Chapter 2: Utility

I. Introduction and definition of Utility The utility approach was developed in the 1870s by William Stanley Jevons (England), Karl Menger (Austria) and Leon Walrus (France). However, it was Alfred Marshall who introduced the concept of Marginal Utility in relation to price in his book Principles of Economics in 1890. Utility may be defined as the want satisfying power of a commodity. II. Characteristics of Utility a) Abstract concept Utility is not a tangible concept and has no physical existence. It is a psychological feeling that one perceives (or receives) from an object. b) Subjective concept It is relative to person i.e. what may have utility for Mr. A may not have utility fro Mr. B. c) Relative to time The same commodity may have different utilities at different times. Example: a raincoat may be useful during the monsoons but is of no use during other times of the year.

d) Relative to place The same commodity may have different utilities at different places. Example: a

blackboard has utility in classroom but not in an auto rickshaw.

e) Different from usefulness Utility is the want satisfying power of a commodity. The want may or may not be beneficial (useful) to the consumer. Example: a cigarette has utility but is not beneficial as it is injurious to health.

f) Different from pleasure Some goods may not give any kind of pleasure on consumption although they may have utility. Example: a bitter medicine.

g) Colourless and neutral concept The want could be harmful or immoral, desirable or undesirable but the commodity has utility as long as it satisfies the want. Example: Mr. A and Mr. B find utility in a knife as Mr. A requires it for cutting vegetables and Mr. B requires it to murder a person. In both cases, the commodity has utility. Thus, the concept of utility is totally neutral and is totally neutral and morally colourless.

h) Depends on urgency/intensity of the want If a person requires a commodity urgently, the utility of the commodity will be high and vice versa. Example: a thirsty man will find the utility

of the first glass of water very high as compared to the subsequent glasses.

i) Multipurpose Some commodities satisfy more than one demand/want. Example: Electricity can be used in industries as well as households.

j) Increases with knowledge When knowledge regarding the nature and uses of a commodity or service increases generally its utility also increases. Example: nuclear energy was initially utilized to make bombs but today, it is used to produce power and for medical purposes.

k) Immeasurable The concept of utility cannot be measured as it is a subjective concept or a psychological feeling. However, Alfred Marshall advocated the Cardinal approach and insisted that utility could be measured in terms of utils. J.R. Hicks, however, gave Ordinal measurability to the concept of utility.

l) Uses money as measuring rod Since it is important to have some kind of explanation of the degree of utility, money is used as the measuring rod. Thus, the price a consumer is willing to pay for a commodity at different times reflects the utility of the commodity.

m) Utility and satisfaction Utility is what you perceive in an object (satisfaction perceived). Satisfaction is the realized feeling when a person purchases a commodity; he hopes for satisfaction but he gets satisfaction only after using it. Sometimes a person hopes for a high degree of utility from a product but when he actually uses it, he may experience post purchase dissatisfaction or cognitive dissonance. III. Types or forms of utility

a) Form utility Form utility refers to the utility of a commodity in a particular form, shape etc. Example: a log of wood would have no utility unless converted into chairs and tables.

b) Time utility A good may have utility at a particular period and have little or n o utility at other times. Example: a raincoat has utility during the monsoons but has little or no utility during the rest of the year.

c) Place utility A commodity may have utility in a particular place but, if taken elsewhere, may have little or no utility. Example: a blackboard has utility in the classroom but has no utility in most other places.

d) Service utility Service utility refers to the utility derived from various services. Example: services derived from barber, teacher, writer etc.

IV. Difference between Marginal Utility and Total Utility Marginal Utility Marginal Utility is the additional utility derived by consuming one more unit of a commodity. Total Utility Total utility is the sun of the utilities (derived by a consumer) from the consumption of all possible units of a commodity (at a given time). Formula: TUn = MU1 + MU2 + MUn

Formula: MU=TUn TU(n-1)

Marginal utility is positive and diminishing in the initial stages of consumption. At a particular stage, if consumption continues, Marginal Utility becomes zero. Further consumption results in negative Marginal utility.

AS a consumer increases consumption, Total utility increases but at a diminishing rate. When Marginal utility becomes zero, Marginal utility is maximum (and constant). This is called the point of satiety. When Marginal utility becomes

negative, Total utility begins to fall.

Marginal utility schedule Total utility schedule

Units 1 2 3 4 5

Marginal utility 10 6 3 0 -2

Units 1 2 3 4 5

Total utility 10 16 19 19 17

V. Law of Diminishing Marginal Utility

(a) Definition: According to Marshall, The law of diminishing marginal utility states that, other things being equal, the total utility of the stock of a commodity to any consumer increases as the stock of that commodity increases at a diminishing rate. In other words, the additional benefit which a person derives from a given increase in his stock of a thing diminishes with every increase in the stock that he already has. Thus, other things being equal, the increase in the stock of a commodity consumed or acquired, is marginal utility diminished i.e. the more you have of a thing, the less you want to have more of it.

(b) Utility Schedule The law of Diminishing Marginal Utility can be explained with the help of the following schedule and illustration:

Unit of the Commodity (mangoes) 1 2 3 4 5 6

Total utility

Marginal utility [MU=TUn TU(n-1)]

10 17 21 23 23 21

10 7 4 2 0 -2

From the above schedule, we see that when the consumer consumes the first mango, Marginal Utility is 10. For the second mango, Marginal Utility falls to 7. As the consumer goes on consuming more mangoes, the Marginal Utility diminishes until it becomes zero. At this point, the Total Utility is maximum and this is called Point of Satiety. If the consumer consumes the sixth unit, Marginal Utility becomes negative.

(c) Utility Curves/Graph

The Marginal Utility curve slopes downwards from the left to the right. This negative slope indicates the inverse relationship between the stock of the commodity and Marginal Utility. The Total Utility rises at a diminishing rate, reaching the Point of Satiety (or the maximum) and then begins to fall (when Marginal Utility becomes negative).

(d) Assumptions

The law of Diminishing Marginal Utility is based of the following assumptions: (i) Homogeneity The law assumes that every unit consumed should be identical in shape, size, colour, quality etc. Example: if the first mango is sour and the second mango is sweet, the second mango will give more utility. Thus, it is assumed that all units are homogenous. (ii) Reasonability There should be reasonability of size or amount of commodity consumed or acquired. Example: if a person consumes ice cream and the first unit is just a small teaspoon, it could probably increase or whet his appetite and the utility derived from the second spoon of ice cream may be greater.

(iii) Continuity Each successive unit should be consumed or acquired immediately. Example: if a mango is consumed now and another after a week, the second may give greater satisfaction.

(iv) Constancy regarding attitude, taste, price of product, income etc. Example: initially, a person may not life bitter gourd but after consuming it a few times, he may acquire a taste for it.

(v) Rationality The person consuming or acquiring a commodity should be a rational person who wants to maximize his satisfaction. Incase of irrational persons, subsequent

units of a commodity may give more satisfaction. Example: an alcoholic.

(vi) Constancy regarding Marginal Utility of money otherwise the consumers preferences may change with an increase in consumption.

(vii) Divisibility We assume that the goods consumed are divisible into smaller units otherwise the law would be inapplicable. Thus bulky goods like a washing machine or a yacht cannot be considered.

(viii) Measurability Marshall assumed Cardinal measurability of the concept of utility i.e. that numbers could be assigned to the concept of utility. He measured utility in the form of utils.

(ix) Singularity of use The commodity consumed or acquired should have only one use. Example: the first unit of electricity may be used for lighting and will give the user a certain amount of satisfaction. Due to shortage of gas, if the second unit is now required for cooking, the second unit has more utility.

(e) Criticisms

(i) Cardinal measurement of utility is not actually possible as utility is a subjective concept and cannot be quantified. However, ordinal measurement is possible.

(ii) Comparison of Marginal Utility is not possible because is it a subjective concept. (iii) Not applicable to indivisible goods The law cannot be applied incase of bulky or indivisible goods (Example: Television, cars) which are a one time purchase especially in underdeveloped or developing countries. (iv) Constant marginal unrealistic concept. utility of money is an

(v) Other unrealistic assumptions or conditions. Thus most assumptions of this law example: homogeneity, reasonability, constancy, rationality etc. are unrealistic. (f) Exceptions The law does not really have major exceptions. Exceptions arise only when the law is misinterpreted. Following are the so called exceptions and the arguments against it. (i) Hobbies It is said that hobbies are an exception as a stamp collector may get more utility from every additional stamp collected. However, his utility from the successive stamps may not increase if each stamp is homogenous hence hobbies are not exceptions to the law. (ii) Alcohol

In case of alcoholics or drug addicts, the need for alcohol or drugs respectively is insatiable but then, a drunkard or a drug addict is not a rational person. (iii) Misers Misers also have an insatiable need for money. However, they cannot be considered as rational people. (iv) Music, movies, poetry and reading Every new poem, piece of new music or book may give greater utility to the consumer. However, if each additional unit consumed is homogenous and is consumed continuously, the law of Diminishing Marginal Utility will hold through. On the other hand, if the same book, poem or piece of music is read or heard several times, the Marginal Utility increases. This happens when the consumer has acquired a taste for the unit consumed. However, this implies that the condition of constancy regarding attitudes, taste etc. has not been fulfilled. (v) Money Although some people believe that money is an exception to the law, it may be proved that this may not be the case as Money represents different commodities and helps to buy various goods. Therefore, it does not fulfill the tradition of homogeneity and singularity of use. Besides, as stock of money increases, its Marginal Utility diminishes. Example: If Rs.100 was given to a beggar and Rs.100 was given to a millionaire, it would be appreciated more by the beggar whose Marginal Utility for money of Rs.100 is greater than that of the millionaire (whose total stock of Rs.100 notes is large.)

 Although the stock of money increases and Marginal Utility falls, Marginal Utility never becomes zero or negative (because money represents different commodities.) (g) Importance or significance of the law 1. Theoretical importance (i) Value in use and value in exchange or paradox of value: The law helps in explaining the distinction between Total Utility which indicates value in use and Marginal Utility which shows value in exchange of a commodity. Thus, it helps in explaining the paradox of value or diamond water paradox. (Water, for instance, has high Total utility or value-in-use as it is highly useful in life but its price of value in exchange is very low or zero. On the other hand, the price of diamonds or their value in exchange is very high. This is because their Marginal Utility is very high due to their relative scarcity but their Total Utility or value-in-use is low.) Paradox of value is important in price analysis and we see the Marginal Utility of a good is more important than Total utility in determining its value in exchange as Marginal Utility indicates the intensity of demand. Total Utility, on the other hand, gives an idea of total satisfaction from a good. (ii) Rationality and consumer equilibrium: This is explained by the law of Diminishing Marginal Utility. It states how a rational consumer attains equilibrium by equating the price of a commodity to its Marginal Utility.

(iii) Basis of the theory of consumption and law of demand: It forms the basis of utility and demand and surplus and elasticity. It demand as it explains the and demand. the laws of equi-marginal the concepts of consumer is the basis of the law of relationship between price

(iv) It is a universal law as it explains a universal tendency. 2. Practical importance (i) To the businessmen: In order to boost sales, businessmen have to reduce their price. With a fall in price, the Marginal Utility gained by the consumer will be greater than the price he pays. Thus, to reach the equilibrium, he will consume or buy more until his Marginal Utility equals the price. (ii) It is important to consumers because they will buy only those commodities whose Marginal Utility is greater than price. (iii) Government or finance ministry is assisted in the imposition of progressive taxation on the rich whose Marginal Utility for money is low. (iv) Welfare policy is based on Diminishing Marginal Utility. Wealth distributed from the rich to the poor people whose Marginal Utility for money people whose Marginal Utility for money the law of is generally i.e. from the is low to the is high.

VI. Relationship between Marginal Utility and Price Any rational consumer will buy a commodity only after comparing utility of the commodity with its price. The rational consumer seeks to maximize his

total satisfaction. In the process, he will buy a commodity up to the point where his Marginal Utility from the last unit consumed is greater than or equal to the price i.e. MUn > / = Pn This may be explained with an example. Let us assume the following: a) A consumer buys apples for Rs.10 per unit. b) One unit of utility can be expressed in terms of Rs.1 Relationship between Marginal utility and Price: Units Marginal Utility (Rs.) 20 Price (Rs.) Relationship

Intra 1 10 MU>P Marginal units Intra 2 18 10 MU>P Marginal units Intra 3 15 10 MU>P Marginal units Intra 4 12 10 MU>P Marginal units Marginal 5 10 10 MU=P unit Extra 6 8 10 MU<P Marginal unit From the above table, we see that the consumer will consume a commodity up to the point where his Marginal Utility is equal to price. If he consumes any more than this, his total satisfaction will decrease. Thus, in the above example, the consumer maximizes his satisfaction when he consumes 5 units of a commodity.

On the other hand, if the price of the commodity falls to Rs.8, in order to maintain the equilibrium between Marginal Utility and price, the consumer will buy the 6th unit where the new price is equal to the Marginal Utility. If the price were to rise to Rs.12, the consumer would buy only 4 units in order to maintain this equilibrium. Thus, when the price falls, the consumer tends to buy more and when the price rises, he buys less of a commodity to maintain equilibrium. This proves that the concept of utility is the basis of the law of demand which states that there is an inverse relationship between price and quantity demanded. VII Law of Equi-marginal Utility Introduction This law is also known as the Law of Consumption and was originally stated by H.H. Gossen and later developed by Alfred Marshall. According to Alfred Marshall, Other things being equal, if an individual has a thing which can be put to several uses, he will distribute the same among these uses in such a way that is has the same Marginal Utility in all cases. Thus the law states that: a) Given the prices of different commodities, b) A consumer with a limited amount of money income c) Would spend it on various commodities d) As to derive the maximum amount of Total Utility Therefore, maximum Total Utility or satisfaction is obtained when the Marginal Utility per last unit of money spent on every commodity is the same. At

this point, the consumer is said to be in equilibrium and marginal utilities of commodities are proportional to their prices, or the ratio of Marginal utility and price is the same for all commodities. Assumptions 1. The consumer is rational i.e. he aims at maximum satisfaction. 2. Cardinal measurement of utility is possible. 3. Prices of goods remain constant. 4. Marginal Utility of money remains constant. 5. Income of the consumer remains constant. 6. All units of the commodity are homogenous. Illustrations and Schedule Let us suppose a consumer has disposable income of Rs. 34 and wants to spend it on 3 goods i.e. X, Y and Z and their prices are Rs. 2, Rs. 3 and Rs. 5 per unit. He has to distribute his income in such a way that the ratio of Marginal Utility of the goods and their prices is the same. The following table helps us to analyse the equilibrium condition of the consumer.

Units of oranges 1 2 3 4 5 6

Marginal MUx/Px Utility of units of X 30 15 20 16 8 6 4 10 8 4 3 2

Marginal MUy/Py Utility of units of Y 24 8 15 9 6 3 1 5 3 2 1 0.33

Marginal MUz/Pz Utility of units of Z 15 3 10 08 05 01 0 2 1.6 1 0.2 1

Thus, we see that the MU/P for commodities X, Y and Z are the same in the two cases: when the consumer consumes 5X, 3Y and 1Z or 6X, 4Y and 2Z. If we take the first combination, the amount the consumer spends is Rs.24 but the budget provided is Rs.34 and by taking the second combination, the consumer would maximize his satisfaction or Total Utility. Criticisms 1. It is too tedious to enlist the marginal utilities of various commodities, taking note of the price and income and then applying the formula to get a combination of the commodities which would maximize satisfaction. 2. Goods are not divisible in all cases and therefore it is difficult to equalize the marginal utilities. Example: Incase of a car, or a washing machine. 3. Like the Law of Diminishing Marginal utility, this law is also based on several unrealistic assumptions.

However, the Law of Equi-marginal utility is widely used to analyse the equilibrium of the consumer and is called the Law of Rational Choice by Professor Samuelson. It is also applied in the field of public finance and the Theory of Distribution.

Chapter 3: Demand
I. Introduction Demand is desire backed by ability (i.e. money/ purchasing power) and willingness to pay for it thus, following other features of the concept of demand.

(i) Demand can be written as follows: Demand = Desire + Ability to pay + Willingness to pay Example: If a beggar desires a car, it cannot become (actual) effective demand as he has no capacity to pay for it. However, if a wealthy man desires to own a car, it becomes demand if he has the capacity and willingness to pay (thus a wealthy misers desire for a car cannot be considered as demand.)

(ii) Demand is always related to price and time. Example: If we say demand for milk is 2 liters, the statement would be ambiguous. However, when we say the demand for milk is 2 liters at 25 rupees per liter, the statement become more clear. To make it even more meaningful, we should specify that demand for milk is 2 liters at 25 rupees per liter per day.

(iii) A statement of demand may be ex-ante or ex-poste.

Example: If we say the demand for milk will be 14 liters per week, the statement is ex-ante. However, the actual demand for milk by the family may be more or less than anticipated i.e. actual or ex-poste demand for milk may be 20 liters for the previous week.

(iv) Demand may be direct or indirect or derived. The consumers demand for consumption goods like clothes, a house etc. is direct demand. On the other hand, the producers demand for factors of production which help in the making of consumption goods is called derived demand. Example: demand for raw materials, machinery, coal etc.

(v) Difference between demand and desire:

Demand

Desire

Demand is a desire backed Desire is a mere wish to by ability to pay and consumer the products willingness to buy. which may not be necessarily backed by purchasing capacity. Demand is always with Desire is independent reference to price, time, i.e. not relative to place and person. anything. Demand has many limits. It depends upon income, tastes, fashion etc. Example: when a rich man wants a car, it is demand. Desire has no limits. It can go to any extent. Example: when a beggar wants a car, it is a mere wish.

(vi) Difference between Individual demand and Market demand: Individual demand Individual demand represents various alternative amount/quantities of a commodity purchased by the consumer at various alternative prices. Individual demand schedule: Price (Rs.) Quantity consumed by A (kg) 5 4 3 2 1 10 11 12 13 14 Market demand Market demand for a commodity represents various alternative quantities purchased by all the consumers of a commodity at different alternative prices. Market demand schedule: Price A 5 4 3 2 1 10 11 12 13 14 B 2 3 4 5 6 C 5 7 10 13 15 Market Demand 17 21 26 31 35 130

II. Determinants of Market Demand The total Market demand for a commodity depends on the following factors:

(i) Price: higher the price of a commodity, lower the demand and vice versa.

(ii) Price of related goods: Related goods are of two types i.e. a) Substitutes b) Complimentary goods If the price of a good falls, its demand would rise and the demand for its substitute good would also fall. Example: Coca cola and Pepsi. On the other hand, incase of complimentary goods, there is an inverse relationship between demand for the good and price of the related good. Example: if price of mobile phones fall, the demand for them would rise and demand for SIM cards would also rise.

(iii) Income and wealth distribution If there is inequality in the distribution of income and wealth, demand for luxury goods may be high. On there other hand, if there is equitable distribution of wealth, demand for necessities and middle income goods would be high.

(iv) Composition of population The age structure and sex ratio influence market demand. Example: In a country where there is broad based population pyramid, the demand for toys, childrens clothes, school books and stationary would

be high and vice versa. Similarly, the sex ratio also influences market demand. Example: in a male dominated economy, demand for shaving creams, razors etc. would be high.

(v) Standard of living Higher the standard of living, greater is the market demand for comforts and luxuries. In countries having low standard of living, demand for necessities would be more.

(vi) Taxes The level and structure of taxes influences market demand. Higher the tax, lower the demand incase of both direct and indirect taxes.

(vii) Consumer preferences When consumers change their preferences for commodities, market demand for these goods would be affected. Example: if a large percent of the population prefers non vegetarian food, demand for poultry and fish would rise thus the utility of the commodity to the consumer or consumer preference determines demand.

(viii) Weather conditions Market demand is affected by weather conditions. Example: demand for soft drinks increases during summer.

(ix) Innovations and inventions

When a new brand, product or service is introduced in the market, the demand for existing brands may be affected. Example: with the introduction of iPods, demand for Walkmans reduced.

(x) Consumers future expectations If the price of the commodity falls and the consumer expects a further fall, the current demand for the product will be low and vice versa.

(xi) Customs and festivals During festivals, demand for certain goods increase. Example: on the eve of Christmas, the demand for sweets and chocolates would rise.

(xii) Advertisements and sales promotions Effective advertisements can increase the sale of the product. This is also true in case of sales promotion campaigns. Example: free samples, door to door promotions.

(xiii) Changes in fashion and habits Market demand is influenced by changed in fashion. Example: demand for long handled umbrellas has increased as it has come back in fashion. Habits also influence Market demand. Example: India has a market for paan masala while the demand for this product is almost negligible in the U.S.A.

III. Law of Demand

(a) Definition The law of demand was given by Alfred Marshall who stated that Ceteris paribus (all other things remaining constant), there is an inverse relationship between price and quantity demanded i.e. other things being equal, the quantity demanded increases with a fall in price and diminishes with a rise in price. The law also indicates that demand (D) is a function (f) of price (p) or D=f(p)

(b) Demand schedule The law may be explained with the help of an example. In the table below, we see that as the price of a commodity rises from Rs.1 to Rs.5, quantity demanded falls from 10kg to 1kg. Thus, there is an inverse relationship between the price of the good and quantity demanded.

Price (Rs.) 1 2 3 4 5

Quantity demanded (kg) 10 8 5 3 1

(c) Demand curve This is a graphical representation of the demand schedule. The demand curve slopes downwards from left to right showing the inverse relationship between price and quantity demanded.

(d) Assumptions The phrase other things being equal or Ceteris paribus refers to the conditions under which the law is applicable. It is assumed that there is no change in the following determinants of demand: Price of related goods i.e. substitutes and complimentary goods. Distribution of income and wealth. Advertisements and sales promotions. Size and growth of population. Composition of population i.e. age structure and sex ratio. Common habits and preferences. Weather conditions. Taxation. Government policy (and no wars). General standard of living. Inventions and innovations.

 Future expectations regarding price and supply. Passion. Quality of product.

(e) Exceptions The law of demand is a universal phenomenon showing an inverse relationship between price and demand. However, sometimes there may be a direct relation between the two variables.

1. Giffin goods It was noticed in England by Sir Robert Giffin that when the price of inferior goods like bread or potatoes fell, the real income of the consumer increases. Out of this increase in real income, the consumer tends to consume more of a superior quality good than the inferior item. Example: when the price of potatoes fell, instead of buying more of it, people bought the same amount or less of it and they used this increase in real income to buy meat or some other superior quality good. This explanation came to be called the Giffins paradox and any commodity in case of which this happened is called a Giffin good.

2. Snob appeal/prestige goods/conspicuous consumption goods Often people buy expensive articles because they are expensive and provide them with a status symbol. Example: demand for art pieces, diamonds etc.

3. Demonstration effect This refers to the tendency of lower income groups to imitate the consumption patterns of higher income groups. This is generally found in developing or less developed countries.

4. Consumers psychological bias/price illusion Often a consumer is wrongly biased regarding the quality of a product when there is a fall in its price. Example: regarding quality of a good during a sale.

5. Ignorance effect If a price of a commodity falls and the consumers are not aware of it, they will not buy more than before. Besides, people may buy more at a high price on account of ignorance regarding quality of a product.

6. Quality and Branded goods Consumers may buy products at a high price if they are branded goods. If the price of a product is raised because of improvement in its quality, demand may rise and vice versa. 7. Fashion Items which are in vogue are in demand whatever the price and when a commodity goes out of fashion, people are unwilling to buy in spite of a fall in price.

8. Speculation regarding future prices or supply of commodity affects demand When consumers expect a rise in price or a fall in supply, current demand may increase.

IV. Difference between Normal Demand Curve and Exceptional Demand Curve

Normal Demand Curve It represents the law of demand

Exceptional Demand Curve It represents exceptions to the law of demand

It shows inverse It shows direct relationship between relationship between price and quantity demand price and quantity demanded It is a downward sloping curve from left to right It is an upward sloping curve from left to right

*Graphs are also a point of difference.

V. Why does the demand curve slope downwards?

1. The Law of Diminishing Marginal Utility The law of demand is based on the law of Diminishing Marginal Utility. According to this law, as a consumer consumes more units of a commodity, he gets less utility from it. Thus, he will stop buying the commodity when Marginal utility = Price. For the

consumer to buy more, the price of the commodity must be reduced. (Draw demand curve graph here.) Therefore, when the price falls demand rises and vice versa accounting for the downward slope in the demand curve.

2. Income effect When the price of X falls, the real income of the consumer rises and is in a better situation to consumer more of a particular commodity. This is called the income effect.

3. Substitution effect If the price of a commodity X falls, it becomes relatively cheaper than the other commodities. This encourages the consumer to substitute commodity X for others in the satisfaction of a particular want. This is known as the substitution effect. Example: if the price of Coke falls the consumer would buy more of it than Pepsi.

4. New consumers When the price of a commodity falls more consumers would be able to afford it and the demand would rise.

5. Increase in uses When the price falls, the commodity would be put to more use and its demand will rise. Example: if price of electricity falls, it will be used not only for lighting and fans but also for cooking etc. resulting in higher demand.

VI. Distinction between Variation (extension and contraction of demand) and Changes/Shifts (or increase and decrease) in demand

Variations in Demand When the demand for a commodity rises or falls due to a change in price, it is called a variation in demand.

Changes in Demand When demand for a commodity rises or falls due to change in determinants of demand other than price, it is called a change in demand. A change in demand caused by determinants other than price may result in a rise in demand or an increase or may lead to a fall in demand or a decrease.

A variation in demand is thus caused by a rise in price resulting in a fall/contraction in demand or by a fall in price resulting in a rise or extension in demand.

Example: when demand for Example: when demand for milk rises due to fall in mil rises due to a rise price. in income (Ceteris paribus). Variation in demand is shown as an upward (contraction) or downward (extension) movement along the same demand curve. A change in demand is shown as a shift in the demand curve to the right (increase) or left (decrease)

In the diagram, a) When price falls from OP to OP, demand extends from OQ to OQ. (This is known as an extension in demand.)

In the diagram, price remains the same but,

a) Demand rises from OQ to OQ. This is known as an increase in demand. Thus it implies that, at the same price, more is b) When price rises from demanded or the same OP to OP, the demand amount as before (OQ) is contracts from OQ to OQ. demanded at a higher price (OP) b) Demand decreases from OQ to OQ thus, it implies that, at the same price (OP), less is demanded (OQ) or the same quantity as before (OQ) is demanded at a lower price. (OP)

VII. Interrelated Demand or Types of Demand

1. Joined or complimentary demand When two or more goods are demanded jointly to satisfy a want, it is called Joint or Complimentary demand. Example: Coffee powder and milk, car and petrol. A rise in demand for one will result in a rise in demand for the other and vice versa.

2. Composite demand This refers to goods which are demanded for various purposes. Example: electricity for lighting, cooking, cooling etc. A change in demand for one use will affect the supply in the other uses and its price will tend to change.

3. Competitive demand When two goods are close substitutes, the demand for one competes with that of the other. Example: Thumbs up and Limca. An increase in demand for one will reduce the demand for the other.

4. Direct demand When a commodity of service is (directly) demanded to satisfy a human want, it is known as direct demand. All consumption goods have direct demand. Example: food, clothing, etc.

5. Derived demand When a commodity or service is demanded to produce other goods demanded in the market it is called derived demand. Example: demand for factors of production such as capital goods, machinery and labour. These are demanded as there is a demand for the product that help produce.

Direct demand When a commodity or service is demanded directly to satisfy a human want, it is called direct demand. All consumption goods have direct demands. Example: food, clothing etc. are directly consumed.

Derived demand When a commodity or service is demanded to produce other goods which have demand in the market, it is known as derived demand. All factors of production or producer goods have indirect demands. Example: machines, labour, raw materials which are indirectly consumed.

Joint demand

Composite demand

When two or more goods are demanded jointly to satisfy a want, it is called Joint or Complimentary demand. A rise in demand for one product will lead to a rise in demand for the other and vice versa. Example: bread and butter, car and petrol. Diagram:

When a good is demanded for several uses, it is a case of composite demand.

A change in demand in one use will affect its supply in other uses. Example: electricity used for heating, cooking etc. Diagram:

Complimentary demand When two or more goods are demanded jointly to satisfy a want, it is called Complimentary or Joint demand. A rise in demand for one product will lead to a rise in demand for the other and vice versa.

Competitive demand When two goods are Close substitutes, the demand for one competes with that of the other. This is called Competitive demand. A rise in demand for one product will lead to a reduction in demand for the other and vice versa.

Example: tea and milk, car and petrol.

Example: Thumbs up and Limca.

Chapter 4: Elasticity

I. Meaning and Definitions Elasticity of demand is the responsiveness of demand to a change in the determinants of demand. It is a quantitative concept. Demand for a commodity depends not only on the price but other factors also. Example: income, population, price of related goods, advertisements etc. Thus, there are as many kinds or types of elasticities of demand as there are determinants. Economists usually focus on price, income and cross elasticity.

a. Price elasticity Price elasticity of demand is the responsiveness of demand to a change in price. It is a quantitative concept. The law of demand, on the other hand, explains the functional relationship between price and quantity demanded. It is a qualitative concept. Price elasticity of demand may be measured by the following formula: ep = Proportionate change in quantity demanded Proportionate change in price demanded

= Percentage change in quantity demanded Percentage change in price demanded

ep= Q/P * P/Q

Therefore,

Where,

ep = Price elasticity Q = change in quantity demanded P = change in price Q = original quantity P = original price

Price elasticity is negative for normal goods and positive for Giffin goods.

b) Income elasticity It refers to the responsiveness of demand to a change in income of the consumer.

ey =

Q/Y * Y

Where, ey = Income elasticity Q = change in quantity demanded Y = change in income Y = original income Q = original quantity demanded

Income Elasticity is positive for normal goods and negative for exceptions like Giffin goods or inferior goods.

c) Cross elasticity It refers to the responsiveness of demand for commodity X to a given change in the price of a related good Y. Related goods could be substitutes or complimentary goods. Thus, ec = Percentage change in quantity demanded of X Percentage change in price of Y Therefore, ec = Qx * Py Py Here, ec
=

Qx

Cross elasticity

Qx = change in quantity demanded of X Py = change in price of Y Py = original price of Y Qx = original quantity demanded of X Cross elasticity for substitutes is positive. Example (for substitute goods): if price of Y increases, demand for Y falls and demand for the substitute X increases this cross elasticity for complimentary goods in negative. Example (for complimentary goods): if price of Y increases, demand for Y falls and demand for X also falls showing a negative relationship.

d) Promotional elasticity (advertising elasticity) This refers to change in quantity demanded of a commodity due to a change un advertising expenditure. ea = Proportionate change in quantity demanded of X Proportionate change in advertisement expense Therefore, ea = Qx * A A Qx

Where, A = original advertisement expenditure A = change in advertisement expenditure

II. Types of Price elasticity Depending on the responsiveness of demand of a commodity to a given change in its price, demand may be elastic or inelastic. The demand which responds greatly to a change in price is called elastic demand. The demand which responds less to a change in price is called inelastic demand. (However, elasticity and inelasticity are not absolute concepts. They are relative i.e. there may be a range of elasticities and inelasticities.)

1. Unit elastic demand When a change in price brings about a proportionate change in quantity demanded, demand is said to be unit elastic and ep = 1. Unit elastic demand is shown by a rectangular hyperbola.

Example: if a 10% change in price brings about a 10% change in quantity demanded, demand is said to be unit elastic.

2. Relatively elastic demand When a change in price brings about a more than proportionate change in quantity demanded, demand is said to be relatively elastic and ep > 1.

Example: if a 10% change in price brings about a 13% change in quantity demanded, demand is said to be relatively inelastic.

3. Relatively inelastic demand When a change in price brings about a less than proportionate change in quantity demanded, demand is said to be relatively inelastic as ep < 1.

Example: if a 10% change in price brings about a 7% change in quantity demanded, D is said to be relatively inelastic.

4. Perfectly inelastic demand When a change in price brings about no change in quantity demanded, D is said to be perfectly inelastic and ep = 0.

Example: a 10% change in price brings about no change in quantity of demand. This is a hypothetical situation.

5. Perfectly elastic demand When a change in price (even a slight change) brings about an infinite change in quantity demanded, D is perfectly elastic and ep = infinity.

Example: a 10% change in price brings about an infinite change in quantity demanded. The figure shows that at OP price, quantity demanded is infinite. However, even a slight rise in price would prevent the consumer from buying a commodity (no demand at all). Thus the degree of elasticity determines the shape or slope of the demand curve.

III. Measurement of Elasticity a) Ratio/Arithmetic/Formula/Percentage method Price elasticity is measured by the following formula:

ep = Proportionate change in quantity demanded Proportionate change in price demanded

= Percentage change in quantity demanded Percentage change in price demanded

ep= Q/P * P/Q

Therefore,

Where,

ep = Price elasticity Q = change in quantity demanded P = change in price Q = original quantity P = original price

Price elasticity of demand for normal goods in negative and for exceptions like Giffin goods, it would be positive.

1. When price is Rs.25, quantity demanded is 80kg. When price falls to Rs.20, quantity demanded rises to 85kg. Find price elasticity. Solution: ep = Change in quantity = -5 * 25 = -5 Change in price 80 = -0.31 Therefore, the good is a normal good and the demand is relatively inelastic. 5 16

2. When price is Rs.3, quantity demanded is 9kg. When price is Rs.4, quantity demanded is 12kg. Find price elasticity. Solution: ep = Change in quantity = -3 * -8 = 1

Change in price

-1

-9

Therefore, the good is an exception to the law of demand (Giffin good) and the demand is unit elastic.

b) Total Outlay method (Total expenditure) This method measures elasticity of demand by studying the direction of change of price and total outlay. Price * Quantity demanded = Total outlay

1. Unit elastic demand Demand is said to be unit elastic when a rise/fall in price brings about no change in total outlay. Example: when price rises from Rs.2 to Rs.4, total outlay remains constant at Rs.20. If price falls from Rs.2 to Rs.1, total outlay again remains unchanged. In the above conditions, demand is said to be unit elastic and ep = 1.

Price 2 4 1

Quantity demanded 10 5 20

Total outlay 20 20 20

2. Relatively elastic demand

Demand is said to be relatively elastic if a rise/fall in price beings about a fall/rise in total outlay respectively. (Inverse relationship)

Price 2 4 1

Quantity demanded 10 4 24

Total outlay 20 16 24

3. Relatively inelastic demand Demand is said to be relatively inelastic if a rise/fall in price brings about a change in total outlay in the same direction. (Direct relationship)

Price 2 4 1

Quantity demanded 10 8 16

Total outlay 20 24 16

c) Geometric/Point/Exact method This was given by Alfred Marshall to measure elasticity of demand at any point on the demand curve. The demand curve may be linear or non linear. Incase of a straight line demand curve DD, elasticity at point C on this demand curve may be found by extending the demand curve to meet the X and Y axis at points A and B. Then elasticity at point C will be the lower segment (CA) upon the upper segment (CB) which is equal to Lower seg. (L) Upper seg. (U)

Incase of a non linear demand curve, a tangent is drawn at point C on the demand curve DD to meet the X and Y axis at A and B respectively. Thus, in this diagram, elasticity at point C on the demand curve DD is equal to AC or L CB U

Thus we see that elasticity may vary at different points along the demand curve. At point B which touches the Y axis, ep = infinity. At point A which is on the X axis, ep = 0. At the midpoint of the demand curve (R), ep = 1. At point C, ep > 1. At point S, ep < 1.

c) Arc Elasticity This method is used to measure larger changes as rarely does the price change infinitesimally. Example: a price change will be from Rs.10 to Rs.10.10 or Rs.10.20 and rarely does it change by infinitesimally small amounts such as from Rs.10 to Rs.10.01 or Rs.10.05. Thus, for larger changes, the arc elasticity method is more appropriate. Thus, arc elasticity measures variations in demand over a range rather than at a point.

ep =

Change in quantity Original quantity + New quantity 2 Change in price Original Price + New Price 2

= Qo Q1 * Po + P1 Po P1 Qo + Q1

IV. Differences between: 1. Income Elasticity and Price Elasticity

Income elasticity The change in demand for a commodity due to a change income is known as Income elasticity of demand. Thus, the income of the consumer affects demand. Income elasticity is positive for normal goods. Income elasticity is negative for exceptions like inferior or Giffin goods.

Price elasticity The change in demand for a commodity due to a change in price of a commodity is known as Price Elasticity of demand. Here, the price of the commodity affects demand. Price elasticity of demand is negative for normal goods. Price elasticity is positive for inferior goods.

2. Income elasticity and Cross elasticity

Income elasticity The change in demand for a commodity due to a change in income is known as Income elasticity of demand. Income is a factor affecting demand. Income elasticity of demand is positive for normal goods.

Cross elasticity The change in demand for a commodity due to a change in price of related goods is known as Cross elasticity of demand. Here, price of related goods affect demand. Cross elasticity is positive for substitutes.

V. Factors determining Elasticity of Demand

1. Nature of Commodity Goods may be classified into luxury goods, comforts or necessities. In general, the demand for necessities is relatively inelastic while demand for comforts and luxuries is relatively elastic. Example: Demand for food grains is relatively inelastic while demand for soft drinks is relatively elastic.

2. Availability of a substitute A good which has no substitute will have relatively inelastic demand. Example: salt. On the

other hand, goods which have a wide range of substitutes will have a more elastic demand.

3. Number of uses If a commodity can be put to several uses, demand is relatively elastic. Example: multipurpose goods like coal and electricity.

4. Complimentary goods Goods which are jointly demanded have relatively inelastic demand.

5. Income A consumer having high income have a relatively inelastic demand for goods while poor consumers have more elastic demand.

6. Proportion of income spent on a commodity (Expenditure) If a proportion of income spent on a commodity is very large, demand will be relatively inelastic.

7. Influence of habits When a person is habituated to consuming certain commodities, the demand for such commodities will be relatively inelastic.

8. Festivals and Celebrations

Demand for certain commodities will be inelastic for festivals. Example: demand for cakes during Christmas or firecrackers during Diwali.

9. Height of price and range of price changes Certain costly luxury goods like cars will have inelastic demand if the change in price is very small. However, if the price change is large, then the demand is elastic.

10. Durability Demand for durable tends to be inelastic in the short run. Example: furniture. Incase of perishables, the demand is relatively elastic.

11. Recurrence of demand If the demand for a commodity is of recurring nature (other things being equal), its price elasticity is higher then that of a commodity which is purchased only once hence demand is generally inelastic for the latter but demand for goods having recurring demand would be more elastic.

12. Possibility of postponement When demand is postpone-able, it will be price elastic. However, goods urgently or immediately required will have inelastic demand.

13. Time

In a short period of time, demand is generally less elastic while in the long period, it becomes more elastic. This is because:

It takes some time for news of a price change to reach the buyer. Consumers may expect a further change, so they may not react to an immediate change in price. People are reluctant to change their habits all of a sudden but gradually, in the long run, habits and demand pattern may change. Durable goods already purchased take some time to exhaust their utility. In the long run, lapse of time results in their wearing out and eventually, they are demanded again. Demand for certain commodities may be postponed for some time, but, in the long run, it has to be satisfied.

VI. Practical Significance of the concept of Elasticity 1. Business or producer If demand is elastic, it will pay to reduce price level as more units will be sold and profits increase. If demand is inelastic, the producer may raise the price without affecting sales.

2. Government In the field of taxation, the finance minister has to consider the relative elasticities. If demand is elastic, tax will raise the price and reduce demand. This will result in lower revenue.

However, if demand is inelastic, it will pay to enforce taxes.

3. Pricing of factors The more inelastic the demand, higher will be the price of the factor and vice versa. Example: If demand for workers is inelastic, trade unions would be successful in raising wages.

4. International trade If the demand for exports of a country is elastic, its exports will rise substantially with a slight deduction in price and vice versa. Similarly, when demand for imports is inelastic, the importing country has to pay a high price.

5. Devaluation This is the official reduction in the external value of the currency in terms of other currencies. Exports become cheaper and imports become more expensive with devaluation. If demand for exports is elastic, devaluation will increase exports and thus increase foreign exchange earnings. Similarly, demand for imports is elastic. It saves foreign exchange reduction in imports. When demand for imports and exports are inelastic, devaluation will have an adverse effect. Thus devaluation will be successful if demand for exports and imports is elastic.

6. Policy of nationalism

Nationalism means taking over by the government. The government would like to take over or nationalize all utility concerns (example: water supply) for which demand is inelastic and if left in the hands of the private sector would be very expensive.

7. Promotional budget The promotional budget of the businessmen depends on elasticity of demand for the product. If demand for the product is elastic, it would pay to increase the promotional/advertisement budget.

Questions and Answers: 1. Differentiate between: (i) Elastic and Inelastic demand

Elastic Demand

Inelastic Demand

Elastic demand is one Inelastic demand is one which responds greatly to which changes little even even a small change in where there is a big price. change in price. Example: luxury goods have elastic demand as demand changes when price increases or decreases. Example: food grains have inelastic demand as demand changes very little even if there is a big change in price.

(ii) Perfectly inelastic and perfectly elastic demand

Perfectly Inelastic demand When a change in price brings about no change in quantity demanded, demand is said to be perfectly inelastic. ep = 0

Perfectly Elastic demand When a change in price (even a slight change) brings about an infinite change in quantity demanded, demand is perfectly elastic. ep =

Example: if a 10% change in price brings about no change in quantity demanded. (This is a hypothetical situation.)

Example: if a 10% price change brings about an infinite change in quantity demanded.

(iii) Income elasticity and Cross elasticity of demand

Income Elasticity Income to the demand income elasticity refers responsiveness of to a change in of the consumer.

Cross Elasticity Cross elasticity refers to the responsiveness of demand for a commodity to a given change in the price of a related good.

(Related goods could be substitutes or complimentary goods.) Here, income is the factor affecting demand. Income elasticity is positive for normal goods and negative for exceptions like Giffin goods. Here, price of related goods affect demand. Cross elasticity is positive for substitutes and negative for complimentary goods.

(iv) Less elastic and more elastic demand

(v) Percentage method and Total Outlay method

Ratio/Arithmetic/Percentage Marshalls Total Outlay method Method This method is used only This method measures when the calculation the elasticity of relates to small changes in demand by studying the price. direction of change in price and total outlay. (Total outlay = Price * Quantity)

(vi) Price elasticity and Income elasticity of demand

Price elasticity The change in demand for a commodity due to a change in price of the commodity is known as price elasticity of demand.

Income elasticity The change in demand for a commodity due to a change in income is known as income elasticity of demand.

Here, the price of a Here, the income of the commodity affects demand. consumer affects demand. Price elasticity is negative for normal goods. Price elasticity is positive for inferior goods. Income elasticity is positive for normal goods. Income elasticity is negative for exceptions like inferior or Giffin goods.

2. Do you agree? Give reasons:

(i) Greater the number of substitutes, more elastic is the demand for the commodity. Ans: I agree. If the price of an item such as Pepsi rises, the demand for it falls and demand for substitute Coca Cola rises. The more the number of substitutes, the more elastic the demand.

(ii) Demand for luxuries is inelastic. Ans: I disagree. Luxury items are used to make our lives more comfortable but are not necessary. Hence, when price of luxury goods increase, demand

decreases and vice versa. Thus, demand for luxury goods is elastic.

(iii) Demand for food grains is inelastic Ans: I agree. Food grains are essential for us as they provide us with nutrition and form a part of our staple diet. Therefore, the demand remains almost fixed even with a rise or fall in price. Hence, demand for food grains is inelastic.

(iv) Demand for salt is elastic Ans: I disagree. Salt is used by all to make food more palatable and is a necessary product. If the price increases or decreases, the demand remains almost the same especially since there are no substitutes. Hence, demand for salt is inelastic.

(v) The demand for prestige goods is elastic. Ans: I agree. Prestige goods are goods purchased to help increase a person social status and prestige. Prestige goods are, thus, not necessities. If the price of such a good increases, the demand decreases and vice versa hence prestige goods so not have elastic demand.

(vi) Perishable goods have elastic demand Ans: I disagree. Perishable goods are consumed repeatedly and on a regular basis. Hence, the demand for perishable goods is inelastic.

(vii) Demand for goods whose use can be postponed is relatively elastic Ans: I agree. The demand for goods whose use can be postponed is relatively elastic as goods whose use is urgently required is purchased before these goods.

(viii) If the demand for the commodity is perfectly inelastic, price elasticity of demand is infinity. Ans:

(ix) Demand for specialized labour is inelastic Ans: I agree. Specialized labour is not commonly available hence people are willing to pay high prices to those specialized in their fields as there is no one else to do the job. Hence, the demand for specialized labour is almost constant even with a change in price which means the demand for it in inelastic.

(x) The Total Outlay method is a less exact method of measuring elasticity

Chapter 5: Supply

I. Concept of Supply Supply is defined as the various amounts of a commodity which a seller is willing and able to sell at any given price during a specific period of time. A statement of supply such as supply of sugar is 50 kg is ambiguous unless it is with reference to

price and time. Thus, if we say supply of sugar is Rs.5/kg per day, the statement would be complete.

II. Difference between Stock and Supply Stock Supply

Stock refers to the total Supply refers to that quantity of goods part of stock actually manufactured and stored. offered for sale at a given price and a particular period of time. Stock is a fund or reservoir. Stock can exceed supply. Stock is a wider concept therefore stock is greater than supply. Stock is relatively less price elastic. Stock is potential supply. Supply is a flow. Supply cannot exceed stock. Supply is a narrow concept therefore supply is lesser than stock. Supply is more price elastic. Supply is the actual amount available for sale.

Note: Incase of durable goods, the entire stock is not offered for sale and a part of it is stored. The seller would offer the entire stock for sale when price rises. Incase of perishable goods, the

III. Determinants of Supply 1. Price of a commodity: When the price of the commodity rises, supply rises and vice versa.

2. Availability of raw materials: The greater the availability of raw materials, greater would be the supply of goods.

3. Goals of the producer: Some producers have ambitious goals and want to capture a larger market share. Some aim at maximizing profits and a few consider the interest of society. Thus, the different motives of the producer affect sales.

4. Sale of technology: Improvement in technology and methods of production increase supply.

5. Cost of production: If cost of production is high, supply will be less and vice versa.

6. Transport facilities: When there is adequate transport and communication facilities, supply would be greater and the market wider and vice versa.

7. Climate or weather conditions: If the weather conditions are favourable, supply would increase and vice versa.

8. Natural calamities like earthquakes etc. would reduce supply. This would also be true during emergency situations like wars etc.

9. Taxation: If heavy taxes are imposed on commodities, supply would reduce and vice versa. If the government provides subsidies to encourage production, supply would increase.

10. Future expectations regarding prices: If prices are expected to rise in the future, supply will be withheld (hoarding will occur). If price is expected to fall in the future, there may be distress sale at present (during current period).

11. Self consumption: If the producers keep more for self consumption, supply will be less and vice versa.

12. Time element: In the short period of time, supply is generally fixed. However, in the long period of time, supply or production can be adjusted to meet the changing demand.

13. Export and Import: Reduced exports and more imports will increase supply within a country.

14. Monetary policy of the government: If the government adopts a liberal monetary policy, supply would increase and vice versa.

15. Nature of market: In a competitive market, supply would be higher. However, incase of a monopoly, monopolists would restrict supply in order to increase their prices and profits.

III. Difference between Individual supply and Market supply

Individual Supply

Market Supply

An Individual supply Market supply schedule is schedule is a tabular a tabular representation representation of the of the various quantities various quantities of the of a commodity offered commodity offered for for sale by all the sale by an individual sellers at different seller at different prices during a given prices during a given period of time. period of time. An Individual supply curve is a graphical representation of the various quantities of a commodity offered for sale by an individual seller at different prices during a given period of time. Market supply curve is a graphical representation of the various quantities of a commodity offered for sale by all the sellers at different prices during a given period of time.

Individual supply schedule Price (Rs.) Quantity supplied (1000s of tons) 10 20 30 40 50 1 2 3 4 5

Market supply schedule

Quantity supplied by:

Price A 10 20 30 40 50 1 2 3 4 5

B 3 4 5 6 7

C 5 7 8 10 12

Market Supply 9 13 16 20 24

*The Market supply was obtained by a horizontal summation of the individual supply of the sellers.

The Individual supply curve is generally steeper and shows a positive relationship between price and

The Market supply curve is generally flatter and also shows a positive relationship between price and quantity

quantity supplied.

supplied.

IV. Law of Supply a) Definition The law of supply states that other things remaining equal, the quantity supplied of the commodity varies directly with price. The law of supply establishes a functional relationship between price (P) and quantity supplied (Q). Q = f(P) When the price of a commodity rises, its supply expands and when the price falls, its supply is reduced.

b) Supply schedule The Supply schedule is a tabular representation of the various quantities of a commodity offered for sale at different prices during a given period of time. The supply schedule also shows a direct relationship between price and quantity supplied. Example: at a higher price, Rs.30, the supply is 3000 tons and at a lower price of Rs.10, the supply is only 1000 tons.

Price (Rs.) 10 20 30

Quantity supplied (1000s of tons) 1 2 3

40 50

4 5

C) Supply curve The Supply curve of the various quantities of a commodity offered for sale at different prices during a given period of time. When the supply schedule is plotted, we get the supply curve, the supply curve slopes upward to the right and this positive slope shows a direct relationship between price and quantity supplied. The various points of the supply curve are alternative and not successive. All the points on the supply curve except one are imaginary (because no seller can say exactly how much quantity he will supply at different prices.) The supply curve is hypothetical in nature.

d) Assumptions The law of supply will hold good only under certain conditions. It is assumed that there is no change in the following: Cost of production. Cost of raw materials. Goals of the producers. State of technology.

 Weather conditions. Transport facilities. Fiscal policy of the government pertaining to taxation and public expenditure. Future expectation regarding prices. Amount kept for self consumption by the producers. Exports and imports. Nature of the market. Monetary policy.

e) Exceptions to the law of supply 1. Regressive supply curve of labour (or the backward sloping curve of labour): It has been noticed that with a rise in the wage rate, the supply of labour (number of hours of work) will rise in the beginning but beyond a certain point, the supply of labour will reduce if the wage rate rises further. In the following illustration, when the wage rate is Rs.3 per hour, the worker works for 5 hours and gets Rs.15. When the wage rises to Rs.5, and later to Rs.7 and Rs.10, he works for 7 hours, 9 hours and 10 hours respectively and his earnings increase to Rs.100. With a further rise in wage to Rs.12, the worker puts in 11 hours and earns Rs.132. However, when the wage rate reaches Rs.14, the worker puts in only 10 hours and the worker earns Rs.140 which is higher than before.

Thus, if the wage rate goes beyond a particular high level, the worker prefers to substitute work by leisure and reduces the supply of labour. Hence beyond a certain level of wage rate, the supply curve of labour slopes backwards. This is called the regressive supply curve of labour or backward sloping supply curve of labour which is an exception to the law of supply.

Supply of labour: Wage rate (Rs.) 3 5 7 10 12 14 Hours of work 5 7 9 10 11 10 Amount earned 15 35 63 110 132 140

2. Fixed income The law of supply does not apply to those who are interested in earning a fixed income from a given

amount of money (a deposit). For instance, if a person wants to give Rs.10,000/year to an institution when the rate of interest is 10%, he will have to keep a deposit of Rs.1,00,000. However, if the rate of interest falls to 5%, the amount of money capital deposited by him should be Rs.2,00,000. Thus for some people, with a rise in rate of interest, the savings will decrease and vice versa.

3. Future expectations regarding prices If the seller expects the price to fall in future, his current supply will be more and vice versa.

4. Need for cash If the seller requires money urgently, he would sell more at a lower price and vice versa.

5. Self consumption With a rise in price of food grains, the farmer may retain more for self consumption and supply less to the market. In all these cases, there is an inverse relationship between price and quantity supplied and hence they are exceptions to the law of supply.

V. Movements or variation in supply (extension and contraction) and changes or shifts in supply (increase and decrease)

a) Movements or variations in supply (extension and contraction) Extension When supply rises due to a change in price while other determinants remain constant is known as an extension of supply. Thus, an extension in supply is caused by a rise in price. There is a movement upwards to the right on the same supply curve. Contraction When supply falls due to a change in price while other determinants of supply remain constant, it is known as a contraction in supply. Thus, a contraction of supply is caused by a fall in price. There is a movement downwards to the left on the same supply curve.

When the price of the commodity rises from OP to OP, the quantity supplied expands from OM to OM.

When the price of a commodity falls from OP to OP, the quantity supplied contracts from OM to OM.

b) Changes or shifts in supply Increase in supply When there is a rise in Decrease in supply When there is a fall in

supply due to factors other than price, it is known as an increase in supply. Thus an increase in supply is caused by: 1.Improvement in technology 2. Better transport facilities

supply due to factors other than price, it is known as a decrease in supply. Thus a decrease in supply is caused by: 1. Bottlenecks/problems in transportation 2. Unfavourable weather

3. Increase in cost of 3.Favourable weather etc. production etc. The supply curve shifts entirely to the right of the original supply curve. The supply curve shifts entirely to the left of the original supply curve.

At the same price OP, more quantity OM is supplied. At a lesser price OP, the same quantity OM is supplied.

At the same price OP, lesser quantity OM is supplied. At a higher price OP, the same quantity OM is supplied.

Difference between demand and supply Demand Supply

Demand refers to the quantities of various commodities purchased at a given price during a specific period of time. Demand is inversely related to price. Demand curve is a graphical representation of the demand schedule and it slopes downwards from left to right. Demand originates from consumers or buyers.

Supply refers to the quantities of various commodities offered for sale at a given price during a specific period of time. Supply is directly related to price. The supply curve is a graphical representation of the supply schedule and it slopes upwards from left to right. Supply originates from producers or sellers.

Chapter 6: Forms of Market

I. Definition and features In ordinary language, market refers to a place where buyers and sellers of a commodity meet physically to exchange goods or services.

In the economic sense, it refers to an arrangement whereby the buyers and sellers of a commodity come in close contact with each other directly or indirectly to buy and sell goods. Following are the features of a market: 1) It is not necessarily a particular place. 2) It refers to an arrangement i.e. conditions and commercial relationships facilitating transactions between sellers and buyers. 3) It implies the existence of potential buyers and sellers. 4) It may be physically identifiable. Example: the cutlery market at Jama Masjid Street or the bullion market at Zaveri Bazaar etc. 5) Existence of different prices for a specific commodity implies different markets for a commodity.

II. Difference between Product market and Factor market Product market There is buying and selling of commodities. Example: market for food grains or produce exchange. Factor market Factors of production i.e. land, labour, capital etc. are transacted. Capital market, real estate market etc. are instances of factor market. Factor services are transferred from factor owners to the producers. Derived demand.

Goods are transferred from the sellers to the buyers. Direct demand.

Price of commodity is determined by demand and supply for the product.

Price is determined by demand and supply for the factors and the price of the factor land is rent, capital is interest, labour is wage and organisation is profit.

III. Types of Market Structure On the basis of:

Geography

Local Market

Regional Market

National Market

International Market

Competition

Perfectly Competitive Monopoly

Imperfectly Competitive Monopoly

Pure Competition

Perfect Competition

Sellers side

Buyers side

IV. Pure Competition Pure Competition was propounded by American economists such as Professor Edward Chamberlain. He distinguished between the concepts of Pure and Perfect competition. Following are the features of Pure Competition:

1. Large number of buyers Thus, each buyer has an insignificant role in the Total Market Demand. There is atomistic competition between the buyers and an individual buyer has negligible effect on the total demand. The buyers are thus the price takers and not the price makers.

2. Large number of sellers There are a larger number of sellers resulting in atomistic competition between the sellers. Each

seller has an insignificant role in the Total Market Supply or output. The seller cannot influence the price of the commodity as each seller sells a small fraction of the output. He has to accept the prevailing price and sell as much as possible at the existing price. The seller is the price taker and not the price maker.

3. Homogenous product The products are identical in brand, appearance, packaging, price etc. They are perfect substitutes for each other.

4. Free entry or exit New firms can enter the market and old firms can leave at their choice. There are no monopolistic barriers to entry and no compulsion to continue to sell.

IV. Perfect Competition Perfect Competition was propagated by British economists. In addition to the features of pure competition, perfect competition has the following characteristics (here, give all points from 1 to 4 of Pure Competition.)

5. Perfect knowledge Perfect knowledge should exist in case of both buyers and sellers regarding conditions in the market, prices of a commodity etc. so as to maintain a uniform price.

6. Perfect mobility There should be perfect mobility of factors between firms, industries and geographical areas i.e. there should be no friction in the movement of factors.

7. No transport costs If transport costs existed, uniformity of price cannot be maintained therefore there is no transport cost otherwise goods in one area would be more expensive than in another. 8. No government intervention There should be no government intervention in the form of controls, rationing, licensing etc. This is to ensure free entry and exit for the firm.

9. Rationality of buyers and sellers Rationality of buyers and sellers is assumed i.e. in order to maximize satisfaction, the buyers buy at the lowest price and seller aim to sell at the highest price thus self interest is maintained.

10. No selling/advertising cost There is no selling or advertising cost as each seller is selling identical products thus advertising and sales promotion would be futile.

Pure Competition and Perfect Competition are rare except in the case of certain agricultural products. However, the theory provides the basis for developing more sophisticated market models like monopoly, oligopoly, monopolistic competition etc. It provides a standard to judge the economic efficiency of less competitive models.

V. Price Determination under Perfect Competition 1. Large number of buyers such that no single buyer is the price maker. 2. Large number of seller. Thus, the sellers are the price takers and not the price makers. 3. Homogenous product, brand, appearance, packaging, price, etc. 4. Free entry and exit. There are no monopolistic barriers to entry. 5. No transport costs. 6. No government intervention. 7. No selling or advertising costs. 8. Perfect knowledge. 9. Perfect mobility. 10. Rationality of buyers and sellers.

Price determination under perfect Competition may be explained with the help of the following illustration:

Market Demand and Supply Schedule Price 5 4 3 2 1 Quantity demanded 100 200 300 400 500 Quantity supplied 500 400 300 200 100

From the market demand and supply schedule we derive the demand and supply curves that intersect at point E. This is the point of equilibrium where quantity demanded = quantity supplied. Comparing the market demand and supply situations at alternating possible situations, we find that at a higher price (example: P), supply exceeds demand

and there is a surplus. This excess supply would leave the sellers competing among themselves is to dispose of their stock resulting in a downward pressure on price as price falls, demand rises and supply falls until eventually equilibrium price is reached where amount demanded = amount supplied. Thirdly, at a lower price, demand will exceed supply leading to competition among buyers. This will push up the price till the price reaches equilibrium level where quantity demanded and quantity supplied will be equal. Thus at equilibrium point, there will be no disappointed buyers or seller in the market under perfect competition. The tendency towards prevalence of one price is the asset test of perfect competition.

VI. Monopoly The word monopoly has been derived from the Greek words mono and poly meaning single seller. It is a market situation having the following features: 1. One seller: There is only one seller or producer of the product. 2. Many buyers: There are many buyers of the product and may have to accept the terms of the monopolists. 3. Entry barriers: There are many barriers to entry of new firms. These barriers will be natural, economic, technological etc. 4. No closed barriers: Due to various barriers, there are no close substitutes for the product. 5. Price makers: The monopolists are the price makers, not the price takers since he controls the entire market supply the entire market supply.

6. Negation of competition: Monopoly is the complete negation or opposition of competition. 7. Firm coincides with industry: A single firm coincides with the industry. Therefore, it has the downward sloping demand curve. 8. Fixes either price or quantity to be sold: The monopolists fixes either price or quantity to be sold but not both. He fixes a price for his product which would maximize his profit. However, though a price maker, a monopolist does not have unlimited powers to charge a high price as he cannot disregard demand. If buyers refuse to buy at a high price, he will have to lower the price. Thus, he will produce that level of output which maximizes profit and change only that price at which maximizes profit and charge only that price at which he is in a position to dispose the entire output. (If he fixes the price arbitrarily, there is no guarantee the product will sell at that price and if he wants to sell the certain output, he will have to adjust the price according to the wishes of the consumer.) The demand curve of the monopolists is downward sloping.

The downward slope of the demand curve indicates that the monopolists can sell more if he lowers the price and can sell less if he raises it.

Monopoly It has one seller.

Perfect competition It has many sellers.

A monopoly firm coincides An industry consists of with the industry. several firms producing identical products. It has complete control over the market supply. An individual seller cannot influence market supply.

Monopolists are the price Sellers and buyers are makers. price takers. There are barriers to entry for new producers. Example: natural, legal etc. Monopoly product has no close substitutes. Price is normally higher than average cost. (An average cost is higher than under perfect competition. Firms enjoy supernormal profit in the long run. No competition, no rival producers. Free entry and exit for new producers.

Products are perfect substitutes to each other. Price is equal to the lowest average cost in the long run. Firms enjoy normal profit in the long run. Competition among sellers and producers.

Exploitation of consumers No exploitation of by charging high prices. consumers and workers.

Under discriminating monopoly, different prices are charged to different buyers of the same product. Monopoly adjusts output to the price determined by considering market demand or adjusts price according to the output he would like to sell.

A uniformed price is charged for all buyers of the commodity.

Seller adjusts output to the given price.

Types of Monopoly 1. Absolute or pure monopoly: This was given by the economist Sraffa. Absolute monopoly is one where a single firm or industry sells a product which has no substitutes. 2. Limited or relative monopoly: A single firm which sells a commodity having lose substitutes. 3. Natural monopoly: A single firm acquires control over the supply of raw materials like mineral resources. 4. Legal monopoly: It is conferred on a firm due to patents, trademarks, copyrights etc. It arises due to statutory regulations of the government. 5. Technological monopoly: This is because of economies of large scale production, use of capital intensive methods, market research, new process of production etc. 6. Joint monopoly: It is through voluntary agreement of a number of big companies or

organizations which acquire monopoly power by forming trusts, cartels, syndicates etc. 7. Public/Social/Welfare monopoly: Public utilities like water supply, railways and telephones are monopolies created for the welfare of the people. These monopolies are service motivated. 8. Private monopolies: It is owned and operated by private individuals or organizations. The main objective is profit maximisation. 9. Simple monopoly: Charges uniform or single price for its product to all consumers. 10. Discriminating monopoly: The firm charges different prices for the same product for different consumers.

Monopolistic competition Monopolistic competition is a combination of monopoly and competition. Pure monopoly and perfect competition do not exist in reality. In the real world, markets have both elements of monopoly and competition and hence these markets are imperfect. The concept of monopolistic competition was developed by American economist Professor Edward Chamberlin. The main features of monopolistic competition are:

1. Large number of seller selling closely related but not identical products An individual firms supply is just a small part of the total supply. Thus the firm has a limited degree of control over the market price but unlike prefect competition, in this market, the firm is

not a price taker. Each firm can formulate its price and output policy independently.

2. Large number of buyers There are a large number of buyers in the market. However each buyer has a preference for a specific brand hence the buying is by choice and not by chance.

3. Free entry and exit of firms There are no barriers to entry under monopolistic competition. Exit is also equally easy. However, the new firm cannot produce an identical product but has to develop a differentiated one which could compete with the already existing product. Excess profits by the existing firms will attract more firms to the market and a loss will compel them to leave the group or industry.

4. Product differentiation The most distinguishing feature of monopolistic competition is that the products produced by different firms are not identical. They are slightly different from each other but are close substitutes. Thus their prices cannot be very different either as they belong to the same class of goods and satisfy the same wants. Product differentiation can be done in different ways:

a) Colour, size, design, taste, perfume etc.: Products may be differentiated on the basis of these features. b) Sales techniques: Product differentiation may be on the basis of sales techniques. Example: after sale service, free home delivery, credit payment facility etc. Product differentiation protects the individual producer. Incase a individual firm increases price, it may not decrease the sales much. Similarly, a price cut may not increase the sales much.

5. Selling cost or non-pure competition Selling costs are those expenditures which are incurred by the firms to create more demand for its product and thus increase sellers. Example: expenditure on advertisements, exhibitions, free samples and other sales promotional measure. Rival firms under monopolistic competition keenly compete with each other through advertisements by which they try to change the consumers wants for their products. These selling costs are peculiar to monopolistic competition only.

6. Group concept Under monopolistic competition, Chamberlin introduced the concept of group in place of the Marshallian concept of industry. Industry refers to a number of firms producing identical products. A group refers to a number of firms producing differentiated products which are closely related.

7. Downward sloping relatively elastic demand curve

The demand curve faced by each firm is downward sloping and comparatively more elastic. This implies that an individual firm can sell more only by reducing the price. The demand for a firms product is therefore elastic. However, it is not perfectly elastic as in perfect competition where commodities are perfect substitutes, nor is it less elastic as in monopoly where the product has no close substitutes.

Since in monopolistic competition large number of close substitutes are available, the cross elasticity of demand for a product is very high.

7. Price and non price competition Firms in this market compete both through price as well as non price competition. Non price competition implies competition through advertisements, sales promotions etc. (Example of monopolistic competition: different brands of soap, toothpaste etc.)

Monopoly One seller. No close substitutes are produced.

Monopolistic competition Large number of sellers. Close substitutes are produced by different firms.

Barriers to entry of firms to the market. Demand for product is inelastic as there is no close substitute available.

Free entry and exit of firms. Demand for the product is elastic as close substitutes are available.

Production Costs Production costs are the costs incurred in producing the product. Example: cost of raw materials, wages, transport costs etc. Production costs create utilities and satisfy consumer demand. Production costs adapt production to demand. They manipulate the product.

Selling Costs Selling costs are costs incurred in selling to obtain the demand for the product. Example: cost of advertisements, salesmen etc. Selling costs create and shift the demand for the product. Selling costs adapt the demand to the product. They manipulate demand.

Production costs increase Supply costs increase the supply of the product demand for the product and the price falls. and price rises.

Perfect Competition It is a market structure where there are a large number of firms that produce and sell homogenous products that are perfect substitutes.

Monopolistic competition It is a market structure in which a large number of firms produce and sell differentiated products which are close substitutes.

Price of the product of the firm is uniform and single price prevails. There is no stiff competition as there are a large number of buyers and sellers.

Firms sell their product at different prices practicing price discrimination. There is competition due too many buyers and sellers but at the same time each seller acquires a monopoly power due to product differentiation. Selling costs have to be incurred to show that their products are special. The firm is a price maker.

There is no selling cost as the product of all firms are the same. The firm is a price taker.

Perfect competition is an Monopolistic competition unrealistic market. is a realistic market situation.

Public Monopoly Owned and controlled by the government. Welfare oriented. Example: railways, water supply etc. Public monopoly serves the interests of the consumers by charging a low price.

Private Monopoly Owned and controlled by private individuals or institutions. Profit oriented. Example: certain products of companies such as Phillips, Apple etc. Private monopoly serves the interests of the producers by charging a high price.

Absolute/Pure Monopoly A single firm controls the market supply of a commodity which has no substitutes, not even a remote one. There is absolutely no competition. The demand for a product is perfectly inelastic and the monopolist can arbitrarily charge his price. The cross elasticity of the products under absolute monopoly is zero. Absolute monopoly is a rare phenomenon.

Limited Monopoly A single firm controls the market supply. There are no close substitutes but there are remote substitutes. There is a threat of competition from distant substitutes. The demand for a product is relatively inelastic and the monopolist must consider the competitors price while fixing his own price. The cross elasticity of demand for the product under limited monopoly is very low. Limited monopoly is a realistic situation.

Market Price

Normal Price

Market price is the price Normal price is the price that prevails in the that prevails in the long market period or very period. short period. Market price is determined by the day to day changes in the forces of demand and supply in Normal price is determined by the forces of demand and supply in the long period.

the market period. Market price is influenced by demand and utility because supply is fixed and perfectly inelastic in the market period. Market price is the result of temporary equilibrium. Long run price is influenced by supply at all costs because supply is relatively or perfectly elastic in the long run. Normal price is the result of permanent equilibrium between the forces of demand and supply normal price is permanent and stable. Normal price is permanent and stable. Normal price is a myth as it is the price which we expect to prevail in the long run hence it is hypothetical in nature.

Market price keeps on fluctuating and it is unstable and temporary. Market price is a reality because it is the price prevailing in the very short period which is experienced.

7. Aggregates

I. a) Meaning of Aggregate Supply Aggregate supply refers to the sum total of all goods and services produced in an economy during a given period of time, usually a year. It refers to National Product or NI.

b) Aggregate supply Aggregate supply is determined by the availability, use and quality of natural resources (N), labour (L), capital resources (K), the state of technology (T) and the level of i.e. actual usage of the resources. Total output is a result of employment of all factors of production. An increase in aggregate supply can be achieved by a change in these factors. Higher the level of employment or actual us of available resources, greater would be the aggregate supply and vice versa. Aggregate supply is given in the following equation: O or A or S = f(N, L, K, T) [The bar above N, L, K, T indicates constancy.]

1. Natural resources: The availability, use and quality of natural resources determine the aggregate supply. Land refers to all kinds of natural resources that are freely formed in nature on, above and below the surface of the earth.

In economics, we are concerned only with those natural resources which are limited in supply and can be used in production. Resources may be renewable example: water, trees etc. and non renewable example: minerals, oil etc. A country rich in natural resources can produce more and vice versa. However, supply not only depends on the availability of natural resources but also on their utilization and quality. Utilization in turn depends upon factors like stock of capital, level of technology and quality of labour. Example: Afghanistan is rich in natural resources but its utilization is very low due to lack of capital and poor technology. In the short run, it is difficult to change these factors and hence they are assumed to be constant.

2. Labour: Labour is a human factor. Labour may be mental or physical effort which contributes to production. Labour refers to productive labour which is paid for and not unproductive labour. The quantity and quality of the labour force determines the aggregate supply. There is a direct relationship between quantity of labour and quality of efficiency of labour with aggregate output or supply. In the short run, land, capital and technology remain constant and the aggregate output depends on the level of employment labour (number of worker and working hours.)

3. Capital resources: Capital is the produced or man made means of production. Example: machinery tools, factory plants etc. Capital includes real capital like physical goods and money capital. It may also be classified as

fixed capital. Example: machinery, tools etc. and working capital. Example: raw materials and fuel. The use of capital increases the efficiency of other factors and increases production rapidly resulting in high rate of growth of NI. Thus the quality, type and utilization of capital goods influence aggregate supply. The total stock of capital is assumed to be constant in the short run as it takes time to increase the supply of capital goods.

4. Level of technology: Technical know-how refers to the application of scientific methods in production. Technological changes generally increase the productivity of labour, capital and other resources. It also improves the quality of goods produced. However, new changes in technology takes time to be introduced hence technology is also assumed to be constant in the short run. Thus aggregate supply is determined by the availability, quality and use of natural resources, capital resources and the state of technology. Aggregate supply is a function of the level of employment in the short run. As employment of labour increases, output will increase more than proportionately in the initial stages but after a point it will increase less than proportionately thus the short run aggregate production function: AS or

= f(N, L, K, T)

Given the fixed factors (N and T), with every additional unit of a factor (L), the total output increases initially at an increasing rate and after

a particular level of employment (OL1), it increases at a diminishing rate i.e. there is a less than proportionate increase in output. This is because of diminishing marginal physical productivity of labour.

The curve shows the level of employment required for the production of different amounts of aggregate output in the economy in the short run. The actual level of employment is, however, determined by aggregate demand and aggregate supply.

II a) Meaning of Aggregate Demand The aggregate demand refers to the total demand for different types of goods and services in an economy at prices during a given period of time.

(b) Aggregate demand thus includes the demand of consumption of goods (C), investment goods (I), government goods and services (G) and the net difference between demand for exports and imports (X-M). Thus, aggregate demand is equal to: AD = C + I + G + (X-M) = GDP

(i) Aggregate consumption expenditure (C): Consumption refers to the total demand for goods and services, for consuming purposes by all private individuals and institutions in an economy. Consumption expenditure (C) is purely autonomous (a) and partly dependent on income (b). Therefore, C = a + b

Aggregate investment expenditure (I) Investment refers to the addition of capital stock of an economy during a given period of time. It is also known as capital formation or capital accumulation. The part of the production that is not consumed during the year but used for further production is called investment. Investment may be classified as:

1. Financial and real investment: Financial investment refers to the purchase of shares, securities, debentures etc. These financial assets add to the money capital of the nation but do not increase the stock of real capital. Real investment is the net addition to the existing capital stock of a country. Example: Machines, raw materials, factory buildings, etc. which are physical assets or real capital and can be used for further production.

2. Cross and net investment: Cross investment refers to the total investment in capital assets like buildings, machines etc. during a particular period of time (usually a year) without deducting depreciation.

Depreciation refers to the wear and tear of fixed capital assets during the process of production. Net investment is defined as Cross investment depreciation during a year.

3. Autonomous and induced investment: Autonomous investment refers to the investment made without reference to income, profit or rate of interest. Most investments by the government on roads, railways, new techniques etc. are autonomous in nature. Autonomous investment is income elastic. Induced investment refers to investment made with reference to profits. Private investment sector is generally profit motivated or induced investment.

4. Fixed and inventory investment: Fixed investment refers to the addition to the stock of fixed capital goods. Example: machinery, factory buildings, transport equipment, telephone etc. Those are investments in capital goods which can be used again and again in the process of production and do not get exhausted while used once. Inventory investment refers to investment in the stock of the inventories like raw materials and semi-finished goods. It refers to investment in working capital goods which get exhausted after a single use.

There are several factors determining investment demand: i) Level of savings (S): Savings refer to the difference between income (Y) and consumption (C) i.e. S = Y C.

Higher the level of income, higher the savings and investment.

ii) Rate of interest: There is an inverse relationship between investment and rate of interest. Higher the rate of interest, lower will be the investment and vice versa. (If interest rate is high, people will borrow less money for investment.)

iii) Marginal efficiency of capital: It refers to the expected rate of return on capital investment. If marginal efficiency of capital is higher, investment would be larger.

iv) Money supply and bank credit: If in an economy, the supply of money in the form of cash and bank credit is more, then investment demand would be higher and vice versa.

v) Technology: Technological innovations lead to higher production and economic expansion resulting in more investment.

vi) Cost of capital goods: The level of investment depends upon the cost of capital goods. A fall in the cost of capital goods will lead to increase in investment and vice versa.

vii) Level of consumption: If there is an increase in consumption, the inducement to invest will be higher and vice versa.

viii) Expectations of future changes: If people are careful about the future, investment demand will be high and vice versa.

ix) Government policies: If the monetary, fiscal and trade policies of the government are liberal, investment will be high and vice versa. The investment demand curve shows the relationship between rate of interest and investment demand. Higher the rate of interest, lower the investment and vice versa. Thus the investment demand curve slopes downwards from left to right.

Aggregate government expenditure: Government or public expenditure refers to the expenditure by the government on consumption and capital goods to satisfy the collective wants of society. Example: expenditure on Central and State governments and local bodies like municipalities, zila parishads and panchayats. The aim of government expenditure is to promote maximum social welfare. The government expenditure also adds aggregate demand.

Government expenditure may be classified as a) Government consumption expenditure: This is on durable goods and non durables goods, wages and salaries, government employees, purchases from abroad etc. b) Capital goods expenditure: Example: Transport, industries, irrigation, construction of roads, dams, etc. The various types of expenditure by the government are: Defense expenditure. Civil expenditure. Example: police, administrative services. Expenditure on elections, legislatures and ministries. Public works programme. Education and health services. Trade, banking, insurance services. Expenditure on economic planning. Development on agriculture, industry and urbanisation. Social security benefits etc. Most of the government expenditure is autonomous in nature. Government incurs developmental expenditure on productive expenditure, nongovernment expenditure i.e. non-productive expenditure for the welfare of the people. All these expenditures by the government add the aggregate demand of the economy

Net earnings from foreign transactions (X M): It refers to the difference between earnings from exports (X) and payments for imports (M) to foreign countries i.e. (X M). This difference between earnings from abroad and payments made abroad may be positive if the value of export is greater than the value of import or negative in the value of imports. The positive difference adds to the National Income (NI) and the negative difference reduces the National Income (NI). The balance of payments refers to the systematic record of all economic transactions, cash, and noncash between the residents of a country and the rest of the world during a particular period of time, usually a year. If exports are greater than imports, there is a surplus and a favourable balance of payments. If imports are greater than exports, there is a deficit and unfavourable balance. When the total receipts by the country are greater than the total payments made abroad there is an addition to the National Income and aggregate demand increases and vice versa. Thus, the determinants of aggregate demand include: Aggregate consumption expenditure (C) Aggregate investment expenditure (I) Government expenditure (G) Net earnings from international transactions (X-M) Thus aggregate demand or total expenditure in an economy indicates the value of total output or total income, Hence, Aggregate demand = National expenditure = National output = National Income.

Exports Sale of goods by one country to a foreign nation. Adds to the countrys foreign exchange and national income. Balance of payment is favourable. Income < Expenditure Country exports good which are in surplus.

Imports Purchase of goods by a country from a foreign nation. Decreases the countrys foreign exchange and national income. Balance of payment is unfavourable. Income > Expenditure Country imports goods which are scarce.

Consumption It refers to the expenditure of goods and services consumed directly. Satisfies human wants directly.

Investment It refers to expenditure of goods and services used for further production. Satisfies human wants indirectly.

Expenditure on Expenditure on investment consumption goods goods add to capital promotes current welfare. formation and future welfare. Expenditure on food, clothing, medical services etc. Income inelastic. Social welfare oriented. Expenditure on raw materials, machinery, irrigation etc. Income elastic. Profit oriented.

Influenced by: Change in level of income, therefore, need for welfare. Change in the size of population. Change in technology. Monetary and fiscal policy of the government.

Influenced by: Change in level of income. Change in price level therefore profitability. Change in the consumption pattern. Possibility of high profit etc.

Fixed investment It refers to the addition of the stock of fixed capital goods like machinery, factory plants, buildings, transport, equipment etc. It is also called fixed capital formation.

Inventory investment It refers to the investment of stock of inventories like raw materials, semi finished goods. Inventory investment is the difference between stock of inventories at the beginning of the year and stock at the end of the year. It refers to investment in working capital. The utility gets exhausted after a single use.

It refers to investment in capital goods. As capital goods can be used again and again in the process of production, the utility does not get exhausted.

It is determined by long term demand. Composition remains the same for many years.

It is determined by short term demand. It goes on changing every year depending on the output produced.

Consumption Consumption refers to that part of income which is used for the purchase of goods and services. Consumption expenditure (C) can be obtained by subtracting savings (S) from income (Y) i.e. C = Y S. With the increase in income, consumption increases in a lesser proportion.

Savings Savings refers to that part of income which is not consumed but is saved for the future. Savings (S) can be obtained by subtracting consumption expenditure (C) from income (Y) i.e. S = Y C With an increase in income, savings increase in a greater proportion.

Consumption refers to the Savings refers to the expenditure in the expenditure for the present. future. Savings leads to investment. Consumption depends upon income (Y) and price level (P) i.e. C = f(Y, P) Savings depend upon level of income and level of consumption i.e. S = f(Y, C)

Cross investment It refers to the total addition to the capital stock of a country during a particular period of time. It includes depreciation of capital assets and other items of expenditure. It is equal to net investment + depreciation. It includes: Loss incurred due to wear and tear of capital. Replacement of worn out capital-like expenditure on tools, paintings etc. Loss of capital due to natural calamities. Broader concept.

Net investment It refers to the net0addition to the capital stock of the country during a particular period of time. It excludes depreciation of capital assets.

It is equal to gross investment depreciation. It does not include depreciation of capital to wear and tear.

Narrow concept.

Consumption

Savings

It refers to that part of It refers tot hat part of

income which is used for income which is not the purchase of goods and consumed but saved for services. the future. Consumption expenditure (C) can be obtained by subtracting savings (S) from income (Y) i.e. C= Y - S With the increase in income, consumption increases in a lesser proportion. It refers to the expenditure in the present. It depends on income (Y) and price level (P) i.e. C = f(Y,P) Savings (S) can be obtained by subtracting consumption expenditure (C) from income (Y) i.e. S = C Y With an increase in income, savings increase in a greater proportion. It refers to the expenditure in the future. It depends on level of income (Y), level of consumption (C). S = f(Y,C)

Chapter 8: Consumption function and Savings function

I. Consumption function a. Definition Consumption function of propensity to consume refers to the functional relationship between the aggregate consumption (C) and aggregate income (Y). The consumption function shows the changes in consumption at different levels of income. Thus, C = f(Y)

b. Schedule Income (Y) [Rs. in crores] 300 400 500 600 700 Consumption (C) [Rs. in crores] 300 380 450 510 560 Savings (S) [Rs. in crores] 0 20 50 90 140

The schedule shows various amounts of consumption at various levels of income. It also indicates that when income increases, consumption also increases but in a lesser proportion. This is known as Keynes psychological law of Consumption. Here, a part of the additional income is not consumed and,

therefore, saved. As a result of an increase in National income: 1. Consumption expenditure increases at a diminishing rate. 2. Savings increase at an increasing rate.

c. Graph

In the diagram, income is shown on the x-axis and consumption on the y-axis. The line is drawn through the origin O to make a 45 degree angle with the x-axis. All points on this line show equality between income and consumption expenditure. aC is the consumption function (propensity to consume). It moves upward to the right showing consumption and income is positively co-related. It has a positive slope showing that consumption increases as income increases but in a lesser proportion. Increase in aC is less than increase in income OBY. Point B is the break-even point when National Income = Consumption expenditure. To the left of the break-even point, consumption is greater than income. The excess consumption expenditure is met by borrowing, foreign aid or using past savings.

To the right of the break-even point (B), consumption expenditure is less than the National Income and there is + savings. Thus, consumption function not only measure the amount for consumption but also the amount saved because as income increases, propensity to consume increases to lesser proportion and propensity to save increases in a greater proportion.

d. Concepts 1. Average propensity to consume (APC): APC = C/Y C = consumption, Y = income As income increases, APC increases. APC shows how a society divides income between consumption and savings. The demand for consumer goods depends on APC.

2. Marginal propensity to consume (MPC): It is the ratio of change in aggregate consumption (AC) to the change in aggregate income (AY). It refers to the additional increase in consumption to the additional increase in income. MPC = C /Y MPC is always positive but less than 1. This is because as income increase, consumption increases but less than the increase in income. Hence, MPC<1.

3. Factors affecting consumption function: According to Keynes, there are two types of factors affecting consumption function:

i) Subjective factors: They are endogenous i.e. internal to the economic system. They are very stable in the short run. They include psychological characteristics of human nature and social practices: a) Precaution: The precautionary motive of people to meet unforeseen contingencies like accidents etc. reduces consumption and increases savings. b) Foresight: In order to provide for future expenses, childrens education or marriage or for old age etc., people reduce consumption and save more. c) Calculation: People reduce their consumption at present to enjoy a higher consumption in future through interest earnings and appreciation of stocks. d) Improvement: People spend less and save more to enjoy a better standard of living and social status in future. e) Independence: People spend less and save more to enjoy freedom without having to depend on others. f) Enterprise: When funds are to be provided for investment, business, speculation etc., consumption expenditure is affected. g) Pride: The desire to have a fortune for the heirs affects consumption function. h) Avarice: People who are greedy for money and misery spend less and save more. There are also motives which entice people to consume more and save less. They are enjoyment, generosity, short sightedness, miscalculation, ostentation and extravagance.

The subjective motives of the government and business enterprises like liquidity, enterprise improvement and financial prudence also affect consumption function.

ii) Objective factors: They are exogenous i.e. external to the individuals in the economics system. They are as follows: a) Windfall gains or losses: When people get windfall gains or losses, their consumption pattern changes suddenly. Example: windfall gains or losses in the stock market can change the consumption pattern of those affected. b) Changes in tastes, preferences and expectations: Sudden changes in tastes and preferences will affect propensity to consume. Example: If war is expected, people will save their consumption due to their fear of scarcity and rising prices. It may also lead to hoarding. c) Prices and wages: A fall in prices and rise in wages will generally increase propensity to consume and vice versa. d) rate of interest: People will consume less and save more at higher rates of interest and vice versa. e) Volume of wealth: Volume of wealth with a person affects interest. f) Distribution of income: A community with more inequalities of income will have a low propensity to consume and vice versa. g) Money, stock or liquid assets: The larger the amount of liquid assets like cash balance, the greater will be the propensity to consume and vice versa.

h) Fiscal policy: The governments tax policy affects consumption levels. Heavy taxes reduce consumption and vice versa. i) Corporate financial policies: The business policies of joint stock companies regarding payment of dividends, reinvestments etc. affect the propensity to consume. j) Consumer credit: Availability of credit on easy terms will affect consumption expenditure. Consumption expenditure is also affected by the indebtedness of the people. k) Sales effect: Advertisements will affect demand and the volume of consumption. If people have adequate stocks of durable goods like TVs, cars etc. there will not be an increase in consumption expenditure in spite of an increase in consumption. l) Money illusion: If people are not aware of corresponding changes in prices and money income, their propensity to consume is affected. m) Population: If the population is large, the percapita income will be low and this will affect consumption. The composition of the population will also affect consumption expenditure. Other factors like life insurance, demonstration effect etc. also affects consumption expenditure. However, Keynes concluded that the most significant function of consumption is income.

II. Savings function

a. Definition

Savings function shows the functional relationship between aggregate savings (S) and aggregate income (Y). Thus, S = f(Y)

b. Schedule Income (Y) [Rs. in crores] 300 400 500 600 700 Consumption (C) [Rs. in crores] 300 380 450 510 560 Savings (S) [Rs. in crores] 0 20 50 90 140

c. Graph

aS is the savings curve. It intersects the x-axis at point B showing that the National Income is OB, savings is zero.

*Marginal Propensity to Save (MPS): It is the ratio of change in savings (S) to a change in income (Y). Therefore, MPS = S/Y. Marginal propensity to save is the extra amount people will save when they receive an extra unit of income. It is the change in savings induced by a change in income. How much savings will be done at any time with increase in income depends on the marginal propensity to save. Since the additional income (Y) is either consumed (C) or saved (S), the sum total of MPC and MPS is equal to 1. Thus MPS = 1 MPC.

III. Determination of effective demand/ Equilibrium level of employment Equilibrium level of income and employment is determined by the interaction of average demand function and average savings function curve. The aggregate supply function indicates the production cost of each level of employment. Income and employment in the economy will be in equilibrium at the point where the amount of money which the entrepreneurs actually expect to receive from employing a certain number of workers is equal to the money they must receive (average demand function) to cover the cost of production (average savings function). Thus the point where ADF=ASF is the point of effective demand and at this point, all the firms earn normal profits.

As long as sales receipts (ADF) is more than production costs (ASF), the number of workers employed keep on increasing because it is profitable for the producers to do so until ADF equals ASF. This can be explained with the help of an example: Employment of workers (lakhs) Average Demand function (Rs. crores) 360 680 1000 1320 1640 Average Savings function (Rs. crores) 200 600 1000 1400 1800 Comparision

10 20 30 40 50

ASF>ADF ASF>ADF ASF=DF ASF<ADF ASF<ADF

Recruitment of works will continue till the number of employed workers is 30 lakhs. Here, the economy will attain equilibrium level of employment. However, if the production cost (ASF) is more than the sales receipts (ADF), the level of employment would be reduced until the sales receipts (ADF) becomes equals the production costs (ASF).

In the graph, aggregate supply curve at E or the point of equilibrium at which effective demand is achieved. If the employment is more or less than ON, the profits would not be maximum. Thus ON is the equilibrium output and level of employment. According to Keynes, the equilibrium level of employment at any time depends on effective demand in an economy which in turn depends on aggregate demand function and aggregate savings function. In the short run, the ASF is more or less stable therefore, ADF is the more important determinant of equilibrium level of income and employment.