Dr. Shabeer K P: June 2018

Open Course

EC5 D01: Economics in Everyday Life

Study Material

Prepared by

Dr. Shabeer K P

Assistant Professor

www.kodencherycollege.ac.in

Syllabus

Module 1: Basic Concepts and the Methods of Economics

What is economics- Definitions of economics- Basic problems of an economy- how the basic problems are solved by different economic systems? Microeconomics and Macroeconomics

Module 2: Micro Economic Concepts

Demand –demand function, demand schedule, demand curve. Supply –supply function, supply curve- market equilibrium. Elasticity: price, income, cross. Determinants of elasticity. Competition vs. Monopoly – Multinational Corporations – Cartels – Mergers – Acquisitions

Module 3: Macro Economic Concepts

National income - GNP, GDP, Per Capita income - Fiscal and monetary policies: meaning and instruments, bank rate, repo rates, reverse repo rate. (concepts only) .Inflation – meaning, types and effects - Budget -: Revenue Expenditure and capital expenditure. Deficit - Revenue Deficit, Fiscal Deficit- Balance of trade- balance of payments - Current account and capital account-FDI-FPI

Reference

1. Dominick Salvatore : Microeconomics : Theory and Applications, Oxford University press, New Delhi

2. Gregory Mankiw: Macro Economics – 6th Edn. Tata McGraw Hill.

3. Errol D‘Souza : Macro Economics – Pearson Education 2008.

4. B. Alvin Prakash : The Indian Economy Since 1991: Economic Reforms and Performance, Pearson Education India

5. Subrato Ghatak : Introduction to Development Economics - Routledge

6. Lekhy : Public Finance and Public Economics – Kalyani publications

Module 1

Basic Concepts and the Methods of Economics

What is Economics?

Knowledge has many branches and economics is an important and useful branch of knowledge. Over the years, economics has assumed as greater importance in view of the fact that knowledge of economics is being used for initiating and accelerating growth in the economies of the world and thus eradicating poverty and unemployment from human race.

Wealth Definition

The science of economics in the form today is just 230 years old. Adam Smith (1723-90) who is regarded as the Father of Economics has brought out famous book An Enquiry into the Nature and Causes of Wealth of Nations in 1776. He defines economics as the “Science of Wealth”. According to Smith, Economics was regarded as the Science which studies about production and consumption of wealth. It enquires into the factors that determine wealth of the country and its growth. In other words, economics is concerned with the problems arising from wealth-getting and wealth-using activities of men. It is that body of knowledge which relates to wealth. Among the followers of Adam Smith, J B Say defined economics as “the study of the laws which govern wealth”. According to F A Walker “economics is the body of knowledge which relates to wealth”. In the words of Nassau Senior “the subject treated by political economist is not happiness but wealth”.

The economics as science of wealth has been severely criticized. In the 17^th and 18^th centuries when religion and ethics had stronghold on men, economics as a science of wealth was treated as “dismal science” and “gospel of mammon”. The main drawbacks of the wealth definition are the following

a) It gives undue importance to wealth. Wealth is considered as an end in itself.

b) The definition ignores human welfare. In fact, human welfare is the ultimate aim of all economic activities.

c) It is too narrow. To the classical economists wealth meant only material goods. They excluded services of all kinds from the purview of economics.

d) It makes economics a mean science. As per the definition all individuals should satisfy their self interest. Man is only guided by the desire to acquire wealth, which is wrong.

e) The definition ignores the problems of scarcity and choice. It is silent about the basic economic problems of scarcity of economic problems of scarcity of resources and the need for choice.

Welfare Definition

Alfred Marshall was the first economist who lifted the economics from the disrepute it had fallen into due its being associated with study of wealth. Marshall defines economics in his book Principles of Economics (1890) as “the study of mankind in the ordinary business of life. It examines that part of individual and social action which is most closely connected with the attainment and with the use of the material requisites of well being. Thus, it is on the one side a study of wealth; and on the other, and more important side, a part of the study of man”. Marshall’s welfare definition gave economics a respectable place among social sciences. Marshall pointed out that, for economics, wealth is not the end in itself; but it is only a means to end. The end being the promotion of human welfare. Economics is concerned with the wealth in the sense that it studied man’s action regarding how he earns his wealth and how he spends it.

Marshall’s welfare definition is not free from criticism. They are the following.

a) It excludes services. Welfare definition included only material goods in the study of economics

b) All material goods do not give us welfare. Material goods like liquor, narcotics etc are material goods ad are scarce in relation to demand. But they do not promote human welfare.

c) Welfare is not measurable. Welfare is subjective and is a personal inner experience. It varies from person to person. Therefore, welfare is immeasurable.

d) It ignores the basic problem of scarcity. The definition is silent about the basic economic problems created by unlimited wants and limited resources.

Scarcity Definition

Lionel Robbins in his book Nature and Significance of Economic Science provided a new definition which is considered to be more scientific and correct. According to Robbins “economics is a science which studies human behaviour as a relationship between ends and scarce means which have alternative uses”. Robbins’s definition is based on three facts. Firstly, man’s wants are unlimited. When a particular want is satisfied others crop up to take its place. Secondly, resources are scarce in relation to wants. The time and means available for satisfying human wants are limited. The third fact is that even the limited resources have alternative uses. In other words, resources can be put to various uses. The use of a scarce resource for one end prevents its use for any other purpose. Thus, according to Robbins, economics studies human behaviour regarding how he satisfies his wants with the scarce resources. The economic problem is one of economizing scarce means in relation to numerous ends.

The important points of criticism leveled against scarcity definition are the following

a) It concealed the concept of welfare. Though there is no fundamental difference between the welfare and scarcity definition, Robbins gives too much stress to scarcity of economic resources.

b) It is only a micro analysis. Robbins is concerned with the problems of scarcity and choice faced by individuals. The macroeconomic characters are missing in the definition.

c) Abundance also can create economic problems. Excess supply of resources also can create economic problems as in the case of depression. But Robbins says that problems arise due to scarcity alone.

d) It ignores economic growth. Today economic development is an important branch of economics. Economic development increases supply of resources. But Robbins assumes that the resources are given.

Growth Definition

Modern age is the age of economic growth. Its main objective is to increase social welfare and improve the standard of living of the people by removing poverty, unemployment and inequalities of income and wealth of the country. Paul Antony Samuelson has given a definition of economics based on growth aspects. According to Samuelson “economics is the study of how people and society choose, with or without the use of money, to employ the scarce productive resources which could have alternative uses, to produce various commodities over time and distribute them for consumption, now or in the future, among various persons or groups in the society”.

Like Robbins, Samuelson has emphasized the problem of scarcity of resources in relation to unlimited wants. He has also accepted the alternative uses of resources. The definition includes time element when he refers to “over time”, which makes the scope of economics dynamic. Samuelson’s definition is applicable even in a barter economy where money measurement is not possible. It gives importance to the problem of distribution and consumption along with that of production. Samuelson emphasizes on the consumption of various commodities produced overtime and on their distribution and for future economic growth. By studying the problems of growth, he also highlights the study of macro economics. In this way, despite various similarities with Robbins definition, growth definition is an improvement over scarcity definition and is also more comprehensive and realistic than the earlier definitions.

The Importance of Economics

Why should we study economics? The overriding reason is that throughout our life, from cradle to grave and beyond one will run up against the brutal truths of economics. The study of economics is important for several reasons. Some of which are discussed below.

1) Understanding the economy and society

Understanding the operation of our economic system enables us to improve its performance and help us to improve its performance and help us to deal with many of the problems that face our country. The economy is such an important part of society that it is impossible to understand society without a basic knowledge of economics

2) Understanding world affairs

Rapid changes are occurring in the world. Just pickup a news paper or turn on television and you get an idea of the many important changes that are taking place. All these issues have economic causes and consequences. Therefore, an understanding of economics will enhance our understanding of world affairs.

3) Being an informed citizen

As consumers, it is important for us to know how to spend our income so that we can derive maximum satisfaction from our purchases. It is also important for us to use our labour services and other resources wisely. As citizens, we must be able to visualize and evaluate the consequences of different causes of action in order to determine which one are most likely to lead to improvement in economic and social wellbeing.

4) Thinking Logically

One of the most important reasons for studying economics is that it develops a particular way of thinking and making decisions. Good decision making requires a careful evaluation of the advantages and disadvantages associated with the decision or choice we make. Economic analysis, to a large extent, is an exercise in logic and thus helps to strengthen our common sense.

5) Getting Personal Satisfaction

There may be a more personal selfish reason for studying economics. Because the study of economics can be intellectually exciting and stimulating, it yields great personal satisfaction. Today, professional economists work in practically every aspect of business and government.

Resource Scarcity and Choice

The word scarce means limited or insufficient. Scarcity of resources is the fundamental problem of every society. As the resources of every society are limited (scarce), the ability of the society to produce goods and services are also limited. In other words, human wants are unlimited and the means to satisfy them are limited, every society is faced with the twin problems of scarcity and choice.

We live in a world where everything is scarce. Human wants are unlimited and the means to fulfill them are limited. At a particular time, the economy can produce only a limited amount of goods and services. This is because of the scarcity of resources like land, labour, capital and organization. These factors of production (inputs) are used to produce goods and services (Economic goods). These factors explain scarcity is the basic problem of every society. Thus, the law of scarcity states that human wants are unlimited and the resources available to satisfy theses wants are limited.

With wants being unlimited and resources scarce, we individually as well as collectively cannot satisfy all our wants. This gives rise to the problem of how to use scarce resources to attain maximum satisfaction. Therefore, scarcity of resources results in the ‘fundamental (basic) economic problem of choice’. As a society cannot produce all the goods and services to satisfy all the wants of the people, it has to make a choice regarding the goods and services to be produced at present. The economic problem fundamentally revolves around the idea of choice.

A decision to produce one good may result in a decision not to produce another good. So, choice involves sacrifice. Thus, every society is faced with the basic problem of deciding what it is willing to sacrifice to produce the goods it wants the most. For example, if the country decides to have more hospitals, it may have to reduce the resources available for the construction of schools. How do individuals, firms, governments and other organizations make decisions about the use of society’s resources?. This question is at the heart of economics.

Central Problems of an Economy

The scarcity society’s resources give rise to various economic problems which have to be solved by economic system if it is to fulfill its purpose. The economic system must determine what goods and services are to be produced and in what quantities, how they are to be produced and how to distribute them amoung the members of the economy. Thus the basic economic problems are

(1) What to produce?

(2) How to produce?

(3) For whom to produce?

The central problems are briefly explained below.

(1) What to Produce?

What to produce means what goods and services are to be produced and in what quantities these goods are to be produced. As resources are limited, no economy can produce as much of every commodity or service as desired by all members of the society. As such production of more of one good means less of other goods. Therefore, every society must decide the goods and services the economy has to produce and how much of these goods are to be produced. This involves the allocation of scarce resources in relation to the composition of total output in the economy. An important choice is to decide what amounts of consumer goods and capital goods are to be produced. Since resources are scarce, if some goods are produced in larger quantities, some other goods will have to be produced in smaller quantities. Economy has to decide not only relative amounts of consumer and capital goods to be produced but it has also to determine the specific quantity of each type of goods. The problem of what to produce is essentially the problem of efficient allocation of scarce resources so that the output is maximum and output-mix is optimum. The objective is to satisfy the maximum needs of maximum number of people.

(2) How to Produce?

Once the economy has decided what goods and services are to be produced and in what quantities, it must decide how the chosen goods shall be produced. Thus, how to produce refers to the choice of the combination of factors and the technique of production to produce goods and services. Clearly, this is a problem of the choice of production techniques. Production of goods can be by using labour intensive (technique which uses more labour and less capital) or capital intensive (technique that uses less labour and more capital) techniques. Here the problem is how to determine an optimum combination of inputs- labour and capital- to be used in the production of goods and services. The scarcity of resources demands that goods should be produced with the most efficient method. Thus, the society would choose that technique of production which minimizes the cost of production. Clearly, the choice between different methods would depend on the factor supply and the prices of the factors of production. The technique to be used also depend upon the type and quantity of goods to be produced.

(3) For whom to produce?

Once, the problems of what and how to produce are solved, then arises the problem for whom to produce. For whom to produce means how produced goods are to be distributed among the people. In other words, for whom to produce means how the national products to be distributed among the members of the society. Thus, it is the problem of sharing the national product. Distribution of national product depends on the distribution of national income. People who have large incomes will get a larger share from the national product. Since goods and services are scarce, no society can satisfy all the wants of all the people. The distributive principle differ from economy to economy and the socialistic principle is from each according to his ability to each according to his needs where as the capitalistic principle is from each according to his resources (money).

How the Central Problems are solved?

Different economies use different methods to solve the central problems of the economy. The shape of economic activities and the nature of economic institutions in a country depend on the type of economic system prevalent in the country. Important economic systems are capitalism, socialism and mixed economy.

In the capitalist economy having the features of private ownership of property, economic freedom and consumer’s sovereignty, the central problems are solved through the market mechanism. That is, what goods are to be produced and what quantities, which methods of production are to be employed for the production of goods and how the output is to be distributed, should be decided by the free play of the forces of demand and supply. Under capitalism, the price mechanism operates automatically without any direction or control by the central authorities. It is the profit motive which determines the production and consumer’s choices determines what to produce, how to produce and how much to produce. Producers try to produce goods and services to meet tastes and preferences of consumers. Under capitalism ‘consumer is the king’.

A socialistic economy is an economic organization in which the means of production are owned and regulated by the state. In a socialistic economy, it is the central planning authority that performs the function of the market. Since all the material means of production are owned, controlled and directed by the government, the decisions about what and how to produce are taken within the framework of central plan. The decisions about the nature of goods to be produced and their prices and quantities are fixed by the central planning authority. Consumer’s choice is limited only to the commodities that the planners decide to produce and offer.

A mixed economy is a blending of capitalistic economy and a socialistic economy. It is the economic system where the price mechanism and economic planning are used side by side. Thus, the mixed economy solves the problem of what to produce in what quantities in two ways. Firstly, the price mechanism helps the private sector in deciding what commodities to produce and in what quantities. In those spheres of production where the private sector compete with the public sector, the nature and quantities of commodities to be produced are decided by the price mechanism. Secondly, the central planning authority decides the nature and quantities of goods and services to be produced where the public sector has a monopoly. Similarly, the problems of how to produce and for whom to produce are solved partly by the price mechanism and partly by the state.

Meaning of Micro Economics

Economic theory is broadly divided into micro economics and macro economics. These terms were first introduced by Ragnar Frisch in 1933. The term micro economics is derived from the Greek word ‘micros’ which means small. The term macro economics is derived from the Greek word macros which means large. Thus, micro economics deals with a small part of the economy of a country. In other words, microeconomic theory (also called Price Theory) studies the economic behavior of individual decision making units (eg. consumers, resource owners, and business firms) in an economy. K E Boulding defines micro economics as “the study of particular firms, particular households, individual prices, wages, income, individual industries and particular commodities”.

Thus, Micro economics is the study of the economic actions of individuals and small group of individuals. In micro economics, we study the various units of the economy and how they function and how they reach their equilibrium. In other words in micro economics, we analyse only a tiny part of the economy at a time. We study the various units of the economy; how they function and how they reach their equilibrium. In other words, in micro economics, we attempt only a microscopic study of the national economy. In micro economics, we enquire about how a particular person maximizes his satisfaction or how a particular firm maximises its profits.

Microeconomics is an important method of economic analysis and it occupies an important place in the study of economic theory. Microeconomics tells us how a free market economy with its millions of consumers and producers works to decide about the allocations of productive resources among the thousands of goods and services. It tells us how the goods and services produced are distributed among the various people for consumption through price (Market) mechanism. Microeconomic theory explains the conditions of efficiency in consumption and production and highlights the factors which are responsible for the departure from the efficiency (optimum). Thus, microeconomics has theoretical and practical importance.

Meaning of Macroeconomics

The word macro is derived from the Greek word ‘makros’ meaning large. Therefore, macro economics concerned with the economic activity in the large. Macroeconomics analyses the behaviour of the whole economic system in totality. It studies the behaviour of large aggregates such as total employment, national product or income, general price level etc. therefore, macroeconomics is also known as ‘aggregate economics’. In the words of K E Boulding “macroeconomics deals not with individual quantities as such but with the aggregates of these quantities; not with individual incomes but with the national income; not with the individual prices but with the price level; not with individual outputs but with the national output”. Thus, Macroeconomics is the study of the economy as a whole or the study of aggregates. It is not concerned with the behavior of individual economic units.

Macroeconomic analysis is very important. It gives us a bird’s eye view of the entire economy. Macro economics try to understand how an actual economy operates and on the basis of that understanding, suggest policies that may be adopted to improve the performance of the economy. In order to solve the general economic problems related to national income, employment, money supply, production etc, the help of macro economics is necessary.

Module II

Micro Economic Concepts

The Nature of Demand

In economics, demand refers to the various quantities of a good or service that people will be willing and able to purchase at various prices during a period of time. It is important to note that a mere desire for a good or service does not constitute demand. Demand implies both the desire to purchase and ability to pay for the good. Unless demand is backed by purchasing power, it does not constitute demand.

Demand Function

Demand for a commodity is determined by several factors. An individual’s demand for a commodity depends on the own price of the commodity, his income, prices of related commodities, his tastes and preferences, advertisement expenditure made by the producers of the commodity, expectations etc. Thus, individual’s demand for a commodity can be expressed in the following general functional form,

Q_x^d = f (P_x, I, P_r, T, A, E)

where, Q_x^d = Quantity demanded of commodity “x”, P_x= Price of commodity x

I =Income of the individual consumer, P_r= Price of related commodities, T = Tastes and preferences of individual consumer, A = Advertisement expenditure and E = Expectations

For many purposes in economics, it is useful to focus on the relationship between quantity demanded of a good and its own price, while keeping other determining factors constant. Thus, we can write the demand function as

Q_x^d = f (P_x)

This implies that the quantity demanded of the commodity x is a function of its own price, other determinants remaining constant.

Law of Demand

Law of demand expresses the functional relationship between price and quantity demanded. According to the law of demand, other things being equal, if the price of the commodity falls the quantity demanded of it will rise and if the price of the commodity rises, its quantity demanded will decline. Thus, according to law of demand, there is an inverse relationship between price and quantity demanded, other things remaining the same. The other things which are assumed to be constant are tastes and preferences of the consumer, the income of the consumer, prices of related commodities etc. Thus, the law of demand assumes that all things other than price remain constant.

The law of demand can be illustrated through a demand schedule and through demand curve. Demand schedule shows various quantities of good or service that people will buy at various possible prices during some specified period, while holding constant all other relevant economic variables on which demand depends. A demand schedule is presented below.

Price	Quantity Demanded
10	20
8	40
6	60
4	80
2	100

We can convert the demand schedule into demand curve by graphically plotting the various price-quantity combinations, as shown below.

Quantity Demanded

Demand curve slopes downwards from left to the right. The downward sloping demand curve is in accordance with the law of demand, which describes inverse price-quantity demanded relationship. The various points on the demand curve represents alternative price -quantity combinations.

Reasons for law of Demand

Let us analyse the reasons for the inverse relationship between price and quantity demanded. This is due to both “income effect” and “substitution effect”.

When the price of the commodity falls, the consumer can buy more quantity of the commodity with his given income. If he chooses to buy the same amount of the commodity as before, some money will be left with him. That is, consumer’s real income or purchasing power increases. This increase in real income induces the consumer to buy more of the commodity. This is called the income effect of the change in price of the commodity. This is the reason why a consumer buys more of a commodity whose price falls. Similarly, an increase in the price of the commodity results in the reduction of real income of the consumer. Hence, the consumer buys less of a commodity whose price rises.

Again, when price of the commodity falls, it becomes relatively cheaper than other commodities. This induces the consumer to substitute the commodity whose price has fallen for other commodities which have now become relatively dearer. This change in quantity demanded resulting from substituting one commodity for another is referred to as substitution effect of the price change. As a result of this substitution effect, the quantity demanded of the commodity whose price has fallen rises. For normal commodities, the income and substitution effect of a price decline are positive and reinforce each other leading to a greater quantity demanded of the commodity.

Exceptions to the Law of Demand

Law of demand is generally believed to be valid in most situations. However, some exceptions have been pointed out. According to Thorestein Veblen, some consumers measure the utility of a commodity entirely by its price. That is, for them, the greater the price of the commodity, the greater it’s utility. These consumers demand more of such commodities the more expensive these commodities are in order to impress people. E.g. Diamonds. This form of conspicuous consumption is called “Veblen effect”. When the price of such commodities goes up, their prestige value also goes up. Consequently, quantity demanded also will rise and law of demand breaks down.

Another exception to the law of demand is the case of some inferior commodities and was pointed out by 19^th century English economist Sir Robert Giffen. He introduced the case of some inferior goods in which there is a direct price-quantity demanded relationship. If the price of an inferior good falls, consumer’s real income increases. So, instead of buying more inferior goods, consumers substitute other superior goods. In such case, quantity demanded of inferior goods falls as price falls. After the name of Robert Giffen, such goods are called “Giffen Goods”. In the case of Giffen goods, positive substitution effect is smaller than negative income effect when the price of such goods falls. With the rise in the price of such goods, its quantity demanded increases and with the fall in the price, its quantity demanded decreases. Thus, the demand curve will slope upwards to the right and not downward in the case of Giffen goods. It should be noted that Giffen good is an inferior good but all inferior goods are not Giffen goods. Though occurs rarely in the real world, Giffen goods represent an exception to the law of demand.

Extension and Contraction in Demand

When as a result of change in price, the quantity demanded rises or falls, extension and/or contraction in demand is said to have taken place (change in quantity demanded). When the quantity demanded of a good rises due to a fall in price, it is called extension of demand. When the quantity demanded falls due to rise in price, it is called contraction in demand.

It should be remembered that extension and contraction in the demand takes place as a result of changes in the price alone when other non-price determinants of demand such as income, prices of related goods etc remain constant. The extension and contraction in demand is shown below.

Q₂

Q_l

P₂

P_l

Quantity Demanded

It can be seen that when the price is OP, the quantity demanded is OQ. If the price falls to OP₂, the quantity demanded rises to OQ₂. Thus, there is extension in demand by the amount QQ₂. On the other hand, if the price of the commodity rises from OP to OP_l, there is a contraction in demand equal to the amount QQ_l. Thus, as result of changes in the price of the good, the consumers move along the same demand curve.

Thus, the movement along the given demand curve is referred to as a change in quantity demanded (extension or contraction in demand). A movement down the demand curve is an increase in quantity demanded (extension in demand). A movement up the demand curve is called a decrease in quantity demanded (contraction in demand).

Increase and Decrease in Demand (Shifts in Demand)

If the non-price determinants of demand such as income of the consumer, prices of related commodities etc change, the whole demand curve will change. The demand curve will shift to a new position in response to changes in any of the factors or variables that were held constant when original demand curve was drawn. When as a result of changes in these factors, the demand curve shifts upwards to the right, an increase in demand is said to have occurred. Increase in demand means the consumer buys more of the goods at various prices than before

An increase in demand is shown below

Quantity Demanded

D_l

In the figure, DD is the original demand curve and D_lD_l is the new demand curve. An increase in demand is shown by a shift in the demand curve to the right. The location of the demand curve has now changed. Now at any given price greater quantity is purchased.

On the other hand, a decrease in demand means entire demand curve shifts to a lower position to the left. Decrease in demand does not occur due to the rise in price but due to changes in other determinants of demand.

A decrease in demand is shown below

D₀

Quantity Demanded

In the figure, DD is the original demand curve and D_oD_o is the new demand curve. A decrease in demand is shown by the leftward shift in the demand curve. A decrease in demand would mean that at any given price smaller quantity would be purchased

Elasticity of Demand

We have seen that the demand for a commodity is determined by its own price, income of the consumer, prices of related goods etc. Quantity demanded of a good will change as a result of a change in the size of any of these determinants of demand.

Elasticity measures the sensitivity of one variable to another. Specifically, it is a number that tells us the percentage change that will occur in the variable in response to one percent increase in another variable. Therefore, elasticity of demand refers to the sensitiveness or responsiveness of quantity demanded of a good to a change in its own price, income and prices of related goods. Accordingly, there are three kinds of elasticity of demand .They are

Price elasticity of demand
Income elasticity of demand
Cross elasticity of demand

Price elasticity of demand measures the sensitivity of quantity demanded to change in own price of g good. Income elasticity of demand measures the sensitivity of quantity demanded to change in income of the consumer. While cross elasticity of demand analyses the responsiveness of quantity demanded of one good to changes in the price of another good.

Price elasticity of demand

Price elasticity of demand refers to the responsiveness or sensitiveness of quantity demanded of a good to changes in its own price. In order to have a measure of the responsiveness of quantity demanded of a good to change in its price that is independent of units of measurement, Alfred Marshall, defined it in terms of percentage or relative change in quantity demanded to price. As such, price elasticity of demand is given by the percentage change quantity demanded of a good divided by the percentage change in its price. The elasticity is usually symbolised by Greek letter eta (η). Thus, we have

η = Percentage change in quantity demanded

Percentage change in price

Now denoting ΔQ for change in quantity demanded and ΔP for the change in price (the symbol Δ is Greek letter delta; it means “the change in”) we have the formula for the price elasticity of demand as

η = ΔQ/Q

ΔP/P

η = ΔQ . P

ΔP Q

Since, price and quantity demanded are inversely related the coefficient of price elasticity of demand (η) is a negative number. In order to avoid dealing with negative values, a minus sign is often introduced into the formula of price elasticity of demand. That is

η = _ ΔQ .P

ΔP Q

Thus price elasticity of demand is measured by a ratio; the percentage change in quantity demanded divided by the percentage change in the price that brought it about. For normal negatively slopped demand curves, price elasticity will be negative, but two elasticities are compared by comparing their absolute values. As such, price elasticity of demand is a pure number that is it has no units of measurement attached to it. This allows meaningful comparison between the price elasticity of demand of different commodities.

The above formula is called point elasticity formula of demand because it measures elasticity at a point on the demand curve. The value obtained for η is just a number like 2 or 5 or ½ and is referred to as the coefficient of elasticity. Since price elasticity is being measured at a point on the market demand curve we are assuming that all other factors that affect market demand remain fixed.

The Arc Elasticity Formula

Formula of point elasticity of demand measures the elasticity at particular point on the demand curve. It can be conveniently used when the changes in the price and resultant quantity demanded are infinitesimally smaller. However, when the price change is large, we have to measure elasticity over an arc of the demand curve rather than at a specific point on it. The arc elasticity measures elasticity of demand between two points on the demand curve. That is, arc elasticity is a measure of average elasticity. Consider the following figure.

Q₁

Q₂

P₂

P_lL

Quantity Demanded

Arc Elasticity

The initial price is P_l and corresponding quantity is Q_l. When price falls to P₂, quantity demanded increases to Q₂. The arc elasticity measures elasticity at the point of the cord that connects the two points A and B on the demand curve defined by the initial and new price level. By taking the average of the two prices and average of two quantities, we can obtain the following formula for the price elasticity of demand

η = _ Δ Q . (P_l + P₂)/ 2

Δ P (Q₁+Q₂)/2

η = _ Δ Q . (P_l + P₂)

Δ P (Q₁+Q₂)

Total Outlay Method

Another method to measure price elasticity of demand is known as total outlay or expenditure method. In this method, changes in the total expenditure made on the good as a result of change in its price is analysed to measure price elasticity of demand. But with the total outlay method, we can know only whether price elasticity is equal to one, greater than one or less than one. With this method, we cannot find out the exact coefficient of price elasticity of demand.

If as a result of the change in price of the commodity total expenditure remains the same, then elasticity of demand for the commodity will be equal to unity. This is so because total expenditure made on the commodity can remain the same only if the proportional change in the quantity demanded is equal to proportional change in price.

On the other hand, due to fall in price of the commodity, quantity demanded rises and, as result, total expenditure made on the commodity increases, then price elasticity of demand is said to be greater than unity. This is so because with the fall in price of the commodity, total expenditure can increase only if the proportional change in quantity demanded is greater than the proportional change in the price.

If as a result of fall in the price of the commodity total expenditure decreases, then price elasticity of demand will be less than unity. This is for the reason that with the fall in price, total expenditure can decrease only if proportional increase in quantity demanded is less than proportional change in price. Thus, through the total outlay method, we can find out whether prices price elasticity is equal to unity or greater than unity or less than unity. Note that with this method, we cannot know the precise value of the price elasticity.

Degrees of Elasticity of Demand

The value of price elasticity of demand ranges from zero to infinity. That is, 0< η <∞. Based on the value of elasticity or degree of responsiveness of quantity demanded, price elasticity of demand is classified into five categories. They are

1) Perfectly inelastic demand

2) Inelastic demand

3) Unitary elastic demand

4) Elastic demand

5) Perfectly elastic demand

Now let us analyse each of them in detail.

(1) Perfectly inelastic demand

When quantity demanded does not change as a result of change in price, demand is said to be perfectly inelastic. Quantity demanded is unchanged when price changes or demand shows no response to change in price. In other words, same quantity will be bought whatever the price may be. Numerical value of elasticity will be zero (η = 0) when there is perfectly or completely inelastic demand. The following figure illustrates the case of perfectly inelastic demand.

P₁

Quantity Demanded

A change in price from P to P_l leaves quantity demanded unchanged at Q units. That is, quantity demanded does not change at all when price changes.

(2) Inelastic Demand

As long as there is some positive response of quantity demanded to change in price, the absolute value of elasticity will exceed zero. The greater the response, the larger the elasticity. However, when percentage change in quantity demanded is less than percentage change in price, demand is said to be inelastic. That is, a certain percentage change in price leads to a smaller percentage in quantity demanded. The coefficient of elasticity will be less than one but greater than zero (0< η <1) when demand is inelastic. This is shown below.

Q₁

P₁

Quantity Demanded

When change in price from OP to OP_l causes a less than proportionate change in quantity demanded. That is, quantity demanded changes by a smaller percentage than the change in price.

(3) Unitary Elastic Demand

If a certain percentage change in price leads to an equal percentage change in quantity demanded, then demand said to have unitary elasticity. Unitary elasticity is the boundary between elastic and inelastic demand. The coefficient of elasticity will be equal to one when demand is unitary elastic (η=1). The demand curve having unitary elasticity over its whole range is shown below

P₁

Q₁

Quantity Demanded

OP and OQ are the initial price and quantity. A fall in price from OP to OP_l causes an equal proportional change in quantity demanded from OQ to OQ_l.

(4) Elastic Demand

When the percentage change in quantity demanded exceeds the percentage change in price, the demand is said to be elastic. That is, a certain percentage change in price leads to a greater percentage change in quantity demanded. The value of coefficient of elasticity will be greater than one but less than infinity when demand is elastic (1<η<∞). This is shown below.

Q₁

P₁

Quantity Demanded

An increase in price from OP to OP_l causes a more than proportionate increase in quantity demanded as shown by the change in quantity demanded from OQ to OQ_l. Thus, a small rise in price brings in more than proportionate fall in quantity demanded.

(5) Perfectly Elastic demand

If a small change in price leads to an infinitely large change in quantity demanded, we can say that demand is perfectly elastic. When demand is perfectly elastic, small price reduction will raise demand to infinity. At the same time, a slightest rise in price causes demand to fall to zero. At the going price, consumers will buy an infinite amount (if available).above this price, they will buy nothing. The coefficient of elasticity will be infinity when demand will be infinite when demand is perfectly elastic (η =∞). The graph for perfectly elastic demand is shown below.

Quantity Demanded

When it is perfectly elastic, demand curve is a horizontal straight line. In his case an infinitely large amount can be sold at the going price OP. A small price increase from OP decreases quantity demanded from an infinitely large amount to zero (hyper sensitive demand).

Determinants of elasticity

Elasticity of demand for any commodity is determined or influenced by a number of factors, which are explained below

1) Nature of the commodity: elasticity of any commodity depends upon the category to which it belongs. Elasticity of demand is low for necessaries and is high for luxuries.

2) Availability of substitutes: commodities having substitutes have more elastic demand. If the commodity has no close substitutes, it will have inelastic demand.

3) Number of uses: if the commodity can be put to many uses, it will have elastic demand. A commodity which cannot be put to more than one use has less elastic demand.

4) Level of income: persons who belong to higher income group their demand for commodities is less elastic. On the other hand, demand for persons in lower income groups is generally elastic.

5) Proportion of income spent: if the consumer spends only a small proportion of income on a commodity at a time, the demand for that commodity is less elastic. But commodities which entail a large proportion of income of the consumer, the demand for them is elastic.

6) Habits: people who are habituated to the consumption of a particular commodity, the demand for it will be inelastic.

7) Level of prices: when the price level is high, the demand for commodities is elastic and when price level is low, the demand is less elastic.

8) Time period: elasticity is low (inelastic) in the short period and higher (elastic) in the long run. In the long run consumers change their consumption pattern.

Income Elasticity of Demand

The responsiveness or sensitiveness of quantity demanded of a commodity to changes in income of the consumer is termed as income elasticity of demand. It is the proportionate or percentage change in quantity demanded resulting from proportionate change in income. Thus we have

η_y = Percentage change in quantity demanded

Percentage change in income

Now denoting ΔQ for small change in quantity demanded and ΔY for the small change in income we may symbolically write the formula for the income elasticity of demand as

η_y = ΔQ/Q

ΔY/Y

η_y = ΔQ . Y

ΔY Q

For the most commodities, increase in income leads to increase in quantity demanded. Therefore, income elasticity is positive. If the resulting percentage change in quantity demanded is larger than the percentage change in income, income elasticity will exceed unity (η_y>1). Then the commodity’s demand is said to be income elastic. If the percentage change in quantity demanded is smaller than the percentage change in income, income elasticity will be less than unity (η_y<1). Then the commodity’s demand is said to be income inelastic. If the percentage changes in income and quantity demanded are equal, income elasticity will be unity (η_y=1). The commodity’s demand is said to have unitary income elasticity of demand. Unitary income elasticity represents a useful dividing line.

There is also a relationship between income elasticity for a commodity and proportion of income spent on it. If the proportion of income spend on the commodity increases as income increases, then the income elasticity of demand for the commodity is greater than unity (η_y>1). If the proportion of income spend on the commodity decreases as income rises, then the income elasticity of demand for the commodity is less than unity (η_y<1). At the same time, if the proportion of income spend on the commodity remains the same as income rises, then the income elasticity of demand for the commodity is equal to unity (η_y=1).

A normal commodity can be further classified as necessities and luxury using income elasticity. A commodity is considered as necessity if the income elasticity is less than unity. That is, in the case of necessities, the proportion of income spend on it falls as income rises. A commodity is considered to be luxury if its income elasticity is greater than unity. The proportion of consumer’s income spend on luxuries rises as his income increases.

Cross Elasticity of Demand

The responsiveness of quantity demanded of one commodity to changes in the prices of other commodities if often of considerable interest. The responsiveness or sensitiveness of quantity demanded of one commodity to the changes in the price of another commodity is called cross elasticity of demand. Thus, cross elasticity of demand can be defined as percentage or proportionate change in quantity demanded of commodity X resulting from a proportionate change in the price of commodity Y. the cross elasticity of commodity X with respect to the price of Y (η_XY) can presented as

η_XY = Percentage change in quantity demanded of X

Percentage change in price of Y

η_XY = ΔQ_X . P_Y

ΔP_Y Q_X

Where ΔQ_Xis the change in quantity demanded of X, ΔP_Yis the change in price of Y, P_Y is the original price of Y and Q_X is the original quantity of X. The coefficient of cross elasticity can vary from minus infinity to plus infinity. Substitute goods have positive cross elasticity and complementary goods have negative cross elasticity.

If η_XYis positive, the commodities X and Y are said to be substitutes. X and Y are substitutes if more of X is purchased when price of Y goes up. That is, an increase in P_Y leads to an increase in Q_X as X is substituted for Y in consumption. For example, consumers usually purchase more coffee when price of tea rises. Thus coffee and tea are substitutes or competing goods. In response to the rise in the price of one good, the demand for the other good rises.

On the other hand, if η_XY is negative, X and Y are said to be complementary goods. When X and Y are complementary goods, less of X will be purchased when the price of Y goes up. That is, an increase in P_Y leads to a reduction in Q_X (and Q_Y). For example consumers usually purchase fewer scooters when the price of petrol goes up. Thus scoter and petrol are complements. Other examples of commodities that are complements are bread and butter, tea and sugar and so on. In the case of complements, a rise in the price of one good brings about a decrease in demand for the other, as they are consumed together.

Nature of Supply

Supply refers to the various quantities of a good or service that sellers will be able to offer for sale at various prices during a period of time. It shows how price of a good or service is related to the quantity which the sellers are willing and able to make available in the market. As in the case of demand, supply refers not to a specific quantity that will be sold at some particular price, but to a series of quantities and a range of associated prices. Supply is a desired flow. That is, it shows how much firms are willing to sell per period of time, not how much they actually sell.

Supply Function

Like demand, supply also depends on many things. In general, quantity supplied of a product is expected to depend on own price, prices of related products, prices of inputs, state of technology, expectations, number of producers (sellers) in the market etc. This list can be summarised in a supply function

Q_X^S = f (P_x, P_r, P_i, T, E, N)

Where Q_X^S = Quantity supplied of commodity x, P_x= Price of the commodity x, P_r= Prices of related products, P_i = Prices of inputs, T = State of technology, E = Expectations and N = Number of producers in the market.

For a simple theory of price, we need to know how quantity supplied varies with the product’s own price, all other things being held constant. Thus we can write the supply function as

Q_X^S = f (P_x)

That is, quantity supplied of commodity x is a function of its own price, other determinants are assumed to remain constant.

Law of Supply

The functional relationship between price and quantity supplied is called the law of supply. According to the law of supply, as the price of the commodity falls, the quantity supplied decreases or alternatively, as the price of the commodity rises the quantity supplied increases, other things being equal. Therefore, there is a direct relationship between of the commodity and quantity supplied.

The law of supply can be illustrated through a supply schedule and supply curve. Supply schedule is a table that shows various quantities of a good or service that sellers are willing and able to offer for sale at various possible prices during some specified period. A supply schedule is presented below

Price	Quantity Supplied
5	40
10	60
15	80
20	100
25	120

Supply schedule shows that as price rises, a greater quantity is offered for sale. By plotting the information contained in the supply schedule on a graph we can derive the supply curve as shown below.

Quantity Supplied

The supply curve is a graph showing various quantities of a good or service that sellers are willing and able to offer for sale at various possible prices. The supply curve slopes upwards because of the direct relationship between price and quantity supplied. Note that the entire supply curve represents supply while a point on the supply curve represents quantity supplied at some specific price.

Why there is a direct relationship between price and quantity supplied? The main reason is that higher prices serve as an incentive for sellers to offer greater quantity for sale. The sellers or producers can be induced to produce and offer a greater quantity for sale by higher prices. It is assumed that sellers or producers aim to maximise profit from the production and sale of the commodity. The higher the prices of the commodity, other things being equal, the greater the potential gain producers can expect from producing and supplying it in the market. Moreover, increases in price may invite new suppliers in the market.

Market Equilibrium

The market equilibrium occurs when the prevailing price equates quantity demanded to quantity supplied. It refers to the price-quantity pair at which this takes place. Consumers bring demand to the market for buying goods to satisfy their wants. Producers or sellers bring supply of their goods to the market to sell them and earn profit. The market demand and supply determine prices of goods and services exchanged between buyers and sellers. Thus, market equilibrium is reached when market demand for and market supply of a good are equal and as a result, equilibrium prices and equilibrium quantities are determined. At such equilibrium, buyers find that they are able to buy exactly the same amount that they are demanding at the prevailing price and sellers are able to sell exactly the amount they are willing to supply at the prevailing price. In other words, there is no incentive for anyone in the market to change their behaviour. Thus equilibrium is the condition, which once achieved tends persist in time.

By bringing together the market demand and supply schedules we can see how market forces determine equilibrium price and quantity of the good. The following table presents a hypothetical demand and supply schedules of commodity X.

Price of commodity X (P_X in Rupees)	Quantity Supplied (Q_X^S)	Quantity Demanded (Q_X^D)	Surplus (+) Shortage(-)	Pressure on Price
5	140	20	120	Downward
4	100	40	60	Downward
3	60	60	0	Equilibrium
2	40	80	-40	Upward
1	20	100	-80	Upward

When the price of commodity X is Rs 1, buyers are willing and able to purchase 100 units but sellers are willing and able to offer only 20 units for sale. Therefore, there is a shortage of 80 units. At price of Rs 5, buyers are willing and able to purchase only 20 units while sellers are willing to offer 140 units. Therefore, there will be a surplus of 120 units in the market. Let us now consider a price of Rs 3. At this price, buyers are willing to purchase 60 units and sellers are willing to offer 60 units for sale. That is, at this price, there is neither a surplus nor a shortage. Quantity supplied of commodity is equal to the quantity supplied. Thus P_X = Rs 3 is the equilibrium price and Q_X^S= Q_X^D=6o is the equilibrium quantity.

At any other price other than the equilibrium price of Rs = 3, market forces are set in motion to raise or lower the price. At the prices above the equilibrium price, the quantity supplied exceeds the quantity demanded. For example, at P_X = Rs 4, sellers are willing to put 100 units of commodity X on the market but buyers are willing to take only 40 units. There will be surplus or excess quantity supplied of the commodity. Then the sellers will attempt to dispose this surplus by lowering the price. As price falls, a greater quantity will be demanded. At lower prices sellers supply smaller quantities and buyers demand larger quantities until the equilibrium price of Rs 3 is reached, at which the quantity supplied of 60 units of commodity X equals the quantity demanded and market clears.

On the other hand, at prices below the equilibrium price, the quantity supplied fall short of quantity demanded. For example, at P_X = Rs 2, buyers are willing to purchase 80 units but sellers will be able to offer only 40 units. There is a shortage or excess quantity demanded. Unhappy with the shortage, and wanting more commodity X, buyers will bid up the price to induce sellers to supply them the desired amount. Then the sellers offer a greater quantity at higher prices. The price will again settle at P_X = Rs 3, because at this price, the quantity demanded equals quantity supplied. Note that, price of Rs 3 is the only price that will prevail in the market. There will be no tendency of this price to change. Such a price is referred to as equilibrium price and quantity traded or exchanged at this price is called equilibrium quantity. The market for the product is said to be in equilibrium when the quantity demanded equals the quantity supplied at a specific price. The determination of equilibrium price and quantity can also be shown graphically by bringing together the market demand and market supply curve on the same graph, as shown below.

Shortage or Excess Demand

Surplus or Excess Supply

P₀

P₁

Quantity

The intersection of market demand curve DD and market supply curve SS at point E defines the equilibrium price P* and the equilibrium quantity Q*. At the equilibrium price, quantity demanded is equal to the quantity supplied. Because there is no excess demand or excess supply there is no pressure for the price to change further.

As said above, the equilibrium between demand and supply is not reached at once. There is the process of changes and adjustments which ultimately results in equilibrium price and quantity. Suppose that price is above the equilibrium level, say at P_l. At such higher price, there is excess supply or surplus of the commodity. Then the sellers would begin to lower prices in order to sell their excess suppliers. This surplus is eliminated as prices fall, quantity demanded increases and quantity supplied would decrease until the equilibrium price P* is reached, at which quantity demanded = quantity supplied. The opposite will happen if the price is below the equilibrium price, say at P_O.There will be excess demand or shortage. Consumers are unable to purchase the entire commodity they want at below-equilibrium prices and they bid up the price. This would put upward pressure on price and quantity supplied increases and until price eventually reach the equilibrium price P*, and the market clears.

Multinational Corporations

Multinational corporations (MNCs) are huge industrial organisations that owns or controls income generation assets in more than one country, and in so doing, produces goods or service outside its country of origin, that is, engages in international production. MNCs are also known as Transnational Corporations (TNCs). Instead aiming for maximisation of their profits from one or two products, the MNCs operates in a number of fields and from this point of view, their business strategy extends over a number of products and over a number of countries. Thus, MNCs are multi-process, multi-product and multi-national composite enterprises. The following are the characteristics of MNCs

a) Giant Size: the assets and sales of MNCs run into billions of dollars and they also make supernormal profits. The MNCs keep on growing even through the route of mergers and acquisitions.

b) International operations: MNCs interests and operations sprawl across national boundaries. In effect, MNCs have become global factories searching for opportunities anywhere in the world.

c) Oligopolistic structure: in course of time, through the process of merger and acquisition, an MNC acquires awesome power. This coupled with its giant size makes it oligopolistic in character.

d) Spontaneous evolutions: MNCs usually grow in a spontaneous and unconscious manner. Very often they develop through ‘creeping incrementalism’.

e) Collective transfer of resources: an MNC facilitate collective transfer of resources. Usually this transfer takes place in the form of a package which includes technical know-how, equipments and machinery, raw materials and finished products, managerial services and so on.

Case for MNCs

The case for MNCs resolve around the potential benefits that an under developed country can hope to get from MNC operations. Some of the potential benefits of MNCs are listed below

1) Capital: MNCs provide capital resources to under developed country. The scarce capital resources may be internally and/or externally generated

2) Technology: the main reason why MNCs are encouraged by the under developed countries is on account of their technological superiorities which these firms possess as compared to national companies. MNCs provide sophisticated technology not available in the host country.

3) Exports and Balance of payments: MNCs can increase exports and create positive balance of payment effects. MNCs have access to superior global distribution and marketing system.

4) Diversification: MNCs have research and development departments engaged in the task of developing new products and superior designs of existing products. They have technology and skills required for the diversification of the industrial base of the host country.

Case Against MNCs

The arguments against the operations of MNCs are summarised below.

1) Payment of dividend and royalty: A large sum of money flows out of the country in terms of payments of dividends, profits, royalties, technical fees and interest to the foreign investors.

2) Distortion of economic structure: MNCs can inflict heavy damage on the host country in various forms such as suppression of domestic entrepreneurship, extension of oligopolistic practices, worsening of income distribution by distorting production structure etc.

3) Technology transfer not conducive: MNCs often do not engage in research and development activities within the under developed countries. Further, technology transferred is of capital intensive in nature which is not useful from the point of view of a labour surplus economy.

4) Political interference: Because of their immense financial and technical power, the MNCs have gained the necessary strength to influence the decision making process in underdeveloped countries. The autonomy and sovereignty of the host countries is in danger.

Cartel

A cartel is an explicit agreement among independent firm on subjects like prices, output, market sharing etc. The desire of the firms to have large joint profits gives urge to form cartels. Cartel may be the arrangements between the producers or sellers for the purpose of regulating competition in the production and selling of the commodity. Example: OPEC.

There are mainly two types of cartels

1) Centralized cartels

2) Market sharing cartel

A centralized or perfect cartel is an arrangement where the firms in an industry reach an agreement which maximize joint profits. So cartel can act as a monopolist. Since the firms in the cartel are assumed to produce homogeneous product, the market demand for the product is the cartel’s demand. It is also assumed that the cartel management knows the demand at each possible price and also the marginal costs of all its firms.

In the market sharing cartel, the firms in the industry produce homogeneous product and agree upon the share each firm is going to have. Each firm sells at the same price but sells within a given region. Such a system can function only if firms have identical costs.

Mergers and Acquisitions

Mergers and Acquisitions (M&A) is a general term that refers to the consolidation of companies or assets. While there are several types of transactions classified under the notion of M&A, a merger means a combination of two companies to form a new company, while an acquisition is the purchase of one company by another in which no new company is formed. In a merger, the boards of directors for two companies approve the combination and seek shareholders' approval. After the merger, the acquired company ceases to exist and becomes part of the acquiring company. In an acquisition, the acquiring company obtains the majority stake in the acquired firms, which does not change its name or legal structure.

Reasons for Merger

Companies would choose to merge together for different reasons:

The combined entity would be larger, and have corresponding larger resources for marketing, product expansion, and obtaining financing. This could help them better compete in the marketplace.
The combined entity could merge similar operations to reduce costs. Corporate and administrative functions, such as human resources and marketing, are often targets for combinations. They might also combine the production areas if the companies produce similar products and reduce costs by having fewer plants or facilities in operation.
The combined entity might have less competition in the marketplace. If the products of the two companies competed for customers, they could combine their offerings and use resources for improving the product, rather than marketing against each other.
The combined entity might have synergy in operations. Synergy is when combined operations show lower costs or higher profits than would be expected by just adding their financial information together on paper. This could be due to economies of scale, where costs are lower due to higher volume of production, or due to vertical integration, where greater control over the production process is achieved due to owning more steps in the production process.

Reasons for Acquisition

Acquisitions are undertaken for strategic reasons. For example:

A company might acquire another company to obtain a specific product. It can be less expensive to purchase a company offering a product you'd like to sell than building the product yourself. Software companies often purchase smaller companies that offer extensions to their product line if they become popular with customers, so they can add the functionality to their primary offering.
A company might acquire other companies to increase its size. A larger company may have more visibility in the marketplace, and also better access to credit and other resources.
A company might acquire another to obtain control over a critical resource. For example, a jewelry company might acquire a gold mine, to ensure they have access to gold without market price fluctuations.

Market Structures

A market is a network of communications between individuals and firms for the purpose of buying and selling of goods and services. The idea of a particular locality or geographical place is not necessary to the concept of market. What is required for the market to exist is the contact between sellers and buyers so that transaction at an agreed price can take place between them. Different markets have different characteristics, but economists have managed to group these characteristics into four broad categories of market structures. These are

Perfect Competition
Monopoly
Monopolistic Competition
Oligopoly

Now let us examine each of the market structure in detail

Perfect Competition

Perfect competition is the market structure that fulfils the following conditions or assumptions

Large number of buyers and sellers

The market includes large number of buyers and sellers so that no individual buyer or seller can influence the existing market price of the commodity. Each buyer buys an insignificant quantity and each seller sells an insignificant part of the total quantity bought and sold. Thus the seller or firm is price taker.

Homogeneous Product

The industry is defined as a group of firms producing a homogeneous product. The technical characteristics of the product as well as services associated with its sale and delivery are identical. There is no way in which a buyer could differentiate amoung the products of different firms

Free entry and exit of firms

There is no barrier to entry and exit from the industry. Firms have freedom of movement in and out of the industry

Profit Maximisation

The goal of all firms is profit maximisation. No other goals are pursued.

No Government regulation

There is no government intervention in the market. Tariffs, subsidies etc are ruled out.

The market structure in which the above assumptions are fulfilled is called pure competition. It is different from perfect competition, which requires the fulfillment of the following two additional assumptions.

Perfect mobility of factors of production

The factors of production are free to move from one firm to another. Workers can move between different jobs. Raw materials and other factors are not monopolized and labour is not unionized.

Perfect knowledge

Buyers and sellers have complete knowledge of the conditions in the market. They have perfect knowledge about the prices at which goods are bought and sold. Therefore, advertisement becomes unnecessary and so there is no selling cost

Monopoly

Literally monopoly means one seller. ‘Mono’ means one and ‘poly’ means seller. Monopoly is said to exist when one firm is the sole producer or seller of a product which has no close substitutes. Thus monopoly is negation of competition. The following are important features of monopoly.

There is a single producer or seller of the product. Entire supply of the product comes from this single seller. There is no distinction between a firm and an industry in a monopoly. The firm and industry are identical in monopoly.
There is no close substitute for the product. If there are some other firms which are producing close substitutes for the product in question there will be competition between them. In the presence of competition a firm cannot be said to have monopoly. Monopoly implies absence of all competition.
There is no freedom of entry. The monopolist erects strong barriers to prevent the entry of new firms. The barriers which prevent the firms to enter the industry may be economic or institutional or artificial in nature. In the case of monopoly, the barriers are so strong that prevent entry of all firms except the one which is already in the field.
The monopolist is a price maker. But in order to sell more a monopolist had to reduce the price. He cannot sell more units at the existing price.
The monopolist aims at maximisation of his profit

Monopolistic Competition

Perfect competition and monopoly are rarely found in the real world and thus they do not represent the actual market situation. Economists often use the term imperfect competition to refer to a market structure that is neither purely competitive nor purely monopolistic. Two forms of imperfect competition are monopolistic competition and oligopoly.

As the name implies, monopolistic competition contains the element of both pure competition and monopoly. Monopolistic competition may be defined as a market structure where there are many sellers who sell differentiated products. Each producer under monopolistic competition enjoys some degree of monopoly and at the same time faces competition. The following are important features of monopolistic competition.

Large number of sellers

The market consists of relatively large number of sellers or firms each satisfying a small share of the market demand for the commodity. Unlike perfect competition, these large numbers of firms do not produce homogeneous products. Instead they produce and sell differentiated products which are close substitutes of each other. Thus there is stiff competition between them.

Product Differentiation

Product differentiation is a key feature of monopolistic competition. Product differentiation is a situation in which firms use number of devices to distinguish their products from those of other firms in the same industry. Products produced by the firms are close substitutes of each other. Products are not identical but are slightly different from each other.

Non price competition: Selling cost

Firms incur considerable expenditure on advertisement and other selling costs to promote the sales of their products. Promoting sales of their products through advertisement is an important example of non-price competition. The expenditure incurred on advertisement is prominent amoung the various types of selling costs

Freedom of entry and exit

In a monopolistically competitive industry, it is easy for new firms to enter and the existing firms to leave it. Firms will enter in to the industry attracted by super normal profit of existing firms and existing firms will leave industry if they are making losses. However entry may not be as easy as in perfect competition because of the need to differentiate one’s product in a monopolistically competitive market.

There is absence of perfect knowledge. That is buyers and sellers do not have perfect knowledge about market conditions
There is no uniform price. Different producers charge different prices for their products because products are differentiated in some way.

Oligopoly

Oligopoly is said to prevail when there are few firms or sellers in the market producing or selling a product. Oligopoly is often referred to as “competition amoung the few”. The simplest case of oligopoly is duopoly which prevails when there are only two producers or sellers of the product. The following are important features of oligopoly

Few firms

The market consists of only a few firms. When there are two or more than two, but not many, oligopoly is said to exist. Each produces a relatively large share of the industry

Interdependence

There is interdependence in decision making of the few firms which comprise the industry. This is because when number of competitors is few, any change in price, output etc by a firm will have a direct effect on the fortune of its rival.

Selling cost

A direct effect of interdependence of monopolist is that the various firms have to employ various aggressive and defensive marketing weapons to gain a greater share in the market or to prevent a fall in the share. For this firms have to incur a good deal of costs on advertisement and other measures of sales promotion.

Group behavior

The theory of oligopoly is a theory of group behaviour. There are few firms in the group which are very much interdependent. Each firm considers not only the market demand but also the reaction of the other firms when any decisions or actions are taken

Indeterminateness of demand curve

Another important feature of oligopoly is the indeterminateness of demand curve. This is because of interdependence of firms in the market. Under oligopoly, a firm cannot assume that its rival will keep their prices unchanged when it make changes in its own price. As a result of this, the demand curve facing an oligopolistic firm loses its definiteness and determinateness.

Collusive Oligopoly

In order to avoid uncertainty arising out of interdependence and avoid price wars and cut throat competition, firms working under oligopolistic market often enter into agreement regarding uniform price and output policy pursued by them. When the firms enter into such collusive agreements formally or secretly, collusive oligopoly prevails. Collusions are two main types, namely cartel and price leadership. In a cartel firms jointly fix a price and output policy through agreements. Cartel aims at joint profit maximization. Cartel will ensure that there is no competition among its members. Under price leadership, one firm sets the price and others follow it. Price leadership is of two types, namely (1) price leadership by a low cost firm and (2) price leadership by a dominant firm. In price leadership, low cost or dominant firm will set the price and other firms will follow them.

Module 3

Macro Economic Concepts

National Income Accounting

The level of economic activity taking place in an economy is of vital importance because it determines the amount of goods and services that will be produced in the economy. That, in turn, gives an indication of the economic wellbeing of the population. National income accounting provides us with useful information about how well the economy is performing. We can define national income accounting as the whole process of measuring and recording various economic aggregates which gives us some indication of the economic health of the country overtime.

Concepts of National Income

Important concepts related to national income are explained below:

(a) Gross Domestic Product (GDP)

GDP is the market value of all final goods and services produced within the economy during a period of time, usually one year. Only final goods and services are included and all intermediate goods used in the production of these goods and services are excluded to avoid double counting or multiple counting. Transactions of commodities not produced in the current year are excluded. Again, illegal transactions are excluded from GDP.

(b) Gross National Product (GNP)

GNP is the market value of all final goods and services produces by domestically owned factors of production at home or abroad during a period of time, usually a year. Thus, GNP of India is the market value of goods and services produced by Indian factors, regardless where those factors are located. For instance, salary of American citizen working in Mumbai is a part of India’s GDP but not GNP. Similarly, the earnings of Indian national working in New York contribute to America’s GDP and India’s GNP. Thus,

GNP = GDP + income earned by domestically owned factors abroad – income earned at home by foreign factors.

In other words, GNP = GDP + net factor earnings from abroad

Thus, the difference between GDP and GNP arises due to the existence of net factor income from abroad.

A part of country’s capital stock like plant and equipments, factories etc, wears out in the process of production. The consumption of fixed capital or the fall in the value of fixed capital due to wear and tear is called depreciation. By subtracting the cost of depreciation from GDP or GNP, the values of NDP and NNP are obtained. Thus,

NDP = GDP – Depreciation

NNP = GNP – Depreciation

Clearly, NDP and NNP mean the market value of final goods and services after providing for depreciation. Therefore, it is also called ‘national income at market prices’.

(d) National Income (or National Income at factor cost)

National income is usually evaluated at the market prices which diverge from the true cost of production, based on the payments to factors of production, due to the presence of indirect taxes and subsidies. Indirect taxes push the market price above the unit cost of production and subsidies do the opposite. So to value aggregate output at factor cost, indirect taxes are deducted and subsidies are added on. Thus

National Income at factor cost = NNP –indirect tax + subsidies

(e) Percapita Income

It is the average income per head. It is calculated by dividing the national income by population of the country. Thus

(f) Personal Income and Disposable income

Personal income is the income received by persons from all sources during a year. It is the income actually received by all persons or households during a given year. Disposable income is the personal income minus taxes to the government. Thus, after a part of personal income is paid to the government in the form of personal taxes like income tax, property tax etc, what remains of personal income is called disposable income. It is the income available to the households for spending and saving.

Methods of Measuring GDP

There three important methods of measuring the national income which are discussed below

(1) Product Method or Value Added Method

Under this method, the value added by all the production units including those producing intermediate goods and services are summed up to arrive at the value of final production. Thus, this method creates national income as the total of production. The money value of all final goods and services produced in a year are summed up. If reliable statistics are available, national income can be calculated more or less accurately by using this method.

(2) Income Method

Here, national income is taken to be the total income earned by all factors of production in the economy. Thus national income is computed as the total of rent, wages, interests and profits earned by the people. Income method approaches national income from the distribution side. The importance of this method is that it gives us an idea about the distribution of national income among owners of factors of production

(3) Expenditure Method

National income can be computed by adding up the total expenditures on goods and services during a year. Individuals spend on consumption of goods and services. They also spend for investment purposes. Similarly government also spends for consumption and investment. Consumption expenditures and investment expenditures of both individuals and government are taken together to calculate national income.

Difficulties of Measurement of GDP

(1) The presence of non-monetized transactions, where no money payment is made, creates the most formidable difficulty in the computation of national income. A considerable part of the product does not come to the market.

(2) Non-availability and unreliability of statistical information create another difficulty. Most producers do not keep correct records of their performance. In under developed countries majority of the people are illiterate and ignorant. They have no proper idea about the money value of their products

(3) Occupational specialization is still incomplete and there is no correct differentiation of economic functions in under developed countries.

(4) In the under developed countries agricultural and industrial sectors are highly unorganized. The producing units are scattered. This factor creates difficulty in collecting information.

(5) The same commodity has a wholesale price and a retail price. The same commodity has different prices in different markets. So it is difficult to decide which of these prices should be taken in to account

Fiscal Policy

The word ‘fisc’ means state treasury and fiscal policy refers to policy concerning the use of state treasury or government finances to achieve certain macroeconomic goals. Arthur Smithies defined fiscal policy as “a policy under which government uses its expenditure and revenue programs to produce desirable effects and avoid undesirable effects on the national income, production and employment”. In more general terms fiscal policy is the government programme of making discretionary changes in the pattern and level of its expenditure, taxation and borrowings in order to achieve certain economic goals such as economic growth, employment, income equality and stabilization of the economy

Instruments of Fiscal Policy

The major fiscal instruments include the following measures

i. Government Expenditure

ii. Taxation

iii. Public Borrowing

iv. Budgetary Policy

The measures are briefly discussed below

i. Government Expenditure

Government expenditure refers to the total expenditure made by the government in the fiscal year. It includes total public spending on purchase of goods and services, payment of wages and salaries to public servants, public investment, infrastructure development and transfer payments (e. g pensions, subsidies). The size and composition of government expenditure is a matter of government discretion. The government expenditure is an injection into the economy; it adds to the aggregate demand. The overall effect of government expenditure on the economy depends on how it is financed and what is its multiplier effect.

ii. Taxation

Tax is the payment by the people to the government against which there is no direct return to the tax payers. Taxes are classified as direct taxes and indirect taxes. Direct taxes include personal income tax, taxes on wealth and property. Indirect taxes include taxes on production and sale of goods and services like value added tax and customs duty.

iii. Public Borrowing

Public borrowings include both internal and external borrowings. Internal borrowings are of two types: (a) borrowings from the public and (b) borrowings from the central bank. While the borrowings from the public results in a transfer of purchasing power from the public to the government, whereas borrowings from the central bank is straight away an injection in to the economy. External borrowings include borrowings from foreign governments, international organizations like IMF and World Bank and market borrowings.

iv. Budgetary Policy

In narrow sense of the term, budgetary policy refers to government’s plans to keep its budget in balance, in surplus or in deficit. When the government keeps its total expenditure equal to its revenue, it means it has adopted a balanced budget policy. When the government decides to spend more than its expected revenue, it is pursuing a deficit budget policy. On the hand, if the government when the government adopts a policy of keeping its expenditure substantially below its current revenue, it is following a surplus budget policy. Balanced, deficit and surplus budgets affect the economy in different ways, to different extents and in different directions.

Effects of Fiscal Policy

a) Fiscal policy and economic growth

Fiscal policy is an important weapon for the achievement of accelerated economic growth in a backward underdeveloped economy. Without appropriate fiscal policy the process of economic growth in the country is bound to suffer. In achieving a fast economic growth, the government has to deploy all the instruments of fiscal policy at its disposal, namely taxation, public expenditure, public borrowing and deficit financing.

Taxation is an indispensable tool for raising finances for economic development. For this purpose the government may resort to both direct and indirect taxation. The incidence of direct taxes mostly falls on the richer sections and hence they are justified. As taxation alone may not yield adequate revenue, the government can resort to public borrowing, short term as well as long term to add to its fund of investible resources. The government of an under developed country should devote quite substantial portion of its expenditure to the building up of the necessary infrastructure facilities and the development of industrial and agricultural sectors of the economy. Lastly, deficit financing has proved to be a dependable tool of financing the economic growth of an underdeveloped economy.

b) Fiscal policy and Distribution

Fiscal policy is an important instrument to reduce income inequalities which are a marked feature of capitalist economy. The two main instruments of fiscal policy, namely, taxation and public expenditure can be deployed to lessen or reduce income inequalities and to bring about a more equal distribution of income and wealth in the society. Direct taxes such as progressive income tax are most effective in the redistribution of income in the society. Indirect taxes like excise duties on luxury commodities can also be helpful in bringing about this redistribution. Public expenditure can be effectively used to help redistribution of income and wealth in the society. The government can device its scheme of public expenditure in such a manner as o help the poor and other socially handicapped sections in the society.

c) Fiscal policy and stabilisation

Economic stability is one of the important objectives of all countries of the world. It recognized as an important instrument to tackle inflationary and deflationary situations in the economy. During inflation, government should reduce its expenditure and rates of existing taxes should be increased. Government should use the fiscal instrument of public borrowing to take away excess purchasing power in the economy. On the other hand, fiscal policy in a depression should aim at increasing both consumption and investment expenditure with a view to stepping up of effective demand. To fight depression government needs to increase its expenditure and cut down its taxation. Further, deficit budgeting is an inevitable ingredient of anti depression fiscal policy.

Monetary Policy

In general, monetary policy refers to the actions taken by the monetary authorities to control and regulate the demand for and supply of money with a given purpose. Harry Johnson defines monetary policy as “a policy employing central bank’s control of the supply of money as an instrument of achieving the objective of general economic policy”. Thus, monetary policy is essentially a programme of action undertaken by the monetary authorities, generally the central bank, to control and regulate the supply of money with the public and flow of credit with a view to achieving predetermined macroeconomic goals.

Instruments of Monetary Policy

The instruments of the monetary policy refer to the economic variables that the central bank is empowered to change at its discretion with a view of controlling and regulating the supply of and demand for money and the availability of credit. The monetary instruments are generally classified under two categories;

General or quantitative credit control
Selective or qualitative credit control

General Credit control Measures

The general measures of monetary control include the following

Bank Rate policy
Variation in cash reserve ratio
Open market Operations
Repo and Reverse Repo Rate

i. Bank Rate Policy

Bank rate is the rate at which the central bank lends money to the commercial bank and rediscounts the bills of exchange presented by the commercial bank. When the commercial banks are faced with the shortage of cash reserves, they approach the central bank to borrow money for short term or get their bills of exchange rediscounted. The central bank rediscounts the bills presented by the commercial bank at a discount rate. This rate is traditionally called bank rate. Thus bank rate is the rate at which central bank charges on the loans and advances made to the commercial banks. The central bank can change this rate- increase or decrease- depending on whether it wants to expand or reduce the flow of credit from the commercial bank.

ii Variable Reserve Ratio

The cash reserve ratio (CRR) is the percentage of total deposits which commercial banks are required to maintain in the form of cash reserve with the central bank. The objective of the cash reserve is to prevent shortage of cash for meeting the cash demand by the depositors. In order to avoid financial crisis in the banking sector, the central bank impose a CRR on the banks. The central bank enjoys legal powers to change the cash reserve ratio of the banks. Maintaining a certain cash reserve under this provision takes the form of a legal requirement. Therefore, cash reserve ratio is also called statutory reserve ratio (SRR).

iii Open market Operations

The open market operations are the sale and purchase of government securities and treasury bills by the central bank of the country. When central bank decides to pump money into circulation, it buys back the government securities, bills and bonds, and when it decides to reduce money in circulation, it sells the government bonds and securities. The open market operations are the most powerful and widely used tool of monetary control. The central bank carries out its open market operations through the commercial banks- it does not deal directly with the public.

iv. Repo rate and Reverse Repo Rate

Repo rate is the rate at which RBI lends to its clients generally against government securities. That is, it is the rate at which the RBI lends money to the banks for a short term. When the repo rate increases, borrowing from RBI becomes more expensive. If RBI wants to make it more expensive for the banks to borrow money, it increases the repo rate similarly, if it wants to make it cheaper for banks to borrow money it reduces the repo rate. Thus, Repo rate is used by monetary authorities to control inflation. In the event of inflation, central banks increase repo rate as this acts as a disincentive for banks to borrow from the central bank. This ultimately reduces the money supply in the economy and thus helps in arresting inflation

Reverse Repo rate is the short term borrowing rate at which RBI borrows money from banks. The Reserve bank uses this tool when it feels there is too much money floating in the banking system. An increase in the reverse repo rate means that the banks will get a higher rate of interest from RBI. As a result, banks prefer to lend their money to RBI which is always safe instead of lending it others (people, companies etc) which is always risky. Repo Rate signifies the rate at which liquidity is injected in the banking system by RBI, whereas Reverse Repo rate signifies the rate at which the central bank absorbs liquidity.

B. Selective Credit control measures

Credit rationing

When there is shortage of institutional credit available for the business sector, priority sectors and essential industries will starve for funds. In order to curb this tendency, the central bank resorts to credit rationing measures. This is done with the view to making credit available to the essential and priority sectors.

Change in lending margins

The commercial bans advance money against the mortgage of assets or properties like building, jewellery, land and so on. The banks provide loans only up to a certain percentage of the value of the mortgaged property. The gap between the value of mortgaged property and the amount advanced is called lending margin. The central bank is empowered to increase the lending margin with a view to decreasing the bank credit.

Moral Suasion

Moral suasion is a method of persuading and convincing the commercial banks to advance credit in accordance with the directives of the central bank in overall economic interest of the country. This method is adopted in addition to quantitative and other qualitative methods, particularly when effectiveness of other methods is doubtful

Direct controls

When all other methods prove ineffective, the monetary authorities resort to direct control measures with clear directive to carry out their lending activities in a specified manner. However, there are rare instances of use of direct control measures.

Inflation

Inflation is a global phenomenon. Though the inflation has widely attracted the economist all over the world, yet there is no generally accepted definition of the term inflation.

Prof. Crowther has defined inflation “as the state in which the value of money is falling, that is, prices are rising”. Hawtrey defines inflation as “the issue of too much currency” Prof. Coulbourn defines “inflation is too much money chasing too few goods”. Thus, economist defines inflation in terms of continuous rise in prices.

Types of Inflation

a) Creeping Inflation

This is the mildest type of inflation. When price rise is very slow it is called creeping inflation. In terms of speed, a sustained rise in prices of annual increase of less than 3% is creeping inflation. This type of inflation serves as tonic for a backward and under developed economy and is regarded as safe and essential for economic growth.

b) Walking Inflation

The rate of increase of the price level acquires greater speed and rapidity under walking inflation. Roughly, the price level under walking inflation rises approximately by 5% annually. Inflation at this rate is a warning signal for the government to control it before it turns into running inflation.

c) Running Inflation

The rate of increase in the prices gets further accelerated under running inflation. The price level rises approximately 10% annually. In case government fails to curb the running inflation in time it may easily develop into galloping inflation

d) Galloping or Hyper Inflation

This is the most dangerous type of inflation. When the prices rise very fast at double or triple digit rates, it is usually called galloping inflation. There is no upward limit to price level may rise in course of time. Keynes has referred to this type of inflation as true inflation.

Effects of Inflation

A period of prolonged, continuous and persistent inflation results in the economic, political, social and moral disruption of society. The effects of inflation are analysed below.

1) Effects on Production

The phenomenon of inflation produces a very deep impact on the production in the economy. Inflation may not always be detrimental to the productive activities. Mild inflation may actually good for the economy particularly when there are unemployed productive resources. But the expansion of money supply after the point of full employment will lead to hyper inflation, which is very harmful for the economy.

Since hyper inflation results in a serious depreciation of the value of money, it discourages savings and the process of capital accumulation and investment suffers a serious setback. Inflation may discourage entrepreneurs and businessmen from taking business risk in production and growing uncertainty may also reduce the foreign capital in the country. Inflation may also leads to hoarding of essential goods both by the traders as well as the consumers. Yet, the worst part of inflation is that it gives stimulus to speculative activities on account of the uncertainty generated by the continually rising price level.

2) Effects on Distribution

Inflation produces a deep impact on the distribution of income and wealth in the society. A prolonged period of persistent inflation results in redistribution of income and wealth in favour of the already richer and more affluent classes of society. Merchants, traders, businessmen and speculators reap rich harvests on account of the windfall profits accruing to them as a result of inflationary rise in prices. At the same time, the fixed income groups such as salaries employees, workers, pensioners etc, are always the losers on account of inflationary rise in prices as their incomes and salaries generally do not rise in the same proportion in which the cost of living increases. Farmers are generally gainers during inflation. The prices of farm products go up while the costs incurred by them do not go up by the same extent.

Thus, inflation is always unjust. It throws economic burden on the shoulders of those sections of the community who are least able to bear it.

3) Non economic consequences

Inflation has far reaching social and political consequences for the society. Inflation is socially inequitable because it redistributes income and wealth in favour of those classes and sections that are already affluent and well off. This creates a sense of grievance in those sections which are adversely affected by inflation. This naturally leads to social conflict in the society which can have very serious political consequences for the country. Besides creating political instability, inflation also deals a serious blow to business morality and ethics.

Moreover, the general morality of the people in the country also suffers a serious decline with the resulting all round corruption in the country. This leads to general discontentment in the public which may results in the loss of faith in the integrity and honesty of the government.

Budget

A budget is the statement of financial plan of the government. It is an important instrument of financial administration, through which all the financial affairs of the state are regulated. It indicates the revenue and expenditure of the last completed financial year, the probable revenue and expenditure estimates for the current year and the estimates of the anticipated revenue and proposed expenditure for the next financial year. Thus, the budget is an annual statement of expenditure and revenue of the government prepared by the financial authority covering the current year, the preceding as well as the year following.

The term budget is derived from a French word ‘bougette’ which means a leather bag or purse or pouch. Rene Stourn defines budget as “a document containing a preliminary approved plan of public revenue and expenditure”. For Bastables “a budget is at once a report on estimates and proposals, that it is the instrument by which all the processes of financial administration are correlated and coordinated”

Revenue Budget and Capital Budget

The government budget is divided into Revenue Budget and Capital Budget. Revenue Budget or Revenue Account is related to current financial transactions of the government which are of recurring in nature. It consist of revenue receipts of the government namely tax revenues, non tax revenues and other revenues and the expenditure met from these receipts. Revenue Budget consists of the revenue receipts of the government and the expenditure is met from this revenues. Revenue Account deals with Taxes, duties, fees, fines and penalties, revenue from currency coinage and mint, Government estates, receipts from Government commercial concerns and other miscellaneous items, and the expenditure there from. Revenue Receipts include receipts from taxation, profits of enterprise, other nontax receipts like administrative revenue (fees, fines, special assessment etc.), gifts grants etc. Revenue expenditure includes interest-payments, defence expenditure, major subsidies, pensions etc.

Capital budget consist of capital receipts and payments. The main form of capital receipts are loans raised by government from the public such as market borrowing, borrowing from the central banking authority, loans received from foreign governments and loan recoveries by central government to state governments. Capital Expenditure includes a) Developmental Outlay b) Non-developmental outlay c) Loans and advances and d) Discharge of debts. Capital expenditure is met out of capital receipts on acquisition of land, buildings and machinery, equipments as also investments in shares etc.

Budget Deficit Concepts

There are different types of deficits depending on the types of receipts and expenditure. The important types of deficits are (i) Budgetary deficit (ii) Revenue deficit (iii) Fiscal deficit and (iv) Primary deficit.

The budgetary deficit shows the gap between total receipts and total expenditures of the government. The budgetary gap is financed by issuing 91-days treasury bills and running down on the government’s cash balances with treasuries and Reserve Bank of India. Budgetary deficit =Total Revenue-Total Expenditure. This concept has been discontinued from 1996-97 onwards.

Revenue deficit is the excess of revenue expenditure over revenue receipts. Revenue Deficit= Revenue Receipts-Revenue Expenditure.

The effective revenue deficit is the difference between revenue deficit and grants for the creation of capital asset. This was first introduced in India in the Union Budget 2009-10.Effective Revenue Deficit=Revenue Deficit-Grants for creation of capital asset.

Fiscal Deficit is the excess of total budget expenditures over the total budget revenue excluding borrowings. In other words, fiscal deficit is budgetary deficit plus borrowings and other liabilities. The gross fiscal deficit is the excess of total expenditure over revenue receipts and non-debt capital receipts.

Fiscal Deficit= Total expenditure - (revenue receipts + non-debt capital receipts).

Net Fiscal Deficit= Gross Fiscal Deficit-Net loans and advances.

Primary Deficit is the excess of fiscal deficit over interest payments. Primary Deficit = Fiscal deficit-Interest payments. Primary Deficit explains how much government borrowing is going to meet expenses other than interest payments. It reveals the extent of burdens in future resulting from current government policy. It is a basic measure of fiscal irresponsibility. A low or zero primary deficits is a pointer to financial discipline of a government.

Balance of Trade and Balance of Payment

International trade is mainly concerned with inflow and outflow of commodities. Balance of trade refers to the difference between the value of commodities exported and the value of commodities imported. A country has a favourable balance of trade if the value of exports exceeds value of imports. If the value of imports exceeds the value of exports, the balance of trade is unfavourable. If the export value is equal to the import value, balance of trade is in equilibrium. Commodity imports and exports entering the balance of trade account are visible items. Hence, the balance of trade is only the balance of visible items.

Balance of payment is a more comprehensive concept. The balance of payment (BoP) is a statistical record of all the economic transactions of the residents of a country with the residents of rest of the world during a particular period of time, usually a year. An international economic transaction refers to the exchange of a good, service or asset, for which payment is required between the residents of one country with the residents of other countries. However, gifts and certain other transfers for which no payment is required are also included in a country’s BoP.

Current and Capital Account

Traditionally, the BoP statistics are two main sections, namely the current account and the capital account. The current account records exports and imports of goods and services and unilateral transfers. The current account balance is the sum of visible balance and invisible balance. Trade balance is referred to as the visible balance because it represents the difference between receipts for exports of goods and expenditure on import of goods which can be visibly seen crossing national frontiers. The invisible balance shows the difference between the revenue received for the export and payment made for imports of services such as shipping, tourism, insurance and banking. In addition, receipts and payments of interests, dividends and profits are recorded as the invisible items.

The capital account records all international transactions that involve a resident of the country concerned changing either his asset or his liabilities to residents of another country. Thus, it is concerned with the movement of financial capital into and out of the country. Capital comes into the country by borrowing, sales of overseas asset and investment in the country by foreigners. These items are referred to as “capital inflows” and are recorded as credit items in the BoP. On the other hand, capital leaves the country due to lending, buying of overseas assets, and purchase of domestic assets owned by foreign residents as these involves payment to foreigners. These items represent “capital outflows” and are recorded as debits in the capital accounts. The summation of the capital inflows and outflows as recorded in the capital account gives the capital account balance.

Foreign Direct Investment (FDI) and Foreign Portfolio Investment (FPI)

Foreign direct investment is the investment in the foreign country that gives the investor a control over investment. But the control need not be 100%. It is a “Business investments”. FDI faces market risk. It is ‘Real’ investment. Examples: purchase of a company abroad, starting a subsidiary or taking over the control of existing firm on other country

On the other hand, foreign portfolio investment is the investment in the foreign country in which the owner of the capital does not have any control over investment. It is a type of lending of capital to get return but there is no control over the use of capital FPI is also known as “rentier investment”, “Financial investment” and “Indirect investment”. Examples: investment in securities, deposits in commercial banks, purchase of equities, bonds, securities and so on

Dr. Shabeer K P

Wednesday, 27 June 2018

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