's ability to
pay back borrowed funds. Investors would demand higher interest rates on the debt, and at some point
interest rates could rise sharply and suddenly, creating broader economic consequences.

 Taxation

 Types of taxes: direct/indirect, progressive/regressive/proportional

 Direct and indirect taxes

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Direct taxes are those whose burden cannot be shifted from one person to another. The impact (initial
burden) and incidence (ultimate burden) of direct taxes fall on the same person. Some examples of
direct taxes are income tax, wealth tax, inheritance tax, gift tax, road tax, capital gain tax etc.

Indirect taxes are those whose burden can be shifted from one person to another. These are the taxes
imposed on the producers which are shifted to the consumers by adding them to the prices of the
products. That is the impact (initial burden) of indirect taxes is borne by the producers while the
incidence (ultimate burden) is borne by the consumers. Some examples of indirect taxes are VAT, GST,
tariff, excise tax, custom tax etc.

 Types of Indirect taxes

Indirect taxes are of two types- specific and ad valorem.

Specific tax is imposed per unit of any good produced or consumed. For example, $2 per unit of good x
produced or consumed. Specific tax causes a parallel shift in the supply curve to the left. Examples
include excise duties. They are the taxes on particular products. Some excise duties are sometimes
referred to as sin tax. Sin taxes are imposed to discourage people from buying products that are not
good for their health.

Ad valorem tax is imposed as a percentage of prices of the goods produced and consumed. For
example, 20% of the price of any good produced or consumed. Ad valorem tax causes a pivotal (non-
parallel) shift of the supply curve towards the left.

Fig: Effect of specific and ad valorem tax

 Progressive, regressive and proportional

 Progressive tax system

It is where the tax rate (% of income paid in tax) increases with an increase in income and vice versa.
5|Page

Calculation:
Individual ‘A’ lives in a hypothetical economy with the tax rates shown in the table and his annual
income is $80,000. The following table shows the calculation of the tax paid by individual ‘A’.
Individual A’S taxable Income Marginal rate of Calculation Tax paid
($80,000) taxation
Up to $10,000 0%
Income between $10,000 and 30%
$25,000
Income between $25,000 and 40%
$50,000
Income above $50,000 ($30,000) 50%
Total income $80,000

 Proportional tax system

It is where the same tax rate is imposed on all levels of income. For example, a 20% income tax.

 Regressive tax system

It is where the tax rate decreases with an increase in income and vice versa. That is, those on lower
incomes pay higher proportion of their income in tax to the government than those on higher incomes.
For example, the indirect taxes imposed on goods / services are regressive in nature

Example:
A’s income=$100
B’s income =$200
Tax paid on purchase of good x = $5
% of income paid in tax by A = 5%
% income paid in tax by B =2.5%

Fig: Progressive, proportional and regressive tax system

6|Page

 Rates of tax: marginal and average rates of taxation (mrt, art)

The marginal rate of taxation (mrt) is the proportion of extra/increased income paid in tax.
Mathematically,

Marginal rate of taxation (mrt) = =

Example-1: if a person earns an extra/additional income of $100 and $30 is paid in tax then, the
marginal rate of taxation is = 0.3 (30%)

That is, 30 % of the extra income of $100 is paid in tax.

The average rate of taxation is the proportion of a person’s total income that is paid in tax.
Mathematically,

Average rate of taxation (art) = =

Example, if a person earns $50,000 and $10,000 is paid in tax then, average rate of taxation is = 0.2 or
20%.

That is, 20% of the person’s total income of $50,000 is paid in tax.

 Reasons for taxation

 To raise revenue to finance government spending on merit goods such as education, health care
services and public goods.
 The government also imposes taxes to influence aggregate demand. If the government wants to
reduce the aggregate demand it will raise the tax rates. For example, if the government aims at
achieving the objective of low and stable inflation, it will raise the tax rate to reduce the
aggregate demand.

On the other hand, if the government wants to increase the aggregate demand, it will reduce
the tax rates. For example, if the government aims at achieving the objective of full
employment, it will reduce the tax rate to increase the aggregate demand.

 A government may use progressive income tax to reduce income inequalities. Progressive
income tax narrows the gap between the disposable income of the rich and people on low
incomes. The gap could be further narrowed by the government using some of the tax revenue
to provide monetary benefits to those on low incomes.

 Taxes are also imposed to discourage the consumption of certain products. For example, taxes
are imposed on demerit goods in order to improve people’s health and environment.
7|Page

 Taxes are also imposed on imports to discourage imports and switch the consumer spending
from foreign goods to domestic goods.

 Types of government spending

Government spending can be divided into the following types:

 Transfer payments

A transfer payment is a payment of money for which there are no goods or services produced and
exchanged. Transfer payments commonly refer to efforts by the governments to redistribute money to
those in need. Government spending on transfer payments includes spending on unemployment
benefits, state pensions, interest payments on national debt etc.

 Current spending

Current government spending is spending on goods and services to provide state-financed services.
Current government spending covers, for instance, the spending on wages of teachers employed in state
schools and medicines used in state hospitals.

 Capital government spending

Capital government spending is the spending on capital goods used in the public sector. Capital
government spending includes, for instance, spending on building state schools and hospitals.

Government spending can also be divided into exhaustive and non-exhaustive spending. Exhaustive
government spending covers current and capital spending. It is the spending which uses resources and
is counted in aggregate demand and GDP.

Non-exhaustive government spending is spending on transfer payments. This spending does not
involve the government deciding how resources are used. The people who receive the payments make
the decision about how to use the resources.

 Reasons for government spending

 To influence the aggregate demand

 To influence the aggregate supply
 To avoid poverty and reduce income inequality
 To provide merit goods and public goods and overcome the problem of market failure
 To gain political popularity
8|Page

 AD/AS analysis of the impact of expansionary and contractionary fiscal policy on the
equilibrium level of national income and the level of real output, the price level and
employment

Expansionary fiscal policy involves increasing government spending and/or decreasing taxes.
Doing any of these things will increase aggregate demand, leading to a higher output, higher
employment, and a higher price level.

On the other hand contractionary fiscal policy involves reducing government spending and
increasing tax rates. It reduces the level of AD. This fall in AD leads to a lower output, lower
employment and a lower price level.

Fig: Effect of expansionary and contractionary fiscal policy on AD/AS model

5.3 Monetary policy

Monetary policy is the use of money supply and interest rate to influence the AD so as to achieve the
macroeconomic objectives.

Expansionary monetary policy (reflationary monetary policy) involves increasing money supply and
reducing interest rate to increase the AD. For example, if a government aims at achieving the objective
of full employment and high economic growth, it should use expansionary monetary policy.

Contractionary monetary policy (deflationary monetary policy) involves reducing money supply and
increasing interest rate to reduce the AD. For example, if a government aims at achieving the objective
of low and stable inflation and equilibrium in the BOP position, it should use contractionary monetary
policy.

 AD/AS analysis of the impact of expansionary and contractionary monetary policy on the
equilibrium national income and the level of real output, the price level and employment
9|Page

Expansionary monetary policy involves increasing money supply and reducing interest. Doing any of
these things will increase aggregate demand, leading to a higher output, higher employment, and a
higher price level.

On the other hand contractionary monetary policy involves reducing money supply and increasing
interest rate. It reduces the level of aggregate demand leading to lower output, lower employment and
a lower price level.

Fig: Effect of expansionary and contractionary monetary policy on AD/AS model

5.4 Supply-side policy

Supply side policy is the policy designed to increase the Aggregate Supply (AS) by improving the
workings of product market and factor market. It may increase or reduce the government intervention
in the price system.

Market-based supply side policies limit the intervention of the government and allow the free market
to eliminate imbalances. The forces of supply and demand are used to eliminate the imbalances.
 Privatisation and deregulation
 Reducing income tax rates.
 Deregulating labour Markets.
 Reducing the power of trades unions.
 Reducing unemployment benefits.
 Deregulate financial markets.
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 Increase free-trade.

Interventionist supply side policies rely on the government intervention in the market.
•increasing spending on the education and training of workers
•increasing spending on infrastructures
•provision of subsidies to private producer

 AD/AS analysis of the impact of supply-side policy on the equilibrium national income and the
level of real output, the price level and employment

Supply-side policies have the ability to increase labor productivity through decreasing income taxes,
increasing the mobility of labor, and through various training programs. This, in total, increases the real
output of the economy.

Supply-side policies can help reduce inflationary pressure in the long term because of efficiency and
productivity gains in the product and labor markets. They can also help create real jobs and sustainable
growth through their positive effect on labor productivity and competitiveness.

Fig: Effect of supply side policy

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Unit- 6: International economic issues (AS Level)

Contents included
International trade
Protectionism
Balance of payments
Exchange rate

 International Trade

It is the exchange of goods and services between the residents of different countries of the world.
International trade gives the benefit of international specialization where different countries or regions
specialize in the production of different goods. International specialization occurs on the basis of
availability of natural and human resources, technology, topography, climatic condition, comparative
advantage etc. International specialization increases the world production and consumption of goods
and services and thus the world economic welfare increases. The benefits of international trade can be
explained using the principles of absolute and comparative advantage.

 Principle of absolute (competitive or clear cut) advantage

According to this principle, countries can gain from trade with each other if they specialize in the
production of the goods in which they have absolute (clear cut) advantage. A country has an absolute
advantage in the production of a good if it can produce the good at a lower cost than its trading partner.
Specialization on the basis of absolute advantage enables the countries to produce the goods in surplus
quantities and they can gain by exchanging the surplus quantities of the goods they produce.

The principle of absolute advantage can be explained using the following example:

Table: Production possibility- absolute advantage

Countries / commodities Cloth Shoes

China 200 100
Korea 100 200
Fig: Production possibility curves- absolute advantage
2|Page

In the above example, China has an absolute advantage in producing cloth while Korea has an absolute
advantage in producing shoes. So, China should specialize in producing cloth while Korea in producing
shoes and both the countries will benefit by exchanging the surplus quantities of the goods they
produce.

Table: The gains from trade- absolute advantage

Countries/commodities Before Specialization After Specialization

(Half resources to each industry) (All resources to specialized industry)
Cloth Shoes Cloth Shoes
China 100 50 200 0
Korea 50 100 0 200
Total World production 150 150 200 200

As seen in the above schedule, before specialization and trade, allocating half resources to each
industry, China produces 100 units of cloth and 50 units of shoes. After specialization, allocating all the
resources to cloth production, it produces 200 units of cloth and thus it has a surplus of 100 units of
cloth.

On the other hand, before specialization and trade, allocating half resources to each industry, Korea
produces 50 units of cloth and 100 units of shoes. After specialization, allocation all the resources to
produce shoes, it produces 200 units of shoes and thus has a surplus of 100 units of shoes.

Now, if China and Korea exchange the surplus quantities of 100 units of cloth with 100 units of shoes,
China’s consumption of shoes will increase by 50 units while Korea’s consumption of cloth will increase
by 50 units. Thus, both the countries gain from trade with each other.

 Principle of comparative advantage

According to this principle, the difference in the domestic opportunity cost ratio between the
countries is the basis of international trade. Countries can gain from trade with each other if they
specialize in the production of the goods in which they have comparative advantage over their trading
partners. A country has comparative advantage in the production of a good if it has a lower
opportunity cost than its trading partner. However, the countries can gain from trade with each other
only if the Terms of Trade (TOT) lies within their domestic opportunity cost ratio.

The principle of comparative advantage can be explained using the following example:
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Table: Production possibilities- comparative advantage

Countries/commodities Bread Cheese

UK 500 250
France 400 100
Fig: Production possibility curves- comparative advantage

In the above example, UK has a comparative advantage in producing cheese while France has a
comparative advantage in producing bread. So, UK should specialize in producing cheese and import
bread from France while France should specialize in producing bread and import cheese from UK.

However, the countries will gain from trade only if the Terms of Trade (TOT) lies within their domestic
opportunity cost ratio. UK will gain from trade if it receives 1 unit of bread by giving up less than 0.5
units of cheese. For example, if it receives 1 unit of bread by giving 0.3 units of cheese, it will have a gain
of 0.2 units of cheese which it saves.

Similarly, France will gain from trade if it gets 1 unit of cheese by giving less than 4 units of bread. For
example, if it gets 1 unit of cheese by giving 2 units of bread, it will have a gain of 2 units of bread which
it saves.

According to this principle, countries will not trade with each other if they have the same domestic
opportunity cost ratio.

Table: Production possibilities with same domestic opportunity cost ratio

Countries/commodities Bread Cheese

UK 500 250
France 400 200
Fig: Production possibility curves with same domestic opportunity cost ratio
4|Page

In the given example, trade between the countries will not occur as they have the same domestic
opportunity cost ratio. The countries would produce everything themselves instead of trading with each
other.

Assumptions:

The principles of absolute and comparative advantage are based on the following assumptions:

 There are just two countries involved in trade

 The countries produce just two goods
 The cost of production and the opportunity cost are constant, shown by straight line PPCs.
 The countries have same resource endowments and technology
 Productivity differs between the countries
 There are no transportation costs involved in trade
 Trade between the countries is free
 Trade occurs in the form of barter

 Limitations of theory of absolute and comparative advantage

 These theories assume that there are only two countries producing two goods. But in practice,
there are many countries producing many goods and trade occurs between many countries
producing different goods.
 These principles assume that there is no transportion costs involved in trade. However, in
reality, this is not true. The existence of transportation costs may eliminate a country’s absolute
and comparative advantage and not make international trade worthwhile.
 It is assumed that trade between the countries is completely free but in reality there are likely to
be trade barriers like tariff, quota, embargo etc. imposed by the governments on trade between
the countries.
 It is also assumed that the factors of production (labor and capital) can switch between products
easily and they will work with same efficiency which in reality cannot happen.

 These theories exclude technology effects. Technological advances affect differences in labor
productivity. It also affects differences in the quality of capital goods in a country, not
considered in the model.
5|Page

Exercise:

1. Explain the difference between absolute and comparative advantage.

2. “The difference in the domestic opportunity cost ratio is the basis of international trade”.
Explain.
Or
Explain how the difference in the domestic opportunity cost ratio between the countries
explains the pattern of international trade.
3. Examine whether the principles of absolute and comparative advantage are the realistic models
to explain the benefits of trade.

 Benefits of specialization and free trade (trade liberalization), including the trading possibility
curve (TPC)

Specialization and free trade increases the world production of goods and services and enables the
countries to consume outside their PPCs. This benefit of specialization and trade can be explained using
the Trading Possibility Curve (TPC).

Example: Let us assume that the Terms of Trade (TOT) between UK and France is 1 Cheese= 3bread (1
bread= 0.33 cheese)

Countries/commodities Bread Cheese

UK 500 250
France 400 100

In the given example, UK has a comparative advantage in producing Cheese while France has a
comparative advantage in producing bread. So, UK specializes in producing Cheese while France
specializes in producing bread.

After specialization, allocating all the available resources to cheese production, UK produces a maximum
of 250 units of cheese. At the given TOT of 1 cheese= 3 bread, if UK exports all 250 units of cheese to
France, it will receive a maximum of 750 (250 x 3) units of bread. This is shown by UK’s TPC.

Fig: TPC and the benefit of trade - UK

6|Page

In the diagram,

Before specialization and trade, allocating half resources to each industry, UK produces and consumes
250 units of bread and 125 units of cheese. This is shown by point ‘a’ on its PPC. After specialization,
allocating all the available resources UK produces a maximum of 250 units of cheese. If it itself
consumes 150 units and exports the remaining 100 units to France, it will receive 300 units of bread in
return. Thus its consumption of cheese increases from 125 units to 150 units and its consumption of
bread increases from 250units to 300 units. Now, UK is able to consume at point ‘b’ on the TPC which
lies outside the PPC.

However, it cannot consume on the broken line segment of the TPC because the maximum quantity of
bread that France can produce is only 400 units. So, UK cannot receive more than 400 units of bread
from France.

Exercise:

 Use economic analysis to explain the benefits of specialization and trade.

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 Terms of Trade (TOT)

It is the rate of exchange of goods between the countries. It measures what quantity of imports that a
given quantity of country’s exports can purchase. For example, if the TOT between two countries is 1x =
2y then, an export of 1x can buy 2y while an export of 1y can buy 0.5x.

The TOT between countries changes over time with the change export and import prices. This change in
TOT is measured using the TOT index.

Mathematically,

TOT Index = x 100

= x 100

= x 100

Note: Base year TOT index is always 100 and base year export price and base year import price is
considered to be 100

Example 1: Since 2000, a country’s export price rises by 20% while its import price rises by 10%. Find the
country’s current year TOT index

TOT index = x 100

=109.09 ˃100

Interpretation:

Since the current year TOT index is greater than 100, the country’s TOT has improved. This means that a
given quantity of country’s exports can buy more imports in the current year than the base year. If in the
base year an export of 100x could buy 100y, in the current year an export of 100x can buy 109.09y.

Example 2: A country’s export price has fallen by 20 % while its import price has risen by 20 %. Calculate
the country’s current year TOT index. (Base year =2015)

TOT Index = x 100

= 66.66 ˂ 100

Interpretation: Since the current year TOT index is less than100, the country’s TOT has worsened. This
means that a given quantity of country’s exports can buy fewer imports in the current
year than the base year. If in the base year an export of 100x could buy 100y, in the
current year an export of 100x can buy only 66.66y.
8|Page

Note: A rise in export prices and a fall in import prices improve the country’s TOT while fall in export
prices and an increase in import prices cause the TOT to worsen.

Exercise-3:

A country’s TOT increased from a base year value of 100 to 120. In the following year its export prices
had increased by 50%. What was the change in price of country’s import?

TOT Index = x 100

=????

So, the country’s import price has increased by 25%.

Exercise:

A country’s export price has fallen by 10 % while its import price has risen by 30%. Calculate the
country’s current year TOT index. (Base year =2015)

TOT Index =

 Factors affecting terms of trade (TOT)

 Change in relative rate of inflation

If the rate of inflation in a country increases above its competitors, its export prices will rise while import
prices fall causing the TOT to improve and vice versa.

Example:
9|Page

TOT Index = x 100

= 150 ˃100

 Change in relative income (GDP)

If a country’s GDP increases, its demand for imports will increase. This will cause the import prices to
rise causing the TOT to worsen and vice versa.

 Change in exchange rate

A fall in exchange rate of the country’s currency reduces its export prices while the import prices rise.
This causes the TOT to worsen and vice versa.

 Change in quality of domestic products

An improvement in the quality of domestic products increases the demand for exports while the
demand for imports decreases. This raises the export prices while the import prices fall causing the TOT
to improve and vice versa.

 Change in relative productivity

An increase in the country’s productivity reduces the costs of production and hence the export prices
fall and imp0rt prices rise. This fall in export prices causes the country’s TOT to worsen and vice versa.

Exercise:
Explain what factors influence a country’s Terms of Trade.

 Impact of Changes in a Country’s Terms of Trade

 Impact on Living standards

An improvement in the terms of trade means that a country can buy a greater quantity of imports for
any given quantity of exports. This will increase the consumption of goods and services in an economy
causing the living standards of the citizens to improve.

 Impact on growth and employment

If the terms of trade improves because of growing demand for exports (leading to higher export prices),
it is likely that economic growth and employment levels will be maintained, or possibly improved.

But if the improvement is because of falling import prices, the rate of economic growth and
employment will fall.

 Impact on the balance of payments

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An improvement in the terms of trade may improve or worsen the country’s balance of payment
position. However, this depends on why the terms of trade have improved.

If a country’s export prices have risen because of a strong growth in demand from its trading partners, it
is likely that export earnings will increase and the BOP position may improve.

But if export prices have risen because the country has increasing costs of production, it is likely that
export earnings may fall, as the country’s exports become less competitive. This will worsen the
country’s BOP position.

 Impact on inflation

An improvement in the terms of trade because of falling import prices could result in lower inflation.
This is because prices of imported goods have fallen and the domestic producers feel the pressure to
lower prices to compete with imports.

A worsening of terms of trade could cause rising inflation. This is because the import of raw materials
and components become expensive causing the costs and prices to rise.

Exercise
Identify and explain the possible economic consequences of a worsening of a country's terms of trade.

6.2 Protectionism

Protectionism is the economic policy of restricting imports from other countries and increasing exports.
Although the free international trade increases the world economic welfare, countries use policies that
restrict free trade. Such policies are used to protect the domestic industries from foreign competition
and prevent the loss of jobs in the domestic economy. They are called protectionist policies as they give
competitive advantage to the domestic industries and protect them from the established foreign firms.
The protectionist policies are also called expenditure switching policies as they switch or redirect the
consumer spending from foreign goods to domestic goods.

Some of the protectionist policies used by the countries are:

 Tariff
 Import quotas
 Embargo
 International trade subsidies (export subsidies)
 Economic and administrative burdens (‘red tape’)
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Tariff

A tariff is a tax on imports. It is of two types-specific and ad valorem. A specific tax is imposed per unit
of imports while ad valorem tax is imposed as a percentage of prices of imports.

Imposition of tariff on imports raises the prices of imports by the amount of tariff imposed. As the prices
of imports increase the domestic consumers switch to the domestic products which have now become
more competitive. This increases the demand for domestic products. Thus the domestic industries are
protected and jobs are saved in the domestic economy.

Fig: Effect of a tariff on wheat imports

In the diagram,

Before tariff,

Price of wheat =
Total qty. of wheat consumed=
Supply of wheat by domestic producers=
Total revenue of domestic producers=
Total quantity of wheat import =
Total revenue of the suppliers of import=

After tariff

Tariff per unit=

Government’s tax revenue from tariff=
Total qty. of wheat consumed =
Supply of wheat by domestic producers=
Total revenue of domestic producers=
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Total quantity of wheat import=

Total revenue of the suppliers of import=

In the above diagram, before tariff, ‘OQ2’ tons of wheat was being consumed at price of Pw. Domestic
production was ‘OQ1’ and imports were Q1Q2. When the tariff is imposed, the world supply curve shifts
upward by the amount of tariff and the market price rises to ‘PW +T’. The total quantity demanded falls
from ‘OQ2’ to ‘OQ4’ because the price has risen.

Domestic producers increase production from ‘OQ1’ to ‘OQ3’ and so their revenue increases from ‘g’ to
‘g + a + b + c + h’. Foreign producers supply the rest, which is now ‘Q3Q4’. They receive the price ‘PW + T’
but have to pay the tariff to the government. Thus, their revenue falls from ‘h + I + j + k’ to only ‘I + j’.
The government now receives tariff revenue of ‘d + e’.

‘Q4 Q2’ tons of wheat is now not demanded. Consumers keep the amount ‘k’ that they would have spent
on the wheat, but there is a loss of consumer surplus equivalent to ‘f’ because the wheat is not
purchased now. This is known as dead-weight loss of welfare because of the loss of consumer surplus.

After the imposition of tariff, ‘Q1 Q3’ tons of wheat is now produced by the less efficient domestic
producers, as opposed to more efficient foreign producers. The foreign producers would produce this
quantity for minimum revenue of ‘h’ whereas; the domestic producers need minimum revenue of ‘h +
c’. Thus ‘c’ represents the inefficiency of domestic producers and a loss of world efficiency, since more
of the world’s resources are being used to produce the good than are necessary. This is another dead-
weight loss of welfare

 Import Quotas

It is a quantitative restriction on imports. It sets a legal limit to the maximum quantities of goods that
the domestic traders can import over a period of time. For example, the EU imposes import quotas on
Chinese garlic and mushrooms.

Setting of import quotas reduces the supply of imports in the domestic market and their prices rise. As a
result, the domestic consumers switch to the domestic products which have now become more
competitive. This increases the demand for domestically produced goods and the domestic industries
grow. Thus the domestic industries are protected and jobs are saved in the domestic economy.

The main difference between tariff and quota is that tariff generates revenue for the government while
quota benefits the traders as they can sell the imports at higher prices.

The following diagram shows the effect of import quotas on a good:

Fig: A quota on wheat import

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In the above diagram, before the quota is imposed, ‘OQ2’ of wheat is purchased at a price of ‘Pw’.
Domestic supply is ‘OQ1’ and the imports are ‘Q 1Q 2’. Let us now assume that the government imposes a
quota of ‘Q 1Q 3’ tons of wheat.

Domestic producers supply ‘OQ1’ at a price of ‘Pw’ and the importers supply their quota of ‘Q1Q3’.
However, once this has happened, there is an excess demand of ‘Q3Q2’ at the price ‘Pw’ and so price
begins to rise. As the price rises, importers are not allowed to supply more wheat, because they have
filled their quota. So, now attracted by the higher price of wheat, the domestic producers begin to enter
the market. As a result, the domestic supply curve has shifted to the right, above ‘Pw’. Eventually, the
price settles at ‘PQuota’ where demand now equals supply again and the total quantity of wheat
demanded falls to ‘Q4’.

Domestic producers now supply ‘OQ1’ and ‘Q3Q4’ tons of wheat at a price of ‘PQuota’. Thus, their revenue
rises from ‘a’ to “a+ c+ d+ f + I + j”. Foreign producers now supply their quota of ‘Q1Q3’ tons of wheat
and also receive a price of ‘Pquota’. Thus, their income changes from ‘b + c + d + e ’ to ‘b + g + h’. This is
usually a fall in income but, in theory, it does not have to be.‘Q4Q3’ of wheat is now demanded.
Consumers keep the amount ‘e’ that they would have spent on the wheat, but there is a loss of
consumer surplus equivalent to ‘k’, because the wheat is not purchased now. This is a dead-weight loss
of welfare, because of the loss of consumer surplus.

After the quota, ‘Q3Q4’, tons of wheat is now produced by less efficient domestic producers as opposed
to more efficient foreign producers. The foreign producers would produce this quantity for minimum
revenue of ‘c + d’, whereas the domestic producers need minimum revenue of ‘c + d + j’. Thus ‘ j
’represents the inefficiency of domestic producers and a loss of world efficiency, since more of the
world’s resources are being used to produce the wheat than are necessary. This is another dead-weight
loss of welfare.

 Embargo

It is a complete ban on the import of some selected commodities by a country. A country imposes
embargo when the domestic producers are able to meet the domestic demand for the commodities.
Imposing embargo forces the domestic consumers to switch to the domestic products as imports are not
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at all available in the domestic market. Thus the domestic industries are protected and jobs are saved in
the domestic economy.

 International trade subsidies (Export subsidies)

In this option, government provides direct subsidies to the domestic producers. This makes the domestic
producers more competitive and their costs fall by the amount of subsidy. This fall in costs encourages
the domestic producers to increase production and hence the supply shifts to the right. This means that
a higher quantity of the domestic demand is met by the domestic producers and hence imports fall. The
demand for domestic good also increases in the foreign market as the foreign consumers find the
domestic goods more competitive. Thus the domestic industries are protected and the loss of jobs is
prevented in the domestic economy.

Fig: A subsidy on domestic wheat production

In the above diagram, before subsidy ‘OQ2’ tons of wheat was being consumed at a price of ‘Pw’.
Domestic production was ‘OQ1’ and the imports were ‘Q1Q2’. When the subsidy is granted, the supply
curve shifts rightward. This shows the costs decrease by the amount of subsidy provided by the
government. The market price stays at ‘PW’ and so the demand remains at ‘OQ2’.

However, domestic producers increase production to ‘OQ3’, because they are now receiving a price of ‘PW
+ subsidy’. This means that their revenue increases from ‘a’ to ‘a + b + e + f + g’. Foreign producers
supply the rest which is now ‘Q3Q2’. Thus their revenue falls from ‘b + c + d’ to only ‘c + d’. The
government pays the subsidy, which is shown by the area ‘e + f + g’ in total.

‘Q1Q3’ tons of wheat is now produced by less efficient domestic producers as opposed to more efficient
producers. The foreign producers would produce this quantity for minimum revenue of ‘b’ whereas the
domestic producers need minimum revenue of ‘b + g’. Thus ‘g’ represents the inefficiency of the
domestic producers and a misallocation of world’s resources, since more of the world’s resources are
being used to produce the wheat than are necessary. This is the dead-weight loss of welfare.

There is no loss of consumer surplus because the price of the wheat does not change. However,
consumers are indirectly affected as governments will use tax revenue to fund the subsidies. This may
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mean higher tax payment and also involve an opportunity cost in terms of reduced government
spending on other things.

 Administrative and economic burden (red tape)

When goods are being imported, there are usually administrative processes to be undertaken. If
these processes are lengthy and complicated then they can act as a restriction to imports. This is
refered to as red-tape. For example, making importers go through complicated paperwork before
they can get their goods into the country will slow down imports. In addition, if the paperwork
requires a large amount of legal work, then it will slow down the process even more and raise the
costs to the importers. Sometimes, countries may designate certain ports of entry that are difficult
to reach and also more expensive. This may cause border delays and again raise costs.

Exercise

Explain any two protectionist policies used by the countries to protect the domestic industries from
foreign competition.

 Arguments for and against trade control/protectionism

 Arguments for trade protection/advantages of trade protection:

• Protection of infant or sunrise industries (Infant industry argument)

An infant industry that is just established and developing may not have the economies of scale that large
industries in other countries may enjoy. The infant industries will not be competitive against foreign
imports until they can gain the cost advantage of economies of scale. Because of this, it is argued that
the infant industries need to be protected against imports until they achieve a size where they can
compete on an equal footing.

• Protection of strategic industries (Strategic industry argument)

Some governments seek to protect the industries that produce the products that are regarded as
strategic, such as weapons, fuel and food. They may not want to be dependent on foreign supplies of
these products. For example, a government may be worried that firms and households in its country
would be seriously disadvantaged if fuel was cut off due to a trade dispute or a military conflict. As a
result, it may protect some home industries producing such strategic goods even if they are relatively
inefficient.

• Health, safety and environmental standards

A country might wish to impose safety, health or environmental standards on goods being imported into
its domestic market in order to ensure that the imports match the standards of domestic products. For
example, the EU banned the imports of beef from US in the 1980s because it was treated with
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hormones. The WTO allows countries to impose such bans as long as the barrier is based on scientific
evidence and as long as the country imposing the ban does not discriminate between the countries
where similar products are traded.

• To prevent dumping (Anti-dumping argument)

Dumping is the selling by a country of large quantities of a commodity, at a price lower than its
production costs, in another country. For example, the EU may have a surplus of butter and sell this at a
very low price to a small developing economy. This may ruin the domestic producers in the developing
country. Where countries can prove that their industries have been severely damaged by dumping, their
governments are allowed, under international trade rules, to impose anti- dumping measures to reduce
the damage.

• Balance of payments correction (Balance of payment argument)

Governments sometimes impose protectionist policies in an attempt to reduce import expenditure and
thus improve a current account deficit whereby a country is spending more on imports of goods and
services than it is earning from its exports of goods and services.

• Government revenue

In many developing countries, it is difficult to collect taxes and so governments impose import taxes
(tariffs) on products in order to raise revenue.

• Protection of jobs (Employment argument)

At any given time in an economy there will be some industries that are in decline (sunset industries)
because they cannot compete with more efficient foreign firms. If such declining industries are large in
numbers, there will be high levels of structural unemployment in the economy. Governments often
attempt to protect such industries in order to avoid this unemployment.

 preventing exploitation of workers (Pauper labor argument)

It is sometimes argued that trade restrictions should be imposed on products from countries where
wages are very low. The view is that, in order to compete with the more efficient foreign firms, the
domestic producers reduce the wages of their workers which, in turn, worsens their living standard.
Imposing trade restrictions increases the demand for domestic products. To increase production the
domestic producers must employ more resources including labor. This increases the demand for labor
and their wages increase. Thus the exploitation of labor in the domestic economy is prevented.

 Arguments against trade protection/disadvantages of trade protection:

• Misallocation of resources
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The imposition of tariffs, or other protectionist measures, in the long run results in losses of allocative
efficiency. Protected producers are not exposed to international competition, do not have enough
incentive to decrease costs or innovate and, in the long run, become less competitive and fall behind the
rest of the world. In addition, tariffs increase prices in the domestic market and distort the price signals
directing investments towards inefficient industries.

• Retaliation and trade war

Protectionist measures tend to be met with some form of retaliation. This will mean that any success in
protecting against imports is likely to result in a fall in exports and chances of trade war.

• Increased costs

Imposition of protectionist policies raises the prices of imported raw materials and components. This
will increase the costs of producing the finished products in the domestic economy.

• Higher prices

Imposition of protectionist policies like tariff, quota etc. raises the prices of goods and services which, in
turn, reduces the level of consumption and consumer welfare is lost.

• Less choice

A key effect of trade protectionism is that consumers will have a limited choice of products and goods
since there may be quotas on how much may be imported. Due to these quotas, consumers will have a
very limited choice as to the quantity, quality, and type of product that would otherwise be available to
them without trade protectionism.

• Domestic firms lack incentive to become more efficient

Competition would diminish if foreign firms are kept out of a country, and so domestic firms may
become inefficient without the incentive to minimize costs. Innovation may also be reduced for the
same reason.

• Reduced export competitiveness

Imposition of protectionist policies raises the costs of producing goods and services in the domestic
economy and thus the export competitiveness of a country is reduced.

Exercise
Explain the “infant industry argument” and “anti-dumping argument” in favor of protectionism.

6.3 Balance of Payment (BOP)

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It is the record of the flow of money between the countries that arises from all types of international
transactions. Money received for exports is recorded as a credit (+) entry while the money paid for
imports is recorded as a debit (-) entry. Following the simple accounting principle, every credit entry (+)
is matched by a debit entry (-).

Equilibrium in BOP position occurs when the credit (+) is matched by the debit (-) entry. BOP
disequilibrium occurs when there is a difference between credit entry and debit entry. BOP deficit arises
when the credit entry is less than the debit entry while BOP surplus arises when the credit entry
exceeds the debit entry.

A country’s BOP is comprised of the following four components:

 Current account
 Capital account
 Financial account
 Net errors and omissions

 Current account of the balance of payments

The current account of BOP consists of the following four sections:

 Trade in goods
 Trade in services
 Income (Net Investment Income)
 Current transfers

 Trade in goods
This section records the flow of money arising from the exports and imports of goods (visible items),
that is, items that can be seen, touched, weighed and counted. For example, if UK exports garments to
Germany, it would be recorded as a credit entry while if UK imports cars from Germany it would be
recorded as a debit entry in the current account of UK’S BOP. The difference between the export and
import of goods is called Balance of Trade in goods or visible balance. So,
Balance of Trade in goods or visible balance = Export of goods - import of goods

 Trade in services
This section records the flow of money arising from the export and import of services (invisible items).
For example, if the residents of UK buy the air flight tickets of foreign airline companies, it would be
recorded as a debit entry while if the foreign residents visit UK for health care services it would be
recorded as a credit entry. The difference between the export and import of services is called invisible
balance.

Invisible Balance = Export of services – import of services

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Note:

 Income (Net Investment Income) or primary income

This section records the income generated from foreign direct investments (FDI) or portfolio
investments. For example, if the British investors buy the shares of foreign companies then, the
dividends or interest received will be recorded as a credit entry while if the foreign investors invest in
the UK then, the interest or dividends paid to foreign investors will be recorded as a debit entry in the
income section of UK’s current account.

 Current transfers or secondary income

This section records the transfer of income made by private individuals, organizations as well as the
central governments. For example, if the central government of UK provides relief fund to the
earthquake victims of Turkey, it would be recorded as a debit entry while if a foreign resident sends a
gift of cash to his friend in the UK, it would be recorded as a credit entry. This section also records the
money sent home by the migrant workers.

Table: Current account balance of country ‘A’ in 2018(in million dollars)

Sections Credit (+) Debit(-) Balance
 Trade in goods 4628 4812 -184
 Trade in services 5081 4925 156
 Income (Net Investment 7824 7765 59
income) or Primary Income
 Current Transfers or 2908 2762 146
secondary income
Current account balance 20441 20264 177

Here,
Balance of trade in goods or visible balance = 4628- 4812= -184 (deficit)
Balance of trade in services or Invisible balance = 5081- 4925 = 156 (Surplus)
Balance of trade (BOT) total trade balance = - 184 + 156 = - 28 (deficit)

Current account balance =20441- 20264 = 177 (surplus)

Primary income = 7824 – 7765 = 59
Secondary income = 2908 – 2762 = 146

 Causes of imbalances in the current account of the balance of payments

Equilibrium/balance in the current account of BOP occurs when the credit (+) is matched by the debit (-)
entry. Disequilibrium/imbalance in current account occurs when there is a divergence between credit
entry and debit entry. Current account deficit arises when the credit entry is less than the debit entry
while current account surplus arises when the credit entry exceeds the debit entry.
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 Causes of current account deficit

Deficit in the current account of BOP may be caused due to number of factors. Some of them include:

 Overvalued exchange rate

If the currency is overvalued, imports will be cheaper, and therefore there will be a higher quantity of
imports. Exports will become uncompetitive, and therefore there will be a fall in the quantity of exports

 Economic Growth

If there is an increase in national income, people will tend to have more disposable income to consume
goods. If domestic producers cannot meet the domestic demand, consumers will have to import goods
from abroad. Therefore if there is fast economic growth there tends to be a significant increase in the
quantity of imports and deterioration in the current account.

 Decline in competitiveness of export Sector

There might be a decline in the competitiveness/export sector in a country because it has to struggle to
compete with the other developing countries. This has led to a persistent deficit in the balance of trade

 Higher Inflation

If India’s inflation rises faster than our main competitors then it will make India’s exports less
competitive and imports more competitive. This will lead to deterioration in the current account.
However, inflation may also lead to depreciation in the currency to offset this decline in
competitiveness.

 Developmental activities

Developing countries depend on developed nations for supply of machines, technology and other
equipment. This leads to increased levels of imports, thereby, resulting in a deficit in the current
account.

 Recession in other countries

If a country’s main trading partners experience negative economic growth, then they will buy less of our
exports, worsening the India’s current account.

 Demonstration Effect
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When the people in underdeveloped countries come in contact with those of developed countries, they
start adopting the foreign pattern of consumption. Due to this reason, their imports increase and it
leads to an adverse BOP for underdeveloped countries.

 Low productivity

Low labor productivity raises the cost of production and makes the domestic products less competitive.
This reduces the exports and increases the imports leading to deficit in the current account of BOP.

 Consequences /effects of current account deficit

 Unemployment

When a country persistently experiences a trade deficit there are predictable negative consequences
that can affect economic growth and stability. If imports are more in demand than exports, domestic
jobs may be lost to those abroad.

 Fall in the value of currency

Increased imports and decreased exports reduce the demand for country’s currency in the foreign
exchange market while the supply of currency decreases. This causes the value of country’s currency to
fall (depreciate) in the foreign exchange market.

 Inflation

A persistent deficit in the current depreciates the value of a country’s currency. This fall in value of
currency raises the import prices. If a country needs to import raw materials, components and
technologies from other countries, it will have to pay higher prices. Thus, the costs of production
increase causing inflation to occur in the domestic economy.

 Rise in interest rates

A persistent trade deficit can often have adverse effects on the interest rates in that country. A
downward pressure on a country's currency causes a depreciation of exchange rate. This fall in exchange
rate raises the AD leading to higher inflation. With inflation occurring in an economy, the rate of interest
also rises.

 Increased debt burden

Growing current account deficits lead to rising external debt. Hence, a major proportion of country’s
GDP has to be spent on debt servicing. This will have serious consequences for financial stability and
future economic growth.
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Exercise
Discuss the causes and consequences of current account deficit.

 Causes of current account surplus

 High income abroad
 Low income in the domestic economy
 Fall in exchange rate
 Low relative inflation
 Gains in comparative advantage
 Rise in factor productivity

 Consequences of current account surplus

 Rise in GDP/economic growth

 Rise in price level (demand- pull inflation)
 Increase in foreign exchange reserve
 Appreciation of exchange rate

Exercise
Discuss the causes and consequences of current account surplus.

6.4 Exchange rates

Exchange rate is the value of a country’s currency in relation to other countries’ currencies. For
example, if the pound-dollar exchange rate is £1=$2, then the residents of US have to pay $2 for £1
while the residents of UK have to pay £0.5 for $1.

 Foreign exchange market

It is composed of all those banks and financial institutions that deal in foreign currencies such as
commercial banks, exchange banks, money exchange etc.

 Demand for currency

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Demand for a country’s currency comes from the residents of other countries. The demand for a
country’s currency arises in the foreign exchange market when:

 The residents of other countries buy the domestic products of the country
 The foreign residents visit the country for various purposes
 The foreign investors invest in the country

For example, the demand for pound (£) arises in the foreign exchange market when:

 The foreign residents buy the British goods and services

 The foreign residents visit the UK for various purposes like education, health care services,
holidays etc.
 The foreign investors invest in the UK

Fig: Demand for pound (£)

 Supply of currency

Supply of a country’s currency comes from the residents of the country. Supply of currency in the
foreign exchange market arises when:

 The domestic residents buy the foreign goods and services

 The domestic residents visit the foreign countries
 The domestic investors invest in the foreign economies

For example, the supply of pound (£) arises in the foreign exchange market when:

 The British residents buy the foreign goods and services.

 The British residents visit the foreign countries
 The British investors invest in the foreign economies

Fig: Supply of pound (£)

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 Determination of exchange rate under the floating (or flexible) exchange rate system
Under the floating exchange rate system, the exchange rate is determined by the free interaction of the
forces of demand and supply of currency in the foreign exchange market. The equilibrium exchange rate
is established when the demand for currency becomes equal to the supply of currency and the foreign
exchange market reaches a state of equilibrium.
Fig: Determination of floating exchange rate

In the diagram, the pound-dollar exchange rate is P (£1=$2) which is determined by the free interaction
of the market forces of demand and supply of pound (£) in the foreign exchange market. This means
that the residents of US have to pay $2 for £1 while the residents of UK have to pay £0.5 for $1.
If the pound-dollar exchange rate was at P2 (£1=$3) then, there would have been a disequilibrium of
excess supply of pound in the foreign exchange market. This excess supply of pound would put pressure
on the pound-dollar exchange rates to fall to P which is the equilibrium exchange rate.
25 | P a g e

On the other hand, if the pound-dollar exchange rates were at P1, there would have been disequilibrium
of excess demand of pound in the foreign exchange market. This excess demand for pound would put
pressure on the pound-dollar exchange rates to rise to P which is the equilibrium exchange rate.

Exercise
What is floating exchange rate system? Explain how the equilibrium exchange rate is determined
under the floating exchange rate system.

 Causes of changes in a floating exchange rate: demand and supply of the currency

The floating exchange rate may change because of the following reasons:

 Change in relative rate of inflation

Eg. If the rate of inflation in UK is higher than its competitors, demand for its exports will fall while the
demand for its imports will rise. This will reduce the demand for pound (£) while the supply of pound (£)
increases in the foreign exchange market. This will cause the pound exchange rate to fall and vice versa.

 Change in relative income (GDP)

Eg. If the GDP in UK increases, demand for its imports will rise, causing the supply of pound to rise.
Demand for pound being unchanged, this rise in supply of pound will cause the pound exchange rate to
fall and vice versa.

 Change in relative rate of interest (return on investments)

Eg. If the rate of interest in UK falls below that of its competitors, Foreign Direct Investments (FDI) in UK
will fall while the British investors will invest more in the foreign economies. This will reduce the
demand for pound (£) while the supply of pound (£) increases in the foreign exchange market causing
the pound exchange rate to fall and vice versa.

 Change in relative investment prospects

Eg. If the investment prospect in UK becomes better than that of its competitors, FDI in UK will increase
and the domestic investors will invest in the UK instead of foreign economies. This will increase the
demand for pound (£) while the supply of pound (£) will decrease in the foreign exchange market. Thus
the pound exchange rate will rise and vice versa.

 Change in the quality of domestic products

Eg. An improvement in the quality of British goods will increase UK’s exports while its imports will fall.
This will increase the demand for pound while its supply decreases in the foreign exchange market. Thus
the pound exchange rate rises and vice versa.
Exercise
26 | P a g e

Explain how the equilibrium exchange rate is determined under the floating or flexible exchange rate
system and what factors cause the floating exchange rate to it change.

 Distinction between depreciation and appreciation of a floating exchange rate

The floating exchange rate changes if there occur any change in the market forces of demand and supply
of currency in the foreign exchange market. For example, supply of pound (£) being unchanged, if the
demand for pound increases in the foreign exchange market, the excess demand for pound will put
pressure on the pound exchange rate to rise. A country’s currency may appreciate or depreciate
following the changes in the demand and/or supply of currency in the foreign exchange market.

 Appreciation of exchange rate

It means an increase in the value of a country’s currency in relation to other countries’ currencies.
Example, if the pound-dollar exchange rate is £1=$2, the residents of US have to pay $2 for £1. Now if
the pound exchange rate appreciates, the residents of US will have to pay more than $2, say $3 for £1.

The exchange rate of a country’s currency appreciates if its demand increases in the foreign exchange
market. The demand for a country’s currency increases in the foreign exchange market when:

 The foreign residents buy more of the country’s goods and services
 The foreign residents visiting a country increases
 The foreign investors invest more in the country

For example, demand for pound (£) increases in the foreign exchange market when:

 The foreign residents buy more British goods and services

 The foreign residents visiting the UK increases
 The foreign investors invest more in the UK

Fig (a): Appreciation of pound (£) exchange rate

Alternatively, the exchange rate of a country’s currency appreciates if its supply decreases in the foreign
exchange market. The supply of a country’s currency may decrease in the foreign exchange market
when:
27 | P a g e

 The residents of the country buy less of foreign goods and services
 The residents of the country visiting foreign countries decreases
 The domestic investors invest less in the foreign economies

For example, supply of pound (£) decreases in the foreign exchange market when:

 The residents of UK buy less foreign goods and services

 The residents of UK visiting foreign countries decreases
 The British investors investing in the foreign economies decreases

Fig (b): Appreciation of pound exchange rate

 Depreciation of exchange rate

It means a fall in the value of a country’s currency in relation to other countries’ currencies. Example, if
the pound-dollar exchange rate is £1=$2, the residents of US have to pay $2 for £1. Now if the pound
exchange rate depreciates, the residents of US will have to pay less than $2, say $1 for £1.

The exchange rate of a country’s currency may depreciate if its demand decreases in the foreign
exchange market. The demand for a country’s currency decreases in the foreign exchange market when:

 The foreign residents buy less of the country’s goods and services
 The foreign residents visiting the country decreases
 The foreign investors invest less in the country

For example, demand for pound decreases in the foreign exchange market when:

 The foreign residents buy less British goods and services

 The foreign residents visiting the UK decreases
28 | P a g e

 The foreign investors invest less in the UK

Fig (a): Depreciation of pound exchange rate

Alternatively, the exchange rate of a country’s currency depreciates if its supply increases in the foreign
exchange market. The supply of a country’s currency increases in the foreign exchange market when:

 The residents of the country buy more foreign goods and services
 The residents of the country visiting foreign countries increases
 The domestic investors invest more in foreign economies

For example, the supply of pound (£) increases in the foreign exchange market when:

 The residents of UK buy more foreign goods and services

 The residents of UK visiting foreign countries increases
 The British investors invest more in the foreign economies

Fig (b): Depreciation of pound exchange rate

29 | P a g e

 Impact/ Effect of appreciation of exchange rate

 Appreciation of exchange rate means an increase in the value of a country’s currency in

relation to other countries’ currencies.

 A country’s currency appreciates if it experiences a surplus in the current account of its BOP
position. When a country experiences a surplus in its current account, its exports increase
while imports decrease. This causes the demand for currency to increase while the supply of
currency decreases in the foreign exchange market. Hence, the excess demand causes the
exchange rate to appreciate.

Fig: Current account surplus and appreciation of exchange rate

30 | P a g e

 Impact/effect of appreciation of exchange rate

 Unemployment increases as demand for domestic goods decreases both in the domestic and
foreign market
 Economic growth rate slows down as AD falls
 Lowers cost-push inflation as import of raw materials and capital goods becomes cheaper and
demand-pull inflation falls as AD falls
 Current account surplus will be replaced by deficit as import spending will rise and export
earnings will fall.

Fig: The reverse J-Curve

 Impact/effect of depreciation of exchange rate

 It means a fall in the value of a country’s currency in relation to another countries’ currencies
 A country’s currency depreciates if it experiences a deficit in the current account of its BOP
position
Fig: BOP deficit and depreciation of exchange rate

 Impact of depreciation of exchange rate

 Unemployment decreases and economic growth rate increases as AD increases

 Cost-push Inflation occurs as economy reaches full employment and demand-pull inflation
occurs as AD increases
 Import inflation occurs as import of raw materials and capital goods becomes expensive
31 | P a g e

 Inflation may also occur as the domestic producers increase their sales in the buoyant foreign
market that reduces the supply of goods in the domestic market
 Current account deficit is replaced by surplus as export earning rises and import spending falls

 Marshall- Lerner Condition

“A fall in exchange rate reduces the current account deficit only if the demand for export and import is
price elastic.” If the PED for exports and imports is greater than 1(elastic), a fall in exchange rate would
reduce import spending and increase export earning causing the current account deficit to decrease.

However, if a fall in exchange rate causes the AD to rise, it will increase inflation in the economy and
cause the current account deficit to increase in the long run.

 The J- curve effect

The J- curve effect is related to Marshall- Lerner Condition. It shows that a fall in exchange rate
increases the current account deficit before it starts to improve it. This is because the demand for
export and import is inelastic in the short run. So imports continue to be high and exports continue to be
low. In the long run, demand for imports and exports becomes elastic and hence a fall in exchange rate
reduces imports while exports increase. Thus the current account deficit decreases.

Fig: The J- Curve

 Advantages and disadvantages of floating exchange rate system

 Advantages

 Automatic stabilization
32 | P a g e

Under the floating exchange rate system any disequilibrium in BOP would be corrected by a change
in exchange rate. For example if a country suffers from a deficit in the BOP then, other things being
unchanged , the country’s currency will depreciate . This will restore the BOP equilibrium by making
the country’s exports cheaper and imports expensive.

 Freedom to make domestic policy

Under the floating exchange rate system the BOP deficit of a country would be corrected by the
change in exchange rate. This gives the government a freedom to pursue internal policy objectives
such as full employment, low inflation etc.

 Requirement of low foreign exchange reserves

Under the floating exchange rate system the governments need not maintain a large foreign
exchange reserve to develop the economy. This is because governments need not intervene in the
foreign exchange market to maintain the exchange rate. Hence the foreign exchange reserves can
fruitfully be used to import capital goods and other items in order to promote faster economic
growth.

 Flexibility and protection from external shocks

If the exchange rate is free to float then it can change in response to external shocks like rise in oil
prices. This will reduce the negative impact of any external shocks.

 Disadvantages

 Uncertainty and diminished trade

The risk and uncertainty associated with flexible exchange rates may discourage the flow of trade
between the countries. For example, suppose an US automobile dealer contracts to purchase 10
British cars for £150,000. At the current exchange rate of say, £1=$2, the US trader has to pay
$300,000 for these cars. But if during the three month delivery period the exchange rate changes to
£1=$3 then, the US trader will have to pay $450,000 for the same cars. This may turn the US trader’s
expected profit into loss.

 High risk of speculation

The day-to-day fluctuations in exchange rate may encourage speculative actions by the currency
speculators. This causes the speculative movement of “hot money” from country to country
resulting in more and mooring exchange rate fluctuations.

 Reduction of investment
The uncertainty created by frequent fluctuations in exchange rate can lead to fall in investment
internally as well as from abroad.
33 | P a g e

 Worsens the existing economic problem

If a country is already experiencing economic problems such as higher inflation or unemployment,
floating exchange rates may worsen the existing problems. For example, if a country suffers from
higher inflation, depreciation of its currency may drive the inflation rate higher because of increased
demand for its goods. However, the country’s current account may also worsen because of more
expensive imports.

Exercise
Discuss whether a floating exchange rate system brings only benefits to an economy.

 AD/AS analysis of the impact of exchange rate changes on the domestic economy’s
equilibrium national income and the level of real output, the price level and employment

 Measures of exchange rate

 Nominal Exchange rate
It is the number of units of the domestic currency that are needed to purchase a unit of a given
foreign currency. For example, if the pound dollar exchange rate is £1=$2 then, the residents of
US have to pay $2 for £1 while the residents of UK have to pay £0.5 for $1.

 Real effective exchange rate or real exchange rate

It is the value of a country’s currency in terms of its real purchasing power.
It takes into account the change in prices as well as the change in exchange rate to assess the
changes in the competitiveness of a country’s products in the global market. A fall in a country’s
exchange rate would make its exports more competitive. While if a country is experiencing
relatively high inflation rate, its export prices will increase making them less competitive.
A real exchange rate shows the price of domestic products in terms of foreign products.

Real exchange rate = Nominal exchange rate x (Foreign CPI / Domestic CPI)
Or
Real exchange rate = Nominal exchange rate x [(1 + Foreign inflation rate) / (1+
Domestic inflation rate)]

Example
In 2010, the Indonesian rupiah exchange rate against USD was around
34 | P a g e

IDR 15, 000 = 1USD and the consumer price index in Indonesia and the United States were at 100. In
2019, the exchange rate changed to IDR 14, 000=1USD. Simultaneously, Indonesia’s inflation rose 5%
due to the consumer price index rising to 105. Meanwhile, the United States’ inflation rate rose 10% due
to the consumer price index rising to 110.

Real exchange rate = 14,000 x (110/105) = IDR14, 666.67

Or
Real exchange rate = 14,000 x (1+10%)/ (1+5%) = IDR14, 666. 67

Here, the real exchange rate tends to be higher than the nominal exchange rate because the prices of
US products rise higher than the price increases for domestic products. Thus, in real exchange rates, the
domestic economy can buy only a few American products. This weakening purchasing power is reflected
in the real exchange rate, which is higher than the nominal exchange rate.

From this case, we can draw the following conclusions:

If the foreign inflation rate is higher than the domestic inflation rate, the real exchange rate will be
higher than the nominal exchange rate.

If the foreign inflation rate equals the domestic inflation rate, the real exchange rate will equal the
nominal exchange rate.

If the foreign inflation rate is lower than the domestic inflation rate, the real exchange rate will be lower
than the nominal exchange rate.

 Trade weighted exchange rate or multinational exchange rate

It is a measure, in index form, of the value of a currency against a basket of currencies. These are
weighted according to the relative importance of the currencies in the country’s trade. For example, if
India undertakes three times as much trade with china as it does with the US, the Chinese Yuan will be
given three times as much weight in the calculation as the US dollar.

Example:
Country X trades with only two countries, Nigeria and Malaysia.
80% of country x’s trade is with Nigeria and 20% is with Malaysia.
The original value of the trade – weighted rate index is 100.
The value of country X’s currency against the Nigerian Naira rises by 10%.
The value of country X’s currency against the Malaysian ringgit rises by 50%.
What will be the value of Country X’s new trade –weighted exchange rate index?
35 | P a g e

Trade-Weighted Index (TWI) = (Exchange rate 1 x Weight 1) + (Exchange rate 2 x Weight 2) +……..+
(Exchange rate n x weight n) / (Weight 1 + Weight 2 +……+ Weight n)
= (110 x 0.8) + (150 x 0.2) / 1
= 118

Here, the purchasing power of country X’s currency has increased as the trade-weighted index has
increased.

6.5 Policies to correct imbalances in the current account of the balance of payments

Most governments seek to achieve balance of payments stability, with money entering the country
equaling money leaving the country. If export revenue equals import expenditure, the country will not
get into international debt. It will also not be giving up the opportunity to buy foreign products that it
can afford.

In the short run, however, a government may welcome more being spent on imports than earned from
exports if this arises from more raw materials and capital goods being imported. A deficit also allows a
country to consume more goods and services than it is producing. However, in the long run a
government may encourage a surplus of export revenue over import expenditure in order to boost
aggregate demand and to provide funds to repay external debt.

 Use of fiscal policy to correct imbalance in the current account of balance of payments

In order to reduce a deficit in the current account of its BOP a country may use contractionary fiscal
policy that includes increasing income tax and reducing government spending.

A rise in income tax will reduce disposable income, leaving less income for household to spend on
imports as well as on domestic products. It also put pressure on the domestic producers to increase
exports as the demand for goods decreases in the domestic market.

Lowering government spending will directly reduce demand for goods and services which may reduce
imports and put pressure on domestic firms to increase their exports.

If a government is seeking to reduce current account surplus, it could use expansionary fiscal policy
that includes lowering income tax and increasing government spending. This will increase consumption
36 | P a g e

expenditure. More imports will be purchased and some products may be diverted from the foreign
market to the domestic market.

 Effectiveness or limitations of fiscal policy in achieving current account balance

Fiscal policy measures may alter current account position in the short term but are unlikely to be a long
term solution. This is because once the policy measures are stopped; households and firms are likely to
go back to spending the same amount on imports relative to the amount of export revenue earned.

Raising taxes may also have adverse side effects. They lower demand, which may increase
unemployment and lower economic growth in the domestic economy.

Higher income tax can also create disincentive effects and so may reduce aggregate supply.

Exercise
Evaluate the effectiveness of fiscal policies in correcting disequilibrium in the current account of BOP.

 Use of monetary policy to correct imbalance in the current account of balance of payments

To reduce the current account deficit a country may use contractionary monetary policy which involves
reducing money supply and increasing the rate of interest. Reducing the growth of money supply will
reduce the spending on imports and reduce the lending capacity of commercial banks. However, it can
be difficult to control the money supply.

Raising interest rate reduce the total spending in an economy causing the spending on imports to
decrease. They also put pressure on the domestic producers to increase exports to make up for a fall in
their sales in the domestic market.

To reduce a current account surplus, a government may use expansionary monetary policy. It involves
increasing the money supply and cut the rate of interest.

 Effectiveness limitations of monetary policy in achieving current account balance

37 | P a g e

In practice, it can be difficult to control money supply. This is because the commercial banks make most
of their profits by lending to their customers. So, they will try to increase their lending even if the central
bank sets limit on their lending.

Using interest rates suffers from the problem of time lag. There is a time lag between changing interest
rates and its effect being transmitted to the macro economy. Some economists have estimated that it
can take as long as 18 months for interest rate changes to have their full impact.

Raising interest may have adverse side effects in an economy. A high interest rate may also have
adverse effect on unemployment and economic growth.

Moreover, households and firms may not respond to the interest rate changes as expected by the
government. For example, government may increase the rate of interest with the expectation that
households and firms will increase saving and reduce spending on imports as well as on domestic
products. However, they may not do so if they expect their income and wealth to increase in the near
future.

Exercise
Evaluate the effectiveness of monetary policy in correcting disequilibrium in the current account of
BOP.

 Use of supply side policy to correct imbalance in the current account of BOP

Supply side policy measures can be used to reduce a current account deficit by making the domestic
products more competitive and by making the domestic market more attractive to invest in.
For example, deregulation and privatization may increase competitive pressure on the domestic firms
to keep the costs and prices low, to improve the quality of domestic products and to become more
responsive to changes in consumer demand.

Increased spending on education and training of workers and increased investment will increase labor
productivity and improve the quality of capital goods. This may reduce the costs and relative prices of
domestic goods and improve their quality. Hence the demand for country’s exports increases while its
imports decrease causing the current account deficit to decrease.

A skillful labor force and better quality capital goods may also attract foreign multinational companies
(MNCs) to set up branches in the country in the expectation that they will be able to produce better
quality goods at low costs. Such MNCs may contribute to the country’s exports.
38 | P a g e

Trade union reforms may enable the domestic firms to work with more flexibility and so be more
responsive to change in consumer demand. This may reduce imports and increase exports causing the
current account and financial account deficit.

 Effectiveness of supply side policies in correcting imbalance in the current account of BOP

 Some supply side policy measures may not be effective in the short term as they can take a long
time to have an effect. For example, increased spending on education and training of workers
will take a long time to improve the international competitiveness of domestic products

 The outcome of some supply side policy measures is uncertain. For example, cutting income tax
may encourage some workers to work for fewer hours if they are currently content with their
earning.

 Similarly, providing more education and training may not be very effective if it is not of a high
quality or it develops skills that will not be in demand in the longer term.

 Privatization may not result in increase in efficiency if the privatized industries become
monopolies and do not take into account the externalities (external costs and benefits).

 Providing subsidies to firms may not always result in lower prices of domestic products. This is
because the firms may not pass on the subsidies to the consumers and the payment of subsidies
may make the domestic firms lazy. There is also a risk that subsidies may provoke retaliation as
foreign firms may see them as unfair competition

Exercise
Evaluate the effectiveness of supply side policy measures in correcting disequilibrium in the current
account of BOP.

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39 | P a g e
1|Page

A Level
Unit 7.1: Utility theory
Worksheet-1

1. The table shows the marginal utility derived by a consumer who devotes the whole of his weekly
income of $32 to two goods X and Y, whose unit prices are $2 and $4 respectively.

In order to maximise his utility, which quantities of X and Y should the consumer purchase?

2. The table shows the marginal utility that a consumer obtains from consuming successive units of
good X.

The price of good X is $4.

What additional information is needed to determine the quantity of X that the consumer will
purchase?
A the consumer’s income elasticity of demand for good X
B the consumer’s price elasticity of demand for good X
C the marginal utility of money to the consumer
D the marginal utility that the consumer obtains from substitute goods
2|Page

3. A household makes the following purchases of fruit.

The household derives twice as much utility from the fifth kg of bananas as from the tenth kg of
apples.
What should the household do to maximise utility from the purchase of these fruits?

4. A utility-maximising consumer spends his disposable income on food and clothing. When his
weekly income is $40 he buys 5 units of food at a unit price of $5. His marginal utility from food
consumption is 10 utility units.
If the price of a clothing unit is $0.50, the consumer's marginal utility from clothing is
A equal to that derived from food.
B utility unit.
C 1 utility unit.
D 10 utility units.

5. What is not held constant when calculating the income effect of a change in the price of a good?
A the consumer’s money income
B the consumer’s preferences
C the consumer’s real income
D the prices of other goods

6. A consumer allocates his expenditure between three goods, X, Y and Z.

The table shows the prices of goods and the consumer's marginal utilities.

How should the consumer's expenditure be reallocated in order to maximise his utility?
3|Page

7. What explains the slope of an individual’s demand curve for a normal good?
A market imperfections
B the law of variable proportions
C diminishing returns
D diminishing marginal utility

8. The relative prices of goods reflect their marginal utilities rather than their total utilities.
What is explained by this statement?
A the law of diminishing returns
B the limitations of marginal utility theory
C the paradox of value
D the role of prices as a rationing mechanism

9. The table shows the total utility that an individual derives from consuming different quantities of a
good.

The individual's marginal utility of money is $1 = 2 units of utility.

What is the maximum quantity of the good that the individual will buy when its price is $6?
A 2 units B 3 units C 4 units D 5 units

10. The diagram shows the marginal utility that an individual derives from a good at different levels of
consumption.

The utility he derives from the last $ he spends on every good is 2 units.
Assuming the marginal utility of money is constant, which quantity will he purchase if the price of
the good is $20?
A 4 units B 5 units C 6 units D 7 units
4|Page

11. A consumer seeks to maximise their utility. Up to what point should they continue to consume
each good?
A until the marginal utility from each good is the same
B until the marginal utility per dollar from each good is the same
C until the marginal utility from each good reaches a maximum
D until the marginal utility from each good is zero

12. A consumer allocates his expenditure between three goods, X, Y and Z.

The table shows the consumer's marginal utilities for these goods and their prices.

How should the consumer's expenditure be reallocated in order to maximise his utility?

13. The table shows the total utility that an individual derives from consuming different quantities of a
good.

The individual’s marginal utility of money is $1 = 2 units of utility.

What is the maximum quantity of the good that the individual will buy when its price is $6?
A 2 units B 3 units C 4 units D 5 units

14. The table shows the marginal utility derived by a consumer who devotes the whole of his weekly
income of $42 to two goods X and Y, whose unit prices are $3 and $6 respectively.

In order to maximise his utility, which quantities of X and Y should the consumer purchase?
5|Page

15. The schedule shows the total utility derived by a consumer of a good X at different levels of
consumption.

The consumer obtains two units of satisfaction from the last cent she spends on each good that
she purchases.
What is the maximum number of units of X that she will consume if the price of X is 6 cents?
A2 B5 C7 D8

16. The diagram shows the marginal utility (MU) that an individual derives from a good at different
levels of consumption.

The utility he derives from the last $ he spends on every good is 3 units.
Assuming the marginal utility of money is constant, which quantity will he purchase if the price of
the good is $10?
A 4 kilos B 5 kilos C 6 kilos D 7 kilos

17. The schedule shows the total utility derived by a consumer of a good X at different levels of
consumption.

The consumer obtains three units of utility from the last $ she spends on each good that she
purchases.
What is the maximum number of units of X that she will consume if the price of X is $5?
A3 B4 C5 D6
6|Page

18. A consumer seeks to maximise his utility.

Up to what point should he continue to consume each good?
A until the marginal utility per dollar from each good is the same
B until the marginal utility from each good is the same
C until the marginal utility from each good reaches a maximum
D until the marginal utility from each good is zero

19. Why does a normal demand curve for a product slope downwards from left to right?
A Buyers’ additional satisfaction declines as consumption rises.
B Consumers are faced with choices between competing products.
C Sellers are willing to accept lower prices on larger orders.
D The average cost of production falls as the scale of production increases.

20. The table shows the total utility that an individual obtains from consuming different quantities of a
good.

The individual’s marginal utility of money is $1 = 3 units of utility.

What is the maximum quantity of the good that the individual will buy when its price is $4?
A 2 units B 3 units C 4 units D 5 units

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 A Level
Chapter 7: The price system and the micro economy

Topics to cover
Theory of consumption
Theory of production
Theory of firms
Market structure

Theory of consumption

7.1 Utility

Utility is the satisfaction derived by the consumers from the consumption of any good or
service. Any good or service consumed by the consumers has the capacity to satisfy the want of
the consumers. The terms utility and satisfaction are interchangeable or synonymous.

 Approaches to utility theory

 Ordinal utility approach

It is based on the fact that the utility of a good / commodity cannot be measured in absolute
quantity but it is possible for a consumer to tell subjectively whether the commodity yields
more or less or equal satisfaction when compared to another. For example, one may prefer a
BMW car to a Nissan car but can’t say by how much.

 Cardinal Utility approach

It assumes that the utility/satisfaction derived from the consumption of any good/ or
commodity can be measured numerically and it is measured using an imaginary unit called utils
or units. For example, consumption of 1 unit of good x yields 12 utils /units of satisfaction.
  Utility Concepts

 Total Utility (TU)

Total utility is the total amount of satisfaction derived by a consumer from the consumption of
a given quantity of a good. It is the sum of marginal utility.
Mathematically,
TU= Σ MU1 + MU2 + MU3 +…………+ MUn
Or, TU = AU x Q

Example: A consumer consumes 4 units of good X and the utility derived from 1st, 2nd, 3rd and
4th units are 10 utils, 8 utils, 6 utils and 4 utils respectively. So,
TU= 10+ 8+6+ 4 utils
=28 utils/units

 Average Utility (AU)

Average Utility (AU) is the utility derived per unit of a good consumed.
Mathematically,

AU =

Example: On consuming 4 units of good x, the total utility derived by the consumer is 28 utils.
So,
AU = utils
= 7 utils

 Marginal utility (MU)

Marginal Utility (MU) is the utility/ satisfaction derived from the consumption of an additional
unit of a good.
Mathematically,

MU =
or

Example: On consuming 4 units of good x, the total utility derived by a consumer is 28 utils. As
the quantity consumed increases to 5 units, the total utility increases to 30 utils. So,
MU = utils
= 2 utils

Table: Relationship between MU, AU and TU

Quantity of good Marginal utility Average Utility Total Utility (TU)

x consumed (MU) (AU)
1 12 utils 12 12
2 10 11 22
3 8 10 30
4 6 9 36
5 4 8 40
6 2 7 42
7 0 6 42
8 -2 5 40
9 -4 4 36
10 -6 3 30

 Nature of MU
It decreases, becomes zero and finally becomes negative as the quantity of the good consumed
increases.

 Nature of AU
As the quantity of good consumed increases, AU decreases throughout but can never be zero or
negative.
 Nature of TU
It increases until MU is positive, reaches the maximum when MU becomes zero and starts to
decrease as MU becomes negative.

Fig: Relationship between MU, AU and TU

  Law of diminishing marginal utility
According to this theory, as the quantity of any good consumed increases, the
utility/satisfaction derived by a consumer from the successive units (MU) goes on decreasing.
In other words, as the stock of a good that a consumer has increases, the utility derived from
the additional units decreases.

Table: MU schedule

Quantity of good X Marginal Utility

consumed
1 12utils
2 10
3 8
4 6
5 4
6 2
7 0
8 -2
9 -4
10 -6

Fig: MU curve
The above diagram is the representation of the law of diminishing marginal utility. It is seen
that as a consumer consumes increasing units of good x, the utility derived from the successive
units (marginal utility) goes on decreasing. The consumer reaches the point of satiety when he
consumes the 7th unit of good x and his satisfaction is maximized on consuming 7 units of good
x. A rational consumer will not consume any unit of good x above the 7th unit as it will reduce
the consumer’s total utility.

 Assumptions of law of diminishing marginal utility

The law of diminishing Marginal utility is based on the following assumptions:

 Utility can be measured using an imaginary unit called utils or units.

 The consumer under consideration is rational.
 There is no time gap between the consumption of different units of the good.
 Different units of the good consumed are homogenous, that is, they are of same shape,
size, quantity and quality.
 The goods under consideration don’t belong to rare, antique, habit forming and
entertaining group.

Exercise
What is law of diminishing marginal utility? Explain how the market demand curve is derived
for the utility theory.
  Consumer’s equilibrium: Equi– marginal principle

The main objective of a consumer is to maximize satisfaction. So, a consumer reaches a state of
equilibrium when he derives maximum satisfaction/ utility from the limited money income
spent on two or more goods. This concept of consumer’s equilibrium can be explained using the
equi-marginal principle or the law of equi-marginal utility which is also called the law of
substitution.

According to the equi-marginal principle, “a consumer’s satisfaction is maximized when he

allocates his limited money income among two or more goods in such a manner that he
derives equal marginal utility from the last unit of money spent on each good”. So, a rational
consumer will continue to substitute one good for another until he derives equal marginal
utility from the last unit of money spent on each good. Once he derives equal marginal utility
from the last unit of money spent on each good his satisfaction will be maximized and he will
not show any further change in his pattern of expenditure as it will reduce his
utility/satisfaction.

Mathematically, a consumer’s satisfaction is maximized if he spends his limited money income

among two or more goods in such a manner that the following algebraic equation is satisfied:

== MUm………………….Utility maximizing rule

Where, MUx= utility derived from the last unit of good x consumed
Px= price paid for last unit of good x
MUy=utility derived from the last unit of good y consumed
Py=price paid for last unit of good y
MUm=MU derived per unit of money spent on each good

Example, Let us assume that a consumer has a money income of $70 which he spends on two
goods x and y that the price per unit of good x and y is $10. So,

The maximum quantity of good x that the consumer can buy = = = 7 units
The maximum quantity of good y that the consumer can buy == = 7 units
 Table: Substitution schedule
Quantity of good x MU derived from good x MU derived from good y
and y consumed
1 14 16
2 12 14
3 10 12
4 8 10
5 6 8
6 4 6
7 2 4

In the above example, the consumer’s satisfaction will be maximized if he consumes the
combination of 3 units of good x and 4 units of good y using the given money income of $70.
This is because on consuming this combination of good x and y, the MU derived from the last
unit of money spent on each good is equalized and the consumer’s satisfaction reaches a
maximum of 88 utils. In addition, this combination of good x and y satisfies the utility
maximizing rule, that is

= = MUm

= =1

No other combinations of good x and y can yield as much satisfaction as the consumer derives
from the consumption of 3x and 4y. Now let us assume that the consumer changes his pattern
of expenditure and consumes 2x and 5y instead of 3x and 4y using the given money income of
$70. This will reduce the consumer’s satisfaction to 86 utils which is less than that derived from
the combination of 3x and 4y. In this case, a rational consumer will substitute good x for good y
to maximize his satisfaction. It is always the case that a rational consumer substitutes towards
the good that yield higher satisfaction. He will continue to substitute good x for good y until he
reaches the combination of 3x and 4y and his satisfaction reaches a maximum of 88 utils. This
shows that it is not rational for a consumer to change his pattern of expenditure once he is in a
state of equilibrium where he derives maximum satisfaction using the given money income.

Table: Comparing utility derived from different combinations of good x and y

Combinations Utility
 7x+0y 14+12+10+8+6+4+2= 56
6x +1y 14+12+10+8+6+4+16= 70
5x +2y 14+12+10+8+6+16+14=80
4x+3y 14+12+10+8+16+14+12=86
3x+4y 14+12+10+16+14+12+10=88
2x+5y 14+12+16+14+12+10+8=86
1x+6y 14+16+14+12+10+8+6=80
0x+7y 16+14+12+10+8+6+4=70

Fig 4: Equi-marginal principle

The above diagram is a representation of equi-marginal principle. The consumer is in

equilibrium when he consumes 3 units of good x and 4 units of good y using the given money
income of $70. This combination of good x and y yields the highest amount of satisfaction to
the consumer (88 utils) as it satisfies the utility maximizing rule, that is,

=MUm.
Now if the consumer changes his pattern of expenditure and consumes 4 units of good x and 3
units of good y instead of 3x and 4y, there will be a net loss of utility of 2 utils (10-8) and his
total utility will fall to 86 utils. Hence, it is not rational for a consumer to change his pattern of
expenditure when he is in a state of equilibrium with the maximum utility derived out of the
given money income.

Exercise
Using the equi-marginal principle, explain how a consumer should spend his limited money
income among different goods in order to maximize his utility.

 Derivation of market demand curve from the law of diminishing marginal utility/
Utility theory

Law of diminishing marginal utility is one of the reasons for an inverse relationship between the
price of a good and its quantity demanded. According to this law, as the quantity of a good
consumed by a consumer increases, the utility derived from the successive units (marginal
utility) decreases. So, a rational consumer will not consume the successive units of the good at
the same price. He will consume the successive units of the good only if the price decreases. It
is always the case that, a rational consumer assigns lower value to the goods that yield lower
satisfaction. Hence, the quantity consumed/demanded of a good increases only when its price
decreases.

Table: Marginal utility derived from a good and the price paid by a consumer
Quantity of good x Marginal utility Price paid/ value assigned
consumed ( utils/units) by consumers (in $)
1 8 40
2 6 30
3 4 20
4 2 10

Fig: Derivation of market demand curve from the law of diminishing marginal utility
In the above figure, ‘DD’ is the consumer demand curve which has been derived from the law of
diminishing marginal utility. It shows that a rational consumer consumes the additional
quantities of a good only when its price falls. This is because the utility derived from the
additional units of the good (MU) decreases as its consumption increases. It is always the case
that a consumer assigns lower value to the goods that yield lower satisfaction/utility.

Exercise
Using equi-marginal principle, explain how a consumer reaches a state of equilibrium.

 Paradox of Value ( Diamond-water paradox)

The utility theory assumes that consumers assign lower value to the goods that yield lower
satisfaction/utility. But the consumers assign lower value to water than diamond, although
water yields higher satisfaction than diamond. This is the paradox of value.
This paradox of value can be explained by differentiating the concept of total utility and
marginal utility. The total utility derived from water is higher than that derived from diamond
as water has multiple uses while diamond has a single use. However, the MU derived from
water goes on decreasing as its consumption increases while the MU derived from diamond
increases as its stock with a consumer increases. This is because water is abundantly available
in nature while diamond is rare. Due to this reason water is valued less than diamond. This
shows that the consumers assign value to the goods on the basis of the MU derived from the
goods and not the TU.
1|Page

A Level
Unit 7.1 and 7.2
Essay questions for practice

1. Explain what is meant in economic theory by consumer equilibrium. [20]

2. Discuss the conditions that would cause the demand for a good to (i) increase and (ii) fall as a result
of a fall in the price of the good. Use indifference curve analysis to support your answer. [20]

3. Explain why indifference curves are usually drawn convex to the origin, are downward sloping and do
not cross each other. [20]

4. Consider, for an inferior good, the relationship between indifference curves, budget lines, price
changes and demand curves. [20]
5. Explain the link between a consumer’s rational behaviour, marginal utility, prices of different goods
and the demand for a good. [20]

6. Explain what economists mean by indifference curves and budget lines and evaluate whether they
might be used together to support rational consumer decision making. [20]

7. With the help of diagrams, use indifference analysis to:

(a) explain what is meant in economic theory by consumer equilibrium and how it is related to a
consumer’s demand curve. [20]
(b) discuss how this equilibrium might be affected by a government fiscal policy that raises taxes
on goods. [20]

8. Explain, with the aid of a diagram, diminishing marginal utility and its link to indifference curves. [20]

9. Discuss, using indifference curve analysis, how the impact of an increase in indirect taxation on the
quantity demanded of a good depends on whether it is a normal or inferior good. [20]

10. Use indifference curve analysis to explain the derivation of an individual demand curve for a normal
good. [20]

11. Discuss, using indifference curve analysis, whether the demand for a good always increases when its
price falls. [20]

12. A rational consumer will always purchase less of an item as the price increases.
Discuss, with the use of indifference curve analysis, whether this statement is correct. [20]
1|Page

A Level
Unit 7.2: Indifference curves and the budget lines
Worksheet-2

1. The diagram shows budget lines of a consumer choosing between two goods, X and Y. Initially the
budget line is MM and the consumer’s preferred position is at point A. Subsequently the money
prices of both goods change shifting the budget line to NN.
Which point could represent the preferred position of the consumer after the change in prices if her
tastes remained unchanged?

2. The diagram shows two indifference curves and two budget lines for two goods X and Y.

The initial position is P. P-R is a substitution effect. R-S is an income effect.

What type of good is good X?
A a Giffen good
B a luxury good
C a normal good
D an inferior good

3. On a diagram the slope of a consumerís budget line becomes steeper.

What can definitely be concluded from this?
A The consumerís income has fallen.
B The consumerís income has risen.
C The price has decreased for the product on the horizontal axis.
D The price has increased for the product on the horizontal axis.
2|Page

4. The diagram shows three budget lines, QR, QT and SR. QR is a consumer’s initial budget line.

Which combination of changes could cause the budget line to shift to SR?

5. The diagram shows a consumerís initial budget line is GH and a set of indifference curves IC1, IC2 and
IC3 for goods R and S. The original equilibrium for the consumer is point X.
The inflation rate is rising faster than money incomes.
What will be the most likely new equilibrium for the consumer if income is spent?

6. The diagram shows attainable indifference curves, I1 and I2, for good X and good Y. Which point
represents the highest level of satisfaction currently attainable?
3|Page

7. The table shows the substitution effect and income effect for a Giffen good and an inferior good as
the price of the good changes. Which combination is correct?

8. The diagram shows budget lines for normal goods X and Y.

What could cause a budget line to shift from PQ to PR?

9. A consumer spends all of their income on two goods, Y and X, and is at position E. The price of X falls
and the price of Y remains constant.
The graph shows indifference curves and budget lines which are used to determine the price, income
and substitution effects that are related to this price change.

Which distance gives the income effect of this price change?

A X1 X2 B X1 X4 C X2 X4 D X 5 X6
4|Page

10. To analyse a consumerís preferences, an indifference curve represents possible combinations of

goods X and Y. The diagram shows a consumerís indifference curve for good X and good Y.

What can be concluded from the diagram?

A Point E is the most desirable combination.
B Point F is less desirable than point G.
C Point G is the least desirable combination.
D Points E, F and G are equally desirable combinations.

11. The diagram shows two indifference curves and two budget lines for goods X and Y.

The consumerís initial position is at point F. The consumer’s preferred final position becomes point H.
What does the movement from F to G represent?
A the income effect of a price fall for X
B the price effect of a price change for X
C the substitution effect of a price fall for X
D the substitution effect of a price rise for X

12. The graph shows the budget line for a household as used in indifference curve analysis.
5|Page

What can be concluded about the amount of income that could be spent by the household?
A It is greater at point R than point S.
B It is greater at point T than point S.
C It is greatest at point S.
D It is the same at points R, S and T.

13. Which statement correctly describes the result of a price increase for an inferior good?
A Both the substitution effect and the income effect cause the consumer to buy less of the good.
B Both the substitution effect and the income effect cause the consumer to buy more of the good.
C The substitution effect causes the consumer to buy less of the good and the income effect causes the
consumer to buy more of the good.
D The substitution effect causes the consumer to buy more of the good and the income effect causes
the consumer to buy less of the good.

14. The diagram shows five budget lines. Line 1 is the original budget line.

Which pair of budget lines shows a relatively higher price for drink compared with food after a move
from budget line 1?
A 2 and 3 B 2 and 4 C 3 and 5 D 4 and 5

15. Broken rice is an inferior good. What would be the resulting income and substitution effect on the
quantity demanded of broken rice if its price falls?
6|Page

16. What does a budget line show?

A the behaviour of a utility-maximising consumer
B the difference between an individual’s consumption and saving
C the monetary value of the disposable income of a consumer
D the maximum combinations of two products that a consumer can buy with a given level of Income

17. When the price of a good falls, the overall effect on the quantity demanded can be separated into
income and substitution effects.
Which statement describes a Giffen good?
A The income effect is irrelevant for a Giffen good.
B The income effect works in the same direction as the substitution effect.
C The income effect works against the substitution effect and is of a greater magnitude.
D The income effect works against the substitution effect but is of a smaller magnitude.

18. Which assumption in relation to an indifference theory diagram is not correct?

A The consumerís income may change.
B The consumer may change their satisfaction-maximising objective.
C The consumers may change their tastes and preferences.
D The relative prices of products may change.

19. The diagram shows an individualís indifference curve, I1, for apples and pears.

What can be concluded from the movement from point X to point Y on this curve?
A The individual can afford more apples than pears.
B The individual has not changed their total utility.
C The individual prefers apples to pears.
D The individual has gained more utility by moving from point X to point Y.
7|Page

20. The line RS in the diagram shows the different combinations of goods X and Y that a consumer can
afford with her present income.

The consumer’s original equilibrium is at M.

What could explain a subsequent change in her equilibrium position to N?
A a change in her tastes
B an increase in the price of X and a fall in the price of Y
C an increase in the price of X and a smaller percentage increase in the price of Y
D equal percentage increases in her income and in both prices

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1|Page

A Level
Unit 7.2: Indifference curves and budget lines
Worksheet-1

1. The diagram shows a consumer’s budget line PQ when the consumer’s income was $20 per day and
the prices of X and Y were $2 and $1.25 respectively.

The consumer’s income increases to $30 and, at the same time, the prices of X and Y change. If the
consumer’s budget line is now RS, what are the new prices of X and Y?

2. In the diagram, KN is a budget line showing the different combinations of two normal goods, X and Y,
that a consumer is able to purchase. A consumer initially chooses point L on the budget line.
In a subsequent period, the consumer chooses the combination of X and Y shown by point M.

What could explain this change?

A a change in the consumer’s preferences
B an increase in the consumer’s income and an increase in the price of Y
C a reduction in the consumer’s income
D a reduction in the consumer’s income and a reduction in the price of X
2|Page

3. The diagrams show a change in a consumer's budget line from an initial position of LL1 to LL2. Which
diagram shows the effect of a fall in the price of X, money income remaining unchanged?

4. In the diagram a consumer's budget line shifts from JK to GH.

Which of the following must be correct?

A There has been a change in the consumer's money income.
B There has been a change in the consumer's real income.
C The prices of both goods have changed.
D The price of good Y has increased relative to the price of good X.

5. What is not held constant when calculating the substitution effect of a change in the price of a
good?
A the consumer’s expenditure on other goods
B the consumer’s money income
C the consumer’s tastes
D the prices of other goods
3|Page

6. In the diagram a consumer’s initial budget line is JK.

Assuming no change in the price of X, what could explain a shift in the consumer’s budget line to GH?

7. In the diagram a consumer's budget line shifts from GH to JK.

Regardless of any other changes that might occur, what must be correct?
A There has been an increase in the consumer's money income.
B There has been an increase in the consumer's real income.
C There has been an equal proportionate increase in the price of X and Y.
D There has been an equal proportionate decrease in the price of X and Y.
4|Page

8. In the diagram a consumer's budget line shifts from JK to GH.

What can definitely be deduced from the diagram?

A There has been an increase in the consumer's money income.
B There has been a reduction in the price of both X and Y.
C There has been no change in the price of X or Y.
D There has been no change in the price of X relative to the price of Y.

9. In the diagram a consumer's budget line shifts from JK to JH.

What can definitely be concluded from the diagram?

A There has been no change in the price of good Y.
B There has been a reduction in the price of good X.
C There has been an increase in the consumer's money income.
D There has been an increase in the consumer's real income.

10. In the diagram a consumer’s initial budget line is JK.

5|Page

Assuming no change in the price of Y, what could explain a shift in the consumer’s budget line to GH?

11. In the diagram a consumer’s budget line shifts from GH to JK.

Regardless of any other changes that might occur, what must be correct?
A There has been an equal proportionate increase in the price of X and Y.
B There has been an equal proportionate decrease in the price of X and Y.
C There has been an increase in the consumer’s money income.
D There has been an increase in the consumer’s real income.

12. In the diagram a consumer’s budget line shifts from JK to GH.

Which statement must be correct?

A There has been an increase in the consumer’s money income.
B There has been a decrease in the consumer’s real income.
C Good Y has become relatively more expensive.
D The price of good X has increased.
6|Page

13. For the purposes of measuring the income effect of a change in the price of a good, what is not
held constant?
A consumer preferences
B relative prices
C the consumer’s money income
D the consumer’s real income

14. In the diagram, an individual initially chooses combination N on budget line LM.
An increase in his money income accompanied by an increase in the price of good Y causes his
budget line to shift to RS, and he now chooses combination T.

How does this affect his economic welfare?

A He is definitely better off because his money income has increased.
B He is definitely worse off because he has to pay more for good Y.
C He is better off since combination T, which he now chooses, was not previously available to
him.
D He is worse off since combinations of X and Y along LN are no longer available to him.

[Link] the diagram a consumer’s budget line shifts from GH to JK.

Which statement must be correct?

A The price of good X has increased relative to the price of good Y.
B The prices of both goods have fallen.
C There has been an increase in the consumer’s real income.
D There has been an increase in the consumer’s money income.
7|Page

16. The line RS in the diagram shows the different combinations of goods X and Y that a consumer can
afford with his present income.

The consumer’s original equilibrium is at M.

What could explain a change in his equilibrium position to N?
A a change in his tastes
B a decrease in the price of X and a bigger percentage increase in the price of Y
C an increase in the price of X and an increase in his income
D equal percentage increases in his income and in both prices

17. The diagram shows two indifference curves and two budget lines for two goods X and Y.

The initial position is P. P to R is a substitution effect. R to S is an income effect.

What type of good is good X?
A a Giffen good
B a luxury good
C a normal good but not a luxury good
D an inferior good but not a Giffen good
8|Page

18. In the indifference curve diagram point M is the consumer’s initial equilibrium and MN is the
substitution effect of a fall in the price of good X.
If good X is a Giffen good which point will be the consumer’s new equilibrium point after the fall in the
price of good X?

19. The diagram shows two indifference curves and two budget lines for goods X and Y.

The consumer’s initial position is at point F. The consumer’s preferred final position becomes
point H.
What does the movement from F to G represent?
A the income effect of a price fall for X
B the price effect of a price change for X
C the substitution effect of a price fall for X
D the substitution effect of a price rise for X

20. The diagram shows two indifference curves for a consumer.

9|Page

What can be concluded if the consumer’s equilibrium moves from Q to R?

A The consumer is acting rationally.
B The consumer’s money income is unchanged.
C The opportunity cost of good Y is constant.
D The price of good X has risen.

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1|Page

7.2 Indifference curves and budget lines

 Budget line (or price line)
A budget line or price line is a graphical representation of various combinations of two goods
that a consumer can buy using the given money income at the given prices of the goods.
Example:
Let, money income (M) = $100
Price of good x = $10 /unit
Price of good y = $20/unit
So,
= = 10 units

= = 5 units
Table: Combinations of good x and y with a budget of $100
( M = Px . Qx + Py . Qy)
Combinations Quantity of good x Quantity of good y ($20
($10/unit) / unit)
A 10 0
B 8 1
C 6 2
D 4 3
E 2 4
F 0 5

Fig: Budget line for an income of $100

2|Page

In the above figure ‘AF’ is a budget for a budget of $100. Points A, B, C, D, E and F on the budget
line represent various combinations of good X and Y that the consumer can buy using the given
money income of $[Link] all the combinations are affordable to the consume, the consumer
remains neutral on deciding which combination to consume using the given money income.

 Effect of change in consumer’s money income on the budget line

Prices of the goods being unchanged, any change in consumer’s money income changes the
affordability of the goods and thus causes a parallel shift in the budget line. An increase in
consumer’s money income causes a rightward/ outward shift while a decrease in money
income causes a leftward/inward shift in the budget line.

Fig: Effect of change in consumer’s money income

3|Page

 Effect of change in the prices of goods on the budget line

 Cosumer’s money income being unchanged, an increase or decrease in the prices of

both the goods will cause the consumer’s real income to fall or rise. This will cause the
budget line to shift to the right or left.

Fig: Effect of rise or fall in the prices of both the goods

 Effect of change in price of only one good

 Consumer’s money income being unchanged, if the price of only one good changes,
then the budget line will pivot. That is, the budget line will shift outwards or inwards
from the pivot point. In such a case, the income effect and substitution effect working
together will cause the budget line to pivot. For example, consumer’s money income
and the price of good x being unchanged, if the price of good y falls, then the consumer
will be able to buy higher quantity of good y at all levels of income. This will cause the
budget line to shift outwards from the pivot point.

 Consumer’s money income and the price of good x being unchanged if the price of good
y falls, the consumer actually has more money to spend on good y or on both good x
and y. Real income has therefore increased, which may mean that a consumer may now
4|Page

actually purchase more of product Y or both the products x and y. This is called the
income effect of price change

 Consumer’s money income and the price of good x being unchanged, as the price of
good y falls, the consumer will substitute good y for good x. This is known as the
substitution effect of price change. It is always the case that the rational consumer will
substitute towards the good that has become relatively cheaper.

Fig: Effect of fall in price of good Y

Fig: Effect of fall / rise in price of good X

5|Page

 Consumer’s money income being unchanged, if the price of one good falls and the price of
another good rises then, the new budget line will intersect the original budget line.

Fig 10: Effect of fall in price of good X and a rise in price of good Y

 Indifference curve analysis

An indifference curve is a graphical representation of various combinations of two goods that
yield equal satisfaction to the consumer. Since all the combinations of two goods are equally
good, the consumer becomes indifferent as which combination to choose.

Table: Substitution schedule

Combinations Quantity of good X Quantity of good Y Total utility/ Marginal Rate of substitution
satisfaction (MRSYX = )
A 20 1 50 utils ----
B 15 2 50 utils = 5
C 11 3 50 utils = 4
D 8 4 50 utils = 3
E 6 5 50 utils = 2
F 5 6 50 utils = 1

Fig: Indifference Curve

6|Page

Note: Slope of an indifference curve= MRS

In the above illustration, ‘I’ is an indifference curve. The points A,B,C,D,E and F on the
indifference curve represent various combinations of good X and Y that yield equal satisfaction/
utility to the consumer(50 utils/units). Moving along the indifference curve (I), we see that the
consumer gives up decreasing units of good X for every additional unit of good Y consumed.
This is because as the quantity of good Y consumed increases, the MU decreases. So, the
consumer gives up decreasing units of good X for every additional unit of good Y. This is
referred to as the diminishing marginal rate of substitution. The slope of indifference curve is
determined by this diminishing MRS.

Note: Marginal rate of substitution is the number of units of one good replaced by every
additional units of another good.

MRS of good Y for good X (MRS YX =)

MRS of Good X for Good Y (MRS xy = )

 Characteristics of indifference curve

7|Page

 An Indifference curve slopes downward from left to right because an increase in the
consumption of one good is followed by a decrease in the consumption of another
good.
 An indifference curve is convex to the origin (inward bending) because of diminishing
marginal rate of substitution.
 Higher indifference curve represents higher utility/satisfaction.
 Indifference curves are parallel to each other and cannot intersect each other. If they
intersect each other then it will contradict the fact that the higher indifference curves
represent higher satisfaction.
Fig: Indifference curve map

 Consumer’s equilibrium: Optimal point of consumption

Consumer’s equilibrium can be explained by bringing together the budget line and the
indifference curve map. The consumer is in equilibrium where the budget line is tangent to
the highest possible indifference curve and the slope of budget line is equal to the slope of
indifference curve. At this point of equilibrium, the optimal consumption occurs where the
consumer derives the maximum satisfaction consuming two goods using the given money
income and the prices of the given goods.

Fig: consumer’s equilibrium: optimal point of consumption

8|Page

In the figure, the consumer is in equilibrium at point a where the budget line ‘MN” is tangent to
the highest possible indifference curve ‘I3’ and the slope of the budget line is equal to the slope
of the indifference curve (). At this point of equilibrium, the consumer consumes OQx of good x
and OQy of good Y. This combination of good X and Y yields 150 utils/units of satisfaction which
is the maximum amount of satisfaction that the consumer could derive using the given money
income.

Point ‘C’ is not the point of consumer’s equilibrium as it is on the lower indifference curve ‘I2’
which represents lower utility than 150 utils. Here the consumer has the scope to move to a
higher indifference curve ‘I3’ by reducing the consumption of good x from Qx2 to Qx and
increasing the consumption of good Y from Qy1 to Qy.

Similarly, point ‘d ’ is also not the point of consumer’s equilibrium as it is on the lower
indifference curve ‘I2’ and the consumer has the scope to move to a higher indifference ‘I3’ by
increasing the consumption of good X from Qx1 to Qx and reducing the consumption of good Y
from Qy2 to Qy.

Point b on the indifference curve ‘I4’ is unattainable as it lies outside the budget line MN.

Exercise
Using indifference curve analysis, explain how a consumer attains a state of equilibrium.

 Effect of change in real Income on consumer’s choice

9|Page

Consumer’s money income being unchanged if the prices of the goods fall, the
consumer’s real income increases. This increase in real income will allow the consumer
to choose a better combination of the goods. This will usually be more of one or both
the goods and the consumer will move to the higher indifference curve.
Fig: Effect of increase in real income on consumer’s choice

In the figure, the consumer is initially in equilibrium at ‘a’ where the budget line MN is tangent
to the indifference curve ‘I1’. At the point of equilibrium the consumer consumes ‘OQx’ of good
X and ‘OQy’ of good Y using the given money income at the given prices of the goods. A fall in
prices of both the goods increases the real income of the consumer and this allows the the
consumer to move to point ‘b’ where the new budget line ‘PQ’ is tangent to the higher
indifference curve ‘I2’. The consumer has increased the consumption of both good X and Y with
the increase in his real income. This shows that both good X and Y are normal / superior goods.

 Effect of change in consumer’s income on superior and inferior goods

Any change in the consumer’s real income causes a change in the consumption of
superior/normal and inferior goods. An increase in the consumer’s real income increases the
consumption of superior goods while the consumption of inferior goods decreases and vice
versa. This effect of change in consumer’s income on superior and inferior goods can be
explained using the following diagram:

Fig: Effect of change in consumer’s income on superior and inferior goods

10 | P a g e

In the figure, the consumer is initially in equilibrium at ‘a’ where the line MN is tangent to the
indifference curve ‘I1’. At the point of equilibrium the consumer consumes ‘OQx’ of good X and
‘OQy’ of good Y using the given money income at the given prices of the goods. An increase in
consumer’s real income shifts the budget line outward to PQ. Now the consumer moves to
point ‘b’ where the new budget line ‘PQ’ is tangent to the higher indifference curve ‘I2’. The
consumer has increased the consumption of good X from ‘Qx to Qx1’ while the consumption of
good Y has been reduced from ‘Qy to Qy1’. This shows that good X is a normal /superior good
while good Y is an inferior good.

 Income and substitution effect of price change

When the price of a good changes (rise or fall) the effect on the quantity demanded is the result
of an income effect and a substitution effect.

Consumer’s money income and the price a good remaining unchanged, if the price of another
good falls, consumer’s real income increases. That is, the consumer has more money to spend
on one or both the goods. Hence, the consumer consumes more of one or both the goods. This
is referred to as the income effect of price change.

Consumer’s money income being unchanged when the price of a good falls, it becomes
relatively cheaper. So, a rational consumer substitutes the relatively cheaper good for the
relatively expensive one. This is referred to as the substitution effect of price change.

This income and substitution effect of price change can be explained using the following
diagrams:

Fig: Income and substitution effect of fall in price ---normal good

11 | P a g e

The above diagram is the representation of income and substitution effect of fall in price of
normal good.

The movement from point A to B along the indifference curve I1 shows the substitution
effect of fall in price of normal good. As the price of normal good falls, it becomes relatively
cheaper. As a result the consumer substitutes this good for other relatively expensive
goods. Hence, its consumption/demand increases with the fall in its price. This, shows that
the substitution effect of the fall in price of a normal good is positive (10 – 4 = 6).

Movement from point B on the lower budget line and indifference curve to point C on the
higher budget line and indifference curve shows the income effect of fall in the price of
normal good. The fall in the price of normal good has increased the real income of the
consumer and hence the quantity demanded of normal good has increased. This shows that
income effect of the fall in price of normal good is positive (17-10 =7).

Calculation:
SE = 10 – 4 = 6
IE = 17 – 10 = 7
TE = 17 – 4 = 13
12 | P a g e

Fig: Income and substitution effect of fall in price – inferior good

The above diagram is the representation of income and substitution effect of fall in price of
normal good. The movement from point A to c along the indifference curve I1 shows the
substitution effect of fall in price of inferior good. As the price of inferior good falls, it becomes
relatively cheaper. As a result the consumer substitutes this good for other relatively expensive
goods. Hence, its consumption/demand increases with the fall in its price. This, shows that the
substitution effect of the fall in price of an inferior good in positive (10 – 4 = 6).

Movement from point C on the lower budget line and indifference curve to point B on the
higher budget line and indifference curve shows the income effect of fall in the price of inferior
good. The fall in the price of inferior good has increased the real income of the consumer but
the quantity demanded of inferior good has decreased. This shows that income effect of the fall
in price of inferior good is negative (7-10 = - 3).

Calculation:
SE = 10 – 4= 6
13 | P a g e

IE = 7 – 10 = -3
TE = 7 – 4 = 3

Fig: Income and substitution effect of rise in price – normal good

The above diagram is the representation of income and substitution effect of rise in price of
normal good. The movement from point A to c along the indifference curve I1 shows the
substitution effect of rise in price of normal good. As the price of normal good rises, it becomes
relatively expensive. As a result the consumer substitutes the relatively cheaper good for the
normal good which has now become expensive. Hence, its consumption/demand decreases
with the rise in its price. This, shows that the substitution effect of the rise in price of a normal
good is negative (7 – 14 = - 7).
Movement from point C on the higher budget line and indifference curve to point B on the
lower budget line and indifference curve shows the income effect of rise in the price of normal
good. The rise in the price of normal good has reduced the real income of the consumer and
14 | P a g e

hence the quantity demanded of the normal good has decreased. This shows that income effect
of the rise in price of normal good is negative (4 - 7 = - 3).

Calculation:
SE = 7 – 14= -7
IE = 4 – 7 = - 3
TE = 4 – 14 = -10

Fig: Income and substitution effect of rise in price – inferior good

The above diagram is a representation of income and substitution effect of rise in price of
inferior good. Movement from point A to C along the initial indifference curve I1 shows the
substitution effect of rise in the price of inferior good (good X). As the price of good X rises, it
becomes relatively expensive. So, the consumer substitutes towards the relatively cheaper
good. This reduces the demand for good X. Hence the substitution effect of rise in price of
inferior good is negative (5 – 14= -9).
15 | P a g e

Movement from point C to B shows the income effect of rise in price of inferior good. As the
price of the good X rises, consumer’s real income falls and the demand for inferior good
increases. This shows that the income effect of rise in price of inferior good is positive (8-5=3).

Calculation:
SE = 5 – 14 = - 9
IE = 8 – 5 = 3
TE = 8 – 14 = -6

Exercise
Using indifference curve analysis, explain the effect of change in the prices of the goods on
the expenditure pattern of the consumers.

 Income and substitution effect of price change in case of giffen goods

Giffen goods are those goods whose demand/consumption decreases when their prices fall and
vice versa. The income and substitution effect of change in the price of giffen goods can be
explained using the following diagrams:

Fig: Income and substitution effect of fall in price of Giffen goods

16 | P a g e

The above diagram is the representation of income and substitution effect of fall in the price of
a Giffen good. Movement from point A to B along the initial indifference I1 shows the
substitution effect of fall in the price of a Giffen good (Good Y). As the price of the giffen good
falls, it becomes relatively cheaper. So, the rational consumer substitutes this good for other
relatively expensive goods. Hence, the substitution effect of the fall in the price of the Giffen
good is positive (15 – 10 = 5).

Movement from point B on the lower indifference curve, I1 to point C on the higher
indifference curve, I2 shows the income effect of fall in the price of the Giffen good. As the
price of the Giffen good falls, its consumption decreases. Hence, the income effect of the fall in
the price of the Giffen good is negative (7 – 15 = - 8).

Calculation:
SE = 15 – 10 = 5
IE = 7 – 15 = - 8
TE = 7 – 10 = -3

Fig: Income and substitution effect of rise in price of Giffen goods

17 | P a g e

The above diagram is the representation of income and substitution effect of rise in the price of
a Giffen good. Movement from point A to B along the initial indifference I1 shows the
substitution effect of rise in the price of a Giffen good (Good Y). As the price of the giffen good
rises, it becomes relatively expensive. So, the rational consumer substitutes other relatively
cheaper good for good Y, which has now become relatively expensive. Hence, the substitution
effect of the rise in the price of the Giffen good is negative (5– 15 = - 10).

Movement from point B on the higher indifference curve I1 to point C on the lower indifference
curve I2 shows the income effect of rise in the price of a Giffen good. As the price of the Giffen
good rise, its consumption increase. Hence, the income effect of the rise in the price of the
Giffen good is positive (10– 5 = 5).

Calculation:
SE = 5 – 15 = -10
IE = 10 – 5 = 5
TE = 10 – 15 = -5
18 | P a g e

 Derivation of market demand curve from the indifference curve analysis

The derivation of demand curve from the budget line and indifference curves can be explained
using the following diagram.

Fig: Derivation of demand curve from the budget line and indifference curves

In the figure, the upper panel shows the change in consumer’s choice with the fall in price of
good Y. AB is the initial budget line with the given money income and the price of good X and Y.
The consumer is in equilibrium at point ‘E’ where the indifference curve I1 is tangent to the
budget line AB. At this point the consumer consumes ‘Oy ’ quantity of good Y using the given
money income. Now consumer’s money income and price of good X being unchanged, price of
good Y falls to Py1. This fall in price of good Y raises the consumer’s real income which causes
the budget line to shift to AB1. The consumer is now in equilibrium at point ‘E1’ where the
higher indifference curve I2 is tangent to the new budget line AB1 .The consumer has increased
the consumption of good Y from OQy to OQy1 as its price has fallen from Py to Py1.

The lower panel of the figure shows the derivation of demand curve from the budget line and
indifference [Link] is the demand curve which shows that the quantity of good Y bought by
the consumer increases from Oy to Oy1 when its price falls from Py to Py1.

Exercise
Explain how the market demand curve is derived from the indifference curve analysis.
19 | P a g e
1|Page

A Level
Unit 7.3: Economic efficiency and market failure
Worksheet-1

1. What is an example of market failure?

A difficulties in allocating property rights
B diseconomies of scale
C high prices caused by increased demand
D the existence of scarcity

2. Why would an economy wish to achieve economic efficiency?

A to achieve an equal distribution of income
B to achieve full employment
C to ensure international competitiveness
D to ensure resources are not wasted

3. What will happen if a firm is taxed by an amount equal to the external costs that it imposes on the
rest of society?
A Production will be increased.
B Resource allocation will be improved.
C Resource allocation will be maximised.
D There will be no effect upon production.

4. The current distribution of goods between two individuals in a two-person economy with given
technology and resources is at point X.
According to the Pareto criterion, which point would definitely indicate increased allocative efficiency?
2|Page

5. What might help achieve allocative efficiency?

A differentiated products
B government subsidies
C monopsony
D supernormal profits

6. Over time the average total cost curve of a firm is lowered.

Which form of efficiency does this represent?
A allocative
B dynamic
C Pareto
D productive

7. What is correct if a firm in a perfectly competitive market is maximising its long-run profits?

8. What can be deduced about an economy where no-one can be made better off without making
someone else worse off?
A Firms succeed in maximising profits.
B Production causes no external costs or benefits.
C The distribution of income and wealth is perfectly equal.
D The resources of the economy are allocated efficiently.

9. What is likely to help create dynamic efficiency?

A Entry barriers are reduced to increase competition in the market.
B Firms are legally bound to produce where price equals marginal cost.
C Taxes on profits are raised to encourage firms to produce where price equals average cost.
D Taxes on retained profits are reduced to encourage investment in new technology.

10. What action by a firm is most likely to raise its dynamic efficiency?
A distributing all its current profit to its existing shareholders
B maximising the labour productivity of its current workers
C minimising the average cost of producing its current output
D retaining its current profit for product research and development
3|Page

11. The current distribution of goods between two individuals in a two-person economy with given
technology and resources is at point X.
According to the Pareto criterion, which point would definitely indicate increased allocative
efficiency?

12. The concept of allocative efficiency assumes that each individual in society is the best judge of their
own economic welfare.
Which example of government intervention is based on an argument which rejects this assumption?
A pollution controls
B subsidies for merit goods
C the provision of public goods
D the regulation of monopolies

13. The diagram shows a firm operating in monopolistic competition.

At which point is the firm allocatively efficient?

14. In an economy, no-one can be made better off without making someone else worse off.
What can be deduced from this?
A Individuals are the best judges of their own well-being.
B Individuals can be relied upon to behave rationally.
C The distribution of income is socially optimal.
D The economy’s resources are allocated efficiently.
4|Page

15. The diagram shows a monopolistically competitive firm. Which point represents allocative
efficiency?

16. What is a necessary condition required to achieve Pareto efficiency?

A when it is not possible for some people to become better off without others becoming worse
off
B when it is possible to produce greater output with the same quantity of inputs
C when resources have spare capacity
D when resources can be re-allocated and total consumer satisfaction can be increased

[Link] is most likely to improve the allocative efficiency of a market?

A a higher market concentration ratio
B collusion between firms in the market
C entry of new firms into the market
D mergers of firms in the market

18. Which statement best defines productive efficiency?

A It is not possible to increase profits by changing the level of production.
B It is not possible to make anyone better off without others becoming worse off.
C It is not possible to produce the level of output at a lower unit cost.
D It is not possible to produce outside the production possibility curve.

19. What is necessary to achieve Pareto efficiency?

A Both consumers and producers must be made better off.
B Everybody must be made equally better off.
C One person must benefit without anyone else being worse off.
D The welfare gains must exceed the welfare losses.

20. In which situation are there definitely positive externalities?

5|Page

A Private benefits exceed private costs.

B Private benefits exceed social benefits.
C Social benefits exceed private benefits.
D Social benefits exceed private costs.

21. In an economy, no one can be made better off without making someone else worse off.
What does not necessarily follow from this?
A The conditions for allocative efficiency have been met.
B The conditions for productive efficiency have been met.
C The distribution of income is socially acceptable.
D The economy is operating at a point on its production possibility curve.

22. What does not pose a threat to the achievement of allocative efficiency?
A imperfect information on the part of consumers
B income inequalities
C the existence of externalities
D the presence of monopolistic elements

23. The diagram shows the production possibility curve for a successful transition economy that moves
from point X to point Y over time.

During the transition process the population of the country expressed a strong preference for increased
privatisation.
What happens to economic efficiency as a result of the transition from point X to point Y?

24. Which condition defines productive efficiency?

6|Page

A All factors of production are fully employed.

B All firms are producing at their profit-maximising levels of output.
C There are no further opportunities for substituting capital for labour.
D The output of all goods is produced at the lowest possible cost.

25. The diagram shows a firm’s long-run cost and revenue curves.

At which level of output is the firm both allocatively and productively efficient?
A OA B OB C OC D OD

26. In the diagram, LM is an economy’s production possibility curve.

Which statement must be correct?

A F is productively inefficient.
B G and H are productively efficient but economically inefficient.
C Only E is economically efficient.
D Only G is productively efficient.

27. An economy is operating at a point inside its production possibility curve.

Why is this described as inefficient?
A Individuals are enjoying too much leisure.
B Labour and capital are combined in the wrong proportions.
C More of one good can be produced without decreasing production of another.
D There are shortages of some goods and an excess supply of others.
28. An economy is operating at a point on its production possibility curve. What is true about the way
the economy’s resources are being used at this point?
7|Page

29. In the diagram, a firm increases its output from OY to OZ.

Which statement about the effect on economic efficiency is correct?

A It will increase because a greater quantity will be produced and higher total revenue will be earned.
B It will increase because the value that consumers place on the product comes closer to the
cost of producing the last unit.
C It will decline because both average and marginal revenue will fall.
D It will decline because both total and marginal cost will rise.

30. The diagram shows the levels of utility corresponding to different allocations of resources between
two people.
The initial allocation is Z.
Which reallocation of resources would definitely be more Pareto efficient?
1|Page

7.3 Efficiency and market failure

 Economic Efficiency
The concept of economic efficiency emerges from the problem of scarcity of resources. Since
the resources are scarce, they must be used in the best possible manner .It means that the
maximum level of infinite human wants are satisfied using those scarce resources. Economic
efficiency is always judged to be desirable as it represents best possible solution to the
economic problem.
There are two parts of economic efficiency- productive efficiency and allocative efficiency.
When both these parts of economic efficiency co-exist then it is determined that the scarce
resources are used in the best possible way. This, therefore, constitutes a situation of efficient
resource allocation.

 Productive Efficiency
It occurs when the goods and services are produced at the lowest possible cost. It implies that
the maximum possible quantity of goods and services are produced using the least possible
resources. Productive efficiency arises when the price of the product becomes equal to the
minimum Average Total Cost, that is, P=Min. ATC

A firm is productively efficient when it is making the best use of resources and producing at the
lowest possible costs. Productive efficiency of the firms can be shown using the firm’s average
total cost curve (ATC Curve). A firm is said to be productively efficient if it produces at the
lowest point of its ATC curve.

Fig: Productive efficiency of a firm

2|Page

The above figure shows the productive efficiency of a firm. A firm is productively efficient if it
produces at point x on its ATC curve. The optimum level of output is Q. If the level of output
produced is more or less than Q, the firm will be productively inefficient. In such situation, it
can achieve productive efficiency by increasing or reducing the level of output to Q.

The concept of productive efficiency can also be explained using the production possibility
curve (PPC). Productive efficiency occurs if an economy produces at any point on its PPC, where
the economy produces the potential level of output using the available resources.

Fig: Productive efficiency in an economy

In the above figure, productive efficiency arises if the economy produces at point Y on its PPC.
At this point the available resources are used in the best possible manner and the output
produced is at the potential level. Productive efficiency doesn’t arise if the economy produces
at point x inside the PPC. This is because at this point the output produced is below the
potential level and more output could be produced if the resources are used more efficiently.

Productive efficiency arises in a perfectly competitive market because of the competition

among the large number of firms producing the same product. In such a market, the firms are
constrained to produce the products at the lowest possible cost. Producing the products at the
lowest possible cost gives the incentive of profit to the firms. That is, the lower the cost, the
greater will be the possible profit. Alternatively, a firm’s failure to produce at the lowest
possible cost may result in bankruptcy as the rival firms will definitely be producing at the
lowest possible cost. The price of the firm’s product that has failed to minimize costs will be too
high and thus there will be low demand.
3|Page

More specifically, the condition necessary for productive efficiency, that is, P=Min. ATC, is
satisfied when the firms in a perfectly competitive market are in long -run equilibrium.

Note: The main objective of a firm is to maximize profit. A firm’s profit is

maximize when marginal cost = marginal revenue (MC=MR)

Fig: Productive efficiency in a perfectly competitive market

In the above diagram, a perfectly competitive market is in equilibrium at point e where MC=MR
(profit maximizing rule). At this point of equilibrium P= Min. ATC, which is the condition
necessary for productive efficiency. The optimum quantity of output is Q. If the level of output
is below or above Q, there would be productive inefficiency. In such situation, a firm can
achieve productive efficiency by increasing or reducing the level of output to Q.
4|Page

 Allocative Efficiency
Allocative efficiency is concerned with allocating the right amount of scarce resources to the
production of the products that are in demand. This means producing the combination of
products that satisfy the greatest possible level of infinite human wants.

Allocative efficiency arises when the price of the product is equal to its marginal cost of
production (the cost of producing one more unit of output), P= MC.
The concept of allocative efficiency can be explained using the following illustration:

Quantity 1 2 3 4 5 6 7
Price($) 5 5 5 5 5 5 5
Marginal Cost($) 2 3 4 5 6 7 8

In the above illustration, allocative efficiency arises if 4 units of the given product are produced.
This is because at this level of output P=MC. If the level of output produced is less than 4 units,
there would not be allocative efficiency as the cost of producing the product is less than the
value put on it by the consumers that is, P˃MC. This shows that the level of output produced is
less than the optimum. So, to achieve allocative efficiency production should be increased to 4
units. On the other hand, if the level of output produced is more than 4 units, the cost of
producing the product is higher than the value put on by the consumers that is, P˂MC. This
shows that the level of output produced is more than the optimum level. So to achieve
allocative efficiency the level of output must be reduced to 4 units.

A competitive market can also lead to allocative efficiency. In such a market, firms are
constrained to produce those products that consumers most desire relative to their cost of
production. There are two motivations for the firms to do so. Firstly, producing the products
that are most desired by the consumers will lead to the highest possible demand and hence the
greatest revenue and profit. Secondly, the firms in a competitive market will be forced to
produce those goods that are most in demand as other firms will definitely be doing so. A
failure to produce such products will force the firms to close.
More specifically, the condition necessary for allocative efficiency (P=MC) is satisfied when
the firms in a perfectly competitive market are in long run equilibrium.

Fig: Allocative efficncy in a perfectly competitive market

5|Page

 Pareto Optimality
Pareto optimality occurs when it is impossible to make someone better off without making
someone else worse off. It is an optimal situation, with resources being allocated in the most
efficient way. Therefore, Pareto Efficiency indicates that resources can no longer be allocated in
a way that makes one party better off without harming other parties.

Pareto optimality arises when an economy is operating on its PPC. In such situation, it is not
possible to increase the output of one good without reducing the output of another good. In
contrast, Pareto optimality would not arise if an economy operates at any point inside the PPC.
This is because if an economy is operating inside the PPC, it would be possible to increase the
output of either type of good without reducing the output of the other good.

If the allocation of resources is not Pareto efficient, then there is scope for improvement.
A Pareto improvement is an improvement to a system when a change in allocation of
resources harms no one and benefits at least one person.
6|Page

Fig: Pareto optimality and improvement in Pareto optimality

 Dynamic Efficiency
It is a form of productive efficiency that benefits a firm over time. Resources are reallocated in
such a way that output increases relative to the increase in resources. It is achieved when a firm
meets the changing needs of its market by introducing new production processes in response
to competitive pressures. By using their excess profits, the firms (in monopoly and oligopoly
markets) can engage in research, development and product innovation in order to protect their
market shares. In turn, this can bring benefits to consumers in the form of new technologies
and lower prices while giving the firms a more efficient means of production.

Dynamic efficiency is a long term phenomenon. Achieving dynamic efficiency requires

investment sourced from within or outside the firm. Initially, it can result in higher costs but the
payback comes later. Without investing a firm may be destined to become less efficient and
may be forced to leave the market. Where a firm is dynamically efficient, its long-run average
cost curve shifts downwards.

Fig: Dynamic efficiency

7|Page

 Market Failure
It means a free market failing to achieve economic efficiency. Market failure exists whenever a
free market, left to its own devices and totally free from any form of government intervention,
fails to make the optimum use of scarce resources. That is, market failure occurs when the
interaction of demand and supply in a market does not lead to productive and/or allocative
efficiency. In other words, there is not an efficient allocation of resources in the free market.

 Reasons of market failure

There are various reasons why a market failure occurs. They include:
 Where there are externalities present in the market
 The provision of merit and demerit goods
 The provision of public and quasi-public goods
 Information failure
 Adverse selection or moral hazards
 Abuse of monopoly power in the market

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1|Page

A Level
Unit 7.3 and 7.4
Essay Questions

1. ‘The existence of externalities implies market failure and therefore that the good should necessarily
be provided by the government.’
Discuss this assertion. [20]

2. ‘Smoking cigarettes causes negative externalities and negative externalities cause market failure
which can only be solved by government intervention.’
To what extent do you agree with this statement? [20]
3. The use of cars in large cities can cause traffic congestion and pollution.
Explain how the use of cars may cause allocative inefficiency and discuss two alternative government
policies that might be used to solve this problem. [20]

4. What is meant by ‘efficiency’ in relation to the use of resources? [20]

5. A country moved from a point within its production possibility curve to a point on its production
possibility curve.
Explain what is meant by economic efficiency. Analyse what happened to economic efficiency in that
country as a result of this movement. [20]

6. Discuss whether economic efficiency is always achievable in a market economy. [20]

7. Using diagrams, explain with examples the meaning of a positive externality for a consumer and a
negative externality for a producer. [20]

8. Discuss the extent to which positive externalities and negative externalities explain all forms of
market failure. [20]

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1|Page

A Level
Unit 7.4: Private costs and benefits, externalities and social costs and benefits
Worksheet -1

1. The diagram shows the private and social marginal costs and benefits curves for the antibiotics
market. The market equilibrium is at point X.

Why does market failure occur?

A There is overconsumption and overpricing.
B There is overproduction and under-pricing.
C There is underconsumption and under-pricing.
D There is underproduction and overpricing

2. The table shows the results of a cost-benefit analysis of the construction of a new airport.

What is the total value, in US$ million, of all the externalities created by construction of the new
airport?
A 30 B 40 C 50 D 90

3. Which statement about a product with external costs must be correct?

A The consumption of the product has positive effects on third parties.
B The private costs of its production exceed the social costs of its production.
C The production of the product has negative effects on third parties.
D The social costs of its production exceed the social benefits of its production.
2|Page

4. The table shows the results of a cost-benefit analysis undertaken by a government when it was
considering investing US$200 million in building a new airport.

The government will build the airport if the net social benefit creates a return of at least 10% on
its investment.
What will the minimum external benefit need to be in US$ million to achieve this?
A 10 B 20 C 30 D 40

5. A project has a social cost of $100 million, a private cost of $40 million and an external benefit of
$20 million. Its net social value is zero.
What can be concluded about the project?
A External cost is greater than external benefit.
B Private cost is greater than external cost.
C Private cost is greater than private benefit.
D Social cost is greater than social benefit.

6. The diagram shows the cost and revenue curves for a firm.
At which price does allocative efficiency occur?

7. In cost-benefit analysis the term net social benefit refers to

A private benefit plus social benefit.
B social benefit minus private benefit.
C social benefit minus private cost.
D social benefit minus social cost.
3|Page

8. A government is considering improving the rail links in its country. It also has to choose one of
four high-speed routes.
The benefits and costs of each route are shown below.
Which route should be chosen?

9. A government school is built by private builders in a residential neighbourhood. The builders ignore
the effects of noise and disturbance.
Why does a free market fail to take into account these external costs of building the school?
A Education is a public good which benefits society.
B Few people who live near the school object to the building.
C The government believes schools should be built privately.
D These costs are not paid for by the builders.

10. In all market structures, what must firms equate to ensure allocative efficiency?
A average cost and average revenue
B average cost and marginal revenue
C marginal cost and average revenue
D marginal cost and marginal revenue

11. In 2015, a company electrified the main railway line between two cities in order to decrease the
journey time. The work was noisy, expensive and took a long time.
What would be the likely outcome of this project?
A External costs increased and private benefits decreased.
B Private benefits decreased and external cost decreased.
C Private benefits increased and private costs increased.
D Private costs increased and external costs decreased.

12. Which measure is specifically designed to reduce divergences between private and social costs?
A equal pay legislation
B minimum wage legislation
C the abolition of tuition fees paid by university students
D the introduction of ‘bus only’ lanes in city centres
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13. What is equivalent to social benefits?

A the amount that the government spends on social security benefits
B the benefit gained by society from total government spending
C the benefit to third parties from household consumption of a good
D the private and external benefits from household consumption of a good

14. The diagram shows the average cost (AC), marginal cost (MC), average revenue (AR) and marginal
revenue (MR) curves for a monopoly.
At which point will allocative efficiency be achieved?

15. When will an economic activity create a net social benefit?

A when (private benefit + external benefit) - (private cost + external cost) is negative
B when (private benefit + external benefit) - (private cost + external cost) is positive
C when (private benefit + private cost) - (external benefit + external cost) is negative
D when (private benefit + private cost) - (external benefit + external cost) is positive

16. How is social cost calculated?

A external cost minus external benefit
B external cost minus private cost
C external cost plus private cost
D social cost minus social benefit
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17. The diagram shows the private and social costs and benefits of production in a free market that
result in market failure.

Which change in output would be necessary to overcome this market failure?

A from K to M
B from M to N
C from M to L
D from N to L

18. Which government policy is not aimed at correcting inefficiency in resource allocation?
A marginal cost pricing in state owned industries
B permits restricting the pollution of rivers by private firms
C requiring firms to pay a minimum wage
D the provision of public goods at zero price

19. The table shows some of the costs and benefits, in $ millions, associated with a road building
project. Both a government department and a profit-maximising private firm are considering
building the road.

Who would be willing to build the road?

A Both would be willing to build it.
B Neither would be willing to build it.
C Only the government department would be willing to build it.
D Only the private firm would be willing to build it.
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20. In the diagram, Q1 is the quantity produced of a good as the result of market forces.

Which concept is present at output Q1?

A a government subsidy
B a negative externality
C a positive externality
D a specific tax

21. The diagram shows the market for a product, the production of which has both external costs and
external benefits.

What is the difference between the level of output that would be produced by the market and the
socially optimum level?
A WX B WY C XY D XZ

22. The government is considering building flood defences along a river. It has calculated the costs and
benefits as follows.

According to cost-benefit analysis, which decision and reasoning about flood defences is correct?
7|Page

23. What is an example of a negative externality?

A Lower profit due to increased competition from new firms entering the market.
B Reduced government funding for a museum.
C The increase in noise levels from aircraft due to the expansion of a large city airport.
D The increase in production costs due to an increase in the cost of importing raw materials.

24. A government is choosing between four routes for a new road. The table provides details of the
costs and benefits associated with each route.
The government wants to get the highest return for taxpayers in terms of the social benefit
relative to the private cost.
Which route will the government choose?

25. The diagram shows the costs and benefits of producing a good. The good has negative externalities
in production and positive externalities in consumption. The free market equilibrium
is at point X.
What is the new equilibrium point when the externalities are taken into consideration?

26. The Airports Commission in the UK recommended an expansion of airport X rather than airport Y.
In considering the social costs and benefits of this decision, what would be taken into account when
calculating the external cost?
A the additional noise pollution suffered by residents local to airport X
B the financial loss suffered by airlines operating at airport Y
C the increase in profits of the firm operating airport X
D the monetary cost of the construction to expand airport X
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27. What is an example of a negative externality?

A the non-provision of public goods by the market
B indirect taxation that fails to internalise the external cost
C monopoly power leading to reduced output and a higher price
D the production of a good that has a harmful effect on a third party

28. What is the main aim of cost-benefit analysis?

A to allow firms to maximise their private benefit and minimise the external cost
B to equate total social benefit to the total social cost of a project
C to find the correct level of direct tax to internalise the external cost of a project
D to find the highest positive difference between total benefit and total cost

29. The diagram shows a firm in perfect competition that creates pollution.

What represents the external cost?

A JK B JM C KL D MK

30. Building a hospital has a social cost of $200 million. The social benefit is $240 million; external
benefit is $150 million.
What can be concluded from this information?
A external benefit is greater than external cost
B external benefit is greater than private benefit
C private benefit is greater than private cost
D the project should not take place
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7.4 Private costs and benefits, externalities and social costs and benefits

Private, external and social costs

 Private costs are those costs that are paid for by someone who produces and consumes
any good or service. It is the difference between social costs and external cost.
Private cost = social cost – external cost

For example, if the value of social cost of an action or decision is equal to $50 m and the value
of external cost is equal to $10 m then,
Private cost = $50 m-$10 m
=$40 m

 External cost is the cost of any production or consumption decision that is borne by the
third party. It represents negative externality that arises when there is a divergence
between social cost and private cost
External cost or negative externality= Social cost – private cost

For example, if the value of social cost of an action or decision is equal to $50 m and the value
of private cost is equal to $40 m then,
External cost or negative externality= $50 m-$40 m
=$10 m

 Social cost is the total cost arising from any production or consumption decision. It is
the sum of private cost and external cost.
Social cost = Private cost + external cost

For example, if the value of private cost of an action or decision is equal to $40m and the
value of external cost is equal to $10 m then,
Social cost = $40m + $10 m
= $50 m

Marginal Private Cost (MPC) is the addition to the private cost from the production or
consumption of an additional unit of a good.
Mathematically,
MPC= MSC – MEC
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Marginal External Cost (MEC) is the addition to the external cost (negative externality) from
the production or consumption of an additional unit of a good.
Mathematically,
MEC= MSC – MPC

Marginal Social Cost (MSC) is the addition to the social cost from the production or
consumption of an additional unit of a good.
Mathematically,
MSC= MPC + MEC

 Private, external and social benefits

 Private benefit is the benefit of any production or consumption decision that is enjoyed
solely by the private decision maker (producers and consumers). It is the difference
between social benefit and external benefit.
Private benefit = social benefit – external benefit

For example, if the value of social benefit of an action or decision is equal to $100 m and the
value of external benefit is equal to $20 m then,
Private benefit= $100 m - $20 m
=$80 m

 External benefit is the benefit of any production or consumption decision that is

enjoyed by the third party. It represents positive externality and arises when there is a
divergence between social benefit and private benefit.

External benefit or positive externality=Social benefit- private benefit

For example, if the value of social benefit of an action or decision is equal to $100 m and the
value of private benefit is equal to $80 m then,
External benefit or positive externality= $100 m-$80 m
=$20 m
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 Social benefit is the total benefit arising from any production or consumption decision.
It is the sum of private benefit and external benefit.
Social benefit= Private benefit + external benefit

For example, if the value of private benefit of an action or decision is equal to $80 m and the
value of external benefit is equal to $20 m then,
Social benefit= $80 m + $20 m
= $100 m

Marginal Private Benefit (MPB) is the addition to private benefit from the production or
consumption of one additional unit of the good.
Mathematically,
MPB= MSB – MEB

Marginal External Benefit (MEB) is the addition to external benefit (positive externality) from
the production or consumption of one additional unit of the good.
Mathematically,
MEB= MSB – MPB

Marginal Social Benefit (MSB) is the addition to social benefit from the production or
consumption of one additional unit of the good.
Mathematically,
MSB= MPB + MEB

 Net Private Benefit (NPB) is the difference between Private benefit and private cost.
Mathematically,
NPB= Private benefit- Private cost

 Net External Benefit (NEB) is the difference between external benefit and external
cost.
Mathematically,
NEB= External benefit- external cost

 Net Social Benefit (NSB) is the difference between social benefit and social cost
Mathematically,
NSB = Social benefit – social cost
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 Definition of positive externality and negative externality

 Defining externalities
They are the spillover effects of the actions/decisions taken by the producers or consumers.
They are said to arise when a third party (someone not directly involved in the production or
consumption decisions) is affected by the actions or decisions of others. Externalities can be of
two types- negative externality and positive externality.

A negative externality arises when the third party has to bear the costs or negative impacts of
any production or consumption decisions taken by others.

A positive externality arises when the third party enjoys the benefits or positive impacts of any
production or consumption decisions taken by others.

It is further possible to distinguish the externalities that arise from production or consumption
decisions.

 Negative production externalities

They arise when the third party has to bear the costs arising from the production of any good or
service. For example, cleanup costs that is imposed on the community or river authority due
to the disposal of chemical wastes by the producers of chemicals.

 Negative consumption externalities

They arise when the third party has to bear the costs arising from the consumption of any good
or service. For example, discomfort and respiratory problems that arise to the non-smokers
due to the consumption of cigarettes by others.

 Positive production externality

It is the benefit enjoyed by the third party that arises from the production of any good or
service. For example, when as a result of medical research, a new drug or vaccine is
developed to combat a serious disease; it not only benefits the recipients but also has wider
benefits to others and to the economy as a result of the reduced incidence of the disease.
5|Page

 Positive consumption externality

It is the benefit enjoyed by the third party that arises from the consumption of any good or
service. For example, the attainment of secondary education not only benefits the students
but the benefits are also extended to their families and to future economic prospects.

 The problem caused by externalities

The presence of externalities in the market leads to an inappropriate amount of goods or
services being produced and consumed. The goods or services will either be overproduced and
over consumed or under produced and under consumed in the free market. This is an
inefficient use of scarce resources or the problem of market failure.

 Externalities and Market Failure

Externalities lead to market failure because a product or service's equilibrium price does not
accurately reflect the true costs and benefits of that product or service. Equilibrium, which
represents the ideal balance between buyers' benefits and producers' costs, is supposed to
result in the optimal level of production. However, the equilibrium level is flawed when there
are significant externalities present in an economy. This is known as a market failure.

 Market failure caused by negative Externalities

When negative externalities are present in an economy, it means the producer and consumers
do not bear all costs, which results in excess production.
An example of negative externality can be a factory that produces chemicals. The production of
chemicals pollutes the environment. The cost of the pollution is not borne by the factory, but
instead shared by society. If the negative externality is taken into account, then the cost of
producing chemicals would be higher. This would result in decreased production and a more
efficient equilibrium. In this case, the market failure would be too much production and a price
that didn’t match the true cost of production.

Fig: Market failure caused by negative production externality

6|Page

Fig: Market failure caused by negative consumption externality

 Market failure caused by positive externality

When positive externalities are present in an economy, the private decision makers don’t take
into account the external benefits which are the real benefit to the society. Hence the goods
involved are produced and consumed in the quantities below the optimum quantity.

For example, merit good like education is under produced and under consumed in an economy
due to the presence of positive externality. Obviously, a person being educated will be
benefited in terms of the attainment of knowledge and higher employment prospects.
However, there are positive externalities beyond the person being educated, such as a more
intelligent and knowledgeable citizenry, increased tax revenues from better-paying jobs, less
crime, and more stability. All of these factors positively correlate with education levels. These
benefits to society are not accounted for when the private decision makers consider the
benefits of education. Therefore, education would be under-produced and under-consumed in
the free market and the free market fails.

Fig: Market failure caused by positive production externality

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Fig: Market failure caused by positive consumption externality

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 What happens to resource allocation if MSB=MPB or MSC= MPC?

If MSB=MPB or MSC =MPC, there would be no externalities present in the economy. That is, the
production or consumption decisions will not have any effects on the third party. In such
situation, the quantity of the goods produced and consumed will be at the optimum level and
the scarce resources will be allocated efficiently.

Fig: Efficient allocation of resources

9|Page

In the figure, the free market is in equilibrium at point ‘E’ where the market demand curve,
D=MPB=MSB intersects the market supply curve S=MPC=MSC. The quantity of the good
produced and consumed is Q and the price is P, which represents the MPB=MSB and MPC=
MSC. Since, there are no externalities present in the market, the quantity of the good produced
and consumed is at the optimum level. Hence, the scarce resources are allocated efficiently and
there is no problem of market failure.

 Cost- Benefit Analysis (CBA)

A cost-benefit analysis is a process/method used by the businesses/economists to analyze
decisions. It assesses the desirability of the project by taking into account the costs and benefits
involved in the project. The business or analyst sums the benefits of a project and then
subtracts the costs associated with taking that action. A project is considered worthwhile if it
generates net social benefit to the society or if the social benefits exceed social costs.
There are many situations where CBA can be used to aid decision making. In all types of
economy there are numerous examples of environmental pollution that result in external costs
being imposed on the local community. These can be far reaching and substantial. CBA helps to
quantify the opportunity costs to society of the various action /decisions and helps to make
right choice of actions.

CBA as a means of decision making involves the following four stages:

The first stage is to identify all of the relevant costs and benefits arising out of any particular
project. This involves establishing what are the private costs, the private benefits, the external
costs and the external benefits.
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The second stage involves putting a monetary value on the various costs and benefits. This is
relatively straight forward where the costs and benefits have market prices. In case, the costs
and benefit don’t have market prices, shadow prices are imputed on them. For example,
shadow prices are imputed on pollution, loss of scenic beauty etc. that arise from the disposal
of chemical wastes by the producers of chemicals.

The third stage involves forecasting future costs and benefits. This stage applies in situations
where the economic projects have longer-term implications that stretch well into the future.
This is of particular significance to the proposed projects where massive capital expenditure is
involved.

The fourth stage is where the decision is made by drawing together the outcomes of all the
previous stages. The principle followed is that if an economic project yields net social benefits
(SB ˃SC) it is considered worthwhile or otherwise the project is rejected.

 Difficulties in using CBA to aid decision making

 It is difficult to identify which costs and benefits should be included. An economic
project may give rise to various types of costs and benefits that may have different
effects on different stake holding groups. In such situation, it becomes difficult to decide
which of these costs and benefits are to be included and which not.

 It is difficult to put accurate monetary values on the costs and benefits that don’t have
market prices. For example, accurate monetary values cannot be imputed to the saving
of time, loss of life due to accidents etc. that arise due to development of rail route.

 CBA doesn’t satisfactorily reflect the distributional consequences of certain decisions,

particularly where public sector investment is involved. For example, in case of a new
retail development, external costs are likely to be highly localised, while external
benefits, in terms of employment creation for instance, are likely to more widely spread.

 Many public sector projects can be very controversial and subject to much local
aggravation from pressure groups. It may be the case that the outcome of CBA is
rejected for political reasons, with the consequence that the most expedient decision
may not be the one recommended by the economists.
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 Difference between CBA and private sector methods of appraisal

 Public sector CBA seeks to include all the costs and benefits while private sector
appraisal includes only the private costs and benefits.

 Public sector CBA often imputes shadow prices to the costs and benefits that don’t have
market prices while private sector appraisal doesn’t impute shadow prices as it does not
take into account the external costs and benefits.

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A Level
Unit 7.5- Types of cost, revenue and profit, short-run and long-run production
Worksheet-1

1. A firm has fixed costs of $300 and can produce two units per hour. Its total variable costs are
$200 for one unit and $300 for two units.
Which cost will fall by the lowest amount when the second unit is produced?
A average fixed cost
B average total cost
C average variable cost
D marginal cost

2. Which is an external economy of scale?

A cheaper costs from purchasing large quantities of inputs
B decreased interest rates on borrowed funds
C increased labour productivity
D relevant training facilities at a local college

3. The diagram shows a firm’s total revenue curve.

What is true at the highest point on the curve?

A Average revenue equals marginal revenue.
B Average revenue is zero.
C Marginal revenue is zero.
D Maximum profits are made.

4. Which is an internal economy of scale?

A efficient local transport networks
B improved access to spare parts as a result of industry growth
C lower risks from supplying a wider range of customers
D the training of skilled labour at a college financed by local firms
2|Page

5. When a firm doubles its variable inputs, its fixed inputs are unchanged and output less than
doubles.
What does this illustrate?
A decreasing average cost
B decreasing marginal cost
C diminishing returns
D diseconomies of scale

6. To maximise total revenue, up to which point should a monopolist increase output?

A where marginal revenue equals average revenue
B where marginal revenue is maximised
C where marginal revenue is zero
D where price elasticity of demand is zero

7. A firm is operating in perfect competition.

What will be the effect on the firm’s revenue if it increases its output by 5 %?
A Its revenue will be unchanged.
B Its revenue will increase by 5 %
C Its revenue will increase by less than 5 %.
D Its revenue will increase by more than 5 %.

8. The diagram shows the total product of labour (TPL) curve for a firm whose only variable factor
input is labour.

What explains the shape of the curve?

A diminishing marginal disutility of work
B increasing marginal disutility of work
C technical diseconomies of scale
D the law of variable proportions

9. What relationship does a firm’s long-run production function describe?

A the firm’s output and the quantities of factor inputs employed
B the firm’s long-run average cost of production and the level of output
C the firm’s long-run average cost of production and the quantities of factor inputs employed
D the prices of factor inputs and the quantities of factor inputs employed
3|Page

[Link] table shows a firm’s total and marginal costs.

What is the average fixed cost of producing 6 units?

A $50 B $60 C $180 D $300

11. A firm experiences external diseconomies of scale and decreasing returns to scale.
How would these changes be illustrated on a cost curve diagram?

12. The diagram shows the demand curve for a firm’s product.

Which diagram depicts the shape of the firm’s corresponding total revenue (TR) curve?

13. Which is a risk-bearing economy of scale?

A greater bargaining power in purchasing from suppliers
B greater diversification of the product range
C lower costs in raising capital
D lower distribution costs by increasing market share
4|Page

14. To increase the number of cleaners at a local school from 10 to 11, the employer has to raise the
hourly rate of pay from $8.00 to $8.50.
What is the marginal cost of labour per hour to the employer?
A $0.50 B $13.50 C $88.50 D $93.50

15. A firm employs a worker who adds less to output than the previous worker employed.
What does this illustrate?
A decreasing marginal costs
B diseconomies of scale
C increasing returns to scale
D the law of diminishing returns

16. A firm estimates that, all else remaining unchanged, an increase in its output will result in an
equal proportionate increase in its revenue.
What can be concluded from this?
A The demand curve for the firm’s product is horizontal.
B The firm operates in a monopolistically competitive market.
C The price elasticity of demand for the firm’s product is –1.
D The supply of the firm’s product is perfectly inelastic.

17. The diagram shows the demand curve for a firm’s product.

Which diagram shows the shape of the firm’s total revenue (TR) curve?
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18. The diagram shows the cost curves for a firm.

What does the firm experience as it increases output from Q1 to Q2?

A decreased average variable cost
B diminishing returns
C economies of scale
D increased profit
19. In the diagram the curve TC shows the relationship between a firm’s total costs and its level of
output.

At output OQ average fixed costs are

20. Which diagram shows the total revenue function for a firm in perfect competition?
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[Link] table below shows the relationship between total output and total costs of a firm given
constant factor prices and fixed factor proportions.

It follows that, over this range of output, the firm experiences

A decreasing returns for output between 100 and 300 and increasing returns for output larger
than 300.
B increasing returns for output between 100 and 300 and decreasing returns for output larger
than 300.
C decreasing returns throughout.
D increasing returns throughout.

22. The price elasticity of demand for a firm’s product is zero.

What will be the effect on the firm’s revenue if it reduces its price by 5%?
A Its revenue will be unchanged.
B Its revenue will decrease by 5%.
C Its revenue will increase by 5%.
D Its revenue will fall to zero.

23. The table shows a firm’s long-run total cost schedule.

Which graph shows the shape of the firm’s long-run average cost curve?
7|Page

24. In the diagram, TC is a firm’s short-run total cost curve.

Which statement is correct?

A Average total cost is minimised at output OQ2.
B Average variable cost is minimised at output OQ1.
C Average variable cost is minimised at output OQ3.
D Marginal cost is minimised at output OQ1.

25. What is an internal diseconomy of scale that often arises as a firm becomes larger?
A a more complex decision-making process
B an increase in the cost of raising finance for investment
C an increase in traffic congestion
D upward pressure on wages in the local labour market

26. A manufacturing firm has one plant of optimum size.

The firm builds a second plant identical to its first plant. The firm then finds that its long-run
average cost has risen.
What could account for the change in its long-run average cost?
A diminishing returns
B external diseconomies of scale
C managerial diseconomies of scale
D technical diseconomies of scale

27. An economist calculates that an owner-managed firm has incurred the following costs over the
course of a year.

By how much does total cost as defined by an economist exceed the total cost as defined by an
accountant?
A $15 000 B $30 000 C $45 000 D $65 000
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28. The table shows the levels of output of a good which can be produced with different combinations
of labour and capital.

Which characteristic of the production function for this good does the table show?
A a fixed ratio between capital and labour inputs
B constant returns to scale
C increasing marginal productivity of labour
D technical economies of scale

[Link] table gives information about a firm’s costs over a given range of output in the short run and
in the long run.

Which conclusions can be drawn about the characteristics of production over this output range in
the short run and in the long run?

30. The table shows a firm’s marginal costs.

The average fixed cost of producing 5 units is $6.

What is the total cost of producing 5 units?
A $46 B $70 C $190 D $230
9|Page

31. A monopolist faces a downward-sloping straight-line demand curve.

Which diagram shows his total revenue curve (TR)?

32. The table shows a firm’s total costs of production.

What is the average variable cost of producing 5 tonnes of output?

A $8.00 B $10.00 C $12.00 D $20.00

33. An economist calculates that a firm has incurred the following costs over the course of a year.

By how much does total cost as defined by an economist exceed the total cost as defined by an
accountant?
A $75 000 B $45 000 C $35 000 D $10 000
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34. The diagram shows a firm’s short-run and long-run average cost curves.

Which curve is the firm’s long-run average cost curve?

A JLN B JLM C KLM D KLN

35. A firm experiences diseconomies of scale over its entire range of output.
What is the shape of its long-run average cost curve?
A It is horizontal.
B It is ‘U’ shaped.
C It slopes downwards.
D It slopes upwards.

36. Which is a financial economy of scale?

A lower costs in raising capital
B lower costs of marketing
C lower risk due to diversification
D lower variable costs of production

37. The diagram shows the cost curves of a firm in a perfectly competitive market.

Which segment of a curve shows the quantity that the firm would be willing to supply to the
market in the short-run?
A VX B UZ C VZ D WZ
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38. What is the name for the relationship between a firm’s output and the quantities of factor inputs
that it employs?
A a long-run average cost function
B a long-run production function
C productive efficiency
D returns to scale

39. A product with infinite elasticity of supply has sales of 1000 units a week at a price of $1 per unit.
Price elasticity of demand is 1.5 over the relevant range.
The government imposes a tax of 10 %.
What will be the government’s weekly tax revenue?
A $15 B $85 C $100 D $150

40. The schedule shows the short-run marginal cost of producing good X.

Given that the total fixed cost is $20, what level of output minimises average total cost?
A 2 units B 3 units C 4 units D 5 units

41. To increase its labour force from 100 to 101 workers, a firm has to increase its daily wage rate
from $500 to $502.
What is the marginal cost of labour per day?
A $2 B $200 C $202 D $702

42. To increase its labour force from 50 to 51 workers, a firm has to increase the daily wage rate from
$600 to $610.
What is the marginal cost of labour per day?
A $10 B $510 C $610 D $1110

43. An industry consists of a large number of firms, all of which produce an identical product.
What could explain why the demand curve facing each individual firm is downward-sloping?
A diminishing marginal utility
B freedom of exit and entry
C imperfect knowledge on the part of consumers
D a limit on the amount consumers have available to spend
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44. As firm X grows in size, it specialises in a narrower range of products.

Which economies of scale will the firm be less able to benefit from?
A financial
B marketing
C risk-bearing
D technical

45. Samsung Electronics, which began as a semiconductor firm making simple memory chips, has
used continuous research and investment to emerge as an industry leader.
In addition, it has applied its strength in semiconductors to other markets including televisions
and mobile phones.
What has taken place?
A external growth and diversification
B external growth and sales revenue maximisation
C internal growth and diversification
D internal growth and sales revenue maximisation

46. A firm in perfect competition currently sells 100 units at $5 each.

What will be the revenue obtained by the firm if it increases its price to $6?
A zero B $100 C $500 D $600

47. An example of forward vertical integration for a computer manufacturer would be a merger with
A another computer manufacturer.
B a computer retailer.
C a silicon chip manufacturer.
D a software developer.

48. How might a firm benefit from external economies?

A by increasing its expenditure on advertising
B by increasing its scale of production
C by locating in an area in which the industry is already established
D by merging with another domestic firm engaged in the same industry
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49. The diagram shows the short-run cost curves of a firm.

Which statement is correct?

A Curve 1 is the average fixed cost curve.
B Curve 2 is the marginal cost curve.
C Curve 3 is the average variable cost curve.
D Curve 4 is the average total cost curve.

50. Which diagram shows a firm’s total fixed cost curve?

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7.5 Types of cost, revenue and profit, short-run and long-run production

 The firm’s revenue

The firm’s revenue is the income received by the firms from the sale of their output/products.

 Total Revenue (TR) is the total amount of money income received by the firms from
the sale of a given quantity of their products/output. It is the sum of Marginal
Revenue.

Mathematically,
TR = ΣMR1 +MR2+…………..+MRn
Or, TR = P x Q
=AR X Q [Average Revenue = Price per unit]

Example:
Quantity sold = 50 units
Price = $10/unit
So, TR=$10 X 50
=$500

 Average Revenue (AR) is the income received by the firms per unit of output sold. It
represents the market price of the product.
Mathematically,

AR = = Price per unit

Example:
If, Q=50 units and TR = $500 then,
AR = = $10 (price per unit)

 Marginal Revenue (MR) is the income received by the firms from the sale of an
additional unit of output.
Mathematically,

MR =

Example:
2|Page

When Q=50 and P=$10/unit, TR=$500. Now, Q increases to 51 units causing the TR to rise to
$510. So,

MR =

=$10

 Revenue of the firms in a perfectly competitive market

The market for a product is said to be perfectly competitive if the product is sold/supplied by
a large number of sellers at the ruling/market clearing price. In such a market structure,
individual firms/sellers don’t have any control over the price of the product. The price of the
product is determined by the free interaction of the market forces of demand and supply. The
individual sellers sell their products at the ruling price but they can decide on the quantity of
the products they wish to sell at the ruling price. Hence, the individual firms/sellers are the
price takers. Example: market for gold, silver, wheat…etc.

Table: Revenue of the firms in perfect competition

Quantity Average Revenue(AR) = price Total Revenue(TR) Marginal Revenue(MR)

sold(Q)
1 10
2 10
3 10
4 10
5 10
6 10
7 10
8 10

Fig: Revenue curves of the firms in perfect competition

3|Page

 Nature of AR/price

AR remains constant/ fixed as the firms the firms don’t have any control over the price of the
product and they sell the product at the ruling price. The AR curve is also the demand curve
of the firms. The AR cure of the firms in perfect competition is a horizontal straight line which
shows that the demand for the product is perfectly elastic.

 Nature of TR

TR increases at a constant rate as the price of the product (AR) is constant. Hence, the TR
curve is a 450 line.

 Nature of MR

MR remains constant throughout as every additional unit of the product is sold at the same
price. Since, AR= MR, the MR curve coincides the AR curve.
4|Page

 Revenue of the firms in imperfect competition

The market for the products is said to be imperfectly competitive if their prices are fully or
partially controlled by the sellers/firms. That is, the firms are the price makers. In such a
market structure, if the firms want to increase the sales of their products, they must reduce
their prices. Hence, the quantity sold increases as the price of the product decreases and vice
versa. Imperfectly competitive market includes the market structures like monopoly,
monopolistic competition, oligopoly etc. Example: market for sportswear, cars…etc.

Table: Revenue of the firms in imperfect competition

Quantity sold(Q) AR=Price TR MR

1 10 10 10
2 9 18 8
3 8 24 6
4 7 28 4
5 6 30 2

6 5 30 0
7 4 28 -2
8 3 24 -4
9 2 18 -6
10 1 10 -8

 Nature of AR:

It decreases throughout as the sale of the firm’s product increases only when the price=AR
decreases. It decreases at a slower rate than the MR. Due to this reason; the AR curve lies to
the right of MR curve.

 Nature of MR:

It decreases throughout as every additional unit of the product is sold at lower price. As the
firms can sell the additional units of their products only by reducing the price, it follows that
the value of MR is always lower than AR.

 Nature of TR:

It increases until the MR is positive, reaches the maximum when the MR becomes zero and
starts to fall when the MR becomes negative.
5|Page

Fig: Revenue of the firms in imperfect competition

 Relationship between price, TR and PED

 If the TR rises with the fall in price of product and vice versa then, PED˃1
 If TR doesn’t change with the change in price of the product then, PED=1
 If TR falls with the fall in price of the product and vice versa then, PED˂1
6|Page

 The firm’s costs of production

They are the costs of the factors of production incurred to produce the finished products.
These are the private costs directly incurred by the firms. Production may also give rise to
external costs but they are not necessarily taken into account by the firms.

 Short-run Costs

Costs in the short run are classified as fixed costs and variable costs.

 Fixed costs or Total Fixed Costs (TFC)

These are the costs that are completely independent of the quantity of output produced.
That is, they don’t change with the change in the quantity of output produced. If the
quantity of output produced is zero, TFC = TC. Example of fixed costs includes cost of
purchasing land, cost of purchasing machines, cost of constructing factory building etc.

Mathematically,

TFC = TC- TVC

 Variable Costs or Total Variable Costs(TVC)

These are the costs that change with the change in the quantity of output produced. If the
quantity of output produced is zero, TVC will be zero. Examples of variable costs include
Labour and raw-material cost etc.

Mathematically,

TVC = TC- TFC

Or, TVC = ΣMC1 + MC2 +……+ MCn

 Semi-variable Cost

It bears the feature of both fixed cost and variable costs. Electricity bill is an example
of semi- variable cost.
7|Page

 Total Cost (TC)

It is the sum of Total Fixed Costs and Total Variable costs. So,

TC = TFC+ TVC
Or, TC = AC (ATC) x Q
Or, TC = (AFC + AVC) x Q

Table: Relationship between TC, TFC and TVC

Output Produced(Q) TFC TVC TC

0 100 100
1 150
2 190
3 220
4 240
5 275
6 330
7 410
8 500

 Nature of TFC
It doesn’t change with the change in the quantity of output produced. It remains fixed/
constant at all levels of output.
 Nature of TVC
As the level of output produced increases, TVC increases at a diminishing rate in the
beginning and eventually it increases at an increasing rate.

 Nature of TC
Like TVC, TC also increases at a diminishing rate in the beginning and eventually increases at
an increasing rate with an increase in the level of output produced.
8|Page

Fig: Relationship between TC, TFC and TVC

 Average Cost or Average Total Cost (AC or ATC)

It is the cost per unit of output produced.

Mathematically,
AC (ATC)=
Or, ATC= AFC + AVC

Or, ATC =

 Average Fixed Cost (AFC)

9|Page

It is the fixed cost per unit of output produced.

Mathematically,

AFC =

 Average Variable cost (AVC)

It is the variable cost per unit of output produced.

Mathematically,

AVC =

 Marginal Cost (MC)

It is the cost of producing an additional unit of output.

Mathematically,
MC =

Table: Short run costs

Q TFC TVC TC AFC AVC ATC MC

0 100 0 100 --- ----- ---- 100
1 100 50 150 100 50 150 50
2 100 90 190 50 45 95 40
3 100 120 220 33.33 40 73.33 30
4 100 140 240 25 35 60
20
5 100 175 275 20 55
35 35
6 100 230 330 16.67 38.33
55 55
7 100 310 410 14.29 44.29 58.58 80
8 100 400 500 12.5 50 62.5 90

 Nature of AC(ATC)

As the quantity of output produced increases, ATC decreases, reaches the lowest and
eventually increases. A fall in ATC shows the occurrence of law of increasing returns while
an increase in ATC shows the occurrence of law of diminishing returns. ATC decreases
10 | P a g e

until the law of increasing returns operates and it starts to increase as the law of
diminishing returns sets in. This nature of ATC gives the ATC curve a classical ‘u’ shape.

Fig: Short run ATC curve

 Nature of AFC

AFC decreases throughout as the quantity of output produced increases. This is because
AFC is derived by dividing the TFC by the quantity of output produced.

Fig: AFC Curve

11 | P a g e

 Nature of AVC

As the quantity of output produced increases, AVC decreases, reaches the lowest and
finally increases. AVC decreases until TVC increases at a diminishing rate and it starts to
increase as the TVC starts to increase at an increasing rate.

Fig: AVC Curve

 Nature of MC

As the quantity of output produced increases, MC decreases, reaches the lowest and
finally increases. MC decreases until TC increases at a diminishing rate and starts to
increase as the TC starts to increase at a increasing rate.

Fig: MC Curve

Note:

The upward sloping segment of the MC curve is also the supply curve of the industry/ market
in which the firms operate. This is because as the level of output is increased the MC starts to
12 | P a g e

increase after reaching the lowest point. That is, the cost of producing the additional unit
increases as the output is increased above the level where MC is the lowest. Hence, a firm
will not be willing to sell the additional units of its product at the same price. It will sell the
additional units of its product only if the price increases. This is because the costs of
producing the additional units will be covered up only if the price of the product rises. So the
upward sloping segment of the MC curve is also the market supply of the product.

 Relationship between ATC and MC

As the quantity of output produced increases, both ATC and MC decrease in the
beginning, reach their lowest point and finally start to increase. ATC and MC become
equal to each other when the ATC is at its lowest. Due to this reason the MC curve always
cuts the ATC curve at its lowest point. MC decreases as well as increases at a faster rate
than the ATC. Due to this reason the MC curve always lies to the left of ATC curve or MC
curve is steeper than the ATC curve.

Fig: Relationship between ATC and MC

Fig: Short run cost relationships

13 | P a g e

Note:

 A firms shutting down point is where the AVC is at its lowest. That is, a firm shuts
down if the market price of the product fails to cover up the lowest AVC.

 The segment of the MC curve above the AVC cure is the short-run supply curve
while the segment above the SRATC curve is the long-run supply curve of the
market/industry.

 Derivation of short-run costs

 Derivation of AFC curve from the TFC curve
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 Derivation of AVC curve from the TVC curve

 Derivation of AC/ATC curve from the TC curve

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Graphically, the AC curve is derived in the same way as AVC is derived from the TVC curve.

AC at each level is the slope of a line drawn from the origin to the corresponding point on the TC
curve. The slope of the ray diminishes as one moves along the TC curve until B is reached. This means
AC must decline till OQ2 is attained. Thereafter, the slope of the line OC rises and the AC takes a
positive slope. So, the AC curve is U-shaped.

 Derivation of MC curve from the TVC curve

How MC is derived from the TVC curve can be known from Fig. 3.19. Graphically, MC curve is the slope
of the TVC curve. The slope of a curve at any one of its points is the slope of the tangent at that point.

Suppose output increases from OQ1 to OQ2 and total cost increases from OC2 to oc1. We have drawn
a tangent on the TVC curve at point S. Thus, MC at this point will be equal to the slope of the tangent,
i.e.,

MC= OC1 – OC2/OQ2 – OQ1 = SR/PR

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 Costs of production in the long-run

In the long run all the factors of production are variable. This gives the firms a greater scope
to lower their costs of production by changing the quantities of all the factor inputs used in
the production process or by introducing a new production technique with higher
productivity. For example, if labour becomes relatively more expensive, a firm will substitute
labour by capital or change the entire production process to lower its costs of production.
This will enable a firm to reduce its price without sacrificing profit. Hence a firm can produce
a given output at a lower cost in the long run than in the short run. This possibility of
lowering the costs of production in the long run can be explained using the long run average
total cost (LRATC) curve.

As seen in the above diagram,

 As the firm increases the scale of production up to OQ, it experiences increasing

returns to scale (output increases by a higher proportion than an increase in inputs).
As a result the unit cost of production falls. This benefit of reduction in the unit cost of
production is referred to as economies of scale.
 The level of output at which the LRATC is the lowest (OQ) is called Minimum Efficient
Scale (MES). As the scale of production is increased above the MES, diminishing
17 | P a g e

returns to scale sets in causing the LRATC to increase. This increase in the LRATC with
an increase in the scale of production is referred to as diseconomies of scale.

 At each point on the LRATC curve the short run rules of production apply. That is, as
the level of output is increased in the short run, SRATC falls due to increasing marginal
returns resulting from division of labour and falling AFC. As the diminishing marginal
returns sets in SRATC starts to rise. In the long run, as the scale of production
increases the long-run costs fall or rise but the short run curve still applies to each
scale. It is important not to confuse the short run reasons for changing costs with the
long run reasons.

 The shape of the LRATC curve is derived from a series of SRATC curves. As output
increases, the scale of operations of the firm increases. The LRATC curve touches or is
tangential to each of the SRATC curves. That is, the LRATC curve envelopes all the
SRATC curves. Hence, it is sometimes known as the firm’s planning or envelope curve.
It represents the lowest possible average cost for each level of output where the
factors of production are all variable. However, it should be noted that the firm is not
necessarily producing at the minimum point on each of its SRATC curves.

 The LRATC curve is flatter U-shaped than the SRATC curves and this shape of the
LRATC curve can be explained by economies of scale and diseconomies of scale.

 Economies of Scale and Diseconomies of Scale

Economies of scale are the reduction in the firm’s unit cost of production in the long run with
an increase in the scale of production. It results from the increasing returns to scale.

Economies of scale are of two types-Internal and external

 Internal economies of scale

Internal economies of scale arise from the growth of the business itself. That is, internal
economies of scale is the reduction in the firm’s unit cost of production in the long run due to
the firm’s own decision of growing in size. Examples include:
18 | P a g e

 Technical economies of scale:

It is the reduction in the firm’s unit cost of production due to the introduction of more
efficient production techniques.

For example, a supermarket chain such as Tesco or Sainsbury's can invest in technology that
improves stock control. It might not, however, be viable or cost-efficient for a small corner
shop to buy this technology.

 Marketing economies of scale

A large firm can spread its advertising and marketing budget over a large output and it can
purchase its inputs in bulk at negotiated discounted prices if it has sufficient negotiation
power in the market.

A good example would be the ability of the electricity generators to negotiate lower prices
when negotiating coal and gas supply contracts. The major food retailers also have buying
power when purchasing supplies from farmers and other suppliers.

 Managerial economies of scale

This is a form of division of labour. Large-scale manufacturers employ specialists to supervise

production systems, manage marketing systems and oversee human resources.

 Financial economies of scale

Larger firms are usually rated by the financial markets to be more 'credit worthy' and have
access to credit facilities, with favourable rates of borrowing. In contrast, smaller firms often
face higher rates of interest on overdrafts and loans.

 Purchasing or Buying economies

Large businesses often receive a discount because they buy in bulk. A large firm can purchase
its factor inputs in bulk at discounted prices if it has greater buying power. They have the
ability to buy more from suppliers at a lower price.

For example, Amazon has huge buying power in the publishing industry.

 Risk-bearing economies

Larger firms produce a range of products. This enables them to spread the risks of trading. If
the profitability of one of the products it produces falls, it can shift its resources to the
production of more profitable products. Risk-bearing economies result from diversification.
19 | P a g e

 External economies of scale

External economies of scale occur due to the reasons other than the firm’s own decision of
growing in size. Examples of external economies of scale include:

 Development of research and development (R and D) facilities in local universities that

serves the local businesses in an area.
 Spending by a local authority on improving the transport network for a local town or
city.
 Relocation of component suppliers and other support businesses close to the main
centre of manufacturing are also an external cost saving.

 Diseconomies of scale

Diseconomies of scale mean an increase in the unit cost of production with an increase in the
scale of production in the long run. It results from the diminishing returns to scale.
Diseconomies of scale are of two types-internal and external.

 Internal Diseconomies:

Internal diseconomies implies to all those factors which raise the cost of production of a
particular firm when its output increases beyond the certain limit. Internal diseconomies may
arise due the following reasons:

(a) Inefficient Management:

The main cause of the internal diseconomies is the lack of efficient or skilled management.
When a firm expands beyond a certain limit, it becomes difficult for the manager to manage
it efficiently or to co-ordinate the process of production.

(b) Technical Difficulties:

Another major reason for the onset of internal diseconomies is the emergence of technical
difficulties. In every firm, there is an optimum point of technical economies. If a firm operates
beyond these limits technical diseconomies will emerge out.

(c) Production Diseconomies:

It may be due to the use of inferior or less efficient factors as the efficient factors are in
scarcity. It happens when the size of the firm surpasses the optimum size.
20 | P a g e

(d) Marketing Diseconomies:

After an optimum scale, the further rise in the scale of production is accompanied by selling
diseconomies. It is due to many reasons. Firstly, the advertisement expenditure is bound to
increase more than proportionately with scale. Secondly, the overheads of marketing
increase more than proportionately with the scale.

(e) Financial Diseconomies:

If the scale of production increases beyond the optimum scale, the cost of financial capital
rises. It may be due to relatively more dependence on external finances.

 External Diseconomies:

External diseconomies mean an increase in the firm’s unit cost of production with an increase
in the scale of production in the long run due to the reasons other than the firm’s own
decision of growing in size.

Some of the external diseconomies are as under:

(a). Diseconomies of Pollution

The localization of an industry in a particular place or region pollutes the environment. The
polluted environment acts as health hazard for the labourers. Thus, the social cost of
production rises.

(b). Diseconomies of Strains on Infrastructure:

The localisation of an industry puts excessive pressure on transportation facilities in the

region. As a result of this, the transportation of raw materials and finished goods gets
delayed. The communication system in the region is also overtaxed. As a result of the strains
on infrastructure, monetary as well as the real costs of production rise.

(c). Diseconomies of High Factor Prices

The excessive concentration of an industry in a particular industrial area leads to keener

competition among the firms for the factors of production. As a result of this, the prices of
the factors of production go up. Hence, the expansion and growth of an industry would lead
to rise in costs of production.
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 Theory of production
Principle of production
The principle of production is that the firms should produce their products at the lowest
possible cost. Producing the products at the lowest costs makes the products efficient,
competitive and profitable. In order to produce their products at the lowest costs, the firms
should find the least cost combination of factor inputs (labour and capital).It is that
combination/mix of factor inputs that can produce the given output at the lowest possible
costs. In order to find the least cost combination of factor inputs, firms substitute the cheaper
factor input for the expensive one.
For example, if labour is relatively cheaper the firms will substitute labour for capital. This
tendency of substituting one factor input for another is called Marginal Rate of Technical
Substitution (MRTS).If labour is substituted for capital, it is called the marginal rate of
technical substitution of labour for capital (MRTSLK =). So a firm may have various alternative
production techniques with different combinations of factor inputs that can be used to
produce a given output. Out of those production techniques, a firm will choose that particular
technique that can produce the given output at the lowest cost.

Example:
Let, price of capital = $20/unit
Price of labour=$10/unit
Production Factor inputs(labour & Output produced Total costs($)
Techniques capital)

A 15L + 5K 500 units $250

B 10L+10K 500 units $300

C 5L+15K 500 units $350

In the above example, A, B and C are the alternative production techniques that can be used
to produce the given output of 500 units. Each of these production techniques has different
mix of factor inputs (labour and capital). Of all these production techniques, the firm will
choose to produce the given output using the production technique A as it can produce the
given output at the lowest cost, that is, $250.
22 | P a g e

Fig : Alternative production techniques/methods

 Production Function
It is the functional relationship between factor inputs used in the production process and the
output produced. It explains how the output increases when the factor inputs used in the
production process are increased continuously.
Qx = F (land, labour, capital……)

 Short-run production function

In the short run, at least one factor input used in the production process remains fixed/
constant. So, the short-run production function explains how the output increases when one
factor input (labour) used in the production process is increased continuously, keeping other
factor input (capital) fixed.

This short-run production function can be explained using the law of variable proportion.
23 | P a g e

The law of variable proportion states that as the quantity of one factor is increased, keeping
the other factors fixed, the marginal product (MP) of that factor (variable factor) will
eventually decline.
This means that as the amount of variable factor is increased continuously, marginal product
(MP) of the factor may increase up to certain point and after that point it starts to diminish.
When the variable factor becomes relatively abundant, the marginal product may become
negative.

Table: Short-run production function: Law of variable proportion

Number of Number of Total product(TP) Marginal Average

machines(QK) workers(QL) product(MP=) Product(AP=)

3 0 0 ----- -----

3 1 4 4 4

3 2 9 5 4.5

3 3 15 6 5
3 4 20
5 5
3 5 24 4 4.8

3 6 26 2 4.33

3 7 26 0 3.7

3 8 24 -2 3

As seen in the table, as the number of workers is increased from 0 to 3, MP increases or TP

increases at an increasing rate. This is referd to as the law of increasing returns. It occurs
because with less than 3 workers, the existing capital was not being used efficiently or they
are used below full capacity. With three workers, the machines are used efficiently. So, from
1 to 3 workers, MP increases or TP increases at an increasing rate.

This means that the output produced by each additional worker is greater than the output
produced by the previous workers employed.
24 | P a g e

As the number of workers is increased above 3,MP decreases while TP continues to increase
but at a decreasing rate. In other words, the MP decreases beyond 3 workers. This is referred
to as the law of diminishing returns.
It occurs because with only 3 machines, the 4th, 5th and 6th workers are able to contribute
less and less additional output to the firm’s production. With only 3 machines, the firm is
literally getting too crowded to allow for continued increase in productivity.

Beyond 6 workers, additional labour adds nothing to total output. The 8th worker actually
causes the total product to fall. This indicates that the presence of 8th worker simply
interferes with, rather than contributes to, the production of the product.

Thus we see that in the short-run keeping one factor input fixed, if another factor input is
increased continuously then, up to a point law of increasing return will occur and eventually
law of diminishing returns will occur.

Fig: Law of variable proportion: short-run production function

25 | P a g e

The above diagram is a representation of short run production function. It is seen that
keeping capital fixed, as the units of labour is increased up to 3 units, Law of increasing
returns occurs. That is, MP increases and TP increases at an increasing rate up to the
employment of 3 workers.

As the number of workers is increased above 3 units, law of diminishing returns occurs. That
is, MP starts to decrease and TP starts to increase at a diminishing rate as the number of
workers is increased above 3 unit

 Things to remember

 Law of increasing returns occurs if the output (TP) increases by a higher proportion
than an increase in the variable factor (labour) or if the MP increases with an increase
in the variable factor (labour).
26 | P a g e

Quantity of % change in Output(TP) % change in

variable factor(L) input/labour output(TP)
2 50% 100 100%
3 200

 Law of constant returns occurs if the output (TP) increases by an equal proportion as
an increase in the variable factor (labour) or if the MP remains constant/unchanged
with an increase in the variable factor (labour).

 Law of diminishing returns occurs if the output (TP) increases by a smaller proportion
than an increase in the variable factor (labour) or if the MP decreases with an increase
in the variable factor (labour).

 Long-run production function

In the long run production function, the relationship between input and output is explained
under the condition where all factor inputs (labor and capital) are variable.

In the long run, the supply of both the inputs, labor and capital, is assumed to be elastic
(changes frequently). Therefore, producers can hire larger quantities of both the inputs. If
larger quantities of both the inputs are employed, the level of production increases. In the
long run, the functional relationship between changing quantity of inputs and output is
explained under laws of returns to scale. The laws of returns to scale can be explained with
the help of isoquant technique.
27 | P a g e

Iso-quant curve
An iso-quant curve is a graphical representation of various combinations of factor inputs
(labour and capital) that can produce the same quantity of output. The factor combinations
are so formed that the substitution of one factor input for other leaves the output
unchanged.
Table: Iso-quant schedule
Combinations Quantity of Quantity of Output MRTS LK
labour(QL) capital(QK)

A 10 16 2000 -----

B 11 11 2000 =5

C 12 7 2000 4

D 13 4 2000 3

E 14 2 2000 2

F 15 1 2000 1

Fig: Iso-quant curve

28 | P a g e

In the figure, IQ is an isoquant curve. Points A, B, C, D, E and F on the isoquant curve

represent various combinations of factor inputs (labour and capital) that can produce the
same quantity of output (2000 units). Since all the combinations of factor inputs are equally
efficient, the producer remains neutral on deciding which combination to choose to produce
the given output. Moving from point A to F along the isoquant curve we can see that capital is
being substituted by labour. This tendency of substituting one factor input for another is
refered to the Marginal Rate of Technical Substitution (MRTS). It can also be seen that every
additional units of labour substitutes decreasing units of capital. This is refered to as the
diminishing marginal rate of technical substitution. This diminishing MRTS describes the slope
of the isoquant curve.

 Marginal Rate of Technical substitution (MRTS)

It is the number of units of one factor input (capital) substituted by every additional unit of
another factor input (labour).In the above example; it is the number of change in capital (k) in
relation to one unit change in labour (L).So,
MRTSLK =

 Characteristics of iso-quant curves

 They are negatively sloped because if one of the factor input is reduced, the other
factor input has to be increased so that the total output remains unaffected.
 They are convex to origin (inward bending) because of diminishing MRTS.
 Higher isoquant curve represents higher output.
29 | P a g e

 Two isoquant curves do not intersect each other as it is against the fundamental
condition that a higher isoquant curve represents higher output.
Fig: Iso-quant map

 Iso-cost curve
An iso-cost curve is a graphical representation of various combinations of factor inputs that
yield the same cost of production. Since all the combinations of factor inputs (labour and
capital) yield the same cost, a producer remains neutral on deciding which combination to
choose to produce the given output.
Example:
Let, price of labour= $10/unit
Price of capital=$20/unit

Table: Iso-cost schedule

Combinations Quantily of Quantity Total factor cost ($)
labour(L) of
capital(K)

A 10 0 $100

B 8 1 $100

C 6 2 $100

D 4 3 $100

E 2 4 $100

F 0 5 $100
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Fig: Iso-cost curve

Fig: Iso-cost map

The long run production function is explained under the law of returns to scale. In the long
run, if all the factor inputs used in the production process are increased continuously then,
upto a level of output , increasing returns to scale occurs and finally diminishing returns to
scale occurs.
 Increasing returns to scale occurs if the output increases by a higher proportion
than an increase in the factor inputs (labour and capital).
 For example, if the quantities of factor inputs are doubled and the corresponding
output is more than doubled, the returns to scale is said to be increasing.

Labour and % increase in Output(TP) % increase in

capital labour and output
capital
31 | P a g e

1+1 ----- 10 ------

2+2 100 22 120

 Constant Returns to scale occurs if the output increases by an equal proportion as

an increase in factor inputs. For example, if the quantities of factor inputs are doubled
and output is also doubled, the returns to scale is said to be constant.

Labour and % increase in Output(TP) % increase in

capital labour and output
capital

1+1 --- 10 -----

2+2 100 20 100

 Diminishing returns to scale occurs if the output increases by a smaller proportion

than an increase in factor inputs. For example, if the quantities of factor inputs are
doubled and the output is less than doubled, the returns to scale is said to be
diminishing.

Labour and % increase in Output(TP) % increase in

capital labour and capital output

1+1 --- 10 -----

2+2 100 18 80

Fig: Returns to scale- Long run production function

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In the above diagram,

 Movement from ‘a’ to ‘b’ along the production line shows increasing returns to scale.
Here 100% increase in factor inputs has caused the output increase by 200%.
 Movement from point ‘b’ to ‘c’ shows constant returns to scale where a 100% increase
in factor inputs has caused the output to increase by 100%. That is both the factor
inputs and output has increased by equal proportion.
 Movement from point ‘c’ to‘d’ shows diminishing returns to scale. Here, 100%
increase in factor inputs has caused the output to increase by 33.33%

 Producer’s equilibrium: Cost minimization in the long run

In the long run, all the factors of production used in the production process are variable. This
gives the firms much greater scope to change the respective mix of its factor inputs so that it
is producing at the most efficient level. So, if the capital becomes relatively cheaper than
labour or if new production process is invented that increases productivity then firms can
reorganize the way in which they produce. Firms must therefore know the costs/prices of the
factors of production they use and see this in relation to their Marginal Product / Marginal
Physical Product (MP/MPP).

The best combination of factor inputs would be the one that satisfies the following equation:

= =
If the factor inputs used in the production process are labour and capital then the equation
would be,

= …………………………….. Cost minimizing rule.

33 | P a g e

The producer would be in equilibrium if it produces the given output at the lowest possible
cost. This concept of producer’s equilibrium can be explained by bringing together the
isoquant curve and the iso cost curves/lines. The producer is in equilibrium at the point
where the isoquant curve is tangent to an iso cost curve and the slope of the isoquant curve is
equal to the slope of the iso cost curve. The cost minimising rule is satisfied at the point of
producer’s equilibrium. That is, the given output is produced at the lowest possible cost at
this point of producer’s equilibrium.

Fig: Producer’s equilibrium: Cost minimization in the long run

In the above diagram, the producer is in equilibrium at point ‘c’ where the isoquant curve is
tangent to the lowest iso-cost curve (OP) and the slope of the isoquant curve is equal to the
slope of the iso-cost curve. The most efficient production occurs at this point where the
producer produces the given output of 100 at the lowest possible cost.
Points ‘a’, ‘b’, ‘d’ and ‘e’ cannot be the points of producer’s equilibrium as they are on the
higher isocost curves. This means that the cost of producing the given output of 100 units will
be higher at these points than at point ‘c’. So, to achieve the most efficient level of
production, the producer should reach at point ‘c’ by changing the respective mix of fator
inputs (labour and capital) used in the production process.

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A Level
Unit 7.5, 7.6, 7.7 and 7.8
Worksheet-1
Essay questions for practice

Answer the following questions

1. ‘It is certain that firms maximise profits where marginal cost equals marginal revenue, and that this is
what all firms seek to do.’
Discuss this assertion. [20]

2. Discuss the different aims a firm might have in order to continue with production. [20]

3. ‘A firm in a perfectly competitive market can make either a supernormal profit or a loss in the short
run but will only make normal profit in the long run.’ Assess whether this statement is true. [20]

4. Discuss what alternative objectives a company might have apart from profit maximisation. [20]

5. Discuss whether it is always advantageous for a firm to grow in size. [20]

6. Explain the economic theory of profit maximisation for a firm and consider whether firms are likely to
follow this theory in fixing their price and output. [20]

7. Explain the relationship between marginal revenue and average revenue and their role in determining
the output and profit of a profit maximising firm in a perfectly competitive market. [20]

8. Discuss the significance of economies of scale for the survival of firms. [20]

9. With the help of diagrams distinguish between normal profit and abnormal profit. [20]

10. Discuss whether firms always want to maximise profits and are able to do so in the way suggested by
economic theory. [20]

11. Explain how a knowledge of its long-run average costs might be useful to a profit-maximising firm.
[20]

12. Discuss whether firms always want, and are able, to maximise profits as suggested by economic
theory. [20]
1|Page

A Level
Units – 7.6, 7.7 and 7.8
Worksheet- 1
Multiple Choice Questions (MCQS)

1. Which explains why, in long-run equilibrium in monopolistic competition, firms make only normal
profits?
A consumer resistance
B decreasing returns to scale
C differentiated products
D freedom of entry and exit

2. A monopolist changes its objective from sales revenue maximisation to profit maximisation.

On the diagram, which areas represent the monopolist’s total profit?

3. Which practices would be classified as price discrimination?

2|Page

4. The diagram shows the position of a profit-maximizing firm in a perfectly competitive industry.

What is the correct analysis of this position?

5. A firm successfully engages in a policy of predatory pricing.

What will happen to the prices charged by the firm in the short run and in the long run?

6. Many public utilities can be described as ‘natural’ monopolies.

Which statement best describes the situation leading to a ‘natural’ monopoly?
A There are high fixed costs and falling average costs over all outputs demanded.
B There are legal restrictions on new entrants.
C A single firm controls the supply of raw materials.
D The firm has a patent on an essential process.

7. There are two firms in an industry. Firm X faces a choice. It can either act independently or work
with its rival. If it acts independently its profit could be $900 a week but it could be only $400 a
week depending on what its rival does. If it works with its rival the joint profit of the two firms
together would be $1400, $700 each. It has no knowledge of what the rival’s policy will be.

Which concept describes this situation?

A contestable market
B kinked demand curve
C principal agent problem
D prisoner’s dilemma

8. What explains the kinked demand curve model of price rigidity in oligopoly?
3|Page

A collusion between all firms in the industry in the setting of prices

B the assumption that a single firm acts as price leader for all firms in the industry
C the individual firm’s expectations about other firms’ responses to its price changes
D the presence of barriers to the entry of new firms into the industry

9. The diagram shows an industry producing under conditions of constant average costs.

Under perfect competition, the industry produces output OV.

Which area measures the increase in the industry’s profits if it were to become a monopoly?
A XYSO B XYWT C XYZT D YZW

10. A firm is engaging in price discrimination.

In order to maximise profits, what should the firm do?
A charge a higher price to consumers earning higher incomes
B charge a higher price to consumers earning lower incomes
C charge a higher price to consumers whose demand for the product is price inelastic
D charge a higher price to consumers whose demand for the product is price elastic

11. The diagram shows the cost and revenue curves of a monopoly.

What is the firm’s objective if it produces output OX?

A to achieve normal profit
B to maximise profit
C to maximise total revenue
D to minimise average cost
4|Page

12. What is the likely outcome for producers and consumers when a market moves from being non-
contestable to being a contestable market?

13. The diagram shows a firm’s marginal and average cost curves.
The firm enters a collusive agreement with other firms in the industry. It is agreed that each firm
will charge a common price, OP, and will restrict the level of its output to a production quota set
by the industry cartel.
The firm is allocated a production quota, Oq.

The firm decides to cheat in order to maximise its profits.

What is its short-run increase in profits?
A PGKL
B PHJL
C PHJL minus PGNM
D PGKL minus LKNM

14. A competitive market becomes a monopoly.

What is likely to happen?
A Consumer surplus will be reduced by the amount of the deadweight loss.
B Producer surplus will be reduced by the amount of the deadweight loss.
C The loss in consumer surplus will be balanced by the increase in producer surplus.
D There will be a transfer of surplus from consumer to producer.

15. A firm wishes to acquire some of the consumer surplus its customers currently enjoy.
How might it achieve this?
A by introducing price discrimination
B by reducing operating costs
C by setting a price that maximises revenue
D by taking advantage of economies of scale
5|Page

16. The diagram shows a firm’s cost and revenue curves.

What could explain why the firm produces output OQ?

A It is operating in a contestable market.
B It is operating in a perfectly competitive market.
C It is seeking to maximise profits.
D It is seeking to maximise sales revenue.

17. A perfectly competitive firm finds that at its current level of output, marginal revenue is $2.00 and
marginal cost is $2.50.
If the firm is a profit maximiser, what will happen to its price and output?

18. To maximise total revenue, up to which point should a monopolist increase output?
A where marginal revenue equals average revenue
B where marginal revenue is maximised
C where marginal revenue is zero
D where price elasticity of demand is zero

19. A firm is operating in perfect competition.

What will be the effect on the firm’s revenue if it increases its output by 5%?
A Its revenue will be unchanged.
B Its revenue will increase by 5%
C Its revenue will increase by less than 5%.
D Its revenue will increase by more than 5%.

20. The goal of firm X is to make a minimum acceptable level of profit.

What does this describe?
A profit maximisation
B profit satisficing
C revenue maximisation
D sales maximization
6|Page

21. The diagram shows that a producer increases output from Q1 to Q2.

What will be the result?

22. The diagram shows a monopolist’s cost and revenue curves.

The monopolist changes its price from P1 to P2 and its output from Q1 to Q2.
Which change in objective is indicated by the move from P1 to P2?
A profit maximisation to sales revenue maximisation
B profit maximisation to sales maximisation subject to earning a normal profit
C sales revenue maximisation to profit maximisation
D sales revenue maximisation to sales maximisation subject to earning a normal profit

23. What is generally associated with the principal agent problem?

A Directors prefer company growth to greater shareholder dividends.
B Managers ignore workers’ concerns about safety in the workplace.
C Shareholders determine the price of products.
D Workers go on strike against managers’ reorganisation plans.
7|Page

24. In many developed economies, large and small firms often exist side by side in the same
industry.
What is most likely to explain the survival of the small firms?
A They each offer a much wider range of products.
B They have a higher minimum efficient scale.
C They pay much higher wages to their staff.
D They provide a more personal level of consumer service.

25. A rock band is due to play at a concert hall. In order to create a good atmosphere, the band’s aim
is to sell all the tickets. Ticket prices are set at the highest price that ensures all tickets will be
sold.
What is the motivation for this price strategy?
A profit maximisation
B revenue maximisation
C sales maximisation
D satisficing

26. When will the principal-agent problem occur?

A when managers are not allowed to become shareholders
B when members of a cartel collude to gain higher profit
C when one firm dominates the market
D when owners have different objectives to managers

27. The diagram shows a firm in monopoly producing OQ units.

Which outcome can be observed in the diagram?

A loss minimisation
B profit satisficing
C revenue maximisation
D unit cost minimization
8|Page

28. What will happen to an industry’s supply curve if firms leave the industry?
A It will shift to the left at any given price.
B It will shift to the right at any given price.
C There will be a downward movement along the supply curve.
D There will be an upward movement along the supply curve.

29. Which characteristic of a market is a reason for a firm to remain small?

A The minimum efficient scale is high.
B The potential for x-inefficiency is high.
C There are significant economies of scale.
D There is limited access to financial capital.

30. What is an example of the principal–agent problem?

A the disincentive effect for entrepreneurs of high government tax rates
B the existence of a trade union to put forward workers’ views to managers
C the lack of consumer knowledge of the quality of firms’ products
D the separation of the owners of a firm from the firm’s managers

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1|Page

Units-7.6, 7.7 and 7.8

 Theory of Firms

 Firms and industries

 The firms

Firms are the business organizations that buy or hire the factors of production to produce goods and
services that can be sold at profit. The types of firms include:

 Sole traders or one-man business.

 Partnership business
 Cooperatives
 Private or public limited companies
 State-owned firms
 Multinational or transnational firms.

 The industry/market

In a competitive market structure, the industry is the sum of all the firms making the same product.
It is the total market supply.

In an imperfectly competitive market structure, the industry is the sum of all the firms producing
within the same product group, that is, things that are close substitutes for each other.

The terms industry and market are interchangeable/synonymous.

 The Growth of the firms

The growth of firms/businesses is strongly linked with the pursuit of profit but the motives behind a
firm’s growth may include:

 The desire to achieve a reduction in ATC over time through the benefits of economies of scale.
This allows the firms to compete more efficiently with rivals because they can afford to cut
prices without sacrificing profits.

 To achieve bigger market share that would boost up the sales revenue and profit. This is
sometimes referred to as the monopoly motive.
2|Page

 To diversify the product range. A multi-product firm has the advantage of being able to spread
the business risks. If one branch of its activity is stagnating or going into decline, there will still
be the revenue from others to keep the firm afloat. Firms often see new business opportunities
in related areas. Sometimes they can use the same production facilities to keep the costs down.
These benefits are called ‘economies of scope’.

 To capture the resources of other businesses. Sometimes, firms may realize that resources are
being underutilized in another firm and that the real value of the firm is currently above its
accounting value. The resulting takeovers and mergers can lead to the firm being brought back
into profit or being broken up. This is because the sum of the parts sold separately is greater
than the current valuation of the whole enterprise. This is sometimes called ‘asset stripping’
and the cash received may be ploughed back into improving the core business.

 How do firms grow?

Firms can grow in two main ways. These are through:

 Internal growth

It occurs when the firms decide to retain some of the profit rather than paying it out to the owners. The
retained profit is ploughed back in the form of new investment in order to increase the productive
capacity. This is most likely to occur in capital-intensive activities where the market is expanding. The
timing of such investment is influenced by the stage of business cycle. Most of such investments occur
when the national economy is approaching a boom period.

 External growth:

It occurs when the business expands by joining with others through takeovers or mergers. The objective
in a takeover bid is to buy sufficient share (51%) from the owners of the firm and thus have control over
the business. A merger is where two or more firms agree to join up with each other resulting in the
formation of a new larger legal entity. Mergers may be more numerous when there is downturn in the
economy or where there is a shrinking market and the firms are left with excess productive capacity.

In practice, both internal and external growth can be going on at the same time. External growth may be
quicker and cheaper route for firms than internal growth, especially when there are large fixed costs.
For example, it may be cheaper for one oil company to buy the assets of another than to expand
existing operations, unless there are large recoverable reserves.

The firms may also grow through diversification. This is where the firms produce or sell a range of
different products. Diversification allows the firms to spread the business risks and exploit an
opportunity in the business. Diversification is particularly evident in the conglomerate enterprises such
as Unilever, Nestle, Tata group etc.
3|Page

 Integration

Integration refers to the ways in which the individual parts of a business come together. Integration
occurs through a merger or takeover. The various forms of integration are:

 Horizontal integration
 Vertical integration
 Backward vertical integration
 Forward vertical integration
 Lateral integration

 Horizontal integration is a process or strategy used by the firms to strengthen their position in
an industry. It involves the merger or acquisition/takeover of a business that is in the same
sector of an industry and at the same stage of production. Typical examples are United Airlines’
merger with Continental Airlines, Craft Foods taking over Cadbury in the UK etc.

Horizontal integration results in the consolidation of business (combination of several business

units or different companies into a single, larger organization).

The prime motive for horizontal integration is to reap the benefits of economies of scale. It can
also lead to access to new markets, increased market power and the opportunity to make
abnormal profit by reducing competition.

 Vertical integration is where a firm grows by moving into a forward or backward stage of its
production process or supply chain. Vertical integration is of following two types:
 Forward Vertical integration is where a manufacturer moves into retailing.
 Backward vertical integration is where a manufacturer takes control over some of its
supplies.
Example, Nestle and other food producers are increasingly involved in the production of coffee
beans, cocoa and milk as well as in their manufacture and distribution to retailers and other
consumers.
Vertical integration has various advantages including improved security and quality of supplies
and reduced supply chain costs.

 Lateral integration is the creation of conglomerate enterprise. It is the beginning of the

diversification of a firm where a firm produces and sells a range of different products.
4|Page

 Differing Objectives of a firm

 Profit Maximisation

The main objective of a firm is to maximize its profit, which is, maximizing the difference between total
revenue and total costs. A firm’s profit is maximized when its marginal cost and marginal revenue are
equalized, that is, MC= MR. So, a profit maximizing firm will increase its output up to the level where MC
= MR. If the cost of making the last unit (MC) is just covered up by the revenue received from selling it
(MR), then the profit margin will fall to zero and the total profit will be the highest. If MC˂ MR, a firm
can increase its profit by increasing the level of output. On the other hand, if MC˃MR the firm can
increase its profit by reducing the level of output.
Fig: The profit maximizing rule

In the above figure, the firm’s profit is maximized when it produces OQ level of output as at this level of
output MC=MR. At this level of profit the firm’s profit is $30(10+8+6+4+2+0) which is the highest profit.
If the output produced is below OQ, the firm’s profit is less than the maximum. So the firm has the
scope to increase its profit by increasing its profit by increasing the level of output. On the other hand, if
the level of output is more than OQ, the firm should reduce its output to increase its profit.

Although the main objective of a firm is to maximize profit, it may not operate at the profit maximizing
output because of the following reasons:

 In practice, it is difficult to identify the profit maximizing level of output.

 Large abnormal profit may attract new entrants into the industry that may abolish the possibility
of making abnormal profit in the long run.
 High abnormal profit may damage the relationship between the firm and its stake holders such
as its consumers and the company workforce as they may see the managers and shareholders
earning large returns.
 High profits may trigger action by the firm’s rivals and it could become a target for a takeover
bid.
5|Page

 Firms with large market shares may wish to avoid the attention of government watchdog bodies
such as the Competition and Market Authorities, Justice Department etc.

 Other/alternative objectives of firms

Dissatisfaction with the traditional assumption of profit maximization has led to a number of alternative
objectives being put forward to explain how the firms behave. These are referred to as managerial and
behavioral objectives of the firms. Some such objectives are:

 Sales revenue (total revenue) maximization

 Sales maximization(Break-even)
 Satisficing profit
 Loss minimization
 Ethical objectives

 Sales revenue(total revenue) maximization

A firm may be prepared to accept lower price and produce above the profit- maximizing output in order
to increase its market share in the growing market. This is a penetration pricing policy. A firm choosing
to maximize its sales revenue would increase its output beyond MC=MR until MR had fallen to zero. This
is because a firm’s sales revenue or TR is maximized when MR falls to zero. There may still be abnormal
profit if TR is higher than TC but it is not always the case. The reason why sales revenue maximization
might be chosen in the large firms is that management salaries might be linked to the value of sales.

Fig: Sales revenue (Total Revenue) maximization

 Sales maximization (Break-Even)

Sales maximisation means achieving the highest possible sales volume, without making a loss. In sales
maximization the firms would increase their output where the total revenue (TR) just covers the total
cost (TC). A higher output than this implies loss-making behavior.
6|Page

Fig: Sales maximisation

In the above figure, Q is the sales maximizing level of output.

To the right of Q, the firm will make a loss, and to the left of Q sales are not maximised.

 Profit satisficing
In this option a firm seeks to make a reasonable level of profits that is sufficient to satisfy the
shareholders and also to keep the other stake holding groups happy, such as the workforce and
consumers. A firm is a coalition of interest groups, each with its own objectives, which may change over
time. Workers will expect pay rises and improvement in working conditions which may raise costs.
Consumers may expect to see prices falling, particularly when there are rival products. The firms may
choose to sacrifice some potential short-term profits to satisfy these expectations.

Fig: Profit satisficing

In the above figure, P1 is the profit maximizing price. A firm with the objective of profit satisficing
reduces the price to P2 and makes a lower profit. It sacrifices some of the short-term profit to make the
stake holding groups such as consumers and work force happy.
7|Page

 loss minimization
The firms aim at minimizing their losses in the short run when they are confronted with adverse
market conditions that prevent profit maximization. Profit maximization or loss minimization
requires the firm to produce at that level of output where marginal cost equals marginal
revenue.
Fig: Loss minimisation

In the above figure, a firm under perfect competition would produce output OQ. Adverse short-run
conditions, however, may mean that at this level of output, price (OP) is insufficient to cover average
total cost (QC) so that the firm makes losses (equal to area PCXY). In the short run, the firm will continue
to produce this level of output as long as price is sufficient to cover average variable cost (OC1) and
make some contribution (equal to area PC1ZY) towards fixed costs, although in the long run a
continuation of this situation of loss-making would force the firm to leave the market.

 Ethical objectives

Business ethics are the moral principles that underpin business behaviour. They are meant to judge
whether actions carried out by organisations and their employees are morally acceptable or not in the
context of the society and the times in which they operate.

Setting ethical objectives is the process by which organisations apply ethical values to their targets and
the actions by which they will achieve them. These ethical values should cover all the actions of the
organisation from tactical to strategic.

Businesses may be faced with some of the following issues, which have ethical dimensions:

 Should we produce in a low-cost developing economy?

 Should we promote products that might damage health?
 Should we seek to undermine our competitors?
 Should we pay minimum wage rates to our employees?
 Should we employ migrant labour to cut costs?
 Should we transfer our production units to countries with less strict health and safety laws?
8|Page

 The principal – agent problem

In a principal-agent relationship, the agent acts on behalf of the principal and should not have a conflict
of interest in carrying out the act. In a business, the business owner is the principal and the manager is
the agent.

The principal–agent problem (also known as agency dilemma or the agency problem) occurs when the
agent (manager) is able to make decisions and/or take actions on behalf of the principal (business
woner).This dilemma exists in circumstances where agents are motivated to act in their own best
interests, that are contrary to those of their principals.

For example: Shareholders of a company appoint managers to look after the proceedings of the
company and earn profits on their behalf. The shareholders expect the managers to distribute all the
profits to the shareholders. But the managers sensing their own growth and salary expectation try to
retain the profits for future as a safe side. This can lead to principle agent problem. It is one of the most
noticed problems in the current situation when most companies are not being managed by the owners
themselves.

Note: Moral hazard is a situation in which one party gets involved in a risky event knowing that it is
protected against the risk and the other party will incur the cost. It arises when both the parties have
incomplete information about each other.

 Different market structures

Market structure describes the ways in which the goods are supplied by the firms in the market. In
economic theory, a wide range of market models have been developed within a spectrum of
competition.

Fig: Spectrum of competition

9|Page

 Perfect Competition

The market for a product becomes a perfectly competitive market if the product is sold by a large
number of sellers at the ruling/market clearing price. For example market for gold, silver, agricultural
products etc.

 Characteristics of perfect competition

 There are a large number of sellers selling the product or the firms have low concentration
ratio.
 The firms sell homogenous product.
 There is complete freedom of entry and exit.
 The firms don’t have market power. That is,the firms don’t have any control over the price of
the product. The firms are the price takers.
 Buyers and sellers have perfect knowledge about the market.
 Factors of production are perfectly mobile.
 The main objective of the firms is to maximize profit.

 Equilibrium of industry/market and firms in perfect competition: Price and output

determination.

 Short run equilibrium:

In the short-run, there is no entry of new firms into the market and the total output is supplied by the
existing firms. A perfectly competitive market / industry attains a state of short-run equilibrium when
the market demand for the product becomes equal to the market supply (D=S). The equilibrium price
and equilibrium quantity of the good is established at this state of market equilibrium.

The firms being the price takers sell the product at the equilibrium/ruling price. Though they can decide
on the quantity of the good they wish to sell at the ruling price. As the main objective of the firms is to
maximize profit, they reach a state of short-run equilibrium when their MC and MR are equalized
(MC=MR). At this state of short-run equilibrium, the firms make abnormal or super normal profit as the
total revenue(TR) exceeds the total cost (TC).
10 | P a g e

Fig: Perfect competition in the short-run

(a)Industry/Market (b) Firm

In the above figure, panel (a) shows the short run equilibrium of a perfectly competitive
market/industry. The market is in equilibrium at point e where D=S. the equilibrium price is ‘P’
($10/unit) and the equilibrium quantity is ‘Q’ (1000 units). Panel ‘b’ shows the short-run equilibrium of a
firm in a perfectly competitive market. The firm is in equilibrium at point ‘a’ where MC=MR. At the state
of short-run equilibrium, the firm is making an abnormal or supernormal profit of ‘PabP1’.

Calculating firm’s short-run profit

AR = Price =Q1 a = OP=$10

AC=Q1 b=OP1=$8
Profit per unit = AR – AC = $10 - $8=$2 = ab =PP1
TR = AR X Q
=$10 X 100
=$1000 (OPaQ1)
TC = AC X Q
= $8 x 100
= $800 (OP1 bQ1)
Profit = TR – TC
=$1000 - $800
=$200 (PabP1) → Abnormal Profit
11 | P a g e

 Long-run equilibrium

The abnormal profit earned by the firms in the short-run attracts new firms into the market in the long-
run. With the entry of new firms, the market supply of the good increases causing the supply curve to
shift rightward. This increase in supply causes the price to fall and the equilibrium quantity increases. As
the price falls, the TR of the firms falls and hence they are able to make only normal profit in the long-
run where the total (TR) just covers the total costs (TC).

Fig: Perfect competition in the long-run.

The above diagram shows the long-run equilibrium of an industry/ market and a firm in perfect
competition. Attracted by the abnormal profit earned by the firms in the short-run, new firms enter into
the market in the long-run. With the entry of new firms, the market supply of the good increases from Q
to Q1 causing the price of the good to fall from P to P1. This fall in price reduces the total revenue of the
firms and hence the firms are able to make only a normal profit in the long run.

The firms in perfectly competitive market are productively as well as allocatively efficient when they are
at the state of long run equilibrium. That is , the conditions necessary for productive efficiency
(P= [Link]) and allocative efficiency (P= MC) are satisfied when the firms in a perfectly competitive
market are at the state of long run equilibrium.

Calculating firm’s long-run profit:

AR = Price =Q2 a = OP1=$8

AC=Qb=OP1=$8

Profit per unit = AR – AC = $8 - $8=0

12 | P a g e

TR = AR X Q
=$8 X 100
=$800 (OP1 aQ2)

TC = AC X Q
= $8 x 100
= $800 (OP1 bQ2)

Profit = TR – TC
=$800 - $800
=0 → Normal Profit

 What is loss situation in perfect competition?

At the equilibrium quantity, if price (AR) is less than average total cost(ATC), firms are making a loss.
Over the long-run, if firms in a perfectly competitive market are earning negative economic profits (loss),
more firms will leave the market, which will shift the supply curve to the left. As the supply curve shifts
left, the price will go up.
Fig: Firms bearing loss in perfect competition

 Imperfectly competitive market structures

 Monopoly

The market for a good/product becomes monopoly if there is a single dominant seller selling the good.
For example, the market for petroleum in Nepal is a monopoly market as Nepal oil Corporation (NOC) is
the only importer and distributor of petroleum in Nepal.

 Characteristics of monopoly
 There is a single seller selling the good. That is, the monopolist has 100% concentration ratio.
 The good sold by the monopolist is typical with no substitutes.
13 | P a g e

 There are significant barriers to enter into and exit from the market.
 The monopolist has full control over the price of the good. The monopolist is a price maker.
 Being the price maker, the monopolist can practice price discrimination.
 The main objective of the monopolist is to maximize profit.

 Equilibrium of a monopoly firm: price and output determination

This is the most extreme, but not the most common, example of market power. A monopoly is a market
with only one seller. A monopolist is free to set prices or production quantities, but not both because he
faces a downward-sloping demand curve. He cannot have a high price and a high quantity of sales – if he
has a high price, people will buy less.

The main objective of a monopoly firm is to maximize profit. So, a monopoly firm reaches a state of
equilibrium when its MC and MR are equalized (MC=MR). At the state of equilibrium, a monopoly firm
may make abnormal profit or only normal profit or it may even bear losses depending on its revenue
and costs at the state of equilibrium.

Fig: Equilibrium of a monopoly firm –abnormal profit

In the above diagram, the monopoly firm is in equilibrium at point ‘E’ where MC=MR. The price charged
by the monopolist is ‘P’ ($10 / unit) and the quantity of the good supplied by the monopolist is ‘Q’
(50 units). At the state of equilibrium, the monopolist is making abnormal profit equal to the area
‘PabP1’
Here,
AR = Price =Qa = OP=$10
AC=Qb=OP1=$8
Profit per unit = AR – AC = $10 - $8=$2 = ab =PP1

TR = AR X Q
=$10 X 50
=$500 (OPaQ)
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TC = AC X Q
= $8 x 50
= $400 (OP1bQ)
Profit = TR – TC
=$500 - $400
=$100(PabP1) → Abnormal Profit
 Monopoly firm making only normal profit

A monopoly firm earns normal profits when the average cost of production is equal to the average
revenue (price) for the corresponding output. In the diagrambelow, at the state of equilibrium the firm
makes only normal profit as the ATC= AR or TC=TR.
Fig: Monopoly firm making normal profit

 Monopoly firm bearing loss

A monopoly firm may bear losses if:

 Its costs are so high that they cannot be covered up by the revenue received from the sales.
 The demand for the monopolist’s product falls causing the sales revenue to fall below that is
enough to cover up the costs of production.

Fig: A monopoly firm bearing a loss

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Calculating monopolist’s profit:

AR = Price =Qb = OP=$8

AC=Qa=OP1=$10
Profit per unit = AR – AC = $8 - $10= -$2 (loss per unit)

TR = AR X Q
=$8 X 50
=$400(OPbQ)

TC = AC X Q
= $10 x 50
= $500 (OP1aQ)

Profit = TR – TC
=$400 - $500
= ̶ $100(P1abP)→Loss

 Comparing Perfect competition with monopoly

 Similarities
 In both the market structures, the main objective of the firms is to maximize profit.
 In both the market structures, the market demand curve for the products is downward sloping /
sloping downward from left to right.

 Differences

The following points of differences can be observed on comparing the characteristics of a perfectly
competitive market with that of a monopoly market:

 Large numbers of sellers/ single dominant seller

 Homogenous product/ typical product with no substitutes
 Freedom of entry and exit/ significant barriers to entry and exit
 The firms in a perfectly competitive market are the price takers/ monopolist is a price maker
 Price uniformity/ price discrimination
 Demand for the firm’s product is perfectly elastic/ Demand for monopolist’s product is inelastic

Some more points of differences can be observed on comparing the behavior of the firms in perfect
competition with that of the behavior of a monopoly firm. The following diagram shows the differences
in the behavior of the firms in perfect competition and the monopoly market:
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Fig: Perfect competition VS monopoly

As seen in the above figure;

 The output produced by a monopoly firm (Q m) is less that the output produced by a firm in
perfect competition (Q C).That is, the output produced by the firms in PC market is at the
optimum level while the output produced by the monopoly firm id below th optimum level.
 The price charged by the monopoly firm (Pm) is higher than the price that prevails in a perfectly
competitive market (PC)
 The monopoly firm is productively inefficient as Price ˃ Min. ATC while a firm in perfect
competition is productively is efficient as P= Min. ATC.
 The monopoly firm is allocatively inefficient as Price (Pm) ˃ MC while the firm in perfectly
competitive market is allocatively efficient as price (Pc) = MC.
 A monopoly firm can make abnormal profit both in the short and long run (pm a b p1) wile a firm
in perfect competition makes abnormal profit in the short-run and only a normal profit in the
long-run.
 If a perfectly competitive market converts into monopoly there occurs deadweight loss (loss of
consumer welfare), shown by the shaded triangle ‘aEE1.’

 Monopolistic Competition
It is a market model where there are large numbers of sellers selling substitutable/ differentiated
products. This market model is closest to perfect competition because of the existence of large number
of sellers and freedom entry and exit. Typical examples of monopolistic competition include fast-food
restaurants, driving schools, hair cutting saloons, dental clinics, beauty parlor, travel agencies etc.
17 | P a g e

 Characteristics of Monopolistic competition

•Large numbers of sellers

•Substitutable/ differentiated products
•Freedom of entry and exit
•The demand for a firm’s product is elastic because of the existence of rival products.
•The firms have control over the prices of the products in that they control the prices of their own
brands.
•The main objective of the firms is to maximize profit

 Equilibrium of a firm in monopolistic competition: price and output determination

In monopolistic competition, the demand for a firm’s product is elastic as a firm competes with a large
numbers of firms selling substitutable or rival products. This gives the firms a scope to increase their
sales revenue and profit by reducing the price of their products in the short run. But the key constraint
in the long- run is the free entry of new firms. The abnormal profit earned by the firms in the short run
attracts new firms into the business in the long-run. With the entry of new firms the market supply of
the products increases and the prices fall. Thus in the long run the firms make only normal profit
covering up all the costs of production and the opportunity cost of investment.

In this market structure, the firms bear a huge cost of advertising and promotion (sunk cost) to build a
strong brand image of their products. This makes the consumers loyal to the brand and hence the
demand for the product becomes inelastic. But the problem is that advertising and promotion is used as
a competing tool by all the firms. In such situation, the demand for the product with the most effecting
advertisement becomes inelastic and the firm can increase its revenue and profit by raising the price of
its product.

Fig: Monopolistic competition in the short and long run

(A)Short-run (B) Long-run

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In the above diagram:

Panel A shows the short-run equilibrium of a firm in monopolistic competition. The firm is in equilibrium
at point E where MC = MR. The equilibrium price is P ($10 per unit) and the equilibrium quantity is Q (50
units). At the state is short run equilibrium, the firm is making an abnormal profit equal to ‘PabP1’.

Panel B shows the long-run equilibrium of a firm in monopolistic competition. Attracted by the abnormal
profit earned by the firms in the short-run, new firms enter into the market in the long-run. With the
entry of new firms in the market, the market supply of the product increases causing the price to fall to
P1 and the sale of individual firm’s product falls to Q1. This results in a fall in the firm’s total revenue and
hence the forms are able to make only normal profit in the long run.

Calculating firm’s profit:

AR = Price =Qb = OP=$10

AC=Qa=OP1=$8
Profit per unit = AR – AC = $10 - $8=ab=PP1= $2

TR = AR X Q
=$10 X 50
=$500 (OPaQ)

TC = AC X Q
= $8 x 50
= $400 (OP1 bQ)

Profit = TR – TC
=$500 - $400
= $100 (PabP1) → Abnormal profit

In panel (B):
AR = AC =Q1a1= OP1= $8
TR=TC= AR X Q=AC X Q = $8 X 30 =$240
Profit= TR – TC
=$240 - $240= 0 ( Normal Profit)

 Comparing Monopolistic Competition with Perfect Competition

 Similarities
 There are large numbers of sellers in both the market structures
 In both the market structures, the main objective of the firms is to maximize profit.
 In both the market structures, there is freedom of entry and exit.
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 In both the market structures, the firms make abnormal profit in the short-run and only normal
profit in the long-run.

 Differences:
 The firms in perfect competition sell homogenous product while the firms in monopolistic
competition sell differentiated or substitutable products.
 The firms in perfect competition don’t have any control over the price of the product while the
firms in monopolistic competition have full or partial control over the prices of their products.
 The firms in perfect competition cannot practice price discrimination while the firms in
monopolistic competition can practice price discrimination.
 In perfect competition, the demand for the firm’s product is perfectly elastic while in
monopolistic competition, the demand for the firm’s product is elastic.
 The firms in a perfectly competitive market are productively and allocatively efficient because
when they are in a state of long run equilibrium (P=[Link] and P=MC) while the firms in
monopolistic competition are productively and allocatively ineffeicient (P ˃Min. ATC and P ˃
MC)

 Oligopoly

It is a market structure where the total output is concentrated in the hands of few (2 -10) sellers. If the
total output is concentrated in the hands of only 2 sellers then the market model becomes a duopoly.
For example, market for cold drinks; sportswear etc. is an oligopoly market as there are few dominant
sellers selling these products.

 Characteristics of an oligopoly market

 There are few (2-10) sellers selling the products.

 The product sold by the firms in an oligopoly market may be homogenous or substitutes.
 There are significant barriers to entry into the market.
 The firms have some/ full control over the prices of the products.
 The firms take interdependent decisions regarding price and output determination. That is, the
pricing and output decision of a firm is influenced by the decisions of the rival firms.
 The risk and uncertainty associated with changing the price makes the price rigid/ inflexible.
 The firms place too high importance to economies of scale.
 The firms may or may not aim at maximizing profit.

The behavior of the firms in an oligopoly market can follow two different routes. In some industries, the
firms may cooperate and form collusion to increase their profit (collusive oligopoly model) while in other
industries there may be cut-throat competition between the aggressive firms (non-collusive oligopoly
model)
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 Collusive oligopoly model

Collusion is an anti-competitive action taken by the firms in an oligopoly market structure. It is where
the firms avoid all types of competition and agree on price and output decision instead of competing
with each other. The objective of such action is to maximize the profit of the whole group. Collusion is
of two types:

 Formal collusion or open collusion (Cartel agreement)

 Informal collusion or tacit collusion (price leadership)

 Formal or open collusion

It takes the form of cartel where the firms agree to set the price within a specified range and each firm is
given a quota to supply the product according to their market shares. In this way, the firms act like a
monopolist and each firm is able to make an abnormal profit like a monopolist does.
However, there is high incentive for the participating firms to cheat on the agreement as there is no any
provision of penalty for the firms cheating on the agreement. The participating firms can cheat on the
agreement and secretly reduce the price and increase the sales revenue and profit. In this way, a firm
can make a higher profit at the cost of the profit of other participating firms.

Fig: Formal collusion or cartel agreement

 Informal or tacit collusion

It takes the form of price leadership where the dominant firm (firm with highest market share) takes the
pricing decision and the small firms have to follow the pricing decision taken by the dominant firm. The
small firms will definitely follow the price rise as it will increase their revenue and profit. But they must
also follow the price cut by the dominant firm. If they see losses in cutting the price and fail to match the
price cut by the dominant firm, they will leave the market or they will be driven out of the market by the
dominant firm.
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Fig: Informal collusion or price leadership

Collusion of any type works well only when:

 There are small numbers of participating firms

 There is strong element of trust among the participating firms
 There is a clear leader to take a lead
 There is no government intervention in the market
 The market conditions are stable
 The agreement is amendable

 Pricing strategy and the prisoner’s dilemma( the game theory)

A common scenario for applying game theory to decision-making is the prisoners' dilemma. Bennie and
Stella were arrested for robbing banks. Each was interrogated in separate rooms, where the
interrogators offered them a choice:
 If they both confessed, they would both get 5 years in prison;
 If one confessed, the confessor would go free while the other one would get 10 years;
22 | P a g e

 If neither confessed, then they would each get 2 years.

There are 4 possibilities, represented by the following payoff matrix:

Table: Prisoners' Dilemma Payoff Matrix

Stella confesses: 5 years Stella silent: 10 years
Bennie confesses: 5 years Bennie confesses: goes free
Stella confesses: goes free Stella silent: 2 years
Bennie silent: 10 years Bennie silent: 2 years

The best possibility for both as a group would be if neither confessed, which would mean that they
would only have to spend 2 years in prison. The worst possibility for both of them as a group is if they
both confessed — then they would have to spend 5 years in prison.

However, as individuals, they may be able to do better or worse, depending on how successfully they
anticipate what the other will do. If Stella confesses, the worst she can do is spend 5 years in prison, and
the best that she can do is go free; likewise for Bennie. In this case, confessing is what is called in game
theory a dominant strategy, which yields the best outcome regardless of what other players do, which is
the strategy to take when it is impossible to anticipate their decision.

For instance, if Stella does not confess, then she will either spend 10 or 2 years in prison, depending on
whether Bennie confesses or not. Stella would probably only choose silence if she was fairly confident
that Bennie would not confess and that she cared enough about him to not choose to confess to free
herself. On the other hand, if she was not confident about Bennie's decision, then she would select the
dominant strategy.

 Pricing strategy and the prisoner’s dilemma( the game theory)

In recent years, the game theory has increasingly been applied in order to understand the behavior of
the firms in an oligopoly market. The game is that firms have to make decisions about the price they
charge and their level of output. Decisions are taken based on the assumptions about the responses of
the rival firms. These decisions have particular implications for the profits earned.

The above table shows the game matrix facing two firms A and B that have large market shares in an
oligopolistic market. Suppose at present there is no price competition and that each firm sells its
23 | P a g e

product for $2. In order to increase market share, both firms are considering reducing their prices from
$2to $1.
At $ 2, each firm is making an annual profit of $2 million. If B reduces its price to $1, its profit would
increase to $2.5 million. This is not good news for A, which has left its price at $2 and seen profits fall to
$1 million. Alternatively, A could cut its price to $1, with B leaving its price at $2. A’s profit would
increase to $ 2.5 million, with B’s falling to $1 million. In this situation both firms know what each other
is considering- if prices are cut to $1 then both firms experience a fall in profit to $1.5 million. As both
firms lose out, the obvious option for them is to collude to retain their prices at $2 in order to gain
higher profit.

 Non-collusive oligopoly

 The kinked demand curve hypothesis

The demand curve facing a firm in a non-collusive oligopoly model has a kink on it. The kink is formed
due to price rigidity that occurs due to the risk and uncertainty associated with changing the price of the
product. The demand for the firm’s product above the existing price is elastic while the demand below
the existing price is inelastic. Because of this difference in the elasticity of demand for the firm’s
product, any change in the price of the product will cause the firm’s total revenue to fall. Due to this
reason, the firms don’t compete by changing the price of the product. Hence, the price becomes rigid
and a kink is formed on the demand curve at the existing price.

Fig: The kinked demand curve

 Price competition
Non-collusive oligopoly occurs when firms don’t cooperate and therefore exist in a strategic
environment where one must consider the actions and reactions of other firms at all times. When firms
don’t actively collude, the dual tendencies to compete and collude are in force. Firms face the choice as
described by the prisoner’s dilemma. This situation can be shown using the following diagram:

Fig: Non-collusive oligopoly model

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The above diagram shows the dilemma regarding price and output faced by an oligopolist.
It is assumed that the firm is itself a price leader or that price leadership has already been established at
P.
If the firm increases its price above P, other firms in the market will not follow. This is because these
firms will be able to sell more themselves, attracting customers from the firm that increased its price.
This is shown by the relatively elastic demand curve above the price p.

If the firm lowers its price, it assumes that other firms in the market will follow this lead so as to protect
their market shares. This starts a price war, the result of which is likely to be that all firms lose out. This
is shown by the relatively inelastic demand curve below the price P.

‘MR’ is the Marginal Revenue Curve of a firm that corresponds the elastic and inelastic segment of the
D=AR curve. The vertical segment (ab) on the MR curve is formed due to the difference in the elasticity
of demand for the good above and below the existing price, P. Higher the difference in the elasticity of
demand for the product, longer will be the vertical segment on the MR curve.

 Non- price competition

Because of the risk and uncertainty associated with changing the price, the firms in the oligopoly market
use non-price competitive tools to maximize their profit. Some of the non-price competitive tools used
by the oligopolists include:
 Product innovation
 Process innovation
 Advertisement and promotion
 Market segmentation (Market segmentation is the process of dividing a market of potential
customers into groups, or segments, based on different characteristics)
 Product proliferation (Product proliferation occurs when organizations market many variations
of the same products)
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 Theory of Contestable market:

The theory of contestable market assumes that it is the ‘fear of competition from the rivals’ rather than
the actual competition that guides the behavior of the firms. Since there is zero cost of entry and exit
and entry and exit is completely free, the new firms can enter into the market and take away the
potential profit by knocking out the existing firm. Due to this fear of competition from the potential
entrants, the existing firms behave in a most competitive manner. They reduce the price and increase
the output to make only a normal profit. In this way they make the business unattractive and prevent
the entry of new firms into the market. This theory assumes that even in a monopoly or oligopoly
market the existing firms act competitively to prevent the entry of new firms.
Airline companies can be a typical example of a contestable market.

 Characteristics of a contestable market:

 Zero cost of entry and exit
 Complete freedom of entry and exit
 Irrelevant size and number of firms
 The firms have access to same technology
 There is overriding threat of new entrants
 The new firms enter into the market on ‘hit and run’ basis
 The firms make abnormal profit in the short run and only a normal profit in the long run.

Fig: A Contestable monopoly

 Natural Monopoly:
The theory of natural monopoly is developed to support the government monopoly in the provision of
utility services such as drinking water, electricity, railways, canals, energy etc. Natural monopoly occurs
when the most efficient number of firm in the industry is only one. A natural monopoly has very high
fixed costs which mean that it is impractical to have more than one firm producing the good or service.
Since a natural monopoly is involved in providing essential utility services to the citizens, it can produce
a good or service even if it bears losses. In case of losses, the firm is subsidized by the government. A
natural monopoly has very high fixed costs and its LRATC decreases throughout as the output increases.
The new firms entering the market will not have the same cost advantage as the natural monopoly and
this prevents the new firms from entering the market.
26 | P a g e

Fig: Natural monopoly

What Is Concentration Ratio?

The concentration ratio, in economics, is a ratio that indicates the size of firms in relation to their
industry as a whole. Low concentration ratio in an industry would indicate greater competition among
the firms in that industry compared to one with a ratio nearing 100%, which would be evident in an
industry characterized by a true monopoly.

The four-firm concentration ratio, which consists of the market share of the four largest firms in an
industry is a commonly used concentration ratio. Similar to the four-firm concentration ratio, the eight-
firm concentration ratio is calculated for the market share of the eight largest firms in an industry. The
three-firm and five-firm are two more concentration ratios that can be used.
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Calculating Concentration Ratio

 Pricing Strategies

 Price discrimination
 Price leadership
 Limit pricing (entry limit pricing)
 Predatory pricing (competitor destroying pricing policy)

 Price discrimination

It is a practice of charging different prices from different consumers for the same product. The main
objective of practicing price discrimination is to make abnormal profit. A firm in imperfectly competitive
market effectively converts consumer surplus into abnormal profit or producer surplus by practicing
price discrimination.

Example:

Let us assume that a monopolist produces 3 units of good x and the cost of producing each unit is $45.
So, TC =$45 x 3= $135.
If the monopolist uses single pricing system and sells each unit of good x at $40 then, TR=$40 X 3 = $120.
If this is the case then, the monopolist is bearing a loss of $15 ($120 - $135) which is enjoyed by the
consumers in the form of consumer surplus. However, if the monopolist practices price discrimination
and sells the three units of good x at $60, $50 and $ 40 respectively then, TR= $60+$50+$40 = $150.
Now, profit = $150 - $135 = $15 which is the consumer surplus converted into producer surplus or
abnormal profit.
Fig: Price discriminating monopolist
28 | P a g e

In the above figure, the area OP1CQ is the total revenue ($150=$60+$50+$40) received by the
monopolist from the sale of three units of good x while the area ‘OPbQ’ total cost ($135) incurred by the
monopolist to produce three units of good x. Since, TR ˃ TC, the monopolist is making an abnormal
profit which is the consumer surplus converted into abnormal profit/ producer surplus by practicing
price discrimination.

Again in the diagram,

 The area ‘OPacQ’ is the common area of TR and TC. The shaded triangle x is the fraction of TR
while the shaded triangle y is the fraction of TC. Here, since the fraction of TR ˃the fraction of
TC, the monopolist is making an abnormal profit.
 If the shaded triangle x = shaded triangle y, the monopolist would have earned only normal
profit.
 If the shaded triangle x ˂ shaded triangle y, the monopolist would have incurred a loss.

 Methods of price discrimination

 On the basis of status

Example: the members of a recreational club are charged lower fees for the services than the non-
members.

 On the basis of age

Example: elderly and children are charged lower for air flight tickets than others.

 On the basis of time

Example: Taxi fares are higher at night than the day time.

 On the basis of geography

Example: goods are sold at higher prices in the narrow geographical regions than the cities.
 On the basis of brand names
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Example: Goods are sold at higher prices in the brand names of the supermarkets than the brand names
of local producers.

 Degrees of price discrimination

 Price discrimination of first degree:

It is where the sellers sell the goods to the consumers at the maximum prices that the consumers are
willing to pay for the goods. In this case the consumer surplus is zero as all the potential benefits are
taken away by the sellers.
 Price discrimination of second degree:
It is where the sellers cannot identify the groups to which the consumers belong and offer the goods at
different price range. The consumers buy the goods according to their ability to pay.
Example: movie and concert tickets, air flight tickets etc.

 Price discrimination of third degree:

It is where the sellers can identify the groups to which the consumers belong and charge different prices
to the consumers of different groups. Example: Charging lower fares to elderly and children for the air
flight tickets

 Conditions necessary of price discrimination

 The market should be imperfectly competitive where the firms have full or partial control over
the prices of the goods.
 There should not be any possibility of reselling the product.
 The market should be segmented on the basis of price elasticity of demand so that higher prices
could be charged in the market segment where demand is inelastic and price should be lowered
in the market segment where demand is elastic.

Fig: Price discrimination on the basis of difference in PED

Market- A Market- B A+B
30 | P a g e

In the above diagram, price charged for the given good is higher in market A (PA) than in market B (PB).
This is because demand for the good is inelastic in market A while the demand is elastic in market B.

 Limit Pricing ( Entry limit pricing)

Limit Pricing is a pricing strategy a monopolist (or the firms in imperfectly competitive market) may use
to discourage entry. If a monopolist sets a profit maximizing price (where MR=MC) the level of
supernormal profit would be so high it attracts new firms into the market. Limit pricing involves
reducing the price sufficiently to deter entry. It leads to less profit than possible in short-term, but it can
enable the firm to retain its monopoly position and long-term profitability.

Fig: Limit pricing

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 Predatory Pricing (Competitor destroying pricing policy)

Predatory pricing, also known as undercutting, is a pricing strategy where a dominant firm deliberately
reduces the price of a product or service to loss-making levels in the short-term. The aim is to drive out
existing or potential competitors from the market, as they will be unable to effectively compete with the
dominant firm without making a loss. Once competition is eliminated, the dominant firm can then raise
prices to monopoly levels in the long-term to recoup their losses.

Predatory pricing can cause consumer harm so is considered anti-competitive in many jurisdictions and
is illegal under some competition laws.

Fig: Predatory pricing

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 Barriers to entry

The existence of significant barriers to entry into an industry differentiates oligopoly and monopoly from
monopolistic competition and perfect competition. Barriers to entry are a range of obstacles that deter
or prevent new firms from entering a market to compete with existing firms. They give firms a degree of
market power in that decisions can be made by existing firms without the risk of their market share or
price being challenged from outside. The construction and maintenance of these barriers can become
part of the firm’s behavior. Some of the main barriers to entry include:

 In some countries, it is impossible for new firms to enter into an industry because the economic
activity is state- owned or the good is produced under the licence from the government. This is a
legal monopoly created to achieve social and political objectives. The economic justification lies
in the concept of natural monopoly, where it is more efficient to have a single producer than to
have competing firms.

 The high fixed cost or set up cost in activities such as electricity generation, aircraft and car
production and pharmaceuticals may deter potential entrants. The barrier here is access to
capital.
 If a firm is shutting down and some costs such as R and D costs cannot be recovered and the
resources are specialized and not easily transferable to other uses,they are regarded as sunk
costs and act as barrier to exit from the industry because the capital investment will be lost.

 Advertisement and brand names with higher degree of consumer loyalty may prove a difficult
obstacle to overcome.

 Economies of scale can be a barrier because the existing large producers are able to produce at
a lower average costs than those just starting up.
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 The production process or the product of a firm may be protected by legal monopoly in the form
of a patent, whereby competitors cannot copy without the permission of the owner.

 Some existing firms may have monopoly access to raw materials, components or retail outlets,
which will make it difficult for new entrants to make an impact.

 In activities such as consumer electronics, the pace of product innovation is so rapid that the
existing firms will be working on the next generation of products while launching the current
range. Unless the new firms have original ideas or can exploit a new market segment, they are
destined to fail.

 Limit pricing- hiding abnormal profit by the existing firms to deter new entrants.

 Collaboration between the existing firms to develop new products may act as a barrier in that
the resources necessary to compete are beyond the means of single new producer.

 Market conditions, such as fall in demand resulting from recession, can leave producers with
surplus productive capacity and this will deter entry.

 Reasons for the survival of small firms

Small scale production firms have the actual survival value side by side with large scale production. The
facts are that small scale firms have a firm footing along with the large scale firms. The reasons are that
small scale firms enjoy certain advantages which are peculiar to their own. The reasons why so many
small firms exist in a world where the economic power lies with large MNCs are as follows:

 There are economic activities where the size of the market is too small to support large firms.
For example, tailoring and repairing concerns.
 The business may involve specialists skill possessed by a very few people.
 Where the product is a service such as solicitors, accountants, hairdressers, etc. the firm will be
small in order to offer the customers personal attention for which they will pay a higher price.
 There are particular obstacles to the growth of small firms. Probably the largest of these is
access to borrowed capital because of the perceived risk on the part of banks.
 The entrepreneur may not want the firm to get bigger because extra profit is not the only
objective and growth might involve a loss of control over the running of the business.
 Recession and rising unemployment can trigger an increase in the number of business start-ups
as former employees try to become self-employed.
 Small businesses may receive financial help under government enterprise schemes because of
their employment and growth potential.
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 The increased access to technology through the internet and mobile phones has reduced the
optimum size of business unit and made small businesses more efficient and therefore
competitive with larger ones.
 When the demand for a commodity is small and is expected to remain as such for many years
to come, then the production will not be carried out on a large scale.

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