padhle/ClassXIIEconomicsStudies-RajeevBansal.md

LATEST EDITION

ECONOMICS

CLASS12

ECONOMI

ECONOMICS

CLASS XII

PART A—INTRODUCTORY MICRO ECONOMICS PART B— INTRODUCTORY MACRO ECONOMICS

Strictly according to the latest syllabus prescribed by State Boards of Bihar, Jharkhand, U.P., Uttarakhand, Haryana, H.P., M.P., Chhattisgarh etc. & Navodaya, Kendriya Vidyalayas

following CBSE curriculum based on NCERT guidelines. Including solved questions of NCERT book, based on new examination pattern and mark distribution Dr. Anupam Agrawal

M. A., Ph. D. (Economics) & Mrs. Sharad Agrawal

M. A.(Economics & English)

Revised Edition S B P D PUBLICATIONS

1st Edition : 2008-09 13th Revised Edition : 2020-21

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Preface

We have great pleasure in presenting to our esteemed readers, the revised edition of our book 'Economics' . The present book has been prepared strictly in accordance to the new syllabus prescribed by the Bihar, Jharkhand U.P., Uttarakhand, Haryana, H.P., M.P. and other states boards & Navodaya, Kendriya Vidyalayas for Class XII.

Special Features of the Present Book : q The book has been divided into two parts. The first part deals with 'Introductory Micro Economics' and second part deals with 'Introductory Macro Economics' . The book in your hand deals with both parts based on the new syllabus and pattern. q Unitwise 'NCERT Corner' based on whole curriculum has been given into this revised edition of the book which will be more helpful for students at the time of examination. q High Order Thinking Skills (HOTS) Questions and Value Based Questions (VBQ) based on the latest CBSE pattern has given into each chapter. q Identifying problems of the subject at students level and discussing them adequately and thoroughly in a lucid manner. q Dividing and subdividing every lesson into useful learning points and discussing them adequately through diagrams and flow charts in a simple language. So that students can grasp the subject matter and evaluate themselves. q Summarising every lesson as 'A Quick Review of the Chapter' so that students could revise whole lesson at a glance. q Mentioning Study Material Included in Chapter in the beginning of every lesson, so that students must prepare and concentrate upon the specific language and contents of the syllabus. q Mentioning Questions in such a style that if students go through our questions,

possible questions of the examination are likely to emerge in their mind. q Classifying questions as, long, short, very short, objective type questions so that students could recaptulate the subject in a better and easy way. q We sincerely express our thanks to Dr. Pankaj Kumar, Patna, who not only removed the rough edges of this book but also helped in revising and presenting this book in a simplified manner. Our special thanks are due to our publisher M/s S B P D Publications presenting this book before you in a record time. We firmly believe that the road to improvement is never ending. Suggestions for the improvement of the book will be thankfully received and acknowledged.

—Authors

Syllabus

Bihar, Jharkhand, Uttarakhand, Haryana, H.P., U.P., M.P. & Other State Boards ECONOMICS XII Paper 1 3 Hours Units PART A : INTRODUCTORY MICRO ECONOMICS

I. Introduction II. Consumer Behaviour and Demand III. Producer Behaviour and Supply IV. Forms of Market and Price Determination

V. Simple Applications of Tools of Demand and Supply Curves 100 Marks Periods Marks 10 25 37 20

— 50 PART B : INTRODUCTORY MACRO ECONOMICS I. National Income and Related Aggregates—Basic Concepts and Measurements II. Determination of Income and Employment III. Money and Banking IV. Government Budget and the Economy V. Balance of Payments 30 25 18 17 14 104 PART A : INTRODUCTORY MICRO ECONOMICS Unit I : Introduction

What is Micro Economics ? Central Problems of an Economy, Production Possibility Curve and Opportunity Cost.

Unit II : Consumer Behaviour and Demand

Consumer’s Equilibrium—Meaning and Attainment of Equilibrium through Utility Approach : One and Two Commodity Cases. Demand : Market Demand, Determinants of Demand, Demand Schedule, Demand Curve, Movement along and Shifts in Demand Curve, Price Elasticity of Demand, Measurement of Price Elasticity of Demand— Percentage, Total Expenditure and Geometric Methods.

Unit III : Producer Behaviour and Supply 37 Periods Production Function— Returns of a Factor and Returns to Scale. Supply—Market Supply, Determinants of Supply, Supply Schedule, Supply Curve Movement along and Shifts in Supply Curve, Price Elasticity of Supply, Measurement of Price Elasticity of Supply—Percentage and Geometric Method. Cost and Revenue—Concepts of Costs, Short Run Costs Curves (Fixed and Variable Costs, Total, Average and Marginal Costs), Concepts of Revenue—

Total, Average and Marginal Revenue and their Relationship. Producer’s Equilibrium—with the help of MC and MR.

Unit IV : Forms of Market and Price Determination 20 Periods Forms of Market—Perfect Competition, Monopoly, Monopolistic Competition—their Meaning and Features.

Price Determination Under Perfect Competition—Equilibrium Price, Effects of Shifts in Demand and Supply.

Unit V : Simple Applications of Tools of Demand and Supply Curves 12 Periods The teacher can be given the flexibility to choose the issues— Rationing, Floors and Ceilings and Food Availability Decline (FAD). Theory (the teachers may also choose alternative examples that are simple and easy to understand).

PART B : INTRODUCTORY MACRO ECONOMICS

Unit I : National Income and Related Aggregates—Basic Concepts and Measurements 30 Periods Macro Economics : Meaning. Circular Flow of Income, Concepts of GDP, GNP, NDP, NNP (at Market Price and Factor Cost), National Disposable Income (Gross and Net); Private Income, Personal Income and Personal Disposable Income, Measurement of National Income—Value Added Method, Income Method and Expenditure Method.

Unit II : Determination of Income and Employment 25 Periods Aggregate Demand, Aggregate Supply and their Components. Propensity to Consume and Propensity to Save (Average and Marginal).

Meaning of Involuntary Unemployment and Full Employment. Determination of Income and Employment—Two Sector Model. Concept of Investment Multiplier and its Working. Problems of Excess and Deficient Demand. Measures to Correct Excess and Deficient Demand—Availability of Credit, Change in Government Spending.

Unit III : Money and Banking 18 Periods Money—Meaning, Evolution and Functions. Central Bank—Meaning and Functions. Commercial Banks—Meaning and Functions. Recent Significant Reforms and Issues in Indian Banking System— Privatisation and Modernisation.

Unit IV : Government Budget and the Economy 17 Periods Government Budget—Meaning and its Components. Objectives of Government Budget. Classification of Receipts—Revenue and Capital; Classification of Expenditure— Revenue and Capital, Plan and Non-plan and Developmental and Non-developmental. Balanced Budget, Surplus Budget and Deficit Budget; Meaning and Implications. Revenue Deficit, Fiscal Deficit and Primary Deficit; Meaning and Implications; Measures to Contain Different Deficits. Downsizing the Role of Government—Meaning and Implications.

Unit V : Balance of Payments 14 Periods Foreign Exchange Rate—Meaning (Fixed and Flexible), Merits and Demerits; Determination through Demand and Supply. Balance of Payments Account—Meaning and Components. A brief analysis about recent exchange rate issues.

Contents

PART A : INTRODUCTORY MICRO ECONOMICS 1. Micro Economics : An Introduction .. 1—7

2. Economy and Its Central Problems ............ 8—22

3. Consumer's Equilibrium (Utility Analysis and Indifference Curve Analysis) ............ 23—38

4. Demand and Law of Demand ............ 39—55

5. Price Elasticity of Demand ............ 56—69

6. Production Functions: Returns to a Factor and Returns to Scale ............ 70—86

7. Production Costs ............ 87—105

8. Concepts of Revenue ............ 106—116

9. Producer's Equilibrium : Meaning and Conditions ............ 117—122

10. Supply and Law of Supply ............ 123—135

11. Elasticity of Supply ............ 136—146

12. Different Forms of Market : Meaning and Features ............ 147—156

13. Market Equilibrium Under Perfect Competition and Effect of Shifts in Demand & Supply ............ 157—177

14. Simple Applications of Tools of Demand and Supply ............ 178—184 PART B : INTRODUCTORY MACRO ECONOMICS

15. Macro Economics : Meaning ............ 1—7

16. Circular Flow of Income ............ 8—16

17. Concepts and Aggregates Related to National Income ............ 17—44

18. Measurement of National Income ............ 45—79

19. Money : Meaning, Evolution and Functions ... 80—92 20. Commercial Banking System and Credit Creation . .. 93—101 21. Central Bank : Meaning and Functions .. 102—112 22. Recent Significant Reforms and Issues in Indian Banking System : Privatisation and Modernisation ... 113—117 23. Aggregate Demand, Aggregate Supply and Related Concepts (Propensity to Consume, Propensity to Save and Investment) ... 118—135 24. Short Run Equilibrium Out Put .. 136—143 25. Investment Multiplier and its Mechanism .. 144—152 26. Problems of Deficient and Excess Demand ... 153—160 27. Measures to Correct Deficient and Excess Demand ...... 161—169 28. Government Budget and Economy . 170—186 29. Foreign Exchange Rate 187—197 30. Balance of Payments Account : Meaning and Components .. 198—206 lModel Paper with OMR Sheet ..(i) lBoard Examination Papers ....(i) l

1

MICRO ECONOMICS : AN INTRODUCTION STUDY MATERIAL INCLUDED IN THE CHAPTER

1.1. Economic Activity : Meaning 1.2. Micro and Macro Levels of Economic Activity 1.3. Subject Matter of Economics 1.4. Nature of Economics : Positive Vs. Normative Science 1.5. Micro Economics : Definitions

1.6. Scope and Branches of Micro Economics 1.7. Significance of Studying Micro Economics 1.8. Limitations of Micro Economic Analysis A Quick Review of the Chapter Questions High Order Thinking Skills (HOTS) Questions Value Based Questions (VBQ) Case Study Based on Evaluation & Multi-disciplinary Questions (MDQ) NCERT Corner

1.1. Economic Activity : Meaning

Economic activity is an important component of subject matter of Economics. All economic activities arising out of unlimited wants and scarce means are included in the subject matter of economics.

Economic Activity ❍ Economic activity is that

activity which is related to

the use of limited resources

❍

for satisfying human wants.

All economic activities do not essentially generate income i.e. all activities which generate income are economic activities but all economic activities do not essentially generate income.

Box 1

According to the modern economists, “That activity is called economic activity which is related to the use of limited resources for satisfying unlimited human wants . ”

All economic activities do not generate income i.e. it is not necessary that income must always be created through economic activities. Income may or may not be generated by performing economic activity. For example, consumption is an economic activity but income is not generated by consuming an article.

1.1.1. Kinds of Economic Activities Economic Activity

↓↓ ↓ ↓ Consumption

● Consumption : Consumption is that economic activity in which utility of goods and services is consumed for satisfying various individual and collective wants. Eating food, drinking water are examples of consumption. Production Exchange Investment

↓↓↓

Product Pricing Factor Pricing

●Production : Production is that economic activity

Agents of Production

1. Land

2. Labour

3. Capital

4. Organisation

5. Entrepreneurship

Box 2

which is associated with adding the utility or value in goods and services. Stitching the cloth after cutting it by the tailor is an example of production activity.

● Exchange : Exchange is that activity in which goods or a factor of production is sold or bought and this transaction is usually made in money. This activity of exchange is also called price determination.

Price determination can be divided into two parts : (i) Product Pricing : It deals with price determination of goods in various market situations like perfect competition, monopoly and imperfect competition. (ii) Factor Pricing : It is related to the price determination of factors of production. In other words, it deals with price determination of land (i.e. rent), of labour (i.e. wage), of capital (i.e. interest) and of entrepreneurship (i.e. profit). Factor pricing is also known as ‘Distribution’ .

● Investment : Investment is that economic activity which is associated with the production of capital goods for producing goods and services in future. Investment indirectly satisfies human wants. For example, producing machine for a tailor is an investment because it makes shirts for people and thus helps indirectly in satisfying human want.

1.2. Micro and Macro Levels of Economic Activity

Analysis of economic activities may be done both at individual level and at entire economy level. Eminent economist of Norway, Ragnar Frish has classified ‘Economics’ in two branches :

(i) Micro Level ,

(ii) Macro Level .

At present two methods— ‘Micro Economic Analysis’ and ‘Macro Economic Analysis’ are used in analysing economic activities. ‘Micro’ and ‘Macro’ have been taken from Greek words ‘Micros’ and ‘Macros’ respectively. Micro means ‘Small’ and ‘Macro’ means ‘Huge’ .

●Micro Economics : Micro

Economics studies the economic activities only of individual units. For example, the behaviour of individual consumer or producer or firm are such economic activities which are associated with individual economic unit and hence are studied in Micro Economics.

● Macro Economics : Macro Economics studies the economic activities at entire economy level. For example, national income, national saving, national investment, total employment, total production, general price level etc. are studied in Macro Economics.

Macro Economics studies how an economy maximises its social welfare by increasing its income and employment level.

1.3. Subject Matter of Economics

Various economists have presented the subject matter of economics in different ways. On the basis of various economists’ view points, the subject matter of economics can broadly be divided into four categories :

Micro and Macro Level Economic Activities

Micro Level Economic Activities: These are the economic activities of individual units like individual household, individual firm, individual

industry etc.

Macro Level Economic Activities : These are associated with the study of groups at entire economy level. For example, aggregate demand and aggregate supply of all goods and services at entire economy level.

Box 3

(i) Wealth-related Viewpoint : Classical eco-nomists Adam Smith, J.B. Say, Walker, Senior etc. have included wealth, its earning, distribution and use in the subject matter of economics. These economists have included economic man and his activities into the subject matter of economics. According to Adam Smith, “Economics is a science of wealth.”

(ii) Welfare-related View point : Marshall, Pigou, Canon estab lished the concept of hu man-welfare (instead of wealth) in the subject matter of economics. Ac cording to welfare-re lated viewpoint, those

Subject Matter of Economics

(i) Wealth-related Viewpoint (Views of Classical Economists —Adam Smith, J.B. Say, Walker, Senior

etc.)

(ii) Welfare-related Viewpoint (Views of Marshall, Pigou, Canon etc. )

(iii) Scarcity-related Viewpoint (Views of Robbins, Wicksteed etc. )

(iv) Growth-related Viewpoint (Views of Samuelson )

Box 4 economic activities should be included in the subject matter of economics which are associated with physical welfare.

(iii) Scarcity-related Viewpoint : Robbins has included ‘problem of choice’ related to limited resources and unlimited ends in the subject matter of economics. According to Robbins those human activities are included in subject matter of economics with which human being tries to fulfil his unlimited ends with limited resources.

(iv) Growth-related Viewpoint : Modern economists like Samuelson has included growth-based activities in the subject matter of economics. According to Samuelson both the aspects i.e., ‘distribution of limited resources’ and ‘economic growth’ are the part of subject matter of economics.

1.4. Nature of Economics : Positive Vs. Normative Science 1.4.1. Economics : As a Positive Science

Positive science is a science which deals with the problems ‘as they are’. Positive Science deals with the analysis of relation between ‘cause’ and ‘effect’. It deals with ‘‘What is ?’’ and leaves the aspect ‘‘What ought to be ?’’

Prof. J.B. Say, Senior and Robbins have placed economics in the category of Positive Science. Every branch of economic analysis establishes a relation between ‘cause’ and ‘effect’. For example :

(i) Consumption : Law of diminishing utility establishes relation between rising consumption (i.e. , cause) and diminishing utility (i.e. , effect). (ii) Production : Law of diminishing productivity also

establishes relation between rising inputs and their diminishing productivity.

(iii) Exchange : The effect of price change on demand and supply is also an example of cause and effect.

(iv) Distribution : Increase in factor supply diminishes their price–it is also an example of cause and effect. (v) Public Finance : The effect of tax on consumption, production and distribution also establishes the relation between ‘cause’ and ‘effect’.

1.4.2 Economics : As a Normative Science

Marshall, Pigou, Hawtrey and Keynes are the names of economists who put economics in the category of normative science. Normative Science is related with the aspect ‘‘What ought to be ?’’ in which positive and negative

Positive Economics

features of economic problems are analysed and their desirability or undesirability is assessed. Various economists do favour for describing the normative aspect of the problem and suggesting ‘‘What ought to be ?’’

1.4.3. Economics : Both Positive and Normative Science

Economics can neither be linked alone with positive science nor alone with normative science, character of economics contains both features—positive as well as normative. According to Friedman, ‘‘Economics is sometimes positive science and sometimes normative science.’’ How an economic problem is solved ?—it is a part of positive science but what should be the solution of the economic problem ?—it is a subject of normative science. Thus, economics is associated with both positive as well as normative science.

Basis Meaning

Positive Economics deals with what is or how the economic problems are

actually solved. Verification Purpose Suggestive Value Judgements Examples

It can be verified by actual data. It aims to make real description of an economic activity. It based upon facts and thus not suggestive.

It does not give any value judgements i.e. it is neutral between ends. 1. Prices in Indian economy are constantly

rising. 2. There are inequalities of income in our economy. 3. In India, unemployment is growing.

Normative Economics

Normative Economics deal with what ought to be or how the economic problems should be solved. It cannot be verified by actual data. It aims to determine the ideals.

It is based upon individual opinion and therefore it is suggestive in nature. It gives value judgements.

1. Indian economy should take steps to control rising prices.

2. Inequalities of income is our economy should be reduced.

3. In India, unemployment should be checked.

1.5. Micro Economics : Definitions (ii)

Small units of an economy are included in Micro Economics e.g. one consumer, one producer, one firm, one industry etc. In other words, individual units are studied in Micro Economics.

Important definitions of ‘Micro Economics’ are as follows :

(i) According to K. E. Boulding , “Micro Economics may be defined as that

Micro Economics

❍ It studies economic relationships or economic problems at the level of an individual i.e., a consumer, a firm, an industry or income of an individual.

❍ It has main instruments of demand and supply.

❍ It solves the three basic central problems of an economy i.e., what, how and for whom to produce.

Box 5

branch of analysis, which studies the economic behaviour of the individual unit, may be a person, a particular household or a particular firm. It is a study of one particular unit rather than all the units combined together.”

According to Handerson and Quant , “Micro Economics is the study of economic action of individual and well-defined group of individuals.”

Above definitions show that ‘‘Micro Economics studies the behaviour of individual economic units. Micro Economics studies the behaviour of different units separately and deals with their interrelations.’’

1.5.1. Characteristics of Micro Economics

Salient characteristics of Micro Economics are as follows : 1. Study of

Individual Economic Units : Various factors

like individual income, production, consumption etc.

are explained with the help of Micro Economics. 2. Study of Micro

Variables : In micro economic analysis

micro variables of the economy are studied. For example,

one firm, one industry, one consumer, one producer

etc. These micro variables generate neglible effect which

does not affect the entire economy.

3. Study of Individual Price Determination : In micro economic analysis, price determination of individual units on the basis of demand and supply is done.

1.5.2. Difference between Micro and Macro Economics

Micro and Macro Economics are two main branches of Economics. Micro Economics deals with individual economic problems whereas Macro Economics is the study of aggregates or of entire economic system. These two approaches differ from each other in the following manner :

Micro Economics

1. It is concerned with an individual economic unit like a consumer, a firm, an industry or income of an individual.

2. It is based on the assumption of full employment.

3. It is based on the assumption of ‘ other things being equal’. This analysis is based on partial equilibrium .

4. Its objective is to study the theories related to optimum distribution of resources.

5. Its nature is comparatively easy.

6. It has main instruments of demand and supply.

7. It is also known as ‘‘Price Theory’’.

Macro Economics

1. It deals with aggregates of economy such as national income, aggregate expenditure, total employment, general price level, etc.

2. It is based on the assumption of under full employment of resources.

3. This is based on general equilibrium analysis.

4. Its objective is to study the theories related with full employment.

5. Its nature is comparatively complex.

6. Its main instruments are aggregate demand, aggregate supply, aggregate saving and investment.

7. It is also known as ‘‘Income & Employment Theory’’.

1.6. Scope and Branches of Micro Economics

Scope of ‘Micro Economics’ includes mainly three theories :

1. Theory of Product Pricing,

2. Theory of Factor Pricing,

3. Theory of Economic Welfare.

● In Theory of Product Pricing , price determination of consumption goods is studied which includes both demand as well as supply sides. Demand side studies the behaviour and consumption pattern of consumers while in supply side, production cost and production conditions are included.

● In Theory of Factor Pricing , price determination of factors of production (i.e. rewards to factors for their contributions in production) is studied.

● Theory of Economic Welfare , is the central point of micro economic analysis in which it is studied how to distribute the given quantities of goods and services among different consumers so as to maximise the economic welfare.

Branches of Micro Economics

Product Pricing Theory Factor Pricing Theory Economic Welfare Theory ↓↓↓

↓↓ ↓↓↓↓ Law of Demand Production and Wage Rent Interest Profit Cost Theory

Box 6 1.7.

Significance of Studying Micro Economics

4.Helpful in Understanding the Problems of Applied Economics : Micro economic analysis helps

1. Necessary to Study the Economy as a Whole : Addition of individual units makes the entire economy. Hence, knowledge of individual units is necessary for economic analysis of the entire economy.

2. Helpful in Determining Economic Problems :

Price determination and distribution problems find important place in economic analysis. These problems are solved with micro economic analysis. Price determination takes place with demand and supply forces which is a part of micro economic analysis.

3. Helpful in Policy Formulation : Individual units

analysis in micro economics helps Government in

formulating economic policies.

in understanding the problems of various branches of applied economics like Public Finance, International Economics etc.

5. Helpful in Understanding the Working of Capitalist Economy :

Capitalist economy is a free economy in which central problems of the economy are solved by ‘Price Mechanism’ (i.e. by inter-play of demand and supply forces). Micro economic analysis is helpful in solving the economic problems of capitalist economy.

1.8. Limitations of Micro Economic Analysis Micro economic analysis fails to adopt the shape of ‘Universal Analysis’ due to its various limitations are as follows :

1. Study not of Whole but of a Fraction : Micro Economics studies only a fraction of the economy and does not study the entire economy. The true picture of the entire economy can not be represented by studying only individual units.

2. Inadequate Analysis : Micro economic analysis is an inadequate analysis because conclusions derived from individual units may not be applicable to entire economy. Micro Economics fails to analyse the collective nature

3. Based on Unrealistic Assumptions : Micro economic analysis is based on the unrealistic assumption of ‘Full Employment’ . Full employment does not prevail in real life, rather it is an exception to the real world.

4. Based on Laissez Faire Concept : Micro economic analysis is based on ‘Laissez Faire’ . Government role remains absent in laissez faire (i.e. free economy). In present days, role of the government is necessary in economic world.

of the entire economy. A QUICK REVIEW OF THE CHAPTER

Economic Activity : That activity becomes economic activity which is associated with the use of limited

resources for satisfying human wants.

☞ All income generating activities are economic activities but all economic activities may not generate income.

Kinds of Economic Activity :

(i) Production, (ii) Consumption, (iii) Exchange : (a) Product Pricing, (b) Factor Pricing, (iv) Investment.

Agents of Production :

(i) Land, (ii) Labour, (iii) Capital, (iv) Organisation, (v) Entrepreneurship.

Micro Economics : Economic activities of individual units are studied in Micro Economics. For example,

behaviour of individual consumer, individual producer, individual firm are studied in micro economic analysis.

Branches of Micro Economics :

Branches of Micro Economics

↓

Product Pricing Theory Factor Pricing Theory Economic Welfare Theory

↓↓↓ ↓↓ ↓↓↓↓ Law of Demand Production and Wage Rent Interest Profit Cost Theory

Macro Economics : Macro Economics studies economic activities at entire economy level. For example, national income, national saving, national investment, total employment, total production, general price level are studied in Macro Economics.

QUESTIONS Ultra Short Answer Type Questions

1. According to which economist Economics is the science of wealth ? [B.S.E.B. (Comm. ), 2016]

2. The word Micros is derived from which word ?

3. What is micro economics ? (J.A.C., (Arts ), 2016)

4. According to which economist Economics is a Normative Science ?

5. Who is the father of Economics ?

[U.S.E.B., 2012; J.A.C. , (Arts ), 2016]

6. “Economics Presents logic of selection.” Who said it ? (B.S.E.B., 2014)

7. Which economist has divided Economics into Micro and Macro

8. What is an economic activity ? [B.S.E.B. , 2012, 17; J.A.C., 2019]

9. What are the different types of Economic Activities ?

10. Do all economic activities generate income ?

11. What is consumption ?

12. What is production ?

13. What is exchange ?

14. What is meant by factor pricing ?

15. Define ‘Micro Economics’.

(C.B.S.E. , 2012; U.S.E.B., 2016, 17) Or

What do you understand by Micro Economics ? (B.S.E.B. , 2014, 17) Or What is Micro Economics ?

9. What is meant by ‘Macro Economics’ ? (J.A.C., 2015) 10. What was the centre point of Marshall’s definition ? (J.A.C., 2011) 11. What is positive economics ? (C.B.S.E., 2011) 12. What is normative economics ? (C.B.S.E., 2011) 13. Define Micro and Macro Economics. (U.S.E.B., 2014) 14. State one example of Positive Economics. (C.B.S.E., 2018)

Short Answer Type Questions

1. Explain ‘Economic Activity’.

2. What are the different kinds of economic activities ? 3. Explain the ‘Micro’ and ‘Macro’ levels of economic activity. 4. Mention the characteristics of Micro Economics.

[B.S.E.B. , 2012 (Arts ); M.P. Board, 2016] 5. What is meant by scarcity in Economics ?

[ B.S.E.B. , 2011 (Comm .)]

6. Mention the factors of production. (B.S.E.B. , 2012)

7. What do you understand by Micro Economics ?

[B.S.E.B. (Arts ), 2014, J.A.C. , 2016]

8. Distinguish between positive economics and normative economics. Give

an example of each. (C.B.S.E., 2017)

9. Write four importance of micro economics.

(M.P. Board, 2014, 15) 10. Explain positive economics and normative economics with example. (U.S.E.B ., 2019) 11. Distingnish between micro economics and macro economics. (Any four )(M.P. Board , 2019) 12.

Differentiate between economic activities and non-economic activities. (Any four) (M.P. Board , 2019) 13. Identify and disuss the nature of the following newspaper reports in terms of positive or normative economic analysis : (i) ‘‘India jumped 23 points in the World Bank’s ease of doing business index to 77th place, highest in 2 years.’’ —The Economic Times (ii) ‘‘Government should further liberalise the business rules.’’ —The Economic Times (CBSE, 2019)

Long Answer Type Questions

1. Define economic activity. Explain the various kinds of economic activities. [B.S.E.B. , 2011 (Comm .)]

2. What do you mean by Micro Economics ? Mention its characteristics.

3. Explain the scope and branches of Micro Economics.

4. Explain the importance of Micro Economics.

5. Explain the uses and limitations of Micro Economics.

6. Economics is both Positive and Normative Science. Explain.

Objective Type Questions

(A) Multiple Choice Questions :

1. Micro Economics includes : [B.S.E.B. , 2016 (Comm. )] (a) Individual unit

(b) Small units

(c) Individual price determination

(d) All the above

2. Consumer behaviour is studied in : [ B .S.E.B., 2015, 17, 18] (a) In Micro Economics

(c) In Macro Economics

(b) Income Theory (d) None of above

3. Which of the following is studied under Micro Economics ? 6. Which of the following is a source of production ?

( J.A.C., 2011 B .S.E.B., (Arts ) 2015) (a) Land (b) Labour (c) Capital (d) All the above

7. ‘Micros’, which means ‘Small’ belongs to : [B.S.E.B., 2011, 15 (Arts )] (a) Arabian word (b) Greek word (c) German word (d) English word

8. Which Economist divided Economics in two branches of micro and macro on the basis of economic activity ?

[ B.S.E.B., 2011, (Comm. )] (a) Marshall (b) Ricardo (c) Ragnar Frish (d) None of the above

9. Who said it—“Economics is a science of wealth.” ? (a) Marshall (c) Adam Smith (b) Robbins (d) J.K. Mehta

10. Who gave the concept of Limited resources & Unlimited wants ? (a) Adam Smith (b) Marshall (c) Robbins (d) Samuelson

11. Which of the following economic activities are included in the subject matter of Economics ? [B.S.E.B. , 2011, 17] (a) Economic Activities related to Unlimited Wants (b) Economic Activities related to Limited Resources (c) Both (a) and (b) (d) None of the above

12. Who was the father of Economics ? [B.S.E.B. (Arts ), 2017] (a) J.B. Say (b) Malthus (c) Adam Smith (d) Joan Robinson

13. Who gave the definition of Economics related to welfare ? (a) Adam Smith (b) Marshall (c) Robbins (d) Samuelson

14. The word ‘micro’ was firstly used by : [B.S.E.B. , 2012, 15 (Arts )] (a) Marshall (b) Boulding (c) Keynes (d) Ragnar Frish

15. According to whom, Economics is a science of human welfare ? (a) A. Marshall (c) J.S. Mill [B .S.E.B., 2015, 17; J.A.C. , 2012, 18 (Arts )]

(b) Paul Samuelson (d) Adam Smith

16. Which of the following is not a factor of production ? [B .S.E.B., 2012, 15] (a) Land (b) Labour (c) Money (d) Capital

17. Which of the following is studied under micro economics ? [B.S.E.B., 2015, 17] (b) Economic aggregate (d) None of above (a) Individual unit (c) National Income (a) Individual Family (c) Individual Industry ( J.A.C., 2016) (b) Individual Firm (d) All of these

18. Which of the following is studied under Macro Economics ? (B.S.E.B. , 2015, 19) (a) National Income (b) Full Employment (c) Total Production (d) All the above

19. Which of the following is a branch of Micro Economics ? (a) Product Price Determination (b) Factor Price Determination (c) Economic Welfare (d) All the above

20. The subject matter of economics is being studied under which branches ?

21. Which of the following is not a Welfare Economist ? [B.S.E.B. (Arts), 2018] (a) J. B. Say (b) Marshall

(c) Pigou (d) Canon 20. Who said, ‘‘Economics is sometimes Positive Science and sometimes Normative Science.’’ [B.S.E.B. (Arts), 2018] (a) Marshall (c) Keynes (b) Freidmen (d) None of these

[Ans. 1. (d), 2. (a), 3. (a), 4. (d), 5. (d), 6. (d), 7. (b), 8. (c), 9. (c), 10. (c), 11. (c), 12. (c), 13. (b), 14. (d), 15. (a), 16. (c), 17. (d), 18. (c), 19. (a), 20. (b)]

(B) Fill in the Blanks : 1. All activities which generate income are ................. activities. 2. Behaviour of individual consumer is a part of ...... Economics. 3. Micro Economics studies economic activities at .............. level. [Ans. 1. economic, 2. Micro, 3. Micro.]

1. Consumer behaviour is studied in Micro Economics. 2. Scope of Micro Economics includes Theory of Product Pricing. 3. ‘Micros’, which means ‘small’ belongs to Arabian Word. 4. All activities are economic activities. 5. Theory of demand is an important component of Micro Economics.

Column : ‘A’

1. Micro Economics

2. Macro Economics

3. Price Determination

4. Study of National Income 5. Study of Consumer Behaviour

‘B’

(a) Macro Economics (b) Micro Economics (c) Individual Firm (d) Exchange activity (e) Full Employment

[Ans. 1. (d), 2. (e), 3. (c), 4. (a), 5. (b).]

(E) Answer in One Word

1. In which branch of economics the study of individual unit is made ?

2. Who said, “Economics is a science of wealth” ?

3. Which form of Economics is applied to the relation between cause and

effect ?

4. Which Economist gave the concept of human welfare ? [Ans. 1. Micro Economics, 2. Adam Smith, 3. Positive Economics, 4. Marshall.]

HOTS High Order Thinking Skills Questions

1. “All economic activities do not essentially generate income.” Explain. (See : Section 1.1)

2. Factor pricing comes under Micro Economics. Why ? (See : Section 1.1.1, Point ii)

VBQ Value Based Questions

1. In what way Economics is a normative science ? (See : Section 1.4.2)

2. Can Micro Economics be treated as an universal analysis ? (See : Section 1.8)

MDQ Case Study Based on Evaluation & Multidisci-plinary Questions

1. Do we include economic welfare in the scope of Micro Economics ? (See : Section 1.7)

2. Can Economics be treated as normative science ? (See : Section 1.4.2) NCERT CORNER

3. Discuss the subject matter of Economics. Ans. See Section 1.3

4. What do you mean by positive economic analysis ? Ans. See Section 1.4.1

5. What do you mean by normative economic analysis ? Ans. See Section 1.4.2

6. Distinguish between Micro Economics and Macro Economics. Ans. See Section 1.5.2 ❐

STUDY MATERIAL INCLUDED IN

ECONOMY AND ITS CENTRAL PROBLEMS

THE CHAPTER

2.1. What is an Economy ? 2.2. Types of Economics or Various Economic Systems 2.3. What is an Economic Problem ? 2.4. Why does an Economic Problem Arise ? Or What are the causes of an Economic Problem ? 2.5. Central Problems of an Economy 2.6. Production Possibility Curve 2.7. Shifting/Rotation of Production Possibility Curve 2.8. Production Possibility Curve and Central Problems 2.9. Opportunity Cost A Quick Review of the Chapter Questions High Order Thinking Skills (HOTS) Questions Value Based Questions (VBQ) Case Study Based on Evaluation & Multidisciplinary Questions (MDQ) NCERT Corner

2.1.

What is an Economy ?

capital or in other words, capitalist economy is that economy in which means of production are controlled and regulated

Economy is such a structure in which various economic activities of a society are performed. In a society, various economic activities for fulfilling the requirements of people and earning their livelihood are performed. For the operation and management of such economic activities, a system, an organisation or a structure is required, which is called an ‘Economy ’.

An economic system is required for operating various economic activities in an economy i.e. , economy is governed by one sort of economic system. In every economy, attempt is made to fulfil maximum requirements of the society with optimum utilisation of limited resources of the country on the basis of adopted economic system.

In words of A. J. Brown, ‘‘An economy is a system by which people get a livelihood and satisfy their wants.’’

2.2. Types of Economics or Various Economic Systems

Economic system is a structure of such institutions with which all economic activities are operated in the soci ety. Every economy is based on an economic system which can be divided into three categories :

1. Capitalist Economy or Market Economy,

2. Socialist Economy or Planned Economy,

3. Mixed Economy

2.2.1. Capitalist Economy or Market Economy

Capitalist economy is a system of economic organisation featured by the private ownership and the use of private profit of man-made and the nature-made by private organisation.

Market economy contains the following important features :

(i) Private Property : Capitalist economic system recognises ‘Law of Inheritance’ and right of individual private property. It also ensures to transfer the property of dead person to its heir.

(ii) Economic Freedom : Capitalist economy grants various economic freedoms to the individual like freedom to work, freedom of choice, freedom of consumption and freedom of saving and investment.

(iii) Laissez Faire & Free Trade : Market economy works under Laissez Faire i.e. , there is no state intervention in economic activities of the society. Market economy is an open economy in which free trade policy is adopted.

(iv) Competition : Competition is an essential feature of market economy. Equilibrium between market forces, i.e. , demand and supply takes place due to competition appearing in the economy.

(v) Price Mechanism : In capitalist economy prices are determined by the automatic adjustment of price mechanism. Price in the market is determined at the point where demand and supply forces become equal.

2.2.2. Socialist Economy or Centrally Planned Economy

Socialist means the system under which economic system is controlled and regulated by government so as to ensure welfare and equality of opportunity to the people in the society or in other words we can say that socialist economy system is that economy system in which means of production are controlled and regulated by government.

The salient features of Socialist Economy are as follows :

(i) Social Ownership : In socialist economy social ownership is found on factors of production. These factors are used for the welfare of the society as a whole. Right to individual property has no place in socialist economy rather it is limited to only selfconsumption goods.

(ii) Absence of Economic Freedom : Individual economic freedom remains absent in socialist economy. What ? How ? and How much ? problems are solved by centralised planning institution according to the needs of the society.

(iii) Passive Role of Price Mechanism : In socialist economy, prices are not determined by price mechanism, rather government takes the use of accounting prices which are determined by government itself on the basis of social interest.

(iv) Absence of Competition : Socialist economy works on planning and direction, as a result of which competition remains absent in the economy.

2.2.3. Mixed Economy

Mixed economy is an economy in which features of both economic systems are found. Thus, it is a golden mixture of capitalism and socialism. Under this economy, there is freedom of economic activities and government interferences for the sake of social welfare. In other words, mixed economy is a blend of both economies.

Mixed Economy contains the following economic features :

(i) Co-existence of Private and Public Ownership : Private and public sectors co-exist in the mixed economy. Both private ownership and profit motive are found in such economic system. Law of Inheritance finds a place in the economy but government imposes progressive taxation to attain economic equality.

(ii) Economic Freedom : Though enough state interference is found in Mixed Economy, people enjoy limited economic freedom of choice, production, investment and saving. Government adopts many controls to check the unlimited economic freedom of the individual.

(iii) Price System : Both price mechanism and profit motive determine the price system simultaneously in the Mixed Economy. Profit motive is managed by the government so that it may not hit the motive of social welfare.

(iv) Limited Competition : Mixed Economy contains limited competition due to the co-existence of both private and public sector. Competition appears in the economy but due to government regulation, economic development activities are not adversely affected.

2.2.4. Comparison between Capitalist, Socialist and Mixed Economies

Basis of Comparison Capitalism Socialism Mixed Economy

1. Meaning

2. Individual Freedom

3. Central

Planning

4. Competition

5. Operation

6. Motive

Private ownership on production factors; their use for private profit motive.

Full individual freedom.

Social ownership on production factors; their use by a central authority.

No individual freedom. No central planning. Complete central planning.

Presence of free competition. Automatic operated economic system. Profit motive supreme. Absence of free competition. Economic system not automatically operated. Social welfare motive supreme.

7. Right to Property 8. Class Struggle

Individual right to own, use and transfer the property. Economic disparities hence classstruggle. No individual right to own property, state right on property.

No class-struggle due to economic equality. Both private and state ownership on production factors.

Individual freedom but of limited size. Central planning but not full in nature. Free but controlled competition.

Not fully automatically operated system. Combination of social motive and profit motive.

Limited right to own property. Economic disparities but controlled.

2.2.5. Comparison between Market Economy and Centrally Planned

Economy Basis Market Economy Centrally Planned Economy 1. Meaning 2. Ownership 3. Decision Making 4. Competition

It refers to an economy in which the means of production are owned, controlled and operated by the private sector. All the means of production (land, labour, capital and enterprise) are private property.

Decisions regarding consumption, production and investment are made independently in the market economy. There exists stiff competition among the firms.

5. Role of Government 6. Problem solving

Government does not play any role. Central problems (what, how, for whom to produce) are solved through price mechanism. It refers to an economy in which the means of production are owned, controlled and operated by the government.

Means of production are owned by the government in case of centrally planned economy. Decision making is done by the government only.

There does not exist any element of competition under centrally planned economy.

Government plays the complete role.

Central problems are solved by Central Planning Authority.

2.3. What is an Economic Problem ?

Economic problem is a problem of choice. Human wants are unlimited and means to satisfy those wants are limited. To fulfil unlimited wants with limited resources creates a problem. These factors of limited means and unlimited needs are both applicable in case of a family and an economy. Income of a family is limited and needs are unlimited. Therefore, unlimited needs of a family cannot be satisfied by its limited income. Similarly, resources of an economy are also limited and due to this limited availability of factors it is not possible for an economy to produce all commodities in sufficient quantity.

Therefore, problem of optimum adjustment of limited means or resources with unlimited wants arises in the economy e.g. limited factors give rise to the problems that how much amount of resources should be utilised for satisfying different wants. For this, we face the problem of ‘Choice’ . Infact, Economics studies this problem of choice which is called ‘Economic Problem’ . Thus, economic problem is concerned with the use of scarce resources compared to unlimited alternative human wants.

2.3.1. Definitions of Economic Problem

(i) According to Eric Roll, “The economic problem is essentially a problem arising from the necessity of choice; choice of the manner in which limited resources with the alternative uses are disposed. It is the problem of the husbandry of resources.”

Economic Problem is Basically a Problem of Choice

Wants are unlimited and resources are scarce. Due to alternative uses of limited resources, efforts are made to create balance between unlimited wants and limited resources. Due to this effort, problem of choice arises. In this way, economic problem is basically a problem of choice.

Box 1

(ii) According to Leftwitch, “Economic problem is concerned with the use of scarce resources among alternative human wants and in using these resources towards the end of satisfying wants as full as possible.”

In short, economic problem arises when limited and scarce resources are subject to optimum use for satisfaction of unlimited wants.

Economic Problem : An Example

Suppose a farmer has one acre of land. Land in form of factor or resource is limited. Either wheat or sugarcane can be planted on this limited land, but both cannot be planted together. A farmer has to choose that which option he should select so that he gains maximum profit. In this way, scarce and limited resources create a problem of choice of alternative uses of resources.

Box 2

2.4. Why does an Economic Problem arise ? Or What are the causes of an Economic Problem ?

Causes of arising economic problem are : (1) Unlimited Wants : Human wants are unlimited.

New wants arise as soon as a want gets satisfied.

Thus, all human wants cannot be satisfied. (2) Difference in Intensity of

Wants : Intensity of

wants differ for different goods. Few wants are very

important for a person and less important for the other.

On the basis of importance, every person keeps his

unlimited wants on different priority basis. (3) Limited or Scarce

Resources : Limited or scarce

resources indicate that their demand exceeds their

supply,

Or [Demand of Resources] > [Supply of Resources] Resources can both be natural or human made but they are limited for satisfying unlimited wants,

Or [Wants] > [Resources]

W > R

Or “Wants exceed Demand.” (4) Alternative Uses of Resources :

Resources are not

only limited, but they have alternative uses also. For

example, electricity can be used in fans, coolers, light,

refrigerators, etc. Again in this case also problem

of choice arises i.e. how to use limited resources

in different alternative uses.

(5) Problem of Choice : No person, family or country

can fulfil all its demand or wants through the limited resources. Thus, they face the problem of choice i.e. which resource to be used in satisfying which want and in which quantity ? In other words, the problem of choice arises and this problem of choice is also called ‘Economic Problem’ .

It is clear from above analysis that problem of choice is basically a economic problem. If resources would have also been unlimited like unlimited wants, then there would have been no problem of choice. In other words, limited resources give rise to economic problems. In brief, unlimited wants and limited resources are the two pillars on which structure of all economic problems stand. “Economics comes into existence only when problem of choice arises.”

Summary of Economic Problem

Unlimited Wants Difference in Intensities of Want Choice of Priorities Why does an Economic Problem Arises ? W > R Problem of Dawn of

Economic Choice Problem

Limited Resources Alternative Uses of Resources Choice of Optimum Use of Resource

Box 3 2.5. Central Problems of an Economy

Economy refers to that economic system through which all economic activities of society are conducted or carried on. Every country is based on some economic system. Different economic systems are ‘Capitalism’, ‘Socialism’ and ‘Mixed Economy’ . Different economic systems follow different methods of operation but due to scarcity of resources, they all face problem of choice between limited means and unlimited ends. These problems are called central problems of an economy.

Central Problems of an Economy

↓ Three Basic Problems ↓ ↓↓↓

What to Produce and How How to For whom much to Produce ? Produce ? to Produce ?

Box 4

According to Prof. Samuelson , every economy has three basic problems of resource allocation :

(a) What to produce and in what quantity ?

(b) How to produce ?

(c) For whom to produce ?

(a) What to produce and how much to produce ?

The very first central problem of economy is related to problem of choice. First and foremost problem of economy is—What to produce or which goods and services should be produced so that maximum wants and needs of people could be satisfied with limited resources. Every economy has to choose that which want should be satisfied and which should be sacrificed, postponed or left ? Regarding what to produce ? many production related options come before us for the solution of this problem. Main options have been given in the chart on the next page.

When an economy decides what to produce; then next problem appears i.e. ‘How much to produce’ ? or we have to decide that what quantity of consumption goods and capital goods should be produced ? For example, if an economy wants to increase production of consumer goods like clothes and tea through limited resources in a definite time-interval then it has to reduce production of capital goods like tractor and television. In fact, producer would like to produce that quantity of goods which maximises his profit.

On the basis of this choice, through available alternatives, a country has to decide that what quantity of limited factors should be used for producing which quantity.

What to Produce ?

Problem of Choice

↓↓↓ Option Option ↓↓ ↓↓↓ ↓

Consumer Goods or Capital Goods Necessary Goods or Luxury Goods ↓↓↓ ↓ e.g. Clothes, e.g. Machine, instruments, e.g. Bread, e.g. Car,

wheat, etc. tractors, etc. clothes, house jewellery etc. Option ↓↓↓

Private Goods or Public Goods ↓↓ e.g. House, scooter, factory, etc. e.g. School, park, hospital, road, etc. Box 5 (b) How to produce ? Second problem before the economy is ‘how to produce’ ? In fact, it is the problem related to the choice_{(ii) of technique. There are two types of techniques of} production :

(i) Labour-intensive Technique : In this technique, more quantity of labour is used as compared to capital. The use of this technique ensures increase in employment and makes solution of unemployment problem.

Capital-intensive Technique : In this technique, more quantity of capital is used as compared to labour. The use of this technique increases production efficiency and productivity.

How to Produce ? ↓ Choice of Technique ↓ ↓↓ Labour-intensive Technique Or Capital-intensive Technique ↓↓ More use of labour as compared to capital More use of capital as compared to labour

Box 6

For example, clothes can be produced by both, handloom (i.e. labourintensive technique) or powerloom (i.e. capital-intensive technique).

How to produce ? —for solution of this problem, we should adopt that technique which utilises lesser limited resources. If the production from both the techniques is the same then the technique using less quantity of limited resources will be called more efficient technique.

(c) For whom to produce ?

After getting the solutions of the problems of what ? how much ? and how ? the next problem arises—“For whom to produce” ? or “How to distribute the production ?”

Problem of Distribution

Two Dimensions

↓↓↓

Personal Distribution Functional Distribution ↓↓ Related with Problem of Inequality Not related with Problem of of Income Distribution Inequality of Income Distribution Box 7

There are two faces of the problem of distribution of production :

(a) First face is related to ‘Personal Distribution’ . It means that how the produce should be distributed between different persons and families in the society. It is also related to the problem of unequal distribution of income.

(b) Second face of the problem of distribution is ‘Functional Distribution’ . It is related to determine how the produce should be distributed among

various factors of production as land, labour, capital and entrepreneur. It is not related to problem of inequality of income distribution.

2.5.1. Additional Central Problems of an Economy : Modern Viewpoint

Besides three basic problems of an economy, economists like Stigler and Leftwitch have given two additional central problems of an economy :

(1) How to Achieve Optimum Utilisation of Resources ?

After getting the solution of problems like what ? how much ? how ? and for whom?; the next problem is to ascertain optimum utilisation of production resources. The production factors in the economy are limited. Thus, next main problem which the economy faces is how to ensure optimum utilisation of resources.

There are two aspects of this problem : (a) To provide full employment to all the factors of

production, as—land, labour, capital etc. (b) To ensure full or optimum utilisation of limited factors

in economy.

In this way, for obtaining full employment, an economy has to solve the problem of unemployment or underemployment of resources and also to ascertain full or optimum utilisation of resources in the economy.

(2) How to Achieve Economic Growth ?

Every economy wants to accelerate the economic growth by increasing its level of production. Increasing productive capacity in the economy is a major problem. Continuous use of limited resources further decreases the quantum of available resources. Therefore, it is necessary to improve and develop additional resources continuously so that economic growth can be achieved by increasing production level.

2.5.2. Solution of Central Problems in Different Economic Systems,

i.e. , Different Economies

Various central problems of what ? how much ? how ? and for whom ? are solved in a different way in different economic systems.

● Solution of Central Problems in a Capitalist Economy : There is private regulation over factors of production in capitalist economy and this economy is independent in field of production and consumption. Economic problems are solved through ‘Price Mechanism’ in which two independent forces— demand and supply become active to determine the price.

● Solution of Central Problems in Socialist Economy : There is control of society over factors of production and economic activities are conducted for the welfare of entire society. Central problems in this economy are solved on the basis of social priorities through ‘Economic Planning’ or ‘Planning Machinery’ .

● Solution of Central Problems in Mixed Economy : There is coexistence of private and public sectors in this economy and both the sectors function under the sphere of economic planning. In mixed economy, price mechanism and planning

mechanism together solve the central problems. 2.6. Production Possibility Curve

Production possibility curve is based on the analysis that factors of production are limited but goods to be produced are unlimited. As a result, problem of choice appears among alternative uses. The economy faces a number of alternative

☞ Production Possibility Curve of an economy show all possible combinations of goods and services which can be produced in the economy with available resources and technological know-how.

Box 8

Introductory Micro Economics

combinations of production which are called production possibilities. If these combinations are represented on a graph, the curve formed is called ‘Production Possibility Curve’ .

Production Possibility Curve : Definition According toSamuelson , “Production possibility curve is that curve which represents the maximum amount of a pair of goods or services that can both be produced with an economy’s given resources assuming that all resources are fully and technique employed.”

In this way, production possibility curve represents various combinations of two or more goods which can be produced in a certain time period through given resources and technical knowledge. To increase production of one goods, the production of other goods has to be decreased. That is why, production possibility curve slopes downward from left to right or from the top to bottom.

Production Possibility Curve : Assumptions The production possibility curve is based on following assumptions :

(i) Fixed and Limited Quantity of Factors of

Production : Factors of production are limited but they can be transferred from one use to the other. (ii) Fuller and Efficient Utilisation of the Available Resources : All factors are fully and efficiently utilised in the economy.

(iii) Constant Technology : Technology of production remains constant, i.e. there is no change in the technology used.

(iv) Two Goods : For convenience, it is assumed that only two goods or two sets of goods are being produced in the economy (e.g. , wheat and clothes or capital and consumer goods).

●

Production Possibility Curve : Characteristics There are two main characteristics of production possibility curve : (i) Production Possibility Curve slopes downward

from Left to Right : Slope of production possibility curve is negative i.e. it slopes downward from left to right. This is due to the fact that in case of most efficient utilisation of available resources, production of both the goods cannot be increased. Among two goods X and Y, production of goodsX would be increased, only when production of goodsY is decreased.

(ii) Production Possibility Curve is Concave to Origin : Production possibility curve is concave to the origin which signifies that if we want to increase production of one goods (goods-X), then we have to sacrifice production of second goods (goods-Y) and the sacrifice of Y goods for every additional X-goods will continuously increase. In other words, PPC is concave due to increasing marginal opportunity cost (MOC) i.e., marginal rate of transformation (MRT). Due to this reason, the production possibility curve becomes concave to the origin.

(iii) Slope of Production Possibility curve (PPC) is defined as the quantity of good Y given up in exchange for additional unit of good X. The slope of PPC is negative.

Slope of PPC = Amount of Good Y Lost

Amount of Good X gained

= Y= Marginal Opportunity Cost

X

●

Production Possibility Curve : Diagrammatic Representation

Production possibility curve can be represented with a diagram on the basis of its characteristics and inherent assumptions. Economy can attain different combinations of production option of two goods by utilising given resources. For example, if two goods—wheat

Production Possibility Curve (also known as transformation curve) is drawn on two basic assumptions : 1. The given resources are fully

and efficiently utilised. 2. Technology remains constant during the entire production process.

Box 9 (consumer goods) and machine (capital goods) are produced, then : (i) First option is that all factors are utilised in production of wheat only and in this case, there will be no production of machine.

(ii) Secondly, it could happen that all factors are utilised in production of machines only. Then, there will be no production of wheat.

(iii) Third option would be that few factors are utilised in production of wheat and others in production of machine.

Table 1 : Production Option Table or Production Possibility Set Options Wheat (Consumer Goods) Machine (Capital Goods) (Lakh Tonne) (Thousand units) A 0 50 B 1 45 C 2 35 D 3 20 E 4 0

It is clear from the table that in option A, 50 thousand units of machine will be produced but production of wheat will be zero. On the contrary, if production as per option E is done, then 4 lakh tonne of wheat will be produced but there will be no production of machines. Between these two extreme points, there are many options as option B (1 lakh tonne wheat + 45,000 machine units) or option C (2 lakh tonne wheat + 35,000 machine units) or option D (3 lakh tonne wheat + 20,000 machine units). These options can be plotted on graph to obtain ‘Production Possibility Curve’ , (curve AE). In Fig. 1, AE is production possibility curve or transformation curve. Wheat and machines have been represented on line OX and OY respectively.

First option is 50 thousand units machine and no wheat which has been represented by point A. In the same way, point B, C and D represent various combinations of wheat and machine. Point E represents 4 lakh tonne wheat and no machines. By joining these points of different combinations, we obtain production possibility curve or transformation curve. Point F in the

figure is unattainable option and point G shows the situation of inefficient or underutilised resources.

2.6.1 When does PPC take shape of a straight line ? PPC takes the shape of of

a straight line when marginal opportunity cost or marginal rate of transformation be comes constant. Mar ginal rate of transforma tion becomes constant when the ratio between the loss of output in good Y and the gain of out put in good X remains constant while some re sources are shifted from production of good Y \mathrm { t o } _ { F i g } . 1the production of good

X.

2.7. Shifting/Rotation of Production Possibility Curve

Production possibility curve never remains constant. Its situation gives on changing because of changing nature of its assumptions. Shifting or rotation of production possibility curve occurs due to change in two factors— Change in quantity of factors and change in technology.

Shifting in Production Possibility Curve

↓Two Reasons

↓↓↓ Change in Resources Change in Technology ↓↓

↓↓ ↓ ↓ ↓ Resources get Increased Resources get Decreased

2.7.1. Change in Resources

(A) Resources get (A) Resources get

Increased : Due to increase in resources, more production of both goods X and Y becomes possible and as a result production possibility curve shifts to right from its original position. In Fig. 2, PP is original production_{Fig . 2possibility curve. Due} More Efficient

Technique for Goods-X Box 10

More Efficient Technique for Goods-Y

to increase in resource this curve shifts to right and new production possibility curve becomes \mathrm { P } _ { 1 } \mathrm { P } _ { 1 }

(B) Resources get Decreased : Due to decrease in resources production of both goods X and Y decreases and as a result, production possibility curve shifts to left from its original position. In Fig. 3, PP is given production possibility curve. Due to decrease in resources, curve PP shifts to left and new production possibility curve becomes \mathrm { P } _ { 1 } \mathrm { P } _ { 1 }

2.7.2. Change in Technique

(A) Efficient Technique for the Production of Commodity-X : Efficient technique for the production

More Efficient Technique for both Goods X and Y

Fig . 3 16

of commodity-X means that more production could be done by using given available resources. There-fore, the entire production possibility curve will not shift but only moves. PP in Fig. 4 is initial production possibility curve. Due to use of more efficient

Fig . 4

technique in production of goods X it rotates to become \mathrm { P P } _ { 1 }

(B) Efficient Technique for the Production of Commodity-Y : Efficient technique for production of commodity Y means that more production of goods-Y could be done with available resources. Therefore, production possibility curve will rotate. In fig. 5, PP is original production possibility curve. On using efficient technique for production of goodsY, initial curve PP rotates to \mathrm { P P } _ { 2 }

Fig . 5

(C) Efficient Technique for the Production of both Commodities X and Y : Efficient technique for the production of both commodities means that more produc-tion of both goods X and Y is possible. Accordingly, pro duction possibility curve will shift to right. In Fig. 6, PP is initial production possibility curve. On using efficient technique, both in production of X and Y production of both the goods X and Y increases F i g . 6due to which PP

curve shifts to \mathrm { P } _ { 1 } \mathrm { P } _ { 1 }

2.8. Production Possibility Curve and Central Problems

Central problems of the economy can be explained with the help of production possibility curve : (A) What to Produce and How much to Produce ?

It is clear from Fig. 7 that if all the factors or resources are used in production of wheat, then production of wheat will be 6 lakh tonne (see point D). On the contrary, if all factors are utilised in production of machines then 50,000 units of machine are produced (see point A).

Introductory Micro Economics On curve AD, all the

combinations of wheat and machine are shown which can be produced with the given resources being utilised efficiently. In other words, if all the resources are fully utilised, production of wheat and machine can be represented on point B and C. At combination B, 45,000_{Fig . 7units of machine and}

2 lakh tonne of wheat can be produced. In the same way, at point C, 35,000 units of machine and 4 lakh tonne of wheat can be produced. It means that for increasing production of wheat, production of machine has to be sacrificed because factors of production are limited. Thus, problem of distribution of factors among different uses arises.

(B) How to Produce ? Second central problem before the economy is “How to produce ?” This problem is related to the choice of technique of production. This situation can be understood from Fig. 8. It is clear from the figure that if available

resources are efficiently

utilised, combinations Fig . 8 of production A, B and C are obtained. If resources are not efficiently utilised, amount of production will be expressed at point E. Point E is situated inside the curve PP. Thus, lower production we get if resources are used with inefficient technique. But if efficient technique of production is used, production of either one or both the goods can be increased.

(C) Full Utilisation of

Resources : Problem of full utilisation of resources can be explained with Fig. 9. When combi nation of production are done at point K on curve AD, factors are fully utilised. On the contrary, if production is done_{Fig . 9inside curve AD at}

point for G, resources will be underutilised. (D) Growth of Resources : Growth of resources is possible only when society can increase the resources or the productivity can be increased. As a result, production possibility curve A shifts to right, i.e . PP curve (Fig. 10) which shows increase in resources. Production combinations on curve PP show relatively more quantity of both machine and wheat. In this way, new curve represents economic growth. Fig . 10

Simple Diagrammatic Representation of Various Central Problems

Point A : Efficient utilisation of resources. Point B : Under-utilisation or inefficient utilisation of resources. Shifting from

PP to \mathrm { P } _ { 1 } \mathrm { P } _ { 1 } —Economic

growth.

Point C : Efficient utilisation

of resources after economic

growth. \cdot F . i g . 11

2.9. Opportunity Cost

Concept of opportunity cost is based on the fact that resources are limited, but have many alternative uses. Since every factor is limited, they cannot be fully utilised in all uses. From point of view of society, utilising a resource for a purpose means that opportunity of using it in other use is to be sacrificed. Opportunity producing cost of a goods is that quantity of goods which we have to sacrifice. That cost which encourages resources in their present use is called opportunity cost. For

☞ Opportunity cost refers to the value of a factor in its next best (or second best) alternative use, or the foregone opportunity of using a productive resource somewhere else rather than in the present use is termed as opportunity cost.

Box 12

example, if certain resources are utilised in production of two commodity— wheat and machine and with similar resources wheat of worth 5 lakh rupees and 4 lakh rupees of machine can be produced. Producer in this case will produce wheat rather than machine or for wheat 5 lakh rupees, machines of 4 lakh rupees has to be sacrificed. In this way sacrificed value of machine will be called

opportunity cost of wheat worth of 5 lakh rupees. Box 11

Concept of Opportunity Cost

Wheat (worth ` 5 lakh) Production of wheat selected Factors (a fixed or definite Options quantity)

or

Machine Sacrifice of Opportunity Cost

(worth ` 4 lakh) machine production of ` 5 lakh wheat = machines of ` 4 lakhs

Box 13

Marginal Opportunity Cost Vs. Total Opportunity Cost

Marginal Opporunity Cost is the ratio of loss and profit of production when a resource is transferred from use-1 to use-2.

Contrary to it, total opporunity cost is not a ratio, rather it shows total loss when a resource is transferred from use-1 to use-2.

Marginal opportunity cost shows the cost of another unit while total opportunity cost shows the cost of all units of production.

Box 14

2.9.1. Opportunity Cost and Production Possibility Curve

Concept of opportunity cost can be understood with production possibility curve. From production possibility curve, we come to know that if we want to increase production of one goods, we have to sacrifice the production of the second or other goods. In this way, basis of the concept of opportunity cost is sacrificed goods or option of opportunity.

Concept of opportunity cost can be expressed through following table :

Introductory Micro Economics

Table 2 : Production Possibility Curve Table Production Options A B

X-Goods Y-Goods

Fig . 12
Above table can be represented with Fig. 12. AF is a production possibility curve representing all alternative combinations of goods X and goods Y, which economy can produce with its available resources. Point C on this curve shows that in a certain time period, 12 units of goods-Y and 2 units of goods-X can be produced. In the same way, at point D, 9 units of goods Y and 3 units o f go ods-X can be

is OY and

Opportunity Cost of an Additional Unit of X in form of Y

1 5 - 1 4 = 1

1 4 - 1 2 = 2

1 2 - 9 = 3

9 - 5 = 4

5 - 0 = 5

\begin{array}{c} \text {Y} \\ \text {-} \end{array} \uparrow

\begin{array}{l} \mathrm{MOC} = \frac {\mathrm{AB}}{\mathrm{BC}} \\ \text {where} \end{array}

produced. Thus, it could be said that if economy moves from point C to point D, then for producing an additional unit of goods-X.3 units of goods-Y is to be sacrificed. PP curve in Fig. 12 represents increasing opportunity cost condition because for increasing an additional unit of goodsX, more units of goods-Y has to be sacrificed gradually.

Or BA < CA ₁ < DA ₂ < EA ₃

2.9.2. Marginal Opportunity Cost or Marginal Rate of Transformation (MRT)

production of goods-X is OX;

AB = loss of output (∆Y) in Commodity Y BC = gain of output

when a few

(∆X) in Commodity X

resources are transferred from

goods-Y to goods X, then loss in

production of

goods \mathrm { X } = \mathrm { Y Y } _ { 1 }

and gain in

production o \mathrm { f } _ { F i g } . 13goods-X = XX1.

Marginal Opportunity Cost

Loss in Production Gain in Production YY \mathrm { A B } _ { 1 } ₁ XX BC

Here, marginal opportunity cost shows the rate at which good Y has to be sacrificed for additional units of X. It is also called Marginal Rate of Transformation which shows the slope of production possibility curve.

Increasing Marginal Opportunity Cost on Production Possibility Curve

Marginal opportunity cost of a goods-X is that quantity of goods-Y which has to be sacrificed for production of an additional unit of goods-X. In other words, decrease in production of goods-Y on increase in production of an additional unit of goods-X is called marginal opportunity cost of that additional unit of goods-X. Thus,

“The rate of sacrifice of commodity Y for additional production of commodity X, is called marginal opportunity cost.”

Marginal Opportunity Cost Y

X

where, Y = Decrease in production of goods-Y

X = Increase in production of goods-X.

Diagrammatic Explanation

Concept of marginal opportunity cost has been shown in Fig. 13. It is assumed that in the beginning resources are used in the manner that production of goods-Y As production of goods-X is increased, its marginal opportunity cost also increases or as we increase production of goods-X, in every step more quantity of goods-Y has to be sacrificed. Cause of increasing marginal opportunity cost is that as the production of a goods is increased, factors involved in its production become less productive. As a result of it for producing an additional unit of goods, more quantity or units of other goods is sacrificed.

Thus, “Increasing marginal cost means increasing slope of production possibility curve and due to this increasing slope, the production possibility curve becomes concave to the origin.’’

Box 15

A QUICK REVIEW OF THE CHAPTER

Economy : Economy is such a structure in which various economic activities of a society are performed. Economic Problem : Economic problem is essentially a problem arising from the necessity of choice. It is the problem of economising of resources.

Why does an Economic Problem arises ?

(i) Unlimited wants, (ii) Difference in wants, (iii) Resources used for satisfaction of wants are scarce or limited, (iv) Alternative uses of resources, (v) Problem of choice.

Central Problems of an Economy :

(i) What and how much should be produced ?, (ii) How to produce ?, (iii) For whom to produce ?, (iv) Problem of efficient utilisation of resources, (v) Problem of achieving economic growth.

Production Possibility Curve (PPC) : This curve represents different combinations of production possibilities of two goods. It is based on two main assumptions :

(i) Constant or fixed technology; (ii) Constant or fixed factors.

Characteristics of Production Possibility Curve :

(i) Slopes downward from left to right, (ii) Production possibility curve is concave to the origin. Factors of shifting Production Possibility Curve : (i) Change in resources or factors, (ii) Change in technology.

Analysis of Central Problems :

(i) Any point on production possibility curve represents that what quantities of goods-X and Y are produced, (ii) Point below production possibility curve represent under-utilisation of resources, (iii) Shifting of production function from left to right represent economic growth.

Opportunity Cost : The opportunity cost or alternative cost of anything is the next best alternative that could be produced instead by the same factors or by an equivalent group of factors costing the same amount of money.

Marginal Opportunity Cost : The rate of sacrifice of commodity Y for additional production of commodity X, is called marginal opportunity cost.

Slope of PPC shows Marginal Opportunity Cost : Slope of production possibility curve increases (because production possibility curve is concave to the origin). Due to this, when resources are transferred from one use to other, increasing tendencies are found in marginal opportunity cost.

Shape of PPC : PPC i.e. Production Possibility Curve is concave to the origin because when factors are diverted from one use to other, marginal opportunity cost tends to increase.

QUESTIONS Ultra Short Answer Type Questions

1. What is the shape of Production Possibility Curve ?

2. ‘Price Mechanism’ is the important feature of which economic system ?

3. What is Opportunity Cost ?

4. Write any two problems of an economy. (J.A.C., 2019)

5. Name the curve which expresses central problem.

6. In which economic system there is co-existence of private as well as public sector ?

7. Why is PPC Concave ? (J.A.C., 2014)

8. Define Production Possibility Set of an economy.

(Raj. Board, 2017)

[JAC, 2014; CBSE , 2017] 17. What does slope of Production Possibility Curve show ? 18. What does a rightward shift in production possibility curve indicate ?

What do you mean by PPC ? [JAC (Arts) , 2014] 10. Why do economic problem arise ? (JAC, 2018) 11. What is meant by alternative uses of resources ? 12. What is the problem of choice ? (C.B.S.E., 2010) 13. What is the meaning of the problem—‘What to Produce’ ? (C.B.S.E., 2010) 14. Explain the two characteristics of economic problem. 15. What is the meaning of the problem—‘How to Produce’ ? (C.B.S.E., 2010) Or Explain the central problem ‘‘how to produce’’ ?

9. Give two reasons for the problem of choice. (U.S.E.B., 2016) 10. What is problem of choice ? (U.S.E.B., 2019) Very Short Answer Type Questions

10. What are the different types of economic systems ?

11. Define capitalist economy.

12. What is meant by socialist economy ?

13. What do you mean by Mixed Economy System ?

14. What is meant by ‘Economic Problems’ ?

15. What is the meaning of ‘Scarcity’ ? (U.S.E.B., 2012, 15) 7. What is planned economy ? (C.B.S.E., 2011) 8. What are the main causes of the origin of economic problem ? 9. What is production possibility curve ? (U.S.E.B., 2011, 17; B.S.E.B., 2013) Or

16. Define opportunity cost.

17. Define marginal opportunity cost.

18. Mention two reasons of problem of choice.(U.S.E.B., 2012) 22. Explain three central problems of an economy.

(J.A.C., (Arts ), 2014) 23. Clarify the central problem that what should be produced. (J.A.C., (Arts ), 2014) 24. Write any two central problems of an economy. (B.S.E.B., 2014) 25. Explain the central problem ‘‘for whom to produce’’ ? (CBSE , 2017) Short Answer Type Questions

1. What is meant by Economic Problem ? Why does an Economic Problem arise ? (U.S.E.B., 2011, 13; J.A.C., 2018)

2. “How to produce ?” Explain this central problem. (C.B.S.E., 2012, 15) Or Explain the central problem of ‘‘Choice of Technique.’’ (C.B.S.E., 2018) Or In what sense the problem—‘How to produce’ ? is a central problem of an economy ? Explain. (U.S.E.B., 2015)

3. What do you understand by production possibiliy curve ? [B.S.E.B, 2015;

U.S.E.B., 2016; J.A.C. , 2017]

4. What are the three main central problems of an economy ? [J.A.C., 2012, 17 (Arts ); B.S.E.B., 2013]

5. How are the central problems solved in Capitalist Economy ?

6. Why does the economic problem relating to the allocation of resources arise ? (B.S.E.B., 2013)

7. Mention the reasons of shifting in Production Possibility Curve.

8. Why does an economic problem arise ? Explain the problem of ‘What to produce ?’ with the help of an example. [B.S.E.B. , 2011 (Arts )]

9. Write a note on the problem—‘For whom to produce ?’ (C.B.S.E., 2013, 15) Or

Explain the problem of ‘For whom to Produce’.

(C.B.S.E., 2018) 10. Why does the Production Possibility Curve become concave to the origin ? (J.A.C., 2015, C.B.S.E. , 2011, 12, 17) 11. Scarcity and choice move simultaneously. Explain. [J.A.C., 2012 (Arts )] 12. With the help of a hypothetical table draw a Production Possibility Curve.

13. Discuss the concept of opportunity cost with an example. (C.B.S.E., 2013) 14. Define Marginal Opportunity Cost along a PPC. 15. What do you mean by ‘‘Planned economy’’ ? (C.B.S.E., 2010) 16. What are the main causes of origin of economic problems ? (C.B.S.E., 2010,12) 17. Why is economic problem regarded as a problem of choice ? [B.S.E.B. , 2011 (Arts )]

14. Explain with the help of a diagram the situations of efficient and inefficient utilisation of resources in an economy. [B.S.E.B. , 2011 (Arts )] Long Answer Type Questions

15. What is an economic problem ? Why does an economic problem arise ? [J.A.C., (Arts ), 2016]

16. Discuss the central problems of an economy.

17. Why do central problems of an economy arise ? Explain the central problem of ‘for whom to Produe’ ? (C.B.S.E., 2018)

18. Explain the problem of—“What to produce ?” with the help of Production Possibility Curve.

19. How will the following factors effect the country’s PPC ? (i)

Technological Advancement.

(ii) Growth of Resources.

6. What is the relation between Marginal Opportunity Cost and Production

Possibility Curve.

7. Why the PPC is in concave form ? Explain your answer with a suitable example. (B.S.E.B., 2013; J.A.C., 2011)

8. Explain the difference between Market Economy and Planned Economy. (C.B.S.E., 2010)

9. What is the effect of change in resources and change in technique on Production Possibility Curve ?

10. Assuming that no resource is equally efficient in production of all goods, name the curve which shows production potential of the economy. Explain its properties. (C.B.S.E., 2016) Objective Type Questions

(A) Multiple Choice Questions :

1. On which base, structure of economic problems has been installed ?

(a) Unlimited Wants (c) Both a & b

(b) Limited Resources (d) None of the above

2. Which of the following statement is true ?

(B.S.E.B. (Comm. ), 2016) (a) Human wants are infinite

(b) Resources are limited

(c) Scarcity problem gives birth to choice

(d) All of these

3. Which is a central problem of an economy ?

[(B.S.E.B., 2010, 11, 18 (Comm./Arts ) B.S.E.B. (Arts ), 2015;

B.S.E.B . (Comm .), 2016, 17; J.A.C., 2018] (a) Allocation of Resources

(b) Optimum Utilisation of Resources

(c) Economic Development

(d) All the above

4. To which factor, economic problem is basically related to :

(a) Choice

(c) Firm Selection

( B.S.E.B., 2019; J.A.C., 2019) (b) Consumer’s Selection (d) None of these

5. Which of the following is the salient feature of factors (or resources) ?

(a) These are limited as compared to wants

(b) These have alternative uses

(c) Both a and b

(d) None of the above

6. In the given figure the movement on the production possibility curve from point A to point B shows.......... : (C.B.S.E., 2019)

(a) Growth of all resources in the economy

(b) Underutilisation of resources

(c) Production of more units of Good X & Less units of Good Y (d) Production of more units of Good Y & Less units of Good X

7. The central problem of an economy is :

(a) What to produce ?

(b) How to produce ?

(c) How to distribute produced goods ?

(d) All the above

8. Which economy has a co-existence of private and public sectors ?

(a) Capitalist (b) Socialist

(c) Mixed (d) None of these

9. The main objective of a socialist economy is :

(a) Maximum production (c) Earning profit

(b) Economic freedom

(d) Maximum public welfare

(a) From left to right (c) From top to bottom

10. In which economy decisions are taken on the basis of price mechanism ?

[B.S.E.B., 2011, 2017] (a) Socialist (b) Capitalist

(c) Mixed (d) None of these

11. The slope of a production possibility curve falls : [J.A.C. (Comm.) , 2017] (b) From right to left (d) From bottom to top

12. Production possibility curve is : [B.S.E.B., 2012 (Arts )] (a) Concave to the axis (b) Convex to the axis (c) Parallel to the axis (d) Vertical to the axis

13. Mention the name of the curve which shows economic problem : [J.A.C., 2012, 19; B.S.E.B ., 2016, 17] (a) Production curve

(b) Demand curve

(c) Indifference curve

(d) Production possibility curve

14. On the basis of ownership of resources, economies are : (B.S.E.B., 2018)

(a) Central Planned Economy

(b) Market Economy

(c) Mixed Economy

(d) All the above

[Ans. 1. (c), 2. (d), 3. (d), 4. (a), 5. (c), 6. (c), 7. (d), 8. (c), 9. (d), 10. (b), 11.

(c), 12. (a), 13. (d), 14. (d)]

(B) Fill in the Blanks :

1. Economic problem is basically a problem of ................ .

2. Economic problem arises because wants exceeds ............. .

3. Production Possibility Curve slopes from ......... to ......... .

4. In ancient time the needs of human beings were ........ . (M.P. Board, 2018)

[Ans. 1. choice, 2. resources, 3. left, right, 4. infinite.]

(C) State True/False :

1. Economic problem is basically a problem of choice.

2. Scarcity problem gives birth to choice.

3. Resources are limited.

4. Capitalist economy has a co-existence of private and public sectors.

5. Production Possibility Curve is parallel to the axis. [Ans. 1. True, 2. True,

6. True, 4. False, 5. False.] (D) Match the following Column : ‘A’

7. Economic problem

8. Opportunity cost of a factor

9. Price Mechanism

10. Co-existence of public and private sectors

11. Socialist Economy

‘B’

(a) Capitalism

(b) Best alternative use (c) Mixed Economy

(d) Problem of choice

(e) Absence of competition [Ans. 1. (d), 2. (b), 3. (a), 4. (c), 5. (e).]

(E) Answer in One Word :

1. With which is economic problem related ?

2. In which economy price mechanism becomes operative ?

3. Which type of slope production possibility curve has ?

4. Which shape production possibility curve has towards origin ?

[Ans. 1. Problem of choice, 2. Capitalism, 3. Negative, 4. Concave.]

HOTS High Order Thinking Skills Questions

1. In what way an economic problem become a problem of choice ? (See : Box 1)

2. “Wants exceed demand.” Does it generate economic problem ? (See : Section 2.4)

3. Price mechanism solves the problems in capitalist society. How ? (See : Section 2.5.2)

4. Technology variations create shifting in production possibility curve. Why ? (See : Section 2.7.2)

5. Why does a production possibility curve become concave to the origin ? (See : Section 2.6)

6. When does PPC be a straight line ?

(See : Section 2.6.1)

7. How does shift arise in PPC ?

(See : Section 2.7)

VBQ Value Based Questions 1. Explain how scarcity and choice go together ? (See : Section 2.3)

2. How does the change in technique affect production possibility curve ? (See : Section 2.7.2)

MDQ Case Study Based on Evaluation & Multi-disciplinary Questions

1. Explain the problem of scarcity by applying the concept of PPC. (See : Section 2.6)

2. What is the slope of production possibility curve ? What does it signify ? (See : Section 2.6 Production Possibility Curve : Characteristics (ii))

3. Marginal opportunity cost on production possibility curve increases with increase in production. How ?

(See : Box 14)

NCERT CORNER

1. Discuss the central problems of an economy. Ans. See Section 2.5.

2. What do you mean by the production possibilities of an economy ? Ans. See Box 8.

3. What is a production possibility curve ? Ans. See Section 2.6.

4. Distinguish between a centrally planned economy and a market economy.

Ans. See Section 2.2.5.

❑

3

CONSUMER’S EQUILIBRIUM

(Utility Analysis and Indifference Curve Analysis) STUDY MATERIAL INCLUDED IN THE CHAPTER

3.1. Who is a Consumer ? 3.2. What is Consumer’s Equilibrium ? 3.3. Meaning of Utility 3.4. Is Utility Measurable ? Or Measurement of Utility :

Cardinal Vs. Ordinal 3.5. Concepts of Utility 3.6. Law of Diminishing Marginal Utility 3.7. Law of Equi-marginal Utility Or Consumer’s Equilibrium using Marginal Utility 3.8. Indifference Curve 3.9. Marginal Rate of Substitution 3.10. Budget Line or Price Line 3.11. Consumer’s Equilibrium in Indifference Curve Analysis 3.12. Comparison between Utility Analysis & Indifference Curve Analysis A Quick Review of the Chapter Questions High Order Thinking Skills (HOTS) Questions

Case Study Based on Evaluation & Multi-disciplinary Questions (MDQ) Value Based Questions (VBQ) NCERT Corner 3.1. Who is a Consumer ?

A consumer is an economic agent who uses goods and services for satisfaction of his/her wants. Consumer is a very broad word which includes all people, families and institutions, etc. Consumer behaviour refers to a process in which a consumer decides that in what way he should plan his expenditure on different goods and services, so as to maximise utility from limited income.

3.2. What is Consumer’s Equilibrium ?

Consumer’s equilibrium refers to the process in which consumer chooses or selects those goods and services from which he can attain maximum satisfaction or utility through his limited income.

At the point of consumer’s equilibrium, consumer attains maximum possible satisfaction with his limited resources which is the ultimate aim of the consumer. According to Samuelson, “The consumer is in equilibrium when he maximises his satisfaction given by his income and the market prices.”

With unlimited wants and limited factors or resources, the aim of a consumer is to derive or obtain maximum satisfaction from his expenditure. When he attains this objective, he is said to be in equilibrium. Thus, a consumer is in equilibrium when, he considers his selection as the best choice in present circumstances, and does not change his selection until present or prevalent conditions change. In other words, “A consumer is said to be in equilibrium, until he does not change his method of expenditure in prevalent conditions or present circumstances.” ,,

3.3. Meaning of Utility

Utility means ‘Want Satisfying Power of a Commodity’ or the capacity of a commodity to satisfy a particular want of consumer. Every commodity has some inherent want–satisfying capacity. Utility is a relative word. Although liquor is harmful for health, but has utility for the person or consumer using it. Desire to consume commodity gives rise to utility. In the words of Frazer, “Utility is simply desiredness.” Even immoral and anti-social acts are of utility to a particular person involved in it. Utility is a function of intensity of want. Greater the consumer’s intensity of consumption for a particular good, greater will be the utility obtained by the consumer with the consumption of that goods. As consumer continues to consume more units of a particular goods, his intensity of consumption for that goods decreases and at last consumer attains full satiety point.

3.3.1. Characteristics of Utility

(1) Utility is a psychological phenomenon. It depends upon the mental status of the consumer.

(2) Utility is subjective, which differs from person to person and place to place. Utility of a particular goods is not same for all consumers.

(3) Utility is a relative concept because it changes from time and place. Woollen clothes have greater utility in winter season and in high altitude areas but have no utility in summer.

(4)Utility is not affected by moral duties or principles. If a person derives utility from immoral acts, goods used in such acts will be useful for that person.

(5) Utility is related to ‘Expected Satisfaction’ and not from ‘Actual Realised Satisfaction’ because expected satisfaction depends upon intensity of consumption.

3.4. Is Utility Measurable ? Or Measurement of Utility : Cardinal Vs . Ordinal

Prof. Marshall presented ‘Cardinal Viewpoint’ and told utility to be measurable. According to this viewpoint, utility can be measured in terms of money. Basis for calculation of utility is the price paid for it. According to Marshall , utility can be assigned cardinal numbers, as 1, 2, 3, ...., etc. On

this basis, we can compare utilities of two goods, e.g., if a consumer pays ` 5 for goods A and `10 for goods B, then we can say that utility derived by the consumer from goods B is twice than that of goods A.

Prof. Hicks was not agreed with the cardinal measurement of utility. In his view, the utility (or satisfaction) is completely a psychological phenomenon which can not be expressed in quantity numbers. On the basis of high or low levels of satisfaction, only ordinal numbers (I, II, III ......) can be granted. Thus Prof. Hicks. presented the Ordinal Viewpoint of utility. 3.5. Concepts of Utility

Utility

Marginal Utility Total Utility 3.5.1. Marginal Utility

The word ‘Marginal’ means ‘One Additional’ . Additional utility derived from consumption of one additional unit of a commodity is called ‘Marginal Utility’ . In other words, “Increase in total utility by consuming one additional unit of a commodity is called marginal utility of that particular unit.”

(i) According to Boulding , “The marginal utility of any quantity of a commodity is the increase in total utility which results from a unit increase in consumption.”

(ii) According to Samuelson , “The term marginal utility refers to extra utility added by one extra last unit of goods.”

Marginal Utility can be measured in the following way : Marginal Utility = Total Utility_n – Total Utility_{n – 1}

\mathrm{Or} \mathrm{MU} _ {n \mathrm{th}} = \mathrm{TU} _ {n} - \mathrm{TU} _ {n - 1}

● Example of Marginal Utility

If utility obtained from the consumption of 10 units is 150 utils and from 11 units, it is 160 utils, then additional utility obtained by consuming 11th unit is 160 – 150 = 10 utils. This is called Marginal Utility of 11th unit.

According to above example,

MU_11th = TU₁₁ – TU₁₀

= 160 – 150 = 10 utils

● Marginal Utility : Tabular Explanation Marginal utility of additional units continue to decrease. If all units of goods are similar or homogenous, consumer will use that commodity till the point of perfect saturation, where ‘marginal utility becomes equal to zero’ . This concept can be presented by the following hypothetical table :

Table 1 : Marginal Utility

Units of Goods X Marginal Utility 140

2 30 Decreasing but 3 20 Positive Utility 410

50 Saturation Point or

Zero Marginal Utility

6 – 10 Decreasing and

7 – 20 Negative Utility

It is clear from table 1 that marginal utility obtained from consumption of one additional unit of goods-X decreases. When a consumer consumes 5th unit of goodsX, he does not obtain any utility because a consumer gets saturated at this point. This is the last point of his consumption. If a consumer continuoes the consumption even after this point, he will get negative utility or disutility. In this way, there are three forms of marginal utility :

(i) Positive Marginal Utility,

(ii) Zero Marginal Utility (Perfect Saturation Point),

(iii) Negative Marginal Utility.

● Diagrammatic Representation

In Fig. 1, MU line

represents marginal

utility. AB part of

the MU line falls

from left to right,

but is positive. Point

B represents point
of perfect saturation
where marginal
utility is zero. Part
BC has been shown
with a broken line Fig . 1
which indicates negative utility or disutility.

3.5.2. Total Utility

Utility obtained by the consumer from all units of consumption is called ‘Total Utility’, i.e., ‘‘Total utility is the addition of marginal utilities attained from various units of consumptions.’’

TU = ΣMU

Or ‘‘Total Utility is the addition of marginal utilities.’’

● Example of Total Utility

Marginal utility and total utility obtained by consuming different units of consumer are shown in table 2 :

Table 2 : Total Utility Units of Marginal Goods-X Utility (MU)

1 40
2 30
3 20
4 10
5 0
6 - 10
7 - 20
Total Utility [TU = ΣMU] 40 40 + 30 = 70 70 + 20 = 90
90 + 10 = 100
100 + 0 = 100
100 - 10 = 90
90 - 20 = 70

In table 2, TU is rising till 5th unit where marginal utility is positive. Total utility is maximum at fifth unit because it is the point of perfect saturation where marginal utility is zero. Total utility decreases at sixth and seventh units because consumer gets disutility or negative marginal utility at these points.

3.5.3. Relationship between Marginal Utility and Total Utility

Relationship between marginal utility and total utility can be understood from Fig. 2. In Fig. 2, ADEF curve represents total utility and ABC is line of marginal utility.

Following conclusions can be drawn from these curves :

(1) Total utility increases till marginal utility is positive. (Point A to point E). (2) Total utility is maximum when marginal utility is zero. (Point E and point B). Point E is uppermost point and at point B, consumer is perfectly saturated due to zero utility. (Point B is called point of saturation).

(3) Total utility starts decreasing when marginal utility is negative. (Point E to G).

● Diagrammatic Representation

Fig . 2

Marginal Utility and Total Utility

Marginal utility and total utility both have an important relationship. Points showing relation between Marginal Utility and Total Utility are :

(i) Both total utility and marginal utility is positive in the beginning.

(ii) As more units of commodity are used, total utility increases with decreasing rate. Total utility increases so long as marginal utility is positive.

(iii) Marginal utility decreases continuously, becomes zero at a point and then becomes negative.

(iv) Total utility is maximum when marginal utility is zero. This is called point of saturation.

(v) Total utility starts decreasing when marginal utility becomes negative. Box 1

3.6. Law of Diminishing Marginal Utility

Law of Diminishing Marginal Utility, also called law of satisfy, is an important law of consumption which is universally accepted. It was first described by Austrian economist, H.H. Gossen and is named after him as Gossen’s First Law.

Law of Diminishing Marginal Utility is a Fundamental and Universal Law According to this law, as we go on utilising standard additional units of a commodity continuously, marginal utility obtained from use of every additional unit decreases. It occurs or happens in all goods and services. Therefore, this law is called Fundamental and Universal

Law of Satisfaction.

According to this law, as the stock of goods increases with people, marginal utility obtained from additional units of that commodity decreases after a limit.

Box 2

3.6.1 Definition

According to Marshall, ‘‘The additional benefit which a person derives from a given stock of a thing diminishes with every increase in the stock that he already has.’

3.6.2. Necessary Conditions for the Application of Law of Diminishing Utility Or Assumptions of the Law

(1) Consumption of goods should be continuous. In case of time gap, this law is not applicable.

(2) Size of consumption units should be proper. Small size of unit increases marginal utility.

(3) All units of consumption should be homogeneous. In case of heterogeneity of units, law becomes inapplicable.

(4) Price of available substitutes of goods should be stable.

(5) Income and consumption propensity of consumer should remain constant.

(6) No change should take place in fashion, nature and interests of consumer.

(7) Only one necessity or want of a consumer can be studied at any particular time. In case of collective wants, this law is not applicable.

3.6.3. Diagrammatic Representation of Law of Diminishing Marginal Utility

Table 3

Units of Ice-Cream Marginal Utility (in utils) 120

216

310

4 4

5 0 (Point of Satiety) 6 - 6

In the diagram, units of ice-cream are shown along the X-axis and MU along the Y-axis. MU from each successive ice-cream is represented by points A, B, C, D and E. As seen, the rectangles (showing each level of satisfaction) become smaller and smaller with increase in consumption of ice-creams. MU falls from 20 to 16 and then to 10 utils, when consumption is

Fig. 3

increased from 1 ^ { \mathrm { s t } } to 2 ^ { \mathrm { n d } } and then to 3 ^ { \mathrm { r d } } ice-cream. 5 ^ { \mathrm { t h } } icecream has no utility (MU = 0) and this is known as the ‘Point of satiety’. When 6 ^ { \mathrm { t h } } icecream is consumed, MU becomes negative. MU curve slopes downwards which shows that MU of successive units is falling.

3.7. Law of Equi-marginal Utility

Or

Consumer’s Equilibrium Using Marginal Utility

‘Law of Equi-marginal Utility’ explains consumer’s equilibrium in utility analysis. This law is also called Gossen’s Second Law. Consumer is rational and his aim is to obtain maximum satisfaction by distributing his income in different fields of consumption. Basis of this law is the ‘Law of Substitution’ according to which a consumer replaces less useful goods by more useful goods. This substitution process continue until all consumption items have equal marginal utility. Consumer attains equilibrium when he does not change his consumption.

Statement of the Law :

‘Law of Equi-marginal Utility’ states that the consumer will distribute his money income between the various goods in such a way that the utility derived from the last rupee spent on each goods is equal. In other words, consumer is in an equilibrium position, when marginal utility of money expenditure on each goods is the same.

According to Lipsey, ‘‘The household maximising its utility will so allocate its expenditure between commodities that the last unit spent on each is equal.’’

3.7.1. Determination of Consumer’s Equilibrium using Marginal Utility Analysis

Consumer’s Equilibrium ↓

Two Situations ↓

↓↓ (A) Single Commodity Consumption

(B) Two or More Commodity Consumption

Box 3

(A) Consumer’s Equilibrium in case of Single Commodity Consumption

When a consumer buys a commodity, he spents money on it and attains some utility by its consumption. According to the ‘Law of Diminishing Marginal Satisfaction’, utility obtained from consumption of every additional unit of that commodity decreases. On the other hand, as per the law, price paid in lieu of those units remains constant or utility of money remains constant. In such case, a consumer will continue consumption upto a limit where marginal utility obtained from the last unit of that commodity becomes equal to the utility of money paid as price of that commodity. By making this adjustment in his expenditure, a consumer maximises satisfaction and he obtains the state of equilibrium.

In short, Consumer’s Equilibrium

\mathrm{MU} _ {x} = \mathrm{MU} _ {m}

i.e., Marginal Utility of Goods-X

= Utility Value of Money Price of Goods-X.

It is clear from above analysis that :

(i) A consumer should buy that quantity of commodity for which marginal utility of goods in the form of money is equal to price of goods. This will be the situation of consumer’s equilibrium.

(ii) If consumer buys one more unit after equilibrium point, marginal utility of the one additional unit of goods will decrease as per the law of Diminishing Marginal Utility. Thus, obtained utility will be less than the utility of money sacrificed in the form of price of goods. Hence, new total utility will be less than the point of maximum utility.

(iii) On the contrary, if a consumer buys one unit less than his equilibrium point price paid for the goods will have higher marginal utility than the marginal utility of money. As a result, total utility obtained by consumer will be less than the maximum utility.

●Explanation with Illustration

Units of Utility from Consumption X-goods of X-goods \left( \mathrm { M U _ { \mathrm { ~ x ~ } } } \right)

Table 4

Utility sacrificed in the form of price of the goods (P _x ) Excess of obtained utility from utility sacrificed

1 2
1 40
2 35
3 30
4 25
5 20
6 15 3
20 20 20 20 20 20 4 (2 - 3) 40 - 20 = 20 35 - 20 = 15 30 - 20 = 10 25 - 20
= 5 20 - 20 = 0 15 - 20 = - 5

Suppose price of X-goods is ` 1 per unit. Marginal Utility of one rupee is 20 utils, which remains constant. It is clear from the table that when a consumer buys 5 units of goods-X, then marginal utility obtained by him is equal to the utility sacrificed as price. In this case, consumer will be in equilibrium and

the total utility will be maximum. In other words, consumer will be in equilibrium, where :

[MU_x ] = [Utility of money paid as price of goods-X]

or \mathbf { M } \mathbf { U } _ { x } = \mathbf { M } \mathbf { U } _ { y }

If consumer buys one more unit of goods-X, he will

have to sacrifice 20 units of utility although he is getting utility equal to 15 units only. Thus, consumer’s utility will now be less than total maximum utility. If a consumer buys less than 5 units, consumer’s utility will also be less than total maximum utility. It means that, at point of equilibrium, marginal utility of goods will be equal to the price the consumer is ready to pay for the commodity. ●Explanation with Diagram

In Fig. 4, E is the point of consumer’s equilibrium. In this case, a consumer consumes ON units of commodity. If he increases his consumption to OQ, DQ utility is obtained by additional NQ quantity of goods. Marginal utility of expenditure remains at previous level CQ. Thus, on consumption of NQ additional units, total utility equal to ECD will be lost.

Fig . 4

If consumption of commodity is limited to OM quantity of goods, consumer will suffer loss equal to ABE. In other words, consumer will postpone his consumption to the point where price of goods becomes equal to marginal utility.

(B) Consumer’s Equilibrium in case of Two or More Commodity Consumption

In real life, a consumer does not spend his whole income on only one goods, but he spends on two or more goods so as to obtain maximum utility from his expenditure.

(i) Case of Same Prices of Various Consumption Goods :

In this case also, consumer will be in equilibrium at the point, where the marginal utilities of the last units of each consumption should be equal to marginal utility of money. When a consumer spends his income on more than two goods, he does comparative study of marginal utilities obtained from different goods. He spends his income on that commodity from which he gets maximum marginal utility, but as per law of diminishing marginal utility if he consumes more of one commodity, marginal utility of that commodity decreases. So a consumer will shift his consumption to other commodities. In that way, consumer will shift his expenditure from goods of less marginal utility to commodity giving higher marginal utility. This substitution series will continue to the limit, till expenditure done on both the goods becomes equal to marginal utility obtained from the last unit of rupee spent. Thus, the ‘Law of Equi-marginal Utility’ states that other things being equal, a consumer gets maximum total utility from spending his given income, when he allocates his expenditure to the purchase of different goods in such a way that the marginal utilities derived from the last unit of money spent on each item tends to be equal. In case of similar prices of consumption goods, a consumer will be in equilibrium, when :

$\mathrm{MU} x \mathrm{MU} y \ldots \mathrm{MU}_{m \mathrm{P} x \mathrm{P} y}$ Marginal Utility of Goods-$\mathrm{X}_{\mathrm{Or}, \text{ Price of Goods-X}}$

MU_x = MU_y = ...... = MU_m

where \mathbf { M U } _ { x } and \mathrm { M U } _ { y } are the marginal utility of goods X and Y respectively, \mathrm { M U } _ { m } is the marginal utility of a unit of expenditure.

(ii) Case of Different Prices of Various Consumption Goods :

In case of different prices of various consumption goods, a consumer will be in equilibrium, when :

Introductory Micro Economics

Marginal Utility of Goods-Y

Price of Goods-Y

= Marginal Utility of Money (Constant) In this way, ratio of marginal utility obtained from a goods to its price should be equal to the ratio of utility obtained from other goods and its price.

Explanation with Illustration

Explanation of the law can be understood from table 5(A) and 5(B):

Table 5(A)

Units of Money MU $_{x}$ MU $_{y}$ 1 40 48 2 36 42 3 32 36 4 28 30 5 24 24 6 20 18 7 16 12

If price of goods-X is ` 2 and price of goodsY is `3 and \mathrm { M U } _ { m } = 1 4 , then marginal utility obtained from money can be calculated.

Table 5(B) :

Marginal Utility obtained from Money

$\mathrm{MU} \times \mathrm{MU} \times \mathrm{Unit}_{\mathrm{P} \times \mathrm{P} \times \mathrm{Y}}$ $140/2 = 2048/3 = 16$ $236/2 = 1842/3 = 14$ $332/2 = 1636/3 = 12$ $428/2 = 1430/3 = 10$ $524/2 = 1224/3 = 8$ $620/2 = 1018/3 = 6$ $716/2 = 812/3 = 4$

It is clear from table 5(B) that for fourth unit of goods-X and second unit of goods-Y, marginal utilities of money is equal.

$^{MU}$ x $^{MU}$ y $^{MU}_{m}$ 14(Constant) $_{P}$ x $^{P}$ y

Explanation with Diagram

Table 5(B) has been shown in Fig. 5. It is clear from Fig. 5 that marginal utility of money is 14, then in case of equilibrium consumer will purchase 4 units of goods-X (see point B) and 2 units of goods-Y (see point A) because at point A and B;

\mathrm{MU} x \mathrm{MU} y \mathrm{MU} _ {m} 1 4 \text {Units} _ {\mathrm{P} x \mathrm{P} y}

If marginal utility of money had been 12 units, then consumer will buy respectively 5 units and 3 units of commodity X and Y at point D and C. MU x MU ^ y \mathrm { M U } _ { m } 1 2 _ { \mathrm { P } \ x \mathrm { ~ P } y }

Fig. 5
It is clear that ratio of utility of goods-X to its price and the ratio of utility of goods-Y to its price are equal. Therefore, Law of Equi-marginal Utility is also called Law of Proportionality.

Conditions of Consumer’s Equilibrium in Marginal Utility Analysis

1. For all the goods purchased by the consumer the marginal utilities of money of one unit (i.e . one rupee) should be equal.

\mathrm{MU} _ {x} = \mathrm{MU} _ {y}

\mathrm{P} _ {x} \mathrm{P} _ {y}

2. Marginal utility of money is constant and in the state of equilibrium it becomes equal to marginal utilities of one unit.

\begin{array}{l} \mathrm{MU} _ {x} = \mathrm{MU} _ {y} = \mathrm{MU} _ {m} \mathrm{P} _ {x} \mathrm{P} _ {y} \\ \text {Box 4} \\ \mathrm{MU} \end{array}

x MU 3.7.2. What happen when is not equal to y _ { \textsf { P } x { \mathsf { P y } } }

In this situation two disequilibrium situations arise : \mathrm { M U } _ { y }

(A) When ^MU x > _ { \mathsf { P } y } : In this case, the consumer_{P x}

is getting more marginal utility per rupee in case of good X as compared to Y. Therefore, he will buy more of X and less of Y. This will lead fall in \mathbf { M U } _ { x } and rise in \mathbf { M U } _ { \mathrm { Y } } . The consumer will continue to buy more of X till

\mathrm{MU} _ {x} = \mathrm{MU} _ {y}

\mathrm{P} _ {x} \mathrm{P} _ {y}

\mathrm{MU} _ {x} \mathrm{MU} _ {y}

(B) When { \mathsf { P } } x \ ^ { < } { \mathsf { P } } y : The consumer is getting

more marginal utility per rupee in case of good Y as compared to X. Therefore, he will buy more of Y and less of X. This will lead fall in MU_y and rise in \mathbf { M U } _ { x } . The consumer will continue to buy more of Y till

\mathrm{MU} _ {x} = \mathrm{MU} _ {y. \mathrm{P} x \mathrm{P} y}

3.8. Indifference Curve

Hicks and Allen presented ‘Indifference Curve Analysis’ as an alternative viewpoint of Marshall’s ‘Utility Analysis’.

Indifference curve analysis presents an ‘Ordinal Viewpoint’ in which the behaviour of consumer is studied on the basis of ‘Ordinal Preferences’. Ordinal approach suggests that utility can not be measured in terms of units. It can only be ranked or compared by giving order numbers (i.e., I, II, III .........).

Indifference curve explains the consumer’s behaviour related with the combination of two goods and this consumer’s behaviour is explained with the help of ‘Indifference Schedule’ or Indifference Set. Various combinations of two goods giving equal satisfaction to the consumer become the component of ‘Indifference Schedule’. When indifference schedule is represented on a graph paper, we get indifference curve.

● Definitions of Indifference Curve :

(i) In the words of Watson, ‘‘An indifference schedule is the list of combinations of two commodities, the list being so arranged that a consumer is indifferent to the combinations, preferring more of any other.’’

(ii) According to A.L. Meyers, ‘‘An indifference schedule may be defined as a schedule of various combinations of two goods that will be equally

satisfactory to the individual concerned. If we depict this in the form of a curve, we get an indifference curve.

Thus, in micro-economics theory an indifference curve is a graph showing different bundle of goods between which a consumer is indifferent. That is, at each point on the curve, the consumer has no preference for any bundle over another. One consumer equivalently refers to each point on the indifference curve as rendering the same level of utility (satisfactions) for the consumer.

Table 6 : Indifference Schedule Combination Goods X Goods Y A1 20 B2 15 C3 11 D4 8 E5 6 F6 5

Fig. 7 shown in Fig. 6) if this indifference schedule is presented in a graph.

In Fig. 6, IC is an indifference curve which is the locus of such points of various combinations of two goods which give the equal satisfaction to the consumer.

3.8.1. Indifference Map

One indifference curve represents one particular level of satisfaction. A group of various indifference curves showing different levels of satisfaction is called indifference map.

Fig. 7 shows four different

^{indifference curves IC 1, IC2, IC3} and IC . Indifference curve IC shows the lowest \mathrm { I C } _ { 4 } \mathrm { I C } _ { 1 } level of satisfaction and \mathrm { I C } _ { 4 } shows the highest level of satisfaction. All

Table 6 expresses the indifference schedule which shows the six combinations of two goods available to the consumer. All combinations A, B, C, D, E or F give the equal satisfaction to the consumer.

We get an indifference curve (as Fig. 6. Indifference Curve the four different indifference curves show different level of satisfaction. 3.8.2. Assumptions of Indifference Curve Analysis The indifference curve analysis is based on the following assumptions :

1. Rationality : The consumer is assumed to be rational. He aims at maximizing his benefits from consumption, given his income and prices of the goods.

2. Ordinality : Utility is expected satisfaction that a consumer gets from given market-basket. In indifference curve analysis, utility is an ordinal concept. Consumer can order or rank the subjective utilities drived from the commodities.

Indifference means that a consumer considers are alternative exactly as good as the other.

3. Diminishing Marginal Rate of Substitution : Scale of preferences are ranked in terms of indifference curves. Indifference curve are downward sloping convex to the origin curves. The slope of indifference curve is called Marginal Rate of Substitution (MRS) of X for Y. MRS is defined as the amount of good Y the consumer is willing to give up to consume an additional unit of good X, while leaving total utility unchanged. An important assumption is that the MRS of X for Y, decreases with greater quantities of good X, i.e. the greater the quantities of X, the MRS willing the consumer will be to give up Y in exchange for X. This relationship is known as Law of Diminishing Marginal Rate of Substitution.

4. Weak Ordering : Consumer shows weak ordering in his choice. It means that consumer can be indifferent in selection between two combinations of goods but he can not express the superiority of one combination over the above.

3.8.3. Characteristics Or Properties of Indifference Curve

1. Indifference curve slopes downward from left to right (i.e., it has a negative slope).

2. Higher indifference curve shows higher level of satisfaction and vice versa .

30

Introductory Micro Economics

3. Two indifference curves of the same consumer never cut each other as different ICs show different levels of satisfaction.

4. Indifference curve never touches any of the axis.

5. Indifference curve is convex to the origin because \mathbf { M R S } _ { x y } is diminishing.

6. Indifference curves need not to be parallel. Indifference curves of perfect substitutes are parallel.

7. The curvature of the indifference curve shows the degree of substitute and complementary nature between two goods.

Monotonic Preference

A consumer’s preferences are monotonic if and only if between any two bundles, the consumer prefers the bundle which has more of at least one of the goods and no less of the other good as compared to other bundle. Example of Monotonic Preference

(i) A co nsumer wi th monotonic preference will prefer the bundle (2, 3) to bundles (2, 2), (1, 3) and (1, 2) bundles.

(ii) A con sumer wi th monotonic preference will prefer the bundle (2, 2) to (1, 1), (2, 1) and (1, 2)

bundles.

Fig . 8

Then, monotonicity of preferences implies that (fig.) point M (which is above the indifference curve) represent a bundle which is prefered to the bundle on the indifference curve.

Box 5

Preference. It means that consumer has welldefined preferences to the set of all possible bundles, on the basis of taste and preference.

Indifference. It means that consumer considers one alternative exactly as good as the other.

MRS. It is defined as the amount of good Y the consumer is willing to give up to consume an additional unit of good X while leaving to utility unchanged.

Monotonic Preference. A consumer’s preferences are monotonic if and only if between any two bundles, the consumer prefers the bundle which has more of at least one of the good and no less of the other good as compared to the other bundle.

Indiff ere nce Curve : It shows different combinations of goods that gives the same level of satisfactions or utility to the consumer.

3.9. Marginal Rate of Substitution

The slope of indifference curve shows Marginal Rate of Substitution. Marginal Rate of Substitution refers to the rate at which the commodities can be substituted with each other, so that total satisfaction of the consumer remains the same.

According to Leftwitch, “The marginal rate of substitution of X for Y (MRSxy) is defined as the amount of Y the Consumer is just willing to give up to get an additional unit of X.”

For maintaining the equal level of satisfaction on the various combinations in an indifference curve, consumer has to reduce the quantity of other goods when he increases the quantity of a goods. For getting one additional unit of a goods, the quantity of other goods left is called the marginal rate of substitution.

Table 7 : MRS Table

Combinations Goods X Goods Y MRS _xy ( Y : X) A 1 20 —

B 2 15 5 : 1
C 3 11 4 : 1
D 4 8 3 : 1
E 5 6 2 : 1
F 6 5 1 : 1

In above table each combination give equal satisfaction. In every next combination, the \mathbf { M R S } _ { x y } is diminishing. The Marginal Rate of Substitution shows the slope of indifference curve. In Fig. 9

Fig. 9 MRS _ { x y } = \mathbf { A P } PB Or MRS \boldsymbol { \mathbf { \rho } } _ { x y } = - \boldsymbol { \mathbf { \rho } } \mathrm { Y } X
For an indifference curve MRS is always negative. MRS tends to decline which makes IC Convex to the Origin.
Why Should MRS be Diminishing in Indifference Curve ?

Marginal Rate of Substitution (MRS) is declining in indifference curve because as consumer goes on increasing good X, the intensity of desire of obtaining one additional unit of X starts declining and the intensity of obtaining other good Y starts increasing. This is the reason why consumer becomes ready to sacrifice lesser amount of

good Y for any additional unit of X. Consequently MRS becomes diminishing. Thus,

Aa > Bb > Cc > Dd > Ee > Ff Due to this declining nature of MRS, indifference curve becomes convex to the origin.

Box 6

3.10. Budget Line or Price Line

The purchase made by the consumer depends on consumer’s income and the prices of goods which he consumes. Thus, income level and prices of goods determine the consumption limits for the consumer.

A budget line is a line which shows all possible combinations of two goods that a consumer can buy with his given income and prices of commodities.

The equation of budget line is

\mathrm{P} _ {x}. \mathrm{X} + \mathrm{Py}. \mathrm{Y} = \mathrm{M}

Where, M = Total Income of the consumer P_x = Price per unit of good X

X = Quantity of good X

P_y = Price per unit of good Y

Y = Quantity of good Y

● Example

Suppose consumer has ` 500 and the prices of the goods X and Y are ` 50 and ` 100 per unit respectively. Table 8 : Alternative Purchase

R0 5

P2 4

Q4 3

K6 2

T8 1

S10 0

Combinations (or Bundles)

Consumption Units _Combinations

Z → Unattainable Combinations with given

Budget Set

Budget set of a consumer means the collection of all combination of goods which a consumer can buy with his income and given prices of the commodities.

Box 7

income and prices.

Budget Constraint The budget constraint shows that a consumer can choose any bundle as long as it costs less or equal to the income consumer has, given income and prices of goods.

In equation from it can be written as :

\mathrm{P} _ {x}. \mathrm{X} + \mathrm{P} _ {y}. \mathrm{Y} \leq \mathrm{M}

Box 8

Table 8 tells that the consumer can purchase combinations R, P, Q, K, T or S with his income and given prices of goods X and Y. R and S are two extreme combinations which consumer can buy if entire income is spent on goods Y and goods X respectively. Combination Z is non-attainable to the consumer with the given income and prices of goods.

Thus, price line or budget line is the locus of such combinations of two goods which a consumer can buy with available income and prices of goods.

Slope of Budget or Price Line
= Tan ∠RSX
= Tan (180° - ∠RSX)

OR = - Tan ∠RSX = -OS

Attainable & Unattainable Combinations
Prices of two goods and consumer's income make consumer's budget line which determines the consumption limits of the consumer. All combination of goods on or within this ceiling line are called attainable combinations while the combinations outside this line are called unattainable combination (See : Point Z in Fig. 10)

Box 9
= - [Negative sign shows negative slope of price line]
Income/P y where; P_x = Price of x, Income/P x
Fig. 10
P_y = Price of y Slope of Budget or P_x Price Line = -P_y

Thus, slope of the price line shows the ratio of prices of the goods. Slope of the price line will change only if the price of atleast one goods gets changed.

3.11. Consumer’s Equilibrium in Indifference Curve Analysis

A consumer
obtains the state of
equilibrium when he
becomes successful in
maximising his satis

faction by purchasing goods with his limited income and given prices of goods. The price line of the consumer is determined by his income and prices of the_{Fig. 12goods he consumes.}

With this given price line, a consumer tries to obtain the maximum possible indifference curve. In indifference curve analysis, there are two conditions of consumer’s equilibrium :

32

Introductory Micro Economics

1. Price line

should be tangent to indifference curve i.e.,

Consumer's Equilibrium Point

at the point of equili brium, the marginal rate

V

of substitution X and Y

y

( \mathrm { M R S } _ { x y } ) ) should be equal to theratio of prices of

goods X and goods Y.

Fig. 11

In Fig. 11, at equilibrium point E Slope of Price Line = Slope of Indiffference Curve Or^{P x} = MRS_{xy P y}

2. For stable equilibrium, indifference curve should be convex to the origin at the point of equilibrium.

i.e. , \mathbf { M R S } _ { x y } should be diminishing at the point of equilibrium.

In Fig. 12, at point K, first condition is getting fulfilled but this equilibrium is not stable because at point K, the \mathbf { M R S } _ { x y } is increasing. In Fig. 12, point E is a point of final equilibrium where \mathbf { M R S } _ { x y } is diminishing.

3.12. Comparison between Utility Analysis & Indifference Curve Analysis

Utility Analysis

1. Utility is cardinal concept.

2. Explains diminishing marginal utility.

3. Consumer’s equilibrium condition : (For two goods)

\mathbf {M U} _ {x} = \mathbf {M U} ^ {y}

\mathrm{P} _ {x \mathrm{P} y}

Indifference Curve Analysis

1. Utility is ordinal concept.

2. Explains diminishing marginal rate of substitution.

3. Consumer’s equilibrium conditions :

(i) Slope of indifference curve = Slope of budget line

(ii) At point of equilibrium, indifference curve should be convex to the origin.

A QUICK REVIEW OF THE CHAPTER

Consumer : Consumer is an economic agent in Economics who satisfies his wants by the process of consumption. Consumer’s Behaviour : Consumer’s behaviour refers to a process in which a consumer decides that in what way he should plan his expenditure on different goods and services, so as to maximise utility from limited income. Consumer’s Equilibrium : A consumer is in equilibrium when, given his income and market prices, he plans his expenditure (on different goods and services) in such a manner that he maximises his total satisfaction. Utility : Utility means want–satisfying power of a commodity or power of a commodity to satisfy wants is called utility.

Marginal Utility : Marginal utility is the extra utility obtained by consuming one extra unit of consumption. Marginal utility may be measured as the difference between the utility of total units of stock consumption of a given commodity minus that of consuming one unit less in the stock considered.

\mathrm{MU} _ {n} = \mathrm{TU} _ {n} - \mathrm{TU} _ {n - 1}

Total Utility : Total utility is the sum of marginal utilities obtained from different units of consumption. TU = (MU)

Relationship between Total Utility and Marginal Utility

(i) When marginal utility obtained from consumption of goods is positive, total utility increases. (ii) When marginal utility is zero, total utility is maximum.

(iii) When marginal utility is negative, total utility decreases.

Law of Diminishing Marginal Utility : According to this law,‘‘Other things being equal, as the quantity of commodity consumed or acquired by the consumer increases, the marginal utility of the commodity tends to diminish.’’

Law of Equi-marginal Utility : The Law states that,‘‘Other things being equal, a consumer gets maximum total utility from spending his given income, when he allocates his expenditure to the purchase of different goods in such a way that the marginal utilities derived from the last unit of money spent on each item of expenditure tends to be equal.’’

$^{MU}$ x $^{MU}$ y .... MU (Constant) P x P m y

Consumer’s Equilibrium for Single Commodity : Consumer is in equilibrium when per rupee

satisfaction^{MU x} becomes equal to marginal utility of money i.e., _{P x} MU_{x MU m P x}

Consumer’s Equilibrium for Many Commodities : A consumer is in equilibrium when per rupee satisfaction of every goods becomes equal to

marginal utility of money. as, MU MU 12 PP P P { \mathrm { M U } } _ { 3 \dots } { \mathrm { M U } } _ { n { \mathrm { M U } } m } 123 n

Indifference Curve : It is the locus of various points showing combination of two goods which give equal satisfaction to the consumer.

Indifference Map : It is a group of various indifference curves of a consumer which shows different levels of satisfaction.

Marginal Rate of Substitution : The units of Y which a consumer leaves for getting one additional unit of goods is known as \mathbf { M R S } _ { x y }

\Delta^ {\mathrm{Y}} \mathrm{MRS} _ {x y} = - \Delta \mathrm{X}

Consumer’s equilibrium conditions in Indifference curve analysis :

(i) Indifference curve should touch price line.

(ii) At point of touch, indifference curve is convex to the origin.

QUESTIONS Ultra Short Answer Type Questions

1. What is meant by utility ? ( U.S.E.B., 2014; J.A.C., 2019)

2. What is marginal rate of substitution ? (U.S.E.B., 2014)

3. What do you understand by Budget set ? (Raj. Board, 2016)

4. Write down the equation of Budget line. (U.S.E.B., 2016)

5. What is marginal utility ?

(J.A.C. , 2014, 16, 17; B.S.E.B., 2019)

6. What is meant by consumer’s budget constraint ? (Raj. Board, 2017)

7. Draw a graph of Budget Line. (J.A.C., 2019)

8. Does total utility always increase ?

9. What is the necessary condition for consumer’s equilibrium under Indifference Curve Analysis ?

Very Short Answer Type Questions

1. What is total utility ?

2. What is the relationship between marginal utility and total utility ? (B.S.E.B., 2018) Or

3. Explain the Law of Diminishing Marginal Utility. [C.B.S.E., 2010, 11, 13, 15, 16; J.A.C. , 2012, 14, 15, 16, 18; MP Board, 2019]

Show with diagram that TU is maximum when MU is zero. (USEB, 2017)

3. What is saturation point ?

4. What is the ‘Law of Diminishing Marginal Utility’ ? [C.B.S.E., 2010; B.S.E.B. (Comm. ), 2017]

5. What is indifference curve ? Or Write definition of indifference curve and show it with a figure. (Raj. Board , 2013)

6. What do you mean by indifference table ? (C.B.S.E. , 2010)

7. What is indifference map ? (C.B.S.E., 2010; U.S.E.B., 2016)

8. Why is budget line a straight line ? (CBSE, 2017)

9. What is the meaning of budget line ?

(C.B.S.E., 2011, 13; J.A.C ., 2011; MP Board, 2019; Raj. Board, 2013;

14. What is marginal utility ?

Short Answer Type Questions

10. Why is indifference curve convex ? Explain. (CBSE, 2017)

11. What is marginal rate of substitution ?

(Raj. Board, 2015, 17)

12. What is the meaning of consumer’s equilibrium? (J.A.C. , 2011; U.S.E.B. , 2013, 15 ) Or

Define Consumer’s Equilibrium. (MP Board, 2019)

13. Draw a diagram showing optimum combination of consumer. (Raj. Board , 2015) [B.S.E.B. , 2016] (MP Board, 2019)

14. Explain the meaning of Consumer’s Equilibrium. [J.A.C. (Arts ), 2016, 17]

15. Mention the meaning and characteristics of utility. (U.S.E.B. , 2012, 19)

16. What do you mean by Consumer’s Equilibrium ? State its assumptions. (B.S.E.B., 2018)

17. Mention the relation between Marginal and Total Utility. (J.A.C. , 2013) Or

Distinguish between marginal utility and total utility. [B.S.E.B. , 2011 (Arts )]

6. What is meant by Consumer’s Equilibrium ? Give its assumptions. [J.A.C.

(Arts) , 2017]

7. Explain the law of equi-margnial utility diagrammatically. (U.S.E.B. , 2011)

8. Explain Consumer’s Equilibrium in case of Two or More Commodities with the help of a Utility Schedule. (C.B.S.E ., 2011)

9. What is indifference curve ? Why indifference curve falls from left to right ? [C.B.S.E., 2012, 17]

10. Define budget line. When does it shift to right ? (C.B.S.E., 2012)

11. Mention the conditions of consumer’s equilibrium in indifference curve analysis.

12. Given the market price of a good, how does a consumer decide as to how many units of that goods to buy ? Explain. (C.B.S.E., 2011,12, 18)

13. What do you mean by marginal utility and total utility ? (B.S.E.B., 2010)

14. A consumer buys two goods X & Y and is in equilibrium. Price of X falls. Explain consumer’s reaction with the help of utility analysis. (C.B.S.E., 2012)

15. What is Budget set ? How does a change in budget set appears ? (C.B.S.E., 2012)

16. Discuss price utility. (B.S.E.B., 2012)

17. What is Utility ? Explain three characteristics of utility. (C.B.S.E., 2018)

18. What is Indifference Curve ? [B.S.E.B. (Comm. ), 2015]

19. What is Law of Equi-marginal Utility ?

20. Show that price and demand of a commodity are inversely related. Use utility analysis. (C.B.S.E. , 2015)

21. Explain the optimum choice of a consumer with help of a diagram. (Raj. Board, 2016)

22. A consumer consumes only two goods X and Y. Marginal utilities of X and Y are 3 and 4 respectively. Prices of X and Y are ` 4 per unit. Is consumer in equilibrium ? What will be further reaction of the consumer ? Give reasons. (C.B.S.E., 2016)

23. Complete the following table : (USEB, 2017) Units 1

TU (in units) 50

MU (in units) 50

2 3 4 5 90 — 140 150 — 30 — — (Ans. TU = 50, MU = 40, 20, 10)

24. Explain the properties of Indifference curve. (USEB, 2017) Or

State the characteristics of indifference curves. (Any three ) (MP Board, 2019)

25. Explain the distinction between budget set and budget line. (MP Board, 2019)

Long Answer Type Questions

1. Explain the relationship between Marginal Utility and Total Utility with the help of a Schedule and Diagram. (C.B.S.E., 2019) 2. Explain the Law of Diminishing Marginal Utility. Discuss the importance and limitations of this law.

(U.S.E.B. , 2010; B.S.E.B. (Comm. ) 2012, 15) 3. Explain the Law of Equimarginal Utility.

(B.S.E.B., 2010, 18)

Or

A consumer consumes two goods. Explain the conditions of consumer’s equilibrium with the help of utility analysis.

( C.B.S.E., 2011) 4. What do you understand by Consumer’s Equilibrium ? Give assumptions and conditions of Consumer’s Equilibrium.

[ C.B.S.E., 2010; B.S.E.B., 2012 (Arts ); J.A.C., 2013,15] 5. Explain the meaning of Consumer’s Equilibrium with the help of a Table and Diagram. (C.B.S.E. , 2012) 6. What is indifference curve ? Explain the consumer’s equilibrium with indifference curve. (C.B.S.E., 2010,11,13; U.S.E.B ., 2011,12, 16)

Introductory Micro Economics 7. State and explain the characteristics of indifference curve.

( C.B.S.E., 2010,11, 16, 18; U.S.E.B ., 2011; B.S.E.B., 2018, 19) 8. Write the meaning of marginal utility. State the conditions of consumer’s equilibrium using marginal utility analysis. (U.S.E.B., 2015) 9. Explain consumer’s equilibrim in case of a single commodity. (J.A.C., 2019) 10. Discuss briefly, using a hypothetical schedule, the concept of Diminishing Marginal Rate of Substitution. (C.B.S.E., 2019) 11. Explain the concept of marginal rate of substitution (MRS) by giving an example. What happens to MRS when consumer moves downward along the indifference curve ?

( C.B.S.E., 2011) 12. Define marginal rate of substitution. Why indifference curve is convex to the origin ? Explain. (C.B.S.E., 2012) 13. Explain the meaning of diminishing marginal rate of substitution with the help of numerical example. (C.B.S.E., 2013, 15)

14. Define indifference map. Explain why does indifference curve of the right show higher level of satisfaction ?

( C.B.S.E., 2012; USEB, 2017) 15. Distinguish between cardinal utility and ordinal utility. Also give examples. (C.B.S.E., 2012) 16. Discuss the law of diminishing marginal utility. What are the necessary conditions for the operation of this law ?

[ B.S.E.B., 2012 (Arts )] 17. Explain the Marginal Rate of Substitution. Why is Indifference Curve convex to the origin. (CBSE, 2017) 18. Explain consumer’s equilibrium with the help of indifference curve ? (B.S.E.B., 2014; U.S.E.B., 2019) 19. What is an indifference curve ? Explain with diagram.

( U.S.E.B., 2014) 20. Explain the Law of Diminishing Marginal Utility with the help of diagram. (U.S.E.B., 2014) 21. What do you mean by budget line and indifference curve ? Explain the indifference map with the help of diagram.

( B.S.E.B., 2014) 22. Define consumer’s equilibrium. Explain its codition under indifference curve analysis. (C.B.S.E, 2015, 18) 23. Explain the conditions of consumer’s equilibrium using indifference curve analysis. (C.B.S.E., 2016) 24. A consumer consumes only two goods X and Y. Explain the conditions of consumer’s equilibrium under Marginal utility analysis. (C.B.S.E., 2017) 25. Define Budget line and Indifference Curve. Also explain why the two are downward sloping from left to right ?

(C.B.S.E., 2017) Objective Type Questions

(A) Multiple Choice Questions : 1. Which of the following statement is true ? (a) Utility means want-satisfying power

(b) Utility is a function of intensity of desire

(c) Desire of consumption gives birth to utility

(d) All the above

Consumer’s Equilibrium

2. Which of the following is a characteristic of utility ? (B.S.E.B. , 2016

(Comm .)] (a) Utility is a psychological phenomenon

(b) Utility is subjective

(c) Utility is a relative concept

(d) All the above

3. Who gave the cardinal concept of utility ?

[B.S.E.B., 2011 (Arts )] (a) Marshall (b) Pigou

(c) Hicks (d) Samuelson

4. Consumer’s behaviour is studied in :

(b) Macro Economics (d) None of the above (a) Micro Economics (c) Income Theory

5. Which is the First Law of Gossen ?

(a) Law of Demand

(b) Law of Diminishing Marginal Utility

(c) Law of Equi-marginal Utility

(d) Consumer’s Surplus

6. Which of the following is true ?

(a) TU increases till MU is positive

(b) TU is maximum when MU is equal to zero

(c) TU declines when MU is negative

(d) All the above

7. How we calculate marginal utility ? (B.S.E.B., 2011, 12) (a) TU/ Q (b) MU/ Q

(c) Q/ TU (d) Q/ MU

8. When TU becomes maximum, MU is : (J.A.C., 2017, 19;B.S.E.B., 2018 (Arts )] (a) Positive (b) Negative (c) Zero (d) None of these

9. Who basically propounded the concept of Law of Equi(B.S.E.B. , 2019) (b) Gossen (d) Mill marginal Utility ? (a) Marshall (c) Ricardo

\mathrm{P} _ {x} (\mathrm{a}) - \mathrm{P} _ {y}

11. Indifference curve is : (a) Convex to the origin (c) Both (a) and (b) true

(a) Usefulness

(b) Morality

(b) - \mathbf {P} _ {x}

\mathrm{P} y (\mathrm{d}) _ {\mathrm{P} x}

(c) Satisfaction of human wants (d) All the above

13. Utility can be measured by : (a) Money

(c) Weight of the good

(b) Exchange of goods (d) None of these

14. Law of equi-marginal utility is called : [B.S.E.B. (Arts) , 2018]

(a) Law of increasing utility (b) Law of diminishing utility (c) Law of substitution 15. Indifference curve slopes : (a) From right to left (c) Both (a) & (b) (d) None of these (b) From left to right (d) None of these

16. The ability of satisfying human want in a goods is called its : (B.S.E.B., 2012) (a) Productivity (b) Satisfaction (c) Utility (d) Profitability

17. The addition of utilities obtained from all units of a goods is called : (a) Marginal Utility (b) Total Utility (c) Maximum Satisfaction (d) Additional Utility

18. Who propounded the ordinal utility theory ? [B.S.E.B., 2012, 18 (Arts )] (a) Marshall (b) Pigou (c) Hicks & Allen (d) Ricardo

19. The propounder of law of diminishing marginal utility is : [B.S.E.B., 2012, 19] (a) Gossen (b) Adam Smith (c) Chapman (d) Hicks

20. Consumer’s equilibrium takes at a point where : [B.S.E.B., 2012 (Arts )] (a) Mu = Price (b) Mu < Price (c) Mu > Price (d) None of the above

21. The capacity of a commodity to satisfy human wants is : [BSEB, 2015, 17] (a) Consumption (b) Utility (c) Quality (d) Taste

22. For the maximum satisfaction of consumer : [B.S.E.B., 2015 (Arts )] (a) Marginal utility of a good should be equal to its price (b) Marginal utility of a good should be greater than its price (c) There is no relation between marginal utility and price (d) None of these 23. When marginal utility is negative, then total utility : [B.S.E.B., 2015 (Arts )] (a) is maximum (b) starts decreasing

(c) increases at decreasing rate (d) None of these

24. According to the law of equi-marginal utility, the condition for consumer’s equilibrium : [B.S.E.B., 2015 (Arts )] MU A \overline { { \mathbf { \Lambda } } } _ { \mathrm { P B M U } } = \mathrm { A } _ { \left( \mathbf { a } \right) _ { \mathrm { P } } } MU B MU P A (b) A _ { \textrm { B } ^ { \textrm { P } } \mathrm { B } } (c) Both (a) & (b) (d) Undefined 25. According to Marshall, utility of a commodity : [ B.S.E.B., 2015 (Arts )] (a) can be measured by money (b) cannot be measured by money (c) can be measured in cardinal numbers (d) Both (a) and (c)

36

Introductory Micro Economics

26. This is required for a budget set : [ B.S.E.B. (Comm.) , 2018] (a) Collection of bundles (b) Prevailing market price (c) Total income of the consumer (d) All the above 27. In diminishing rate of substitution : (a) More of Goods 1 (c) More of both 1 & 2 28. Utility in economics means :

[ B.S.E.B. (Comm.) , 2018] (b) Less of Goods 2

(d) A and B both

( MP Board , 2019) (a) Want satisfying power of commodity

(b) Pleasure (c) Happiness

(d) Usefulness

29. The slope of indifference curve shows : (MP Board, 2019) (a) The Price Ratio (b) Diminishing

(c) Factor Substitution (d) Marginal Utility [Ans. 1. (d), 2. (d), 3. (a), 4. (a), 5. (b), 6. (d), 7. (a), 8. (c), 9. (b), 10. (a), 11. (a), 12. (d), 13. (a), 14. (c), 15. (b), 16. (c), 17. (b), 18. (c), 19. (a), 20. (a), 21. (b), 22. (a), 23. (b), 24. (c), 25. (d), 26. (d), 27. (d), 28. (a), 29. (b)]

(B) Fill in the Blanks :

1. Utility means ................ satisfying power of a commodity.

2. Total utility is the sum of ................... utilities.

3. When MU is zero, TU is .............. .

4. Marginal Utility Curve is ............... curve.

5. At saturation point marginal utility is ................. .

6. Consumer’s Equilibrium is that situation when total utility is.............. .

7. Indifference curve is ................. to the origin.

8. Basically utility are of .......... types. (MP Board, 2019)

9. A higher indifference curve always shows a level of satisfaction. (MP,

Board, 2019) [Ans. 1. want, 2. marginal, 3. maximum, 4. demand, 5. zero, 6.

maximum, 7. convex, 8. Three, 9. High]

(C) State True/False :

1. Marshall gave the cardinal concept of utility.

2. MU = TU_{( n + 1)} – TU_n .

3. TU = MU.

4. Indifference curve is convex to the origin.

5. Law of equi-marginal utility is called ‘Law of increasing Utility’.

[Ans. 1. True, 2. False, 3. True, 4. True, 5. False.] (D) Match the following

Column :

‘A’

1. Point of Saturation

2. Utility Analysis

‘B’

(a) Addition of marginal

Utility

(b) Oridnal Viewpoint

3. Indifference Curve Analysis (c) Cardinal Viewpoint 4. Total Utility (d) Total Utility 5. Law of Diminishing Utility (e) Gossen

[Ans. 1. (d), 2. (c), 3. (b), 4. (a), 5. (e).]

(E) Answer in One Word :

1. What is the value of marginal utility at point of saturation? 2. What becomes to total utility at zero marginal utility ? 3. What shape indifference curre adopts towards origin ? 4. Who gave the concept of utility analysis ?

[Ans. 1. Zero, 2. Maximum, 3. Convex, 4. Marshall.] HOTS High Order Thinking Skills Questions

1. Is utility measurable ? What is cardinal number based utility ? (See : Section 3.4)

2. Why does total utility becomes maximum when marginal utility becomes zero ?

(See : Section 3.5.3)

3. At which rate TU rises when MU falls ?

(See : Section 3.5.3)

4. Law of Substitution becomes the basis of consumer's equilibrium in utility analysis. How ?

(See : Section 3.7)

5. “Budget line provides ceiling to the consumption.” How ? (See : Section 3.10)

6. What happens when Mu >^Muy P

7. The law of diminishing marginal utility is a fundamental and universal law. How ?

(See : Box 2)

2. What is the behaviour of the consumer in Monotonic preference ?

(See : Box 5)

3. Why MRS should be diminishing ?

(See : Section 3.9)

4. A consumer consumes two goods X & Y and is in equilibrium. Price of X good rises. Explain the reaction of consumer with the help of utility analysis. (See : The explanation of Fig. 5)

5. If IC is not convex to origin at the point of equilibrium, the consumer can not obtain the point of stable equilibrium. Comment.

(See : Section 3.11)

Case Study Based on Evaluation & Multi-disciplinary Questions

1. ‘‘Consumer's equilibrium point would be always located on the budget line.’’ Why ?

(See : Section 3.11)

2. Why should indifference curve be convex to budget line at the point of equilibrium ?

(See : Section 3.11)

3. What is the relation between slope of price line and MRS in consumer’s equilibrium ?

(See : Section 3.11)

4. What reason makes indifference curve convex to origin ? (See : Box 6)

Consumer’s Equilibrium

NCERT CORNER

Q. 1. What do you mean by the budget set of a consumer ? Ans. See Box 8.

Q. 2. What is budget line ?

Ans. See Section 3.10.

Q. 3. Explain why the budget line is downward sloping ?

Ans. See Section 3.10.

Q. 4. A consumer wants to consume two goods. The prices of the two goods are `4 and `5 respectively. The consumer’s income is `20 : (i) Write down the equation of the budget line.

(ii) How much of goods x can the consumer consume if she spends her entire income on that goods ?

(iii) How much of goods y can she consume if she spends her entire income on that goods ?

(iv) What is the slope of the budget line ? Ans. (i) Equation of the budget line is : ₁ p x p y ₂ = M 4x 5y = 20 (because P₁ = 4, P₂ = 5, M = 20)

(ii) 4x 5y = 20 Since y = 0 4x + 5 × 0 = 20,

_ {x} = 2 0 _ {4},

4 x = 2 0 x = 5

The consumer can consume 5 units of goods x if the consumer spends his entire income on goodsx . (iii) Since 4x 5y = 20

x = 0

4 \times 0 + 5 y = 2 0

5 y = 2 0

_ {y} = 2 0

y = 4 ^ {5}

The consumer can consume 4 units of goodsy if the consumer spends his entire income on goodsy .

(iv) Slope of the budget line = P ^ { \mathrm { ~ 1 4 } } = 0 { \cdot } 8 . \mathbf { Q } . 5 . . Based on question 4. p \ 2 \ 5

How does the budget line change if the consumer’s income increases to ` 40 but the prices remain unchanged ?

Fig.

\text {Ans.} p _ {1} = 4

p _ {2} = 5

\mathrm{M} = 4 0

4 x + 5 y = 4 0

4 x + 5 \times 0 = 4 0

4 x = 4 0

x = 4 0 4 = 1 0 \text { units }.

4 \times 0 + 5 y = 4 0

5 y = 4 0

y = 4 0 5 = 8 \text {units}.

The budget line will change as under :

In the diagram, budget line RS has changed to \mathsf { R } _ { 1 } \mathsf { S } _ { 1 }

Q. 6. Based on question 4.

How does the budget line change if the price of goods y decreases by a rupee but the price of goods x and the consumer’s income remains unchanged ?

Introductory Micro Economics

Goods X (Units)

Fig.

Ans.

\mathrm{M} = 2 0

New p _ { \ : 2 } = 5 - 1 = \mathrm { ^ { \circ } } 4

New y = 204 = 5unit

The budget line will change as under :

The original budget line was RS. The new budget line is \mathrm { R } _ { 1 } \mathrm { S } .

Q. 7. Based on question 4.

What happens to the budget set if both the prices as well as the income double ? Ans. M = 20 2=`40 New p _ { \mathrm { ~ 1 ~ } } = 4 ~ 2 = \mathsf { \tilde { 8 } }

^{x = 40} 8 = 5 Units

\mathrm{New} p _ {2} = 5 2 = ^ {\prime} 1 0

^{y = 40} 10 = 4 Units

38

There will be no change in the budget set because all variables of the budget set do change in the same proportion.

Q. 8. Suppose a consumer can afford to buy 6 units of goods 1 and 8 units of goods 2 if she spends her entire income. The prices of the two goods are `6 and `8 respectively. How much is the consumer’s income ? Ans. Goods 1 orx = 6

p _ {1} = 6

\text {Goods 2 ory} = 8

p _ {2} = 8

\mathrm{M} = p _ {1} x + p _ {2} y = 6 6 + 8 8 = 3 6 + 6 4 = 1 0 0

Thus, Consumer’s Income = `100. Q. 9. Suppose a consumer wants to consume two goods which are available only in integer units. The two goods are equally pric. at `10 and the consumer’s income is `40. (i) Write down all the bundles that are available to the consumer.

(ii) Among the bundles that are available to the consumer, identify those which cost her exactly `40.

Ans. (i) M = 40, P₁ = 10

\mathrm{X} = 4 0 1 0 = 4 \text {units}

\mathrm{P} _ {2} = 1 0

\mathrm{Y} = 4 0 1 0 = 4 \text {units}

All the sets of two goods that are available to the consumer are as under :

(0, 0) (0, 1) (0, 2) (0, 3) (0, 4)

(1, 0) (1, 1) (1, 2) (1, 3)

(3, 0) (3, 1)

(4, 0)

(ii) Following bundles cost exactly`40 :

(0, 4) (1, 3) (2, 2) (3, 1) (4, 0). Q. 10. What do you mean by ‘monotonic preferences’ ? Ans. Consumer’s preference becomes monotonic if and only if the consumer between various bundles of two goods prefers the bundle which has more of at least one of the goods and no less of the other goods as compared to the other bundle.

Q. 11. If a consumer has monotonic preferences, can she be indifferent between the bundles (10, 8) and (8, 6) ?

Ans. No, if a consumer has monotonic preferences, she cannot be indifferent between the bundles (10, 8) and (8, 6). She would prefer the bundle (10, 8) to (8, 6) because bundle (10, 8) has more of both goods. Q. 12. Suppose a consumer’s preferences are monotonic. What can you say about her preference ranking over the bundles (10, 10), (10, 9) and (9, 9) ? Ans. When a consumer’s preferences are monotonic, the bundles will be ranked as under :

Bundle Rank

(10, 10) I

(10, 9) II

(9, 9) III

Q. 13. Suppose your friend is indifferent to the bundles (5, 6) and (6, 6). Are the preferences of your friend monotonic ? Ans. No, the preferences of my friend are not monotonic because bundle (6, 6) should monotonically be preferred to bundle (5, 6).

4

DEMAND AND LAW OF DEMAND

STUDY MATERIAL INCLUDED IN THE CHAPTER

4.1. Demand : Relation with Desire and Want 4.2. Demand : Meaning and Definitions 4.3. Demand Function and Determinants of Demand 4.4. Demand Schedule 4.5. Demand Curve and Its Slope 4.6. Types of Demand 4.7. Law of Demand 4.8. Why Demand Curve Slopes Downward ? 4.9. Exceptions to the Law of Demand 4.10. Change in Quantity Demanded and Change in Demand A Quick Review of the Chapter Questions High Order Thinking Skills (HOTS) Questions Value Based Questions (VBQ) Case Study Based on Evaluation & Multi-disciplinary Questions (MDQ) NCERT Corner.

4.1. Demand—Relation with Desire and Want

In general sense, ‘ Desire ’, ‘Want ’ and ‘Demand ’ are considered as synonym to each other but they have different meanings in Economics. Human desires are infinite and unlimited. All wants of human being are not fulfilled. Human psychology inspires human being to have good consumption level. Human beings have limited resources to fulfil their unlimited wants. Those desires on which we become ready to spend money, get converted

Thus Demand < Wants < Desires

Or

Desires > Wants > Demand

4.2. Demand : Meaning and Definitions

‘‘The quantity demanded is a particular amount the buyers are willing and able to buy at a given price during a given time, other things being equal.’

into wants. When wants are fulfilled, they become demand. In other words, when ‘Desires’ are fulfilled or satisfied by using purchasing power, they become ‘Demand’.

‘Desire’, ‘Want’ and ‘Demand’ can be explained through an example. When a poor person imagines to travel through aeroplane, it is said to be a ‘Desire’ . When a prosperous person buys ticket to travel by aeroplane, it is called want because he has the capacity to buy the air ticket and when he buys ticket, his want gets converted to ‘Demand’.

In this way, area under demand is contracted if

compared with desire and want.

Three circles with radius OA, OB and OC have been

(i) According to J. S. Mill,

‘‘Demand is an amount of

a thing which a person is

willing to buy at a given

price.’’

(ii) According to Benham, ‘‘The demand for anything, at a given price, is the amount of it which will be bought per unit of time at that price.’’ (iii) According to Meyers , ‘‘The demand for a goods is a schedule of the amounts

Demand and ‘Quantity Demanded’ Demand for a commodity is always expressed with reference to price. Quantity Demanded, on the other hand, refers to a specific quantity to be purchased against a specific price of the commodity.

Box 1 shown in Fig. 1. Circle with

radius OA shows desire (which is unlimited and infinite). These desires cannot be fulfilled with limited means. Ability to fulfil only few desires decreases the area of want to the circle of radius OB. All the wants are not satisfied due to which area of demand further contracts to circle of radius OC.

Fig. 1 that buyers would be willing to purchase at all possible prices at any one instant of time.’’

On the basis of above definitions, there ought to be

five inherent elements in demand :

(i) Desire for a goods,

(ii) Sufficient resources to buy the goods,

(iii) Willingness to spend,

(iv) Given price,

(v) Given time period.

4.3. Demand Function and Determinants of Demand

Demand function is the functional relationship between demand of a goods and factors affecting it.

According to Prof. Watson , ‘‘Demand function in any market at a particular point of time expresses relationship between different quantities of goods that could be purchased and the elements determining these quantities.’’

Demand Function ↓

Individual Demand Function expresses relation between demand for goods and factors determining it for a consumer. It can be expressed through following equation :

\mathrm{D} _ {x} = f \left(\mathrm{P} _ {x}, \mathrm{P} _ {r}, \mathrm{Y}, \mathrm{T}, \mathrm{F}\right)

Where P_x = Price of Goodsx ,

P_r = Price of Related Goods,

Y = Monetary Income of Consumer, T = Tastes and Preference of Consumer,

\mathrm{D} _ {x} = \text {Demand for Goods} x

F = Expectation of change in Price in Future

For knowing the effect of price change on demand of a goods, we have to assume other factors as constant. Functional relation between price of a goods and its demand is called ‘Price Demand Relationship’ or ‘Price Demand’ . It can be represented as :

Dx = f (P_x )

4.3.2. Market Demand Function

Market Demand Function expresses relationship between market demand of any goods and various elements determining it. Two more factors have been included in Market Demand Function :

P = Size of Population,

Y_d = Distribution of Income

\mathrm{Or}, \mathrm{D} _ {x} = (\mathrm{P} _ {x}, \mathrm{P} _ {r}, \mathrm{Y}, \mathrm{T}, \mathrm{E}, \mathrm{P}, \mathrm{Y} _ {d});

Where D_x = Demand of Goodsx ,

P_x = Price of Goodx ,

P_r = Price of Related Goods

Y = Income of all Consumers for a Goods in Market,

T = Tastes of Consumers,

E = Expectations of Consumers,

P = Size of Population,

Y_d = Distribution of Income

4.3.3. Determinants of Demand

or

Factors Affecting Demand

(1) Utility of the Goods : Utility means want-satisfying power of a commodity. It is a subjective factor which varies from person to person. Goods having greater or more utility will be in greater demand and viceversa.

(2) Income Level : Income level directly affects demand. Higher the level of income, higher will be the demand and lower the level of income, lesser will be the demand.

(3) Distribution of Wealth : Distribution of wealth also affects demand. If the distribution of wealth in society is unequal, then luxurious goods will be demanded by affluent section of society. But as the distribution of wealth becomes equal, there will be increased demand of necessary and comfortable goods.

(4) Price of the Goods : Price of the goods directly affects the demand for it. At a lower price, demand will become high and vice-versa.

(5) Price of Related Goods : Related goods are of two types :

(a) Substitute Goods : Those goods which can be

used in place of each other. e.g. , Sugar-Gur, TeaCoffee, etc.

(b) Complementary Goods : Those goods which are used together., e.g ,. Car-Petrol, Ink-Pen, BreadButter, etc.

In case of substitutes, change in price of a goods affects demand of other goods in same direction, but in case of complementary goods, price change of one goods changes demand of other goods in the reverse direction.

(6) Taste, Fashion, etc. : These factors also affect demand. When any particular goods is in fashion, its demand will definitely increase.

(7) Expected Future Change in Price : Government regulation, natural calamities, possibility of war, etc. affects demand of goods.

4.4. Demand Schedule

Demand schedule can be defined as a table representing quantities of the goods which will be demanded by the consumer at various possible prices at a given moment of time.

In the words of Samuelson , ‘‘Table relating to price and quantity of demand is called the Demand Schedule.’’ Types of Demand Schedule ↓↓↓

Individual Demand Schedule

Market Demand Schedule

Box 3 4.4.1. Individual Demand Schedule

Individual demand schedule is related to an individual and expresses the quantity of goods demanded by an individual at different prices in the market per unit of time.

Table 1 : Individual Demand Schedule Per Unit Price Quantity Demanded by (in `) Consumer ( A )

Above table shows that as the price per unit of goods falls, quantity demanded by an individual increases. 4.4.2. Market Demand Schedule

It can be constructed through the various individual demand schedules. Market demand schedule represents the total market demand at various prices. It is constructed by horizontal additions of quantities at various prices shown in the individual demand schedules.

Price of Demand of Demand of Market Demand Milk (in Consumer ` per A litre) (In litre)
Consumer B
(In litre)
20 3
16 4
12 5
10 6
2 3 5 8
= Demand of Consumer A+ Demand of Consumer B
3 + 2 = 5
4 + 3 = 7
5 + 5 = 10
6 + 8 = 14

Table 2 : Market Demand Schedule

Above table states that when \boxed { \overline { { \overline { { 3 } } } } } _{The inverse relation} price of milk decreases, its demand ship between price decreases. When price of milk is of good and quantity ` 20 per litre, quantity demanded^{demanded is found} by consumer A and B is 3 \mathrm { l i t r e } e^{both in individual} and 2 litre respectively. Hence, demand schedule

^{and market demand} total market demand is 3 + 2 = _ { \mathrm { s c h e d u l e } . } 5 litre milk at price ` 20 per \operatorname* { l i t r e } _ { \cdot _ { \mathbf { B 0 X } 4 } } 4.5. Demand Curve & Its Slope

When a demand schedule is graphically represented, we get a demand curve. It shows the inverse relationship between price and quantity demanded. Due to this inverse relationship, demand curve slopes downward from left to right. It shows that higher the price, lower will be the quantity demanded and

vice versa.

Individual Demand Individual Demand

Schedule Curve ↑↑

Demand Schedule Demand Curve ↓↓ Market Demand Market Demand

Schedule Curve

4.5.1. Individual Demand Curve

Individual demand curve shows various combinations of the quantity of goods demanded by an individual consumer at different prices. Individual demand schedule has been shown in Fig. 2. Quantity demanded by consumer A has been represented on X-axis and per unit price on Y-axis. When price of goods is `10 per unit, he buys only one unit of it. When price decreases to ` 8 per unit, quantity demanded increases to 3 units. Demand curve DD slopes downward from left to right, which shows that when price decreases, demand increases and vice-versa . In this way, the individual demand curve is negatively sloped.

Fig. 2

4.5.2. Market Demand Curve

By representing market demand schedule on a graph, we can obtain ‘Market Demand Curve’ . This curve represents demand of goods at different price for all the consumers in the market. Market demand curve is a horizontal summation of individual demand curves.

In Fig. 3, quantity of milk has been shown on Xaxis and price of milk on Yaxis. In panel (i) and (ii), individual demand curve of consumer A and B has been represented.

In panel (iii), market demand curve has been represented. When price of milk is ` 10 per litre, then consumer A and B demand 6 and 8 litres of milk respectively. Hence, at price ` 10, market demand is 6 + 8 = 14 litre of milk.

In this way, market demand curve is obtained by adding individual demand curves. It is horizontal summation of individual demand curves. Its slope is negative which shows the inverse relationship between price and quantity demanded.

4.5.3. Individual Demand

Fig . 3 vs . Market Demand

1. It is the quantity demanded of a commodity by an individual consumer at a given price during a given period of time.

2. It may or may not follow the Law of Demand, i.e. it is possible that an individual consumer may demand more even at higher price.

3. Individual demand is not affected by all the factors affecting market demand.

4.6. Types of Demand

Individual Demand Market Demand

1. It is the quantity demanded of a commodity by all the consumers at a given price during a given period of time.

2. It always follows the Law of Demand, i.e., market demand always falls with rise in price and vice-versa .

Demand

↓↓ ↓ ↓ Price Income Cross Other Kinds Demand Demand Demand of Demand

↓↓↓ ↓ ↓ Superior or Inferior Joint Derived Composite Normal Goods Goods Demand Demand Demand Box 5

4.6.1. Price Demand

Price demand refers to those quantities of goods which are demanded by a consumer at various prices during a particular timeperiod. Ceteris paribus (i.e. , other things being equal), when price of goods increases its demand decreases and vice-versa . ‘Ceteris paribus’ means at the point of time when consumer demands

Fig . 4 goods, income, taste, 3. Market demand is affected by all the factors affecting individual demand.

interest and behaviour of consumer remains unchanged or constant. Due to inverse relationship between price and demand, slope of price demand curve is negative i.e., it falls from left to right. Price demand curve has been represented in Fig. 4. DD curve falling from left to right is price demand curve and reveals that there is inverse relation between price and quantity demanded. At price OP, OQ quantity of good is demanded when price decreases to \mathrm { O P } _ { 1 } , quantity demanded increases to \mathrm { O Q } _ { 1 }

4.6.2. Income Demand

Generally, income demand is related to the quantity of goods and services demanded by a consumer at different income levels in a given time period when other things remain constant. Income demand curve is also known as Engel’s Curve, after the name of German economist, Engel.

Income demand depends on the nature of goods. Goods can be divided into two groups :

(1) Superior or Normal Goods,

(2) Inferior Goods.

1. Income Demand in Superior or Normal Goods

Normal goods (or superior goods) are those goods in case of which there is a positive relationship between price and quantity demanded. Income demand curve in superior or normal goods is positively sloped i.e. , it rises from left to right. It denotes that every increase in income of the consumer increases demand of superior goods and vice-versa . It has been illustrated in Fig. 5. DD curve in Fig. 5 is income demand curve for superior goods. At OY level of income, OQ quantity of goods is demanded. When income increases to OY, other things being equal, quantity demanded also increases to \mathrm { O Q } _ { 1 }

2. Income Demand in Inferior Goods

Fig . 7 commodity varies directly with the prices of substitute goods. Substitutes are such products which have the capacity to satisfy the same needs, i.e. , they can be used for the same purpose in place of each other, e.g. , Tea-Coffee. In this case, when price of one goods increases, other things being equal, demand of

Fig . 5 Inferior goods are the goods which are consumed by a consumer due to insufficient level of income, e.g. ,

Difference Between Inferior Good and Giffin Good 1. Law of demand becomes applicable in inferior goods while in Giffin goods , it does not

apply.

2. On inferior good consumer spends a very little portion of his income and as a result income effect remains weak. But in Giffin good, a considerable part of the income is spent which makes income effect much stronger.

Box 6

substitutes also increases, e.g. , price of coffee increases, then demand of tea also increases. This condition has been represented in Fig. 7. DD curve in figure represents demand curve of substitute goods. When price of goods-Y is OP_Y , demand of substitute goods-X is OX₁ .

Fig . 6

Coarse grains, vegetable, ghee, etc. In this case, as the income of consumer increases, he reduces consumption of inferior goods and increases consumption of superior goods or we can say, income demand curve for inferior goods is negatively sloped and falls from left to right. DD curve indicates income demand curve for inferior goods. At OY level of income, demand of inferior goods is OQ. When income increases to OY, demand of inferior goods decreases to OQ₁ and shifts to the consumption of superior goods. This paradox of income demand was first observed by an English economist, Robert Giffin and after him, this paradox is called ‘Giffin’s Paradox’. ¹

4.6.3. Cross Demand (Demand in Related Goods)

Other things being equal, change in demand of goods Y due to change in price of goods X is called ‘Cross Demand’ . In other words, cross demand of any goods observes relative change in demand of one goods due to change in price of other goods. These goods can be of two types :

(1) Substitute Goods : Cross demand is positive in case of substitute goods as demand for given 1 Also see Fig. 9 and its explanation.

If price of goods increases to \mathrm { O P } _ { \mathrm { Y 1 } } , then many consumers would shift on consumption of goods X due to which demand of goods-X increases to \mathrm { O X } _ { 2 }

(2) Comple

mentary Goods : Cross demand is negative in case of complementary, goods as demand for the given commodity varies inversely with the prices of complementary goods. Complementary goods are used together for satisfying a particular \dot { F } \dot { { g } } . 8want, e.g. , scooter

petrol. If price of scooter increases, then demand of its complementary goods is affected although price of petrol remains unchanged. In this way, inverse relation exists between price and quantity demanded of complementary goods. In Fig. 8, DD curve shows demand of complementary goods. If price of goods-Y increases from \mathrm { O P } _ { 1 } to \mathrm { O P } _ { 2 } , then demand of complementary goods-X decreases from \mathrm { O X } _ { 1 } to \mathrm { O X } _ { 2 }

4.6.4. Other Kinds of Demand

(1) Joint Demand : Joint Demand appears in case of complementary goods. When two commodities are complementary to one another and cannot be used separetely, they have joint demand. Bread and butter, sugar and tea, pen and ink are a few examples of joint demand. In joint demand, a change in demand of one commodity brings about the proportionate change in demand of complementary goods.

Introductory Micro Economics

(2) Derived Demand : Demand for a factor of production is not a direct demand, it is an indirect or derived demand. Derived demand is a demand which arises or is derived from the demand for some other commodity or factor. Demand for labour or raw material is dependent on (or derived from) the demand of that final product in which this factor is used.

(3) Composite Demand : When a goods can be put to variety of uses, the total market demand for such goods makes ‘Composite Demand’ . Electricity has composite demand because electricity can be put to several uses like domestic lighting, heating, industrial energy source, etc. When these varieties of demand are added together, we get composite demand for electricity.

4.7. Law of Demand

Law of demand explains qualitative relation between price of goods and quantity demanded. Every consumer has a psychology to buy less amount or quantity of anything at high price and more quantity at low price. Ceteris paribus (other things being equal), there is inverse relationship between price of a goods and quantity demandedi.e. when price is high, demand is low and when price is low, demand is high.

Why are goods demanded ? Goods are demanded due to utility inherent in it. The ability to satisfy human wants is called utility. Demand of a goods arises because that goods has the ability to satisfy our want. Thus, the demand of a goods is the use of its utility. Box 7

Law of Demand ‘‘The Law of Demand states that, other things being equal, the amount demanded increases with a fall in price and diminishes with a rise in price.’’

Box 8

In other words, there is an inverse relation between price of a goods and its demand. When price increases, demand decreases and vice-versa .Law of Demand is a ‘qualitative statement’ and not a ‘quantitative statement’ . This law locates the direction of price and

demand change and not the quantity of change.

Thus, P Q

Where,P = Price of Commodity Q = Quantity Demanded 4.7.1. Meaning of

‘Other things being Equal’ Or

Assumptions of the Law of Demand

Law of demand is based on few assumptions. These assumptions are :

(1) Consumer’s income should remain constant.

(2) Consumer’s taste, nature, etc., should remain constant.

(3) Price of related goods should remain constant.

(4) Consumer remains unknown with new substitutes.

(5) There is no possibility of price change in future.

4.8. Why Demand Curve Slopes Downward ? Or Why more goods purchased at lower price ?

Slope of demand curve is negative, i.e. , it falls from left to right which means that less goods are bought or demanded at high prices and vice-versa . Negative slope of demand curve is due to following reasons :

(i) Law of Diminishing Marginal Utility : Law of demand is based on law of diminishing marginal utility. According to it, marginal utility of a goods diminishes as an individual consumes more units of a goods. In other words, as a consumer takes more units of a goods, the extra utility or satisfaction that he derived from an extra unit of the goods goes on falling. The law of diminishing marginal utility means that the total utility increases but at a decreasing rate. Marshall has stated this law as :

‘‘The additional benefit which a person derives from a given increase of his stock of a thing diminishes with every increase in the stock that he already has.’’

At low price, more units of a goods is demanded and vice-versa . In short,

Purchase of More

Units of a Good

Decreasing Low Marginal Price Utility

Law of Demand

P

I Q

In the same way,

Purchase of less High High Units of a Good Marginal Utility Price

^I Law of Demand P _Q

(ii) Increase in Purchasing Power or Income Effect : When price of a goods decreases, real income or purchasing power of consumer increases due to which he can maintain his previous level of consumption with less expenditure. In this way, at lower prices, more goods could be purchased. On the contrary, when price of a goods increases, real income of consumer decreases due to which his consumption decreases. This is the law of demand.

In short, Units of a Good Decrease in Price of

Goods

Marginal Price Increase in Purchase Real Income of More

or Purchasing Goods Power

Law of Demand

P

I Q

Demand and Law of Demand

In the same way,

Increase in Price of

Goods

Decrease in Real Income or Purchasing Decrease in Purchase of

P

Law of Demand

I Q

(iii) Substitution Effect : Substitution effect is due to inverse relation between price and demand of a goods. Whenever there is a change in the relative prices of goods, a rational consumer will be induced to substitute the relatively dearer commodity by buying the cheaper one. Such effect of the change in relative prices of goods is thus, described as the substitution effect. Substitution effect is the change in quantity demanded of a commodity resulting from a change in its price relative to the prices of other commodities, the consumer’s real income or satisfaction level being held constant. In this way, due to substitution effect, at low price, demand increases and at high price demand decreases.

(iv) Change in Number of Consumers : Change in price also affects the number of consumers. When price decreases, number of consumers increases as cheaper goods can be purchased by many consumers, i.e. , even those consumers start purchasing goods which were not using it earlier due to high prices. On the contrary, when price increases, many consumers stop consumption or decrease it due to which demand decreases, i.e. , low price increases demand and high price decreases it. This is the Law of Demand.

4.9. Exceptions to the Law of Demand

In few cases, law of demand is not applicable. These conditions are called ‘Exceptions’ and are as follows : (i) Expected rise in Future Price : In few unexpected circumstances like natural calamities, war, etc., consumers continue to demand goods even after price increases because they expect future increase in price. In this case, Law of Demand invalidates and direct relation between demand and price of goods comes into existence.

(ii) Prestigious Goods : Due to false show, Law of Demand is not applicable in prestigous goods. To show prestige and social status rich persons of the society purchase dear goods, i.e. , change in price does not affect demand of prestige goods as diamond, jewellery, etc. In fact, rich people increase the consumption of prestige goods when price increases because they show false prestige.

(iii) Ignorance of Consumer : When a consumer due to ignorance considers that by giving high prices, he has purchased superior and durable goods, then high price does not affect demand. On the other hand, when price of any

goods is decreased, then due to ignorance consumer considers that goods as inferior. In this case, when price decreases, consumption also decreases and Law of Demand becomes inapplicable.

(iv) Giffin’s Paradox : Giffin’s paradox arises when one of the two goods of consumption

Demand Curve Exceptional

is superior and other is inferior.

Inferior goods are

those goods which are

consumed by the consumers due to their low

income level. In such a case, when

price of inferior_{Fig. 9goods decreases,}

then consumer decreases consumption of inferior goods due to their increased purchasing power. In this way, decrease in price of inferior goods decreases its consumption. Thus in Giffin goods, the Law of demand is not applicable. This paradox was first observed by an English economistRobert Giffin and named after him as‘Giffin’s Paradox’ . In 19th century, inspite of rise in bread price, people demand it more because it remained comparatively cheaper as compared to its substitutes like fish, mutton, etc. As a result, poor people consumed more of bread with every increase in price of bread and reduced intake of fish, mutton etc. This paradox is known as‘Giffin Paradox’.

DD is demand curve of inferior goods which slopes upward from left to right. At OP price, quantity of goods purchased is OQ. When price decreases to \mathrm { O P } _ { 1 } and \mathrm { O P } _ { 2 } , quantity of inferior goods demanded or purchased also decreases to \mathrm { O Q } _ { 1 } and \mathrm { O Q } _ { 2 } respectively. This is exception to law of demand.

(1) Law of demand is applicable in case of normal goods and inapplicable in case of Giffin goods.

(2) Demand curve in case of normal goods is negatively sloped from left to right and positively sloped in case of Giffin goods and rises from left to right.

(3) Income effect of normal goods is positive, i.e. , increase in income increases demand of normal goods, and income effect in case ofGiffin goods is negative, i.e. increase in income decreases demand of Giffin goods.

Box 9 4.10. Change in Quantity Demanded & Change in Demand

There are two conditions of change in demand : (A) Change in Quantity Demanded

Or, Movement along the same Demand Curve Or, Extension or Contraction of Demand When change in demand takes place due to change

in price only, then these changes occur on the same demand curve. This type of change create ‘Contraction’ and ‘Extension of Demand’ .

‘‘Other things being equal, when due to decline in prices demand of a goods increases, it is called ‘Extension of Demand ’ and when due to price increase, demand decreases, it is called ‘Contraction of Demand’ .’

We can conclude that extension and contraction of demand appear on the same demand curve.

(B) Change in Demand

Or, Shifting of the Demand Curve

Or, Increase or Decrease in Demand

Shifting of demand curve means shifting of curve from its initial position either to left or to right. When demand changes due to factors other than the price demand also changes. When demand increases, demand curve shifts to the right and while demand decreases, it shifts to the left.

Change in Quantity Demanded

Change in Demand

Movement on the Demand Curve Shifting of Demand Curve

Table 3 : Extension of Demand Per Unit Price of Demand of Orange (in `) Orange (Units) 510 320

Fig. 10

It is clear from table 3 that when price of orange decreases from ` 5 to ` 3 demand of orange increases from 10 units to 20 units. Therefore, consumer shifts from point A to point B on the same DD curve. Movement along the same demand curve from point A to B is called ‘Extension of Demand’ .

● Contraction of Demand

When due to increase in price of goods, demand of goods decreases and as a result consumers moves to left or upward along the same demand curve. This situation is called ‘Contraction of Demand’ .

Extension Contraction Increase in in Demand in Demand Demand or Upward or Right

Shifting of Due to Change in Prices Demand

Curve Decrease in Demand or

Left Shifting of Demand Curve

Due to Change in Factors Other than Price Box 10 4.10.1. Extension and Contraction of Demand

When due to change in price demand is changed and it is called ‘Extension of Demand’ or ‘Contraction of Demand’ .

● Extension of Demand

Other things being equal, when more quantity of a goods is demanded due to price decrease, then consumer transfers to right on the same demand curve. This situation is called ‘Extension of Demand’.

Table 4 : Contraction of Demand Price of Orange Demand of Per Unit (`) Orange (Units) 320 510

It is clear from table 4 that when price of orange per unit increases from ` 3 to ` 5, demand of orange decreases from 20 to 10 units. As a result, consumer shifts from point A to point B, which is to right or upward from point A. Shifting along the same DD curve from point A to point B is called ‘Contraction of Demand’.

Representation of ‘Demand Extension’ and ‘Demand Contraction’ in One Diagram

Extension and contraction of demand has been represented simultaneously in one diagram (Fig. 12). At price of PQ, demand of a goods is OQ. When price increases to \mathrm { P } _ { 1 } \mathrm { Q } _ { 1 } , demand of a goods decreases from OQ to \mathrm { O Q } _ { 1 } Change of quantity demanded from OQ to \mathrm { O Q } _ { 1 } is called ‘Contraction of Demand’.

Fig. 13

Fig. 12

In the same way, when price decreases to \mathbf { P } _ { 2 } \mathbf { Q } _ { 2 } , demand of a goods increase to \mathrm { O Q } _ { 2 } from OQ which represents ‘Extension of Demand’.

Above analysis reveals that extension as well as contraction of demand takes place on same demand curve.

Box 11

4.10.2. Increase in Demand and Decrease in Demand Or Shift in Demand Curve

When demand of a goods changes due to factors other than the price like taste, fashion, income initial demand curve shifts either to left or to right. As a result, situations of increase in demand or decrease in demand take place.

● Increase in Demand

When due to factors other than price of goods, more quantity of goods is purchased at that price or same quantity of goods is purchased at higher price, it is called ‘Increase in Demand’ . In this case the entire demand curve shift upward from left to right.

Increase in Demand

Same Price, More Demand Or More Price, Same Demand Table 5 Table 6 Price Per Unit Demand Price Per Unit Demand 10 5 5 10 10 10 10 10

Fig. 14

Both the above situations, i.e. , increase in demand due to same price or constant demand at increased price represent ‘Increase in Demand’ .

Causes of Increase in Demand

Causes of increase in demand are :

(a) When income of a consumer increases. (b) When price of substitute goods increases. (c) When price of complementary goods decreases.

(d) When taste, hobbies and priorities of consumer change due to change in fashion or season.

(e) Increase in number of buyers.

(f) When there is possibility of price rise in future.

(g) When there is possibility of increase in income in future.

Box 12

● Decrease in Demand

When due to factors other than price, less quantity of goods is demanded at that price or same quantity of goods is demanded at less price, it is called ‘Decrease in Demand’ . In this case, the entire demand curve shifts downward to the left of the initial demand curve.

Decrease in Demand

Same Price, Less Demand Or Less Price, Same Demand

Table 7 Table 8 Price Per Unit Demand Price Per Unit Demand 10 10 10 10

Fig. 15

Fig. 16

Both the above situations, i.e ,. same price and less demand or less price and same demand represent ‘Decrease in Demand’ .

Causes of Decrease in Demand

There are the following reasons for decrease in demand :

(a) When income of a consumer decreases. (b) When price of substitute goods decreases. (c) When price of complementary goods increases. (d) When taste, hobbies and priorities of consumer

decreases due to change in fashion or climate. (e) Decrease in number of buyers.

(f) When there is possibility of decrease in price in future.

(g) When there is possibility of income decrease in near future.

Box 13 Shifts in Demand Curve (Representation of both the Situations in one Diagram)

When demand of goods changes due to change in factors other than price, it is called increase or decrease in demand. Due to increase or decrease in demand, demand curve shifts either to the left or right. When demand increases, demand curve shifts upwards or to right direction. On the contrary, when Fig . 17 demand decreases, demand curve shifts downward or to left. In Fig. 17, DD is initial demand curve. When demand increases, DD curve shifts to \mathrm { D } _ { 1 } \mathrm { D } _ { 1 } which shows more demand at the same price and when demand decreases, DD curve shifts to \mathrm { D } _ { 2 } \mathrm { D } _ { 2 } demand curve which shows less demand at the same price.

Box 14

4.10.3. Distinction between ‘Extension in Demand’ and ‘Increase in Demand’

Extension in Demand Increase in Demand

1. In this case, demand increases only due to price decline (other things being euqal).

2. It means more demand of goods at lower price.

3. Movement along the same demand curve from initial higher point to lower point takes place.

4. Demand curve does not change.

5. In this case, due to factors other than price, demand of goods increases.

6. It means, greater demand of goods at same price or same demand at higher price.

7. Demand curve shifts upward to the right side of the original or initial demand curve.

8. Demand curve changes.

4.10.4. Distinction between ‘Contraction of Demand’ and ‘Decrease in Demand’ Contraction in Demand

1. It is a situation in which demand of goods decreases due to price increase (other things being equal).

2. It means less demand of goods at high price.

3. Movement along the same demand curve from lower to upper point takes place.

4. Demand curve does not change.

Decrease in Demand

1. In this case, demand of goods decreases due to change in factors other than price (other things being equal).

2. It means less demand at same price or same demand at lower price.

3. Demand curve shifts downward to left side of the original curve.

4. Demand curve changes.

Distinction between Change in Demand and Change in Quantity Demanded

Change in quantity demanded means ‘Extension and Contraction of Demand’ . It happens when price of related goods changes (Fig. 18). Change in demand means increase or decrease in demand. It happens when factors other than price of a goods changes (Fig. 19).

Fig. 18 Fig. 19

Box 15

A QUICK REVIEW OF THE CHAPTER

● Demand : Demand is that quantity of goods which a person is willing to buy at a given price. There should be five inherent elements in demand :

(a) Desire for the goods.

(b) Sufficient resources to buy the goods.

(c) Willingness to spend.

(d) Given price.

(e) Given time period.

● Quantity Demanded : It is that quantity of goods which a consumer is willing and able to buy at a specific price in specified or definite time.

● Demand Function : Demand function expresses functional relation between demand of goods and various factors determining it.

\mathrm{D} _ {x} = f (\mathrm{P} _ {x}, \mathrm{P} _ {r}, \mathrm{Y}, \mathrm{T}, \mathrm{F})

D_x = Demand of Goods-X

\mathrm{P} _ {x} = \text {Price of Goods - X}

P = Price of Related Goods

Y = Income of Consumer

T = Taste of Consumer

E = Expectation of Change in Price in Future

50

Introductory Micro Economics

Demand Schedule : Demand schedule expresses relation between prices of goods and quantity purchased at these prices.

Individual Demand Schedule : Individual demand schedule represents quantity of goods demanded by an individual at different prices in a definite time period.

Market Demand Schedule : Market demand schedule represents the total market demand at various prices. In this way, market demand schedule is horizontal summation of individual demand schedule.

Demand Curve : When demand schedule is represented on a graph, we obtain Demand Curve.

Individual Demand Curve : Individual demand curve shows various combination of quantity of goods demanded by an individual consumer at different prices.

Market Demand Curve : By representing market demand schedule on graph, we obtain market demand curve. It represents demand of goods at different prices for all the consumers in the market.

Law of Demand : Law of Demand expresses inverse relation between price of goods and its quantity demanded.

Why does Demand Curve slope Downwards ?

There are many reasons for downward slope of demand curve, as :

(a) Law of Diminishing Marginal Utility,

(b) Income Effect,

(c) Substitution Effect and

(d) Change in Number of Consumers.

Exceptions to the Law of Demand : There are following exceptions to the Law of Demand : (a) Expected rise in Future Price,

(b) Prestigious Goods,

(c) Ignorance of Consumer,

(d) Giffin’s Paradox.

Income Demand : Other things being equal, ‘Income Demand’ refers to that quantity of goods and services which the consumer is ready to buy at different levels of income in a definite time-period.

Normal Goods : Normal goods are those goods whose income effect is positive and price effect is negative.

Inferior Goods : Inferior goods are the goods whose income effect is negative.

Giffin Goods : Giffin goods are those inferior goods whose income effect is negative and price effect is positive. Law of Demand is not applicable in case of Giffin goods.

Related Goods : Goods are related when (a) Price of goods-X affects demand of goods-Y, or (b) Demand of one goods increases or decreases the demand of other goods. Related goods are classified as : (i) Substitute goods, (ii) Complementary Goods e.g. , Car and petrol are related and complementary goods; Tea and coffee are related and substite goods.

Substitute Goods : Substitute goods are such products which have the capacity to satisfy the same need. Tea and coffee are substitutes. When price of goods increases, demand of substitute goods also increases and when price decreases, demand also decreases.

Complementary Goods : These goods are used together for satisfying particular want, e.g. , scooter-petrol. If price of scooter increases, demand of its complementary goods is adversely affected, although price of petrol remains unchanged. In this way, inverse relation exists between price and quantity demanded of complementary goods.

Cross Demand : Other things being equal, change in demand of related goods Y due to change in price of goodsX is called Cross Demand.

Joint Demand : When more than one goods are demanded together to fulfil one purpose, then such demand is called Joint Demand., e.g. , Bat-ball, Scooter-petrol.

Derived Demand : When demand of goods arises itself from the demand of other goods, such a demand is called ‘Derived Demand’. Demand for factors of production represents derived demand.

Movement along Demand Curve : When demand of goods changes due to change in price of that goods, it is represented at different points of the same demand curve. It is called movement, along demand curve. It shows ‘Extension and Contraction’ of demand. Demand curve does not change in both these conditions.

Extension of Demand : Other things being equal, when demand of goods increases due to decline in price of that goods, then it is called ‘Extension of Demand’ . Movement along the same demand curve to lower point is called ‘Extension of Demand’ .

Contraction of Demand : Other things being equal, when demand of goods decreases due to increase in price of that goods, it is called ‘Contraction of Demand’ . Movement along the same demand curve from lower to upper point is called ‘Contraction of Demand’ .

● Shifting of Demand Curve : Shifting of demand curve refers to the situation, when demand curve shifts either to upward or downward to the original demand curve. These changes occur when factors other than price as income, fashion, etc., change due to which demand also changes.

● Increase in Demand : When due to change in factors, other than price of goods, demand of goods increases, it is called ‘Increase in Demand’ . In this case, demand curve shifts to right of the original curve, i.e. , in upward direction.

● Causes of Increase in Demand : There are following causes of increase in demand : (a) Increase in income of the consumer,

(b) Increase in price of substitute goods,

(c) Decrease in price of complementary goods,

(d) Increase in hobbies, taste and price of consumer,

(e) Increase in number of buyers,

(f) Possibility of price rise,

(g) Possibility of increase in income of the consumer.

● Decrease in Demand : When due to change in factors, other than price of goods, demand of a goods decreases, it is called ‘Decrease in Demand’ . In this case, demand curve shifts to left of the original curve i.e. in downward direction.

● Causes of Decrease in Demand : Causes for the decrease in demand are :

(a) Decrease in income of consumer,

(b) Decrease in price of substitute goods,

(c) Decrease in price of complementary goods,

(d) Decrease in taste, interest and priorities of consumer for goods,

(e) Decline in number of buyers,

(f) Possibility of decrease in prices,

(g) Possibility of expected decrease in price,

(h) Possibility of decrease in income of the consumer in future.

QUESTIONS Ultra Short Answer Type Questions

1. Which term is used for Income Demand Curve ? (B.S.E.B. , 2014)

2. What is the demand function ? (Raj. Board , 2015)

3. Define ‘demand’. [J.A.C., 2016 (Arts )]

4. Write the meaning of Ceteris Paribus. (Raj. Board, 2016)

5. Write down types of demand. (U.S.E.B., 2016)

6. When does ‘shift in demand’ take place ? (C.B.S.E., 2016)

7. When does ‘increase in demand’ take place ?

(C.B.S.E., 2016)

8. Is law of demand a qualitative statement or quantitative statement ?

(U.S.E.B., 2017)

9. When is a good considered an inferior good ?

(C.B.S.E., 2017) 10. When is a good considered a normal good ? [CBSE,

2017] 11. When does ‘change in demand’ take place ? (CBSE , 2018) 12.

When does ‘change in quantity demanded’ take place ? (CBSE , 2018)

Very Short Answer Type Questions

1. What is meant by Demand ? (U.S.E.B., 2010)

2. What is a Demand Schedule ? (J.A.C., 2010; U.S.E.B., 2019)

3. Name two determinants of Demand.

4. What is meant by Law of Demand ? (C.B.S.E., 2010; U.S.E.B., 2014)

5. State the Law of Demand. What is meant by the assumption “Other things remaining the same”? (J.A.C., 2011) 6. What do you understand by Substitute Goods ? Give two examples. (U.S.E.B., 2013) 7. Explain complementary goods and substitutes with an example. [Raj. Board, 2016; J.A.C. (Art ), 2017; B.S.E.B. (Arts ), 2018] 8. Mention two exceptions of Law of Demand.

6. Distinguish between ‘Desire’ and ‘Demand’.

[B.S.E.B. (Arts), 2013; J.A.C. (Comm. ), 2017] 10. What is the slope of Demand Curve for Giffin Goods ? 11. Define normal goods. (U.S.E.B., 2017) 12. What is the relationship between price and Demand ? (B.S.E.B., 2019) 13. What is meant by Extension or Expansion of Demand ? 14. What is meant by Contraction of Demand ? 15. Define Market Demand. (C.B.S.E., A.I., 2012, 13; Raj. Board, 2017) 16. Explain any one reason of the shifting of Demand Curve. (C.B.S.E., 2012) 17. What does the movement on the same Demand Curve show ? 18. What is Increase in Demand ? Or What does the movement of demand curve towards right show ? [C.B.S.E., (O.D.), 2013] 19. How is price affected by increase in demand ? (B.S.E.B., 2019) 20. What do you mean by ‘Giffin’ goods ? [U.S.E.B., 2010; B.S.E. B. (Comm ). 2015] 21. What is the meaning of change in demand ? [J.A.C., 2012, B.S.E.D. (Comm. ), 2015] 22. What is ‘Giffin Paradox’ ? (B.S.E.B. , 2014)

52

Short Answer Type Questions

1. Distinguish between ‘Extension in Demand’ and ‘Increase in Demand’. What causes the increase in demand ?

2. Explain the factors that effect the Market Demand of a commodity. (Raj. Board, 2017; J.A.C., 2019)

3. Explain the Law of Demand with the help of a demand schedule.

[U.S.E.B., 2010,11, J.A.C. (Comm.) 2013; B.S.E.B. (Comm. ), 2018] Or Discuss the Law of Demand.

[B.S.E.B., 2012; (Comm.) , 2017]

4. Why does demand curve of normal goods slope downward from left to right ?

[U.S.E.B., 2013; J.A.C. , 2014; B.S.E.B. (Comm. ) 2015]

5. Distinguish between extension of demand and increase in demand with the help of diagram.

(C.B.S.E., 2010; U.S.E.B., 2013)

6. Explain Giffin’s Paradox in brief. [B.S.E.B. (Arts ), 2015]

7. What are the exceptions of Law of Demand ? [J.A.C. (Comm.), 2012, 13; BSEB, 2019]

8. State four factors causing increase in demand. (J.A.C. , 2012)

9. State four factors causing decrease in demand. (J.A.C. , 2012) 10. What is meant by demand curve and demand function ? Clarify. (U.S.E.B., 2019) 11. Distinguish between :

(a) Normal Goods and Inferior Goods.

2019. 12. Distinguish between ‘Change in Demand’ and ‘Change in Quantity Demanded’ for a commodity. (B.S.E.B., 2011, 14) Or

Explain the difference between ‘change in demand’ and ‘change in quantity demanded’. (C.B.S.E., 2015) 13. State the Law of Demand and the assumptions behind it. [B.S.E.B. (Comm. ) 2015] 14. How does a change in the price of related goods affect the demand of a commodity ? Explain.

(C.B.S.E., 2011, 13, 16) 15. Distinguish between Individual’s Demand and Market Demand. Name the factors affecting demand for a good by an individual. (C.B.S.E., 2018) 16. How will an increase in the price of coffee affect the demand for tea? Use diagram. [J.A.C. (Arts ), 2013, 16] 17. What do you mean by Demand Curve? Why does demand curve slope downward left to the right ?

[B.S.E.B. , 2015 (Arts )] 18. Goods X and Y are substitutes. Explain the effect of fall in price of Y on demand for X. (C.B.S.E., 2010, 13) 19. What are the assumptions of the law of demand ? (J.A.C., 2010, 14) 20. Why does demand curve slopes downward ?

(BSEB, 2015, 18; J.A.C., 2013, 19) 21. How does the increase in consumer’s income affect the demand of a commodity ? (C.B.S.E., 2011, 13, 16) 22.

What do you mean by inferior good ? Explain with example. (U.S.E.B., 2012) 23. ‘‘Demand curve is depiction of law of demand.’’ Clarify. [B.S.E.B., (Arts ), 2014]

Introductory Micro Economics

24. Distinguish between contraction of demand and decrease in demand. [J.A.C., (Arts ), 2016]

25. Explain in brief any three causing elements for increase in demand. [JAC, (Arts ), 2014]

26. Define ‘market demand’ for a good. State the factors that affect it. (C.B.S.E., 2015) Or

Define demand. Name the factors affecting market demand. (C.B.S.E., 2018) 27. What is the effect of shift in demand curve towards the left on quantity of commodity and its price. Explain with help of a diagram. (Raj. Board, 2017)

28. What are the essential elements of demand ?

(MP Board, 2019)

Long Answer Type Questions

1. Explain ‘Individual Demand’ and ‘Market Demand’ with the help of schedules. (C.B.S.E ., 2016)

2. Explain the law of demand with the help of a diagram. Explain any five factors affecting demand of a commodity. (B.S.E.B., 2012, 18) Or

What is Demand ? Explain the determinants of demand. (C.B.S.E., 2016)

3. Why does Demand Curve slope downward from left to right ? [B.S.E.B., 2011, 13; J.A.C., (Comm. ), 2017] Or

Why does Law of Demand operates ?

4. Explain the Law of Demand and what are its assumptions ? [J.A.C., 2010; BSEB (Comm.) 2017]

5. What is Demand Curve ? Why does demand curve slope downwards ? Are there exceptions to it ?

6. Explain with the help of a diagram, the effect of the following changes on the demand of a commodity :

(i) Fall in the price of the substitute goods.

(ii) Fall in income of its buyer.

7. Explain with the help of a diagram, the effect of the following changes on

the demand of a commodity :

(i) Increase in the price of complementary goods. (ii) Increase in the price of substitute goods.

8. Explain with the help of a diagram, the effect of the following changes on the demand of a commodity: (C.B.S.E., 2012) (i) A fall in the price of complementary goods. (ii) A fall in the income of its buyer.

9. Explain the effect of the following on demand for a goods : (C.B.S.E. , 2015) (i) Rise in income, (ii) Rise in prices of related goods. 10. Explain the determinants of demand. (J.A.C., 2011) 11. Distinguish between inferior goods and normal goods. Also give examples. (C.B.S.E., 2012) 12. Explain the shift of demand curve. (Raj. Board, 2013) 13. Distinguish between giffin goods and inferior goods. (B.S.E.B. , 2014) 14. Explain shift in the demand curve and movement along with demand curve with the help of diagram. (B.S.E.B. , 2014) 15. Explain any three causes of a rightward shift in demand curve (C.B.S.E. , 2015) 16. Distinguish between individual demand and market demand. (MP Board , 2019) 17. Distinguish between substitute goods and complementary goods. (MP Board , 2019)

Objective Type Questions

(A) Multiple Choice Questions :

1. Which element is essential for demand ?

(a) Desire to consume (b) Given price

(c) Willingness to spend (d) All the above

2. Demand Curve generally slopes : (B.S.E.B. , 2011, 17, 18) (a) Upward from left to right

(b) Downward from left to right

(c) Parallel to X-axis

(d) Parallel to Y-axis

3. In which goods, price fall does not make any increase in (B.S.E.B. , 2019)

(b) Comfort Goods

(d) None of the these

demand ?

(a) Necessary Goods (c) Luxuries Goods

4. Which of the following factor affects demand ? (a) Price (b) Change in income (c) Taste of the Consumer (d) All the above

5. Goods, which can alternatively be used, are called :

(a) Complementary Goods (c) Comfort Goods 6. Law of Demand is a :

(a) Qualitative Statement (c) Both (a) and (b)

[ B.S.E.B., 2016 (Comm. )] (b) Substitute Goods (d) None of the these

[ B.S.E.B. (Comm. ) 2015] (b) Quantitative Statement (d) None of the above 15. The slope of the demand curve of a normal good is :

(a) Negative (c) Zero

( B.S.E.B., 2015, 17) (b) Positive (d) Undefine

16. With the increase in income consumer decreases the consumption of which goods ? (a) Inferior Goods (c) Giffin Goods (B.S.E.B. , 2015, 17)

(b) Normal Goods (d) Both (a) and (b)

17. Which is a reason of change in demand ? (B.S.E.B. , 2015, 19) (a) Change in consumer’s income (b) Change in price of related goods (c) Population increase (d) All of these

18. The demand curve of a goods shifts from DD’ to dd’ (C.B.S.E. , 2015)

19. Which of the following is a demand function ? [B.S.E.B. (Comm. ) 2018] (a) \mathsf { P } _ { x } \left( \mathsf { b } \right) \mathsf { D } _ { x } = \mathsf { P } _ { x }

(c) \mathrm { D } _ { x } = f ( \mathrm { P } _ { x } ) (d) None of the these

8. When change in the price of goods-X affects the demand of goods-Y, this demand is called :

(b) Income Demand (d) All the above (a) Price Demand (c) Cross Demand

9. For normal goods, Law of Demand states the ............ relationship between price and quantity of goods : (a) Direct (b) Positive

(c) Increase (d) None of the above

10. Which of the following is a reason for fall in demand ? (a) Fall in Income (b) Fall in Number of Buyers (c) Fall in Taste of Consumer (d) All the above

11. With rise in coffee price, the demand of tea :

(B.S.E.B., 2012, 16; J.A.C., 2018) (a) Rises (b) Falls

(c) Remains stable (d) None of the these

12. Contraction in demand appears when :

(J.A.C., 2012; B.S.E.B., 2018) (a) Price rises and demand falls

(b) Price rises and demand also rises.

(c) Price remains stable and demand falls

(d) Price falls but demand remains stable

13. For a change in which of the following, there is no change in demand ? (B.S.E.B., 2015, 17 ) (a) Change in price (b) Change in income (c) Change in taste and fashion

(d) none of these

14. With a rise in price the demand for Giffin goods : [B.S.E.B., (Arts ),

2015] (a) Increases (b) Decreases

(c) Remains constant (d) becomes unstable This shift can be caused by :

(a) fall in the price of the goods.

(b) rise in the price of the goods.

(c) rise in the price of substitute goods.

(d) rise in the price of complementary goods.

19. Increase in the price of petrol there will be car demand curve in : (MP Board , 2019) (a) Rightward shift (b) Upward movement (c) Leftward shift (d) Downward movement [Ans. 1. (d), 2. (b), 3. (a), 4. (d), 5. (b), 6. (a), 7. (c), 8. (d), 9. (c), 10. (d), 11. (a), 12. (a), 13. (d), 14. (a), 15. (a), 16. (c), 17. (d) , 18. (c), 19. (c)]

(B) Fill in the Blanks :

1. Table relating to price and quantity demanded is called

2. Demand Curve slopes ................. from left to right.

3. Demand curve for substitute goods slopes ................ from left to right.

4. Income effect for normal goods is ................... .

5. Movement on the same demand curve is called .............. and ............ of demand.

6. Demand curve will shift to the .................... with increase in consumers.

[Ans. 1. demand schedule, 2. downward, 3. upward, 4. positive, 5.

extension; contraction, 6. right.]

(C) State True/False

1. Demand curve generally slopes upward from left to right.

2. Goods, which can alternatively be used are called ‘Substitute Goods.

3. Law of Demand is a qualitative statement.

54

Introductory Micro Economics

4. With an increase in income consumer decreases the consumption of Giffin goods.

5. The slope of the demand curve of a normal good is positive. [Ans. 1.

False, 2. True, 3. True, 4. True, 5. False.] (D) Match the following Column

‘A’

1. Gross Demand

2. Derived Demand

3. Joint Demand

4. Demand Function

5. Slope of demand curve

‘B’

(a) Scooter-Petrol

(b) Complementary Goods (c) Shift in Demand curve (d) Downwards (e) D _ { x } { = } f ( \mathbf { P } _ { x } )

[ Ans. 1. (b), 2. (c), 3. (a), 4. (e), 5. (d).]

(E) One Word Answer :

1. What relation does price has with demand for normal goods ? 2. What shape demand curve adopts for normal goods ? 3. Is law of demand a qualitative statement ?

2. What type of income effect becomes for normal goods ?

[Ans. 1. Inverse, 2. Negative slope, 3. Yes, 4. Positive.]

High Order Thinking Skills Questions HOTS

1. The word ‘demand’ differs with the term ‘quantity demanded’. How ? (See : Box 1)

2. Income demand for inferior goods creates Giffin's Paradox. Explain.

Or

Which is such a good in which demand rises even if consumer’s income falls ?

(See : Point 2 of Section 4.6.2)

3. Why do complementary goods have cross demand ? (See : Point 2 of Section 4.6.3)

4. Why does income effect of Giffin's goods become negative ? (See : Point 2 of Section 4.6.2)

VBQ

Value Based Questions

1. What type of cross demand appears in substitute goods ?

(See : Section 4.6.3)

2. Why are goods demanded ?

(See : Box 7)

3. How does rise in purchasing power make the slope of demand curve negative ?

[See : Section 4.8 Point (2)]

4. Giffin good must be inferior good, while inferior good may or may not be ‘Giffin good’. Comment.

(See : Box 9)

MDQ

Case Study Based on Evaluation & Multi-disciplinary Questions

1. In what circumstances does a demand curve get a shifting ? (See : Point B of Section 4.10)

2. Can a demand curve become positively sloped ? (See : Section 4.9 Point 4)

3. What is the effect of increase in purchasing power in slope of demand curve ?

(See : Section 4.8 Point 2)

4. ‘A fall in price of a commodity always leads to expansion of its demand.’ Do you agree ?

(Hint : Not always, only in normal goods.)

NCERT CORNER

Q.1. Suppose there are two consumers in the market for goods and their demand functions are as follows :

\mathbf { d _ { \lambda _ { 1 } } } \left( \mathbf { p } \right) = 2 \mathbf { 0 } - \mathbf { p } for any price less than or equal to 15 and \mathbf { d } _ { 1 } \left( \mathbf { p } \right) = \mathbf { 0 } at any price greater than 15. d { \bf \Gamma } _ { 2 } \left( \mathbf { p } \right) = 3 \mathbf { 0 } - 2 \mathbf { p } for any price less than or equal to 15 and \mathbf { d } _ { \mathbf { \lambda } _ { 1 } } ( \mathbf { p } ) = \mathbf { 0 } at any price greater than 15. Find out the market demand function. Ans. \mathrm { d } _ { 1 } \left( \mathrm { p } \right) = 2 0 - \mathrm { p } \ldots ( \mathrm { i } )

\mathrm { d } _ { 2 } \left( \mathrm { p } \right) = 3 0 - 2 \mathrm { p } \ldots ( \mathrm { i i } ) Market Demand ( \mathrm { d } _ { 1 } + \mathrm { d } _ { 2 } ) = 5 0 - 3 \mathrm { p }

Market demand for any price less than or equal to 15 is 50 – 3p and market demand at any price greater than 15 is zero.

p
10
3
and
d
1
(
p
) = 0 for
p
10
3
Since all the 20 consumers have identical demand, the market demand function would be found out by adding the individual demand functions of 20 consumers.

Q. 2. Suppose there are 20 consumers for a goods and they have identical demand functions : d (p)
= 10 - 3p for any price less than or equal to 10
3
and d 1(p) = 0 at any price greater than 10
3. What

is the market demand function ?
Ans. Number of consumers = 20
Demand function of a consumer = d(p) = 10 - 3p for

The Market Demand function will be : $d(p) = 200 - 60p \text{ for } p^{10} \text{ and } d_{1}(p) = 0 \text{ for}_{3}$ p 10. 3

Q. 3. Consider a market where there are just two consumers and suppose their demands for the goods are given as follows :

$p d_{1} d_{2}$ 1924

2 8 20 3 7 18 4 6 16 5 5 14 6 4 12

Calculate the market demand for the goods. Ans. Table showing Market Demand for the Goods

Quantity Price demanded

(^` ) by Consumer Quantity Market demanded Demand

by Consumer ( d _ { 1 } + d _ { 2 } ) ( d _ { 1 } ) ( d _ { 2 } )

1 9 24 33 2 8 20 28 3 7 18 25 4 6 16 22 5 5 14 19 6 4 12 16

Q. 4. What do you mean by normal goods ? of two goods which are substitutes of each other. Ans. See Section 4.6.2. Ans. See Section 4.6.3. Q. 5. What do you mean by ‘inferior goods’ ? Give Q. 7. What do you mean by complements ? Give exsome examples. amples of two goods which are complements Ans. See Section 4.6.2. of each other.

Q. 6. What do you mean by substitutes ? Give examples Ans. See Section 4.6.4(1). ❐

5

PRICE ELASTICITY OF DEMAND

STUDY MATERIAL INCLUDED IN THE CHAPTER

5.1. Elasticity of Demand : Introductory Concept. 5.2. Elasticity of Demand Or Price Elasticity of Demand 5.3. Methods of Measuring Elasticity of Demand 5.4. Various Degrees of Elasticity of Demand in a Straight Line Demand Curve 5.5. Flatter the Demand Curve, Greater the Elasticity. 5.6. Factors Affecting Elasticity of Demand 5.7. Importance of Elasticity of Demand Thinking Skills (HOTS) Questions disciplinary Questions (MDQ) Numerical Questions

5.1. Elasticity of Demand : Introductory Concept

Elasticity means tendency of increasing or decreasing elasticity, which depends on two factors—‘Nature of Goods’ and the ‘Pressure on it’ . When goods undergoes greater change in response to less pressure (or force), it is said to be highly elastic and when it produces less change in response to high pressure, it is said to be less elastic. Goods which produce meagre or no change are said to be inelastic. On the basis of this concept, elasticity of demand has been explained to observe change in demand due to change in price.

5.2. Elasticity of Demand

A Quick Review of the Chapter Questions High Order Value Based Questions (VBQ) Case Study Based on Evaluation & MultiNCERT Corner Or

Price Elasticity of Demand 5.2.1. Important Definitions

(i) According to Marshall, “ The Elasticity (or responsiveness) of demand in a market is great or small according as the amount demanded increases much or little for a given fall in price, or diminishes much or little for a given rise in price.”

(ii) According to Samuelson , “This is a concept devised to indicate the degree of responsiveness of quantity demanded to changes in market

prices.”

Difference between Law of Demand and Elasticity of Demand Demand of goods changes due to change in price of the goods but changes in demand are not uniform in all cases. Law

of Demand is only a ‘Qualitative Statement’ as it does not explain the quantity of change in demand due to change in price. It only explains the direction of the change. ‘Elasticity of Demand’ is an effort by economist to present law of demand in form of ‘Quantitative statement’ . We can say that, other things being equal, elasticity of demand expresses change in quantity of demand relative to change in price of goods. Points of difference between Law of Demand and Elasticity of Demand are :

(a) Law of demand is a ‘qualitative statement’ which expresses the change in direction of demand due to change in

price of the goods while elasticity of demand is a ‘quantitative statement’ which measures the quantitative change in demand of goods due to price change.

(b) Law of demand in general conditions, indicates inverse relation between price of goods and demand for it while elasticity of demand can be positive or negative.

(c) Law of Demand expresses only price-demand relationship, while elasticity of demand can also measure the change in quantity demanded due to change in income, related goods, etc.

Box 1

It is clear from the above definitions, that : ‘‘It is a ratio of percentage change in quantity demanded

‘‘Price elasticity of demand may be defined as the per^{to percentage change in price of that commodity.’’} centage change in the quantity demanded of a

commodity Elasticity of Demand ( $e_{d}$ ) =

divided by the percentage change in price of that commodity.’’ Proportionate Change in Quantity Demanded

Or Proportionate Change in Price

Price Elasticity of Demand

In Fig. 1, DD is Demand Curve which represents inverse relationship between price of a commodity and quantity demanded of it when other things remain constant. At point P, consumer is consuming OA quantity of goods at price OC. When price decreases by P, consumption increases by Q. In other words, consumption increases due to decline in prices. According to figure,

e _ {d} =

Proportionate Change in Quantity Demanded Proportionate Change in Price = Q/Q P/P

5.2.2. Degrees of Elasticity of Demand

There are five degrees of elasticity of demand : where

Q = Change in Demand, Q = Initial Demand, P = Change in Price, P = Initial Price

But elasticity of demand is negative because there is inverse relationship between demand of goods and its price.

e
d
=
Q/Q
P/P
QP=QP
QP_{ed=P Q}

Some Unique Facts about Price Elasticity 1. The Coefficient of price elasticity of demand is always a negative number due to inverse relationship between price and quantity demanded. So, minus sign is ignored while writing the value of elasticity.

2. The coefficient of price elasticity of demand is a pure number and is independent of price and quantity units. (It does not contain ‘Rupees’ or ‘Kilogram’ etc.)

Degrees of Elasticity of Demand

(1) Relatively Elastic Demand : When due to change in price of goods, demand changes proportionately greater than change in price, then demand of that goods is called ‘Relatively Elastic Demand’, Or

1. Relatively Elastic Demand ( e > 1 )

2. Relatively Inelastic Demand ( e < 1 )

3. Unit Elastic Demand (e = 1)

4. Perfectly Inelastic Demand (e = 0)

5. Perfectly Elastic Demand (e = ) In other words,

Proportionate

Change in Demand Proportionate Change in Price

\mathrm{Q} > \mathrm{P} _ {\mathrm{QP}}

Illustration 1. (Example of Relatively Elastic Demand)

Price of Goods Demand of Goods { \bf 5 } \left( { \bf P } _ { 1 } \right) { \bf 1 0 } \left( { \bf Q } _ { 1 } \right) 4 \left( \mathbf { P } _ { 2 } \right) 1 5 \left( \mathbf { Q } _ { 2 } \right)

\mathrm{P} = \mathrm{P} _ {2} - \mathrm{P} _ {1} = 4 - 5 = - 1

\mathrm{Q} = \mathrm{Q} _ {2} - \mathrm{Q} _ {1} = 1 5 - 1 0 = 5

\mathrm{Demand} _ {e}

Q/Q 5 / 10 5 5=1
P/P1 1 / 5 10 1
=-2.5 [Negative sign represents inverse price-demand relationship] Or e > 1

58
Introductory Micro Economics
59

(This condition has been represented in Fig. 2, where demand is affected in greater, proportion than change in price or relative change in demand is greater than relative change in price.)

●

Illustration 1A. When price of a goods rises from ` 5 per unit to `6 per unit, its demand falls from 20 units to 10 units. Compare expenditures on the goods to determine whether demand is elastic or inelastic.

Solution :

Price Quantity Total (` / unit) (units) Expenditure P × Q 5 20 100 6 10 60

In this case, rise in price leads to fall in the total expenditure, so the demand will be elastic i.e., e _ { d } > 1 . (2) Relatively Inelastic Demand : When change in price causes proportionately less change in demand, then demand of such goods is called ‘Relatively Inelastic Demand’ Or

Proportionate >

Change in Price Proportionate Change in Demand

P

\mathrm{Or} _ {\mathrm{P}} > \mathrm{QQ}

Fig . 3
Illustration 2. (Example of Relatively Inelastic Demand)

Price of Goods Demand of Goods 10 \left( \mathbf { P } _ { 1 } \right) 4 \left( \mathbf { Q } _ { 1 } \right) 2 \left( \mathbf { P } _ { 2 } \right) 5 \left( \mathbf { Q } _ { 2 } \right)

Determine the Price Elasticity. Solution : Given that;

\mathrm{P} = \mathrm{P} _ {2} - \mathrm{P} _ {1} = 2 - 1 0 = - 8

\mathrm{Q} = \mathrm{Q} _ {2} - \mathrm{Q} _ {1} = 5 - 4 = 1

We know that,

_e = Proportionate Change in Demand Proportionate Change in Price \mathrm { Q } / \mathrm { Q } _ { 1 } 1 / 4 \mathrm { P } / \mathrm { P } _ { 1 } 8 / 1 0 1 10 0.3125 4 8

Or e is less than unity. [In Fig. 3, due to change in price, demand of a goods increases by Q. It shows that elasticity of demand is less than unity.]

(3) Unit Elasticity of Demand : When change in price of goods produces similar proportionate change in demand, then demand of that goods is called ‘Unit Elasticity of Demand’ , Or

Proportionate Change in Price Proportionate Change_{> in Demand}

Fig . 4

Illustration 3. (Example of Unit Elasticity of Demand)

Price of Goods Demand of Goods 10 \mathbf { \left( P _ { \lambda _ { 1 } } \right) 1 0 0 } \left( \mathbf { Q } _ { \lambda _ { 1 } } \right) \mathbf { 1 5 } \left( \mathbf { P } _ { \textrm { 2 } } \right) \mathbf { 5 0 } \left( \mathbf { Q } _ { \textrm { 2 } } \right) Determine the Price Elasticity. Solution : Given that, \mathbf { P } = \mathbf { P } _ { 2 } - \mathbf { P } _ { 1 } = 1 5 - 1 0 = 5 \mathrm { Q } = \mathrm { Q } _ { 2 } - \mathrm { Q } _ { 1 } = 5 0 - 1 0 0 = - 5 0 We know that, = Proportionate Change in \mathrm { D e m a n d } _ { e } Proportionate Change in Price \mathrm { Q / Q } \ : 1 \ : 5 0 \ : / \ : 1 0 0 \ : 1 \ : \mathrm { p / P } _ { 1 } \ : 5 \ : / \ : 1 0 Or, elasticity of demand is unity.

Rectangular Hyperbola

A Special Case of Demand Curve

When Demand Curve is in the form of ‘Rectangular Hyperbola’ , then at all points of Demand Curve, elasticity of demand becomes unity. Under rectangular hyperbola, area of all quadrilaterals is equal because each quadrilateral represents total expenditure on goods. It can be concluded that in case of unit elastic demand, expenditure on a

Fig . 5

constant, even if price increases or decreases. In Fig. 5, Area OBTP = Area \mathrm { O E J P } _ { 1 } Hence, elasticity of demand becomes unity at all

points of Demand Curve. When it takes the shape of rectangular hyperbola.

Box 3

(4) Perfectly Inelastic Demand : When change in price of goods produces no change in demand, then demand of that goods is called ‘Perfectly Inelastic Demand’ . Or

Proportional Change = 0 in Demand

Fig . 6

Illustration 4. (Example of Perfectly Inelastic Demand)

Price of Goods Demand of Goods \mathbf { 1 0 \left( P _ { 1 } \right) 1 0 0 \left( Q _ { 1 } \right) } \mathbf { 1 9 } \left( \mathbf { P } _ { 2 } \right) \mathbf { 1 0 0 } \left( \mathbf { Q } _ { 2 } \right)

Determine the Price Elasticity. Solution : Given that,
Q = Q2 - Q1 = 100 - 100 = 0 Q
Thus, Q = 0
1
We know that,
e = Proportionate Change in Demand
Proportionate Change in Price
=
DP/P1
D
Q/Q
1
=
DP/P
0=0
1

i.e. Elasticity of Demand is zero.

[This situation has been shown in Fig. 6. When demand is perfectly inelastic, then demand curve becomes parallel to Y-axis.]

(5) Perfectly Elastic Demand : When negligible or no change in price of goods

P

produces a large change in demand, then demand of such goods is said to ‘Perfectly E l a s t i c ^ { \prime } . In such condition of demand, demand becomes zero, at the minute or minor increase in price of goods. In perfect competition, Demand Curve in market is perfectly or infinitely elastic. But in real and practical life, demand for any goods is not perfectly elastic. In case of perfectly elastic demand,

_ \mathrm{P} = 0

In this way, demand curve DD for perfectly elastic demand conditions is

parallel to X-axis. ● Illustration 5. (Example of Perfectly Elastic Demand)

Price of Goods Demand of Goods
10 (P₁) 100 (Q₁)
10 (P₂) 120 (Q₂)

60
Introductory Micro Economics
60
Determine the Price Elasticity.
Solution : Given that,
P = P2 - P1 = 10 - 10 = 0 Thus,
P
P
1
= 0 10 = 0
We know that, e =
Proportionate Change in Demand Proportionate Change in Price
e
=
Q/Q1 Q/Q1
P/P1 0
e =
Thus, elasticity of demand is infinitely elastic or perfectly elastic.
(In Fig. 7, perfectly elastic demand curve has been shown parallel to X-axis).

Comparative Representation of all Five Degrees of Demand Elasticity
Degree of Type of Elasticity Elasticity
1. e > 1 Relatively Elastic Demand
2. e < 1 Relatively Inelastic Demand
3. e = 1 Unit Elastic Demand
4. e = 0 Perfectly Inelastic Demand

5. e = Perfectly Elastic Demand Proportionate change in demand is greater than proportionate change in price. Q P Q P

Proportionate change in demand is less than proportionate change in price. Q P Q P

Proportionate change in demand is equal to proportionate change in price.

Proportionate change in demand is zero with any change in price.

Demand changes without any change in price.

Elasticity of this nature is impractical and hypothetical. Box 4 Characteristics

Flatter dem and curve has more elastic demand
Fig . 8 5.3. Methods of Measuring Elasticity of Demand

Measurement Methods (1) Proportionate or Percentage Method (2) Geometric or Point Method (3) Total Expenditure Method

Price Elasticity of Demand

5.3.1. Percentage or Proportionate Method

This method was propounded by Prof. Flux . According to this method, for calculating the elasticity of demand, proportionate or percentage change in demand is divided by proportionate or percentage change in price.

Or e _ { d } =

(–)Proportionate or Percentage Change in Demand Proportionate or Percentage Change in Price

Change in Demand 100 e d = (–) Initial Demand Change in Price 100 Initial Price ₁ Q Q Q Q Q ₁ P P P P P e d ( ) Q Q P P { ^ { \mathrm { p } } \mathrm { { } } ^ { \mathrm { Q } } \mathrm { { O r } } ^ { e } } _ { d } ( \mathbf { \Sigma } ) \mathrm { { Q _ { p } } }

1200 1000 1001000200 100_20%1000

Elasticity of Demand Percent Change in Demand Percent Change in Price

20%_1.3315%

Elasticity of Demand is 1.33 ( i.e. , greater than 1) 5.3.2. Geometric or Point Method

This method is also called ‘Geometrical Method’ . To calculate elasticity of demand at any point on the Demand Curve, a tangent to that point is drawn.

On the basis of Geometrical Method,Lower Segment_{ed Upper Segment}

In Fig. 9, to calculate elasticity of demand at point R on the Demand Curve DD, a tangent AB has been drawn. RB is lower segment and RA is upper segment. Thus, at point R, elasticity of demand will be

Lower Segment RB_{e Upper Segment RA}

Fig . 9

Different points on the same Demand Curve have different Elasticity of Demand In Fig. 10, P and Q are two different points on same Demand Curve DD. Elasticity at point P PB _Elasticity

at point Q QB' It is clear that elasticity is not the QA'

same at points P and Q. Thus, different points on the same demand curve have different elasticity of demand.

Fig . 10
Box 5
5.3.3. Total Expenditure Method

This method was propounded by Prof. Marshall . In this method, amount of change and direction of change in total expenditure are determined as a result of change in price of commodity.

Total Expenditure = Commodity Price × Commodity Demand Only three degrees of the elasticity of demand can be calculated by this method :

(i) Equal to Unit Elasticity : When total expenditure remains constant due to increase or decreases in price, elasticity of demand is equal to unity.

(ii) Greater than Unit Elasticity : When total expenditure increases due to decrease in price or total expenditure decreases due to increase in price, elasticity of demand is greater than unity. (iii) Less than Unit Elasticity : When total expenditure decreases due to decrease in price or total expenditure

increases due to increase in price, elasticity of demand is less than unity.

Elasticity of Demand 1. Greater than Unit (e>1) 2. Unit (e= 1)

Increases ( ↑) or Decreases (↓) Increases (↑) or or Decreases (↓) Increases ( ↑) or Decreases (↓)

All the above three conditions have been represented in Fig. 11. In Fig. 11, elasticity of demand is greater than unit from point A to point B because total expenditure is increasing on decline in prices and total expenditure is decreasing on increase in prices. Elasticity of

demand is equals to unit from point B to C because total expenditure remains constant on either increasing or decreasing the prices.

Elasticity of demand is less than unit from point C to D because total expenditure decreases on decrease in price and increases on increase in price of the goods.

● Illustration 7 : When price of a goods falls from ` 10 per unit to ` 9 per unit, its demand rises from 9 units to 10 units. Compare expenditures on the goods to find price elasticity of demand. Solution :

Price Quantity (\/unit) Demanded (units) 10 9

Total

Expenditure (P × Q) 90

910 90

In this case, price elasticity of demand is unitarily elastic (e _d = 1) as with a fall in prices, the total expenditure remains unaffected.

5.4. Various Degrees of Elasticity of Demand in a Straight Line Demand Curve

All the five degrees of the elasticity of demand can be represented on straight line demand curve by ‘Point Method’.

(i) At point R, elasticity of demand is unit because lower segment RB is equal to upper segment AR.

(ii) At point A, demand is perfectly elastic because upper segment is zero.

(iii) At point B, demand is perfectly inelastic because lower segment is zero.

(iv) Between line RB, elasticity of demand at all points is less than unit because segment is less than the upper segment.

(v) Between line AR, elasticity of demand is more than unit because at every point lower segment is greater than upper segment.

Fig . 13

price is OP and demand is OQ. Fig . 12

It is clear from above analysis that elasticity of demand is different at different points on the same Demand Curve. Elasticity of demand is high at high price level and elasticity of demand

decreases on decrease in price.

In Fig. 13, at point a \ : , e = 1 , when

Atpoint b , e > 1 when price increases to \mathrm { O P } _ { 1 } and demand decrease to \mathrm { O Q } _ { 1 } Atpoint c , e < 1 , when price decreases to \mathrm { O P } _ { 2 } and demand increases to \mathrm { O Q } _ { 2 }

5.5. Flatter the Demand Curve, Greater the Elasticity If two demand curves intersect each other, then at the point of intersection, flatter the curve, more elastic it is.

Proof. In Fig. 14, demand curves \mathrm { D } _ { 1 } and \mathrm { D } _ { 2 } intersect each other at point A. At point A, initial price and initial demand for both curves are OP and OQ respectively.

On decrease in price from OP to \mathrm { O P } _ { 1 } , proportional

change ^P is same for both the curves._P

Price Elasticity of Demand

Fig . 14

\mathrm{D} _ {1} \mathrm{D} _ {1}

Proportionate change in demand \mathrm { Q Q } _ { 1 } \mathrm { O Q }

At point C on demand Curve \mathrm { D } _ { 2 } \mathrm { D } _ { 2 } Proportionate ^QQ2 change in demand_OQ It is clear from the figure, that \mathrm { Q Q } _ { 2 } \mathrm { Q Q } _ { 1 }

i.e. , with equal proportionate change in price, elasticity of demand is greater at point C than point B. So, demand, curve \mathrm { D } _ { 2 } \mathrm { D } _ { 2 } (which is more flatter compared to \mathrm { D } _ { 1 } \mathrm { D } _ { 1 } ) has

more elasticity. Hence, it is clear that, ‘‘When two demand curves intersect each other, then at the point of intersection, flatter the curve, more elastic it is.’’

Three distinct situations when elasticity of demand remains same at all points of demand curve

Box 6
5.6. Factors Affecting Elasticity of Demand goods, use of substitutes

decreases. Tea, coffee, gur, Elasticity of demand is influenced by the following

factors :

(1) Nature of the Goods : On the basis of nature of the goods, goods are classified into three parts : sugar, etc., are examples of substitutes.

(3) Alternative Uses : When goods could be used in only one way, its demand will be inelastic and when it would be used in many ways, its demand will

(a) Necessaries, (b) Comfortable, (c) Luxury. Demand elasticity of necessaries is inelastic because its demand is independent of increase or decrease in price. Demand elasticity of comfortable goods is moderately elastic, while luxurious goods are more elastic.

(2) Availability of Substitutes : When substitutes of any goods is available, then demand elasticity of such goods is highly elastic, because when price of these goods increases, substitutes are used in place of it. In the same way, on decrease in price of these be elastic. For example, coal has many uses—it can be used in railways, houses, industries, etc. Demand of coal for railway is inelastic but for house purpose, its demand is elastic as many cheaper

Factors affecting Elasticity of Demand

(1) Nature of the Goods (2) Availability of Substitutes

(3) Alternative Uses (4) Postponement of Consumption

(5) Expenditure Amount (6) Income Level (7) Price Level (8) Time Period (9) Joint Demand or

Complementarity of Goods (10) Nature and Habits Box 7

alternative goods like wood, cooking gas etc. could be used in place of it.

(4) Postponement of Consumption : If consumption of any goods can be postponed, its demand becomes elastic, e.g. , a person has two woollen clothes. If due to some reason, price of woollens clothes increases, then consumer postpones the idea of buying another sweater in current year. In such a case, demand of woollen clothes for current year will be highly elastic.

(5) Expenditure Amount : Goods on which large part of income is spent, are highly demand elastic and those goods on which small part of income is spent, their demand is generally inelastic. That is why, demand of television, radio, cycle, scooter, etc,. is more elastic as compared to salt, wheat etc.

(6) Income Level : Elasticity of demand for rich people is generally inelastic because increase in price level does not affect them severely while elasticity of demand for poor people is highly elastic because increase in prices affect their purchasing power a lot.

(7) Price Level : Elasticity of demand also depends on price level of the goods. Elasticity of demand will be greater at high price level and less at low level of price.

(8) Time Period : In short run, demand for goods is generally less elastic because usually a consumer changes his habits in long run and but not in shortrun. Moreover, supply of output cannot be increased readily in shortrun.

(9) Joint Demand or Complementarity of Goods : Few goods are demanded alongwith other goods. These are called complementary goods and their demand is inelastic. For example, scooter-petrol, shoes-socks, etc.

(10) Nature and Habits : If a consumer is used to or habitual of any goods, then price change will not affect his demand for goods and his demand for that goods will be perfectly inelastic.

5.7. Importance of Elasticity of Demand

Elasticity of demand is not merely a theoretical concept but it is useful from practical point of view also. Its importance is as follows :

(1) Useful in Theory of Value : According to Marshall , price of goods depends upon relative potential of demand and supply of it. Modern economists present demand and supply curve and revenue and cost curves respectively. Cost curve depends upon time element, while revenue curve depends on elasticity of demand.

(2) Useful for the Monopolist : A monopolist uses price discrimination policy to maximise his production by taking different prices from different consumers in different markets. A monopolist charges higher price in market of having lower elasticity and charges lower prices in the market with higher elastic demand.

(3) Useful in the Theory of Distribution : Elasticity of demand determines the rewards to factors of production. Demand of factors of production is

derived in nature. Inelastic factors of production get higher reward and viceversa .

(4) Useful for Government : An efficient Finance Minister makes efforts to earn maximum income and remove inequality of income and wealth. For imposing tax, he keeps in mind the elasticities of different goods. Goods whose demand is inelastic will be taxed more because price change will not affect its demand while highly demand elastic goods will not be taxed because increases in their prices will adversely affect their consumption.

(5) Useful in International Trade : Terms of trade between two countries depend on the elasticity of demand and supply of their imports and exports. If demand of exports is inelastic, then high price can be taken from the foreigners. In this way, elasticity of demand affects ‘Terms of Trade’ .

(6) Fare and Freight : Before deciding fare and freight in transportation company visualises whether demand of transportation is elastic or inelastic. If demand of certain transportation is inelastic, then cost of using or hiring that particular transportation will be made costlier.

A QUICK REVIEW OF THE CHAPTER

Difference between Law of Demand and Elasticity of Demand : Law of Demand is a qualitative statement which determines only the direction of change in demand with change in price. Elasticity of demand is a quantitative statement which gives quantitative measure of change in demand due to change in price.

Price Elasticity of Demand : Price elasticity of demand is the ratio between proportionate change in demand to proportionate change in price.

e

Proportionate Change in Demand Q/Q

^d Proportionate Change in Price P/P

Degrees of Price Elasticity of Demand :

(a) Perfectly Elastic (e = ), (b) Perfectly Inelastic (e = 0), (c) Unit Elasticity (e = 1), (d) Elasticity more than unity (e > 1), (e) Elasticity less than unity (e < 1).

Perfectly Elastic Demand ( e = ) : When even small increase in price produces infinite changes in demand, then it is called perfectly elastic demand. In this, curve is parallel to X-axis.

Perfectly Inelastic Demand, ( e = 0) : When change in price produces no change in demand, then such a demand is called perfectly inelastic demand. Such a demand curve is perpendicular to X-axis.

Unitary Elastic Demand ( e = 1) : In unit elastic demand percent change in price of goods produces similar percent change in demand. Such a demand curve is a Rectangular Hyperbola and elasticity of demand at every point on this curve is unity.

Greater than Unitary Elastic Demand ( e > 1) : In such demand, percent change in price of commodity causes greater percentage change in quantity demanded.

●●

Less than Unitary Elastic Demand ( e < 1) : In such demand, percent change in price of a commodity causes relatively less change in quantity demanded.

Measurement of Price Elasticity of Demand :

(a) Total Expenditure Method,

(b) Percent or Proportionate Method,

(c) Point Method.

Total Expenditure Method :

(i) Elasticity of demand is unity, (e = 1) when increase or decrease in price causes no change in total

expenditure, i.e. , total expenditure remains constant.

(ii) Elasticity of demand is greater than one (e > 1), when due to decrease in price total expenditure increases

or increase in price causes decline in total expenditure, i.e. , in this case inverse relationship between

price and total expenditure on commodity is instabilised.

(iii) Elasticity of demand is less than one (e < 1), when total expenditure increases on increase in price

of goods or total expenditure decreases on decrease in price of goods, i.e. , Elasticity of demand is greater

than one in case of positive relationship between price of a commodity and total expenditure incurred

on it.

Percentage or Proportionate Method :

_ {e d} = \mathrm{Q/Q}

P/P

Geometric or Point Method :

Elasticity of Demand Lower Segment of Demand Curve

Upper Segment of Demand Curve

Factors affecting Elasticity of Demand :

(a) Nature of Goods, (b) Substitutes, (c) Alternative Use of Goods, (d) Postponement of Consumption, (e) Amount of Expenditure, (f) Income Level, (g) Price Level, (h) Time Period, (i) Complementarity of Goods, (j) Nature and Habits.

Flatter the Demand Curve, Greater the Elasticity : When two demand curves intersect each other, then at the point of intersection, more flatter the curve, greater will be its elasticity.

QUESTIONS Ultra Short Answer Type Questions

1. What is Law of Price Demand ? (B.S.E.B. , 2014)

2. What is the Law of Price Elasticity of Demand ? (B.S.E.B. , 2014)

3. Give an example of perfectly inelastic demand. (Raj. Board , 2016)

4. Mention any two categories of price elasticity of demand. (Raj. Board, 2017)

5. Write the formula to measure Elasticity of Demand on a straight line Demand Curve.

Very Short Answer Type Questions

1. What do you understand by price elasticity of demand ? [Raj. Board, 2013, 16; J.A.C. , 2014, 19; B.S.E.B., (Arts ) 2018; C.B.S.E. , 2019] 2. When is elasticity of demand called Unitary ?

( J.A.C. 2015; B.S.E.B.(Comm. ) 2015; U.S.E.B., 2015) 3. When the demand becomes Perfectly Elastic Demand ? 4. What is meant by Perfectly Inelastic Demand ?

[C.B.S.E., (O.D.) 2013] 5. When does demand become Elastic ?

Or

What is elastic demand ? Clarify. (U.S.E.B., 2017) 6. When does demand become Inelastic ? (C.B.S.E., 2013) 7. Explain percentage and proportionate method of measurement

of elasticity of demand. [J.A.C. (Arts ), 2014, 16]

8. What are zero elasticity and infinite elasticity ? (B.S.E.B. , 2014) 9. What is the elasticity of demand at the point A and B on the given demand curve AB ?

( B.S.E.B. , 2014) 10. Write the meaning of perfectly elastic and perfectly inelastic demand.

(B.S.E.B. , 2018)

Fig . Short Answer Type Questions

1. What is meant by Price Elasticity of Demand ? How many kinds of degrees it has ? (U.S.E.B., 2011, 12)

2. Show the different degrees of Elasticity of Demand with the help of a diagram.

3. Define elasticity of demand. Explain the formula for calculating it. 4. How does the nature of the good affect the elasticity of demand ? (C.B.S.E., 2013)

4. How is elasticity of demand measures with the help of the point method ? 6. Discuss any five factors affecting the Price Elasticity of Demand. [J.A.C., 2010, 16; U.S.E.B., 2013; C.B.S.E., 2013, 15; B.S.E.B ., 2016, 18]

66

Introductory Micro Economics

7. Show with diagrams : (a) Unit Elasticity (c) Zero Elasticity

[J.A.C., (Arts ), 2017] (b) Infinite Elasticity 8. What do you understand by Price Elasticity of Demand ? State any four factors which influence it. (B.S.E.B. , 2010; U.S.E.B ., 2016) 9. Draw a demand schedule of a commodity whose Price

Elasticity of Demand in unitary ? 10. Show that points illustrating all types of Elasticity of

Demand on a straight line Demand Curve which touches both the axis.

11. How does the availability of close substitutes of goods effect the Price Elasticity of Demand of that goods ? Explain. (C.B.S.E., 2013) 12. Explain the geometric method of measuring price elasticity of demand.

12. What do you mean by income elasticity of demand ? 14. Mention the elasticity of demand for following goods : (J.A.C., 2012; (Comm .), 2017]

(a) Wheat (b) Salt (c) Radio (d) Orange (e) Electricity (f) Rice (g) Diamond (h) Milk.

15. By which percentage method elasticity of demand is measured ? (B.S.E.B. , 2014) 16. Draw the demand curves with price elasticity of demand \boldsymbol { e } _ { p } : [B.S.E.B. (Arts ), 2014]

(a) e _ { p } = 0 ( \mathrm { b } ) e _ { p } =

(c) 0 < e _ { p } < 1 \left( \mathrm { d } \right) 1 < e _ { p } <

17. Price elasticity of demand of good X is – 2 and of good Y is –

18. Which of the two goods is more price elastic and why? (C.B.S.E ., 2016) 18. What is meant by inelastic demand ? Compare it with perfectly inelastic demand ? (C.B.S.E ., 2018)

Long Answer Type Questions

1. What do you understand by Price Elasticity of Demand ? What are its degrees ? [B.S.E.B. (Arts), 2013;U.S.E.B., 2013; Raj. Board, 2015; J.A.C., 2018] 2. Explain the Expenditure Method of measuring Price Elasticity of Demand of a commodity.

( J.A.C., 2015,B.S.E.B. (Arts), 2015) 3. Explain the different methods of measuring price elasticity of demand. (J.A.C., 2019) 4. Define price elasticity of demand for a commodity. What would be the shape of demand curve of a commodity when its price elasticity of demand is (i) Zero, (ii) Infinite ?

5. Explain the factors determining price elasticity of demand. [J.A.C. , 2016 (Arts )]

6. ‘‘If two demand curves intersect each other, then at the point of intersection, flatter the curve more elastic it is.’’ Explain.

7. Define ‘Price Elasticity of Demand’. Briefly explain any two methods of measuring it. (J.A.C., 2011, 19)

8. What is Price Elasticity of Demand ? How is it measured ? [J.A.C., 2014, 17; U.S.E.B., 2015; B.S.E.B., 2016, 18]

9. Explain the geometric method of price elasticity of demand with diagram. (U.S.E.B., 2019; Raj. Board, 2015) Objective Type Questions

(A) Multiple Choice Questions :

1. Elasticity of demand is a :

(a) Qualitative Statement (b) Quantitative Statement (c) Both (a) and (b) (d) None of the above 2. Which of the following is a formula for measuring the

elasticity of demand ? [B.S.E.B., 2012 (Arts )] (a) Proportionate Change in Demand

Proportionate Change in Price

(b) Proportionate Change in Price

Proportionate Change in Demand

(c) Change in Demand

Change in Price

(d) None of the above

3. For Giffin goods, price elasticity of demand is : [B.S.E.B., 2011, 17

(Comm. )] (a) Negative (b) Positive

(c) Zero (d) None of the above

4. Following figure shows : (J.A.C., 2019)

D

Fig . (a) High Elastic Demand (b) Perfectly Elastic Demand (c) Perfectly Inelastic Demand (d) Inelastic Demand

5. Which of the following shows elasticity less than one ? (a) Necessity Goods (b) Comforts (c) Luxuries (d) All the above

6. With which method, elasticity of demand is measured ? [B.S.E.B., 2011 (Arts )] (a) Total Expenditure Method (b) Percentage or Proportionate Method (c) Point Method (d) All the above

7. Elastic demand is shown by : (a) \mathrm { ~ Q ~ P _ { ( b ) } ~ P ~ Q ~ } Q P P Q (c) \mathrm { ~ P ~ Q ~ } (d) None of these \mathbf { \partial } \cdot \mathbf { P } \mathbf { \Lambda } \mathbf { Q }

8. What is the price elasticity in following example ? Price of Goods 5 \left( \mathrm { P } _ { 1 } \right) 4 \left( \mathbb { P } _ { 2 } \right)

(a) – 2.5

(\mathrm{Q} _ {1})

(\mathrm{Q} _ {2})

(d) None of these

9. Who propounded the percentage or proportionate method of measuring elasticity of demand ? [B.S.E.B (Arts), 2018] (a) Marshall (b) Flux (c) Hicks (d) None of these 10. Which of the following factor affects elasticity of demand ?

(a) Nature of Goods (c) Income Level

( B.S.E.B (Comm.), 2015) (b) Price Level

(d) All of these

11. How many types elasticity of demand has ? [J.A.C., (Comm. ), 2017; B.S.E.B., 2015, 17, 19] (a) Three (b) Five (c) Six (d) Seven

Price Elasticity of Demand 12. Following figure shows :

67 (D) Match the following Column :

Fig.

(a) High elastic demand

(b) Perfect elastic demand

(c) Perfect inelastic demand

(d) Inelastic demand

13. Elasticity of demand for necessities is :

(c) Greater than unity (d) Less than unity

14. Price elasticity of demand means : [J.A.C., 2012; 16 (Arts )] (a) Change in demand due to change in price

(b) Change in demand

(c) Change in real income

(d) Change in price

15. If a demand of a good changes by 60% due to. 40% change in price, the elasticity of demand is :

( B.S.E.B. (Arts ), 2015, 18) (a) 0.5 (b) – 1.5

(c) 1 (d) 0

16. The elasticity of demand at the mid-point of a straight line (B.S.E.B.

(Comm. ), 2015) (b) will be unity

(d) None of these

demand curve : (a) will be zero (c) will be infinity

17. For luxury goods the demand is : (B.S.E.B., 2015, 17) (a) Inelastic (b) Elastic

(c) Highly Elastic (d) Perfectly Inelastic [Ans. 1. (b), 2. (a), 3. (b), 4. (b), 5. (a), 6. (d), 7. (a), 8. (a), 9. (b), 10. (d), 11. (b), 12. (c), 13. (a), 14. (a), 15. (b), 16. (b), 17. (c)]

(B) Fill in the Blanks :

1. Perfectly elastic demand curve is parallel to .............. axis.

2. For a rectangular hyperbola, the demand curve has ............ elasticity.

3. When total expenditure remains constant with increase or decrease in price, elasticity of demand is ..............

4. For Giffin goods, price elasticity of demand is ................ .

5. For luxuries, elasticity of demand is ............... than one. [Ans. 1. X, 2.

unitary, 3. one, 4. positive, 5. greater.] (C) State True/False

1. Elasticity of demand for necessities is zero.

2. Elasticity of demand is a qualitative statement.

3. Flatter demand curve has more elastic demand.

4. Marshall propounded the percentage method of measuring elasticity of demand. 5. There are six types of elasticity of demand. [Ans. 1. True, 2. False, 3. True, 4. False, 5. False.]

‘A’ 1. Necessities

2. Rectangular Hyperbola Demand Curve

3. Comfortable Goods

4. Luxury Goods

5. Giffin Goods

‘B’

(a) Elasticity of demand is positive

(b) Zero Elastic Demand

(c) Relatively Elastic Demand (d) Greatly Elastic Demand (e) Unitary Elastic Demand

[ Ans. 1. (b), 2. (e), 3. (c), 4. (d), 5. (a).]

(E) Answer in One Word :

1. What is elasticity of perfectly elastic demand ? 2. What is the elasticity for luxury goods ?

2. What type of elasticity is found in Giffin goods ? 4. What is the elasticity of demand in rectangular hyperbola ?

[Ans. 1. Infinite, 2. Highly elastic, 3. Positive, 4. Unity.]

HOTS High Order Thinking Skills Questions

1. Why is elasticity of demand called as quantitative statement of law of demand? (See : Box 1)

2. Explain the relationship between slope and elasticity of demand curve ? (See : Section 5.5)

3. Show that effect of an increase in price on total expenditure depends on the value of price elasticity.

(See : Section 5.3.3)

4. Why are the demand of salt and water is elastic ? [(See : Section 5.6, Point (1)]

VBQ Value Based Questions

1. Why is elasticity of demand always negative ? Give reason. (See : Section 5.2)

2. How does a rectangular hyperbola shape of demand curve affect the elasticity of demand ?

(See : Box 3)

3. Do the different points of the same demand curve show the different elasticity ?

(See : Box 5)

MDQ Case Study Based on Evaluation & Multi-disciplinary Questions

1. Elasticity of demand quantifies the law of demand. How ? (See : Section 5.1)

2. In which special case demand curve becomes rectangular hyperbola ? (See : Box 3)

3. Do the various points of the same demand curve have different elasticity of demand ? Why ?

(See : Box 5)

4. The flatter the demand curve, elasticity will be more. How ? (See : Section 5.5)

68 NUMERICAL QUESTIONS

1. Calculate price elasticity of demand by percentage method from the following :

Price Per Unit (`) 5 6

Expenditure (`)

500

[Ans. e _d = 1.25 (More than unit elastic)]

2. Find out elasticity of demand from the following table : Price Per Unit (`) Quantity Demanded (Kgs.) 10 20

925

[Ans. e _ { d } = 2 . 5 ]

3. Calculate price elasticity of demand from the following information :

Price Per Unit (`) Quantity Demanded 20 300

22 240

[Ans. e _ { d } = - 2 ]

4. Calculate Elasticity of Demand : (JAC, 2019) Price Per Unit (`) Demand in Units 24 30 12 36

[Ans. 0.4 (Inelastic Demand or less than 1)] 5. Compare the elasticity of demand of commodity ^ \prime \mathrm { A } ^ { \prime } and ‘B’ on the basis of the following information : Commodity \mathbf { \delta A } ^ { \prime } Price Total Per unit Expenditure (`)(`) 420 515 Commodity \mathbf { \epsilon } ^ { \prime } B \mathbf { \gamma } ^ { \prime } Price Total Per unit Expenditure (`)(`) 315 416

[Ans. \textit { e } _ { d } for commodity A = Greater than unity, \textit { e } _ { d } for commodity B = Less than unity] 6. From the following data, calculate the price elasticity of demand : (C.B.S.E., 2011) PQ

9 100

9 150

[Ans. \boldsymbol { e } _ { p } = \infty ]

7. A consumer buys 50 units of a good at a price of ` 10 per unit. When price falls to ` 5 per unit he buys 100 units. Find out price elasticity of demand by the total expenditure method. (U.S.E.B., 2012) [Ans. \boldsymbol { e } _ { d } = 1 ]

8. A consumer buys 10 units of a good at a price of ` 9 per unit. At price of ` 10 per unit he buys 9 units. What is price elasticity of demand ? Use expenditure approach. Comment on the likely shape of demand curve on the basis of this measure of elasticity. (C.B.S.E., 2012) [Ans. \boldsymbol { e } _ { d } = 1 ; Demand curve will be Rectangular Hyperbola.] 9. A consumer buys 10 units of a goods at a price of ` 6 per unit. Price elasticity of demand is (–) 1. At whats price

Introductory Micro Economics will he buy 12 units ? Use expenditure approach of price elasticity of demand to answer this question. (C.B.S.E.,

2011) [Ans. ` 5 per unit)]

10. As a result of 5% fall in the price of a goods its demand rises by 12%. Find out price elasticity of demand and say whether demand is elastic or inelastic and why ?

[B.S.E.B., 2012 (Arts )] [Ans. e = 2·4, elastic demand because more than 1)]

11. A consumer buys 20 units of a good at a price of ` 5 per unit. He incurs an expenditure of ` 120 when he buys 24 units. Calculate price elasticity of demand using the percentage method. Comment upon the likely shape of demand curve based on this information. (C.B.S.E., 2012) [And. e { \bf \nabla } _ { d } = \infty ; Demand curve Parallel to X-Axis]

12. What will be the effect of 10% rise in price of a good on its demand, if price elasticity of demand is : (a) zero (b) – 1 (c) – 2 ? (C.B.S.E. , 2016, 18) [Ans. (a) 0, (b) 10%, (c) 20%]

13. The market demand for goods at ` 4 per unit is 100 units. The price rises and as a result its market demand falls to 75 units. Find out the new price, if the price elasticity of demand of that good is – 1. [B.S.E.B. (Arts ), 2013] [Ans. ` 5]

14. When price of a good is ` 7 per unit a consumer buys 12 units. When price falls to ` 6 per unit he spends ` 72 on the good. Calculate price elasticity of demand by using the percentage method. (C.B.S.E., 2012) [Ans. \boldsymbol { e } _ { d } = 0 ]

15. Price elasticity of demand of a goods is (–)1. At a given price the consumer buys 60 units of the goods. How many units will the consumer buy if the price falls by 10 per cent ? [Ans. New Quantity q + \Delta q = 6 0 + 6 = 6 6 ]

16. A 4% rise in the price of X increases total expenditure incurred by a consumer of X commodity. A 4% fall in price of Y has no effect on total expenditure incurred by a consumer of Y. Compare price elasticity of demand of goods of X and Y.

[Ans. e _p of X < 1, e _p of Y = 1]

17. As a result of 5% fall in price of goods, demand rises from 300 units to 318 units. Find out price elasticity of demand. (C.B.S.E., (O.D.), 2013) [Ans. e _ { p } = 1 . 2 ]

18. When price of a goods is ` 13 per unit, the consumer buys 11 units of that goods. When price rises to ` 15 per unit, the consumer continues to buy 11 units. Calculate price elasticity of demand. (C.B.S.E., 2011) [Ans. \boldsymbol { e } _ { p } = 0 ]

19. The quantity demanded of a commodity at a price of ` 10 per unit is 40 units. Its price elasticity of demand is (–) 2. Its price falls by ` 2 per unit. Calculate its quantity at the new price.

[Ans. Change in Quantity = 16, Quantity demanded = 40 + 16 = 56]

20. 8 units of a goods are demanded at a price of ` 7 per unit. Price elasticity of demand is (–) 1. How many units will be demanded if the price rises to ` 8 per unit ? Use expenditure approach of price elasticity of demand to answer this question. (C.B.S.E., 2011) [Ans. 7 units)]

Price Elasticity of Demand

21. 5 per cent fall in the price of X leads to a 10% rise in demand for X. A 2% rise in the price of Y leads to a 6% fall in demand for Y. Calculate and compare price elasticity of demand of X and Y.

[Ans. e _p of X = 2, e _p of Y = 3]

22. The price of a commodity is `10 per unit and quantity demanded at this price is 50 units. Its price falls to ` 6 per unit. How much will be its quantity demanded at the new price if the coefficient of its price elasticity of demand is 0.5 ?

[Ans. 60 Units]

23. Define elasticity of demand. The quantity demanded of a commodity at a price of ` 8 per unit is 60 units. Its price falls by 25 per cent quantity demanded rises by 120 units. Calculate its price elasticity of demand, is its demand elastic ? Give reasons for your answer.

[B.S.E.B., 2011 (Arts )] [Ans. e _ p = 4 . Yes demand is elastic]

24. The price elasticity of demand for a good is 0.4. If its price increases by 5%, by what percentage will its demand fall ? (C.B.S.E., 2013) [Ans. 2% fall]

25. Price elasticity of demand for a product is unity. A household buys 25 units of the product at a price of `5 per unit. If the price of the product rises to`6 per unit, how much quantity of the product will be bought by the household ? [Ans. 20 Units]

26. A consumer purchased 10 units of a commodity when its price was ` 5 per units. He purchased 12 units of the commodity when its price falls to`4 per unit. What is the price elasticity of demand for the commodity at that price ? [J.A.C., (Arts ), 2017] [Ans. e = –1]

27. Price of a commodity falls from `4 to `3 per unit. As a result total expenditure on it rises from`200 to`300. Find out price elasticity of demand by percentage method. [Ans. 4, More than unit elasticity]

28. Price of a commodity rises from, `5 to `6 as a result, the demand falls from 100 units to 80 units. Find out price elasticity of demand by percentage method. [Ans. \boldsymbol { e } _ { p } = 1 (Unit elastic)]

29. A consumer buys 20 units of goods at `10 per unit. When its price falls by 10% its demand rises to 22. Find out price elasticity of demand. [Ans. 1 (Unit elastic)]

30. The coefficient of price elasticity of demand of a commodity is 5. When its price is`10 per unit, its quantity demanded is 40 units. If the price falls to`5 per unit, how much will be its quantity demanded ? [Ans. 140 Units]

31. If the price of a commodity rises by 40% and its quantity demanded falls from 150 units to 120 units. Calculate the elasticity of demand. (C.B.S.E ., 2019) [Ans. ed = 0.5]

Ans. Elasticity of demand ( $e_{d}$ ) along with linear demand curve q = a - bp $^{e_{d}} = b q$

= 20 25 = 0.8.

Given, D(p) = 10 - 3p

NCERT CORNER

Q. 1. Explain price elasticity of demand.

Ans. See Section 5.2.1.

Q. 2. Consider the demand for goods. At price `4, the demand for the goods is 25 units. Suppose price of the goods increases to `5, and as a result, the demand for the goods falls to 20 units. Calculate the price elasticity.

Ans. p _ { 0 } = 4 q _ { 0 } = 2 5

p _ {1} = 5 q _ {1} = 2 0

25 20 4

$= 54_{2554251}$

Q. 3. Consider the demand curve $\mathrm{D}(p) = 10 - 3p$ . What

is the elasticity at price { \bar { \mathbf { 5 } } } _ { 3 2 }

Therefore, a = 10 and b = -3

At price = 53, $q =^{5} = 510335$

Q. 4. Suppose the price elasticity of demand for goods is – 0.2. If there is a 5% increase in the price of the goods, by what percentage will the demand for the goods go down ?

Ans. $e_{p} = -0.2$ (given)

% p = 5 (given)

$= \%^{q}$ We know $e_{p\% p}$

-0.2 = %

q
5
% q = (-0.2) 5 = -1
The demand for the goods will go down by 1%. Q. 5. Suppose the price elasticity of demand for goods is -0.2. How will the expenditure on the goods be affected if there is a 10% increase in the price of the goods?
Ans. e_p = -0.2 (given)
% p = 10 (given)
We know e_p = %q
% p
-0.2 = %
q
10
% q = (-0.2) 10
% q = -2
Since, the percentage decline in quantity (2) is less than the percentage increase in price (10), the expenditure on the goods will go up.

Q. 6. Suppose there was a 4% decrease in the price of goods and as a result, the expenditure on the goods increased by 2%. What can you say about the elasticity of demand ?

Ans. % decrease in price = 4 (given)
% increase in expenditure = 2 (given)
If the fall in price leads to % increase in expenditure, price elasticity is more than one.

PRODUCTION FUNCTION :

RETURNS TO A FACTOR AND

RETURNS TO SCALE

STUDY MATERIAL INCLUDED IN THE CHAPTER

6.1. What is Production ? 6.2. Concepts of Production : Total Product, Marginal Product and Average Product

6.3. Production Function 6.4. Types of Production Function 6.5. Returns to a Factor : Law of Variable Proportion

6.6. Long-run Production Function or Returns to Scale 6.7. Difference between ‘Returns to a Variable Factor’ and ‘Returns to Scale’ A Quick Review of the Chapter Questions High Order Thinking Skills (HOTS)

Questions Value Based Questions (VBQ) Case Study Based on Evaluation & Multi-disciplinary Questions (MDQ) Numerical Questions NCERT Corner

6.1. What is Production ?

Generally speaking, production implies manufacture of physical goods but from scientific point of view human being can neither create nor destroy any goods. Human being can only make goods useful. That means, to increase or to create utility in any goods is called production.

Definitions

(i) According to Ely , “Production means creation of economic utility.”

(ii) According toThomas ,“Production is best defined as the addition of values.”

(iii) According to H. Smith , “Production is the process that creates utility in goods.”

6.2. Concepts of Production : Total Product, Marginal Product and Average Product Three Concepts of Production Total Product Marginal Product

TP = MP or
TP = AP × L

where, L = Units of Factor ● Total Product (TP)
MP_n = TP_n - TP_(n-1) or
MP = TP
L
Average Product
AP = TP
L
where,
L = Units of Factor
Total product is the total amount of goods and services produced in a given period by using various factors of production. Total Product (TP)

Table 1 : Total Product Table 2 : Marginal Product

Factor A Factor B (Land) (Labour) Fixed Factor Variable Factor Total Product (TP)

MP refers to change in TP when one more un it of the vari able factor is used, fixed factor remaining constant.

Rising MP increases TP at a rising rate i.e. rising MP signifies rise in TP at increasing rate.

Similarly falling MP implies rising TP at diminishing rate. When MP becomes zero, any rise in TP gets stopped i.e. at zero MP, TP becomes the highest.

Negative MP results in fall in TP.

Box 1

3 4 5 6 7 40 90 130 160 180 180 160

TP in Table 1 has been shown with a hypothetical example.

In this example, land is fixed factor and labour is variable factor of production. To increase the level of production, as we increase the units of variable factor, Total Production (TP) increases initially. But after this, TP increases slowly and a point comes when TP starts decreasing. It happens because fixed factors are not fully utilized in the beginning, but as we go on increasing the units of variable factor, fixed factors are efficiently utilized. But after it, on increasing units of variable factor, production starts declining.

It is clear from the above table, on increasing variable factor (labour) with fixed factor (land), TP increases till sixth unit of labour. At sixth unit of labour, total production is

maximum but after employing seventh unit of labour, TP decreases. Marginal Product (MP)

Marginal product is the change in total product due to applying one more or less unit of variable factor.

\mathrm{MP} _ {n} = \mathrm{TP} _ {n} - \mathrm{TP} _ {(n - 1)}

Where, MP^th Unit_n = Marginal Product of n

TP_n = Total Product of n Units \mathrm { T P } _ { ( n - 1 ) } = \mathrm { T } otal Product of (n –1) Units. MP can alternatively be calculated with the following formula :

MP = TP

Where, TP = Change in Total Production L = Change in Variable Factor (Labour)

Factor A Factor B (Land) (Labour) Fixed Factor Variable Factor

Total Product (TP)

Marginal Product (MP)

It is clear from the above table that MP increases in the beginning, but starts decreasing afterwards. MP becomes zero at some level of production and becomes negative in the end. It should be noted that TP is maximum at the point where MP is zero.

In the table, at the 6th unit of variable factor labour, MP is zero while TP is maximum at this point. At seventh unit of labour, MP is negative.

Average Product (AP)

Average product (AP) is per unit production of the variable factor. Average product (AP) is obtained by dividing TP (i.e., Total Product) by L (i.e., Variable Factors).

AP is also called per unit productivity.

AP = TP

L

Where, AP = Average Product

TP = Total Product

L = Units of Variable Factors (Labour) Table 3 : Average Product

Factor A Factor B Total Product Average (Land) (Labour) (TP) Product TP

Fixed Factor Variable Factor AP = L

1 1 40 40

1 2 90 45

1 3 130 43.3

1 4 160 40

1 5 180 36

1 6 180 30

1 7 160 22.8 It is clear from table 3 that AP increases in the beginning but starts declining from the third unit, although TP remains positive. AP or Average Product is neither zero nor negative.

● Illustration 1.

Fill up the following Table : Total Marginal Labour Product Product

(TP) (MP) 125 245 360 470 575 675 770 860 in inputs causes change in size of production or output. In this way, physical relationship between Average inputs and outputs is called production function. Product Production function is based on only physical (AP) quantitative relationship and prices are not included in it. Mathematically, Production Function $Q_x = f(A, B, C, D)$ Where, $Q_x =$ Physical Production of Goods X. A, B, C & D are different factors of production. • Definitions Solution : (i) According to Watson, “Production function is the relationship between a firm’s production and Labour TP $MP_n = TP_n - TP_n$ _-1 AP = the material factors of production.” (L) (ii) According to Leftwich, “The term production 1 25 25 2 45 45 - 25 = 20 3 60 60 - 45 = 15 4 70 70 - 60 = 10 5 75 75 - 70 = 5 6 75 75 - 75 = 0 7 70 70 - 75 = -5 8 60 60 - 70 = -10

1 10
2 8
3 6
4 4
5 2
6 0
7–2
8–4
Solution :

● Illustration 2.

Fill up the following Table :

_{25/1 = 25} function refers to physical relationship between 45/2 = 22.5 a firm’s inputs of resources and its output of 60/3 = 20 goods or services per unit of time, leaving prices

^{70/4 = 17.5 aside.” 75/5 = 15} ☞ Production function is not an economic

problem,75/6 = 12.5

70/7 = 10

$60 / 8 = 7.5$

Labour Marginal Product (L) (MP)

Total Product (TP)

Average _{TPProduct L (AP)}

Labour MP TP = Σ MP

1 10 10

2810+8=18

3618+6=24

4 4 24 + 4 = 28

$5228 + 2 = 30$

6 0 3 0 + 0 = 3 0

7 - 2 3 0 - 2 = 2 8

$8 - 428 - 4 = 24$

6.3. Production Function

but it is a technical problem. In other words, production function does not establish economic relations, but establishes the technical relationship between factors of production and output. Production function of a firm is based on a given technique of production or given technical know-how . A firm chooses that technique of production with which it can maximise its production by optimum utilisation of available factors of production. Improvement in production technique will definitely improve production.

Box 2

6.3.1. Assumptions of Production Function Production function is based on following assumptions :

(1) Production function is related to a definite time period.

(2) In short run, few factors of production are fixed and others are variable. AP = (3) In long run, all inputs of production function

^{become variable.10/1 = 10} (4) There is no change in technical level in short run._18/2

= 9 6.3.2. Characteristics of Production Function 24/3 = 8

28/4 = 7 (1) Production function is an engineering concept.

_{30/5 = 6} It explains physical quantitative

_{30/6 = 5} relationship between factors of production and

28/7 = 4^output.

24/8 = 3

(2) Prices of input and output are not included in production function. In this way, it is independent of the prices of input and output. Functional relationship between physical inputs and (3) Production function is related to a definite time physical outputs is termed as ‘Production Function’ . period. It differs or changes with different timeIt tells us that in a fixed period of time, change periods.

(4) Production function is based on constant technical conditions. On change in technical conditions, production function also changes and a new production function is obtained by firm.

(5) When a firm keeps some of its factors of production function fixed and some variable, then it is called Law of Variable Proportion or shortrun production function.

(6) When a firm changes all its inputs in the longrun, then such a production function is called long-run production function or Returns to Scale. (7) Production function presents technical summary of production.

6.4. Types of Production Function Production Function

Variable Proportion Production Function Constant Proportion Production Function

Short Period Production Function Long Period Production Function

Such Production Function which Contains both Fixed and Variable Factors

● Variable Proportion Production Function Or Short–run Production Function

Fixed and Variable Factors Production factors are of two types :

(i) Fixed Factors

(ii) Variable Factors

Fixed factors are those factors which remain constant at all production levels, even at zero level of production. Machines, Building are the examples of fixed factors.

Variable factors are those factors which get increased in quantity with every increase in production level. At zero level of production, use of variable factors are also nil. Labour, raw material are the examples of variable factor.

Box 3

In variable proportion production function, proportion of factors utilised changes because in shortrun, all factors cannot be changed. Those factors which cannot be changed due to short period, are called fixed factors. Few factors of production are variable in the short-run. Capital, capital goods, land, production technique, etc., are mainly fixed factors or remain unchanged in short period, while labour units are variable. Size of plant also remains unchanged

in short-run. In this way, few factors of production are fixed and few are variable in short-run. By changing variable factors ratio of factors utilized also changes and consequently quantity of production or output varies. This is called ‘Variable Proportion Production Function’ . ● Constant Proportion Production Function

Or

Long Period Production Function

In constant proportion production function, the ratio of factors utilised or in use remain constant. This type of production function is related to long-run. Long-run signifies that period or duration in which a firm can change

Such Production Function in which all Factors of Production are Variable

all its factors of production. In other words, no factor remains fixed in longrun. Factors of production cannot be classified into fixed and variable factors in the long-run. Scale of production can be completely changed in longrun. A firm has sufficient time to change its factor of production and the scale of production in longrun. In other words, a firm can conveniently change its factors of production in long-run to change its scale of production. So, ratio of factor utilisation remains constant in long-run, only scale of production changes. That is why, long-run production function is also called Returns to Scale.

6.5. Returns to a Factor : Law of Variable Proportion

When a firm in short-run, keeps some of its factors of production fixed and remaining variable, then change in the amount or quantity of output or production is known as ‘Laws of Returns’ . There are three Laws of Returns

(1) Increasing Returns to a Factor or Law of

Increasing Returns.

Vital Differences in Shortrun Production Function and Long-run Production Fuction :

1. Short run production function is ‘‘Variable Production’’ based production while the long run production is ‘‘constant proportion’’ based production function.

2. In short-run production function, ratio of factors use changes while scale changes in case of long run production function.

3. Short-run production function exhibits returns to a factor while the longrun production function exhibits returns to scale.

Box 4

(2) Constant Returns to a Factor or Law of

ConstantReturns.

(3) Decreasing Returns to a Factor or Law of Dimini-shing Returns.

(1) Increasing Returns to a Factor or Law of Increasing Returns Law of increasing returns appears in the initial stage of production. When variable factor is increased on fixed factors of production, total production increases and it signifies increasing returns to a factor. ● Definition According to Benham, “Increasing returns to a factor states that as the proportion of one factor in a combination of factors is increased upto a point, the marginal productivity of the factor will increase.”

● Explanation

Law of increasing returns operates due to organisational improvement that occur due to increased use of factors of production. Working efficiency of factors increases and external as well as internal economies of large scale are obtained in the production. Consequently, optimum utilisation of fixed and indivisible factors becomes possible and AP alongwith MP continues to increase. Table 4 : Increasing Returns to a Factor

Units of Total Average Marginal Variable Production Production Production

Factor (TP) (AP) (MP) (Labour) 14 4 4 210 5 6 3 19 6.3 9 4 33 8.25 14 5 51 10.2 18 6 76 12.7 25

● Diagrammatic Representation

If table 4 is plotted on graph paper, then in case of increasing returns to a factor, following shapes of AP and MP are obtained. It is clear from the figure that, as production is increased and units of variable factors are increased, AP and MP both start increasing. But increase

Fig. 1

in MP is greater as compared to AP. ● Causes of Operation of Increasing Returns to a Factor

There are following causes of operation of increasing returns to a factor : (a) Fixed Factors : Costs of fixed factors is also fixed.

Cost per unit of production decreases with every increase in production. As a result of it, this law becomes operative.

(b) Indivisibility of Factors : This reason was pointed out by Mrs. Joan Robinson . According to Mrs. Robinson, there are few factors, which cannot conveniently be divided and it becomes necessary to use them in available quantity (e.g., big and heavy machines, engines, etc.). Fixed factors could not be fully utilised in the beginning with lesser units of variable factor. But as the variable factors continue to increase, fixed factors are optimally utilised. As a result of it production increases but cost starts decreasing. In this way indivisibility of factors leads to the operation of the law of increasing returns to a factor.

(c) Better Co-ordination between Factors : Till fixed factors are under utilised, increase in units of variable factor increases co-ordination between fixed and variable factors. As a result of it, production increases at a greater pace.

Increasing Returns to a Factor and Cost From the point of view of the cost, Increasing Returns to a factor is called Law of Decreasing Cost. Under it, if quantity of variable factor is increased, MP i.e., marginal product in creases due to which AC and MC start declining. Increasing returns and de creasing costs are similar under constant prices. That

is why, law of increasing

returns is also called law

of decreasing cost.

Under law of increasing Fig. 2 returns, when AP increases, MP also increases at a greater pace.

In terms of cost, when AC decreases, MC also decreases at a greater pace.

Box 5

(2) Constant Returns to a Factor Or Law of Constant Returns It refers to the situation in which marginal productivity does not increase when more units of variable factors are added to production. In this case, MP becomes constant and total production increases at a constant rate. The situation between increasing returns to factor and decreasing returns to factor is called ‘Constant Returns to a Factor’ or ‘Law of Constant Returns’ . When law of increasing returns to factor ends, law of constant returns operates for a moment and immediately after it, law of decreasing returns becomes operative.

● Definition :

According to Hanson , “Constant returns to a factor occurs, when additional application of the variable factor increases output only at a constant rate .’’ In this way, Law of Constant Returns is related to or represents optimum or ideal combination between factors of production. According to this law, as we increase the quantity of variable factor, total production also increases with the increase of factor ratio. So, AP and MP remain at a common point in this law, but this is a temporary phase.

Table 5 : Constant Returns to a Factor Unit of Total Average Marginal Variable Production Production Production

Factor (TP) (AP) (MP) (Labour) 1 303030 2 603030 3 903030 4 120 30 30 5 150 30 30 6 180 30 30

● Diagrammatic Representation

In Fig. 3, AP and MP in case of Law of Constant Returns to Factor has been represented. AP and MP become parallel to X-axis as both are equal to each other and constant also.

Fig. 3 Constant Returns to a Factor and Cost

In case of the ‘Law of Constant Returns to a Factor’ , cost is also constant as a result of which ‘Law of Constant Cost’ operates. Similarly, AC and MC also become equal to each other (Fig. 4).

Fig . 4 Box 6

(3) Decreasing Returns to a Factor Or Law of Diminishing Returns Law of Diminishing Returns operates when marginal productivity (MP) of variable factors start decreasing and as a result of it, Total Production (TP) increases at a decreasing rate. In this case, marginal cost of the production increases.

☞ Law of diminishing returns is the third law of shortrun production function, but modern economists consider all the three laws of production as single law and name it as ‘Law of Variable Proportion’ . According to modern economists, there is only one law of production ‘Law of Diminishing Returns’ . Law of increasing returns and law of constant returns to a factor are basically two unstable stages of law of diminishing returns to a factor.

Box 7

6.5.1. Modern View of Law of Diminishing Returns

When amount of variable factor is increased with some fixed factors in the process of production, then due to division of labour and specialisation, indivisible factors are optimally and efficiently utilised and ideal combination is established at a point between factors of production. After this point, if variable factors are again increased, then MP starts declining. Classical economists named this situation or condition

as ‘Law of Diminishing Returns’.

Definitions :

(i) According to Stigler , “As equal increments of one input are added, the inputs of other productive services being held constant, beyond a certain

point the resulting increments of product, will decrease, i.e., the marginal product will diminish.”

(ii) According to Mrs. Joan Robinson , “The law of diminishing returns, as it is usually, formulated states that with a fixed amount of any one factor of production, successive increase in the amount of others will, after a point, yield a diminishing increment of output.”

(iii) According to Benham , “As the proportion of one factor in a combination of factors is increased, after a point, the marginal and average product of the factor will diminish.”

● Assumptions of the Law

1.One factor of production is variable and others are fixed.

2.All units of variable factor are homogeneous.

3.There is no change in level of technique.

4.Fixed factors are indivisible.

5.Different factors of production are imperfect substitutes.

^{6.Fixed factors are limited and scarce.} ● Explanation of the Law or Three Stages of

Production

Three stages of variable proportion have been depicted in the Table 6 :

Table 6 : Stages of Law of Variable Proportion Fixed Variable Total

Average Factor Factor Product Product

(TVF) (TP) AP=
11 6 6
1216 8
1 3 30 10
1 4 40 10
1545 9
1648 8
1 7 48 6.8
1 8 44 5.5
1 9 38 4.2

Above table explains all the three stages of variable proportion :

(1) Stage of Increasing Returns :

In the first stage, as the units of variable factor are increased with fixed factor, increased production takes place because as we increase units of variable factor, optimum utilisation of fixed factor becomes possible.

Thereby, total production, average production and marginal production all increase in the beginning of stage of production.

There are two parts of the first stage. In the first part, MP and AP both increase. At third unit of variable factor, MP is maximum. At fourth unit,^TP MP decreases but AP continues to increase. In the^TVF beginning, both AP and MP increase but in second part of the stage, AP increases, although MP continues to decrease. The mid-point between first and second stage of production is called ‘Point of Inflexion’ . First stage ends at the point where AP is maximum. In the first stage, AP is increasing continuously from starting till end. That is why, this stage is also called stage of Increasing Average Return or Increasing Return Stage.

(2) Stage of Diminishing Returns :

In the second stage, AP and MP both are decreasing. This stage ends at the point, where MP becomes zero. In this stage, TP increases at a decreasing

Marginal Product
(MP)
6
10
14 → 10
5
3
0
-4
-6
Stages
I Stage of Production
Point of Inflexion →

II Stage of Production III Stage of Production

Product ( i.e., TP) starts declining. Due to decreasing TP and negative MP, this stage is also called ‘Stage of Negative Returns’ .

● Diagrammatic Representation

Fig . 5

Stage I : Till ON quantity of variable factor. Stage II : In between NS quantity of variable factor. StageIII : After OS quantity of variable factor. In Fig. 5, Law of Variable Proportion has been represented. Other factors being fixed, change in quantity of one factor results in three different stages

rate because MP is decreasing but remains positive. of production. In this stage, AP continues to decline and so, this stage is also called ‘Stage of Decreasing Average Product’ .

(3) Stage of Negative

Returns : In this third stage of production, MP becomes negative or less than zero. Due to negative Marginal Product, Total

Point of Inflexion ● First Stage : Stage of Increasing Returns : _{Point of inflexion is that point} This stage has been shown till ON quantity of _{where the slope of TP curves} variable factor. At the end of this stage, MP and changes till this point of inflexion AP become equal to each other (see point Q). In TP increases at the increasing this stage, AP increases continuously and MP is ^{rate because marginal product} positive and greater than AP as a result of which_{(MP) rises upto this}

point. After TP increases at the increasing rate. Reasons forthis point of inflexion, MP starts increasing returns to a factor is that with lessdeclining (but remains positive) amount of variable factor in the beginning, optimumwhich results increase in TP but utilisation of fixed factors does not become possible.at decreasing rate.

_{In Fig. 5, point F is the point} As more and more units of variable factor are of inflexion. employed, intensive use of fixed factors becomes _{Box 8} possible and production increases. In this way, additional units of variable factor increases efficiency of fixed factors. Fixed factors being indivisible cannot be used in lesser amount from technical point of view. So, they cannot be used with less amount of variable factor. Hence, more units of variable factor are used and it increases production. This is called increasing returns. In this stage, TP curve is shown from point O to point K. OK can be divided into two parts or the first stage can be divided into two parts :

(a) Point O to Point F : TP is increasing with increasing rate because MP is continuously increasing till point P. From point O to point F, TP is convex to X-axis.

(b) Point F to Point K : Total production increases but at a decreasing rate because MP decreases but is positive (see point P to point Q). TP curve between point F to point K is concave to X-axis. Point F on Total Product curve at which MP is maximum is called ‘Point of Inflexion’ . After this

point, total product increases at a decreasing rate._{● Second Stage : Stage of}

Diminishing Returns :

This stage has been shown on TP curve between point K and point T. In this stage, although TP increases but at a decreasing rate because both MP and AP i.e. marginal product and average product decreases. This stage, ends at the point, where MP is zero (Point S).

When MP is zero, then TP is maximum (see point T). This stage explains that if OS units of variable factors are used, TP will be maximum. Reasons for decreasing returns in this stage are that fixed factors of production cannot be increased in short-run. When ON units of variable factors are used with fixed factors, then MP decreases till zero level due to over–utilisation of fixed factors and as a result of which internal diseconomies occur. In other

words, extensive use of variable factors with fixed factors results in decline or decrease in MP.

● Third Stage : Stage of Negative Returns In this stage, Total Production (TP) starts decreasing after point T because at point T, marginal productivity of variable factors is zero. If after point S, an additional unit or marginal unit of variable factor is used, then marginal productivity of that additional unit becomes negative and as a result TP starts declining. Therefore, this stage is called ‘Stage of Negative Returns’ . In this stage, variable factors exceed fixed factors. This disbalanced or unequal ratio between the two, makes marginal productivity of variable factors negative.

Table 7 : Stages of the Law of Variable Proportion

Stage TP MP

Stage I Increasing Returns to Factor

Stage II Diminishing Factor Returns to

Stage III Negative Returns to Factor

Starts from origin and increases at an increasing rate. TP is convex. Increases at a decreasing rate till it reaches the maximum point. TP is concave. Falls continuously but is positive. TP is downward sloping. Inceases, reaches a maximum.

Phases

Reference

Point (Fig. 5)

From origin to point K.

Falls continuously till it is equal to zero. From point K to point T.

Negative. Point T onwards.

Under which stage production Work is advantageous ?

A rational producer will prefer production in second stage. When units of variable factor are increased in the beginning, then total production (TP) increases because indivisible factors are fully utilised. If a producer stops production in first stage, he would be devoid of additional profits which he could have attained by utilising additional units of variable factor. Therefore, it is profitable for the producer to increase units of variable factor till he receives increasing TP. A rational producer will use at least ON units of variable factor. At OS units of variable factor, MP is zero and after it, MP becomes negative which implies that profit of producer will decrease. Thus, producer will not use more than OS units of variable factor. Only second stage of production is profitable, where units of variable factor are more than ON, but less than OS. Although, MP is decreasing, but is positive, which will necessarily increase TP. Decreasing marginal productivity (MP) is an indicator of risk because MP afterwards becomes zero and then negative. Producer regulates his production before entering third stage. In this way, production is profitable in second stage.

Box 9

● Causes of the Application of Variable Returns being fixed, unit of one variable factor (say labour) 1. Fixation of one or more than one Factors of is increased continuously, then proportion of variable

Production : When other factors of production factor (labour) to fixed factor also changes continuously. In other words, increasing labour units work with less units of fixed factor and hence, the productivity of labour decreases and law of diminishing returns comes in operation.

2. Indivisibility of Factors : Maximum factors of production are indivisible. These indivisible factors till their optimum use increase productivity. If more units of variable factors continue to be used even after this optimum point, productivity of variable factor decreases and law of diminishing returns becomes operative.

3. Factors of Production are not perfect substitutes to each other : Mrs. Joan Robinson considers imperfect substitutability of factors as the main

Can the Working of Law of Diminishing Returns be postponed? Due to many factors like use of modern inventions, scientific technical improvement, efficient management and organisation, agricultural mechanisation, improvement in transportation and communication facilities, etc., can temporarily postpone the working of law but law of diminishing returns cannot be permanently postponed or evaded.

Box 10

cause of operation of the law. According to her, one factor can be substituted for another upto a certain limit as factors are imperfect substitutes of each other. Therefore, scarcity of one factor cannot be compensated by other. In other words, substitutability of factors is not infinite due to which law of diminishing return operates.

4. Scarcity of Factors : Supply of few factors of production is fixed and limited (for example, land), so, when one factor of production is limited, producer has to produce with its limited available quantity. As a result, proportion of limited factor to variable

factor changes and law of diminishing return operates.

Importance of the Law

(1) Fundamental Law of Economics : This law is not only applicable in agriculture, but also applicable in fishery, industries, mining, building construction, etc. Taking into consideration the practicability of law, Wickstead has considered Law of Diminishing Returns, “As universal as the law of life and death.”

(2) Basis of Malthusian Population Theory : Malthusian theory explains that population increases at a greater pace than agriculture because law of diminishing returns is operative in agriculture.

(3) Basis of Marginal Productivity Theory : In this theory, factors of production are rewarded according to their marginal productivity. Due to law of diminishing return, decreasing marginal productivity of variable factors is obtained.

(4) Affects Living Standard of People Residing in an Area: Population in an area increases at a greater pace than that of other factors of production and hence, living standard of people residing in an area is negatively affected owing to operation of the law of diminishing returns.

(5) Incentive for Inventions : To postpone operation of the law of diminishing returns, there is incentive for inventions. In this way, law of diminishing returns is important from both theoretical and practical point of view.

6.6. Long-run Production Function or Returns to Scale

Returns to scale refers to long-run production function when none of the factors of production remains fixed. All factors of production become variable and they can be changed also. Scale of production can be changed in the long-run. Internal and external economies are obtained in production due to technical improvement, division of labour, specialisation, etc. These economies are not permanent and they get converted to diseconomies in the continuous process of production. In the initial stage of production, these internal and external economies give ‘Increasing Returns to Scale ’, but when they get converted to diseconomies at later stage of production, law of diminishing returns comes into existence.

● Definition :

According to Watson , “Returns to Scale refers to the behaviour of total output as all inputs are varied in the same proportion and is a long-run concept.”

Three Returns to Scale Related to Long Period

A. Increasing Returns to Scale B. Constant Returns to Scale C. Diminishing Returns to Scale

Economies of scale are more than diseconomies of scale. Economies of scale are equal to diseconomies of scale. Diseconomies of scale are more than Economies of scale.

Proportionate production increase is more than factor proportionate increase.

Proportionate production increase is equal to factor proportionate increase.

Proportionate production increase is less than factor proportionate increase.

● What are Economies of Scale ?

Economies of scale refers to the situation in which on increasing the scale of production, unit cost of production reduces or decreases and output per unit of factor inputs increases. Economies of scale are classified as :

(a) Internal Economies,

(b) External Economies.

(a) Internal Economies are firm specific. They occur with the expansion of firm, i.e., internal economies occur inside the firm. Internal economies are a function of the size of firm. As size of production increases, a firm uses its factors of production more efficiently under specialisation policy. Internal economies occur as a result of specialisation and division of labour which decreases long-run average cost. Internal economies can be classified as : 1.Economies of division of labour and

specialisation.

2. Technological Economies :

(i) Optimum utilisation of plant.

(ii) Full utilisation of indivisible factors.

(iii) By using by-product in production process. 3. Managerial Economies :

(i) By encouraging increase in efficiency.

(ii) By functional specialisation.

4. Marketing Economies.

5. Financial Economies.

6. Risk-bearing Economies : To reduce possibility

of losses by producing many things simultaneously. (b) External

Economies are industry specific. They arise as a result of expansion of the industry. Profits of industry are equally obtained by all firms in the industry. External economies can be classified as : 1. Availability of efficient labour at cheap rate

because competition among producers reduces

and they are able to get efficient and skilled

labours at cheap rates.

2. Development of transportation and communication facility reduces or minimises cost.

3. Development of financial institutions, availability of credit at cheap rate.

4. Development of many industries in an area, easy availability of raw material.

5. Increase in efficiency of labourers by imparting

6. Obtaining information related economies by

publication of investigation and business magazines. ● Diseconomies of Scale

If production is increased after a certain limit, then economies of scale get converted to ‘Diseconomies of Scale’.

Diseconomies of scale are of two types : 1. Internal Diseconomies,

2. External Diseconomies.

Main reason for appearing internal diseconomies is that when production expands, it becomes difficult to regulate or control production organisation. It becomes impossible for management bodies to establish co-ordination between different units of big organisation. Supervision is obstructed due to which cost of production increases as factors are not optimally utilised. In this way, after a certain point LAC curve rises upward which indicates uneconomical condition.

External diseconomies occur due to increased demand of different factors as a result of expansion of industry. When industry expands, demand of factors increases and thereby their prices increase. Increasing factor prices, raises cost curves of all firms. Scarcity of factors, increases competition because every firm in order to get those scarce factors will give higher prices.

In this way, expansion of industry beyond a limit gives rise to ‘Internal and External Diseconomies’ which increase long-run cost of production. (A) Increasing Returns to Scale

Increasing returns to scale occurs when a given percentage increase in all factor inputs (in some constant ratio) causes proportionately greater increase in output. In this way, if factors of production are increased by 10%, then production increases more than 10%. Increasing returns to scale occur due to division of labour and specialisation. Division of labour and specialisation increases productivity of labour. Due to increase in size of the scale, more efficient and specialised machines are used which give increasing returns to scale.

In Increasing Returns to Scale,

Proportionate increase in production > Proportionate increase in factors of Production

Increasing return has been shown in Fig. 6. On

increasing factors of production by 10%, production

increases by 15%. This condition shows law of

increasing returns to scale. It has been shown

by scale line OS in Fig. 6.

Fig. 6

(B) Constant Returns to Scale

Constant returns to scale occurs when a given percentage increase in all factor inputs (in some constant ratio) causes equal proportionate increase in output, i.e.,. If factors of production are increased by 10%, then production also increases 10% and 10% decrease in factors of production causes similar percentage decrease in output.

Constant returns to scale has been shown in Fig. 7. OS₁ is the scale line which shows constant returns to scale and is at 45° to X-axis.

Fig . 7

In Constant Returns to Scale

Proportionate increase in Production = Proportionate increase in factors of production

(C) Diminishing Returns to Scale : Diminishing returns to scale occurs when given percentage increase in factor of production causes

proportionately lesser increase in output. Main reason responsible for it is when production increases beyond

a limit, it

Fig . 8 becomes difficult for producer to control or regulate production. As a result of it, internal and external economies get converted to internal and external diseconomies and diminishing returns to scale occurs or comes into existence. Diminishing returns to scale has been shown in Fig. 8.

When factors of production are increased by 15%, then production increases by 10% only. OS₂ is the scale line showing diminishing return to scale. In Diminishing Returns to Scale

Proportionate increase in Production < Proportionate increase in factors of production

6.7. Difference between ‘Returns to a Variable Factor’ and ‘Returns to Scale’

The points showing the difference between ‘Returns to a Variable Factor’ and ‘Returns to Scale’ are as follows :

1. Time Period : ‘Returns to a Variable Factor’ is related to short-run production function, while ‘Returns to Scale’ is related to long-run production function.

2. Number of Variable Factors : ‘Returns to a Variable Factor’ occurs when only one factor is variable and other factors are kept fixed. ‘Returns to Scale’ refers to the condition when all factors of production are variable.

3. Scale of Production : In ‘Returns to a Variable Factor’ scale of production does not change but ‘Returns to Scale’ scale of production is changed.

4. Factor Ratio : Factor ratio changes in case of ‘Returns to a Variable Factor’ , while factor ratio remains constant in case of ‘Returns to Scale’ .

Causes of Application of Returns to Scale ● Increasing Returns to Scale : When scale of production is increased, economies of scale are obtained. Increasing returns to scale is obtained due to following factors :

1. Indivisibility of Factors : Few factors are indivisible due to which they cannot be used in parts. In

the beginning, these factors are not optimally utilised. But on increasing scale these indivisible factors are optimally utilised and increasing returns to scale are obtained.

2. Division of Labour : Prof. Chamberlin considers ‘Division of Labour’ as the main cause of increasing returns to scale. Division of labour increases efficiency which ultimately leads to increasing returns to scale.

3. Specialisation : Division of labour leads to specialisation due to which more efficient factors can be

^{used. As a result, production increases and increasing returns to scale are obtained.} ● Constant

Returns to Scale : On increasing production, economies of scale after a limit changes into diseconomies of scale. As scale of production is increased, economies of scale become equal to diseconomies of scale. This condition is called ‘Constant Returns to Scale’ . Constant returns to scale occurs for a short

^{time after which diminishing returns to scale occurs.} ● Diminishing Returns to Scale : When size of production continues to expand, diminishing returns to scale occurs. On increasing production after a limit, diseconomies of scale exceeds economies of scale due to diminishing returns to scale come into existence. Managerial economies change into losses due to which this law becomes applicable.

Box 11

A QUICK REVIEW OF THE CHAPTER

^{● Total Production : Total Production refers to total output produced in a definite time period.} ●

Average Production : Amount of per unit production is called average production. To get average production, we divide total output by amount of variable factor.

^TP AP =_L

Production Function : Returns to A Factor and Returns to Scale

Marginal Production : Change in total production level due to use of one more or one less unit of variable factor, is called Marginal Production. \mathbf { M P } _ { n } = [ \mathbf { T P } _ { n } - \mathbf { T P } _ { n - 1 } ] or TP

Production Function : Production function is the functional relationship between physical inputs and output. In production function, only physical values of output and inputs are taken into consideration and the market prices are not included in it.

\mathrm{Q} _ {\mathrm{x}} = f (\mathrm{A}, \mathrm{B}, \mathrm{C}, \mathrm{D})

Types of Production Function : Production function is of two types : (i) Short-run Production Function or Returns to a Factor : It is related to short-run, when only

one factor of production is variable and others are fixed. Since unit of variable factors are increased continuously, so factor ratio changes in this production function.

(ii) Long-run Production Function or Returns to Scale : It is related to long-run and all the factors are changed in same ratio in this case. In this case, proportional relation between production and factor of production in the long-run is called returns to scale.

Two Important Types of Production Function are :

(i) In constant ratio type production function, input ratio is same at all levels of production which is possible in long-run only. Such production function generates returns to scale in long run.

(ii) In variable ratio type production function, input ratio changes which causes change in production in the short period. Such production function generates returns to a factor in short run.

Laws of Production Or Law of Variable Proportion : When one or more factors are kept constant

and units of variable factor are increased, then production first increases, becomes constant and then decreases.

According to this law, there are three stages of production :

First Stage : Marginal product decreases after becoming maximum.

Average product becomes maximum

and total product increases.

Second Stage : Average production starts decreasing and total production increases at a decreasing rate

and reaches maximum or uppermost point where MP becomes zero.

Third Stage : AP continues to decrease, total production starts decreasing and marginal product becomes negative.

Causes for Operation of the Law of Variable Proportion : (i) One or more factors being constant,

(ii) Indivisibility of Factors, (iii) Limited Factors, (iv) Production factors being perfect substitutes.

Can the Law of Diminishing Return be Postponed ? : Improvement in technique of production and

discovery of fixed factors substitutes can postpone the law of diminishing returns.

Returns to Scale : Returns to scale refers to the behaviour of total output as all inputs are varied in

the same proportion. It is a long-run concept.

These returns to scale are of three types :

1.Increasing Returns to Scale.

2.Constant Returns to Scale.

3.Decreasing Returns to Scale.

(1) Increasing Returns to Scale : Increasing returns to scale occur when K% increase in factors of production increase production more than K%.

(2) Constant Returns to Scale : Constant returns to scale occur when K% increase in factors of production causes similar, i.e., K% increase in output.

(3) Decreasing Returns to Scale : When on increasing factors of production, production increases at lesser rate or ratio, then it is called decreasing returns to scale.

Internal Economies of Scale : Economies which occur due to expansion of any individual firm. These

economies benefit only that individual firm.

Types of Internal Economies of Scale :

(i) Economies of Division of Labour and Specialisation.

(ii) Technical Economies (Optimum Use of Plant).

(iii) Managerial Economies.

(iv) Marketing Economies.

(v) Financial Economies.

(vi) Economies related to Risk or Risk related Economies.

● External Economies of Scale : These economies occur due to expansion of industry. Its profit is not limited to one or two firm, but to all firms in the industry.

● Types of External Economies of Scale :

(i) Availability of efficient labour.

(ii) Expansion of transportation and communication facilities.

(iii) Development of financial institutions.

(iv) Supply of raw material.

(v) Improvement in working efficiency of labour by training.

QUESTIONS Ultra Short Answer Type Questions

1. What do you mean by short-term production function ? (U.S.E.B. , 2014; CBSE , 2017)

2. What is short-run period ? (Raj. Board , 2014)

3. What is remuneration of human labour ? (B.S.E.B. , 2014)

4. What is variable factor ? [J.A.C., 2015, 16 (Arts )]

5. Write down nature of factors in short-run.(U.S.E.B., 2016)

6. Write the formula of production function.

(Raj. Board, 2017)

7. What is fixed factor ? (J.A.C ., 2019)

8. What is the name of relationship between input used and output produced by a firm ? (U.S.E.B., 2019)

Very Short Answer Type Questions

1. What is meant by Production Function ?

[B.S.E.B. (Art) , 2018 ; J.A.C., 2012, 15, 17, 19;

U.S.E.B., 2015]

Or

Explain the concept of a Production Function.

[C.B.S.E., 2011, 17; U.S.E.B. , 2011, 13 17;

Raj. Board, 2013]

Short Answer Type Questions 1. Define marginal product. (Raj. Board, 2013) Or

What is Marginal Production ?

2. Explain the relationship between the marginal product and the total product of an input.

[Raj. Board, 2013; B.S.E.B. (Comm. ), 2018] 3. Distinguish between the concepts of the short-run and the

long-run. (Raj. Board, 2013) 4. Explain the Law of Diminishing Marginal Product. (Raj. Board, 2015) 5. Explain the Law of Variable Proportions.(Raj. Board, 2015) Or

Explain the three stages of the Law of variable proportion.

Use diagram. [J.A.C. , 2016 (Arts )] 6. Distinguish between Returns to Scale and Returns to a Factor. [B.S.E.B., 2011 (Arts ); J.A.C. , 2018] 7. What is meant by returns to a factor ? [U.S.E.B., 2015; B.S.E.B . (Comm .), 2016] 8.

What do you mean by ‘Increasing Returns to Scale’ ? Why do they appear ? [U.S.E.B., 2013; B.S.E.B ., 2016 (Comm .)] 9. Explain the Law of Constant Returns to Scale. Why does this law appear ?

10. Explain the Law of Diminishing Returns to Scale. [B.S.E.B. (Arts ), 2015] 11. What is meant by Returns to Scale? State the reasons for increasing returns to scale. (Raj. Board, 2017) 12. What do you understand by Production Function ? Explain

briefly short-term production function. [B.S.E.B., (Comm.) 2013] 13. What do you understand by Total Product, Average Product and Marginal Product ? (U.S.E.B. , 2019) 14. What are the causes of operation of Law of Variable Proportion ?

15. What is a production function? What are the other names

of long run and short run production function. (Raj. Board , 2016) 16. Define marginal product. Sstate the behaviour of marginal

What is average production ? Or Define average product of an input. [J.A.C. , 2016, 18]

( J.A.C., 2010) 4. What do you understand by Variable Factors of Production ?

(J.A.C., 2011) 5. What is meant by Fixed Factors of Production ? 6. What is meant by Laws of Returns ?

7. What is meant by Law of Increasing Returns ? 8. What is meant by Laws of Diminishing Returns ? 9. What is meant by Laws of Constant Returns ? 10. Mention the stage of Law of Variable Production. 11. What is meant by the concept of ‘Returns to Scale’ ? [U.S.E.B. , 2011; B.S.E.B., 2015; J.A.C., 2016, 18] 12. In which production period do the Returns to Scale appear ? 13. What is meant by Increasing Returns to Scale ? 14. What do you mean by Variable Factors ?

8. What do you mean Long-run Production Function ? (U.S.E.B, 2011)

9. Define production function. Distinguish between short-run and long-run production functions. (C.B.S.E. , 2016) Long Answer Type Questions 1. Explain the Law of Variable Proportion. [C.B.S.E., 2010, 12, 13;B.S.E.B., 2012 (Arts ); Raj. Board , 2013, 16] Or

Returns to Scale. [B.S.E.B. (Comm.), 2013, 18] 5. Explain the ‘Returns to

Explain the law of variable proportion of an input. Or

Explain the three stages of law of variable proportion. (J.A.C. , 2012) 2.

What is Law of Diminishing Returns ? Why does this law become operative ?

Or

Write a note on diminishing marginal return. (J.A.C. , 2011) 3. Distinguish between ‘Returns to Scale’ and ‘Returns to a

Variable Factor’. Also mention the reasons of increasing returns.

4. What is meant by Returns to Scale ? Using a suitable diagram, explain the concepts of Increasing, Constant and Diminishing

Scale’ using numerical examples. 6. Explain, with the help of numerical examples, the effect on

total output of a goods when all the inputs used in production of that goods are increased simultaneously and in the

same proportion. [J.A.C. (Arts ), 2017] 7. Explain the laws of returns to scale with the help of suitable diagram.

8. What is law of variable proportion ? Explain the behaviour

of MP as per of this law. (C.B.S.E., 2012) 9. What is meant by the returns of a factor ? State the reasons of increasing returns of an input. [J.A.C., 2012

diagram. (U.S.E.B., 2019) 12. What is meant by “diminishing returns to a factor” ? Discuss any two reasons for the operation of diminishing returns to a factor. (C.B.S.E., 2019) 13. Explain the law of diminishing returns in context of

agriculture. [B.S.E.B., (Arts ), 2014] 14. What do you mean by production function ? Discuss the

main characteristics. [J.A.C. , 2014, 16 (Arts )] 15. Explain the law of variable proportions with the help of

(C.B.S.E., 2015; J.A.C., 2014, 19) 16. Differentiate between fixed input and variable input.

Explain the Law of Diminishing Marginal Product. (B.S.E.B., 2014) 17.

Explain the changes that take place in total product and

marginal product under increasing returns to a factor. (C.B.S.E. , 2015) Objective Type Questions

(A) Multiple Choice Questions :

1. In production function, production is a function of :

[ B.S.E.B., 2015 (Comm. ), 2017] (a) Price (b) Factors of Production (c) Total Expenditure (d) None of these 2. The basic reason of operating the Law of Diminishing

Returns is : [B.S.E.B., 2011 (Arts )] (a) Scarcity of Factors

(b) Imperfect Substitution between Factors

(c) Both a and b (d) None of these

3. Which of the following explains the short-run production function ?

[B.S.E.B. (Comm. ), 2018] (a) Law of Demand

(b) Law of Variable Proportion

(c) Returns to Scale (d) Elasticity of Demand

4. Long-run production function is related to : (B.S.E.B., 2011, 16, 17, 18) (a) Law of Demand (b) Law of Increasing Returns (c) Laws of Returns to Scale (d) Elasticity of Demand

5. In which stage of production a rational producer likes to operate in shotrun production ? (B.S.E.B., 2018) (a) First Stage

(c) Third Stage

(b) Second Stage (d) None of these

6. Law of variable proportion explains three stages of production. In the first stage of production :

(a) Both MP and AP rise (b) MP rises

(c) AP Falls (d) MP is zero

7. At which time all the factors of production may be changed ? (B.S.E.B., 2015, 17, 19; J.A.C., 2018) (a) Short run (b) Long run

(c) Very Long run (d) All the three

8. Production function is expressed as : [B.S.E.B., 2011,12 (Comm. )] (a) \mathrm { Q } _ { x } = \mathrm { P } _ { x } \left( \mathrm { b } \right) \mathrm { Q } _ { x } = f \left( \mathrm { A } , \mathrm { B } , \mathrm { C } , \mathrm { D } \right) \left( \mathrm { c } \right) \mathrm { Q } _ { x } = \mathrm { D } _ { x } (d) None of these

9. Which factors among following we find in short-run production process ? (a) Fixed Factors (c) Both (a) & (b) (b) Variable Factors (d) None of these

10. A curve which rises first and starts declining after that is called : (B.S.E.B., 2011, 19) (a) APP (b) MPP (c) TPP (d) All these

11. What is/are factor of production ? (B.S.E.B., 2011, 17) (a) Land (b) Labour (c) Capital (d) All these

12. Law of variable proportion is related to : (B.S.E.B., 2012, 17) (a) Both short-run & long-run (b) Long-run (c) Short-run (d) Very Long-run

13. An active factor of production is : [B.S.E.B., 2015; JA.C. , 2017] (a) Capital (b) Labour (c) Land (d) None of these

14. If all the factors of production are increased by same proportion and as a result output increases by a greater proportion then it is called : [B.S.E.B., 2015, (Arts )] (a) Constant returns to scale (b) Decreasing retuns to scale (c) Increasing returns to scale (d) None of these

15. When the Average Product (AP) is maximum, the Marginal Product (MP) is : (a) Equal to AP (c) More than AP [ C.B.S.E. , 2018] (b) Less than AP (d) Can be any one of the above

16. Which of the following is not a factor of production ? [B.S.E.B. (Arts ), 2018] (a) Land (b) Labour (c) Money (d) Capital

17. The average product curve in the input-output plane, will be : (C.B.S.E. , 2019) (a) An ‘S’ shaped curve

(b) An inverse ‘S’ shaped curve

(c) A ‘U’ shaped curve

(d) An inverse ‘U’ shaped curve

[Ans. 1. (b), 2. (c), 3. (b), 4. (c), 5. (b), 6. (a), 7. (b), 8. (b), 9. (c), 10. (d), 11

(d), 12. (c), 13. (b), 14 (c), 15. (a), 16. (c), 17. (d).]

(B) Fill in the Blanks :

1. Addition to TP when one unit of factor is added, is called................

2. Short-run production function is termed as................ 3. Returns to Scale are associated with................run period. 4. In short-run, a rational producer will try to keep him in.........

stage of production.

5. When MP is zero, TP is................

[Ans. 1. Marginal Product (MP), 2. Law of Variable

Proportion, 3. long, 4. second, 5. maximum.]

(C) State True/False

1. At long-run all the factors of production may be changed. 2. An active factor of production is capital.

2. Short-run production function is called law of variable proportion.

3. Average production refers to total output produced in a definite time period.

4. Production function is the functional relationship between physical inputs and output.

5. The law of diminishing return is universal. (MP Baord, 2019)

[Ans. 1. True, 2. False, 3. True, 4. False, 5. True, 6. True ] (D) Match the

following Column :

1. Production function

2. Long-run production function

3. Reason for operation of law of variable proportion 4. Marginal Production

4. Production

[Ans. 1. (e), 2. (c), 3. (a), 4. (b), 5. (d).]

(E) Answer in One Word :

1. In which period, returns to scale do appear ?

2. What retation between output and inputs are called for ? 3. What is the value of MP when TP is maximum ? 4. How many types are of returns to scale ?

[Ans. 1. Long run, 2. Production function, 3. Zero, 4. Three.]

HOTS High Order Thinking Skills Questions

1. Production function is not an economic problem but a technical problem. Why ?

(See : Box 2)

2. In short-run, scale of production cannot be changed. Why ? (See : Box 3)

3. Which stage should be adopted by the producer in shortrun for his production process and why ?

(See : Box 7)

4. Why does the indivisibility of factors in the short-run bring variable returns ?

(See : Section 6.5)

VBQ Value Based Questions

1. What is the relation of inflexion point with marginal productivity in law of variable proportion ?

(See : Fig. 5)

2. In what stage of production in short period, a rational consumer finds production work profitable ?

(See : Box 7)

‘B’

(a) Limited factors

(b) \mathrm { T P } _ { n } - \mathrm { T P } _ { n - 1 }

(c) Law of Return to Scale (d) Creation of economic utility (e) Factors of production

MDQ Case Study Based on Evaluation & Multi-disciplinary Questions

1. What is the relevance of stages of production function in the short period ?

(See : Section 6.5.1)

2. A rational producer should concentrate his production in second stage. Why ?

(See : Second 6.5.1 (Second stage).

3. Under what conditions ‘Returns to a factor’ and ‘Returns to Scale’ appear ?

(See : Box 4)

4. Marginal product is the rate of total product. How ? (See Box 1) NUMERICAL QUESTIONS

5. Identify the three phases of the law of variable proportions from the following and also give reason behind each phase : (U.S.E.B., 2011) Units of Variable Input 123 45

Total Physical Product (units) 10 22 30 35 30 [Ans. : Stage I

Stage II

upto 2nd unit

at 2nd unit

Stage III : after 2nd unit

2. On the basis of information given in the following table, what can you say about the nature of returns to the variable factor (labour) at various levels of its employment ?

Units of Variable Total Product Factor (Labour) (kgs.)
00
15
211
318
425

Units of Units of Fixed Variable TP$_{L}$ Factor Factors

10 0 0 10 1 60 10 2 — 10 3 — 10 4 300 10 5 — 10 6 —

AP${L}$ MP${L}$

—— — — — 85 — — 100 — — — 50 55 —

[ Ans. Marginal Product : 5, 6, 7, 7, 6, 5

Law of increasing return is operating upto 3rd unit; Law of Constant returns during 3rd and 4th and afterwards law of diminishing return is applicable.]

3. The following table gives the total product schedule of labour. Find the corresponding average product and marginal product schedules of labour :

L 012345 TP _L 0 1535504048

[Ans. AP → 0, 15, 17.5, 16.6, 10, 9.6; MP → 0, 15, 20, 15, – 10, 8] 4. Complete the following table :

[ Ans. TP_L = 60, 170, 270, 300, 350, 330

AP_L = —, 60, 85, 90, 75, 70, 55

MP_L = —, 60, 110, 100, 30, 50, – 20

5. Identify the different output levels which mark the different phases of the operation of law of variable proportion from Total Product (kgs.)

the following data : Units of Variable Factor (Labour)

[Hint : Calculate marginal product by adding one additional column.] [Ans.

Stage I : upto 2nd unit (operation of the law of increasing return to variable factor.)

State II : 3-4 units (operation of the law of constant returns to variable factor.)

State III : 5th unit (operation of the law of diminishing returns to scale)] 6. Complete the following table : (Raj. Board, 2013) Labour Units Total Marginal Product Product Average Product 135 250 369 492 [Ans. MP_L → –, 15, 19, 23; \mathrm { A P _ { L } } → 35, 25, 23, 23] 7. Complete the following table : (CBSE , 2013)

L A P _ {L} M P _ {L}

[ Ans. \mathrm { A P _ { L } } \longrightarrow 8 , 1 0 , 1 0 , 9 , 8 , 7 ; \mathrm { M P _ { L } } \longrightarrow 8 , 1 2 , 1 0 , 6 , 4 , 2 ] 8 . The following table gives the marginal product schedule of labour. It is also given that total product of labour is zero at zero level of employment. Calculate the total and average product schedules of labour :

[Ans. TP → 3, 8, 15, 20, 23, 24; AP → 3, 4, 5, 5, 4.6, 4] 9. Complete the following table :

Labour Total Units Product

Marginal Product Average Product

[Ans. TP → 10, 18, 24, 28, 30; AP → 10, 9, 8, 7, 6]

NCERT CORNER

Q. 1. Explain the concept of a production function. Ans. See Section 6.3.

Q. 2. What is the total product of an input ? Ans. See Section 6.2.

Q. 3. What is the average product of an input ? Ans. See Section 6.2.

Q. 4. What is the marginal product of an input ? Ans. See Section 6.2.

Q. 5. Explain the relationship between the marginal product and the total product

of an input.

Ans. See Section 6.2.

Q. 6. Explain the concepts of the short run and the long-run.

Ans. See Box 4.

Q. 7. What is the Modern view of Law of Diminishing Returns ? Ans. See Section 6.5.1.

Q. 8. What is the Law of Variable Proportions ? Ans. See Section 6.5.1.

Q. 9. When does a production function satisfy constant returns to scale ? Ans. See Section 6.6.

Q. 10. When does a production function satisfy increasing returns to scale ?

Ans. See Section 6.6.

Ans. Table showing Average Product and Marginal Product Units of Labour Total Product of Labour Average Product (L) (TP$_{L}$) (AP = TP$_{L}$/L) Marginal Product (Addition to TP$_{L}$)

Q. 11. When does a production function satisfy diminishing returns to scale ? Ans. See Section 6.6.

Q. 12. The following table gives the total product schedule of labour. Find the corresponding average product and marginal product schedules of labour :

00 — —
115 15 15
2 35 17.5 20
3 50 16.67 15
440 10 10
548 9.6 8

Q. 13. The following table gives the average product schedule of labour. Find the total product and marginal product schedules. It is given that the total product is zero at zero level of labour employment : L 123 456

TP _L 2 3 4 4.25 4 3.5 Ans. Table showing Total Product and Marginal

Product Units of Labour Average Product of Labour TP Total Product of Labour (L)
AP
L
L
L = AP L × L Marginal Product of Labour (Addition to TP L)
00 0 0
12 2 2
23 6 4
34 12 6
4 4.25 17 5

54 20 3 6 3.5 21 1

Q. 14. The following table gives the marginal product schedule of labour. It is also given that total product of labour is zero at zero level of employment. Calculate the total and average product schedules of labour :

L 123 456 MP _L 357 531 Ans. Table showing Total Product and Average Product

Units of Labour Marginal Product of Labour Total Product of Labour Average Product of Labour (L) ( M P _ { L } ) ( T P _ { L } ) =

000 0

1 3 0 + 3 = 3 3

2 5 3 + 5 = 8 4

3 7 8 + 7 = 1 5 5

4 5 1 5 + 5 = 2 0 5

5 3 2 0 + 3 = 2 3 4. 6

6 1 2 3 + 1 = 2 4 4

❑

7

PRODUCTION COSTS

STUDY MATERIAL INCLUDED IN THE CHAPTER

7.1. Meaning of Production Cost and Cost Function 7.2. Classification of Production Cost 7.3 . Production Costs . Relation between AC and MC 7.6. Production Costs in Long Period 7.7. Numerical Questions High Order Thinking Skills (HOTS) Questions Case Study Based on Evaluation & Multi-disciplinary Questions (MDQ) 7.4. Marginal Cost (MC) 7.5 Illustrations A Quick Review of the Chapter

Value Based Questions (VBQ) Numerical Questions NCERT Corner. 7.1. Meaning of Production Cost

and Cost Function

Every firm or producer has to arrange various factors of production for the production. The expenditure made for using these factors in the production process is termed as ‘Cost of Production’ . Production cost mainly depends upon the quantity of production. Generally, cost of production rises with increase in production.

A cost function shows the functional relationship between output and cost of production.

Hence,

C = f (O)

‘‘Cost is the Function of Output.’’ 7.2. Classification of Production Cost

Classification of Cost

Money Cost Real Cost Opportunity Cost

Explicit Cost 7.2.1. Money Cost

Implicit Cost Normal Profit

Cost of production measured in terms of money is called the ‘Money Cost’ . Money cost is the monetary expenditure made by the producer for hiring various factors of production. Money cost is, therefore, the payment made for the factors in terms of money.

(7) Management Expenses,

(8) Advertisement Expenses,

(9) Transportation Expenses,

(10) Payment made to Insurance Companies, (11) Normal Profit, (12) Fuel Expenses.

According to J.L. Hanson, “The money cost of

producing a certain output of a commodity is the sum

of all the payments to the factors of production engaged

in the production of the commodity.”

● Items Included in Money Cost Money Costs Money cost includes the following items :

(1) Expenditure on Raw Material,

(2) Wages and Salaries,^Or

Explicit Costs i.e ., cost of hiring inputs from the market

Implicit Costs

i.e. , cost of using self-owned inputs.

Normal Profit

^{(3) Expenditure on Indivisible Big Machines,} Total Money Cost = Explicit Cost + Implicit Cost_{(4) Interest paid on Capital, + Normal Profit(5) Rent, i.e ., Payment to} Land/Building Owner,

(6) Depreciation, Box 1

(A) Explicit Costs

Explicit costs refer to the actual money outlay of the firm to buy or hire the productive resources,

it needs in the process of production._{● Definition}

According to Leftwitch, “Explicit costs are those cash payments which the firms make to outsiders

^{for their services and goods.”} ● Items Included in Explicit Costs

(a) Expenditure on Raw Material,

(b) Wages of Labour,

(c) Interest Payments,

(d) Rent of Land/Building,

(e) Depreciation,

(f) Advertisement Expenses,

(g) Insurance Expenses,

(h) Expenses made in Tax Payment, etc.

(B) Implicit Costs

Implicit costs are payments which are not directly or actually paid out by the firm as no contractual disbursement is fixed for them. It includes the prices of such services and factors which are used in production process but are not directly paid. For example, the services of the entrepreneur is a part of implicit cost as he gets no direct payment for his own services given in production process. Hence, “Implicit costs are costs of self–supplied

^factors.” ● Definition

According to Leftwitch, “Implicit Costs are costs of self-owned and selfemployed resources .”_{● Items Included in Implicit Costs}

(a) Remuneration of services given by entrepreneur himself.

(b) Interest of the capital supplied by the entrepreneur.

(c) Rent of land or premises belonging to the entrepreneur himself and used in his production.

(d) Normal profit of entrepreneur, compensation needed for his management and organisational activity.

(C) Normal Profit

The minimum return which the entrepreneur must

receive to continue the production process is known

as ‘Normal Profit’ . If the entrepreneur does not get

this minimum amount, he stops the production

process. Normal profit is a part of total cost. Difference between Explicit & Implicit Costs

Explicit Cost

1. It is money expenditure incurred by a firm in hiring factors for production process.

2. It is shown in firm’s books of accounts.

3. It is a payment concept. (Example : Rent, wage,

Implicit Cost

1. It is not money expenditure because it is the cost of factors owned by the firm itself.

2. It does not enter in the firm’s books of accounts.

3. It is a receipt concept. (Example : wages of self labour, Interest etc.) rent for self owned premises etc.)

^{Box 2} 7.2.2. Real Cost The concept of opportunity cost can be explained with an example. A person can obtain three services : Degree College Lecturer (Salary ` 80,000), Bank Officer (Salary ` 50,000) and Sales Officer (Salary 40,000). The person will opt the job of a Degree College Lecturer and sacrifice two another available jobs. The next best alternative sacrificed by

the person is the job of bank officer with salary of ` 40,000. Hence, the opportunity cost of selected job (Salary ` 80,000) is ` 50,000 (i.e., the salary of next best alternative).

7.3. Production Costs

This concept was propounded by Marshall. Efforts and sacrifices made in the production process create real cost. Real costs are also termed as social costs because the society faces a number of difficulties during the production process.

● Definition

According to Marshall, “The exertion of all the different kinds of labour that are directly or indirectly involved in making it together which the abstinences or rather the waiting required for saving the capital used in making it : all these efforts and sacrifices

together will be called the real cost of production of the commodity .” 7.2.3. Opportunity Cost

Austrian economists modified the concept of ‘Real Cost’ and presented the concept of opportunity cost. Resources are limited to unlimited needs and hence, the production of one goods means the sacrifice of the other. According to Benham, “The opportunity cost of anything is the next best alternative that could be produced instead by the same factors or by equivalent group of factor costing the same amount of money .” Hence, opportunity cost of a factor refers to its value available in its next best alternative use.

Production Costs

Production Costs Production Costs in Short Period in Long Period Fixed Cost Variable Costs Only Variable Costs No Fixed Cost 7.3.1.

Box 3

Production Costs in Short Period

Short-run production process includes two kinds of factors :

(i) Fixed Factors : Fixed factors are unalterable during the production

process.

Production Costs

(ii) Variable Factors : The factors which can be altered during the production process. Amount spent on hiring, fixed factors are termed as ‘Fixed Cost’ while the rewards given to variable factors are termed as ‘Variable Cost’ .

Short Period Fixed Factors Fixed Costs Total Costs Total Costs Variable Factors Variable Costs Box 4 Thus, in short period, production costs include the following two costs :

(i) Fixed Costs : Fixed costs are the sum total of expenditure incurred by the producer on the purchase or hiring of fixed factors of production.

Examples :

(ii) Variable Costs : Variable costs are the expenditure incurred by the producer on the use of variable factors of production. Examples : (1) Cost of raw material, (2) Wages to casual labour, (3) Power expenes. Thus, Total Cost = Fixed Cost + Variable Cost Total cost of production is the sum of all expenditure incurred by the producer in producing a given quantity of a commodity. ☞ In Short Period, Total Cost = Total Fixed Cost + Total Variable Cost TC = TFC + TVC ● Total Fixed Cost

to bear the fixed cost even if production level becomes zero. Fig. 1 shows that even at zero Fig. 1

89

production, total fixed cost is OK. When production level changes to Oq or \mathrm { O q } _ { 1 } , total fixed cost OK remains unaltered. Hence, Total Fixed Cost (TFC) line becomes parallel to X-axis.

● Total Variable Cost (TVC)

Variable costs are dependent on production level. Variable cost increases with increase in production level. In Fig. 2, TVC represents total variable cost line with originates from the origin O. It signifies that variable cost becomes zero at \mathtt { z e r o } _ { F i g . } . 2production level.

Total variable costs \mathrm { K } _ { 1 } \ : \mathbf { q } _ { 1 } , \mathrm { K } _ { 2 } \ : \mathbf { q } _ { 2 } ......... are shown at production levels { \mathrm { O q } } _ { 1 } \mathrm { O q } _ { 2 } ......... respectively which shows that total variable cost increases with increase in production level.

● Total Cost (TC) In Short Period Total Cost = Total Fixed Cost +

Total Variable Cost In Fig. 3, TC curve is obtained by adding TFC and TVC at various production levels. TC curve starts from that point of Y-axis where TFC touches Yaxis (point S in Fig. 3) because TVC is zero at zero production level and hence, TC becomes equal to TFC at zero production level. TC and TVC rise parallel because the difference between TC and TVC signifies TFC which remains constant at all the Production levels.

Fig . 3 Distinction between Fixed Cost and Variable Cost

Fixed Cost

1. It is related to fixed factors of production.

2. Fixed cost does not vary with production level, i.e ., fixed cost remains unchanged with increase or decrease of production level.

3. Total fixed cost remains unchanged even at the zero production level.

4. Graphically, TFC curve is parallel to X-axis.

5. It appears only in short period of production. There is

Variable Cost

1. It is related to variable factors of production.

2. Variable costs vary with production level, i.e., variable cost increases with increase in production and vice versa .

3. Total variable cost becomes zero at zero production level.

4. Graphically, TVC curve is inverse S-shaped.

5. It appears in both short period and long period of prono fixed cost in Long Period. duction. Box 5

Introductory Micro Economics

7.3.2. Short Period Average Costs Derivation of Average Cost Short Period

Average Cost

Average Fixed Costs + Average Variable Cost

Average Cost (AC)

Per unit cost of producing a commodity is termed as average cost. Average total cost or average cost is total cost divided by total units of output.

ATC Or AC = TC

In Short Period,

\mathrm{TC} = \mathrm{TFC} + \mathrm{TVC}

By dividing both sides by q

\mathrm{^{TC} q} = \mathrm{TFC} + \mathrm{TVC} _ {\mathrm{q}}

or

AC = TFC TVC

q q

or \mathrm { A C } = \mathrm { A F C } + \mathrm { A V C }

Thus, in short period, average cost is the addition of average fixed cost (AFC) and Average Variable Cost (AVC).

Fig. 4
In Fig. 4, AC curve is shown which is like the English letter ‘U’. Why is Short-Run AC Curve U-shaped ?

Law of variable proportion is operational in short period. In beginning due to increasing returns, cost declines and after that cost becomes constant and rising due to constant and decreasing returns respectively appearing in production process. These three phases of changing returns in short period cause three changes in cost in short period which make average cost curve Ushaped.

Box 6

Fig . 5 shows the derivation of AC curve from TC curve. At production levels \mathrm { Q } _ { 1 } , \mathrm { Q } _ { 2 } , \mathrm { Q } _ { 3 } perpendiculars have been drawn for obtaining R, K and T points respectively. These points have been connected with point O (i.e., origin) and obtained OR, OK and OT lines which represent the slopes of AC curve at production levels \mathrm { Q } _ { 1 } , \mathrm { Q } _ { 2 } and \mathrm { Q } _ { 3 } . From these slope lines, points R , K and T have been obtained with which AC curve is obtained.

Fig . 5 Box 7

Average Fixed Cost

If we divide Total Fixed Cost (TFC) by quantity of production, we obtain Average Fixed Cost (AFC).

\mathrm{AFC} = \mathrm{TFC} _ {\mathrm{q}}

Where q = quantity of production

Average fixed cost declines with every increase in production level because TFC is constant. Fig. 6 shows average fixed cost.

Average Fixed Cost

Fig . 6
Production Costs

Salient features of AFC curve are as follows : (A) It slopes downward from left to right because

total fixed cost is constant, i.e., AFC falls with increase in production.

(B) Initially AFC falls sharply and later on it falls slowly.

(C) AFC never touches any axis, i.e., AFC takes the shape of a rectangular hyperbola.

(D) AFC can never be zero.

Derivation of Average Fixed Cost Curve AFC curve can be obtained by TFC curve using the geometrical method. Fig. 7 shows the derivation of AFC curve. From point \mathrm { Q } _ { 1 } a perpendicular has been drawn on TFC line which touches it at point A. Similarly, points B and C are obtained from production levels \mathrm { Q } _ { 2 } and \mathrm { Q } _ { 3 } Lines OA, OB and OC are drawn from the origin which show the slopes of AFC at various production levels. From these slope lines OA, OB and OC, points A , B and C have been obtained at production levels \mathrm { Q } _ { 1 } , \mathrm { Q } _ { 2 } and \mathrm { Q } _ { 3 } respectively. By joining

AFC is Rectangular Hyperbola. Why ? AFC curve is rectangular hyperbola because Total Fixed Cost (TFC) remains constant at all points of AFC,i.e., the multiplication between AFC and production quantity at all points of AFC remains constant. It is the reason why AFC declines when production quantity increases. The elasticity at all points of a rectangular hyperbola curve remains unitary.

Fig. 7

Average Variable Cost (AVC)

When Total Variable Cost (TVC) is divided by production quantity (q), we obtain Average Variable Cost (AVC).

\mathrm{AVC} = \mathrm{TVC} _ {\mathrm{q}}

The nature of AVC depends on the average productivity of variable factors used in the production. Average productivity of variable factor initially rises, becomes constant and then falls at the end. Hence, AP curve takes the shape of ‘inverted U’. Productivity and cost are inversely related, i.e., when AP rises,

Fig . 8

AVC falls and when AP falls, AVC rises. AVC takes just three opposite shapes of AP and as a result AVC adopts the shape of ‘U’ as shown in Fig. 8.

Derivation of Average Variable Cost (AVC) Curve The derivation of AVC from TVC is shown in Fig. 9. AVC declines initially due to increasing returns appearing in the first stage of p r o d u c t i o n .

Afterwards, AVC becomes constant at minimum point and then rises due to constant and decreasing returns appearing in the p r o d u c t i o n respectively.

In Fig. 9, points K, T and R have been obtained on TVC

Fig. 9
curve by drawing perpendiculars from \mathrm { Q } _ { 1 } , \mathrm { Q } _ { 2 } and \mathrm { Q } _ { 3 } respectively. Slope lines OK, OT and OR have been drawn by which points K , T and R are obtained. By connecting these points K , T and R , we obtain the AVC curve.

Is AC is the summation of AFC and AVC ?

Figure 10 shows that AC = AFC + AVC (A) At Production Level \mathrm { O Q } _ { 1 } AVC = TQ₁ (Or SK) AFC = KQ₁ So, AC = AFC + AVC = KQ₁ + TQ₁ = \mathrm { S Q } _ { 1 } (Because TQ₁ = SK)

92

Introductory Micro Economics

(B) Similarly, at Production Level \mathrm { O Q } _ { 2 } \mathrm { A V C } = \mathrm { T } _ { 1 } \mathrm { Q } _ { 2 } ( \mathrm { O r } \mathrm { S } _ { 1 } \mathrm { T } _ { 1 } ) \mathrm { A F C } = \mathrm { T } _ { 1 } \mathrm { Q } _ { 2 }

\begin{array}{l} \mathrm{So,AC=AFC+AVC} \\ = \mathrm{T} _ {1} \mathrm{Q} _ {2} + \mathrm{T} _ {1} \mathrm{Q} _ {2} = \mathrm{S} _ {1} \mathrm{Q} _ {2} (\text {Because} \end{array}

Fig. 10

(C) At Production Level { \mathrm { O Q } } _ { 3 }

\mathrm{AVC} = \mathrm{K} _ {1} \mathrm{Q} _ {2}

\mathrm{AFC} = \mathrm{T} _ {2} \mathrm{Q} _ {3} \left(\mathrm{Or} \mathrm{S} _ {2} \mathrm{K} _ {1}\right)

\begin{array}{l} \mathrm{So,AC=AFC+AVC} \\ = \mathrm{T} _ {2} \mathrm{Q} _ {3} + \mathrm{K} _ {1} \mathrm{Q} _ {3} = \mathrm{S} _ {2} \mathrm{Q} _ {3} \end{array}

(Because \mathrm { T } _ { 2 } \mathrm { Q } _ { 3 } = \mathrm { S } _ { 2 } \mathrm { K } _ { 1 } ) Hence, in all the three situations, AC is the summation of AFC and AVC.

7.4. Marginal Cost (MC)

\mathrm{So}, \mathrm{MC} _ {n} = \mathrm{TC} _ {n} - \mathrm{TC} _ {(n - 1)}

or

\mathrm{MC} _ {n} = \mathrm{TVC} _ {n} - \mathrm{TVC} _ {(n - 1)}

Thus, marginal cost is associated with only variable cost and not with fixed cost.

i. e., \mathrm{MC} = \mathrm{TVC}

Box 10 Proof

We know that,

\begin{array}{l} \mathrm{MC} _ {n} = \mathrm{TC} _ {n} - \mathrm{TC} _ {n - 1} \dots .. (1) \mathrm{TC} = \mathrm{TFC} + \mathrm{TVC} \dots .. (2) \text {Putting the value (2) in} \\ \text {(1) we get} \\ \mathrm{MC} = (\mathrm{TFC} + \mathrm{TVC}) _ {n} - (\mathrm{TFC} + \mathrm{TVC}) _ {n - 1} \\ \mathrm{TFC} _ {n} + \mathrm{TVC} _ {n} - \mathrm{TFC} _ {n - 1} - \mathrm{TVC} _ {n - 1} \text {Since} \mathrm{TFC} _ {n} = \mathrm{TFC} _ {n - 1} \\ \mathrm{TFC} _ {n} + \mathrm{TVC} _ {n} - \mathrm{TFC} _ {n} - \mathrm{TVC} _ {n - 1} = \mathrm{TVC} _ {n} - \mathrm{TVC} _ {n - 1} \text {So, MC} = \mathrm{TVC} _ {n} - \\ \mathrm{TVC} _ {n - 1} \end{array}

For example, if the total cost of producing 100 units of output is ` 1,020 and the total cost of 99 units is ` 990, then

\begin{array}{l} \mathrm{MC} _ {1 0 0 \mathrm{th}} = \mathrm{TC} _ {1 0 0} - \mathrm{TC} _ {9 9} \\ = 1, 0 2 0 - 9 9 0 = \cdot 3 0 \end{array}

In other form, MC = Marginal means one additional. It is the addition made to the total variable cost or total cost by producing one more unit of output.

The marginal cost of the n th unit of output is the total cost of producing ‘n ’ units minus the cost of producing ^ { \mathfrak { s } } n - 1 ^ { \mathfrak { s } } units (i.e., one less in the total ‘n ’) of output.

\mathrm{Or} \mathrm{MC} _ {n} = \mathrm{TC} _ {n} - \mathrm{TC} _ {(n - 1)}

Where \mathbf { M C } _ { n } = \mathbf { M a r g i n a l } Cost of n th unit \mathrm { T C } _ { n } = \mathrm { T o t a l } \mathrm { C o s t } of n units \mathrm { T C } _ { ( n - } ₁₎ = Total Cost of (n – 1) units

Marginal cost only depends on variable cost, not on fixed cost.

Fig. 11

The points showing the relation between AC and MC are : (1) Both are calculated by total cost :

^{Total CostAC =} Total Output ^{Change in Total CostMC =} Change in Total Output

(2) Initially AC falls, MC also falls but MC starts rising even though AC continues to fall. Hence, in state of falling AC, marginal cost is less than average cost (MC < AC).

(3) When AC becomes minimum, MC cuts AC from below ,i.e., minimum average cost is equal to marginal cost (AC = MC).

(4)When AC starts rising, MC becomes more than AC (i.e., MC > AC). Production Costs

It is not compulsory that MC should fall only when AC falls. MC may take all three situations falling, minimum and rising while AC is falling. (See : fig. 12)

Fig. 12
In Fig. 12, AC and MC curves are shown. AC is falling till point A and MC continues to be lower than AC. In this situation, MC falls more sharply than AC. At point A, MC is intersecting AC at its minimum point from below. AC starts rising from point A and beyond A, MC rises sharply and becomes more than AC.

In short, MC (When MC > AC, AC is rising) AC MC (When MC = AC, AC is constant) MC (When MC < AC, AC is falling) 7.5.1. Relation of MC Curve with AVC

MC has the same relation with AVC as it has with AC. In other words, MC also cuts AVC at its minimum point from below.

Short-Run Cost Curves : Diagrammatical Representation of AFC, AVC, MC and AC Curves Simultaneously : All short-run cost curves are shown in

Fig. 14. As production increases, the difference between AC and AVC diminishes which signifies the declining AFC with increased production. MC curve cuts AC and AVC at their

minimum points from below. Fig . 14
Box 12

7.6. Production Costs in Long Period

None of the production factor remains fixed in long period. All factors become variable in long period. Producer can increase the number of all factors of production, i.e., producer can alter its plant size in the long period.

Long Period Costs

Long Period Total Costs Long Period Long Period Average Costs Marginal Costs

Long Period Total Cost Curve

All factors of production become variable in long period. As long period total cost is the addition of the costs of various production factors, LTC adopts the same shape as short-run Total Cost Curve (STC) has. In Fig. 15 STC originates from any point of Y-axis (except the origins) while LTC originates from the origins. It happens because in short period total cost is never zero even at zero production level (as STC becomes equal to total fixed cost which never becomes zero) but in long-run, at zero production level, LTC becomes zero because all the factors are variable in the long period.

(B)

Fig. 15

Long Period Average Cost Curve (LAC) Long-run average cost can be obtained by dividing long-run total cost by production quantity. Hence,

\mathrm{LAC} = \mathrm{LTC} _ {\mathrm{q}}

Where, LAC = Long Period Average Cost LTC = Long Period Total Cost q = Production Quantity

Long Period Marginal Cost Curve (LMC) Long Period Marginal Cost (LMC) is the addition made to the total cost of producing one additional unit of output in the long-run.

Relation between LAC and LMC

LAC and LMC adopts the same relationship as AC and MC have in short period.

Or

(i) When LAC falls, LMC is less than LAC.

(ii) LMC cuts LAC

point, i.e., when LAC becomes minimum, LAC becomes equal to LMC. (iii) When LAC rises, LMC becomes more than LAC.

Production TC TFC TVC AVC MC (Units) (‘) (‘) (‘) (‘) (‘)
1 80 50 130 130 80
2 150 50 200 100 70
3 235 50 285 95 85
4 330 50 380 95 95

Long-run Average Cost (LAC) curve and marginal cost (LMC) curve are ‘U’ shaped but more flatter than SAC and SMC because scale of production can be altered in the long period.

Box 13

7.7. Numerical Illustrations

1. Given below is the cost schedule of a firm. Its total fixed cost is `50. Calculate AVC and MC at each given level of output :

Production (Units) : 1 2 3 4 Total Cost ( `) : 80 150 235 330 Solution :

2. From the following data, calculate average variable cost of each given level of output :

Production MC TVC

1 2000 2000

2 1500 3500

3 1200 4700

4 1500 6200

5 2000 8200

6 2700 10900

7 3500 14400

4. Calculate TFC, TVC, AFC, AVC, ATC and MC from the following

Output : 0 1 2 3 4 5 TC : 180 300 400 510 720 1000 Solution :

Output TC TFC TVC AFC AVC ATC MC (Units)

0 180 180 — 0 —
1 300 180 120 180 120 300 120
2 400 180 220 90 110 200 100
3 510 180 330 60 110 170 110
4 720 180 540 45 135 180 210
5 1000 180 820 36 164 200 280

5. From the following data, calculate average variable cost of each at given

Output (Units) : Marginal Cost ( `) : Solution :

Output Marginal
(Units) Cost (``)

1 80
2 70

3 72
4 78 1 2 3 4 80 70 72 78
Total Average Variable Variable Cost (
)
Cost
TVC Q

80 80
150 75

222 74
300 75

3. A firm’s fixed cost is ` 2,000. Compute the TVC, AVC, TC and ATC from the following table :

Production Marginal Cost 1 2,000

2 1,500 3 1,200 4 1,500 5 2,000 6 2,700 7 3,500

4000 4000 2000 5500 2750 1750 6700 2233.33 1566.66 8200 2050 1550.00 10200 2040 1640 12900 2150 1816.66 16400 2342.85 2057.14

Production (Units) 1 2 3 4 Marginal Cost ( `) 40 30 35 39 Solution :

Product (Units) 1 Marginal Total Average Cost Variable Variable Cost Cost TVC _{= Q} 40 40_{40 40 1} 2 30 70 70 35 2 3 35 105 105 35 3 4 39 144 144 36 4

6. From the following data on the cost of production Solution : of a firm, find out (i) Average Fixed Cost and (ii) Average Variable Cost of producing 5th Output TC FC AFC VC AVC

unit : 0 50 50 ∞ 0 0 Units of Output 0353 80 50 16.6 30 10 Total Cost 5 120 50 10 70 14 ( ` in Thousands) 50 80 120
Ans. (i) AFC = ` 10; (ii) AVC (Fifth unit) = ` 14. 7. A firm's total cost schedule is given in the following table :
Production : 012345678(in units)
Total Cost ( ` ): 40 120 170 180 210 260 340 440 550

(a) What is the total fixed cost of this firm ? (b) Derive AFC, AVC, ATC and MC schedules. Solution :

(a) Because total cost of production is ` 40 at zero quantity, it is total fixed cost of the firm. (b)

Production TC TFC TVC AFC AVC ATC MC
0 40 40 — ∞ — ∞ —
1 120 40 80 40 80 120 80
2 170 40 130 20 65 85 50
3 180 40 140 13.33 46.67 60 10
4 210 40 170 10 42.5 52.5 30
5 260 40 220 8 44 52 50
6 340 40 300 6.67 50 56.67 80
7 440 40 400 5.71 57.14 62.85 100
8 550 40 510 5 63.75 68.75 110

8. From the following data on the cost of production of a firm calculate (i) Average Fixed Cost and (ii) Average Variable Cost of producing four units and the marginal cost of the fourth unit : Production (Kgs.) : 0 1 2 3 4 Total Cost : 80 102 122 140 156 Solution : Output TC FC AFC VC AVC MC

0 80 80 ∞ 0— — 1 102 80 80 22 22 22 2 122 80 40 42 21 20

Output Fixed Cost Cost Cost
0 100
1 100
2 100
3 100
4 100
60 56 60 64

3 140 80 26.6 60 20 18 4 156 80 20 76 19 16 Ans. (i) AFC (Fourth unit) = ` 20; (ii) AVC (Fourth unit) = ` 19; (iii) MC (Fourth unit) = ` 16. 9. Total fixed cost of a firm is ` 100. Its average variable cost at different levels of output is given below. Calculate total cost and marginal cost at each level of output : Output (Units) : 1234 Average Less More Cost ( `) : Solution :

Average Total Total Marginal Variable Variable Cost Cost Cost

— — 100 — 60 60 160 60 56 112 212 52 60 180 280 68 64 256 356 76

96 Introductory Micro Economics 10. From the cost function of a firm given below, find out TFC, TVC, AVC : Output (Units) : 01234 TC ( `) : 50 70 90 105 120 Solution :

Output TC (‘) TFC (‘) TVC (‘) AVC (‘)
0 50 50 — —
1 70 50 20 20
2 90 50 40 20
3 105 50 55 18.3
4 120 50 70 17.5

ATC =` 40 TC =` 40` 20 =` 800

11. Complete the following table :

Output Total Variable Average Variable Marginal (Units)

Cost Cost Cost (‘)(')(‘) 1— 12 — 220 — — — — 10 10 440 — —

Solution : Completed table is as follows :

Output Total Variable Average Variable Marginal (Units)

Cost Cost Cost ( ` )( ` )( ` ) 112 12 12 220 10 8 330 10 10 440 10 10 12. A firm is producing 20 units. At this level of output, the ATC and AVC are respectively equal to

` 40 and ` 37 Find out the TFC of the firm.

Solution :

$= \cdot 800 - \cdot 740 = \cdot 60 \text{ Ans.}$

13. The following table shows the MC at different levels of output by a firm. Its TFC is ` 120. Find out ATC and AVC at each level of output :

Solution :

Output TFC MC TC ATC TVC AVC (`)(`)(`)(`)(`)(`) 0 120 — 120 ∞ 0 0 1 120 40 160 160 40 40 2 120 30 190 95 70 35 3 120 26 216 72 96 32 14. Complete the following table :

Production AVC TC MC

120 80 —

215 — —

320 — —

Solution :

Production FC AVC VC TC MC 1 602020 80 20

2 601530 90 10 3 602060 120 30

15. From the following data, calculate average variable cost of each given level of output : Output (Units) : 1234 Marginal Cost ( `) : 70 60 62 Solution :

Output Marginal Total Variable (Units) Cost (`) Cost (`)

170 70

2 60 130

3 62 192

4 72 264 16. Complete the following table :

Output Total Variable Average Variable (Units) Cost Cost ( `)( `)( `) 72 Average Variable Cost (`)

70

65

64

66

Marginal Cost

110 — — —— 8 6

327 — — — — 10 13

Solution :

Completed table is as follows :

Output Total Variable Average Variable Marginal (Units) Cost Cost Cost (` ) (` )(` ) 110 10 10 216 8 6 327 9 11 440 10 13 17. Given below is the cost schedule of a firm. Its total fixed cost is ` 100. Calculate AVC and MC at each given level of output :

Production (Units) : 1234 Total Cost ( `) : 350 450 610 820 Solution :

Production TC TFC TVC AVC MC (Units) (`)(`)(`)(`)(`) 1 350 100 250 250 250 2 450 100 350 175 100 3 610 100 510 170 160 4 820 100 720 180 210

18. The following table shows the cost function of a firm. Calculate its average fixed cost and marginal cost at each level of output : 98

Output (Units) : 0 1 2 3 TC ( `) : 90 120 145 175 Solution :

Production TC TFC AFC MC 0 90 90 — 1 120 90 90 30 2 145 90 45 25 3 175 90 30 30 A QUICK REVIEW OF THE CHAPTER

Money Cost : Cost of production measured in terms of money is called ‘Money Cost’ . Real Cost : Efforts and sacrifices made in production process are called real cost. It is also called ‘Social Cost’ because the society faces a number of difficulties in the production process.

Opportunity Cost : Opportunity cost of a factor refers to its value available in its next best alternative use.

Explicit Cost : These are direct contractual monetary payments incurred through market transactions. It refers to the expenditure made by a firm in hiring productive resources in production process. Implicit Cost : Implicit costs are the costs of use of factors which a firm does not buy or hire but already owns. It includes the prices of such services and factors which are used in production process but are not directly paid.

Normal Profit : The minimum essential profit which the entrepreneur must receive to continue his production process is termed as ‘Normal Profit’ .

Fixed or Supplementary Cost : Fixed costs do not change with change in output. Such cost arises in short period due to the use of fixed factors. There is no fixed cost in long period.

Variable Cost : Variable cost varies with change in output. Such cost arises

due to the use of variable factors in production process.

Total Cost : The total expenses made by a firm for producing a particular quantity of the commodity is known as ‘Total Cost’ . In short-run, total cost includes both fixed as well as variable cost while in long-run, total cost only includes variable cost.

Average Cost (AC) : The cost per unit of production is known as ‘Average Cost’ .

AC = Total Cost (TC)

Output (q)

Marginal Cost (MC) : It is the addition made to the total cost by producing one more unit of output. Relationship between AC and MC : Both AC and MC are calculated by Total Cost (TC) but (i) When AC falls, AC > MC (ii) When AC becomes minimum, AC = MC

(iii) When AC rises, AC < MC

Short Period and Long Period Costs : In short-run, TC includes both TFC and TVC but in long-run distinction between fixed and variable factors disappear because all factors become variable and hence, in longrun, TC includes only variable costs.

Both Short Period and Long Period AC Curves are U-shaped but longrun AC curve becomes more flatter than short-run AC curve. SAC becomes U-shaped because of law of variable proportion while LAC is U-shaped because of returns to scale.

QUESTIONS Ultra Short Answer Type Questions

1. What is cost function ?

2. When is Average Cost at its minimum ? (B.S.E.B., 2014)

3. What is marginal cost ? (J.A.C., 2015)

4. Which cost curve is a rectangular hyperbola?

(Raj. Board , 2016)

5. What is the relation between Average Variable Cost and Average Total Cost, if Total Fixed Cost is zero?

( C.B.S.E. , 2016, 18) 6. What happens to the difference between Average Total Cost and Average Variable Cost as production is increased ?

( C.B.S.E. , 2016) 7. What is the relation between MC and AC when AC is constant? (C.B.S.E. , 2016) 8. What is Average Cost ? [J.A.C. (Arts ), 2017] 9. Define Opportunity Cost. [J.A.C. (Arts ), 2017] 10. Define Fixed Cost. [J.A.C. (Arts ), 2017; B.S.E.B. , 2019; C.B.S.E., 2018] 11. What is the formula of finding marginal Cost ?

(B.S.E.B. , 2017; C.B.S.E., 2018) 12. What happens to the difference between Total Cost and Total Variable Cost as output is increased ? (C.B.S.E., 2018) 13. What happens to the difference between Average Total Cost and Average Variable Cost as production is increased ? (C.B.S.E., 2018)

Very Short Answer Type Questions

1. What is money cost ?

2. Define real cost.

3. What is meant by opportunity cost ? Or [J.A.C. (Comm. ), 2017, 19]

Give the meaning of Opportunity cost.

4. What is meant by social cost ?

5. What is explicit cost ?

6. Explain the meaning of implicit cost.

7. What is meant by Fixed Cost ? [J.A.C. (Comm. ), 2017]

8. What is meant by Variable Cost ? Give two examples. [C.B.S.E., 2013;

J.A.C. (Comm. ), 2017; B.S.E.B. , 2019]

9. What is Average Cost (AC) ?

10. Define Marginal Cost (MC).

(C.B.S.E., 2013; B.S.E.B. , 2016) 11. Give one example each for fixed cost and variable cost. (C.B.S.E., 2013) 12. What are the total fixed cost, total variable cost and total cost of a firm ? (U.S.E.B. , 2016) 13. Does the difference between Average Cost (AC) and Average Variable Cost (AVC) remain constant ? (C.B.S.E. , 2015) 14. What will be the condition of MC curve when AC declines ? 15. Can AFC curve touch X-axis ?

16. Why are Total Cost Curve and Total Variable Cost Curve parallel to each other ?

17. What is meant by cost ? (C.B.S.E., 2011) 18. Why is average total cost greater than average variable cost ?

18. Distinguish between marginal cost and average cost. 20. What are MC,

TC and AC ?

21. What nature average fixed cost adopts on rise in production ? (C.B.S.E., 2012) 22. Explain the nature of total variable cost on rise in production. (C.B.S.E., 2012) 23. When AC falls, what is the behaviour of MC curve ? 24. Why is short-run cost curve U-shaped ? (J.A.C. , 2014; B.S.E.B., 2014, 18)

Short Answer Type Questions

1. What is cost function ?

2. What is meant by real cost ? How does it differ from money cost ? (C.B.S.E., 2013, 18)

3. Explain the concept of opportunity cost.

4. Draw Average Cost (AC), Average Variable Cost (AVC) and Marginal Cost curves in one diagram.

[C.B.S.E., 2012; B.S.E.B., 2012 (Arts )] 10. Why is short-run cost curve Ushaped ? Explain briefly. [J.A.C., 2012; U.S.E.B., 2017; B.S.E.B., 2018] 11. What is Marginal Cost and Average Cost ? Why is average cost curve Ushaped ? (J.A.C., 2010) 12. Distinguish between explicit and implicit costs. (C.B.S.E., 2011; U.S.E.B., 2013) 13. Define Variable cost. Explain the behaviour of TVC on increasing production. (C.B.S.E., 2011) 14. What is Opportunity Cost ? Explain with numerical example. (C.B.S.E., 2012) 15. A person is both owner and manager of the shop taken on rent. Identify explicit and implicit costs on this information. (C.B.S.E., 2012) 16. Explain short run average cost and long run average cost with diagram. (Raj. Board, 2015) 17. Explain short run marginal cost and long run marginal cost with diagram. (Raj. Board, 2015) 18. Define cost. Distinguish between fixed and variable cost. Give one example of each. (C.B.S.E. , 2016) 19. Explain the relationship between long run average cost curve and long run marginal cost curve with the help of a diagram. (Raj. Board, 2017)

Long Answer Type Questions

1. Describe the various types of production costs. Explain the mutual relationship between Average Cost and Marginal Cost. [B.S.E.B. (Comm. ), 2018]

2. Explain the relationship between Average Cost Curve, Average Variable Cost Curve and Marginal Cost Curve. [B.S.E.B. (Arts ), 2018] 3. What do you mean by production cost ? Distinguish between Explicit cost and Implicit cost.

[ B.S.E.B., 2010; J.A.C. (Comm. ), 2017] 4. What are Total Fixed Cost, Total Variable Cost and Total Cost of a firm ? How are they related ? (U.S.E.B., 2014) 5. Why is short-run average cost curve U-shaped ? Explain briefly. [J.A.C. (Arts) 2014; J.A.C., 2015, 17] 6. Discuss the short-run cost curve with the help of diagram. (B.S.E.B., 2014) 7. Explain the meaning of average cost. In short run why average cost curve is ‘U’ shaped ? (B.S.E.B., 2019)

100

Objective Type Questions

(A) Multiple Choice Questions :

1. Which of the following is included in money cost ?

(a) Normal Profit (c) Implicit Cost

[ B.S.E.B. (Arts ), 2018] (b) Explicit Cost

(d) All the above

(a) AC = TFC – TVC

(c) AC = TFC + AVC

14. What is an opportunity cost ?

Introductory Micro Economics

12. When average cost is decreasing what status marginal cost has as compared to average cost ?

(a) MC > AC (b) MC = AC

(c) MC ≤ AC (d) MC ≠ AC

13. Which statement of the following is true ?

14. Which of the following is not fixed cost ? [B.S.E.B. , 2011, 12, 17] (a) Insurance Premium (b) Interest (c) Cost of Raw Material (d) Rent of the Factory

15. With the increase in production the difference between total cost and total fixed cost : (a) Remains Constant (b) Increases (c) Decreases (d) Both Increases or Decreases

16. Changes in production quantity affect : (B.S.E.B. , 2019) (a) Both Fixed and Variable Cost (b) Only Variable Cost (c) Only Fixed Cost (d) None of the above

17. What happens when production is shut down ? (a) Fixed Cost Increases (b) Variable Costs Decline (c) Variable Costs become zero (d) Fixed Costs become zero

18. Which of the following is correct ? [B.S.E.B. , 2018] (a) TVC = TC – TFC (c) TFC = TVC + TC (b) TC = TVC – TFC (d) TC = TVC × TFC

[ B.S.E.B., 2012 (Arts )] (b) AC = AFC + TVC (d) AC = AFC + AVC

( B.S.E.B., (Comm ), 2015) (a) The alternative foregon (c) Transfer earnings (b) The opportunity lost (d) All of these

7. Average variable costs can be defined as : [B.S.E.B. , 2015 (Comm. )] (a) TVC × Q (b) TVC + Q (c) TVC – Q (d) TVC ÷ Q

8. With increase in output, the difference between total cost and total variable cost : (a) Decreases (c) Remains Constant

( B.S.E.B. , 2019) (b) Increases

(d) None of the above

9. Which factors are used in short-run production process ? (a) Fixed Factors

(c) Both a & b (b) Variable Factors (d) None of the above

10. Following figure shows : [B.S.E.B. , 2011 (Arts )] (a) Total Fixed Cost

(c) Total Cost

(b) Total Variable Cost (d) None of the above

Fig. 11. The alternative name of opportunity cost is : (a) Economic Cost (c) Marginal Cost (b) Equilibrium Price

(d) Average Cost

(B.S.E.B., 2016, 17) 15. The shape of average cost curve is :

( B.S.E.B., (Comm ), 2015) (a) U-shaped

(b) Rectangular Hyperbola shaped

(c) Line parallel to x -axis

(d) None of these

16. The average fixed cost at 5 units of output is ` 20. Average variable cost at 5 units of output is ` 40. Average cost of producing 5 units is : (C.B.S.E. AI., 2017) (a) ` 20 (b) ` 40 (c) ` 56 (d) ` 60

17. When the total fixed cost of producing 100 units is ` 30 and the average variable cost is ` 3, total cost is : (C.S.E.B., 2018) (a) ` 3 (b) ` 30 (c) ` 270 (d) ` 330

18. Average fixed cost curve : (C.B.S.E., 2019) (a) is a straight line parallel to x-axis

(b) is straight line parallel to y-axis

(c) falls as more units are produced

(d) rises as more units are produced

19. Which of the following formula is correct for calculating marginal cost ? : (C.B.S.E., 2019) (a) \mathrm { M C _ { N } = T F C _ { N } - T F C _ { N - 1 } \left( b \right) M C _ { N } = A C _ { N } - A C _ { N - 1 } \left( c \right) } 0 { \bf M } { \bf C } _ { \mathrm { N } } = \mathrm { A V C } _ { \mathrm { N } } - \mathrm { A V C } _ { \mathrm { N - 1 } } ( { \bf d } ) { \bf M } { \bf C } _ { \mathrm { N } } = \mathrm { T C } _ { \mathrm { N } } - \mathrm { T C } _ { \mathrm { N - 1 } } [ { \bf A } { \bf n } { \bf s } _ { \mathrm { \perp } } \mathrm { ~ ( d ) } , 2 . ( { \bf c } ) , 3 . ( { \bf b } ) ,

20. (b), 5. (c), 6. (a), 7. (d), 8. (c), 9. (c), 10. (b), 11. (a), 12 (c), 13. (d), 14 (d),

21. (a) 16 (d), 17. (d), 18. (c), 19. (d).]

(B) Fill in the Blanks :

1. In cost function, cost is a function of.................

2. Cost of self-owned resources is called................costs.

3. Fixed cost is not found in................run period.

4. ................curve is rectangular hyperbola.

5. Marginal cost depends only on................costs.

6. Per Unit Cost of Production is called .............. . [Ans. 1. output, 2.

implicit, 3. long, 4. AFC, 5. variable, 6. Average Cost]

(C) State True/False

1. Total Money Cost = Explicit Cost + Implicit Cost + Normal + Profit.

2. AC curve is U-shaped.

3. Average Cost is the difference between Average Variable Cost and

Average Fixed Cost.

4. The difference between Average Total Cost and Average Variable Cost is constant.

5. TVC = TC – TFC

[Ans. 1. True, 2. True, 3. False, 4. False, 5. True.]

Production Costs

(D) Match the following Column :

‘A’

1. Money Cost

2. Fixed Cost

3. Only Variable Cost

4. Rent of the Factory

5. Opportunity Cost

‘B’

(a) Fixed Cost

(b) Expenditure on raw material (c) Long-run

(d) Transfer Earning

(e) Short-run

[ Ans. 1. (b), 2. (e), 3. (c), 4. (a), 5. (d).]

(E) Answer in One Word :

1. In which period, fixed cost of production arises ? 2. What is the shape of average cost curve ?

2. Which curve is rectangular hyperbola ?

3. Which cost does not arise in long period ?

[Ans. 1. Short period, 2. U-shaped, 3. AFC, 4. Fixed Cost]

HOTS

High Order Thinking Skills Questions

1. Fixed Cost disappears in long-run. Why ?

(See : Section 7.6)

2. AFC curve can never touch axis. Why ? Give reasons. (See : Box 8)

3. Why is short-run AC curve U-shaped ?

(See : Box 6)

4. Why does AFC curve become rectangular hyperbola ? [See : Box 8]

Value Based Questions

VBQ

1. Is AFC rectangular hyperbola ? Why ?

(See : Box 8)

2. Marginal cost is related only with variable cost, not with fixed cost. How ?

(See : Section 7.4)

3. The distance between AC and AVC goes on decreasing as production increases. Why ?

(See : Box 12)

MDQ

Case Study Based on Evaluation & Multi-disciplinary Questions

1. ‘‘Marginal Cost depends only on variable cost.’’ Do you agree ? Why ? (See : Box 10)

2. The distance between AC and AVC curve goes on diminising as output level increases. Why ? (See : Box 12)

3. Is it necessary MC to fall when AC declines ? (See : Box 11)

Numerical Questions 1. Calculate the Total Fixed Cost (TFC), Total Variable Cost (TVC) and Marginal Cost (MC) from the following table : Production (in units) Total Cost 0 1 2 3 4

50 100 120 150 210 [Ans. TFC : 50, 50, 50, 50, 50
TVC : 0, 50, 70, 100, 160
MC : -, 50, 20, 30, 60]
From the following table calculate Total Variable Cost and Average
Variable Cost. (U.S.E.B., 2015) Output Units 1 2 3 4 Marginal Cost 70 60
62 72
TVC [Hint : TVC= MC and AVC =q ]
[ Ans. TVC = 70, 130, 192, 264; AVC = 70, 65, 64, 66] 3. Calculate Total
Variable Cost (TVC) and Marginal Cost
(MC) of a firm with following table. The Total Fixed Cost
(TFC) is ` 12 : (U.S.E.B., 2012) Units TC
1 20
2 26
3 31
4 38
[Ans. TVC = 8, 14, 19, 26
MC = -, 6, 5, 7]
4. If fixed cost is ` 20, calculate the following :
(J.A.C., 2012)
Production Fixed Marginal (Units) Cost Cost
0 20 0
1 20 10
2 20 15
3 20 25
(A) Total Variable cost (TVC) (B) Total Cost (TC) [Hint : MCn = TCn - TCn
-1 or MCn = TVCn - TVCn - 1] [Ans. TVC = 0, 10, 25, 50
TC = 20, 30, 45, 70]
5. Complete the following table : (C.B.S.E., 2013) Production (Units) AC
MC
1 12 —
2 10 —

3 — 10 4 10.5 — 5 11 — 6 — 17

[Ans. AC—12, 10, 10 , 10.5, 11, 12 MC—12 , 8 , 10, 12 , 13 , 17] 6. Fill in the blanks in the following table :

Units TFC TC TVC AFC AVC ATC MC (‘) (‘) (‘) (‘) (‘) 0 60 60
1 60 120
2 — 180
3 — 200
4 — 210
5 — 225
6 — 260
7 — 330

102

Introductory Micro Economics

[ Ans. TVC (`) = 0, 60, 120, 140, 150, 165, 200, 270 Hint : AFC (`) = —, 60, 30, 20, 15, 12, 10, 7.5 AVC (`) = —, 60, 60, 46.6, 37.5, 33, 33.3, 88.5 ATC (`) = —, 120, 90, 66.6, 52.5, 45, 43.3, 47.1

MC (`) = —, 60, 60, 20, 10, 15, 35, 70] 7. Complete the following table if Average Fixed Cost (AFC) at one unit of output is`60 :_{[ Ans.}

Output ( Q ) TC TVC TFC AVC AFC MC 1 90 2 105 3 115 4 120 TVC = AFC × Q$_{TVC}$ TVC = TC - TFC; AVC =$_{Q}$

TVC = 30, 45, 55, 60

TFC = TFC

Q

\mathrm{MC} _ {n} = \mathrm{TC} _ {n} - \mathrm{TC} _ {n - 1}

TFC = 60, 60, 60, 60

AVC = 30.0, 22.5, 18.3, 15.0 AFC = 60, 30, 20, 15

MC = –, 15, 10, 0.5]

8. Calculate short run average cost and short run marginal cost on the basis of units of output and total variable cost in the given table : (Raj. Board., 2012) Output Total Variable Cost Short Run Average Cost Short Run Marginal Cost (Units) (`) (`) MC (`)

1 30 — —

2 40 — —

3 48 — —

4 52 — —

^TVC [Hint : MC_n = TVC_n –TVC_n–1 ; AC =_q ]

[ Ans. SRAC = 30, 20, 16, 13 SRMC = -, 10,8,4]

9. Fill up the blanks of the following table and answer the following questions :

(a) At what production level, Average Fixed Cost (AFC) and Average Variable Cost (AVC) will be equal ?

(b) At what production level, AC will be minimum ?

(c) At what production level, AVC will be minimum ? Output FC AFC (a) At 5 units of production, AFC & AVC will be equal (b) At 4 units of production, AC will be minimum (c) At units of prodcution, AVCwill be minimum.]

Output TFC TVC
0 40 —
1 40 20
2 40 36
3 40 48

[Ans. TC = AC Quantity of Output
TVC = AVC Quantity of Output AC = AFC + AVC
Or
AC =
TC
Quantity of Output
TC AC AVC 8 1.0 2.8
8.8
1.2 3.4
35.7
7.15

10. Complete the following table : Unit of Output Total Cost Average Cost Marginal Cost

1 2 20 27 — — — — (JAC, 2018, 19)

3 4 5 6 35 55 70 80 — —

[Ans. AC = 20, 13.5, 11.67, 13.75, 14, 13.33 MC = –, 7, 8, 10, 15, 10] Production Costs

11. Calculate missing values of average fixed cost, average variable cost, short-run period average cast and short-run period of marginal cost in the given table :

MC = 0, 30, 20]

TFC

[Ans. AFC = Q = 40₁ = 40

TVC

12. Cost function of a firm is given below : Production (Unit) 0 1 Total Cost (`) 120 150 Calculate the following :

(i) Total Fixed Cost (TFC)

(ii) Total Variable Cost (TVC)

(iii) Average Fixed Cost (AFC)

(iv) Average Variable Cost (AVC) (v) Marginal Cost (MC)

( B.S.E.B., 2014Raj. Board, 2016) TC AFC AVC SRAC SRMC 40 — —— — 60 ? 20 60 20 76 20 18 ? 16 88 13.33 ? 29.33 ?

TC

SRAC = Q =76 = 38₂

SRMC = TC_n – TC_{n –1} = 88 – 76 = 12]

2 3 4 5 6 170 186 200 220 270 AFC = 0, 120, 60, 40, 30, 24, 20 AVC = —, 30, 25, 22, 20, 20, 25

MC = —, 30, 20, 16, 14, 20, 50] 13. A firm is producing 20 units. At this level of output, ATC and AVC are respectively equal to` 40 and` 37. Find out TFC of this firm. [J.A.C. (Arts ), 2017]

[Ans. TFC = 120, 120, 120, 120, 120, 120, 120 [Ans. AFC = 3 TVC = 0, 30, 50, 66, 80, 100, 150_{TFC = 20 × 3 = 60]} 14. Complete the following table :

Production Total Cost _{TFC TVC MC (Units) (`)}

0 150

1 180

2 200

[Ans. TFC = 150, 150, 150

15. Complete the following cost schedule : (C.B.S.E ., 2019) Quantity (in units) 0 1 2 3 4 Total Cost (in`) 200 — — — 490 Total Variable Cost (in`) 0 — 180 — — Average Variable Cost (in`) — 100 — 80 — [Ans. TC = 200, 300, 380, 440, 490 TVC = 0, 100, 180, 240, 290 AVC = 0, 100, 90, 80, 72.5 NCERT CORNER Q. 3. What are the average fixed cost, average

Q. 1. Briefly explain the concept of the cost function. ^{variable cost and average cost of a firm ? How} Ans. are they related ? See Section 7.1. Ans. See Section 7.3.2. Q. 2. What are the total fixed cost, total variable Q. 4. Can there be some fixed cost in the long run ? cost and total cost of a firm ? How are they If not, why ? _{related ? Ans. See Section 7.6. Ans. See Section 7.3.1.} 104

Q. 5. What does the average fixed cost curve look like ? Why does it look so ? Ans. See Box 8.

Q. 6. What do the short run marginal cost, average variable cost and short-run average cost curves look like ? Ans. See Box 8.

Q. 7. Why does the SMC curve cut the AVC curve at the minimum point of the AVC curve ? Ans. See Section 7.5.1.

Introductory Micro Economics Q. 8. At which point does the SMC curve cut the SAC curve ? Give reason in support of your answer.

Ans. See Section 7.5. Q. 9. Why is the short run marginal cost curve ‘U’ shaped ? Ans. See Section 7.4 & 7.5. Q. 10. What do the long run marginal cost and the average cost curves look like ? Ans. See Section 7.6.

Q. 11. The following table shows the total cost schedule of a firm. What is the total fixed cost schedule of this firm ? Calculate the TVC, AFC, AVC, SAC and SMC schedules of the firm : Q 0123456 TC 10 30 45 55 70 90 120 Ans.

0 10 10 1 30102010203020 2 45 10 35 5 17.5 22.5 15 3 55 10 45 3.33 15 18.33 10 4 70 10 60 2.5 15 17.5 15 5 90 10 80 2 16 18 20 6 120 10 110 1.67 18.33 20 30

TVC

Q. 12. The following table gives the total cost schedule of a firm. It is also given that the average fixed cost at 4 units of output is `^Q 5. Find the TVC, TFC, AVC, AFC, SAC and SMC schedules of the firm for the corresponding values of output :

Q 0123456 TC 20 50 65 75 95 130 185 Ans. Q TC TFC TVC AFC AVC SAC SMC

0 20 20 – ––– – 1 50 20 30 203050 30 2 65 20 45 10 22.5 32.5 15 3 75 20 55 6.67 18.33 25 10 4 95 20 75 5 18.75 23.75 20 5 130 20 110 4 22 26 35 6 185 20 165 3.33 27.5 30.83 55

Q. 13. A firm's SMC schedule is shown in the following table. The total fixed cost of the firm is ` 100. Find the TVC, TC, AVC and SAC schedules of the firm : Q 0123456 SMC — 500 300 200 300 500 800

L = 100, K = 100

\mathrm{Q} = 2 \mathrm{L} ^ {2}. \mathrm{K} ^ {2} \mathrm{L} = 5, \mathrm{K} = 2 = 2 \times 5 ^ {2} \times 2 ^ {2} = 2 \times 2 5 \times 4 = 2 0 0

Ans. TVC Q SMC _{( = Σ SMC )} TFC TC AVC SAC 0 – – 100 100 – – 1 500 500 100 600 500 600 Production Costs

2 300 800 3 200 1,000 4 300 1,300 5 500 1,800 6 800 2,600

Q. 14. Let the production function of a firm be, Q = 5L ^1/2 K ^1/2 Find out the maximum possible output that the firm can produce with 100 units of L and 100 units of K.

Ans. Production Function

1 1

1 1

Q = 5 × 100 × 100 = 5 × 10 × 10 = 500 Maximum Possible Output = 500. Q. 15. Let the production function of a firm be, Q =

Find out the maximum possible output that the firm can produce with 5 units of L and 2 units of K. What is the maximum possible output that the firm can produce with zero unit of L and 10 units of K ? Ans. Production Function

Maximum Possible Output = 200 Q = 2L² .K² L = 0, K = 10 100 900 400 450 100 1,100 333.33 366.67 100 1,400 333.33 350 100 1,900 360 380 100 2,700 433.33 450

Q = 5L + 2K
Ans. Production Function
Q = 5L + 2K, L = 0, K = 10
= 5 × 0 + 2 × 10 = Zero
Maximum Possible Output
= Zero

$= 2 \times 0^{2} \times 10^{2} = \text{Zero}$ Maximum Possible Output = Zero

Q. 16. Find out the maximum possible output for a firm with zero unit of L and 10 units of K when its production function is

Q. 17. Will a profit-maximising firm in a competitive market produce a positive level of output in the short-run if the market price is less than the minimum of AVC ? Give an explanation. Ans. See Section 7.5.1 Q. 18. Will a profit-maximising firm in a competitive market produce a positive level of output in the long–run if the market price is less than the minimum of AC ? Give an explanation. Ans. See Section 7.6

口

CONCEPTS OF REVENUE

STUDY MATERIAL INCLUDED IN THE CHAPTER

8.1. Meaning of Revenue8.2. Concepts of Revenue8.3. Revenue Curves of Various Markets8.4. Demand Curves in Different Markets : A Comparison8.5. Importance of Revenue Curves8.6. Numerical Illustrations A Quick Review of the Chapter Questions High Order Thinking Skills (HOTS) Questions Value Based Questions (VBQ)

Case Study based on Evaluation & Multi-disciplinary Questions (MDQ) Numerical Questions NCERT Corner. 8.1. Meaning of Revenue The objective of the firm is to maximise its profit.

Revenue is that sales proceeds which a firm obtains Profit is the difference between the sales proceeds (i.e., revenue) and cost.

from the sale of its output. According toDooley, ‘‘The Profit = Revenue – Cost revenue of a firm is its sales receipts or money receipts At given cost, profit will depend on the revenue obtained from the sale. from the sale of the product. ’’ 8.2. Concepts of Revenue Concepts of

Revenue

Total Revenue

TR = P × Q Or

TR = (MR)

Total Revenue (TR) Total revenue is obtained by multiplying the quantity sold by its price per unit. In other words,

Total Revenue = Total Receipts from Sale

= Quantity sold × Price per unit

For example, a seller sells 500 units at the price `10 per unit, then

Total Revenue = 10 × 500 = `5,000

Marginal Revenue (MR)

Marginal revenue is the addition made to the total revenue by selling one more units of the item. Thus, marginal revenue is the change in total revenue on account of the sale of one more unit of output. In other words, marginal revenue is the rate of change in total revenue.

Symbolically,

\mathrm { M R } _ { n } = \mathrm { T R } _ { n } - \mathrm { T R } _ { n - 1 } Marginal Revenue Average Revenue

\mathrm{MR} = \mathrm{TR} \mathrm{AR} = \mathrm{TR}

\mathrm{QQ}

Or

\mathrm{MR} _ {n} = \mathrm{TR} _ {n} - \mathrm{TR} _ {n - 1}

Where, MR_n = Marginal Revenue ofn th unit

TR = Total Revenue ofn units \mathrm { T R } _ { n - 1 } = Total Revenue of (n – 1) units

In other form,

MR = TR = Change in Total Revenue

Q Change in Quantity Sold

Average Revenue (AR)

Revenue obtained per unit of output sold is termed as‘Average Revenue’ . It is simply the total revenue divided by units sold.

\mathrm{AR} = \mathrm{TR}

Q =

Total Revenue

Units of Output Sold ''Average revenue (AR) always represents the price of the commodity per unit.''

Concepts of Revenue

In short,

Total Revenue (TR)

According toDooley ,‘‘Total revenue is the sum of all sale receipts or income of a firm.’’ Marginal Revenue (MR)

According toFerguson ,‘‘Marginal revenue is the change in total revenue which results from the sale of one more or one less unit of output.’’ Average Revenue (AR)

According toMcConnell ,‘‘Average revenue is the per unit revenue received from the sale of a commodity.’’

Box 1 8.2.1. Why does Average Revenue Curve become

Demand Curve ?

Or

Average Revenue is price per unit. Why ?

Average revenue means the price per unit received by the seller. Besides, price is the payment per unit made by the consumer for buying the commodity. Seller’s receipt is buyer’s payment. Hence‘Per Unit Revenue’ and‘Per Unit Price’ are one and the same thing. Due to this reason, average revenue curve and firm’s demand curve become the same.

It is clear now that :

(1) AR represents price,i.e., AR is price per unit. (2) AR line represents demand curve.

When can MR be Zero or Negative ? MR can be zero or negative under monopoly and monopolistic competition but it is not possible under situation of perfect competition because in perfect competition AR = MR and AR

(i.e., price) cannot be zero or negative. Under situations of monopoly and monopolistic compe

When MR falls, TR increases at a decreasing rate.

When MR = 0, TR becomes maximum.

●

When MR becomes negative, TR starts falling. (See : Fig. 4)

Box 2

8.3. Revenue Curves of Various Markets

(A) Revenue Curves in Perfect Competition In perfect competition, the demand of the commodity is perfectly elastic (e = ) because a firm is pricetaker in perfect competition. Price is determined by the industry and the determined price is accepted by the firm. A perfect competitive firm can sell any quantity at this given price.

AR and MR in Perfect Competition

Fig. 1

As per the formula,_{e AR = MR e 1If e =}

Then,

AR = MR₁

Or AR = MR

Or AR = MR

Thus, in perfect competition, AR and MR are equal tition : and this line is a horizontal line parallel to X-axis MR can be zero or negative if price falls. as shown in Fig 1.

Illustration 1. Table 1

Quantity Sold (Q)

TR = MR

Therefore,

AR Per unit Price (P) Total Revenue Marginal Revenue { \mathrm { T R } } = \mathbf { P } \times \mathbf { Q } \ \mathbf { M } \mathbf { R } \ _ { n } = \mathrm { T R } _ { n } - \mathrm { T R } _ { n - 1 }

2 0 2 0 2 0 - 0 = 2 0

2 0 4 0 4 0 - 2 0 = 2 0

2 0 6 0 6 0 - 4 0 = 2 0

2 0 8 0 8 0 - 6 0 = 2 0

2 0 1 0 0 1 0 0 - 8 0 = 2 0

Above Table 1 represents the situations of Total Revenue (TR), Average Revenue (AR) and Marginal Revenue (MR). TR rises at a constant rate because AR remains constant. MR becomes equal to AR in perfect competition.

Introductory Micro Economics

Relation between AR and TR in Perfect Competition

In perfect competition, the area below the price line (i.e., AR curve) shows the total revenue. In perfect competition,

TR = Price × Quantity sold In perfect competition, AR remains constant and as a result

\mathrm{AR} = \mathrm{MR}

Price line is the same as MR curve. We know

Therefore, the area under the MR curve corresponding at all output levels becomes equal to TR.

Fig . 2
Fig. 2 shows that at price line (i.e., AR curve) firm produces, and sells OQ quantity at price OP per unit, the area under MR becomes equal to PKQO which represents TR.

Box 3

(B) Revenue Curves in Monopoly

Under monopoly market situation, both AR and MR curves fall from left to right. It implies that the firm has to cut down the price if it has to sell more units of output. On the contrary, a monopolist firm can sell less units of the product at higher price. Thus, in monopoly price is inversely related to quantity sold, i.e., more sale at less price and less sale at higher price. As a result, margnial revenue falls for more quantity sold. Both AR and MR fall but the fall in MR is more steeper than that of AR and as a result, MR remains lower than AR.

Fig. 3 shows the AR and MR curves. Both AR and MR curves are falling. MR is falling more steeply.

No. of Units Sold 1 2 3 4 5 6 7 8 9 10 11 12 Total Average Revenue Revenue = Price (TR) 20 38 54 68 80 90 98 104 108 110 110 108 (AR) 20 19 18 17 16

Marginal Revenue (MR)

Above table 2 shows that a monopolist firm curtails the price for every additional unit to be sold. As a result, TR rises but at a decreasing rate. At 11th unit of sale, MR becomes zero where TR becomes maximum. For 12th unit of sale, MR becomes negative and as a result, TR starts declining.

Remember

The slope of the line joining the origin and any point on TR curve shows the average revenue (AR)i.e. , price. The slope of TR curve at any production level shows the slope of marginal revenue (MR).

Box 4

Diagrammatical Representation

Table 2 can be shown with Fig. 4 and the shapes of TR, AR and MR and their relationship can also be explained in the following ways :

1. For the first unit of sale, AR, MR and TR are equal.

2. TR rises till MR remains positive.

3. TR becomes maximum when MR becomes zero.

4. TR starts falling when MR becomes

negative.

(C) Revenue Curves in Monopolistic Competition In monopolistic competitive market, firms produce close substitute goods (i.e., not homogeneous). In such situation, a firm can attract the customers of the other firm by curtailing down the price of the commodity and similarly, a firm will lose its own customers if it raises the price. So, both AR and MR curves are downward from left to right. AR and MR curves of monopolistic competition are more

Concepts of Revenue

flatter than that of monopoly. This situation has been shown in Fig. 5.

AR & MR in Monopolistic Competition

Fig. 5

Relation between AR and TR in Monopoly and Monopolistic Competition In both markets—monopoly and monopolistic competition— AR is greater than MR (i.e., AR>MR). Both AR and MR fall down from left to right but MR falls more sharply as compared to AR. MR is the additional revenue obtained by selling one additional unit of output \left( \mathrm { M R } _ { 1 } = \mathrm { T R } _ { 1 } - \mathrm { T R } _ { 0 } \right) Thus, if revenue obtained from every additional unit sold is added up, it will amount to Total Revenue (TR). Accordingly, area under MR curve shows TR (see

Box 5

Fig . 6

8.4. Demand Curves in Different Markets : A Comparison

Fig. 7 shows that :

In perfect competition, Demand Curve ( i.e., AR curve) is perfectly elastic and becomes parellal to X-axis as a horizontal line (see Fig. 7A).

In monopoly, Demand Curve ( i.e., AR curve) is less elastic or unit elastic and falls down from left to right (see Fig. 7B) .

In monopolistic competition, Demand Curve is more elastic and falls down from left to right but it is more flatter as compared to the Demand Curve of monopoly (see Fig. 7C).

Dependence of AR and MR Curves on Elasticity of Demand

Mrs. Joan Robinson has established a mathematical relationship between Average Revenue (AR), Marginal Revenue (MR) and Elasticity of Demand (e ) :

In Perfect Competition : e =

e Hence, \mathrm { A R } = \mathrm { M R } _ { e \mathrm { ~ 1 ~ } } \mathrm { M R } _ { 1 } or MR

AR = MR

i.e., AR and MR are equal in perfect competition. In Monopoly and Monopolistic Competition :

e > 1 (lete = 2)

^e Hence, AR = MR_{e 1}

\mathrm{Or} \mathrm{AR} = \mathrm{MR} 2 _ {2 1 = 2 \mathrm{MR}}

AR > MR

i.e. AR is greater than MR.

Box 6

e 8.5. Importance of Revenue Curves \mathrm { A R } = \mathbf { M R } _ { e 1 }

In economic analysis, AR and MR curves play a vital This formula establishes the conditions of AR and role in a firm’s decision-making. MR in various market situations. We know the following from AR and MR curves :

110

Introductory Micro Economics

E

1. Firm is earning profit or incurring loss. (i) If \mathrm { A R } > \mathrm { A C } _ { \mathrm { \Omega } } ; Firm will have profit. (ii) If \mathrm { A C } > \mathrm { A R } ; Firm is incurring losses. (iii) If \mathrm { A R } = \mathrm { A C } ; ; Firm is having normal profit.

2. AR and AC curve also show whether the firm is at full capacity utilisation or not. If AR touches AC at its minimum point (as happens in perfect competition), firm is said to be at full capacity utilisation point. In other conditions, the firm will not work at full capacity point.

3. MR plays a dominant role in determining the equilibrium point of a firm. A firm obtains equilibrium where,

(i) MR = MC

(ii) MC cuts MR from below.

8.6. Numerical Illustrations

1. The demand schedule facing a monopoly is given below. Derive its TR, AR and MR schedules : Price ( `) : 0 10 20 30 40 50 60 70 Quantity

Demanded

Price Quantity TR ( ` ) (units) ( ` ) 0 8 0 10 7 70 20 6 120 30 5 150 40 4 160 50 3 150 60 2 120 70 1 70

Solution :

Q TR MR AR Production ( ` ) ( ` ) ( ` )

(Units) 1 14 14 14 2 24 10 12 3 24 0 8 4 16 –8 4

3. Complete the following table :

Production (Units) 10
20
30

Solution : Production (Units) TR (` ) AR (` ) MR (` )

TR AR/Price MR ( ` ) ( ` ) ( ` ) 200 120 40

Complete the following table :

Q TR Production ( ` )
(Units)
1 14
2 24
3 24
4 16

Solution :

AR Or Price per Unit

MR AR(`)(`)
_______

4. From the following table calculate TR, AR and MR : Price : 3 4 5 Sold Units : 10 8 6 Solution : TR : 30 32 30 AR : 3 4 5 MR : — +2 –2

5. Fill in the following table :

AR Or Price Sold TR MR per Unit Units (‘) (‘) 10 — 100 — 11 9 — -1 12 — 96 -3 13 7 — -5 14 — 84 -7 15 5 — -9 16 — 64 -11

Sold Units TR MR ( ` ) ( ` )
10
11
12
100
10 = 10
9
96
12 = 8
100 — 11 × 9 = 99 99 - 100 = - 1
96 96 - 99 = - 3

Concepts of Revenue
13 7 13 × 7 = 91 91 - 96 = - 5
84
14 14 = 6 84 84 - 91 = - 7
15 64 5 15 × 5 = 75 75 - 84 = - 9
16 16 = 4 64 64 - 75 = -11

6. Complete the following table : Solution :
Sold Units (‘) Sold Units TR MRTR (‘) AR (‘) MR (‘)
1
2
3
4
5
6
Solution :
Sold units (‘)
1
2
3
4
5
6
10
—
—
5 100 100
6 180 80 — 9 — 7 240 60 — — 6 8 280 40 28 — — 9 300 20 — — 2 9.
Complete the following table :
Q MR TR AR — — 0
Production (‘) (‘) (‘) (Units)
TR (‘) AR (‘) MR (‘) 1 10 — — 10 10 10 2 8 — — 18
9
8
3 0 — — 4 -2 — —
24 8 6 Solution :
28 7 4 Q MR TR AR
30 6 2 Production (‘) (‘) (‘)

AR = TR

30 5 0 (Units) 7. Find out TR, MR and AR : $^{1\ 10\ 10\ 10}$ Price ( `): 1 2 3 4 5 6 $7^{2\ 8\ 18\ 9}$ Demand : 20 18 16 14 12 10 $8^{3\ 0\ 18\ 6}$ Solution :

4 –2 16 4 10. The MR schedule of the monopoly firm is given Price ( ` ) Demand TR ( ` ) MR AR ( ` ) below. Derive the TR and AR schedules : P Q TR = P×Q ( ` ) AR = TR/Q Production ^{(units) : 0 1 2 3 4 5 6 71 20 20 20 1} MR ( `) : — 14 10 7 5 0 –3 –5 2 18 36 16 2

Solution :

3 16 48 12 3 Production (units) MR TR AR
4 14 56 8 40 — 0 —
5 12 60 4 51 14 14 14
6 10 60 0 6 2 10 24 12 7
8
56
4
7
3 7 31 10.33

^{4 5 36 9} 8. Find MR on the basis of the following data : _{5 0 36 7.20} Sold Units : 5 6 7 8 9 6 –3 33 5.5 TR : 100 180 240 280 300 7 –5 28 4

A QUICK REVIEW OF THE CHAPTER

Total Revenue (TR) : Total revenue is the total sales receipts of the output produced. TR is obtained by multiplying the quantity sold (Q) by its selling price (P) per unit.

TR = PQ

Average Revenue (AR) : Average revenue obtained per unit of output sold is termed as‘Average Revenue’ .

It is worthnoting that :

(i) AR is also price per unit.

(ii) AR curve also represents demand curve.

Marginal Revenue (MR) : Marginal revenue is the addition made to the total revenue by selling one more units of the item.

MR =

TR TR TR

Q n n 1

Revenue Curves in Different Markets :

(i) In perfect competition, AR is a horizontal line which is parallel

\rho = \infty

to X-axis and AR = MR.

\mathrm{AR} = \mathrm{MR}

\varnothing <   1

(ii) In monopoly and monopolistic competition, AR curve falls down from left to right but in monopolistic competition AR and MR

curves become more elastic.

Relationship between TR and MR : MR refers to that additional revenue which a firm obtains by selling one more unit of the item.

0

Perfect Competition

Monopoly

TR represents addition of MR of various units sold, i.e.,

TR = MR

MR also represents the rate of change in TR. Hence,

(i) When MR rises, TR rises at the increasing rate.

(ii) When MR falls (but positive), TR rises at the decreasing rate. (iii) When MR is zero, TR becomes maximum.

MR

(iv) When MR is negative, TR starts declining.

^{Relationship between AR and MR : Fig . 8} (i) When AR is constant, AR = MR (Case of Perfect Competition)

(ii) When AR falls, AR > MR

(Case of both Monopoly and Monopolistic Competition but in monopolistic competition AR and MR have high elasticity.)

(iii) MR can be negative but AR can never be negative. AR represents price per unit which can never be negative.

QUESTIONS Ultra Short Answer Type Questions

1. When is Marginal Revenue Zero ?

2. When is Marginal Revenue negative ?

3. What is Total Revenue ? (BSEB , 2014)

4. What is the slope of Average Revenue Curve in Monopoly ? Very Short Answer Type Questions

5. What is Marginal Revenue (MR) ?

[J.A.C. , 2011, 19;C.B.S.E. (O.D.) , 2013]

2. Explain the relation between Total Revenue and Marginal Revenue.

3. When marginal revenue is zero, what will be the total revenue ?

4. When total revenue is maximum, what will be the marginal revenue ?

5. What type of relation between price and marginal revenue does a competitive firm has ?

6. What types of shapes do AR and MR curves adopt in perfect competition

?

7. What type of shapes do AR and MR curves adopt in monopoly and monopolistic competition ?

8. When does the TR start declining ?

9. In which market marginal revenue becomes equal to price ? (C.B.S.E. , 2013)

Short Answer Type Questions

1. What do you mean by Total Revenue, Average Revenue and Marginal Revenue ?

[B.S.E.B. (Arts), 2013; (Comm. ), 2018;J.A.C., 2013] 2. Explain the relationship between Marginal Revenue and Total Revenue.

3. Explain the relation between MR and AR. Use diagram. (U.S.E.B, 2012,13)

4. Show with the help of diagram that TR remains at maximum when MR becomes zero.

5. Explain the concept of Marginal Revenue.

(U.S.E.B., 2010)

6. Draw in a single diagram the AR and MR curves of a firm which can sell any quantity of goods at a given price ? Explain. (C.B.S.E., 2011)

7. What is the behaviour of Average Revenue in a market in which a firm can sell more only by lowering price ? (C.B.S.E., 2012)

8. What is the behaviour of Marginal Revenue in a market in which of the output it produces at a given price ? (C.B.S.E., 2012)

9. What is Total Revenue, Average Revenue and Marginal Revenue ? (J.A.C. , 2016) 10. What is the shape of AR curve and MR curve in Perfect Competition, Monopoly and Monopolistic Competition ?

Concepts of Revenue

Long Answer Type Questions

1. Explain Total Revenue, Average Revenue and Marginal Revenue with example.

[ U.S.E.B., 2015;Raj. Board, 2017;B.S.E.B. , 2018] 2. Explain the total revenue, marginal revenue and average revenue with the help of illustration.

[J.A.C ., 2016 (Arts )] 3. Explain the demand curve of monopoly firm. (J.A.C ., 2011) 4. Explain the relationship between AR and MR and give examples. 5. Explain the concept of AR.

Objective Type Questions (A) Multiple Choice Questions : 1. AR is

\mathrm{TR} _ {\mathrm{Q}}

\mathrm{TR} _ {\mathrm{Q}}

2. MR is shown as : (a) \mathrm { T R } _ { \mathrm { Q } } (c) AR Q (b) Q P

(B.S.E.B. , 2011) (B.S.E.B. , 2014) (d) None of these [B.S.E.B. (Comm. ), 2018] (b) \mathrm { T R } _ { \mathrm { Q } } (d) None of these

3. In which market AR curve is parallel to X-axis ? (a) Perfect Competition (b) Monopoly (c) Monopolistic Competition (d) In all the above

4. Which of the following is a true statement ? (a) AR indicates price (b) AR Curve and Demand Curve are the same (c) Both a & b (d) None of the above

5. In which market MR may become zero or negative ? (a) Monopoly (c) Both a and b

6. In which market AR = MR ? (a) Monopoly

(c) Both a & b

(b) Monopolistic Competition (d) Perfect Competition

(b) Monopolistic Competition (d) Perfect Competition

7. In monopoly and monopolistic competition :

[B.S.E.B. (Comm. ), 2018] (a) AR = MR

(b) AR > MR

(c) AR < MR

(d) None of these

8. To which market, following figure

belongs ?

(a) Perfect Competition

(b) Monopoly

(c) Monopolistic

Competition

(d) None of the above

9. With which condition, firm will get maximum profit ? (B.S.E.B., 2018) (a)

Where MR = MC

(b) Where MC curve cuts MR from below (c) Both a and b (d) None of the above 10. In perfect competition, which of the following remains constant ? (a) AR (c) Both AR and MR

11. In perfect competition : (a) AR = MR

(c) AR < MR

(b) MR

(d) None of these

[ B.S.E.B. , 2012 (Arts )] (b) AR > MR

(d) \mathrm { A R } + \mathrm { A C } = \mathrm { M R }

12. When 5 units of a goods are sold, total revenue is `100. When 6 units are sold, marginal revenue is`8. At what price are 6 units sold ? (a)`28 per unit (c)`18 per unit

13. Average revenue equals :

( C.B.S.E., 2017) (b)`20 per unit

(d)`12 per unit

(a) Total revenue divided by the quantity produced (b) Price

(c) Both a and b

(d) None of these

14. Let TR be total revenue, Q be production quantity and ‘n’ the number of units, then MR equals : [CBSE , 2017] (a) TR \phantom { } _ { n } - \mathrm { T R } _ { n - 1 } (b)Change in TR Change in Q (c) Both a and b (d) None of these 15. Which of the following relation is correct ? [B.S.E.B. (Comm. ), 2018]

(a) MR = AR

^{e 1} (b) TR = MR^{e 1} e e

(c) Both a and b (d) None of these 16. A firm is able to sell any quantity of a good at a given price.

The firm’s marginal revenue will be : (C.B.S.E., 2018)

(a) Greater than average revenue

(b) Less the average revenue

(c) Equal to average revenue

(d) Zero

[Ans. 1. (a), 2. (a), 3. (a), 4. (c), 5. (c), 6. (d), 7. (b), 8. (b), 9. (c),

10. (c), 11. (a) 12 (c), 13. (c), 14. (c), 15. (a), 16. (c)] (B) Fill in the Blanks :

11. Marginal Revenue is the rate of change in................Revenue. 2.

................always represents the price of the commodity per

3. When MR is................, TR becomes maximum. 4. In perfect competition AR = ............

4. Increase in the revenue due to increase in sale of one extra unit of output is................

[Ans. 1. Total, 2. AR, 3. zero, 4. MR, 5. Marginal Revenue.] (C) State

True/False

1. \mathbf { M } \mathbf { R } _ { n } = \mathbf { M } \mathbf { R } _ { n + 1 } - \mathbf { T } \mathbf { R } _ { n }

2. AR and MR became equal is perfect competition. 3. MR can be negative AR can never be negative. 4. In monopoly and monopolistic competition AR < MR. 5. AR always represents the price of the commodity per unit.

[Ans. 1. False, 2. True, 3. True, 4. False, 5. True.]

(D) Match the following Column : ‘A’

1. Average Revenue

2. If MR = O

3. When MR negative

4. Average Revenue Curve

5. Monopoly and monopolistic competition [ Ans. 1. (e), 2. (c), 3. (a), 4. (b), 5. (d).] (E) Answer in OneWord : 1. In which market price remains constant ? 2. If MR = 0, then what will be TR ? 3. \mathrm { T R } _ { \mathrm { N } } - \mathrm { T R } _ { \mathrm { N } - 1 } = \updownarrow

‘B’

(a) TR falls

(b) Demand curve

(c) TR maximum

(d) AR > MR

(e) Price of the commodity per unit

MR : –, 8, 9]

2. Calculate the MR and AR on the basis of quantity sold, price and total revenue given in the table : (B.S.E.B. , 2014) Quantity Sold Price TR AR MR 4. What does TR \mathrm { Q } represent ?

1 9 9 [Ans. 1. Perfect competition, 2. Maximum, 3. \mathrm { M R } _ { \mathrm { N } } , 4. MR.] 2 8 16

High Order Thinking Skills Questions HOTS

Ans. (i) AR = Price 1. When can MR be zero or negative \stackrel { ? } { \cdot } \mathrm { S o } \mathrm { A R } = 9 . , 8(See : Box 2)

(ii) MR n = \mathrm { T R } _ { n } - \mathrm { T R } _ { n - 1 } 2 . Why does AR and MR become equal in perfect competi tion ? So for Quantity 1, MR = 9 ^{(See : Box 3)} For Quantity 2 , \mathrm { M R } = 1 6 - 9 = 7

3. ‘‘Area under MR curve shows TR.’’ Explain._{3. Complete the following table :(See :} Boxes 3 & 5)

Output Average Marginal Total Value Based Questions ^{(Units) Revenue Revenue} VBQ Revenue (`) (`) (`)

1. Why does Average Revenue curve become demand curve ? 1 — 15 — (See : Section 8.2.1) 2 — — 26

2. Why does AR curve become paralle to X-axis in perfect compe_{3 11 — —}

tition ? 4 — 3 —(See : Point (A) of Section 8.3)

3. Why does AR line in monopolistic competition become more [Ans. AR : 15, 13, 11, 7.5 flatter as compared to monopoly ?_{MR : 15, 11, 7, 3}

(See : Section 8.4) TR : 15, 26, 33, 36 ]

Case Study Based on Evaluation & Multi-disci

4. Calculate Total Revenue, Average Revenue and Marginal TIDQ

plinary Questions

Revenue on the basis of following table : Price (`) : 4 5 1. Why does AR curve fall from left to right in monopoly ?

(See : Point (B) of Section 8.3) 2. Can Marginal Revenue be zero or negative ? (See : Box 2) 3. Why does MR become lesser than AR in monopoly mar

Sales ( Units ) : 3 2 [Ans. TR : 12, 10, 6 AR : 4, 5, 6 MR : –, 2, 4] ket ? 5. Complete the following table : (See : Box 5) Numerical Questions (Units) (`)

(—) 2 ⁹ [ Ans. Price ( ` ) : 6, 4, 2, 1 Output (Units) : 1, 2, 3, 4

Total Revenue ( `) : 6, 8, 6,4

Marginal Revenue ( `) : –, 2, –2, (– 2)]

6. Complete the following table : (U.S.E.B., 2012) Unit Price per Unit TR MR (`)

1 15 — —

2 13 — —

3 11 — —

4 10 — —

5 7 — — Hint : Q × AR = TR

\mathrm { M R } _ { n } = \mathrm { T R } _ { n } - \mathrm { T R } _ { n - 1 } [Ans. TR : 15, 26, 33, 40, 35

MR : –, 11, 7, 7, –5

7. Complete the following table : Output Total Marginal (Units) Revenue Revenue

( n ) (`) (`)

2 — 4

3 12 —

4 8 —

Average Revenue (`) 8 — 4

2 Hint : MR_n = TR_n – TR_{n – 1} , AR =TR , TR = MR n

[ Ans. TR : 8, 12, 12, 8 AR : –, 4,0 ,– 4

MR : 8,6, 4, 2].

8. Compute the TR, MR and AR in the following table. Market price of goods is` 10. (U.S.E.B. , 2016;JAC , 2019) AR Quantities TR MR

6

Ans. TR : 10, 20, 30, 40, 50, 60.

MR : –, 10, 10, 10, 10, 10. AR : 10, 10, 10, 10, 10, 10 9. Complete the table :

Production (units) Price (`) TR 1 5 2 6 3 7

[ Ans. TR : 5, 12, 21 AR : 5, 6, 7 MR : –, 7, 9]

AR MR

10. Calculate Total Revenue, Average Revenue and Marginal Revenue on the basis of following table : Sales : 3 4 5 Price (`) : 10 9 8

[ Ans. TR : 30, 36, 40 AR : 10, 9, 8 MR : –, 6, 4]

11. Complete the table : (U.S.E.B. , 2019)

Production (units) TR AR MR 1 15 2 25

3 25 4 21 [Ans. AR : 15, 12.5, 8.33, 5.25 MR : –, 10, 0, – 4]

NCERT CORNER

Q. 1. How are the total revenue of a firm, market price and the quantity sold by the firm related to each other ?

Ans. Total revenue of a firm is product of market price and quantity sold. Thus,

Total Revenue = Market Price × Quantity sold by the Firm.

Q. 2. Why is the total revenue curve of a price-taking firm an upwardsloping straight line ? Why does the curve pass through the origin ? Ans. The total revenue curve of a price-taking firm is an upward-sloping straight line because it changes at a constant rate. The total revenue curve of a pricetaking firm passes through the origin (point O) because the total revenue of the firm becomes zero at zero output.

Q. 3. Compute the total revenue, marginal revenue and average revenue schedules in the following table. Market price of each unit of the goods is `10.

Quantity Sold (Q) TR MR AR

Quantity Price per TR = MR AR =

Sold (Q) Unit (P) (Q × P) (Addition TR Q

Q. 4. From the schedule provided below, calculate the total revenue, and the price elasticity of demand : Quantity Marginal Revenue Ans.

Quantity ( Q )

1 2 10 6 3 4 5 6 2 2 2 0 7 8 9 0 0 – 5

Marginal Revenue (`)

Total Average Revenue Revenue (`) (`)

( MR ) 1 2 3 4 5 6 7 8 9 10 6 2 2 2

10 10

16 8

18 6

20 5

22 4.40

22 3.67

22 3.14

22 2.75

17 1.89

Price

Elasticity of Demand

^{AR e} AR – MR —

4

1.50

1.67

1.83

1

1

1

0.27

Q. 5. What would be the shape of the demand curve so that the total revenue curve is :

(a) a positively sloped straight line passing through the origin?

(b) a horizontal line ?

Ans. (a) The shape of the demand curve would a straight horizontal line so that the total revenue is a positively sloped straight line passing through the origin. It may be shown in the enclosed figure :

(b) The total revenue curve can be a horizontal line. In such a case, demand curve will be downward sloping. It may be shown in the figure.

TR Because AR Q

Q. 6. What is the value of the MR when the demand curve is elastic? Ans. The value of MR will be positive when the demand curve is elastic.

MR = AR
e 1
e

STUDY MATERIAL INCLUDED IN

9

PRODUCER’S EQUILIBRIUM : MEANING AND CONDITIONS

THE CHAPTER

9.1. Who is a Producer ? 9.2. Meaning of Producer’s (or Firm’s) Equilibrium 9.3. Methods of Producer’s (or Firm’s) Equilibrium A Quick Review of the Chapter Questions High Order Thinking Skills (HOTS) Questions Value Based Questions (VBQ) Case Study Based on Evaluation & Multidisciplinary Questions (MDQ) Numerical Questions NCERT Corner.

9.1. Who is a Producer ?

Producer is an economic agent who associates various factors of production and makes production so as to earn the maximum possible profit.

Total profit of a producer is the difference between total revenue and total cost.

Total Profit = Total Revenue – Total Cost

If total revenue exceeds total cost, producer obtains profit and on the contrary, if total cost exceeds total revenue, producer incurs loss. A rational producer always tries to maximise profit and minimise the loss. 9.2. Meaning of Producer’s (or Firm’s) Equilibrium

Equilibrium means—absence of change. A firm obtains equilibrium when it does not succeed in getting additional profit either by increasing or decreasing the production level. In other words, equilibrium point is the point of optimum possible profit . The objective of the firm is to ensure the maximum profit and here the point ensuring the maximum profit becomes the point of equilibrium.

A firm or a producer has to decide the following two aspects :

1. Under given cost and revenue conditions, what production level should be decided by the firm where it obtains the maximum profit?

2. At what price, the firm should sell its production ?

Both the above aspects are correlated and both aspects explain the situation of maximum profit.

● Producer’s Equilibrium : Definitions (i) According to Hanson, "A producer will be in equilibrium when it is of no advantage to increase or decrease his output." (ii) According to Koutsoyiannis, ‘‘A producer is in equilibrium when he maximises his profits.’’

(iii) According to McConnell, "In the short-run the producer will be in equilibrium when he produces that output at which he maximises profit or minimises loss ."

9.3. Methods of Producer’s (or Firm’s) Equilibrium Methods of Producer’s or Firm’s Equilibrium

I. Total Revenue and Total Cost Method II. Marginal Revenue

and Marginal Cost Method 9.3.1. Producer’s Or Firm’s Equilibrium : Total Revenue and Total Cost Curve Method

In this method, the difference between total revenue and total cost is obtained at various production levels. The difference between total revenue and total cost refers to total profit.

Total Profit = Total Revenue – Total Cost \pi = \mathrm { T R } - \mathrm { T C }

The difference between TR and TC varies at various production levels. The maximum difference between TR and TC signifies maximum profit of the producer and hence, a producer obtains equilibrium at that production level where the difference between TR and TC becomes maximum.

This method can be explained in two different situations :

(A) Producer’s Equilibrium under Perfect Competition

(B) Producer’s Equilibrium in Non-perfect Competition (i.e. , Monopoly and Monopolistic Competition)

(A) Producer’s Or Firm’s Equilibrium under Perfect Competition In perfect competition, a firm can produce any quantity at a given price because a perfectly competitive firm is ‘Price-taker’ and ‘Quantityadjuster' . Hence, in perfect competition, TR curve slopes upward from left to right. In Fig. 1, TR and TC lines have been shown. Till production level \mathrm { Q } _ { 1 } , TC is greater than TR and hence, the producer will not be in equilibrium before production level \mathrm { O Q } _ { 1 } because of loss (as TC > TR). At point T, both TR and TC are equal which refers to zero profit situation. Between production levels

Fig . 1
\mathrm { Q } _ { 1 } and \mathrm { Q } _ { 2 } , Total Revenue exceeds Total Cost \mathrm { ( T R > T C ) } which represents the range of profit. In this method, the difference between TR and TC is obtained at various production levels in this range of profit. The maximum difference distance between TR and TC represents the situation of equilibrium.In Fig. 1, corresponding situation is shown at production level Q at which the vertical distance between TR and TC (i.e. , KN) is maximum. At point \mathrm { Q } _ { 2 } again, profit disappears because \mathrm { T R } = \mathrm { T C } and beyond \mathrm { Q } _ { 2 } situation of loss appears (as \mathrm { T C } > \mathrm { T R } ) . Hence, the producer will not be in equilibrium after production level \mathrm { O Q } _ { 2 } . Above explanation shows that the producer will obtain equilibrium at production level OQ because of the maximum profit obtained.

Break-even Point

Break-even point show that situation where both revenue and cost become equal for the producer. Hence TR = TC (See Fig. 1 & 2) Or MR = MC (See Fig. 3 & 4) Break-even point show normal profit (i.e. , No profit – No Loss). At this point, firm only obtain all its costs without any profit.

Box 1

(B) Producer’s Or Firm’s Equilibrium in Nonperfect Competition ( i.e. , Monopoly and Monopolistic Competition)

In non-perfect competition (i.e. , situations of monopoly and monopolistic competition) a producer can only sell more when he reduces the price. Under these circumstances, TR curve rises upward but at a decreasing rate because TR rises with more sale but at a decreasing rate due to declining MR. In Fig. 2, Total Revenue and Total Cost curves are shown as TR and TC respectively. Points T and S are breakeven points which show loss before production \mathrm { O Q } _ { 1 } and after production \mathrm { O Q } _ { 2 } respectively. Production profit area ranges between production levels \mathrm { Q } _ { 1 } and \mathrm { Q } _ { 2 } . The firm will be in equilibrium at point Q where the difference between TR and TC (i.e. , KN in Fig. 2) is maximum.

Fig . 2

Total Revenue and Total Cost method of producer’s equilibrium is not practical because :

(1) It is a geometrical method in which the measurement of the vertical distance between TR and TC becomes difficult. Error may arise in drawing tangents on TR and TC.

(2) Per unit profit and cost cannot be measured in the figure. Per unit profit and per unit cost will be calculated as

(i) Per Unit Profit =

(ii) Per Unit Cost = Total Profit Total Production

Total Cost

Total Production Box 2 9.3.2. Producer’s Or Firm’s Equilibrium :

Marginal Revenue and Marginal Cost Curve Method

A firm’s equilibrium can also be explained through marginal revenue and marginal cost method. In this method, the difference between Marginal Revenue (MR) and Marginal Cost (MC) is calculated. This difference between MR and MC shows the profit. Production is profitable when MR exceeds MC and when MR becomes equal to MC, profit will be maximum. This point is termed as‘breakeven point’ . If the producer continues the production even after this break-even point, MC becomes more than MR which states the situation of loss. Producer’s equilibrium with MR and MC method can be explained in two situations :

Producer‘s Equilibrium : Meaning and Conditions (A) Producer’s Equilibrium in Perfect Competition. (B) Producer’s Equilibrium in Nonperfect Competition

(Monopoly and Monopolistic Competition). (A) Producer’s Equilibrium in Perfect Competition

Perfect competitive firm as shown in Fig. 3 obtains

OP price in the market. For perfect competitive

Average Revenue = Marginal Revenue AR = MR

MC curve (as shown in Fig. 3) cut MR at two points E and \mathrm { E } _ { 1 } which are known as ‘break-even points’ . At these points MR is equal to MC. At point \mathrm { E } _ { 1 } , production level is \mathrm { O Q } _ { 1 } and if the producer stops the production and obtains the equilibrium at point E, he will be deprived of possible additional profit arising from extending production upto \mathrm { O Q } _ { 2 } . Between production range \mathrm { O Q } _ { 2 } and \mathrm { O Q } _ { 1 } , the MR exceeds MC. At production level \mathrm { O Q } _ { 2 } , again MR = MC (Point E in the Fig. 3). But if production is further increased, MC becomes greater than MR which states the situation of loss. Hence, a producer will not produce after \mathrm { O Q } _ { 2 } . He will also not stop production at production level \mathrm { O Q } _ { 1 } as he will be deprived of the profit (area \mathrm { E } _ { 1 } ME in Fig. 3). Hence, E will be the only point of final consumer’s equilibrium.

In short, two conditions should be fulfilled for a firm’s equilibrium in perfect competition :

1. Marginal Revenue = Marginal Cost MR = MC

2. MC curve must rise to intersect the horizontal

MR curve from below. (B) Producer’s Equilibrium in Non-perfect Competition We know that, in monopoly and monopolistic competition markets Average Revenue > Marginal Revenue Fig . 3 119 In Fig. 4, both AR and MR curves fall downward from left to right. MC curve cuts MR curve at two points A and B where MR = MC at both the points. Points A and B signify Fig. 4 production levels \mathrm { O Q } _ { 1 } and \mathrm { O Q } _ { 2 } respectively. If the producer stops the production at production \mathrm { O Q } _ { 1 } , he will be deprived of the profit available between production range \mathrm { O Q } _ { 1 } and \mathrm { O Q } _ { 2 } . After production \mathrm { O Q } _ { 2 } , MC becomes more than MR which indicates the loss. Hence, the producer will be in equilibrium at production level \mathrm { O Q } _ { 2 } , i.e. , at point B where MR = MC. Producer will not try to increase the production beyond B because of loss which appears beyond production \mathrm { O Q } _ { 2 } (i.e. , MC > MR). Thus, like perfect competition, a firm has to fulfil two following conditions for obtaining equilibrium in monopoly and monopolistic competition : 1. Marginal Revenue = Marginal Cost MR = MC 2. MC curve must cut MR from below. Conditions of Producer’s or Firm's Equilibrium

In every market situation (perfect competition or monopoly or monopolistic competition), a firm has to fulfil two conditions for obtaining equilibrium :

(i) Necessary Condition : The necessary condition for maximising profit of a firm is

Marginal Revenue = Marginal Cost

MR = MC

(ii) Supplementary Condition : Besides the necessary condition MR = MC, supplementary condition must also be fulfilled, i.e. , MC should cut MR from below. (In other words, at point MR = MC, MC must be rising.)

AR > MR_{Box 3}

A QUICK REVIEW OF THE CHAPTER

● Producer’s or Firm’s Equilibrium : A firm obtains equilibrium when it earns maximum profit. The difference between TR and TC should be maximum.

● What is Profit ? The difference between Total Revenue (TR) and Total

Cost (TC) is referred as total profit. Profit = TR – TC

(cost includes normal profit)

● Conditions of Profit Maximisation :

(i) Necessary Condition :

Marginal Revenue = Marginal Cost MR = MC

(ii) Supplementary Condition : At the point where MR = MC, marginal cost (MC) curve must cut MR from below, i.e. , at equality point (MR = MC), MC should be rising.

● Break-even Point : This situation arises when

TR = TC

Or MR = MC

QUESTIONS Ultra Short Answer Type Question

1. What is the necessary condition for firm’s equilibrium ? Very Short Answer Type Questions

2. What is meant by Producer’s Equilibrium ?

3. What are the conditions of Profit Maximisation ?

4. What is Break-even Point ? 4. What is Equilibrium Price ? 5. What is maximum profit ? Short Answer Type Questions

(B.S.E.B., 2018) (J.A.C ., 2019)

1. What is the meaning of Firm’s Equilibrium ? [B.S.E.B., (Arts ), 2018]

2. Explain the necessary conditions of a Firm’s Equilibrium.

3. How Firm’s Equilibrium is determined by Total Revenue and Total Cost Method ?

4. How Firm’s Equilibrium is determined by Marginal Revenue and Marginal Cost ?

5. Explain producer’s equilibrium using a schedule. Use total cost and total revenue approach. (C.B.S.E. A.I. , 2013)

6. What is meant by producer's equilibrium ? What are its main conditions ? (U.S.E.B. , 2014; C.B.S.E., 2015)

7. How does a firm's equilibrium determined by the method of TR and TC ? (U.S.E.B. , 2015; J.A.C ., 2019) Long Answer Type Questions

8. What do you mean by Firm’s Equilibrium ? Mention the required condition for Firm’s Equilibrium.

(U.S.E.B ., 2016) 2. Explain the Total Revenue and Total Cost Method of a

Firm’s Equilibrium.

3. Explain the producer’s equilibrium with Marginal Revenue and Marginal Cost Method. [C.B.S.E., 2010, 11, 12, 18; J.A.C ., 2019] 4. What do you mean by producer's equilibrium ? Explain the conditions of consumer's equilibrium by TR and TC method ? (C.B.S.E., 2011,13; U.S.E.B., 2013) 5. Explain firm’s equilibrium in perfect competition. 6. Explain firm’s equilibrium in Non-perfect competition. Objective Type Questions

(A) Multiple Choice Questions : 1. For a firm’s equilibrium : (B.S.E.B. (Comm. ), 2015) (a) MR = MC (b) MR > MC

(c) MR < MC (d) MR = MC = 0 2. Which is a method of producer’s equilibrium ?

(a) TR and TC Method (b) MR and MC Method (c) Both a and b (d) None of the above 3. For every market, which condition has to be fulfilled for

firm’s equilibrium ? [B.S.E.B., (Comm. ), 2018] (a) AR = MC

(b) MR = MC

(c) MC curve should cut MR from below

(d) Both b and c

4. In final equilibrium of firm :

(a) MC curve cuts MR from above

(b) MC curve cuts MR from below

(c) Both a and b are true

(d) None of the above is true

5. The basic condition of firm’s equilibrium is :

[J.A.C., 2012; B.S.E.B., 2016 (Comm. )] (a) MC = MR (b) MR = TR (c) MR

= AR (d) AC = AR

6. With which condition, firm will get maximum profit ? [B.S.E.B. (Arts ),

2018] (a) Marginal Revenue = Marginal Cost

(b) Marginal Cost cuts Marginal Revenue Curve from the

below

(c) Both A and B

(d) None of these

[Ans. 1. (a), 2. (c), 3. (d), 4. (b), 5. (a), 6. (c)]

(B) Fill in the Blanks :

1. Total Profit = (................) – (Total Cost).

2. A producer is in equilibrium when he maximises his................

3. At firm’s equilibrium MR should be equal to................

4. At break-even points MR = ................

[Ans . 1. Total Revenue, 2. profit, 3. MC, 4. MC] (C) State True/False

1. The difference between TR and TC is called total profit.

2. For a firm’s equilibrium, MR = MC.

3. At break-even point MR = MC.

4. The difference between MR and TC shows the profit.

5. In final equilibrium of firm MC curve cuts MR from above. [Ans. 1. True,

6. True, 3. True, 4. False, 5. False.]

Producer‘s Equilibrium : Meaning and Conditions

(D) Match the following Column : ‘A’

1. Firm’s equilibrium

2. Producer’s equilibrium

3. Total Profit

4. Perfect Competition

5. Imperfect Competition

‘B’

(a) TR and TC method (b) AR = MR

(c) AR > MR

(d) TR – TC

(e) MR = MC

[ Ans. 1. (e), 2. (a), 3. (d), 4. (b), 5. (c).]

(E) Answer in One Word :

1. What is the first condition of firm’s equilibrium ? 2. Where does breakeven point appear ?

2. What is profit ?

3. At which point firm’s profit become maximum ?

[Ans. 1. MR = MC, 2. MR = MC or TR = TC, 3. TR – TC, 4. MR = MC.] HOTS

High Order Thinking Skills Questions 1. Why do we need supplementary condition for producer's equilibrium ?

(See : Section 9.3.2)

2. Why should MC cut MR from below at the point of firm's equilibruim ? (See : Section 9.3.2)

VBQ

Value Based Questions

1. Can a producer/firm obtain final equilibrium under the condition of falling marginal cost ? (See : Section 9.3.2)

2. Supplementary condition should also be met with essential condition for a firm’s equilibrium. Why ? (See : Box 3)

MDQ

Case Study Based on Evaluation & Multi-disciplinary Questions

1. Define break-even point. Do they have any relation with firm's equilibrium ? (See : Section 9.3.2 and Box 1)

2. On which break-even point, firm’s stable equilibrium takes place ? (See : Section 9.3.2)

3. Given below is a cost and revenue schedule of a producer. At what level of output is the producer in equilibrium? Give reasons for your answer. (C.B.S.E., (O.D.), 2013)

Output (Units) ( Q )

MR (`) MC (`)

1 8 10 2 8 8 3 8 7 4 8 8 5 8 9

Ans. At 4th unit where MR = MC and after it MC rises. NCERT CORNER

Q. 1. What conditions must hold if a profitmaximising firm produces positive output in a competitive market ? Ans. See Box 3.

Q. 2. Can there be a positive level of output that a profit-maximising firm produces in a competitive market at which market price is not equal to marginal cost ? Give an explanation. Ans. See Section 9.3.2 (B)

Q. 3. Will a profit-maximising firm in a competitive market ever produce a positive level of output in the range where the marginal cost is falling ? Give an explanation. Ans. See Section 9.3.2 (A)

Q. 4. The following table shows the total revenue and total cost schedules of a competitive firm. Calculate the profit at each output level. Determine also the market price of the goods.

Quantity Sold TR ( ` ) TC ( ` ) Profit
0 0 5
1 5 7
2 10 10
3 15 12
4 20 15
5 25 23
6 30 33
7 35 40
Ans.
Quantity TR Price = TC Profit =
Sold (Q) ( ` ) TR ( ` ) ( TR - TC ) Q
(` ) ( ` ) 0 0 - 5 — 1 5 5 7 - 2 2 10 5 10 0 3 15 5 12 + 3 4 20 5 15 + 5 5 25 5
23 + 2 6 30 5 33 - 3 7 35 5 40 - 5

Q. 5. The table, given ahead, shows the total cost schedule of a competitive firm. It is given that the price of the goods is `10. Calculate the profit at each output level. Find the profit maximising level of output.

Price ( ` ) TC ( ` ) Ans.
Quantity Price TR TC Profit = 05 Sold (Q) ( ` ` ` ` )( ` ` ` ` )( ` ` ` ` )( TR - TC )
115 ( ` ` ` ` )
222 010 — 5 — 5

327 110 10 15 - 5
431
210 20 22 - 2

310 30 27 + 3 538 410 40 31 + 9
649 510 50 38 + 12
763 610 60 49 + 11
881

710 70 63 + 7
810 80 81 - 1
9 101 9 10 90 101 - 11
10 123 10 10 100 123 - 23

Q.6. The market demand curve for a commodity and the total cost for a monopoly firm producing the commodity is given by the schedules below. Use the information to calculate the following :

Quantity 01234567 8
Price 52 44 37 31 26 22 19 16 13
Quantity 01234567 8
Total Cost 10 60 90 100 102 105 109 115 125

(a) The MR and MC schedules.

(b) The quantities for which the MR and MC are equal.

(c) The equilibrium quantity of output and the equilibrium price of the commodity. (d) The total revenue, total cost and total profit in equilibrium.

Ans. (a) MR and MC Schedules.

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0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0

5 22 110 6 105 3 5
6 19 114 4 109 4 5
7 16 112 - 2 115 6 - 3
8 13 104 - 8 125 10 - 21
(b) At 6th quantity MR and MC are equal.
(c) Equilibrium quantity of output is 6 units and equilibrium price is ` 19.
(d) At Equilibrium
TR = ` 114
TC = ` 109
Profit = 114 - 109 = ` 5 □

10

SUPPLY AND LAW OF SUPPLY

S TUDY MATERIAL INCLUDED IN THE CHAPTER

10.1. Meaning of Supply 10.2. Difference between ‘Supply’ and ‘Stock’ 10.3. Difference between ‘Supply’ and ‘Quantity Supplied’ 10.4. Difference between ‘Individual Supply’ and ‘Market Supply’ 10.5. Supply Schedule 10.6. Supply Curve 10.7. Supply Function Or Factors Affecting the Supply 10.8. Law of Supply 10.9. Movement Along and Shift in Supply Curve or Change in Quantity Supplied and Change in Supply 10.10. Effect of Technological Improvement on Supply Curve 10.11. Effect of Change in Prices of Production Factors on Supply Curve 10.12. Effect of GST on Supply Curve 10.13. Effect of Change in Price of Substitutes on Supply Curve 10.14. Effect of Production Period on Supply Curve A Quick Review of the Chapter Questions High Order Thinking Skills (HOTS) Questions disciplinary Questions (MDQ) NCERT Corner.

10.1. Meaning of Supply

Supply of goods refers to those quantities which a seller is ready to sell at various prices at a certain point of time. Like demand, supply is also related with a certain time and price.

● Definitions

(i) According to Thomas , “The supply of goods is the quantity offered for sale in a given market at a given time at various prices’’.

(ii) According to Mayers , “We may define supply as a schedule of the amount of goods that would be offered for sale at all possible prices at any one instant of time, or during any one period of time (e.g., a day, a week and so on) in which conditions of supply remain the same.’’

10.2. Difference between ‘Supply’ and ‘Stock’

‘Supply’ and ‘Stock’ are not synonyms in Economics. Stock refers to that quantity of goods which is available with the sellers in the market at a particular point of time while supply refers to that quantity which the seller is ready to sell at a particular price and a particular point of time. Thus, supply is that part of stock which is actually brought into the market for sale. If the prevailing price of goods in the market is low, seller will supply lesser quantity inspite of having larger stock. In other words, supply will be lower than stock at lower price and vice versa .

Value Based Questions (VBQ) Case Study Based on Evaluation & Multi

For example, if the stock of wheat in the market in June, 2019 is 1,500 quintals and the prevailing market price of wheat is ` 1,000 per quintal. If the seller is ready to sell only 100 quintals of wheat at this prevailing market price, then the supply of wheat is only 100 quintals.

For perishable goods (like milk, vegetables, etc.), there is no difference between ‘Stock’ and ‘Supply’ because the producer (or seller) has to sell complete stock at prevailing market price but for durable goods the seller can wait for better or higher price and hence, supply becomes less than stock in case of lower price.

10.3. Difference between ‘Supply’ and ‘Quantity Supplied’

‘ Supply ’ refers to those quantities of goods which the seller presents for sale in the market at various prices at a particular point of time. Thus, supply refers to a supply schedule which explains those quantities of goods being presented for sale by the seller at various prices. On the other hand, ‘quantity supplied ’ refers to that particular quantity which the seller presents to sell at a particular price and at a particular point of time. Thus, ‘quantity supplied is a component of supply schedule.

10.4. Difference between ‘Individual Supply’ and ‘Market Supply’

Individual supply refers to supply of a commodity by an individual firm in the market. Market supply refers to supply of a commodity by all the firms in the market producing/selling that particular commodity. Thus, if, at a given price, firm A is willing to sell 200 units of a commodity and firm B is willing to sell 300 units, and if there are only two firms producing this particular commodity, market supply (also called industry’s supply) will be 200 + 300 = 500 units.

10.5. Supply Schedule

When various quantities which are sold at various prices in the market are represented in a table, it is called supply schedule. Thus, supply schedule is a tabular presentation of various quantities of a commodity offered for sale corresponding to different possible prices.

Supply Schedule

Individual Market

Supply Schedule Supply Schedule 10.5.1. Individual Supply Schedule

Individual supply schedule refers to supply schedule of an individual firm in the market. It shows supply response of a particular firm in the market.

Individual supply schedule expresses different quantities supplied by a firm at different prices.

Table 1 : Individual Supply Schedule Price of Commodity per unit ( ` ) Quantity Supplied by Firm A

Table 1 explains that supply of commodity increases with increase in price.

10.5.2. Market Supply Schedule

When the total quantity which all the firms (or sellers) are ready to sell at various prices in the market are represented in a table, it becomes market supply schedule. Thus, market supply schedule refers to supply schedule of all the firms in the market producing a particular commodity. Sum total of the firms producing a particular commodity is called ‘Industry’ . In other words, market supply schedule refers to the supply schedule of the industry as a whole. It shows supply response of all the firms (producing a particular commodity) in the market.

Table 2 : Market Supply Schedule Commodity Seller Seller Seller Market Price per unit A B C Supply ( ` ) A + B + C

42 21 2+2+1=5
54 34 4+3+4=11
66 55 6+5+5=16
78 87 8+8+7=23
8 10 11
9 12 13

Table 2 explains the total quantities of the commodity being presented by all three sellers A, B and C at various prices in the market. The table explains the direct relationship between ‘prices’ and ‘quantities supplied’, i.e. , market supply increases with increase in price and vice versa .

Factors to be noted in Supply Schedule

(i) Market supply schedule assumes that the taste, knowledge and technical know-how of all sellers are similar.

(ii) Market supply schedule is more continuous than ‘Individual Supply Schedule’.

(iii) Both individual and market demand schedules are equally affected by time.

(iv) Both the schedules represent the direct relationship between price and quantity supplied.

Box 1

9 10 + 11 + 9 = 30

11 12 + 13 + 11 = 36

10.6. Supply Curve

Supply curve is obtained from supply schedule. Supply curve is a graphic presentation of supply schedule, indicating positive relationship between price of a commodity and its quantity supplied. Due to positive relation between supply quantity and price, the supply curve is upward sloping.

Supply

Individual Supply Schedule

Market Supply Schedule Individual Supply Curve

Market Supply Curve

Fig. 1

10.6.1. Individual Supply Curve

Individual supply curve is a graphic presentation of supply schedule of an individual firm in the market. Sloping upwards, it indicates positive relationship between price of a commodity and its quantity supplied. When data shown in table 1 are represented on a graph paper, we get ‘Individual Supply Curve’ SS (as shown in Fig. 1) which is upward sloping and represents the positive relationship between price and quantity supplied. OP price in the Fig. 1 is that price at which seller makes the supply zero, i.e. , at price OP or below OP price seller is not ready to sell any quantity of the goods. This price is called ‘Reserve Price’ or ‘Minimum Supply Price’.

10.6.2. Market Supply Curve

Market supply curve is a graphic presentation of market supply schedule. Like individual demand curve, market supply curve slopes upward which represents positive relationship between price and total quantity supplied. Thus, market supply curve is a horizontal summation of individual supply curves of all the firms in the industry.

In Fig. 2, market supply curve SS is obtained by horizontal summation of individual supply curves \mathrm { S _ { A } \mathrm { S _ { A } , \mathrm { S _ { B } \mathrm { S _ { B } } } } } and \mathsf { S } _ { \mathrm { C } } \mathsf { S } _ { \mathrm { C } } . Market supply curve made from table 2 shows that at per unit price of ` 4, market supply is 2 + 2 + 1 = 5. When price increases to ` 5 per unit, the market supply becomes 4 + 3 + 4 = 1 1

Fig. 2 10.7. Supply Function

The functional relationship between supply of the quantity supplied. At higher price, quantity supplied will be higher and vice versa .

2. Price of Related Goods : The supply of a_{commodity and its determining factors is} called supply commodity is also indirectly affected by the pricefunction. of related goods. For example, with increase in priceSupply function can be represented in the form of of rice, supply of wheat falls because increased pricefollowing equation : of rice will induce producers for producing rice andSX = f (PX, Pr, Pf, T, N, G, EX, GP) hence, wheat production will fall which furtherWhere, SX = Supply of Commodity X decreases the supply of wheat.

P X ^{= Price of Commodity X} 3. Prices of Production Factors : Supply of a \mathrm { ~ \mathsf ~ { ~ P ~ } ~ } _ { \mathrm { { r } } } = ^{Price of Related Goods} commodity is also affected by the price of factors \mathrm { P _ { f } } = Price of Production Factors used in the production of the commodity. If the factor

T = Technique price decreases, cost of production also declines, N = Number of Firms accordingly supply increases. Conversely, if the _{G = Objective of Firm} factor price increases cost of production also increases

_{EX = Expected Future Price} and supply tends to decrease. _{GP = Government Policy} 4. Technological Level : Technological level and its 10.7.1. Determinants of Supply of a Commodity

change also affects supply of the commodity. Improvement in the technique of production reduces

1. Price of the Commodity : There is a direct^{cost of production. Consequently, profits tend to} relationship between price of a commodity and its^{increase inducing an} increase in supply.

2. Number of Firms : Market supply of a commodity also depends upon number of firms in the market. Increase in the number of firms results in the increase in market supply. On the other hand, decrease in the number of firms results in the decrease in market supply of a commodity.

3. Goal of the Firm : If the goal of the firm is to maximise profits, more quantity of the commodity will be offered at higher price. On the other hand, if the goal of the firm is to maximise sales or maximise output or employment more quantity will be supplied even at the prevailing price in the market.

4. Expected Future Price : Expected price change in the future also affects the supply. If the producer expects price of the commodity to rise in the near future, current supply of the commodity should reduce. On the other hand, the price is expected to fall in future, current supply will increase.

5. Government Policy : ‘Taxation and Subsidy’ policy of the government also affects market supply of the commodity. Increase in taxation tends to reduce the supply, while subsidies tend to induce the producer to provide greater supply of the commodity.

10.8. Law of Supply

Producer always wants to sell his commodity at a higher price for maximising his profit. In other words, other things being equal, more is supplied at higher price and less at a lower price. Thus, price of commodity and its supply are positively related. In functional form,

\mathrm{S} = f (\mathrm{P})

where S refers to supply of the commodity and P for price.

Thus, supply function of a commodity represents a direct relationship between supply of commodity and its price.

The law of supply states, that other things remaining constant, the higher the price, the greater the quantity supplied or the lower the price, the smaller the quantity supplied.

Or

Law of supply states the positive relationship between price of the commodity and its supply. That is the reason why supply curve slopes upward from left to right.

Box 2

● Assumptions of the Law of Supply 1. There is no change in the income level of buyers

and sellers in the market.

2. There is no change in the price of substitute goods.

3. Prices of production factors remain constant. 4. Technological level remains constant. 5. Government policy should remain constant. 6. There should be no change in the tastes, habits, fashion, etc., of both buyers and sellers.

☞ Attention Students : The law of supply can also be explained with ‘Supply Schedule’ and ‘Supply Curve’ .

Please see Table 1 and Fig. 1.

10.8.1. Exceptions of the Law of Supply

The law of supply states the direct relationship between price of commodity and its supply but in certain circumstances this law does not operate, i.e. , the direct relation between price of a commodity and supply is not established. Such cases are termed as exceptions of the law of supply. Certain exceptions of the law of supply are as follows :

(1) The law of supply does not apply strictly to agricultural products whose supply is governed by natural factors. If due to natural calamities, the production of wheat is less, then its supply will not increase, however high the price may move.

(2) The law of supply is not operative in perishable goods. Sellers may be willing to sell more units of perishable goods although their price may be

falling.

(3) The law also fails in goods having social distinctions. Supply of goods having social distinction will remain limited even if their price may rise high.

10.9. Movement Along and Shift in Supply Curve or Change in Quantity Supplied and Change in Supply

Change in supply occurs mainly due to two reasons :

(A) Change in Quantity Supplied or Movement along a Supply Curve due to Change in Price : Extension & Contraction of Supply. Other things being equal, price change causes change in supply. These changes do appear in accordance with the ‘Law of Supply’, e.g. , supply falls as price comes down and supply rises as prices go up. Such changes in supply are termed as ‘Extension of Supply’ and ‘Contraction of Supply’ or ‘Movement along the Supply Curve’ . In short, due to change in price movement along the same supply curve results either in ‘Extension of Supply’ or ‘Contraction of Supply’.

(B) Change in Supply or Shift in Supply Curve due to Factors other than Price : Increase and Decrease in supply.

When supply changes due to factors other than price (like technological improvement, development of modes of transport, increase in income, etc.), such changes are referred as ‘Increase in Supply’ or ‘Decrease in Supply’ or ‘Shifting of the Supply Curve’ . In such situation, the original supply curve shifts either to the left or to the right.

Change in Quantity demanded

Change in Supply

Movement along a Supply Curve Shifting of the Supply Curve Due to Change in Price only Due to Change in Factors other than Price Extension of Supply Contraction of Supply

Increase in Supply Decrease in Supply

No Change in Original Supply Curve Shifting in Original Supply Curve Shifting of Supply Curve towards Right Shifting of Supply Curve towards

Left 10.9.1. Extension and Contraction of Supply

When supply changes only due to change in price of the commodity, it is referred either as ‘Extension in Supply’ or ‘Contraction in Supply’.

1. Extension of Supply : Other things being equal, when the quantity supplied of a commodity increases due to rise in its price, it is called ‘Extension of Supply’. It is shown with table 3 and Fig. 3.

Table 3 explains that at price ` 1 per pen, the quantity supplied is 10 units. When price increases to ` 5 per pen, the quantity supplied becomes 50 units.

Fig. 3

Table 3 : Extension of Supply Price Quantity (in ````` ) Supplied 1 10 5 50 Description

Extension of Supply due to increase in Price

Extension of supply is explained in Fig. 3. SS is the supply curve of pen. When price of pen is ` 1, supply is of 10 pens. When price rises to ` 5, the supply extends to 50 units. The producer moves from point ‘A’ to point ‘B’ on the same supply curve. Thus, movement from the lower point to the higher point on the same supply curve is called ‘Extension of Supply’ .

2. Contraction of Supply : Other things being equal, when quantity supplied of a commodity decreases due to fall in its price, it is called ‘Contraction of Supply’ .

Table 4 : Contraction of Supply

Price (in “”) 5
1

Quantity Supplied 50 10

The above table 4 shows that when the price of pen is ` 5, the supply is of 50 units of pen. When price falls to ` 1, then the supply contracts to 10 units of pen. Contraction of supply is also illustrated with the help of Fig. 4. SS is the supply curve of pen. When the price is ` 5, supply is 50 units. The

Description

Contraction of Supply due to fall in Price

Fig. 4 supply is shown by point ‘A’ on SS curve. Conversely, when the price falls to` 1, the supply contracts to 10 units. The supply falls from point ‘A’ on SS curve to point ‘B’. Thus, movement from higher point A to lower point B on the same supply curve is known as ‘Contraction of Supply’ .

Representation of ‘Supply Extension’ and ‘Supply Contraction’ in a Single Diagram

When supply changes only due to change in price, such changes appear on the same supply curve. Such changes are called ‘Extension in Supply’ and ‘Contraction in Supply’ .

Other things being

equal, when quantity

Fig. 5 supplied of a commodity increases due to rise in its price, it is called ‘Extension in Supply’ and conversely, when quantity supplied of a commodity decreases due to fall in its price, it is called ‘Contraction in Supply’ . It is worthnoting that ‘Extension in Supply’ and ‘Contraction in Supply’ do appear on the original supply curve. In Fig. 5, movement along A to B represents ‘Extension in Supply’ and along A to C represent ‘Contraction in Supply’ .

Box 4

10.9.2. Shift in Supply

Or

Increase and Decrease in Supply

When the supply of a commodity changes due to factors other than its own price (like income change, fashion change, etc.), then it is called increase or decrease in supply.

1. Increase in Supply

When the quantity supplied increases at the same price or the quantity supplied remains constant at lesser price, it is termed as ‘Increase in Supply’

Table 5 : Increase in Supply Price of Pen per Unit Quantity Supplied (in ````` )

Same Price → More Quantity Supplied

(A) 3 3

34

Less Price → Same Quantity Supplied

(B) 3 3 23 → More Supply

Fig. 6

(A) Same Price In table 5 (A), when price of pen is ` 3 per pen, its supply is 3 units. Price remains constant at ` 3 per pen but quantity supplied increases to 4 units. This situation refers to ‘Increase in Supply’ .

(B) Less Price → Same Supply

In table 5 (B), when price of pen is ` 3 per pen, its supply is 3 units. If price falls to ` 2 per pen, quantity supplied remains constant at 3 units. This situation also refers to ‘Increase in Supply’ . Both the above situations are explained in Fig. 6. If the initial supply curve is SS, point ‘A’ indicates supply of 3 pens at ` 3 per pen. Under the influence of change in the factors other than the price, supply curve SS will shift downwards to the right as \mathsf { S } _ { 1 } \mathsf { S } _ { 1 } . Point ‘B’ on the new supply curve \mathsf { S } _ { 1 } \mathsf { S } _ { 1 } shows that supply increases to 4 pens at the same price of ` 3. Likewise, point ‘C’ on the new curve shows that although price has fallen to ` 2 per pen yet the quantity supplied remains 3 units, i.e. , as before. New supply curve \mathsf { S } _ { 1 } \mathsf { S } _ { 1 } represents increase in supply.

Causes of Increase in Supply ● Improvement in technology.

● Reduction in the price of factors of production causing fall in cost of production.

● When price of substitutes decreases.

● Change in goals of producers (Shifting from profit maximisation to sales maximisation).

● Increase in number of firms in the industry. ● Expected price fall in future.

● Reduction in taxes.

● Increase in subsidy.

Box 5

2. Decrease in Supply

When the quantity supplied decreases at the same price or the quantity supplied remains the same at a higher price, it is termed as ‘Decrease in Supply’ .

Table 6 : Decrease in Supply

Price of Pen per Unit Quantity Supplied (in ````` )

Same Price → Less Quantity Supplied

(A) 3 3

32

More Price → Same Quantity Supplied

(B) 3 3

43

(A) Same Price Less Supply : In table 6 (A), when price is ` 3, quantity supplied of pen is 3. Even when price remains to be ` 3, quantity supplied of pens reduces to 2. It is a situation of decrease in supply.

Fig. 7

(B) More Price Same Supply : In table 6 (B), when price is ` 3, quantity supplied of pens is 3. If price rises to ` 4, quantity supplied of pens remains at 3. It also is a situation of decrease in supply. Both the above situations of decrease in supply have been shown in Fig. 7. SS is the initial supply curve. At ` 3, the supply is of 3 pens as indicated by point ‘K’ on it. When due to change in ‘Factors other than

Price’ , supply decreases, the new supply curve shifts upwards to the left and becomes \mathsf { S } _ { 2 } \mathsf { S } _ { 2 } . Point R, on the new supply curve indicates that at the same price of ` 3, the new supply has fallen down to 2. Point T on the new supply curve means that even at a higher price of ` 4, the quantity remains at 3. Thus, new supply curve S₂ S_{2represents decrease in supply.}

Causes of Decrease in Supply

● High cost of production due to obsolete technique and machines.

● High cost of production due to increased prices of factors of production.

● Increase in prices of substitutes.

● Decrease in number of firms in industry.

● Expected price rise in near future.

● Change in the goal of firm (from sales maximisation to profit maximisation.)

Box 6

● Representation of ‘Increase in Supply’ and ‘Decrease in Supply’ in a Single Diagram

When due to change in factors other than price of the commodity,

supply changes, then

the situations of

‘Increase in Supply’

and ‘Decrease in

Supply’ appear. In both

the situations, supply

curve gets changed.

In situation of ‘Increase

in Supply’ , supply curve

shifts to the right_{Fig. 8while in situation of}

‘Decrease in Supply’ , supply curve shifts to the left. In Fig. 8, shifting of SS curve to \mathsf { S } _ { 1 } \mathsf { S } _ { 1 } shows ‘Increase in Supply ’ while to \mathsf { S } _ { 2 } \mathsf { S } _ { 2 } shows ‘Decrease in Supply ’.

10.9.3. Distinction between ‘Extension in Supply’ and ‘Increase in Supply’ Extension in Supply

1. It means, higher quantity supplied at higher price of commodity.

2. It happens when price of the commodity increases, other factors

remaining constant.

3. Movement towards right on the same supply curve takes place in it.

Increase in Supply

1. It means less supply at same price or same supply at higher price.

2. It happens when the factors other than price change.

3. Supply curve shifts towards left in it.

Fig. 9 Fig. 10

10.9.4. Distinction between ‘Contraction in Supply’ and ‘Decrease in Supply’

Contraction in Supply

1. It means, less quantity supplied at lower price.

2. It happens when the price of a commodity declines, other factors remaining constant.

3. Movement towards left takes place on the same supply curve in it.

Decrease in Supply

1. It means, more supply at same price or same supply at lower price.

2. It happens when the factors other than the price of commodity change.

3. Supply curve shifts towards right in it.

Fig. 11 Fig. 12

10.10. Effect of Technological Improvement on Supply Curve

Technological improvement brings reduction in cost of production—both marginal and average cost of production decline and as a result, more can be produced with less production expenditure. Accordingly, producers will be ready to supply more at existing price and the supply curve will be shifted towards right.

supplied at price OP. After technological improvement supply curve shifts to the right and becomes \mathsf { S } _ { 1 } \mathsf { S } _ { 1 } where quantity supplied increases to \mathrm { O Q } _ { 1 } at the same price OP.

Hence, technological improvement brings the situation of ‘Increase in Supply’ .

10.11. Effect of Change in Prices of Production Factors on Supply Curve

The change in prices of factors of production (i.e. , inputs) also brings change in supply curve. Input prices

Fig. 13

In Fig. 13, SS is the supply curve before any technological improvement where OQ is the quantity

Fig. 14 may increase or decrease. In case of increase in input prices, both marginal and average cost tend to rise. Accordingly, producers will be willing to supply less at the existing price. This implies a situation of shifting of supply curve to the left or decrease in supply. On the other hand, if input prices tend to fall, both marginal and average cost will decline. Accordingly, producers will be willing to supply more at the existing price. This implies a situation of shifting of supply curve to the right or increase in supply. In Fig. 14, SS is initial supply curve. When inputs prices increase, supply curve will shift backward to \mathsf { S } _ { 1 } \mathsf { S } _ { 1 } and when input prices fall, supply curve shifts forward to \mathsf { S } _ { 2 } \mathsf { S } _ { 2 }

10.12. Effect of GST on Supply Curve

Government imposes Goods and Service Tax (GST) on the production of goods. GST is a tax which is imposed on value added. Goods and Service Tax (GST) increases both average and marginal costs.

In such a situation, Fig . 15 a producer will be willing to sell less at the existing price or he will sell the same quantity of the commodity only at a higher price. This implies a situation of decrease in supply or backward shifting in supply curve. In Fig. 15, SS is the supply curve before the imposition of GST and initially, at OP price, the producer was willing to sell PA quantity. After GST is levied he is willing to sell only PB at existing price OP. Supply curve shifts backward from SS to \mathsf { S } _ { 1 } \mathsf { S } _ { 1 } as a result of GST.

10.13. Effect of Change in Price of Substitutes on Supply Curve

Supply of a commodity is also affected by change in prices of its own substitute goods. For example, tea and coffee are two substitutes.

If tea , for example, becomes expensive, the

producers of coffee

will hold the stocks

and wait for the price

of coffee to rise. At

the existing price of

coffee, they should

be willing to sell less

of coffee. This is a

situation of decrease Fig . 16

in supply or backward shift in supply curve. On the other hand, if price of coffee comes down, the producers of coffee would like to clear their stocks as fast as possible because of the fear of shifting buyers from coffee to tea. Thus, more of coffee will be offered for sale at its existing price.

This is a situation of increase in supply or forward shift in supply curve. In Fig. 16, initial supply curve SS shifts to right as \mathsf { S } _ { 1 } \mathsf { S } _ { 1 } in case of fall in price of substitutes and to left as \mathsf { S } _ { 2 } \mathsf { S } _ { 2 } in case of rise in price of substitutes.

10.14. Effect of Production Period on Supply Curve

Marshall has divided production period into three parts :

1. Very Short Period or Market Period. 2. Short Period.

2. Long Period.

Supply adopts different roles in all the above three production periods :

(i) Supply Curve in Very Short Period : Production remains constant in very short period and it cannot be changed at all. Supply of a commodity can only be increased upto its existing stock. Perishable goods (like green vegetables, milk, etc.) and stock of goods (like eggs, fruits, etc.) have constant supply in very short period and hence, according to Fig. 17, supply curve becomes vertical to X-axis which explains that the supply is not affected by price change in very short period.

Fig . 17

(ii) Supply Curve in Short Period : Supply in short period can be increased to some extent by using more variable factors of the production (like labour) but fixed factors (like building, plant, machinery, etc.) remain constant.

Accordingly, supply is responsive to price change but only to a limited extent. Hence, in short period supply curve SS remains less elastic as shown in Fig. 18.

Fig . 18

(iii) Supply Curve in the Long Period : In the long period of production, all production factors become variable and no factor remains constant. Supply in the long period can also be changed with change in technology and plant. Hence, supply becomes high sensitive to price change in the longrun and as a result long-run supply curve S_L S_{Lbecomes high elastic as shown in} Fig. 18.

A QUICK REVIEW OF THE CHAPTER

● Supply : Quantity of a commodity which is presented in the market for sale at various prices. ● Stock : It refers to the quantity which is available with sellers for sale.

● Individual Supply Schedule : It refers to the relation between price of a commodity and quantity to

be sold by an individual firm.

● Market Supply Schedule : It refers to the summation of supply schedules of all firms in the market

producing a particular commodity.

● Individual Supply Curve : It shows the quantity supplied by an individual firm at various prices. ● Market Supply Curve : It is a horizontal summation of individual supply curves of all firms in the industry.

● Reserved Price : It refers to that price below which the seller stops supplying commodities for sale. ● Supply Function : It refers to the functional relationship between supply of a commodity and its determinants.

\mathrm{S} _ {\mathrm{X}} = f (\mathrm{P} _ {\mathrm{X}}, \mathrm{P} _ {\mathrm{r}}, \mathrm{P} _ {\mathrm{f}}, \mathrm{T}, \mathrm{N}, \mathrm{G}, \mathrm{E} _ {\mathrm{X}}, \mathrm{G} _ {\mathrm{P}})

Where, S_X = Supply of Commodity

P_X = Price of Commodity

P_r = Price of Related Goods

P_f = Price of Production Factors

T = Technique

N = Number of Firms

G = Goal of Firm

E_X = Expected Future Price

^{G P = Government Policy} ● Factors Affecting the Supply of a Commodity :

1. Price of Commodity

2. Price of Substitutes

3. Price of Production Factors

4. Technological Level

5. Number of Firms in the Market

6. Goal of Firm

7. Expected Future Prices

8. Government Policy.

● Law of Supply : Other things being constant, supply increases with rise of price and supply decreases with fall in price. i.e . price of good and supply have direct relationship P α Q.

● Change in Supply : Change in supply is of two kinds :

(i) Movement along a supply curve due to change in price.

(ii) Shifting of supply curve due to change in factors other than price.

● Movement along a Supply Curve : Due to change in price only, two types of movement take place on a supply curve :

(A) Extension of Supply,

(B) Contraction of Supply.

(A) Extension of Supply : Other things being constant, when supply increases due to increase in price only, it is termed as ‘Extension of Supply’ .

(B) Contraction of Supply : Other things being constant, when supply decreases due to decrease in price only, it is termed as ‘Contraction of Supply’ .

● Shift of Supply Curve : In shifting of a supply curve, original supply curve either shifts upward or downward. This change appears when supply increases or decreases due to change in factors other than price (like income, fashion, etc.)

(A) Increase in Supply : It refers to more supply at same price or same supply at lower price. It happens due to change in factors other than price and in this situation supply curve shifts to the right. (B) Decrease in Supply : It refers to less supply at same price or same supply at higher price. It happens due to change in factors other than price and in this situation supply curve shifts to the left.

QUESTIONS Ultra Short Answer Type Question

1. State whether supply is more or less than stock when price is low ? Very Short Answer Type Questions

2. What is meant by Supply ?

3. What is Supply Schedule ?

4. State the Law of Supply.

(C.B.S.E. , 2011)

[ J.A.C ., 2016, 18 (Arts )]

4. What is meant by ‘Extension in Supply’ ?

5. What is meant by ‘Contraction in Supply’ ?

6. Define ‘Increase in Supply’. (C.B.S.E. , 2011)

7. What do you mean by ‘Decrease in Supply’ ? (C.B.S.E. , 2011)

8. Mention one point of difference between ‘Increase in Supply’ and ‘Extension in Supply’. (J.A.C. , 2017)

9. In which direction does the Supply Curve move in case of ‘Decrease in Supply’ ?

10. Mention one point of difference between ‘Contraction in Supply’ and ‘Decrease in Supply’.

11. What is the relationship between ‘Individual Supply’ and ‘Market Supply’ ?

12. What is ‘Market Supply’ ? (C.B.S.E., 2013) 13. Give one reason for a rightward shift in supply curve. 14. Mention one reason of increase in supply. (C.B.S.E., 2013) Or

When does increase in supply take place ? (C.B.S.E. , 2016) 15. Mention one reason of decrease in supply.

(C.B.S.E., 2013) 16. Distinguish between individual supply and market supply. (J.A.C., 2014) 17. Explain the market supply with the help of a table. (Raj. Board , 2016) Short Answer Type Questions

1. What is meant by Supply ? Mention the salient factors affecting the Supply of a Commodity.

[Raj. Board., 2015; C.B.S.E. , 2017] 2. Explain ‘Supply Schedule’ and ‘Supply Curve’ ?

[ C.B.S.E, 2016; B.S.E.B. (Arts ), 2018] 3. How does the change in factor prices affect the supply of a Commodity ? (C.B.S.E., 2012) 4. How is the supply of a commodity affected by the prices of other commodities ? (C.B.S.E., 2012) 5. What is Law of Supply ? Explain it with illustration and diagram. [B.S.E.B. 2011, 13, 19; J.A.C. , 2012, 19; U.S.E.B. , 2016] 6. Mention the exceptions of the Law of Supply.

7. What do you mean by Extension in Supply ? Explain it with illustration and diagram.

8. What do you mean by Increase in Supply ? Explain it with illustration and diagram.

9. Make distinction between ‘Extension in Supply’ and ‘Increase in Supply’ with diagram. (J.A.C ., 2019) 10. Explain the distinction between ‘Contraction in Supply’ and ‘Decrease in Supply’ with diagram.

10. What will be the effect of technological advancement on the supply of the commodity ? (U.S.E.B., 2015) 12. Name the three factors that can shift a supply curve. (J.A.C., 2011) 13. Define market supply. What is the effect on the supply of a goods when the government imposes tax on production of that goods ? (C.B.S.E., 2011) 14. Distinguish between “change in quantity supplied” and “change in supply”. Use diagrams. (C.B.S.E., 2012) 15. What is the difference between ‘supply’ and ‘stock’ of a good ? (B.S.E.B., 2012; J.A.C., 2012, 18) 16. Define market supply of a good. Mention three reasons of shifting supply curve to the right. (J.A.C., 2012) 17. What is meant by change in supply ? What are the reasons of change in supply ? (J.A.C., 2012) 18. Describe in brief any three determining elements of supply of a good ? [J.A.C. (Arts ), 2014; B.S.E.B., 2019] Or

Write names of three factors determining supply. (M.P. Board, 2019) 19. What are the causes of change in supply ? [B.S.E.B, 2014; J.A.C. (Arts ), 2014]

Long Answer Type Questions

1. Define supply. Mention the causes which determine the supply of a commodity. [B.S.E.B., 2016 (Comm. )]

2. Explain the five factors on which the supply of a commodity depends.

(Raj. Board, 2013; J.A.C., 2013)

3. What do you mean by ‘Supply Schedule’ and ‘Supply Curve’ ? Explain with illustration and diagram. (C.B.S.E., 2016)

4. Explain the distinction between change in quantity supplied and ‘change in supply’. Use diagrams. (C.B.S.E. , 2016)

5. Explain the effect of the following on market supply of a good : (C.B.S.E., A.I., 2015) (i) Increase in input prices

(ii) Reduction in per unit tax

6. Explain the factors determining the supply curve of a firm. (Raj. Board , 2016)

7. Examine the effect of (a) fall in the own price of good X and (b) rise in tax rate on good X, on the supply curve. Use diagrams. (C.B.S.E. , 2016)

Objective Type Questions

(A) Multiple Choice Questions :

1. Supply is associated with : (B.S.E.B., 2015) (a) A Time Period (b) Price (c) Both a & b (d) None of the above

2. Determinating factor of supply of goods is :

(B.S.E.B., 2015) (a) Price of Goods

(b) Price of Related Goods

(c) Price of Factor of Production

(d) All the above

3. Which of the following statement is true ? (B.S.E.B. , 2018)

(a) Price and quantity have direct relationship (b) Supply curve rises from left to right

(c) Supply is affected by many factors

(d) All the above

4. Which of the following function shows the laws of supply ? (B.S.E.B., 2019)

(\mathbf {a}) \mathbf {S} = f (\mathbf {P}) (\mathbf {b}) \mathbf {S} = f ^ {\prime} ()

(c) S = f \setminus ( \mathrm { Q } ) (d) None of the above 5. On which assumption, the law of supply depends ?

(a) There should be no change in income levels of buyers and sellers in the market

(b) Prices of factors of production remain stable

(c) Technological level remains constant

(d) All the above

6. If other things being same, what does the positive relationship between price and supply quantity signify ? (b) Elasticity of Supply (d) Supply Function (a) Law of Demand

(c) Law of Supply 7. The reason of decrease in supply is : (B.S.E.B., 2016, 19)

(a) Increase in Production Cost

(b) Increase in Price of Substitutes

(c) Fall in number of Firms in the Industry

(d) All the above

8. The figure given right shows : [B.S.E.B. , 2017, 18 (Arts )]

(a) Extension in Supply

(b) Contraction in Supply

(c) Increase in Supply

(d) None of the above

9. What is called that quantity of a goods which a seller becomes ready to sell in the market at fixed price and particular time ?

(a) Supply

(c) Elasticity of supply

[ B.S.E.B. , 2017 (Comm. )] (b) Demand

(d) Elasticity of demand

10. ‘‘Supply creates its own demand.’’ Who said it ? (M.P. Board, 2018) (b) Ricardo

(d) Keynes

(a) Prof. J. B. Say (c) Prof. Pigou

[Ans. 1. (c), 2. (d), 3. (d), 4. (a), 5. (d), 6. (c), 7. (d), 8. (a), 9. (a), 10. (a).]

(B) Fill in the Blanks :

1. Supply is................than stock at lower price.

2. Law of Supply states the................relationship between price and supply of commodity.

3. For normal goods supply curve is................sloping.

4. Contraction in supply means less supply at................price.

5. ................refers to the quantity which is available with the seller for sale.

6. The supply of factors depend on..................cost. (M.P. Board, 2018) [Ans.

7. lower, 2. positive, 3. upward, 4. lower, 5. Stock, 6. production.]

(C) State True/False :

1. Supply curve varies with time period.

2. Supply and stock are synonyms in economics.

3. Increase in technique increases the supply.

4. The law of supply does not apply strictly to agriculture products.

5. The supply curve is downward sloping.

[Ans. 1. True, 2. False, 3. True, 4. True, 5. False.] (D) Match the following Column : ‘A’

1. Exception to the law of supply

2. Reason of increase in supply substitutes

3. Reason of decrease in supply

4. Supply curve shifts towards left

5. Production remains constant

‘B’

(a) Increase in subsidy (b) Increase in price of

(c) Decrease in supply (d) Very short period (e) Perishable goods

[ Ans. 1. (e), 2. (a), 3. (b), 4. (c), 5. (d).]

(E) Answer in One Word :

1. What type of relation price and supply have ? 2. On which goods a law of supply is not applicable ? 3. Supply quantity decreases with fall in price— What does it

show ?

4. What happens to supply curve when change in supply takes place ?

[Ans. 1. Direct, 2. Perishable goods, 3. Contraction in supply, 4. Shift in supply.]

HOTS High Order Thinking Skills Questions

1. What causes a downward movement along a supply curve of a commodity ? (See : Fig. 4 & its explanation)

2. Are ‘Supply’ and ‘Stock’ synonyms in Economics ? Give examples. (See : Section 10.2)

3. Under what circumstances, we get a movement along the same supply curve ? (See : Point A in Section 10.9)

4. Diagrammatically explain the effect of change in prices of production factors on supply curve. (See : Section 10.11)

VBQ Value Based Questions

1. What does the change in prices of substitutes affect supply curve ? (See : Section 10.13)

2. Does GST affect the supply curve ?

(See : Section 10.12)

3. Improvement in technique increases the supply. How ? (See : Section 10.10)

MDQ Case Study Based on Evaluation & Multi-disciplinary Questions

1. If Govt. imposes GST on the production of goods, what will be the effect on supply curve ? (See : Section 10.12)

2. Does the price change of substitutes effect supply curve of goods ? (See : Section 10.13)

3. “Supply curve varies with time period.” Why ? (See : Section 10.14) NCERT CORNER

Q. 1. How does technological progress affect the supply curve of a firm ? Ans. See Section 10.10

Q. 2. How does the imposition of an unit tax affect the supply curve of a firm ?

Ans. See Section 10.12

Q. 3. How does an increase in the price of an input affect the supply curve of a firm ? Ans. See Section 10.11

Q. 4. How does an increase in the number of firms in a market affect the market supply curve ? Ans. See Section 10.6.2

Q. 5. Consider a market with two firms. The following table shows the supply schedules of the two firms : the SS ₁ column gives the supply schedule of firm 1 and the SS column gives the supply schedule of firm 2. Compute the market supply schedule.

Price ( ` ) SS 1 (units) SS 2 (units)

00 0
10 0
20 0
31 1
42 2
53 3
64 4

Ans.
Price SS 1 SS 2 Market Supply (` ) (units) (units) (units)

(= SS 1 + SS 2 )

00 0 0
10 0 0
20 0 0
31 1 2
42 2 4

Q. 6. Consider a market with two firms. In the following table, columns labelled as SS ₁ and SS ₂ give the supply schedules of firm 1 and firm 2 respectively. Compute the market supply schedules.

Price ( ` ) SS 1 (kgs.) SS 2 (kgs.)
00 0
10 0
20 0
31 0
4 2 0.5
53 1
6 4 1.5
75 2
8 6 2.5
Ans.
Price SS 1 SS 2 Market Supply ( ` ) (kgs.) (kgs.) (kgs.) (= SS 1 + SS 2 )
00 0 0
10 0 0
20 0 0
31 0 1
4 2 0.5 2.5
53 1 4
6 4 1.5 5.5
75 2 7
8 6 2.5 8.5 Q. 7. There are three identical firms in a market. The following table shows the supply schedules of firm 1. Compute the market supply schedule :
Price ( ` ) SS 1 (Units)
00
10
22
34

46 58 610 712 814 Ans. Three Identical Firms

Price (`) SS ₁ SS ₂ SS ₃ Market Supply (Units) (Units) (Units) ( S S _ { \mathrm { ~ 1 ~ } } + S S _ { \mathrm { ~ 2 ~ } } + SS ₃ ) 00 0 0 0 100 0 0 222 2 6 344 4 12 466 6 18 588 8 24 610 10 10 30 712 12 12 36 814 14 14 42 ❐

ELASTICITY OF SUPPLY

STUDY MATERIAL INCLUDED IN THE CHAPTER

11.1. Elasticity of Supply : Meaning11.2. Kinds (Degrees) of Elasticity of Supply11.3. Factors Influencing Elasticity of Supply11.4. Measurement of Supply Elasticity11.5. Numerical Illustrations A Quick Review of the Chapter Questions High Order Thinking Skills (HOTS) Questions Value Based Questions (VBQ) Case Study Based on Evaluation & Multidisciplinary (MDQ) Numerical Questions NCERT Corner.

11.1. Elasticity of Supply : Meaning

Like the Law of Demand, Law of Supply is also a ‘qualitative statement' . This law of supply only establishes the direction of change in quantity supplied due to change in price but does not present the ‘quantitative’ change in supply due to change in price. This quantitative change is measured by the ‘Elasticity of Supply’ .

Elasticity of supply is the measurement of quantitative change in supply due to change in price. In other words, price elasticity of supply is the proportionate change in supply consequent upon proportionate change in price.

Statement of Elasticity of Supply

Definitions :

(i) According to Marshall , "Elasticity of supply refers to the change in quantity supplied of a commodity in response to change in its price."

(ii) According to Samuelson, "Elasticity of supply is the degree of responsiveness of supply of a commodity to a change in its price."

(iii) According to Bilas, "Elasticity of supply is defined as the percentage change in quantity supplied divided by percentage change in price."

Price elasticity of supply is a measurement of the percentage change in quantity supplied of a commodity in response to some percentage change in its price.

_{Elasticity of Supply ( e} ) = Proportionate Change in Quantity Supplied_{s Proportionate} Change in Price

\mathrm{Q} / \mathrm{Q} _ {\mathrm{s}} \mathrm{QP} _ {e \mathrm{s} = \mathrm{ss} = .}

P/P P Qs P = Initial PriceWhere : P = Change in Price e _ { \textup { s } } = Elasticity of supply

_{Qs = Initial quantity supplied} The elasticity of supply is positive because Q s

= Change in quantity supplied

of the direct relationship between price and quantity supplied. 11.2. Kinds (Degrees) of Elasticity of Supply

A price change does not bring equal change in supply of different goods, i.e., the supply of different goods are affected differently due to a change in price.

The kinds (degrees) of elasticity of supply can be divided into five categories

Degrees of Elasticity of Supply

$(e_{s})$ ● Perfectly Elastic Supply $(e_{s}=)$ ● Greater than Unitary Elastic Supply

(e _ {s} > 1)

Unitary Elastic Supply ( \boldsymbol { e } _ { s } = 1 )

Less than Unitary Elastic Supply or Inelastic Supply ( e _ { s } < 1 )

Perfectly Inelastic Supply ( \boldsymbol { e } _ { s } = 0 )

(1) Perfectly Elastic Supply ( \pmb { e } _ { s } = ) When supply changes even with out price change (or negligible change), supply be comes infinite which shows the situation of ‘Perfectly Elastic Supply’. This concept is only theoretical and has no application

Perfectly Elastic Supply

Fig . 1
Fig. 1 illustrates this situation. SS is the perfectly elastic supply curve which is parellal to X-axis. Fig. 1 explains that supply reduces to zero, even when price is slightly reduced. Fig. 1 also shows that quantity supplied is infinite when price of the goods is OS.

●

Illustration 1

Supply schedule of commodity X for a producer is as follows. Calculate the elasticity of supply :

Price per unit (in `) Quantity of Supply 5 6 in real life. Solution : In Table 5 10

Change of Price ( { \mathrm { ~ P } } ) = 5 - 5 = 0 Initial Price ( \mathrm { P } ) = 5

Change in Quantity Supplied ( \mathrm { { Q } ) = 1 0 - 6 = 4 } Initial Supply Quantity ( \mathbf { Q } ) = 6

Hence,

Elasticity of Supply = Proportionate Change in Quantity Supplied Proportionate Change in Price

\mathrm{Q/QQP} _ {= \mathrm{P/PQP}}

= 4 5 2 0

Hence, supply elasticity is infinite,i.e., this supply table gives the perfectly elastic supply curve.

(2) Greater than Unitary Elastic Supply ( \textbf { \em e } _ { s } > 1 ) When proportionate change in quantity supplied is more than proportionate change in price, elasticity of supply becomes greater than unity ( e _ { s } > 1 )

\mathrm{Q} ^ {\mathrm{P}} \mathrm{Or} _ {\mathrm{Q}} > _ {\mathrm{P}}

When supply changes by 30% as a result of 10% change in price, supply elasticity becomes greater than unity.

Fig . 2

Fig. 2 shows this situation of supply having elasticity greater than unity which shows the greater response of supply due to change in price.

Illustration 2

Supply schedule of commodity X for a producer is as follows. Calculate the elasticity of supply :

Price ( ` ) Quantity of Supply
20 30
30 60
Solution :
Change of Price ( P) = 30 - 20 = 10 Initial Price (P) = 20
Change in Quantity Supplied ( Q) = 60 - 30 = 30 Initial Supply Quantity (Q) = 30

Proportionate Change in Quantity Supplied_{=Proportionate Change in Price} Q / Q 30 / 30 30 20 2

Hence, supply elasticity is greater than unit.

(3) Unitary Elastic Supply ( e _ { s } = 1 ) : When the corresponding proportionate change in quantity supply

becomes equal to the

Fig. 3

change in price, supply elasticity becomes equal to one.

Q
Or
Q
=
P

P

For example, if supply changes by 10% due to 10% change in price, the supply elasticity becomes equal to one. Fig. 3 shows unitary elastic supply curve SS in which proportionate change in quantity supplied (10%) is equal to the proportionate change in price (10%).

Illustration 3

Calculate the elasticity of supply from the following supply schedule :

Price ( ` ) Quantity of Supply
10 20
15 30
Solution :
Change of Price ( P) = 15 - 10 = 5 Initial Price (P) = 10
Change in Quantity Supplied ( Q)
= 30 - 20 = 10 Initial Supply Quantity (Q) = 20
Solution :
Initial Price (P) = 10
Change in Price ( P) = 20 - 10 = 10 Initial Supply Quantity (Q) = 40
Change in Quantity Supplied ( Q)
= 60 - 40 = 20
Proportionate Change in Quantity Supplied Proportionate Change in Price
= Q / Q 20 / 40 0.5
P / P 10 / 10

Hence, supply elasticity is less than unitary. (5) Perfectly Inelastic Supply ( { \pmb e } _ { S } = { \pmb 0 } )

When there is no change in supply as a result of price change, the supply elasticity is called to be

Proportionate Change in Quantity Supplied Proportionate Change in Price = Q / Q 10 / 20 1 \mathrm { ~ P ~ / ~ P ~ 5 ~ / ~ } 1 0

Or The supply elasticity is equal to one. (4) Less than Unitary Elastic Supply Or Inelastic Supply ( \pmb { e } _ { s } < 1 ) When the pro

elastic supply

portionate change

in quantity sup plied is less than

p r o p o r t i o n a t e change in price,

For example, if proportionate change in supply is 10% due to 20% change in price, supply elasticity is less than unitary. Fig. 4 shows less than unitary supply curve. Fig. 4 shows that 20% price change only brings 10% change in quantity supplied and hence, supply elasticity becomes less than unitary.

Illustration 4

Show that the following supply schedule gives less than unitary elastic supply :

perfectly inelastic Or

For example, even after 50% increase in price, the change in supply is zero, such elasticity is said to be perfectly inelastic.

Fig. 5 shows the perfectly inelastic supply. When price increases to \mathrm { O P } _ { 1 } { } ^ { \mathrm { Q } } = 0 _ { \mathrm { Q } }

Fig. 5
Price ( ` ) Quantity of Supply 10 40 20 60

from OP, supply remains constant at OS. This situation shows the supply having zero elasticity and the supply curve becomes vertical to X-axis.

Illustration 5
Does the following supply schedule represents perfectly inelastic supply
?
Price ( ` ) Quantity of Supply 20 20
40 20
Solution :
Supply Change ( Q) = 20 - 20 = 0
Initial Supply (Q) = 20
Hence, Proportionate Change in Supply
=
Q
Q = 0 20 = 0
Thus, e_S =
Proportionate Change in Quantity Supplied
Proportionate Change in Price
Q / Q 0 0 = P / P P / P So, the given supply table shows perfectly inelastic supply.

Degree of Elasticity Elasticity 1. Perfectly Elastic Supply$_{s}$ 2. Elasticity Greater than Unity 3. Unitary Elastic Supply

s 1 1 _ { s }

4. Elasticity less than unity or Inelastic_s 1 Supply

5. Perfectly Inelastic Supply

_s 0

Details

Supply changes without any change in price P 0 Supply change is more than price change

Q^P P Q P Equal proportionate change in price and supply Q P Supply change is less than price change { \mathsf { Q } } ^ { \mathrm { Q } } { \mathsf { P } } ^ { \mathrm { P } } Q P No change in supply even after price change Q 0

Q

Box 1

Points to Remember

e _ { S } = 1 Unit elastic supply curve rises from the origin.

‘‘Every supply curve rising through origin always

shows supply elasticity

equal to one ( e _ { s } = 1 )

irrespective of the angle

made with X-axis.”

In Fig. 6, all the three supply curves A, B and C show the unit elastic ity because :

(a) Every curve rises

through origin.

(b) Every curve slopes

upward.

Fig . 6

(c) Every supply curve

is a straight line.

e _ { S } > 1 Supply curve having elasticity greater than one slopes upward (i.e., positively sloped), originating from any point of Y-axis (except the origin). (Fig. 6A)

Fig . 6A

e _ { S } < 1 Supply curve having elasticity less than unity slopes upward (i.e., positively sloped), originating from any point of X-axis (except the origin). (Fig. 6B)

Box 2
11.2.1. Comparison of Supply Curves

When two supply curves intersect each other, the supply curve having the higher slope shows more elasticity and the curve having lesser slope shows less elasticity.

P

Fig . 7
In Fig. 7, SS is the supply curve which shows the higher slope and high elasticity ( e _ { s } > 1 ) and \mathsf { S } _ { 1 } \mathsf { S } _ { 1 } is the supply curve having lesser slope and less elasticity ( e _ { s } < 1 ) .

11.3. Factors Influencing Elasticity of Supply The following factors influence the elasticity of supply :

(1) Nature of Goods : The nature of goods affects the elasticity of supply. Durable goods have relatively more supply elasticity while on the contrary, perishable goods have relatively lesser supply elasticity because perishable goods cannot be stored.

(2) Cost of Production : Elasticity of supply is also influenced by cost of production. If average cost increases sharply with increase in production, supply will be having less elasticity. On the contrary, if average cost increases slowly with increase in production, supply will be more elastic.

(3) Change in Future Price : If producers expect higher price of the commodity in future, they reduce the present supply and hence, supply becomes inelastic. On the contrary, present supply will increase if future expected prices are higher which make the supply more elastic.

(4) Natural Constraints : The elasticity of supply is also influenced by the natural constraints in the production of a commodity. If we wish to produce more teak wood, it will take years of plantation before it becomes usable. Supply of teak wood will therefore be less elastic.

(5) Technique of Production : If the production technique of a commodity isquite complex and needs large stock of capital, then the supply of that commodity will beless elastic , because production cannot be easily increased. On the other hand, goods involvingsimple technique of production will have relatively more elastic supply .

(6) Risk Bearing Capacity : Entrepreneur’s ability to bear the risk also affects the supply elasticity. If the entrepreneurs are willing to take risk, the supply becomes more elastic. On the contrary, if entrepreneur’s hesitate to take risk, the supply becomes inelastic.

(7) Time Element : Elasticity of supply is also influenced by time factor. (See : Section 10.14 in Chapter 10). Longer the time period, greater will be the elasticity of supply and vice versa . Time period can be divided into three parts :

(a) Very Short Period : In very short period, there is insufficient time to change output, so supply is perfectly inelastic .

(b) Short Period : In short period, the plant capacity is fixed but output can be changed by changing the intensity of its use. Supply is, therefore,elastic .

(c) Long Period : In the long period, all desired changes including changes in plant capacity can be made and supply becomes still more elastic .

11.4. Measurement of Supply Elasticity

There are two methods of measuring the elasticity of supply :

1. Proportionate Method or Percentage Method,

2. Point Method or Geometric Method.

11.4.1. Proportionate Method Or Percentage Method

According to this method, elasticity of supply ( e _ { S } ) , is the ratio between‘percentage change in quantity supplied’ and ‘percentage change in p r i c e ^ { , } of the commodity. Or

= Proportionate Change in Quantity Supplied_{es Proportionate Change in Price} Change in Quantity Supplied e s

= Initial Quantity Change in Price

Initial Price _{1}^{QQ} Q 100 e_{s} =^{Q} Or$^{Q}$ _{1}^{PP} P 100$_{PP}$ Q e s

= Q Q P P Q P

P P Q_{es} = Q P

(Where e_{s} = Supply Elasticity; Q_{1} = New Supply; P_{1} = New Price; P = Initial Price; P = Change in Price; Q = Initial Supply; Q = Change in Supply)

Illustration 6

The price of a commodity is `12 per unit and its quantity supplied is 500 units. When its price rises to `15 per unit, its quantity supplied rises to 650 units. Calculate its price elasticity of supply. Is supply elastic ? Solution :

= 25 1.25
20
Ans. Supply Elasticity = 1.25

P = ` 12, P₁ = ` 15, P = ` 15 - ` 12 = ` 3 Q = 500, Q₁ = 650, Q = 650 - 500 = 150 Units
P Q 12 150 1.2 es = Q P 500 3

Ans. Supply Elasticity = 1.2 and Hence, supply is elastic.

Illustration 7

The price of a commodity is ` 5 per unit and its quantity supplied is 600 units. If its price rises to `6 per unit, its quantity supplied rises by 25 percent. Calculate its price elasticity of supply.

Solution :

Proportionate Change in Price =^P 100¹ 100 20%_{P 5}

Q = 600, Proportionate Change in Supply = 25%

Proportionate Change in Quantity Supplied_{es = Proportionate Change in Price}

11.4.2. Geometric (or Point) Method

Supply elasticity can also be measured through point method or geometric method. Fig. 8 shows the geometric method of supply elasticity.

Fig . 8

In Fig. 8, SS supply curve and in every segment of the figure, supply elasticity has been calculated.

Every supply line SS has been extended upto point B and a perpendicular PM has been drawn from point B to X-axis.

Supply elasticity on these supply lines at point P can be measured by the following formula :

_es = BM

OM

Hence,

(i) In Fig. 8 (A), OM < BM and hence, at point

P in Fig. 8 (A) e _ { s } < 1

(ii) In Fig. 8 (B), OM = BM and hence, at point P in Fig. 8 (B) e _ { s } = 1

(iii) In Fig. 8 (C), BM > OM and hence, at point P Fig. 8 (C), e _ { s } > 1

In Fig. 8, the supply curves are as straight line. If supply curve is not a straight line, we have to draw a tangent on this curve as shown in Fig. 9. In this figure, BB tangent has been drawn at point B of supply curve SS. From point P, a perpendicular PM is also drawn on X-axis. At point P, the supply elasticity is

Thus,e _ s < 1
Hence, supply elasticity at point B on SS curve is less than one.

11.5. Numerical Illustrations

1. The price of a commodity is `10 per unit and its quantity supplied is 500 units. If its price falls by 10% and quantity supplied falls to 400 units. Calculate price elasticity of supply. Solution :
P = `10 10% fall in price
10
New Price (P₁) = 10 10 100
= `10 – `1 = `9 Change in Price = P₁ – P = `9 – `10 = `-1
Q₁ = 500, Q = 400, Q = 400 – 500 = -100
e P Q 10 100 = 2 s = Q P 500 1 Ans. Supply elasticity is 2.
2. When the price of a commodity falls from
`10 per unit to `9 per unit, its quantity supplied falls by 20%. Calculate its price elasticity of supply.
Solution :
P Qes = Q P
es = Proportionate Change in Quantity of Supply
Proportionate Change in Price
P = `10, P₁ = `9, P = 9 – 10 = -1 % Change in Price
P 100¹ 100 10%=P 100
es = 20% 2.
10%
Ans. Supply elasticity = 2.
1/2
Introductory Micro Economics
1/2
3. If the market price of a commodity is `4, a seller is willing to sell 600 units of the commodity. When the price rises to `5, he is willing to sell 850 units of the commodity. What is seller’s elasticity of supply ?
Solution :
e
s

=
P Q
Q P
P = ` 4, P₁ = ` 5, P = ` 5 - ` 4 = `1 Q = 600; Q₁ = 850, Q = 850 - 600 = 250
1, 000₁.₆ es = 4 250
600 1 600

Ans. Supply elasticity is greater than one. 4. Price elasticity of supply for a product is

e
s
=
P Q
Q P
P = ` 5, P₁ = ` 6, P = ` 6 - ` 5 = ` 1 Q = 25, Q₁ = M, Q = M - 25
e_s = 1
1 =
5 M 25 25 1
1 =
1 M 25 5 1
1 = M 25
5
5 = M - 25

M = 5 + 25 = 30 Units
Ans. Firm will be ready to supply 30 units of the goods.

5. The quantity supplied of a commodity at a price of `8 per unit is 400 units. Its price elasticity of supply is 2. Calculate the price at which its quantity supplied will be 600 units. Solution : Let the New { \mathrm { P r i c e } } = \mathbf { P } _ { 1 }

P = `8, P = P₁ - 8
Q = 400, Q₁ = 600, Q = 600 - 400 = 200
P Q e_s = Q P
e_s = 2
2 =
8 200
400 P 8₁ 2(P₁ - 8) = 4
2P₁ - 16 = 4
2P₁ = 16 + 4 = 20
P₁ = 10

Ans. 600 units will be supplied at price ` 10 per unit.

6. The co-efficient of elasticity of supply of a commodity is 3. A seller supplies 20 units of this commodity at a price of `8 per unit. How much quantity of the commodity will the seller supply when price rises by ` 2 per unit ?

Solution : Let the seller supplies X units of goods e _ { s } = 3

P = `8, P₁ = `10, P = `10 - `8 = `2
Q = 20, Q₁ = X, Q = X - 20
e
s
=
P Q Q P

=
8 X 20 X 20 20 2 5
3 = X 20
5
X - 20 = 15
X = 15 + 20 = 35
Ans. Seller will supply 35 units.

7. A seller of apples sells 80 quintals a day when the price of apples is `4 per kg. The elasticity of supply of apple is known to be 2. How much quantity the seller supplies when the price rises to ` 5 per kg ?

Solution : Let the seller supplies X Qts. of apples. Here P = `4, P1 = `5, P = `5 - `4 = `1
Qs = 80, Q1 = X, Qs = X - 80 es = 2
e
s
=
P Qs Qs P
4 X 80= 280 1
X 80= 401
X - 80 = 40
X = 80 + 40 = 120 Qts.
Ans. Seller will supply 120 quintals of apples.
Elasticity of Supply

$_{e}$ = Proportionate Change in Quantity Supplied $_{s}$ Proportionate Change in Price e s = Q P Q. P Q P P Q

A QUICK REVIEW OF THE CHAPTER

Elasticity of Supply : Price elasticity of supply is a measurement of the percentage change in quantity supplied of a commodity in response to some percentage change in its price.

Degrees of Elasticity of Supply :

(i) Perfectly Elastic Supply ( \pmb { e } _ { s } = ) : When a slight change in price makes the supply zero, the supply elasticity becomes perfectly elastic.

(ii) Greater than Unitary Elastic Supply ( \textbf { \em e } _ { s } > 1 ) : When the

proportionate change in quantity supplied is more than proportionate change in price, supply elasticity becomes greater than unity.

(iii) Unitary Elastic Supply ( \textbf { \em e } _ { s } = 1 ) : When the proportionate change in quantity supplied is equal to the proportionate change in price, the supply elasticity becomes equal to one.

(iv) Perfectly Inelastic Supply ( \textbf { \em e } _ { s } = \textbf { 0 } ) : When no change in quantity supplied takes place even after any price change, supply elasticity becomes zero which shows perfectly inelastic supply. (v) Less than Unitary Elastic Supply ( \textbf { \em e } _ { s } < 1 ) : When the proportionate change in quantity supplied is less than the proportionate change in price, the supply elasticity is less than

one ( e _ { s } < 1 ) .

Factors Influencing the Elasticity of Supply :

(i) Nature of Goods

(ii) Cost of Production

(iii) Expected Price Change in Future (iv) Natural Constraints

(v) Production Technique

(vi) Time Element

Measurement of Supply Elasticity :

= Change in Supply / Initial Supply

^e s Change in Price / Initial Price Q / Q_{= P / P}

QUESTIONS Very Short Answer Type Questions

1. What do you mean by ‘Elasticity of Supply’ ?

2. Mention the four determinants of elasticity of supply.

3. How many types does the supply elasticity have ?

4. What do you mean by elastic supply ?

5. Mention the formula for the measurement of the Elasticity of Supply.

6. What is meant by Zero Elastic Supply ?

Short Answer Type Questions

1. Explain the meaning of Supply Elasticity. Also explain the methods of measuring it. (U.S.E.B ., 2011)

2. What are the different types of supply elasticity ?

3. State the factors which influence the elasticity of supply.

4. Draw supply curves with price elasticity of supply throughout equal to (i) zero, (ii) one, (iii) infinite and (iv) less than one.

5. What does price elasticity of supply mean ? (U.S.E.B., 2014) Long

Answer Type Questions

1. Define price elasticity of supply. Explain the two methods of measuring it. (B.S.E.B. (Comm). , 2015)

2. Explain the supply elasticity. Which factors do influence it ? (U.S.E.B ., 2012)

3. Explain the methods of measuring elasticity of supply. (J.A.C. , 2012)

4. Explain with diagram various categories of price elasticity of supply.

(U.S.E.B. , 2017) Objective Type Questions

(A) Multiple Choice Questions :

1. When supply increases more with a result of small increase in price, the nature of supply will be : [B.S.E.B., 2016 (Comm. )]

Introductory Micro Economics

(a) Elastic (b) Inelastic

(c) Perfectly Elastic (d) Perfectly Inelastic

2. When the proportionate change in the supply of goods is more than the proportionate change in its price, the elasticity of supply will be : (a) Less than Unit

(c) Greater than Unit (b) Equal to Unit (d) Infinite

3. If the price of the goods rises by 40% and supply increases by only 15%, the supply of goods will be :

(a) Highly Elastic (c) Inelastic

( B.S.E.B. , 2010, 18) (b) Elastic

(d) Perfectly Inelastic

4. The measurement of the elasticity of supply is expressed as : [B.S.E.B. , 2011 (Arts )]

(a) Q /Qs s _(b) Q 1 P/P P P

(c) Qs { \mathrm { ~ P ~ } } ( { \mathrm { d } } ) ^ { \mathrm { ~ P ~ P ~ } } \mathrm { Q s } \mathrm { Q s } \mathrm { Q s }

Fig. 10

(a) Perfectly Elastic Supply
(b) Perfectly Inelastic Supply
(c) Elastic Supply
(d) Inelastic Supply

(a) Elastic Supply
(b) Perfectly Inelastic Supply
(c) Perfectly Elastic Supply

(d) Inelastic Supply

7. Which of the following figure is correct ?

(a) Perfectly Elastic Supply e _ { s } =

(b) High Elastic Supplye _ s > 1

(c) Perfectly Inelastic Supplye s = 0

(d) All the above

8. \boldsymbol { e } _ { s } = 0 means that elasticity of supply is :

[B.S.E.B. (Arts ), 2018] (a) Perfectly Elastic Supply

(b) Perfectly Inelastic Supply

(c) Less Elastic Supply

(d) Unit Elastic Supply

9. If the price of goods rises by 60% but supply increases by only 5%, the supply of goods will be :

(a) Highly Elastic (b) Elastic

(c) Inelastic (d) Perfectly Inelastic

[ B.S.E.B., 2011 (Comm .)] 10. The elasticity of a straight line supply curve originating from the centre of origin is :

(a) Less than unity

(b) greater than unity

(c) equal to unity

(d) equal to zero [B.S.E.B. (Arts ), 2015] [Ans. 1. (a), 2. (c), 3. (c), 4. (a), 5.

(a), 6. (b), 7. (d), 8. (b), 9. (c). 10. (c)]

(B) Fill in the Blanks :

1. Perfectly ................. supply curve is parallel to Y-axis.

2. Unit elastic supply curve rises from.....................

3. In very short period, supply is perfectly............... .

4. Whene _ s = , supply curve is ................. to X-axis.

5. For goods like milk, supply elasticity is.............. . [Ans. 1. inelastic, 2.

origin, 3. inelastic, 4. parallel, 5. zero.]

(C) State True/False :

1. Law of supply is a qualitative statement.

2. The elasticity of supply is positive because of the direct relationship

between price and quantity supplied.

3. The kinds of elasticity of supply can be divided into three categories.

4. The nature of goods not affect the elasticity of supply.

5. There are two methods of measuring the elasticity of supply.

[Ans. 1. True, 2. True, 3. False, 4. False, 5. True.] (D) Match the following Column :

\text {A}

1. Perfectly elastic supply

2. Meaning ofe _ s = 0

3. Durable goods

4. Perishable goods

5. Unit elastic supply curve

‘B’

(a) Perfectly inelastic supply (b) Elastic supply

(c) Inelastic supply

(d) Rises from orgin

(e) e _ { s } =

[Ans. 1. (e), 2. (a), 3. (b), 4. (c), 5. (d).]

Elasticity of Supply

(E) Answer in One Word :

1. What is the elasticity if supply curve is parallel to Y-axis ? 2. What elasticity of supply takes place in very short period ?

2. If supply curve originates from orgin, what is the elasticity of supply curve ?

3. Ife \mathbf { \Lambda } _ { s } = \operatorname { w h a t } will be the shape of supply curve ? [Ans. 1. e _ { s } = 0 , 2

Perfectly Inelastic, 3 . e _ { \textrm { s } } = 1 _ { \textrm { \em { ‰} } } , 4. Parallel to X-axis.]

High Order Thinking Skills Questions 1. Unit elastic supply curve rises from the origin. Why ?

(See : Fig. 6 and its explanation)

2. Why does the lesser slope of supply curve show less elastic

(See : Section 11.2.1)

3. Why does the elasticity of supply become positive ?

(See : Last Part of Section 11.1)

VBQ

Value Based Questions

1. The supply curve having unit elasticity always rises upward from origin. Why ? (See : Fig. 6)

2. Does the efficiency of an entrepreneur for risk bearing depend on elasticity of supply ?

(See : Point 6 in Section 11.3)

3. Greater the production time period, more will be the elasticity of supply of good. How ?

[See : Point 7 (iii) in Section 11.3)

Case Study Based on Evaluation & Multi-disciplinary Questions

1. Does the nature of goods influence elasticity of supply ? (See : Point 1 in Section 11.3)

2. Can the time element effect the elasticity of supply ? (See : Point 7 in Section 11.3)

3. The supply curve having elasticity less than one always rises upward from any point of X-axis. Why ?

(See : Fig. 6 B)

Numerical Questions

1. Price of a commodity increases from ` 10 to ` 12 as a result of which supply gets increased from 35 to 42. Calculate the elasticity of supply. [Ans. e _s = 1]

2. The price of a commodity is `12 per unit and its quantity supplied is 500 units. When its price rises to ` 15 per unit, its quantity supply rises to 650 units. Calculate its price elasticity of supply. Is its supply elastic ? [Ans. e _ { s } = 1.2, Yes, Supply is elastic]

3. Co-efficient of supply elasticity of goods is unity. Firm supplies 25 units at the price`5 per unit. Its price increases to ` 6, how many units will be supplied by the firm ? [Ans. 30 units]

4. Calculate the supply elasticities on the basis of data in three given sets :

Set I Set II Set III Price Supply Price Supply Price Supply 60 400 48 100 78 200 58 300 50 200 80 300

[ Ans. Set I : e _ { s } = 7 { \cdot } 5 ; ; Set II : \cdot e _ { s } = 2 4 ; Set III :e _ s = 1 9 \cdot 5 ] 5. A producer supplies 80 units of a good at a price of` 10 per

unit. Price elasticity of supply is 4. How much will be supply at` 9 per unit. (C.B.S.E. , 2016)

[Ans. 48 units]

6. A 5% fall in the price of a commodity results in a fall in its quantity supplied from 400 units to 370 units.

Calculate its price elasticity of supply. Is its supply elastic ? [Ans. e _ { s } = 1 . 5 , Yes]

7. The price elasticity of supply of commodity Y is half, the price elasticity of supply of commodity X. 16 per cent rise in the price X results in a 40 per cent rise in its supply. If the price of Y falls by 8 per cent, calculate the percentage fall in its supply.

[Ans. 10% Decrease]

8. When price of a good rises from`8 per unit to`10 per unit producer supplies 40 units more. Price elasticity of supply is 2. What is the quantity supplied before the price change ? Calculate. (B.S.E.B., 2018)

[Ans. 80 Units]

9. When the price of a commodity falls from`12 per unit \mathbf { t o } 9 per unit, the produces supplies 75 percent less output. Calculate price elasticity of supply. (C.B.S.E., 2018)

[Ans. $e_s = 3$.] 10. When the price of a commodity changes from `4 per unit to `5 per unit, its market supply rises from 100 units to 120 units. Calculate the price elasticity of demand. Is supply elastic? Give reason. [Ans. $e_s = 0.8$; Inelastic supply.] (C.B.S.E., 2018) 11. When the price of a commodity falls from `10 per unit to `9 per unit, its quantity supplied falls by 20%. Calculate its price elasticity of supply. (C.B.S.E., 2016) [Ans. $e_s = 2$] 12. Due to 10% rise in the price of a commodity, its quantity supplied rises from 400 units to 450 units. Calculate its price elasticity of supply. Is its supply elastic? [Ans. $e_s = 1.25$, Yes] 13. Price of goods increases from `5 to `7 and supply increases from 100 to 150. What type of change in supply will it be called? [Ans. $e_s = 1.25$; which is greater than unit elastic supply.] 14. When price of a good rises from `10 to `12 per unit, the producer supplies 10% more. Calculate price elasticity of supply. (C.B.S.E., 2016, 18) [Ans. $e_s = 2$] 15. Co-efficient of supply elasticity of goods is 1.25 At the price of `5 per unit, the seller supplies 10 units. What will be supply if the price increases to `7 per unit? (C.B.S.E., 2013) [Ans. 15 units]

16. When the price of butter in market increases from `20 per kg. to`21 per kg., the producer increases his supply from 3,000 kgs. to 3,500 kgs. Calculate the price elasticity of supply. [Ans. e _ { s } = 3 . 3 ]

17. Price elasticity of supply of a commodity is 5. A producer supplies 500 units of this product at a price of ` 5 per unit. At the price of`6 per unit, how much quantity of this product will be supplied ? [Ans. 1,000 units]

18. The price elasticity of supply of a good is 0.8. Its price rises by 50%. Calculate percentage increase in its supply. (C.B.S.E., 2013) [Ans. 40%]

19. As a result of 15% increase in price level of a goods, its supply increases from 300 units to 345 units. Calculate the supply elasticity. (C.B.S.E., O.D., 2013) [Ans. \boldsymbol { e } _ { s } = 1 ]

20. When the price of a good rises from `20 per unit to`30 per unit, the revenue of the firm producing this good rises from `100 to`300. Calculate the price elasticity of Supply.

(C.B.S.E., 2013) [Ans. e _s = 2]

21. The price of a commodity is `5 per unit and its quantity supplied is 600 units. If its price rises to`6 per unit, its quantity supplied rises by 25%. Calculate its price elasticity of supply.

$\text{[Ans. } e_{s}=1.25\text{]}$

22. On the basis of following supply table, calculate the price elasticity when price per unit declines from`5 to`3 :

Price (` ) 6 5 4 3 2 Supply ( kgs. ) 6,000 5,500 4,500 3,000 0 [Ans. $e_s = 1 \cdot 14$]

23. The quantity supplied of a commodity at a price of ` 8 per unit is 200 units. Its price elasticity of supply is 2. Calculate the price at which its quantity supplied will be 250 units. (C.B.S.E. (O.D.), 2013) [Ans. ` 9] 24. The price of a commodity is`10 per unit and its quantity supplied at this price is 500 units. If its price falls by 10 per cent and quantity supplied falls at 400 units, calculate its price elasticity of supply.

[Ans. e _s = 2]

NCERT CORNER

Q. 1. What does the price elasticity of supply mean ? How do we measure it ? Ans. See Section 11.1 & 11.4

Q. 2. A firm earns a revenue of `50 when the market price of goods is ` 10. The market price increases to ` 15 and the firm now earns a revenue of `150. What is the price elasticity of the firm’s supply curve ? Ans. TR = `50

Q. 3. The market price of goods changes from `5 to `20. As a result, the quantity supplied by a firm increases by 15 units. The price elasticity of the firm's supply curve is 0.5. Find the initial and final output levels of the firm.

0.5 Q0 = 5
Q0 = 10

Hence, Q1 = Q0 + 15
Q1 = 10 + 15 = 25
Hence, Initial Output of Firm = 10
Final Output of Firm = 25.

Q. 4. At the market price of `10, a firm supplies 4 units of output. The market price increases to `30. The price elasticity of the firm's supply is 1.25. What quantity will the firm supply at the new price?

Ans. P0 = `10
Q0 = 4 Units
P1 = `30
es = 1.25

Q P0 es = Q ×
0 P
Q 10 1.25 = 4 × 30 10
1.25 = Q × 10 4 20
Q 1.25 = 8

Q = 1.25 × 8
= 10 Units
Q1 = Q0 + Q
= 4 + 10 = 14 Units

New Supply = 14 Units.

DIFFERENT FORMS OF MARKET : MEANING AND FEATURES

STUDY MATERIAL INCLUDED IN THE CHAPTER

12.1. Meaning of Market 12.2. Classification of Market (On the basis of Competition) 12.3. Comparison among Various Markets A Quick Review of the Chapter Questions High Order Thinking Skills (HOTS) Questions Value Based Questions (VBQ) Case Study Based on Evaluation & Multidisciplinary Questions (MDQ) NCERT Corner.

12.1. Meaning of Market

Generally speaking, market refers to that place where buyers and sellers assemble and make transactions. But in Economics, physical presence of buyers and sellers is not essential for defining market. In modern times, transactions of the commodities are done with modern tele-communication sources. Generally, bargaining takes place between buyers and sellers and transaction takes place only when one price is accepted by both the parties.

● Definitions

(i) According to Benham, “Market should be defined as any area over which buyers and sellers are in such a close touch with one another either directly or through dealers that the prices obtainable in one part of the market affect the prices paid in other parts.”

(ii) According to Stonier & Hague, “Economists take market as an organisation in which the buyers and sellers of a commodity are in close contact with each

(2) Presence of both Buyers and Sellers : An area is called the market where both buyers and sellers are present. Absence of any one creates hindrance in converting the area into market.

(3) One Commodity : In Economics, every commodity has different market, e.g., market of wheat, market of sugar, etc.

(4) One Price of the Commodity : Market contains one single price of the commodity due to competition between buyers and sellers.

Hence, on the basis of above features the market can be defined as :

“In economics market signifies the presence of such groups of buyers and sellers of a commodity who freely compete with each other and as a result one price prevails in the market.”

12.2. Classification of Market (On the Basis of Competition)

other.” Market

(iii) According to J.K. Mehta, “A market refers to a situation in which a commodity is demanded at a place where it is presented for sale.” In simple words, the market does not refer to any particular place but the entire area where the buyers Perfect Zero Competition Competition Imperfect Oligopoly Competition

and sellers of a commodity are in close contact to each other. Market in Economics refers to a set of sellers and buyers whose activities affect the price Monopoly at which a particular commodity is sold. Monopolistic Competition

12.1.1. Characteristics of Market

Main characteristics (or features) of the market are as follows :

(1) One Area : The term market in Economics does not refer to any fixed place but indicates that area where buyers and sellers are present and compete with each other.

12.2.1. Perfect Competition

Perfect competition is that market situation in which a large number of buyers and sellers are found for homogeneous product. Single buyer or the seller are not capable of affecting the prevailing price and hence, in a perfectly competition market, a single market price prevails for the commodity.

● Definitions

(i) According to Leftwitch, "Perfect competitive is a market in which there are many firms selling identical products with no firm large enough relative to the entire market to be able to influence market price."

(ii) According to Mrs. Joan Robinson, "Perfect competitive prevails when the demand for the output of each producer is perfectly elastic."

Under Perfect Competition, a firm is ‘Price-taker’, not 'Price-maker' Due to large number of buyers and sellers in perfect competition, individual firm becomes unable to affect the price. Industry has a number of firms producing homogeneous products and hence, individual firm has a very small share in the supply of industry. This results in single price in the market which is not affected by individual firm. Due to this very feature, a firm operating in an industry under perfect competition is only a ‘pricetaker’ and ‘quantityadjuster’ .

Y Industry Y
D
(Price Maker) Firm
S (Price Taker)
E P AR=MR P
D
S
O Q Output X O Output X Fig . 1

In Fig. 1, the price of the commodity OP is being determined by demand and supply forces at point E. This determined price OP is accepted by each firm working in the industry and adjusts its production quantity accordingly. A perfectly competitive firm cannot alter the price but it can produce and sell any quantity and hence, for a firm price line is horizontal line parallel to Xaxis.

Box 1

● Characteristics or Features of Perfect Competition

(1) Large Number of Buyers and Sellers : Perfect competitive market has a large number of buyers and sellers and hence, any buyer or seller cannot influence the market price. In other words, individual buyer or seller cannot influence the demand and supply conditions of the market.

(2) Homogeneous Product : The units sold in the market by all sellers are homogeneous (or identical) in nature.

(3) Free Entry and Exit of Firms : In perfect competition, any new firm may join the industry or any old firm may quit the industry. Hence, there is no restriction on free entry or exit of firms into/from the industry.

(4) Perfect Knowledge of the Market : In perfect competition, every buyer has the perfect knowledge of market conditions. None of the buyers will buy the commodity at higher price than the prevailing price in the market. Hence, only one price prevails in the market.

(5) Perfect Mobility of Factors : In perfect competition, the factors of production are perfectly mobile. Factors can easily be mobile from one industry to other industry (or from one firm to other firm) without any difficulty.

(6) No Transportation Cost : Transportation cost remains zero in perfect competition due to which one price prevails in the market.

12.2.2. Pure Competition and Perfect Competition

The concept of ‘Pure Competition’ is more real (but narrow) than the concept of ‘Perfect Competition’ . Chamberlin has made a distinction between ‘Perfect Competition’ and ‘Pure Competition’ . In the words of Chamberlin, “Pure competition means competition unallowed by monopoly elements. It is a much simpler and less exclusive concept than perfect competition for the latter may be interpretated to involve perfection in many other respects than in the absence of monopoly.”

Hence, Pure Competition involves the following features :

1. Large number of buyers and sellers.

2. Homogeneous product.

3. Free entry or exit of firms into the industry.

Besides the above three conditions, perfect competition involves three additional features :

1. Perfect knowledge of the market.

2. Perfect mobility of factors.

3. No transportation cost.

Demand Curve of a Firm under Perfect Competition is Perfectly Elastic

A perfectly competitive firm is price taker and so it can take the price more than the prevailing price in the market. In perfect competition, a buyer has to pay the same price for every additional unit.

i.e., Average Revenue =_{Fig . 2Marginal Revenue}

AR = MR

Hence, price remains constant under perfect competition and the demand curve for an individual firm becomes perfectly elastic.

Box 2

12.2.3. Monopoly : Meaning

Monopoly is the addition to two words, i.e., ‘Mono’ + ‘Poly’ , i.e. single seller in the market. Being the single seller in monopoly market, a firm has full control on the supply of the commodity. In pure monopoly even no close substitute of the product is available in the market.

In monopoly, no distinction arises between ‘firm’ and ‘industry’ i.e. , firm is industry and industry is firm.

Definitions :

(i) According toMcConnell, “Pure monopoly exists when a single firm is the sole producer of a product for which there are no close substitutes.”

(ii) According toBraff, “Under pure monopoly there is a single seller in the market. The monopolists demand is market demand. The monopolist is a price-maker. Pure monopoly suggests a no substitute solution.”

(iii) According toLeftwitch, “Pure monopoly is a market situation in which a single firm sells a product for which there are no good substitutes. The firm has the market for the product all to itself. There are no similar products whose price and sales will influence the monopolist’s price or sales.”

Features of Monopoly

The main features of monopoly are as follows :

(1) Single Seller and Large Number of Buyers : Monopoly market consists single seller of the product but the number of buyers stands very large. No buyer can influence the price of the product due to his large number in the market.

(2) No Close Substitutes : Monopoly firm produces such commodity which has no close substitute and as a result the cross elasticity of demand becomes zero.

(3) Monopolist as a Price-maker : Being the single seller in the market, the monopolist firm is itself a price-maker. A monopolist firm can determine both price and quantity but not simultaneously (i.e., either price or quantity at a particular time).

(4) No Entry of New Firm : The entry of new firm into the industry is strictly prohibited. There is no competitor of monopoly firm in the market. (5) Demand Curve Negatively Sloped : Monopolist demand curve is negatively sloped and marginal revenue (MR) is less than average revenue (AR). The slope of demand curve depends on elasticity of demand.

\begin{array}{l} \mathrm{MR} = \mathrm{AR} \\ e 1 e \end{array}

e \operatorname{Or} \operatorname{AR} = \operatorname{MR} _ {e 1}

(6) Possibility of Price Discrimination : Price discrimination refers to the situation in which seller charges different prices from different consumers of different places for the same commodity. Monopoly market may have the possibility of price discrimination.

Firm is Price-maker in Monopoly

In monopoly, there is single producer (or seller) in the market and entry of new firm is strictly prohibited. In this market situation, there is no distinction between firm and industry,i.e., firm is industry and industry is firm. In monopoly, the demand curve is negatively sloped. Like a competitive firm, a monopolist is not price-taker but is price-maker. But a monopolist can not decide both price and quantity simultaneously. If he wants to increase the sale, he has to curtail down the price. In monopoly market,

Marginal Revenue < Average Revenue MR < AR because in monopoly e \mathrm { ~ 1 ~ } _ { \mathrm { M R } } = \mathrm { A R } _ { e }

^ {e} \mathrm{Or} \mathrm{AR} = \mathrm{MR} _ {e 1}

Thus, the relation between AR and MR d e pe nd s on th e elasticity of demand. Fig. 3 shows the AR and MR curves. Both

AR and MR fall but Fig . 3 MR is less than AR.

Box 3

Monopolist’s full Control on Price but Supply Quantity not Predetermined

A monopolist can not determine the price of his product and the demand quantity simultaneously. At a particular point of time he can either determine price or his sold quantity. If he fixes the price, he will adjust his supply as

per the demand from consumer side and contrary to it, if he wants to predetermine his supply level (i.e. , sold quantity) he has to sell at the price where his supply matches the demand from consumer side.

Box 4

Causes of Emerging Monopoly A few important reasons of emerging monopoly are as follows : (1) Centralisation of Raw

Material : When the raw material of the production of a particular commodity is centralised at a particular place, monop oly situation emerges. For example, Bengal was hav in g

Causes of Emerging Monopoly (1) Centralisation of

Raw Material (2) Legal Monopoly (3) Cut-throat

Competition (4) Patent Rights

Box 5

monopoly of jute industry before the partition of the country. (2) Legal Monopoly : Some monopoly is established

through the law. For example, when the government provides monopoly power of water distribution in a particular city to a particular industry, it gives birth to legal monopoly.

(3) Cut-throat Competition : When firms make cartels for saving them from cut-throat competition and controlling the supply of the commodity, monopoly emerges.

(4) Patent Rights : Patent rights also create monopoly situation. Producers obtain patent rights or trademark monopoly regarding the shape, design or other characteristics of the product. Patent rights prohibit the use of trademark by others.

12.2.4. Monopolistic Competition : Meaning

In real life, we do not have perfect competition or pure monopoly. The real market contains both the elements of competition and monopoly which is termed as monopolistic competition. In this market situation, a group of producers produce 'differentiated products' which is not identical but close substitutes to each other.

● Definitions :

(i) According to Leftwitch, “Monopolistic competition is a market situation in which there are many sellers of a particular product but the product of each seller is in some way differentiated in the minds of consumers from the product of every other seller.”

(ii) According to Leibhafsky, “Monopolistic competition has come today to mean a state of affairs in which there is large number of sellers selling nonhomogeneous or slightly differentiated products and in which freedom of entry exists.”

Thus, in monopolistic competition, there are a number of sellers producing differentiated products which are close substitutes to each other. A monopolistic competitive market contains both the elements of monopoly as well as competition.

● Features of Monopolistic Competition (1) Large Number of Sellers : This market contains a large number of sellers who compete with each other with close substitutes. Firms under monopolistic competition, an individual firm has a limited share in the market.

(2) Differentiated Product : The products produced by the firms of the group are not identical but close substitutes to each other. Their products differ from one another in shape, size, packing etc.

(3) Unrestricted Entry and Exit : Any firm may join the group and may produce another close substitutes. Unrestricted entry of firms increases the production of close substitutes.

(4) Selling Costs : Selling cost is the unique feature of monopolistic competition. Advertisement and publicity are important in this market situation. The expenses on advertisement and publicity are called 'Selling Costs' .

(5) Imperfect Knowledge of the Market : Buyers have imperfect knowledge of the market under monopolistic competition due to which buyers prefer a particular goods in comparison with its close substitution.

(6) Non-price Competition : It is a salient feature of mono-polistic competitive market. Firm provides many facilities for attracting the buyers. Such facilities include post-sale services, replacements, discount sale, gift scheme, etc.

(7) Price Policy of Firm : Like perfect competition, a monopolistic competitive firm is not pricetaker but every firm in the group has its own price policy. Monopolistic competitive firm decides price and quantity of its product.

Demand Curve in Monopolistic

Competition is More Elastic

Y Y

Perfect Competition _{Pure Monopoly}

e = \yen e <   1 _ {\mathrm{AR=MR}}

O

\mathrm{xMR} ^ {\mathrm{AR}} \mathrm{O} ^ {\mathrm{X}}

Y Monopolistic Competition

e _ {> 1 \mathrm{AR}}

^{MR XO} Fig . 4

Demand curve under monopolistic competition is more elastic and slopes downward from left to right. A demand curve under monopolistic competition is neither perfectly elastic like perfect competiton, nor unit elastic like pure monopoly. The demand curve under monopolistic competition is less elastic as compared with perfect competition and more elastic as compared with monopoly (see Fig. 4).

↓↓↓↓

Box 6

12.2.5. Oligopoly : Meaning

Oligopoly is that form of imperfect competition in which there are only few firms in the industry (or group) producing either homogeneous products or may be having ‘product differentiation’ in a given line of production. Important features of oligopolistic market are :

(i) Few sellers.

(ii) Interdependence among sellers regarding policies about price and output determination.

(iii) High cross elasticities of demand for products of different firms.

(iv) Advertisement and selling cost (i.e. Non-price competition).

(v) Constant struggle of rivals against rivals.

(vi) Indeterminateness of demand cruve.

(vii)Price Rigidity (As a result Kink demand curve ).

Classification of Oligopoly

(1) On the basis (2) On the basis of Production of Entry (3) On the basis (4) On the basis of Collusion of Price Leadership ↓↓ ↓ ↓ ↓↓ ↓ ↓ ↓ ↓ ↓ ↓

Perfect Imperfect Open Closed Oligopoly Oligopoly Oligopoly Oligopoly Collusive Oligopoly Non-collusive

Oligopoly Partial Complete Oligopoly Oligopoly ↓↓ ↓ ↓ ↓ ↓ ↓ ↓

When all firms make homogeneous products

When When firm outside make close firms substitute can freely

enter into group

No entry for outside firms into the group No

competition due to agreement among firms No agreement and firms compete each other When one firm dominates in market No acceptance of leadership (All firms do have equal status)

Box 7 12.3. Comparison among Various Markets

↓↓ ↓ Perfect Competition and Monopoly Perfect Competition and Monopolistic Competition Monopoly and Monopolistic Competition

12.3.1. Distinction between Perfect Competition and Monopoly Perfect Competition Monopoly

1. Average revenue and marginal revenue are equal. AR = MR

2. Price (AR) is equal to marginal cost (MC). AR = MC

3. Long-run production is possible only in constant cost conditions.

4. Normal profit is the only possibility in long-run.

5. Higher production quantity and lower price are obtained.

6. Firm obtains equilibrium at its optimum size.

7. No price discrimination is possible because buyer

8. Number of firms making homogeneous product is very large.

9. Entry and exit of firms in the industry is free and allowed.

10. Average revenue is greater than marginal revenue.

AR > MR

2. Price (AR) is greater than marginal cost (MC).

AR > MC

3. Long-run production is possible in all cost conditions : decreasing, constant and rising.

4. Profit is obtained in long-run under all the three cost conditions.

5. Higher price and lower production quantity are obtained.

6. Firm obtains equilibrium at its less than optimum size level.

7. Price discrimination is possible whic his profitable. has the perfect knowledge of the market.

8. Single firm in the industry, i.e., firm is industry and industry is firm.

9. Entry of new firm into the industry is prohibited.

12.3.2. Distinction between Perfect Competition and Monopolistic Competition Basis of

1. Nature of Commodity

2. Knowledge of Market

3. Mobility of Factors 4. Effect on Price of Commodity 5. Revenue Curve

4. Price and Cost 7. Selling Cost

5. Size of the Plant

Perfect Competition Monopolistic Competition

Homogeneous and identical product. Close substitutes ( i.e ., product No product differentiation. Perfect knowledge of market to both buyers and sellers. Perfect mobility among factors. Firm is price-taker and cannot influence the price. AR equals MR and both are parallel to X-axis. differentiation). Imperfect knowledge of market to both buyers and sellers. Imperfect mobility among factors. Not price taker but every firm has its own price policy. AR and MR both are highly elastic and fall from left to right, MR is less than AR.

Price = Marginal Cost No selling cost. Price > Marginal Cost Selling costs appear due to non-price competition.

Optimum size of the plant. Less than optimum size of the plant. 12.3.3. Distinction between Monopoly and Monopolistic Competition Basis of Difference 1. Nature of Commodity 2. Relation between Firm and Industry 3. Revenue Curve

4. Entry and Exit of Firms 5. Selling Cost

5. Price and Profit 7. Price Discrimination Monopoly Single product and no close substitute.

No difference between firm and industry because there is only one firm into the industry. AR and MR both fall but AR is relatively less elastic. In pure monopoly condition, more elastic (but not perfectly elastic

Monopolistic Competition Product differentiation, i.e ., products of firms are close substitutes. Group has a large number of firms. AR and MR both fall but AR is relatively

demand curve (AR) is rectangular hyperbola which has unit elasticity at all points. No entry of new firms.

Advertisements may be informative, not competitive. Firm obtains abnormal profit in the longrun. Price discrimination policy may be Firm may not charge different prices

from adopted. different consumers. like perfect competition).

Old firms may quit the group or new firms can join the group. Competitive advertisement may take place.

Firms obtain only normal profit in the longrun. 12.3.4. Distinction among Perfect Competition, Monopoly and Monopolistic Competition Basis of Difference 1. Status

2. Number of Buyers and Sellers 3. Nature of Product

3. Price Deter-mination Perfect Competition Unrealistic.

Large (unlimited) number of both buyers and sellers. Homogeneous and no product differentiation. Industry determines the price which is accepted by all firms. Firms are quantityadjusters at given price. Monopoly Unrealistic.

One seller but large number of buyers. Homogeneous and no product differentiation. Both price and quantity are determined by monopoly firm but both cannot be determined simultaneously.

Realistic (Market situation of real life). Large (but limited) number of both buyers and sellers. Commodities close substitutes; product differentiation appears. Both price and quantity are determined by firm but price policy of other firms is taken into consideration.

5. Price Constant price prevails. 6. Advertisement or Selling Cost

No advertisement. Means no selling cost Price discrimination may appear. Only informative advertisement.

7. Demand Curve 8. Profit Possibility 9. Production Capacity

10. Entry and Exit

Perfectly elastic demand curve.

Normal profit in long- run. Relatively less elastic or unit elastic demand curve.

Abnormal profit in long-run. Close substitute goods may have different prices.

Advertisement becomes essential part; selling costs appear; advertisement becomes a part of nonprice competition.

More elastic demand curve.

Normal profit in long-run.

Full utilisation of production capacity.

Free entry or exit by firms. No use of maximum production capacity.

No possibility of new firm entry.

No use of maximum production capacity.

Unrestricted entry of firms into the group.

A QUICK REVIEW OF THE CHAPTER

● Market : Market does not refer to any particular place but the entire area where buyers and sellers of a commodity are in such close contact with each other, that sale and purchase of the commodity is effected.

● Characteristics of Market : (i) One Area, (ii) One Commodity, (iii) Presence of both Buyers and Sellers, (iv) One Price of the Commodity.

● Types of Market (on the basis of Competition) : (i) Perfect Competition, (ii) Monopoly, (iii) Monopolistic Competition, (iv) Oligopoly.

● Perfect Competition : Perfect competition is a market situation where there is a large number of buyers and sellers of a homogeneous product. There is perfect knowledge and perfect mobility in the market. The price is determined not by the firm but by the industry. There is a single uniform price in the market.

● Features of Perfect Competition : (1) Large Number of Buyers and Sellers, (2) Homogeneous Product, (3) Perfect Knowledge, (4) Free Entry or Exit of the Firms, (5) Perfect Mobility, (6) No Extra Transport Cost.

● Monopoly : It refers to the market in which there is a single seller of a commodity with complete control over its price.

● Features of Monopoly : (1) A Single Seller and Many Buyers, (2) No Close Substitutes, (3) Full Control over Price, (4) Barriers to the Entry of New Firms, (5) Possibility of Extra-normal Profits both in the Short Period as well as Long Period, (6) Downward Sloping Demand Curve, (7) Possibility of Price Discrimination.

● Monopolistic Competition : It refers to the market in which there are large number of sellers selling differentiated products to a large number of buyers. Each firm has a partial control over price of the product.

● Features of Monopolistic Competition : (1) Large Number of Buyers and Sellers, (2) Product Differentiation, (3) Freedom of Entry and Exit, (4) Incurrence of Selling Costs, (5) Imperfect Knowledge of the Market, (6) Existence of Non-price Competition, (7) Firm’s demand curve slopes downward but is flatter than under monopoly.

QUESTIONS Ultra Short Answer Type Questions

1. In which market, firm is a ‘Price taker’ ?

(U.S.E.B., 2017) Or Under which form of market firm becomes price taker ? (C.B.S.E., 2017) 2. In which market form Average Revenue and Marginal Revenue of a firm always equal ? (C.B.S.E., 2010; J.A.C., 2012)

3. Under which market form, a firm cannot influence the price ? (C.B.S.E., 2010)

4. What is monopolistic competition? (U.S.E.B. , 2016)

5. To which market does price discrimination feature belong ? 6. How many firms are there in the monopoly market ? (J.A.C., 2011, 15, 19) 7. What is Oligopoly ? (U.S.E.B., 2014) Or Define Oligopoly. (B.S.E.B., 2014)

Very Short Answer Type Questions

1. Define Market of a Commodity. (J.A.C., 2010) Or Define Market. (J.A.C., 2014) 2. Define Perfect Competition. Or What is Perfect Competition ? 3. Define Pure Competition. 4. Define Monopoly. (C.B.S.E., 2010) Or What is Monopoly ? 5. Define Monopolistic Competition. Or

What is Monopolistic Competition ? 6. What is meant by differentiated products ? 7. When a firm is ‘price taker’ ? (U.S.E.B., 2011,13; C.B.S.E. (O.D.), 2013) 8. What is meant by Price Discrimination ? (U.S.E.B., 2011) 9. Why do the AR and MR become equal in Perfect Competition ? 10. Mention the difference between the demand curve of Monopoly and Monopolistic Competition. 11. Name the characteristics which make monopolistic competition different from perfect competition.

12. Explain one feature of oligopoly. 13. When is a firm ‘price maker’ ? ( C.B.S.E., 2010) (C.B.S.E., 2010) (C.B.S.E., 2011)

13. Draw the demand curve of a monopoly firm. (J.A.C., 2012, 14) 15. In which market does the condition AR = MR prevail ? (J.A.C., 2019) Short Answer Type Questions

14. Mention the basic features of Market. [U.S.E.B., 2010; J.A.C. (Comm. ), 2017, 18]

15. Mention three features of perfect competitive market. [J.A.C., 2015; U.S.E.B., 2016; B.S.E.B. (Comm. ), 2018] Or

Explain any two main features of perfect competition (J.A.C., 2014)

3. Differentiate between Perfect Competition and Pure Competition. (B.S.E.B., (Art ), 2014)

4. Elaborate three main features of monopoly form of market. (B.S.E.B., 2012, 13, 19; Raj. Board 2015; CBSE, 2019)

5. Distinguish between Perfect Competition and Monopoly. (J.A.C., 2014, 16)

6. Mention three main features of Monopolistic Competition. (U.S.E.B. , 2013; B.S.E.B., (Arts ) 2015)

7. Why is the demand curve under Monopolistic Competition become more elastic as compared to that of perfect competition ? (C.B.S.E., 2013)

8. Distinguish between Perfect Competition and Monopolistic Competition. [B.S.E.B., (Arts ) 2011, 18]

9. Mention any three features of perfect competition. Draw the AR curve in this market. (J.A.C., 2012, 14, 15) 10. What is the shape of demand curve of a firm in perfect competition ? (B.S.E.B., 2015, 18) 11. Draw average revenue (AR) and marginal revenue (MR) curves of a firm under perfect competition and monopoly. (U.S.E.B., 2017) 12. Draw demand curve facing a seller under condition of Perfect Competition, Monopolistic Competition and Monopoly, clearly reflecting the differences in their elasticities of demand. Draw all the three curves in a single diagram. (B.S.E.B. (Arts), 2013)

10. What is the difference between monopoly and monopolistic competition ? [J.A.C., 2014, 16; B.S.E.B. (Comm. ), 2018]

11. State any four features of imperfect competition. (J.A.C., 2011)

12. Explain the implications of freedom of entry and exit of firms under perfect competition. (C.B.S.E., 2011)

13. Explain the implication of ‘homogeneous product’ feature of perfect competition. (C.B.S.E., 2010, 15; J.A.C., 2016)

14. Why is number of firms small in an oligopoly market ? Explain. (C.B.S.E., 2010,12)

15. Explain the implications of the feature perfect knowledge of the market in perfect competition. (C.B.S.E., 2011)

16. Explain the implications of large number of sellers in perfectly competitive market. (C.B.S.E., 2012, 15)

17. Explain the implications of large number of buyers in perfectly competitive market. (C.B.S.E., 2012)

18. Why are firms interdependent in oligopoly market ? (C.B.S.E., 2012, 15)

19. Explain the feature ‘‘Large number of buyers and sellers’’ under perfect competition. (C.B.S.E., 2013)

20. Explain the monopolist’s equilibrium with average and marginal curves. (Raj. Board, 2013)

21. Explain the significance of ‘barriers to entry’ feature of monopoly. (C.B.S.E., A.I. , 2015)

22. Explain the significance of ‘product differentiation’ feature of monopolistic competition. (C.B.S.E., A.I. , 2015)

Long Answer Type Questions

1. Explain the implications of following in a perfectly competitive market : (C.B.S.E. , 2016, 18) (a) Large number of sellers

(b) Homogeneous product

2. Distinguish between monopoly and oligopoly. Mention the main features of monopoly. (U.S.E.B. , 2016)

3. Explain the implications of the following in an oligopoly market :

(C.B.S.E. , 2016, 18) (a) Barrier to entry of new firms

(b) A few big sellers

4. Define Market. Explain the four bases on which different markets are defined. [J.A.C., (Arts ) 2012, 14, 16, 18]

5. What is Perfect Competition ? Explain the characteristics of Perfect Competition.

(B.S.E.B. , 2010, 12; U.S.E.B., 2011; Raj. Board , 2016, 17)

6. Explain briefly the conditions that are necessary for Monopolistic Competition.

(C.B.S.E., 2013; B.S.E.B. (Arts), 2015,)

7. Define Perfect Competition and Monopoly. Explain the main differences between the two. (J.A.C., 2013)

8. What is Monopoly ? What are its main features ? (J.A.C., 2013; Raj.

Board, 2017) Or

Explain the important characteristics of Monopoly Market. [U.S.E.B., 2011; J.A.C. (Comm. ), 2017]

9. Explain three characteristics of Monopolistic Competition. Which of the characteristics separates it from perfect competition and why ? (C.B.S.E., 2018) 10. "Under Perfect Competition, the seller is a price-taker, under Monopoly, he is a price-maker." Explain. (U.S.E.B., 2013) 11. How is price determined under perfect competition ? Explain. (Raj. Board, 2013) 12.

What is oligopoly market ? Discuss its salient features. (U.S.E.B., 2012, 15, 17; Raj. Board, 2015 Or

What is oligopoly market? How do firms bahave in oligopoly? (Raj. Board , 2016) 13. Distinguish among perfect competition, monopoly and monopolistic competition. (U.S.E.B., 2012) 14. Explain the implications of the following :

(a) Freedom of entry and exit of firms under perfect competition (C.B.S.E., 2018) (b) Non-price competition under oligopoly

15. What is perfect competition ? Explain the characteristics of perfect competition. (J.A.C., 2019) 16. Distinguish between perfect comptition and Monopolistic competition on the basis of the following :

(C.B.S.E., 2019) (i) Number of sellers

(ii) Nature of Product

(iii) Selling cost

Objective Type Questions

(A) Multiple Choice Questions :

1. Which is a characteristic of the market ?

[ B.S.E.B. (Comm.), 2015] (a) One Area

(b) Presence of both Buyers and Sellers

(c) Single Price of the Commodity

(d) All the above

2. What does a monopolist market show ?

(a) Production process (c) Nature of market

( B.S.E.B., 2016, 19) (b) Distribution system (d) None of these

3. Market situation where there is only one buyer is :

(a) Monopoly (c) Duropoly

[ B.S.E.B., (Comm. ) 2012, 16] (b) Monopsony

(d) None of the above

4. In which market product differentiation is found ? (B.S.E.B., 2018, 19) (a) Pure Competition (b) Perfect Competition (c) Monopoly (d) Monopolistic Competition

Or

Differentiated product is a characteristics of :

( CBSE, 2018) (a) Monopolistic competition only

(b) Oligopoly only

(c) Monopoly

(d) Both monopolistic competition and oligopoly

5. Which of the following is true in perfect competition ? (a) Firm is pricetaker, not price-maker (b) Firm’s demand curve is perfectly elastic (c) AR = MR (d) All the above

6. Which one is not a feature of monopoly ? (B.S.E.B., 2010, 18) (a) One buyer and many sellers (b) Lack of Close Substitutes (c) Restrictions of New Firms (d) All the above

7. Which one of the following is true for monopoly ? (B.S.E.B., 2019) (a) Firm is price-maker (b) Demand curve slopes downward (c) Price discrimination possibility arises (d) All the above

8. Which one is a feature of monopolistic competition ? (B.S.E.B. (Comm. ), 2015) (a) Differentiated Product (b) Selling Cost (c) Imperfect Knowledge of the Market (d) All the above

9. A market in which there is free entry and exit, the market is : [B.S.E.B. (Arts), 2018] (a) Monopolistic Competitive Market (b) Imperfect Competitive Market (c) Perfectly Competitive Market (d) None of these

10. There are large number of buyers and sellers in : [C.B.S.E., 2017; MP Board, 2019] (a) Perfect competition only (b) Monopolistic competition only (c) Both a and b (d) Oligopoly

11. Which of the following remains constant in perfect competition ? [J.A.C. (Comm. ), 2017; B.S.E.B., 2019] (a) AR (b) MR (c) Both AR and MR (d) None of these

12. Which of the following is the feature of pure competition ? (a) Perfect knowledge of the market (b) Perfect mobility of factors (c) Homogenity by products (d) All the above

13. Which of the following is a feature of perfect competition ? (a) Large Number of Buyers & Sellers (b) Homogeneous Units of the Product (c) Perfect Knowledge of the Market (d) All the above

14. The concept of monopolistic competition is given by : (a) Hicks (c) Mrs. Robinson

[ B.S.E.B., (Arts ) 2012] (b) Chamberlin (d) Samuelson

15. Which of the following is not a feature of perfect competition ? [B.S.E.B., (Arts ) 2015] (a) Large number of buyers & sellers (b) Homogeneity of product

(c) Advertisement and selling cost

(d) Perfect knowledge of the market

16. In which market is AR equal to MR ?

[B.S.E.B., (Arts ) 2015; J.A.C., 2019] (a) Perfect competition (b) Oligopoly

(c) Imperfect competition (d) Monopoly

17. There is inverse relation between price and demand for the

product of a firm under : (C.B.S.E. , 2016) (a) only monopoly

(b) only monopolistic Competition

(c) both under monopoly and monopolistic competition (d) only perfect competition

18. Differentiated product is a characteristic of :

(C.B.S.E. , 2016) (a) only Monopolistic Competition

(b) only Oligopoly

(c) both Monopolistic Competition and Oligopoly (d) monopoly

19. Homogeneous product is a characteristic of :

(C.B.S.E. , 2016) (a) only perfect competition (b) only perfect oligopoly (c) Both (a) & (b) (d) None of the above [Ans. 1. (d), 2. (c), 3. (b), 4. (c), 5. (d), 6. (a), 7. (d), 8. (d), 9. (c), 10. (c), 11. (c), 12. (d), 13. (d), 14. (b), 15. (c), 16. (a), 17. (c), 18. (c), 19. (a).]

(B) Fill in the Blanks :

1. In perfect competition, producers should sell................... product in the market.

2. Demand curve of perfect competitive firm is............elastic.

3. In...................market, firm is price-taker.

4. Possibility of price discrimination arises in.......... market.

5. In Monopoly AR...................MR.

[Ans. 1. homogeneous, 2. perfectly, 3. perfect competition, 4. monopoly, 5. exceeds]

(C) State True/False

1. Perfectly competitive firm is not price maker.

2. A monopolist is price maker.

3. In perfect competition, AR = MR.

4. In monopoly there is one buyer and many sellers.

5. There is inverse relation between price and demand for the product of a firm under both monopoly and monopolistic competition.

[Ans. 1. True, 2. True, 3. True, 4. False, 5. True.] (D) Match the following

Column :

‘A’

1. Perfect competition

2. Monopoly

3. Market

4. Monopolistic competition

5. Pure competition

‘B’

(a) Single seller of a commodity

(b) Competition unallowed by monopoly elements

(c) One area

(d) Large number of buyers and sellers

(e) Differentiated product

(E) Answer in One Word :

1. In which market, firm is price taker ?

2. In which market AR = MR ?

3. In which market price discrimination take place ?

4. Product differentiation belongs to which market ? [Ans. 1. Perfect competition, 2. Perfect competition, 3. Monopoly, 4. Monopolistic competition.]

HOTS High Order Thinking Skills Questions

1. Perfectly competitive firm is not price-maker. Why ? (See : Box 1)

2. In which market situation a firm can adopt the policy of price discrimination ?

(See : Last Point of Monopoly Features in Section 12.2.3) VBQ Value

Based Questions

1. The concept of pure competition is narrow as compared with perfect competition. How ?

(See : Section 12.2.2)

2. In which market condition demand curve become the highest elastic ? (See : Box 6)

3. A monopolist is a price maker. How ? (See : Box 3) MDQ Case Study Based on Evaluation & Multi-disciplinary Questions

4. Why does the demand curve in monopolistic competition become more elastic ? (See : Box 6)

5. A firm in perfect competition is only quantity adjuster. Why ? (See : Box 1)

6. A monopolist cannot determine price and quantity demanded of a commodity simultaneously. Why ? (See : Box 4)

NCERT CORNER

Q. 1. What are the characteristics of a perfectly competitive market? Ans. See Section 12.2.1.

Q. 2. What is the ‘price line’ ?

Ans. Price line means the demand curve. (See Box 1) Q. 3. What is the relation between market price and marginal revenue of a price-taking firm ? Ans. Market price and marginal revenue of a pricetaking firm are equal to each other. See Box 1 [Ans. 1. (d), 2. (a), 3. (c), 4. (e), 5. (b).] ❐

STUDY MATERIAL INCLUDED IN

MARKET EQUILIBRIUM UNDER PERFECT COMPETITION AND EFFECTS OF SHIFTS IN DEMAND & SUPPLY

THE CHAPTER

13.1. What is Equilibrium Price ? 13.2. Determination of Equilibrium Price under Perfect Competition 13.3. Time Element and Equilibrium Price 13.4. Change in Demand and Equilibrium Price 13.5. Change in Demand and Equilibrium Price : Elasticity-based Two Exceptional Situations 13.6. Change in Supply and Equilibrium Price 13.7. Change in Supply and Equilibrium Price : Elasticitybased Two Exceptional Situations 13.8. Effects of a Simultaneous Change in Demand and Supply on Equilibrium 13.9. Price Determination in Monopoly A Quick Review of the Chapter Questions High Order Thinking Skills (HOTS) Questions Value Based Questions (VBQ) Case Study Based on Evaluation & Multi-disciplinary Questions (MDQ) NCERT Corner 13.1. What is Equilibrium Price ?

The word ‘ Equilibrium ’ means—absence of changing tendency. Hence, equilibrium price refers to that situation in which changing tendency in price determining forces

“Equilibrium price is that price which is determined by demand and supply forces at that point where the demand of commodity and the supply of the commodity become equal to each other.”

becomes absent.

Equilibrium Price Determining Factors

Demand of Supply of Commodity Commodity Equal to each other

Box 1

Equality between demand and supply at equilibrium price means that the determined price is acceptable to both buyers and sellers, i.e. , the quantity which the buyer wants to buy at equilibrium price, will be sold by the seller at the same price.

13.2. Determination of Equilibrium Price under Perfect Competition

Before Marshall , economists had a dispute over the issue of price determination in perfect competition. One viewpoint advocated for the price determination by cost of production (i.e. , supply side). David Ricardo was the pioneer of this viewpoint and outrightly ignored the role of demand side in price determination. Jevons, Walras, etc., on the other hand stressed on demand side in price determination. They advocated that price is determined by marginal utility of the commodity (i.e. , the demand side). Both the above viewpoints were contrary to each other.

Marshall ended this dispute by putting the view that price is determined by both the production cost (i.e. , supply curve) and utility of the commodity (i.e. , demand curve). According to Marshall, ‘‘The price is determined at that point where demand and supply of the commodity becomes equal to each other .’’

Marshall presented the example of a scissor. According to him, as both the blades of a scissor are essential to cut a piece of paper, similarly both the forces— demand and supply—will be essential in price determination.

Dispute in Equilibrium Price Determination Two Opposite Views David Ricardo Jevons and Walras

Price is determined by Cost Side i.e. , Supply Force

Both the views were co-ordinated by Marshall

Price is determined at the point where Price is determined by Utility Side, i.e. , Demand Force

Demand of Commodity = Supply of Commodity

Box 2 ● Price Determination by Equality between Demand and Supply : Table and Diagram Representation According to Marshall , ‘‘Price of a commodity is determined by both demand and supply curves .’’ Demand curve is related to the consumer and it falls down from left to right which explains the inverse relationship between demand of the commodity and its price. Consumer tries to buy more at lower price. On the other hand, supply curve belongs to producer

Table 1 Price per Unit (`) Supply of the Commodity

10 100 8 80

and it rises upward from left to right which explains the direct relationship between supply of the commodity and its price. Producer will place higher supply at higher price and vice versa . So the producer tries to sell more at higher price and vice versa . Hence, two opposite forces become operational in the market and the price is determined at the point where the demand for the commodity becomes equal to supply of the commodity.

Demand for the Commodity 20 40

660 60 4 40 2 20

Table 1 shows the demand and supply units of the commodity at various existing prices. Table explains that at price ` 10 per unit, the supply exceeds demand (100 > 20). This situation of ‘excess supply ’ will increase competition among sellers who reduce the price to sell its product. The process of this price cut continues till excess supply is eliminated and demand becomes equal to supply. In table, this equality between demand and supply appears at price ` 6 per unit which is the ‘equilibrium price ’ in the market. On the other hand, if price is reduced to ` 4 per unit, the situation of ‘excess demand ’ (80 > 40) arises which will push price in the market till the point where demand and supply become equal to each other. Table 1 is represented in Fig. 1.

80

100

Details

Excess Supply (Supply > Demand) Equilibrium (Demand = Supply) Excess

Demand (Demand > Supply) Fig . 1

In Fig. 1, DD and SS curves are demand and supply curves respectively. In perfect competition, with ‘price-mechanism ’ demand and supply forces determine the price where demand becomes equal to supply. The determined ‘equilibrium price ’ satisfy both the consumer and the seller (i.e. , where demand for the commodity becomes equal to supply of the commodity.) In Fig. 1, this equilibrium price is shown at point E. At equilibrium point E,

Equilibrium Price = OP Or EQ Demand for the Goods = Supply of the Goods

Equilibrium Quantity = OQ

At this equilibrium price, both the consumer and the seller are satisfied. What a seller wants to sell at a particular price, consumer wants to buy at that price.

If any change appears in this equilibrium price, demand and supply forces make action and reaction so as to re-establish the equality between demand and supply.

Two situations of change in equilibrium price may arise :

● (A) First Situation

If the prevailing price exceeds ‘equilibrium price ’, price starts declining due to ‘excess supply ’ and continues to decline till price becomes again equal to ‘equilibrium price ’.

In Fig. 1, if price is \mathrm { O P } _ { 1 }

Demand for the Goods \mathbf { \Sigma } = \mathbf { P } _ { 1 } a

Supply of the Goods \mathbf { \Sigma } = \mathbf { P } _ { 1 } b

Hence, ‘Supply Exceeds Demand ’

i.e. ,P₁ b>P₁ a

Distance ab ( i . e . , \mathrm { \bf ~ P } _ { 1 } \mathrm { \bf ~ b } - \mathrm { \bf ~ P } _ { 1 } \mathrm { \bf ~ a } ) shows excess supply. This excess supply ab brings down the price due to competition among sellers and the equilibrium price OP is retained.

Demand for the Commodity = Supply of the Commodity

● (B) Second Situation

If the prevailing price is less than ‘equilibrium price ’, price starts rising due to ‘excess demand ’ and continues to rise till price becomes again equal to ‘equilibrium price ’.

In Fig. 1, if price is \mathrm { O P } _ { 2 }

Demand for the Goods = P₂ d

Supply of the Goods = P₂ c

Hence, ‘demand exceeds supply ’

Distance cd ( i . e . , \mathrm { \bf ~ P } _ { 2 } \mathrm { \bf ~ d } - \mathrm { \bf ~ P } _ { 2 } \mathrm { \bf ~ c } ) shows excess demand. This excess demand cd raises the price due to competition among buyers and the equilibrium price OP is retained.

Above explanation shows that demand and supply forces are capable enough to maintain the following situation :

● In perfect competitive market, price is determined by demand and supply forces which is termed as ‘price determination by industry under perfect competition .

● In perfect competition, price is determined by the industry.

● In perfect competition, price determined by the industry is accepted by the every firm. i.e. ,

● In perfect competition, every firm in the industry is price-taker.

Y Industry Y
D
(Price Maker) Firm S (Price Taker)
E p AR=MR p
D
S
O X O X

Fig . 2

● In perfect competition, the individual firm may not alter the price, determined by the industry. Firm can only adjust the quantity produced at the price taken from the industry.

Box 3

13.3. Time Element and Equilibrium Price

Marshall presented the concept of ‘time element ’ in price determination process. According to Marshall, ‘‘Demand and supply forces re-adjust themselves in various production periods .’’ Marshall divided the various production periods on the basis of supply forces. Demand forces does not play any role in the classification of ‘time ’.

On the basis of supply, Marshall divided the production time into three periods :

(1) Very Short Period or Market Period, (2) Short Period,

(3) Long Period.

(1) Very Short Period or Market Period This period refers to the very short time duration in which no possibility of change in stock or increase in production arises. Supply becomes perfectly inelastic and as a result supply cannot be altered. Price is determined by both demand and supply forces but price is influenced by only demand conditions due to perfectly inelastic supply. Price rises proportionately to the rise in demand and vice versa . ☞ The price of a commodity which prevails in the market at a particular time is called market price.

Box 4

The time duration of very short period depends on the nature of the commodity. For perishable goods, this period is of one day. Green vegetable, fish, milk are examples of perishable goods. For durable goods (like wheat, egg, tea, etc.), this period may have duration of one week or more.

Fig . 3

The price determination in very short period is shown in Fig. 3. In this period, supply becomes totally passive in price determination and takes the shape of parallel straight line to Y-axis. Supply remains unaffected by

change in demand. When demand increases to \mathrm { D } _ { 1 } \mathrm { D } _ { 1 } , price increases to \mathrm { O P } _ { 1 } and when demand decreases to \mathrm { D } _ { 2 } \mathrm { D } _ { 2 } , price decreases to \mathrm { O P } _ { 2 }

(2) Short Period

In short period, supply is not perfectly inelastic but can be altered to some extent to match the changed demand conditions. In this period, fixed factors of the production cannot be changed and hence, supply can only be increased to a certain extent only. In short period, supply has more important role than that of very short period in price determination. In short-run, supply becomes active but due to many fixed factors in the short period, supply does not become as strong as demand in price determination. Fig. 4 shows the price determination process in the short period. Initial demand DD and initial supply SS cut each other at point E when the price OP and quantity OQ are determined.

Fig . 4

When demand rises to \mathrm { D } _ { 1 } \mathrm { D } _ { 1 } in short-run, production quantity (i.e. , supply) can be increased to \mathrm { O Q } _ { 1 } but demand being more stronger than supply, price rises to \mathrm { O P } _ { 1 } from OP. Similarly, when demand decreases to \mathrm { D } _ { 2 } \mathrm { D } _ { 2 } , supply is reduced to \mathrm { O Q } _ { 2 } and price also declines to \mathrm { O P } _ { 2 }

(3) Long Period

Long period refers to that market duration in which supply can fully be adjusted to changed demand conditions. In this period, every factor of production becomes variable and as a result supply becomes \boxed { \overline { { \overline { { 3 } } } } } Price determined by demand and supply forces in long-run is called 'Normal Price '. According to Marshall , "Normal price is that price which tends to prevail

in a market when full time is given to the forces of demand and supply to adjust themselves."

Box 5

highly elastic and plays the dominant and active role in price determination.

● Comparison among all the Three Time Periods : Single Diagram Representation :

Price determination in perfect competition takes place on the basis of demand and supply conditions. The elasticity of supply depends on the time period. As time duration increases, supply elasticity also increases. The effect of time period on price determination has been shown in Fig. 5.

Fig . 5

☞

Very Short Period : Perfectly inelastic supply, price totally influenced by demand conditions only. Short Period : Supply can be adjusted to an extent, intensive use of fixed factors by increasing variable factor; less elastic supply.

Long Period : All production factors become variable; full adjustment in supply in accordance with changed demand becomes possible; high elastic supply.

Box 6

In figure,

MPS → Market Period Supply Curve which is perfectly

inelastic (e = 0) supply cannot be increased beyond \mathrm { O Q } _ { 1 }

SRS → Short-run Supply Curve which is less elastic (e < 1), supply can partially be increased to \mathrm { O Q } _ { 2 }

LRS → Long-run Supply Curve which is highly elastic (e > 1); supply can fully be adjusted and can be increased to \mathrm { O Q } _ { 3 }

In Fig. 5, initially \mathrm { D } _ { 1 } \mathrm { D } _ { 1 } demand curve cuts all the three supply curves MPS, SRS and LRS at point E where price and quantity are determined at OP and \mathrm { O Q } _ { 1 } respectively. Now if demand rises \mathrm { D } _ { 1 } \mathrm { D } _ { 1 } , \mathrm { t o } \mathrm { D } _ { 2 } \mathrm { D } _ { 2 } , all the three time periods will react differently to this demand increase.

In changed situation,

(i) Very Short Period or Market Period →New Equilibrium Point \mathrm { E } _ { 1 } { \mathrm { P r i c e } } = \mathrm { O P } _ { 1 }

Quantity = OQ₁ (unchanged) i.e. , price rises to \mathrm { O P } _ { 1 } from OP.

(ii) Short Period → New Equilibrium Point \mathrm { E _ { 2 P r i c e } = O P 2 }

Quantity = \mathrm { O Q } _ { 2 }

i.e. , price rises to \mathrm { O P } _ { 2 } and quantity gets increased to \mathrm { O Q } _ { 2 }

Figure explains that new short-run price \mathrm { O P } _ { 2 } is less than new market price { \mathrm { O P } } _ { 1 } \left( { \mathrm { O P } } _ { 2 } < { \mathrm { O P } } _ { 1 } \right) . It happens because supply in the short-run can be increased to \mathrm { O Q } _ { 2 } from \mathrm { O Q } _ { 1 } due to less elastic supply conditions.

(iii) Long Period → New Equilibrium Point \mathrm { E _ { 3 P r i c e } = O P 3 }

\text {Quantity} = \mathrm{OQ} _ {3}

i.e. , supply can be increased to { \mathrm { O Q } } _ { 3 } from \mathrm { O Q } _ { 1 } due to high elastic supply. Due to more adjusting nature new long price \mathrm { O P } _ { 3 } less than new market price ( \mathrm { O P _ { 1 } } ) and new short-run price \mathbf { ( O P _ { 2 } ) } ).

i. e., \mathrm{OP} _ {3} <   \mathrm{OP} _ {2} <   \mathrm{OP} _ {1}

Thus, it is clear that ‘‘as production time period increases, supply plays more dominant role in price determination.’’

13.3.1. Market Price and Normal Price

A deep relation is found between market price and normal price. Market price

has changing tendency

which normal price signifies

a permanent trend. After

every change, market price

has the tendency to become

equal to normal price. In

other words, market price

tends to oscillate, i.e. ,

moves up and down around

the normal price. Market Fig . 6 price tends to be equal to normal price momentarily. (See Fig. 6.)

Comparison between Market Price and Normal Price Market Price

1. Market price is determined in very short period under perfect competition.

2. Demand side is stronger than supply side in this pricedetermination because in very short period supply remains constant.

3. It is determined by unstable equilibrium between demand and supply and as a result fluctuations in market price appear.

4. Producer can earn profit, normal profit or even loss in this market price.

5. Market price is a reality which actually prevails in the market.

6. Market price is a fluctuating phenomenon and it

Normal Price

1. Normal price is determined in long period with demand and supply conditions under perfect competition.

2. Supply is more stronger in this price determination because in long-run supply can fully be adjusted to chan-ged demand conditions.

3. It is determined by stable equilibrium between demand and supply.

4. Only normal profit is obtained in this normal price.

5. Normal price is a myth.

6. Normal price is a stable phenomenon. oscillates around the normal price (see Fig. 6).

Box 7 13.4. Change in Demand and Equilibrium Price Supply conditions remaining constant, change in demand brings change in determined equilibrium price and quantity demanded. The important reasons for change in demand are :

● Change in consumer’s income. ● Change in price of related goods. ●

Change in availability of substitute. ● Population increase.

● Change in fashion, taste, etc.

Change in Demand and Equilibrium Price

Increase in Demand Decrease in Demand

Increase in Increase in

Equilibrium Equilibrium

Price Quantity

13.4.1. Increase in Demand

Supply remaining constant, increase in demand alone brings rise in both price and quantity demanded. Decrease in Decrease in Equilibrium Equilibrium Price Quantity

13.4.2. Decrease in Demand

Fig. 8 shows the equilibrium when the demand alone decreases (while the supply curve SS remains constant).

Fig. 7

Fig. 7 shows the equilibrium when the demand alone increases (while supply curve SS remains constant).

Initially, DD and SS curves cut each other at point E where the price OP and quantity OQ are determined. With the supply curve remaining same ( i . e . remaining SS), the changed demand curve \mathrm { D } _ { 1 } \mathrm { D } _ { 1 } finds new equilibrium point at \mathrm { E } _ { 1 } with new price \mathrm { O P } _ { 1 } and new quantity \mathrm { O Q } _ { 1 }

Fig. 8

Initially, DD and SS curves cut each other at point E where the price OP and quantity OR are determined. With the supply curve remaining same (i.e. , remaining SS), the changed demand curve \mathrm { D } _ { 2 } \mathrm { D } _ { 2 } finds new equilibrium point at \mathrm { E } _ { 2 } with new price \mathrm { O P } _ { 2 } and new quantity \mathrm { O Q } _ { 2 }

13.5. Change in Demand and Equilibrium Price : Elasticity-based Two Exceptional Situations

Change in Demand

Increase in Demand Decrease in Demand

When Elasticity of Supply When Elasticity of Supply When Elasticity of Supply When Elasticity of Supply is Perfectly Elastic e _ { \textup { s } } =

is Perfectly Inelastic e _ { \textrm { s } } { = } 0

is Perfectly Elastic

e _ {\mathrm{s}} =

is Perfectly Inelastic e _ { \textrm { s } } { = } 0

No Change in Equilibrium Price but Increase in Equilibrium Quantity Increase in Equilibrium Price but no Change in

Quantity

No change in Equilibrium Price but Decrease in Equilibrium Quantity Decrease in Equilibrium Price but no Change in Quantity

13.5.1. Increase in Demand and Supply Elasticity

● When Elasticity of Supply is Perfectly Elastic ( \pmb { e } _ { \textrm { \bf s } } = )

Increase in demand for a commodity does not bring any change in its price when the supply of the commodity is perfectly elastic but it brings an increase in equilibrium quantity.

Fig. 9 shows the E as the point of equilibrium where perfectly elastic supply curve (SS) intersects demand curve (DD). OP is the equilibrium price. Forward shift in demand curve from DD to \mathrm { D } _ { 1 } \mathrm { D } _ { 1 } leaves price of the commodity unaffected at OP. The quilibrium point shifts from E to \mathrm { E } _ { 1 } indicating increase in equilibrium quantity from OQ to \mathrm { O Q } _ { 1 }

will be obtained at \mathrm { E } _ { 2 } . Price remains constant at OP but new quantity gets reduce to \mathrm { O Q } _ { 2 } from OQ.

Fig. 9

● When Elasticity of Supply is Perfectly Inelastic ( \textbf { \em e } _ { \textbf { s } } = \textbf { 0 } )

In the situation of perfectly inelastic supply, increase in demand causes a full impact on price of the commodity keeping the equilibrium quantity unchanged.Fig. 10 shows E as the point of equilibrium where perfectly inelastic supply curve (SS) intersects demand curve (DD). OP is the equilibrium price.

Fig. 11

● When Elasticity of Supply is Perfectly Inelastic ( \textbf { \em e } _ { \textbf { s } } { = } \textbf { 0 } )

With perfectly inelastic supply, decrease in demand brings increase in price but new equilibrium quantity remains the same.

In Fig. 12, \mathsf { S } _ { 1 } \mathsf { S } _ { 1 } is perfectly inelastic supply with initial DD curve, equilibrium price OP and equilibrium quantity OQ are obtained with decreased demand, new \mathrm { D } _ { 2 } \mathrm { D } _ { 2 } curve reduces price to \mathrm { O P } _ { 2 } but the new quantity remains constant at OQ.

Fig. 10

Forward shift, i.e. , increase in demand curve from DD to \mathrm { D } _ { 1 } \mathrm { D } _ { 1 } shifts equilibrium point from E to \mathrm { E } _ { 1 } . The price of the commodity increases from OP to \mathrm { O P } _ { 1 } but equilibrium quantity remains constant at OQ.

13.5.2. Decrease in Demand and Supply Elasticity

● When Elasticity of Supply is Perfectly Elastic ( \pmb { e } _ { \textrm { \bf s } } = )

When the supply of the commodity is perfectly elastic, decrease in demand for a commodity does not cause any change in its price but the new equilibrium quantity is reduced.

Fig. 11 shows the initial equilibrium level at point E with initial DD and SS curves where OP price and OQ quantity are determined. On decrease in demand, new demand curve becomes \mathrm { D } _ { 2 } \mathrm { D } _ { 2 } . New equilibrium

Fig. 12

Change in Demand and Supply Elasticity

● Increase or decrease in demand for a commodity does not cause any change in its price in case of perfectly elastic supply ( \boldsymbol { \mathrm { e } } _ { \mathrm { s } } = \infty ) of the commodity; only equilibrium quantity change.

● In a situation of perfectly inelastic supply ( \mathbf { e } _ { \mathrm { s } } = 0 ) , increase or decrease in demand causes a full impact on price of the commodity in the same direction but equilibrium quantity remains constant.

Box 8

13.6. Change in Supply and Equilibrium Price

Remaining demand conditions constant, change in supply (increase or decrease) brings change in both equilibrium price and equilibrium quantity. The main reasons for the change in supply are :

● Change in price of raw material (It brings change in cost of production).

● Change in labour cost i.e. , wages.

● Use of new production technique.

● Extension or contraction of production scale.

Change in Supply and Equilibrium Price Increase in Supply Decrease in Supply Decrease in Equilibrium Price 13.6.1. Increase in Supply Increase in Equilibrium Quantity Increase in Equilibrium Price 13.6.2. Decrease in Supply Decrease in Equilibrium Quantity

Remaining the demand conditions constant increase in supply brings a decrease in price and increase in equilibrium quantity.

Fig. 14 shows the situation of decrease in supply (when demand condition remains constant).

Fig. 13

Figure 13 shows that while demand remains unchaged due to increase in supply, the supply curve shifts downwards (rightwards) from SS to \mathsf { S } _ { 1 } \mathsf { S } _ { 1 } The new supply curve \mathsf { S } _ { 1 } \mathsf { S } _ { 1 } intersects the demand curve at point \mathrm { E } _ { 1 } . Thus, new equilibrium point will be \mathrm { E } _ { 1 } . At point \mathrm { E } _ { 1 } , the equilibrium price will fall from OP to \mathrm { O P } _ { 1 } and equilibrium quantity increases from OQ to \mathrm { O Q } _ { 1 }

Fig. 14

Due to decrease in supply, the supply curve will shift upwards (leftwards) from SS to \mathsf { S } _ { 2 } \mathsf { S } _ { 2 } . T he new supply curve \mathsf { S } _ { 2 } \mathsf { S } _ { 2 } intersects the demand curve at point \mathrm { E } _ { 2 } . At point \mathrm { E } _ { 2 } , the equilibrium price will increase from OP to \mathrm { O P } _ { 2 } and equilibrium quantity decreases from OQ to \mathrm { O Q } _ { 2 }

13.7. Change in Supply and Equilibrium Price : Elasticity-based Two Exceptional Situations

When Demand is Perfectly Elastic e _ { d } =

When Demand is Perfectly Inelastic \boldsymbol { e } _ { d } = 0

When Demand is Perfectly Elastic e _ { d } =

When Demand is Perfectly Inelastic \boldsymbol e _ { d } { = } 0

No Change in Equilibrium Price but Increase in Equilibrium Quantity

Decrease in Equilibrium Price but no Change in Quantity No Change in Equilibrium Price but Decrease in Quantity Increase in Equilibrium Price but no Change in Quantity

13.7.1. Increase in Supply and Demand Elasticity

● When Demand is Perfectly Elastic ( e _ { d } = ) Fig. 15 shows the change in price and quantity when supply increases with the perfect elastic demand. Initial demand curve DD and supply curve SS intersect at point E where equilibrium price OP and equilibrium quantity OQ are obtained. With perfect elastic demand, when supply increases to \mathsf { S } _ { 1 } \mathsf { S } _ { 1 } , the new equilibrium point becomes \mathrm { E } _ { 1 } which indicates no price change but increases the equilibrium quantity to \mathrm { O Q } _ { 1 } from OQ.

● When Demand is Perfectly Inelastic ( \textbf { \em e } _ { d } = \textbf { 0 } ) Fig. 18 shows the effect on price and quantity when supply alone decreases (while the demand is perfectly inelastic). Initial equilibrium point is E where initial DD and SS curves intersect each other. A point \mathrm { E } , price OP and quantity OQ were determined. When supply decreases, with new supply curve \mathsf { S } _ { 2 } \mathsf { S } _ { 2 } , new equilibrium takes place at point \mathrm { E } _ { 2 } which brings no change in quantity but new price increases from OP to \mathrm { O P } _ { 2 } .hange i

Fig. 15

● When Demand is Perfectly Inelastic ( \textbf { \em e } _ { d } = \textbf { 0 } ) Fig. 16 shows the change in price and quantity when supply decreases with the perfect inelastic demand. Fig. 16 shows E as the point of equilibrium where supply curve SS intersects perfectly inelastic demand curve DD. OP is the equilibrium price. Downwards shift in supply curve from SS to \mathsf { S } _ { 1 } \mathsf { S } _ { 1 } leaves equilibrium quantity of the commodity unchanged at OQ. The

equilibrium point shifts from E to \mathrm { E } _ { 1 } indicating decrease in equilibrium price from OP to \mathrm { O P } _ { 1 }

Fig. 16

13.7.2. Decrease in Supply and Demand Elasticity ● When Demand is Perfectly Elastic ( e _ { d } = )

Fig. 17 shows the change in price and quantity when the supply decreases with the perfect elastic demand. With initial demand curve DD and supply curve SS, OP price and OQ quan-tity are determined at equilibrium point E. Due to decrease in supply, new supply curve becomes \mathsf { S } _ { 2 } \mathsf { S } _ { 2 } and new equilibrium takes place at \mathrm { E } _ { 2 } with no change in price OP but the equilibrium quantity will be reduced to \mathrm { O Q } _ { 2 } from OQ.

Fig. 17 Fig. 18

Change in Supply and Demand Elasticity

(i) Increase or decrease in supply of a commodity does not cause any change in its price in case of perfectly elastic demand of the commodity, only equilibrium quantity changes—quantity increases with increase in demand and quantity decreases with decrease in demand.

(ii) In a situation of perfectly inelastic demand, increase or decrease in supply causes a full impact on price of the commodity in opposite direction (i.e. , increase in supply causes fall in price and decrease in supply causes rise in price) but equilibrium quantity remains constant.

Box 9

13.8. Effects of a Simultaneous Change in Demand and Supply on Equilibrium

So far, we have confined ourselves to the effects of change in demand alone or change in supply alone on equilibrium price.

But in real life, there are simultaneous changes in demand and supply. With the help of the following diagrams, we can study the effect of simultaneous changes in demand and supply on equilibrium price under two heads :

I. Simultaneous Increase in Demand and Supply. II. Simultaneous Decrease in Demand and Supply. I. Simultaneous Increase in Demand and Supply There are three possibilities of simultaneous increase

in demand and supply :

(A) When Increase in Demand is greater than Increase in Supply In Fig. 1 9 ( \mathrm { A } ) , \mathrm { D } _ { 1 } \mathrm { D } _ { 1 } is the initial demand curve and \mathsf { S } _ { 1 } \mathsf { S } _ { 1 } is the initial supply curve. \mathrm { O P } _ { 1 } is equilibrium price and \mathrm { O Q } _ { 1 } equilibrium quantity. Due to increase in demand , \mathrm { D } _ { 2 } \mathrm { D } _ { 2 } becomes the new demand curve. Due to increase in supply, new supply curve takes the shape of \mathsf { S } _ { 2 } \mathsf { S } _ { 2 } . In this situation, demand has increased more than supply. Hence, price increases to \mathrm { O P } _ { 2 } and quantity to \mathrm { O Q } _ { 2 } . Consequently, when demand increases more than supply, both price and quantity will rise.

(B) When Increase in Demand and Increase in Supply both are Equal Fig. 19

In Fig. 19 (B), the situation is shown in which increase in demand is equal to the increase in supply. Hence, price remains unchanged, i.e. , \mathrm { O P } _ { 1 } but the equilibrium quantity increases from \mathrm { O Q } _ { 1 } to \mathrm { O Q } _ { 2 } . Thus, when demand and supply increase equally, no change in equilibrium price takes place but equilibrium quantity increases.

(C) When Increase in supply is more than Increase in Demand

In Fig. 19 (C), a situation is shown in which increase in supply is more than increase in demand. Hence, price falls from \mathrm { O P } _ { 1 } \mathrm { O P } _ { 2 } but the quantity Fig. 20 increases from \mathrm { O Q } _ { 1 } to \mathrm { O Q } _ { 2 } . Thus, when supply increases more than demand, price tends to fall but quantity increases.

II. Simultaneous Decrease in Demand and Supply There are three possibilities of simultaneous decrease in demand and supply :

(A) When decrease in demand is more than decrease in supply

In Fig. 20 ( \mathrm { A } ) , \mathrm { D } _ { 1 } \mathrm { D } _ { 1 } is the initial demand curve and \mathsf { S } _ { 1 } \mathsf { S } _ { 1 } initial supply curve. \mathrm { O P } _ { 1 } is equilibrium price and \mathrm { O Q } _ { 1 } is equilibrium quantity. Due to decrease in demand, new demand curve takes the shape of \mathrm { D } _ { 2 } \mathrm { D } _ { 2 } and due to decrease in supply, new supply curve takes the shape of \mathsf { S } _ { 2 } \mathsf { S } _ { 2 } . In this situation, demand has decreased more than supply. Hence, price decreases to \mathrm { O P } _ { 2 } and quantity to \mathrm { O Q } _ { 2 } Consequently, when demand decreases more than supply, both price and quantity decrease.

(B) When Decrease in Demand and Decrease in Supply both are Equal In Fig. 20 (B) the situation is shown in which decrease in demand and decrease in supply both are equal. Hence, price remains unchanged (i.e. , \mathrm { O P } _ { 1 } ) but the equilibrium quantity decreases from \mathrm { O Q } _ { 1 } to \mathrm { O Q } _ { 2 } . Thus, when demand and supply decrease equally, no change in equilibrium price takes place but equilibrium quantity decreases.

(C) When Decrease in Supply is more than Decrease in Demand In Fig. 20 (C), the situation is shown in which decrease in supply is more than decrease in demand. Hence, price rises from \mathrm { O P } _ { 1 } to \mathrm { O P } _ { 2 } but the quantity decreases from \mathrm { O Q } _ { 1 } to \mathrm { O Q } _ { 2 } . Thus, when supply decreases more than demand, price tends to rise but quantity decreases.

13.9. Price Determination in Monopoly ● (I) Monopoly Price or Equilibrium during Short Period

During short period, monopoly price, normal profit and loss do production work in three conditions. It is a wrong concept that monopoly always earns profit only during short period. In which situation the monopoly will work under profit, normal profit and loss during short period, it will depend on the demand curve of market and on the cost conditions of the market monopoly firm like the complete competitive firm can also face loss during short period. In the situation of short period loss, the monopolist will think to do the production upto that point upto which he does not get the cost of the goods equal to Average Variable Cost (AVC) or more than that. Generally monopolist does not get close substitute of the produced goods. because of which the monopolist can make efforts to equal the cost of goods to the average cost in order to prevent his loss during short period but it is only an effort. We cannot deny the possibility of monopoly loss in short period. The situation of loss for the monopolist during short period is not the impossible condition. In brief, all the possible situations of monopoly during short period can be understood with the help of following figures :

Fig . 21 : Monopoly : Short Period Profit (i) Profit Situation : The short period profit situation of monopolist is shown in Figure 21. The demand curve AR of monopoly goods and its related marginal revenue curve MR are shown in the figure. The balance of monopoly is shown at point E. Where both the conditions of monopoly balance are being fulfilled. At this point MR = MC. In the situation of this balance, the cost of the goods will be RX or OP. At this cost, the monopolist will do the production of OX goods. In the figure, per unit cost is SX or OQ i.e ., the monopolist is getting continuous profit equal to the distance RS. It is clear from the figure that the monopolist will get profit equal to PRSQ on the whole output OX. In brief,

Fig . 22 : Monopoly : Normal Profit Because at point

R, AR = AC

In brief, Price = OP

Output = OX

Monopolist is getting zero profit.

(iii) Situation of Loss : The situation of short period loss of monopolist is shown in Figure 23. The demand of monopoly goods can be so much weak in some circumstances that the price of monopoly goods could be reduced even from the average cost of the goods. It will be the situation of loss. The monopolist on getting more price from the Average Variable Cost (AVC) in short period works in the hope that this loss in the long-term will be converted into profit. In the figure RX is the per unit cost of the goods whereas SX is the average cost of that per unit i.e ., per unit output is undergoing loss of SR. The output of goods is OX because of which, the output is under going in loss equal to PRSQ.

Output = OX
Total Loss = Per unit Loss × Total Output = QP.OX
= PQSR Area

= PQRS Area

Price = OP

Output = OX

Total Profit = Per Unit Profit × Output = PQ.OX

(ii) Situation of Normal Profit : The normal profit of monopolist is shown in Figure 22. The normal profit is also called zero profit. Normal profit means that the monopolist determines the price of goods equal to the average production cost of the goods. In the figure, the balance point of monopolist is E. Where the average cost of the goods RX and price of the goods both are there. In this situation, the monopolist is not getting any surplus.

Fig . 23 : Monopoly : Short Period Loss In brief Price = OP

● (II) Monopoly Price or Equilibrium during Long Period

There is complete control of the producer on supply in the monopoly market. Long period is that period of production wherein monopolist fully adjusts his supply according to demand situations. That is why it is said that the price is mainly determined on the basis of supply situations in long period. The monopolist will adjust the supply of the goods in market in order to profit maximisation so that he could get profit in every situation. In short period, the supply could not be adjusted according to demand due to limited period because of which, the conditions of profit, normal profit and loss in short period monopoly market are created but the monopolist gets only profit due to the adjustment of supply in long period. Per Unit Profit = OP – OR = PR or ST

Total Profit PRTS Area.

(ii) Monopoly Balance in Constant Returns Situation (or Constant Cost Situation) : In Figure 25, the monopoly balance in constant returns situation is shown where average cost and marginal cost are mutually equal due to constant returns.

Fig. 24

The firm and industry get internal and external economies in the beginning due to large scale output in long period but these savings get converted into diseconomies after one point. When the firm and industry get internal and external savings, then the law of increasing returns to scale is applied i.e., the marginal cost gets decreased gradually on increasing the size of output. As the size of the output gets increases and the marginal cost decreases, then the average cost also decreases but the rate of decreasing of average cost is less than the decreasing of the rate of marginal cost. In the similar process, we get one such ideal point on increasing more output quantity where marginal cost and average cost should be mutually equal. This, we call the rule of constant returns to scale. After this point, the internal and external savings get converted into diseconomies and the law of decreasing returns to scale is applied. The marginal cost gets increased in such situation, As a result of which, the average cost also gets increased but the marginal cost increases rapidly than the average cost.

All three situations of monopolist in long–term increasing returns, constant returns, and decreasing returns get profit.

(i) Monopoly Balance in Increasing Returns Situation (or Decreasing Cost Situation) : In Figure 24, the monopoly balance is shown in the increasing returns (or decreasing cost) situation where AC and MC both are declining but MC curve declines more rapidly. According to balance situations, there will be the monopoly balance on point E where both the conditions of balance are being fulfilled.

At balance point E,

Per Unit Price = OP or SQ Per Unit Cost = OR or TQ

Total Output = OQ
Fig. 25
At balance point E
Per Unit Price = OP or SQ
Per Unit Cost = OR or EQ.
Total Output = OQ
Per Unit Profit = PR or SE

Total Profit = PRES Area

(iii) Monopoly Balance in Decreasing Return Situation (or Increasing Cost Situation) : In Figure 26, Monopoly balance in decreasing returns situation (or increasing cost situation) is shown. Both AC and MC increases due to decreasing returns but MC is more than AC.

Fig. 26

At balance point E,

Per Unit Price = OP or SQ

Per Unit Cost = OR or TQ

Total Output = OQ

Per Unit Profit = PR or ST

Total Profit = PRTS Area

Thus, there is profit to monopolist in all kinds of cost situations during long period.

A QUICK REVIEW OF THE CHAPTER

● Equilibrium : Equilibrium is a state in which forces making change in opposite direction are perfectly in balance so that there is no tendency to change.

● Equilibrium Price : The equilibrium price, is the price at which demand and supply are equal to each other or where purchases and sales of buyers and sellers respectively coincide.

● Equilibrium Quantity : Equilibrium quantity is that quantity at which quantity demanded is equal to quantity supplied.

● Determination of Equilibrium Price : Equilibrium price is determined at the point where supply is equal to demand.

● Time Element and Equilibrium Price : Shorter the time period, greater will be the significance of demand in price determination, similarly, longer the time period, greater will be the significance of supply in price determination.

(1) Very Short Period : In the very short period, supply is fixed. It is a period of time when supply can at best be increased upto the existing stocks. Production cannot be increased because very short period, by definition, is the one during which all factors of production are constant. (2) Short Period : During the short period, supply can be increased to some extent with greater application of variable factors. Accordingly, the significance of supply increases in the determination of equilibrium price.

(3) Long Period : In long period, supply can fully be adjusted itself to all possible changes in demand, as in the long period, all factors are variable and can be employed to increase output to any extent. In long-run, supply becomes fully active in price determination.

● Market Price : It is the price determined by demand and supply forces in very short period. This price actually prevails in the market and it fluctuates and oscillates around normal price.

● Normal Price : It is long-run price which is determined by stable equilibrium between demand and supply. Market price oscillates around normal price.

● Effects of Change in Demand on Price : If supply remains, increase in demand raises and decrease in demand lowers the price.

● Two Specific Situations of Change in Demand :

(A) Change in Demand in case of Perfectly Elastic Supply : Increase or decrease in demand for a commodity does not cause any change in its price in case supply of the commodity is perfectly elastic. Only the equilibrium quantity increases or decreases respectively.

(B) Change in Demand in case of Perfectly Inelastic Supply : Increase or decrease in demand for a commodity does not cause any change in equilibrium quantity in case the supply of the commodity is perfectly inelastic. Only the equilibrium price increases or decreases respectively.

● Effects of Change in Supply on Price : Demand remaining constant, increase in supply means fall in equilibrium price and decrease in supply means rise in equilibrium price.

● Two Specific Situations of Change in Supply :

(A) Change in Supply in case of Perfectly Elastic Demand : Increase or decrease in supply of a commodity does not cause any change in its price in case demand for the commodity is perfectly elastic. Only the equilibrium quantity increases or decreases respectively.

(B) Change in Supply in case of Perfectly Inelastic Demand : In case of perfectly inelastic demand decrease in supply results in an increase in price and increase in supply leads to a decrease in price. The equilibrium quantity remains constant.

● Effect of a Simultaneous Change in Demand and Supply on Equilibrium Price : (1) When demand increases more than supply equilibrium price will increase. (2) When demand and supply increase equally no change takes place in price. (3) When supply increases more than demand price falls.

QUESTIONS Ultra Short Answer Type Questions

1. Who has given the concept of time element in the determination of price ?

2. What is known as short-run price ?

3. What is market price ?

4. What is normal price ?

5. What do you mean by equilibrium price ?

Very Short Answer Type Questions

1. Define Equilibrium Price. ( B.S.E.B. , 2014; J.A.C., 2015)

2. Define Market Equilibrium.

3. What is meant by Equilibrium Quantity ?

4. Define excess demand for a commodity in the market ?

5. Define excess supply for a commodity in the market ?

6. Where is the Equilibrium Price determined ? [B.S.E.B ., 2016 (Comm. )]

7. Who determines price under Perfect Competition ? (B.S.E.B ., 2019)

8. What is the shape of demand curve of a firm under Perfect Competition ?

9. How is price affected by Decrease in Demand ? 13. What is price taker firm ? (C.B.S.E., 2012) 14. Explain the difference between excess demand and excess supply. (Raj. Board, 2017) 15. What is market price ? [B.S.E.B. (Arts), 2018]

Short Answer Type Questions

1. What is meant by Equilibrium Price and Equilibrium Quantity ?

2. What is equilibrium price ? Give diadram.(J.A.C., 2019)

3. How the price is determined under Perfect Competition ? (J.A.C., 2013)

4. What can be the effect on an increase in both the market demand and

market supply of a commodity on its price ? Explain.

5. Explain with the help of a diagram the effect of a decrease in supply of a commodity on its Equilibrium Price and Quantity.

6. Explain with the help of a diagram the effect of an increase in the supply of a commodity on its Equilibrium Price and Quantity.

7. ‘‘Demand and supply are the two blades of scissors.’’ Explain this statement with reference to price determination.

8. What do you mean by equilibrium price ? How is it determined ? (B.S.E.B ., 2010)

9. How is price determined under Monopoly market ? (B.S.E.B ., 2010) 10. Explain the relation between market price and normal price. (U.S.E.B., 2011)

10. What are the effects of simultaneous change in demand and supply on equilibrium price ?

11. If the prevailing market price is above the equilibrium price, explain its chain of effects. (C.B.S.E., 2018)

Long Answer Type Questions

1. Differentiate between Market Price and Normal Price. (J.A.C. (Comm. ), 2017)

2. What do you mean by Equilibrium Price ? How is it determined in perfect competition ? Explain with the diagram. (J.A.C., 2012, 16)

3. What do you understand by Equilibrium Price ? How is it affected by Demand and Supply ?

4. How equilibrium price will be affected when demand decreases ? (J.A.C ., 2011)

5. Market for a good is in equilibrium. There is simultaneous “Increase” both in demand and supply of the good. Explain its effect on market price.

[C.B.S.E ., 2012; J.A.C. (Arts ), 2017]

6. Market for goods is in equilibrium. There is an ‘increase’ in supply of good. Explain the chain of effects of this change. (C.B.S.E ., 2011)

7. How will the Equilibrium Price and Equilibrium Quantity be affected, if supply curve shifts downward while demand curve remains constant ?

8. Define Equilibrium Price. Explain with the help of a diagram the effect of an increase in demand of a commodity on its Equilibrium Price and Equilibrium Quantity. (C.B.S.E ., 2011)

9. How is price determined under monopoly ? Discuss. [B.S.E.B ., 2012; U.S.E.B. , 2016; J.A.C ., 2016 (Arts )] 10. What do you mean by Perfect Competition? Discuss the conditions of short-run equilibrium of a firm under perfect competition. (J.A.C ., 2019) 11. Define equilibrium price of a commodity. How is it determined? Explain with the help of a schedule. Or

With the help of a demand and supply schedule, explain the meaning of

excess demand and its effect on price of a commodity.

12. ‘‘Under perfect competition, the seller is a price taker, under monopoly he is the price maker.’’ Explain. (U.S.E.B., 2015) 13. Define the relationship of Average Revenue and Marginal Revenue under perfect competition with diagram. 14. How is price determined in perfect competition ? (J.A.C., 2015; U.S.E.B., 2019) 15. Market for a good is in equilibrium. Explain the chain of reactions in the market if the price (i) higher than equilibrium price and (ii) lower than equilibrium price. (C.B.S.E., 2012) 16. Why a perfectly competitive firm in long run may not earn supernormal profit ? Explain. (C.B.S.E., 2013) 17. Explain the role of time element in the determination of price in perfect competition.

13. The market for commodity X is in equilibrium. The prices of its inputs fall. Explain with the help of a diagram its chain of effects on equilibrium price, quantity demanded and quantity supplied. (C.B.S.E., 2015) 19. Draw a diagram from the following table and find the equilibrium price :

Price in ` 10

Demand 100

Supply 20

(U.S.E.B., 2017, 19) 15 20 25 30 80 60 40 20 40 60 80 100 (a) Bargaining

(c) Marginal utility (b) Production cost (d) Demand & supply 13. In perfect competition, a firm : (a) Determines price (c) Both a & b

(b) Obtains price (d) None of these

Objective Type Questions

(A) Multiple Choice Questions :

1. Which factor determines Equilibrium Price ?

2. In very short period, supply will be : (B.S.E.B., 2012) (a) Perfectly elastic

(c) Elastic

(b) Perfectly inelastic (d) None of the above

(a) Demand for Commodity (c) Both a & b

( B.S.E.B. , 2016, 19) (b) Supply of Commodity (d) None of the above

2. Who said, ‘‘Price is determined by both Demand and Supply Forces” ? [B.S.E.B. , 2011 (Arts )] (a) Jevons (b) Walras

(c) Marshall (d) None of the above

3. Price of a commodity is determined at a point where : (B.S.E.B., 2018; U.S.E.B., 2019) (a) Demand exceeds (b) Supply exceeds (c) Demand equals supply (d) None of the above

4. What is true for perfect competition market ?

(a) Price is determined by both Demand and Supply Forces (b) Price is determined by the industry

(c) Each firm of the industry is Price-taker

(d) All the above

5. Who gave the concept of ‘ Time Element ’ in price determination process ?

(a) Ricardo

(c) Marshall

[ B.S.E.B. (Arts ), 2018] (b) Walras

(d) J.K. Mehta

6. How many categories of production duration have been made by Marshall on the basis of supply ? (a) Two (b) Three (c) Four (d) Seven

7. Which is a reason of change in demand ? (a) Change in Consumer’s Income (b) Change in Prices of Related Goods (c) Population increase (d) All the above

8. Which statement is correct ?

(a) In very short period, supply is perfectly inelastic, price is affected by both demand conditions.

(b) Supply curve elasticity depends on time period

(a) Demand > Supply (c) Demand = Supply

15. Which is not a condition for equilibrim of a monopoly firm ? (B.S.E.B.

(Arts ), 2015) (a) Average Revenue = Marginal Cost

(b) Marginal Revenue = Marginal Cost

(c) Marginal Cost should cut the Marginal Revenue Curve

from below

(d) Both b & c

16. Demand curve of a firm is perfectly elastic under : (C.B.S.E. , 2016, 18)

(a) Perfect Competition

(b) Monopoly

(c) Monopolistic Competition

(d) Oligopoly

17. A perfect competitive firm faces :

[B.S.E.B. (Comm. ), 2017] (a) Fixed Price (b) Constant AR (c) Constant MR

(d) All the above

18. In equilibrium position : [B.S.E.B. (Comm. ), 2018]

(a) The amount to be sold is equal to the amount to be purchased

(b) Market supply is equal to market demand

(c) Neither the firm nor the consumer wants to be destabilised

(d) All the above

19. In every market situation which condition is necessary to be fulfilled for a firm’s equilibrium ? (B.S.E.B., 2018)

(a) AR = MC (b) MR = MC

(c) MC curve should cut the MR curve from below

(d) B and C both

20. Price of a good is determined at a point where ?

(c) Both a & b

(d) None of the above 9. Market Price is found in :

(a) Short Period Market [B.S.E.B., 2011, 16, 17, 18] (b) Long Period Market

( B.S.E.B., 2019) (b) Demand < Supply

(d) None of these

(c) Very Short Period Market (d) None of these 10. The price of a goods is determined by : [J.A.C., 2018]

(a) Demand (b) Supply

(c) Both demand & supply (d) Government 11. Market price is associated with : [B.S.E.B. (Arts ), 2018]

(a) Price of very short period (b) Normal price (c) Permanent price (d) All the above 12. The price of a goods in perfect competition is determined

by :

[Ans. 1. (c), 2. (c), 3. (c), 4. (d), 5. (c), 6. (b), 7. (d), 8. (c), 9. (a), 10. (c), 11. (a), 12. (d), 13. (b), 14. (b), 15. (a), 16. (a), 17. (d), 18. (d), 19. (d), 20. (c)]

(B) Fill in the Blanks :

1. Price of a commodity is determined by both...............and ..............curves.

2. In a...................period, supply becomes totally inelastic. 3. Long-run price is also termed as...................price. 4. ...................price is a fluctuating phenomenon.

3. Long-run supply curve is highly...................

4. The price at which demand and supply become equal is called ............. price.

[Ans. 1. demand; supply, 2. very short, 3. normal, 4. Market, 5. elastic, 6. normal]

(C) State True/False :

1. Price of a commodity is determined at a point where demand equals supply.

(D) Match the following Column :

‘A’

1. Price of short period

2. Price of long period

3. Supply becomes totally inelastic

4. Determination of price of a good

5. Point where demand and supply are equal

[ Ans. 1. (e), 2. (a), 3. (b), 4. (c), 5. (d).]

(E) Answer in One Word :

1. In which market firm’s demand curve is perfectly elastic ? 2. Which word is used for Long-run price ?

2. In which production period market price is found ? 4. What is the essential condition of firm’s equilibrium ?

[Ans. 1. Perfect competition, 2. Normal price, 3. Short Period, 4. MR = MC.]

HOTS High Order Thinking Skills Questions

1. What is the role of demand force in classification of production time ? (See : Section 13.3)

2. Normal price is a stable phenomenon. Why ?

(See : Section 13.3.1)

3. With perfectly inelastic supply increase in demand brings change in price. Why ?

[See : Second Point of Section 13.5.1 (Fig. 10)]

VBQ Value Based Questions

1. Normal price shows a stable tendency while the market price has the tendency of change. How ?

(See : Section 13.3.1)

2. How does the price react with simultaneous change in demand and supply ?

(See : Section 13.8)

3. With which condition of supply, increase in demand makes no change in price ?

(See : First Point of Section 13.5.1 Fig. 9)

MDQ Case Study Based on Evaluation & Multi-disciplinary Questions

1. If supply is perfectly inelastic, what will be the result of increase in demand ?

(See : Fig. 10)

2. When the increase in demand and increase in supply are equal, what will be the effect on equilibrium price ? [See : Fig. 19 (B)]

3. Market price is found in long period.

4. On the basis of supply, Marshall has divided the production in seven categories.

5. The price of a good in perfect competition is determined by demand and supply.

6. Normal price is constant.

[Ans. 1. True, 2. False, 3. False, 4. True, 5. True.]

‘B’ (a) Normal price

(b) Very short period

(c) Both demand and supply (d) Equilibrium price

(e) Market price

3. When equilibrim price of a good is less than its market price, there will be competition among the sellers. Why ? Give reason. [See : Fig. 1 and its explaination]

NCERT CORNER

Q. 1. What is the relation between market price and average revenue of a price-taking firm ? Ans. Market price and average revenue of a pricetaking firm are equal to each other. Thus,

Market Price = Average Revenue Q. 2. What is the supply curve of a firm in the shortrun ?

Ans. The supply curve of a firm in the short run is the rising part of the Short-run Marginal Cost (SMC) curve from and above minimum Average Variable Cost (AVC) together with 0 (zero) output for all prices less than the minimum Average Variable Cost (AVC).

Q. 3. What is the supply curve of a firm in the longrun ?

Ans. The supply curve of a firm in the long-run is the rising part of the Long-run Marginal Cost (LMC) curve from the above minimum Long-run Average Cost (LAC) together with 0 (zero) output for all prices less than the minimum Long-run Average Cost (LAC).

Q. 4. Explain market equilibrium.

Ans. See Section 13.2

Q. 5. When do we say there is excess demand for a commodity in the

market ?

Ans. See Section 13.2

Q. 6. When do we say there is excess supply for a commodity in the market ? Ans. See Section 13.2

Market Equilibrium Under Perfect Competition........Demand & Supply

Q. 7. What will happen if the price prevailing in the market is :

(i) above the equilibrium price ?

(ii) below the equilibrium price ?

Ans. See Section 13.2

Q. 8. Explain, how price is determined in a perfectly competitive market with fixed number of firms.

Ans. See Section 13.2

Q. 9. Suppose the price at which equilibrium is attained in Question 5 is above the minimum average cost of the firms constituting the market. Now if we allow for free entry and exit of firms, how will the market price adjust to it ?

Ans. If there is free entry and free exit of firms, the equilibrium price is always equal to minimum average cost of the firms because if price exceeds minimum average cost it shows profit which attracts more firms till profit is changed to zero profit and vice versa .

Q. 10. At what level of price do the firms in a perfectly competitive market supply when free entry and ex it i s allow ed in t he m arke t ? How is equilibrium quantity determined in such a market ?

Ans. Price will remain fixed at perfectly competitive market supply. The quantity supplied will be

determined by the market demand and supply. If the market demand increases, there will be no change in the price but equilibrium quantity will increase.

Q. 11. How is the equilibrium number of firms determined in a market where entry and exit is permitted ?

Ans. Hint :

Number of Firms = Total Market Supply

Supply of a Firm Q. 12. How are equilibrium price and quantity affected when income of the consumers :

(a) increase (b) decrease

Ans. (a) See, Section 13.4.1

(b) See, Section 13.4.2

Q. 13. Using supply and demand curves, show how an increase in the price of shoes affects the price of a pair of socks and the number of pairs of socks bought and sold.

Ans. Shoes and pair of socks are complementary goods. In case of complementary goods, a fall in the price of one goods (shoes) will cause the demand of the other goods (socks) to rise andvice versa.

Q. 14. How will a change in price of coffee affect the equilibrium price of tea ? Also explain the effect on equilibrium quantity also through a diagram.

Fig. 27

Ans. Tea and coffee are substitute goods. In case of substitute goods, a fall in the price of one goods (coffee) will cause the demand of the other goods (tea) to fall andvice versa.

Q. 15. How do the equilibrium price and quantity of a commodity change when price of input used in its production changes ? Ans. When price of input used in the production of a commodity changes, the supply of the commodity also changes. A rise in the price of input will reduce the supply of the commodity and supply curve will shift leftward. A fall in the price of input will increase the supply of the commodity and supply curve will shift rightward. In both the cases, equilibrium price and equilibrium quantity will change.

Q. 16. If the price of a substitute (Y) of goods X increases, what impact does it have on the equilibrium price and quantity of goods X ? Ans. X and Y are substitute goods. When the price of Y increases, there will be an increase in the demand of X. As a result, the demand curve of goods X will shift rightward. The equilibrium price will increase and equilibrium quantity will increase.

Q. 17. Compare the effect of shift in demand curve on the equilibrium when the number of firms in the market is fixed with the situation when entry-exit is permitted.

Ans. When the number of firms in the market is fixed, the equilibrium of the market is determined at a price when market demand equals market supply. If there is shift in the demand curve, the equilibrium position will also change. An increase in demand will increase both price and quantity and vice versa.

But when the entry and exit is permitted, the equilibrium price will be equal to the minimum average cost of the firms because with free entry and exit, each firm will always earn normal profit. As a result, supply curve is perfectly elastic. In such a case, increase in demand will raise the quantity andvice versa but price will remain constant in both the cases.

17

Introductory Micro Economics

Q. 18. Explain through a diagram the effect of a rightward shift of both the demand and supply curves on equilibrium price and quantity. Ans. See Section 13.8

Q. 19. How are the equilibrium price and quantity affected when : (a) both demand and supply curves shift in the same direction? (b) demand and supply curves shift in opposite directions ? Ans. See Section 13.8

Q. 20. A shift in demand curve has a larger effect on price and smaller effect on quantity when the number of firms is fixed compared to the situation when free entry and exit is permitted. Explain.

Ans. When the number of firms is fixed, a shift in demand curve will affect the equilibrium price as well as equilibrium quantity. A rightward shift in the demand curve will increase both the equilibrium price and quantity andvice versa. On the other hand, when free entry and exit of firms is permitted, a shift in demand curve will not affect the equilibrium price but will affect only the equilibrium quantity. A rightward shift in the demand curve will increase the quantity and a leftward shift will decrease the quantity. Hence, the given statement is true.

Q. 21. Suppose the demand and supply curves of commodity X in a perfectly competitive market are given by :

\boldsymbol {q} ^ {\mathrm{D}} = 7 0 0 - \boldsymbol {p}

q ^S = 500 + 3 p for p 15

= 0 for 0 p < 15

Assume that the market consists of identical firms. Identify the reason behind the market supply of commodity X being zero at any price less than ` 15. What will be the equilibrium price for this commodity ? At equilibrium, what quantity of X will be produced ?

4 p = 2 0 0

p = 5 0

Hence, equilibrium price is`50

Equilibrium quantity is = 700 -p = 700 - 50 = 650 Q. 22. Considering the same demand curve as in Question 21, now let us allow for free entry and exit of the firms producing commodity X. Also assume the market consists of identical firms producing commodity X. Let the supply curve of a single firm be explained as $q^{S} = 8 + 3p$ for $p$ 20 $_{f}$ = 0 for 0 $p < 20$ (a) What is the significance of $p = 20$ ? (b) At what price will the market for X be in equilibrium ? State the reason for your answer. (c) Calculate the equilibrium quantity and number of firms. Ans. Demand curve for a commodity is $q^{D} = 700 - p$ Supply curve of a single firm is $q^{S} = 8 + 3p$ for $p$ 20 = 0 for 0 $p < 20$ (a) The significance of $p = 20$ is that it is the minimum average cost of the firms. A firm is not willing to supply at a price lower than this. (b) The market for X will be in equilibrium at a price of `20 because with free entry and exit market will be in equilibrium at a price which equals the minimum average cost of the firms. At this price market supply will be equal to the market demand. (c) From the demand curve, we get equilibrium quantity : Ans. Market demand curve is $q^{D} = 700 - p$ Market supply curve is $q^{S} = 500 + 3p = 0$ for $p$ 15 for 0 $p < 15$ The market supply of commodity X will be zero at any price less than `15 because it is the minimum average cost of producing commodity X. The firms will be at loss if they supply at a price less than `15. Thus, supply curve will start from `15 as a price. At Equilibrium Price $q^{D} = q^{S}$ $700 - p = 500 + 3p$ $q_{0f} = 700 - 20 = 680$ $Atp_{0} = 20$ each firm supplies $q_{0f} = 8 + 3p$

$q_{0\mathrm{f}} = 8 + (3\times 20) = 68$ Equilibrium number of firms is $q^{0}n_{0} = _{q0f}$ $= 680$ 68 $= 10$ Market Equilibrium Under Perfect Competition......Demand & Supply 175

q ^ {\textbf {D}} = 1, 0 0 0 - p

\boldsymbol {q} ^ {\mathrm{S}} = 7 \boldsymbol {0 0} + 2 \boldsymbol {p}

(a) Find the equilibrium price and quantity. (b) Now suppose that the price of an input used to produce salt has increased so that the new supply curve is

q ^S = 400 + 2p How does the equilibrium price and quantity change ? Does the change conform to your expectation ?

(c) Suppose the government has imposed a tax of ` 3 per unit of sale of salt. How does it affect the equilibrium price and quantity ?

Ans. Demand curve of salt is $q^{D} = 1,000 - p$ Supply curve of salt is $q^{S} = 700 + 2p$ (a) At equilibrium, demand and supply of salt are equal Therefore, $q^{D} = q^{S}$ $1,000 - p = 700 + 2p$

- 3p = -300 3p = 300 p = 100 Equilibrium Price = `100 Equilibrium Quantity = 1,000 - p = 1,000 - 100 = 900 (b) Demand curve of salt is $q^{\text{D}} = 1,000 - p$ New supply curve of salt is input used to produce salt increases, supply is reduced at a given price. Hence, both equilibrium price and quantity have decreased from their previous level. (c) Tax (+) = `3 Pre-tax demand curve is 1,000 - p Post-tax demand curve is 1000 - 3 - p 997 - p Pre-tax supply curve is 700 + 2p Post-tax supply curve is = 700 + 2 (p - 3) = 700 + 2p - 6 = 694 + 2p At Equilibrium $q^{\text{D}} = q^{\text{S}}$ 997 - p = 694 + 2p 3p = 303 p = 303/3 p = `101 Equilibrium Price = `101 Equilibrium Quantity = 997 - p = 997 - 101 = 896 As a result of tax of `3 per unit, equilibrium price has increased from `100 to `101 and equilibrium quantity has decreased from 900 to 896. Q. 24. Suppose the market determined rent for apartments is too high for common people to afford. If the government comes forward to help those seeking apartments on rent by imposing control on rent, what impact will it have on the market for apartments ? Ans. If the government fixes the rent below the $q^{\text{S}} = 400 + 2p$ Therefore, $q^{\text{D}} = q^{\text{S}}$ 1,000 - p = 400 + 2p -3p = 400 - 1,000 3p = 600 p = 200 Equilibrium Price = `200 Equilibrium Quantity = 1,000 - p = 1,000 - 200 = 800 Increase in Price = 200 - 100 = `100 Decrease in Quantity = 900 - 800 = 100. The changes in equilibrium price and quantity

conform to our expectations. When price of an market determined (equilibrium) rent, quantity supplied in the market will be less than quantity demanded which will lead to excess demand of the apartments for rent because government would not allow to have the rent more than the controlled rent. In order to meet this situation, the government has to arrange apartments at controlled rent. If the government fails to do it, it will lead to black marketing.

Q. 25. A monopoly firm has a total fixed cost of ` 100 and has the following demand schedule : Quantity 1 2 34 5678910 Price 100 90 80 70 60 50 40 30 20 10 Find the short–run equilibrium quantity, price and total profit. What would be the equilibrium in the long-run ? In case the total cost was ` 1,000, describe the equilibrium in the short–run and in the long–run.

176 Introductory Micro Economics Ans.

Quantity Price TR ( Q )( P )( Q × P ) 1 100 100

Quantity Price IR (Q)(P)(Q*P) 1100 100
2 90 180
3 80 240
4 70 280
5 60 300
6 50 300
7 40 280
8 30 240
9 20 180
10 10 100

Short–run equilibrium quantity = 6
Price = ` 50

Profit = 300 – 100 = ` 200 In the problem, monopoly firm has fixed cost. Hence, a firm will be at equilibrium where MR is zero. Q. 26. If the monopolist firm of Question 4, was a public sector firm. The government set a rule for its manager to accept the government fixed price as given ( i.e ., to be a price–taker and therefore, behave as a firm in a perfectly competitive market) and the government decide to set the price so that demand and supply in the market are equal. What would be the equilibrium price, quantity and profit in this case ? Ans. If the government sets a rule for the firm to accept the government

fixed price as given the equilibrium price will be equal to ` 10, quantity supplied will be 10 and profit will be zero. Q. 27. Comment on the shape of the MR curve in case the TR curve is a (i) positively, (ii) horizontal straight line.

Ans.

(i) When TR curve is positively sloped straight line, MR curve is horizontal straight line because MR changes at a Constant Rate due to uniform price. It is shown as under :

(ii) When TR curve is horizontal straight line, MR curve is negatively sloped straight line. It is shown as under :

MR TC Profit (Addition to TR) (TR - TC)
— 100 Nil
80 100 80
60 100 140
40 100 180
20 100 200
0 100 200
- 20 100 180
- 40 100 140
- 60 100 80
- 80 100 Nil

Fig. (ii)

Q. 28. Will the monopolist firm continue to produce in the short–run if a loss is incurred at the best short–run level of output? Ans. A monopolist firm will continue to produce in the short–run even with the losses if price exceeds AVC.

Fig. (i) Fig. (iii)

Q. 29. Explain why is the demand curve facing a firm

under monopolistic competition negatively sloped.

Ans. Demand curve facing a firm under monopolistic competition is negatively sloped because it can sell more goods only by lowering the price. It means price and demand are inversely related to each other. Hence, Demand Curve (AR) becomes negatively sloped.

Q. 30. What is the reason for the long–run equilibrium of a firm in monopolistic competition to be associated with zero profit ?

Ans. Under monopolistic competition, there is free entry and exit of firms. In case of profit, more new firms will join the group and convert the profit into zero profit. In case of loss, few firms will leave the group and loss will be converted into zero profit.

Q. 31. List the three different ways in which oligopoly firms may behave.

Ans. There are three ways :

(1) Collusion of firms to avoid competition.

(2) Small firms may accept the leadership of dominant firm.

(3) Firms may adopt price rigidity policy for showing no interest in price change.

Q. 32. If duopoly behaviour is one that is described by Cournot, the market demand curve is given by the equations q = 200 – 4 p and both the firms have zero costs, find the quantity supplied by each firm in equilibrium and the equilibrium market price.

Ans. Market Demand Curve Equation $q = 200 - 4p$ $200 - 4p = 0$ $4p = 200$ Equilibrium Price $(p) =$ `50 Equilibrium Quantity $(q) = 200$ 50 = 4 Number of Firms = 2 Quantity supplied by each firm = 4 2 = 2

Q. 33. What is meant by prices being rigid ? How can oligopoly behaviour lead to such an outcome ? Ans. Price rigidity means that oligopolist firms are unwilling to change the price. Once a price has been determined, a firm will avoid changing it. Price cut will be followed by all which will curtail down firm's profit while price rise may not be followed by other firms which will reduce the sale of price raising firm. Hence, no tendency of price change.

口

14

SIMPLE APPLICATIONS OF TOOLS OF DEMAND AND SUPPLY

STUDY MATERIAL INCLUDED IN THE CHAPTER

14.1. Introduction 14.2. Application of Demand and Supply Curves in Price Determination of Commodity

14.3. Application of Demand and Supply Curves in Factor Price Determination 14.4. Application of Demand and Supply Curves in Food Availability Decline Theory Questions High Order Thinking Skills (HOTS) Questions Value Based Questions (VBQ) Case Study Based on Evaluation & Multi-disciplinary Questions (MDQ) NCERT Corner

14.1. Introduction become important in ‘Commodity Price Determination ’

Demand and supply forces play the decision-making as well as ‘Factor Price Determination ’. In both the circumstances equality between demand and supply

role in economic analysis. Both Demand and Supply tools determines the price.

Application of Demand and Supply Tools in Economic Analysis Commodity Price Determination Factor Price Determination Rent Wage Interest Profit

14.2. Application of Demand and Supply Curves in Price Determination of Commodity

Demand and supply are two important forces which play dominant role in price determination.

In the market, the price of the commodity is determined at a point where

Demand for Commodity = Supply of Commodity

The price at which demand for and supply of the commodity becomes equal, is termed as ‘equilibrium price ’. In other words, equilibrium price refers to that price at which buyer (i.e., demand side) is ready to buy and the seller (i.e., supply side) is ready to sell. Buyers demand the commodity due to its utility while the seller sells it for earning profit.

In the words of Marshall, “The ‘equilibrium price’ is the price at which the quantity of goods which the sellers are willing to offer is equal to the quantity which the buyers want to purchase.

● Demand for Commodity

The demand for the commodity is made by the buyer because of its utility. In practise, the demand for the commodity is

governed by the ‘Law of

Demand’, i.e., higher

demand by the consumer

at lower price and less

demand at higher price.

Thus, consumer’s (or

buyer’s) Demand Curve

DD slopes downward from

^{left to right. Fig. 1} ● Supply of Commodity

Supply of the commodity

is made by the seller

because seller (or

producer) wants to earn

profit by selling the com

modities. In practise, the

supply of the commodity is governed by the ‘Law of Supply ’, i.e., more quantity of the commodity is supplied at higher price_{Fig. 2and less quantity at lower} price. Thus, the supply curve of the commodity slopes upward from left to right which states the direct

^{relationship between price and quantity supplied.} ● Commodity Price : Demand-

Supply Equilibrium Buyer wants to give the least price while the seller wants to take the maximum price of the commodity. Barga-ining takes place between both the parties and at last, the price of the commodity is determined at the price where both demand for and supply of the

Fig . 3

commodity become equal. This price is called ‘ equilibrium price ’. If Fig. 3, price determination of the commodity by

demand and supply forces has been shown. Demand Curve DD and Supply Curve SS cut each other at point E where price OP is determined. This price OP (or EQ) shows the equilibrium price.

14.2.1. Price Limits

Government makes intervention to fix limits of price to alter the price determined by demand and supply forces :

(i) Price Ceiling Limit, (ii) Price Floor

Limit. (i) Price Ceiling Limit : This price ceiling limit signifies that price which a seller can charge at the maximum due to government

intervention. In Fig 4, this price ceiling is shown at price \mathrm { O P } _ { 1 }

Fig . 4

If the prevailing market price OP seems to be higher to the government, it may fix the price ceiling of OP₁ price to provide a relief to the poor people. To solve the problem of

excess demand ( i.e., scarce supply) this price takes help of rationing and fixes a limited constant consumption quota for every income group people.

(ii) Price Floor Limit : Price floor limit signifies that minimum price which government fixes at the minimum to support the producers. For agricultural products this price is known as minimum support price .

Fig. 5 shows that in case of excess supply, government fixes price floor limit at \mathrm { O P } _ { 2 } , so as to prevent any price fall tendency appearing due to excess supply cd . Such price floor limit saves the producers from losses.

14.3. Application of Demand and Supply Curves in Factor Price Determination

Demand and supply forces also play dominant role in factor price (i.e., their reward) determination. According to the modern theory of distribution, the factor price is determined by demand and supply forces in the same way as commodity price is determined by demand and supply forces. In perfect competition, factor price is determined at that point where the demand for factor becomes equal to its supply. Hence, the modern theory of distribution is termed as ‘Demand and Supply Theory of Factor Price Determination ’.

● Demand for Factor

Factor demand is not direct demand but it is derived (or indirect) demand i.e., demand for factors of production depends on the demand for goods which are produced with these factors. For example, labour demand for cloth industry depends on the demand for finished cloth. Higher demand for cloth increase the demand for labour in cloth industry and vice versa.

● Supply of Factor

Supply of factor of production is determined by its opportunity cost. Opportunity cost is that money income which can be obtained by factor of production in next best alternative use. Hence, a factor of production must get that award in its present use which it can obtain in next best alternative use. Higher the supply of factor, higher will be the supply of production. Hence, the supply curve of a factor slopes upward from left to right.

Fig. 5 Fig. 6

● Factor Price : Demand-Supply Equilibrium

The reward to a factor of production will be determined at that point where factor demand becomes equal to factor supply. In Fig. 6 factor demand curve DD and factor supply curve SS cut each other at point E where factor price OP is determined. If factor price increases to \mathrm { O P } _ { 1 } , factor supply exceeds factor demand which brings down factor price to OP. On the contrary side, if factor price comes down to \mathrm { O P } _ { 2 } , factor demand exceeds factor supply which pushes factor price to OP.

14.3.1. Application of Demand and Supply in Determination of Rent

Modern economists feel that the rent arises due to ‘specificity of the factor’ or the supply elasticity of the factor.

According to modern economists, the supply elasticity of factor determines its reward.

According to modern economists, the difference between actual earning and its transfer earnings is termed as ‘rent ’.

Rent = [Actual Earning] – [Transfer Earning] Transfer earning of a factor is that money income which it can earn in its next best alternative use.

Box 1

● Rent Determination : Based on Supply of Factor According to modern economists a factor can earn rent only when its supply is less than perfectly elastic. Thus, the rent earned by a particular factor depends on supply elasticity of that particular factor. Supply elasticity of a factor is of three types : (1) Perfectly Elastic Supply,

(2) Perfectly Inelastic Supply,

(3) Less than Perfectly Elastic Supply.

(1) Perfectly Elastic Supply

A perfect elastic supply of a factor means that any quantity of a factor can be obtained at a particular fixed price, i.e., factor of production is not scarce. In other words, factor is perfectly specific. In this situation, the actual earning and transfer earning of a factor become equal their difference becomes zero which shows ‘zero rent ’.

If Fig. 7, SS is the factor supply curve which is perfectly elastic. With factor demand curve DD, factor demand and factor supply become equal at point E where at OP factor price, ON units of factor are employed. At this situation actual earnings (area OPEN)

and transfer earnings Fig . 7

(area OPEN) are equal. Hence, rent becomes zero at perfectly elastic factor supply.

(2) Perfectly Inelastic Supply

When factor supply is perfectly inelastic, change in factor price does not affect its supply, i.e., supply remains constant even at zero price. In this situation, the transfer earnings of the factor becomes zero and hence, the total actual earnings of the factor is converted into rent. Fig. 8 shows this situation. In Fig. 8 point E is the point of equilibrium between supply SS and demand DD where OP factor price is determined. The entire actual earnings of the factor OPEN becomes rent because transfer earnings in this case is zero. Fig . 8

(3) Less than Perfectly Elastic Supply

Factor supply is said to be less than perfectly elastic when factor supply increases relatively in smaller proportion as compared to increase in factor demand. In this situation, factor’s actual earning becomes more than transfer earning

because factor supply

lags behind to increase

in factor demand and

hence, factor will earn

rent equal to the

difference between

actual earning and

transfer earning.

In Fig. 9, factor demand

curve DD and factor Fig. 9

supply curve SS cut each other at point E. Factor’s actual earning is OPEN while its transfer earning is OSEN.

In such situation,

Rent = Actual Earning – Transfer Earning Area PSE = Area OPEN – Area OSEN 14.3.2. Application of Demand and Supply in Determination of Wage

Wage is that price which is paid to the labour for his services given in production process. In other words, the price of the labour is called ‘wage ’. According to the modern economists, price of the labour is determined by demand and supply forces in the same manner as price of the commodity is determined by relative forces of demand and supply.

Thus,

“Wage is determined by demand and supply forces of labour and wage is determined at the point where demand for labour becomes equal to supply of labour. ”

● Demand for Labour

Labour is demanded by the producers. Labour demand depends on his productivity. A producer employs additional labour till the point where the marginal productivity of additional unit of labour becomes the price paid to the labour. Hence, the marginal productivity of labour is the ceiling of wage to be paid to the labour and producer will not pay more than this ceiling price to the labour.

● Demand Curve of Labour

Wage and demand for labour has inverse relationship, i.e., higher number of labour will be demanded at lower wage and less labour unit at high wage. Hence, demand curve of labour slopes downward from left to right (Fig. 10).

● Supply of Labour Labour supply is made by labourers. As the supply of commodity depends on its production cost, similarly the supply of labour depends on its production cost (i.e., minimum expenditure required to keep the labour at the subsistence

Fig. 10

level). Hence, the lower ceiling of wage is determined by the subsistence level of labourers. Labour will not be ready to work at the wage below the subsistence level.

● Supply Curve of Labour

Wage and labour supply have positive relationship, i.e., at lower wage, less labour supply will be available and at higher wage, more labour will be available for work. That is the reason why labour supply curve slopes upward from left to right but after a certain limit labour supply declines with increase in wages because labour prefer leissure after getting wages beyond a particular limit. Fig . 11

In such a situation, labour supply curve becomes backward sloping (Fig. 11).

● Wage Determination : Dem-and and Supply Equilibrium

When perfect competition exists in both commodities and factor market, wage rate is determined by the equilibrium between demand for labour and supply of labour.

In Fig. 12, \mathrm { D } _ { \mathrm { L } } \mathrm { D } _ { \mathrm { L } } is

labour demand curve

and \mathsf { S } _ { \mathrm { { L } } } \mathsf { S } _ { \mathrm { { L } } } is labour

supply curve. Both

these curves cut each other at point E, i.e., at point E demand for labour is equal to supply of labour. In this situation, wage Fig . 12 rate OW is determined.

14.3.3. Application of Demand & Supply in Determination of Interest

Classical economists propounded the theory of demand and supply for determining the interest rate. Like commodity price determination, interest rate is also determined by the demand for capital and supply of capital. The interest rate is determined at that point where demand for capital becomes equal to supply of capital.

● Demand for Capital

Capital is demanded for its productivity. Demand for capital refers to the demand for investment. As more and more capital is used, marginal productivity of capital declines. Hence, producer will use capital till that point where marginal productivity of capital declines and becomes equal to rate of interest. According to classical economists, when interest rate falls, demand for capital increases and vice versa . Hence, capital demand curve declines from left to right (Fig. 13). Fig. 13

● Supply of Capital

Supply of capital depends upon saving. Saving is that part of income which is not spent on consumption. Supply of savings depend on real factors like abstinence, waiting or time preference of con sumption. The change in these real factors

brings change in sav ings. High interest rate induces savings and vice versa. Hence, supply_{Fig. 14curve of capital (or saving)}

is upward sloping from left to right (Fig. 14). ● Interest Rate

Determination : Demand-Supply

Equilibrium

Interest rate is determined at the point where

demand for capital (i.e., investment) becomes equal to supply of capital (i.e., saving). In Fig. 15, investment curve DD and savings curve SS cut each other at point E where interest rate OR is determined.

Fig. 15

14.3.4. Application of Demand and Supply in Determination of Profit

According to modern economists, profit is also a price. Like the commodity price determination, profit is determined with the demand and supply forces. According to the modern theory of profit, profit is determined at the point where the demand for entrepreneurs is equal to the supply of entrepreneurs.

● Demand for Entrepreneur

Entrepreneur’s demand

is made on the basis of

its marginal productivity.

Higher the marginal

productivity of

entrepreneur, more

demand of them will be

there. The demand curve

for entrepreneur slopes

downward from left to^{Fig. 16}

right which shows that marginal revenue productivity (MRP) of

entrepreneurs declines with increase in their number (Fig. 16).

● Supply of Entrepreneur

Supply of entrepreneurs depend on the profit earned in the industry. Higher the rate of profit, more will be the supply of entrepreneur. Hence, profit and supply of entrepreneurs are directly related and its supply curve slopes upward from left to right (Fig. 17).

● Profit Rate Determination : Demand and Supply Equilibrium Profit rate is determined by the related forces of demand & supply of entrepreneurs. Normal rate of profit is determined at the point where the demand for entrepreneurs becomes equal to their supply. In Fig. 18, DD is entrepreneur’s demand curve and SS is the supply curve. Both the ^ { \ ' } F i g . 17curves cut each other

at point E where profit rate OP is determined. 14.4. Application of Demand and Supply Curves in Food Availability Decline Theory

Indian economist Prof. Amartya Sen, a Nobel Laureate in Economics (1998) has propounded a new theory known as Food Availability Decline Theory (i.e., FAD Theory). According to the theory, natural calamities (like flood, droughts, etc.), the production of staple food falls which makes the supply of the scarce food as

Fig . 18 compared to demand. Exceeding demand as compared to supply makes price of the food high and as a result poor people become deprived of good availability. Consequently mass poor population faces starvation in the region.

Fig. 19 shows the explanation of FAD Theory. If we take three families A, B and C in the market—A being the poorest, B being of middle status and C stands at the richest status.

Fig. 19

Fig. 19 shows that at the market demand \mathrm { D D } _ { \mathbf { M } } and supply \mathsf { S } _ { 1 } \mathbf { M } _ { 1 } , the price of food comes at \mathrm { O P } _ { 1 } at which all the three families can afford to buy the food. But when due to short supply, price increases to \mathrm { O P } _ { 2 } , family A is

thrown out of the consumption of the food. At higher price \mathrm { O P } _ { 3 } , both families A and B become deprived of the food availability and face starvation.

The above theory of Prof. Sen concludes that decline in food availability due to natural calamities leads to starvation and deaths in the area.

QUESTIONS Ultra Short Answer Type Question

1. Who has given the concept of Food Availability Decline Theory ?

2. What is meant by Price Floor ? [C.B.S.E., 2017] Very Short Answer Type Questions

3. What is Equilibrium Price ?

4. Which are the two forces in determining the price of the goods ?

5. Who makes demand of goods ?

6. Who makes the supply of goods ?

7. What is Derived Demand ?

8. What is Rent ?

Short Answer Type Questions

1. How is Interest Rate determined ?

2. How is Profit Rate determined ?

3. What is the shape of wage supply curve ?

4. Which forces determine wage rate ?

5. What is Interest ?

6. With the help of demand supply curves show the minimum support price. [BSEB, (Arts ), 2014]

7. What is meant by price ceiling ? Explain its implication. (C.B.S.E., 2018)

8. Mention the uses of Demand and Supply in price determination of goods.

9. Mention the uses of Demand and Supply curves in price determination of a factor.

10. Discuss the price ceiling with the help of a diagram. (Raj. Board, 2013)

11. What is Rent ? What are the three types of elasticity of supply of factor ? Objective Type Questions

(A) Multiple Choice Questions :

1. Which determines the equilibrium price ?

(a) Demand (c) Both a & b (b) Supply

(d) None of the above

2. Which is the component of factor price determination ? [B.S.E.B. (Comm.

), 2016] (a) Rent (b) Wages

(c) Interest (d) All of the above

3. Price of a goods is determined at a point where : (a) Demand of the commodity is high

(b) Supply of the commodity is high

(c) Demand of the commodity and supply of the commodity is equal

(d) None of the above

4. Rent is = ?

(a) Actual Income – Transfer Earnings

(b) Actual Income + Transfer Earnings

(c) Transfer Earnings

(d) None of the above

5. Which of the following is correct ?

(a) Labour Demand comes from producer

(b) Demand of labour depends on its productivity.

(c) Marginal productivity of labour is its maximum wage

(d) All the above

6. Every firm uses labour upto the point : (B.S.E.B., 2018)

(a) Where labour’s marginal productivity is equal to the wage rate

(b) Where labour’s marginal productivity is less than the wage rate

(c) Where labour’s marginal productivity is more than the wage rate

(d) None of these

7. Government decides ‘Price Celing’ : (B.S.E.B., 2018)

(a) On necessary goods

(b) Which is less than the price decided by market

(c) To make it affordable to the common man

(d) All of these

[Ans. 1. (c), 2. (d), 3. (c), 4. (a), 5. (d), 6. (a), 6. (d).] (B) Fill in the Blanks :

1. Factor demand is a....................demand.

2. For agricultural products price floor limit is also known

as....................

3. FAD theory is given by....................

4. Wage and labour supply have....................relationship. 5. As per modern

viewpoint, rent arises due to....................of

the factor.

[Ans. 1. derived, 2. minimum support price, 3. Prof.

Amartya Sen, 4. Positive, 5. Specificity]

(C) State True/False :

1. The price at which demand for supply of the commodity becomes equal, is called equilibrium price.

2. Rent = Actual Earning – Transfer Earning.

3. Wage is the price which is paid to the labour for his services given in productioin process.

4. Food availability declive theory was propounded by Prof. Marshall.

5. Every firm uses labour upto the point where marginal

productivity is less than the wage rate.

[Ans. 1. True, 2. True, 3. True, 4. False, 5. False.]

(D) Match the following Column :

1. Food Availability Decline Theory

2. Price Ceiling Limit

3. Price Floor Limit

4. Demand of factors

5. Determination of equilibility price

[ Ans. 1. (e), 2. (a), 3. (b), 4. (c), 5. (d).]

(E) Answer in One Word :

1. What type of demand a factor has ?

2. Which forces determine price ?

3. Who gave FAD Theory ?

[Ans. 1. Derived Demand, 2. Demand and Supply, 3. Prof. Amartya Sen.] HOTS High Order Thinking Skills Questions

1. Why does the supply curve of labour become backward sloped after a certain wage level ?

(See : Section 14.3.2 Fig. 11)

2. How do natural calamities bring starvation ? (See : Section 14.4) VBQ Value Based Questions

3. Is rationing a solution of limited supply ?

(See : Point (i) of Section 14.2.1)

2. Why does the supply curve of labour bend backward after a limit ? (See : Fig. 11)

MDQ Case Study Based on Evaluation & Multi-disciplinary Questions 1. What is the relationship between the Food Availability Decline Theory and natural calamities ?

‘B’ (a) Rationing

(b) Minimum support price (c) Derived demand

(d) By demand and supply (e) Prof. Amartya Sen

(See : Section 14.4)

2. Rationing is required in case of limited supply. Do you agree

with this statement ?

(See : Point (i) of section 14.2.1)

NCERT CORNER

Q. 1. In what respect do the supply and demand curves in the labour market differ from those in the goods market ? Ans. See Section 14.3.2

Q. 2. How is the optimal amount of labour determined in a perfectly competitive market ? Ans.

In perfect competitive market, optimum amount of labour is determined at the point where wage rate becomes equal to marginal productivity of labour.

Q. 3. How is the wage rate determined in a perfectly competitive labour market ?

Ans. See Section 14.3.2

Q. 4. Can you think of any commodity on which price ceiling is imposed in India ? What may be the consequences of price ceiling ? Ans. See Section 14.2.1

15

MACRO ECONOMICS : MEANING

STUDY MATERIAL INCLUDED IN THE CHAPTER

15.1. Macro Economics : Introduction 15.2. Scope of Macro Economics 15.3. Importance of Macro Economics

15.4. Limitations of Macro Economics 15.5. Distinction between Micro and Macro Economics 15.6. Mutual Dependence of Micro and Macro Economics 15.7. Some Basic Concepts of Macro Economics Goods 15.8. Stock and Flow 15.9. Concept of Investment 15.10. Depreciation

Consumption Goods Producer A Quick Review of the Chapter Questions High Order Thinking Skills (HOTS) Questions Value Based Questions (VBQ) Case Study Based on Evaluation & Multi-disciplinary Questions (MDQ) NCERT Corner.

15.1. Macro Economics : Introduction

Macro Economics is another important branch of economic analysis. Macro Economics studies such aggregates which represent the entire economy; like total employment, total income, total production, total investment, total saving, total consumption, aggregate demand, aggregate supply, general price level, etc. The term Macro in English has its origin in the Greek term Makros which means Large. In the context of Macro Economics, ‘large’ means economy as a whole. Thus, Macro Eeconomics is defined as that branch of Economics which studies economic activities (including economic issues or economic problems) at the level of an economy as a whole.

●Definitions :

The important definitions of Macro Economics are as follows :

(i) According to K.E. Boulding, ‘‘Macro Economics deals not with individual quantities as such but with

(iii) According to M. H. Spencer, ‘‘Macro Economics is concerned with the economy as a whole or large segments of it. In Macro Economics, attention is focused on such problems as the level of unemployment, the rate of inflation, the nation’s total output and other matters of economy-wide significance. ’’ The above definitions make it clear that Macro Economics studies the determinants of national income and causes of economic fluctuations in a country. Macro Economics got due importance after the publication of Keynesian book ‘The General Theory of Employment, Interest & Money (1936)’.

15.1.1. Characteristics of Macro Economics

1. Study of Macro Units : Macro Economics studies the macro units of the economy like national income, total production, total employment, general price level, etc.

2. Related to Whole Economy : Macro Economics

the aggregates of these

quantities; not with

individual incomes but

with the national

income; not with

individual prices but

with the price level;

not with individual

output but with the

national output .’’

(ii) According to Schultz,

‘‘The main tool of

analysis. ’’ studies the policies related to the economy as a whole.

Macro Economies ❍It deals with the functioning of economic system as a whole. ❍ It deals with aggregates of economy such as national income, aggregate expen diture, total employment, general price level etc.

❍ It helps in analysing the reasons for economic fluctuations and provide remedies.

Box 1

It does not analyse the effects of macro policies on an individual unit but studies the effect on the society as a whole.

3. Macro Economic Variable : Macro Economic variables are important part of subject matter of Macro Economics. Macro economic variables are related with the entire economy. A few macro economic variables are : national saving and investment, GNP, national income, total employment, aggregate demand, aggregate supply, etc.

4. Macro Tools : The various tools used in Macro Economics for the fulfilment of different objectives are called macro tools. Important macro economic tools are : (i) Fiscal Policy, (ii) Monetary Policy, and (iii) Income Policy.

15.2. Scope of Macro Economics

Scope of Macro Economics

Income and Theory of General Employment Price Level

Theory and Inflation ↓↓ Theory of Investment

Consumption Theory Theory of Trade Cycle Or Explanation of Economic Fluctuations Theory of Macro

Economic Theories of Growth Distribution Box 2 The important subject matter included in the scope of Macro Economics are as follows :

1. Income and Employment Theory : Macro Economics production, total consumption, total investment, general price level, etc., and for it, the use of macro tools is essential.

deals with the national income. It includes the study 2.Economic Growth : Both developed and of various components of national income and underdeveloped countries have a primary goal of measurement methods of national income. Macro achieving a higher rate of economic growth. It Economics is also concerned with the determination requires appropriate growth-oriented policies after a of the level of employment in the whole system and detailed investigation of forces operating in the variations in it. It studies about aggregate demand, economy. Macro Economics helps in providing basic aggregate supply, consumption, savings and investment raw materials in this study. functions relating to employment theory. 3. To Study the Working of the Economy : For

2. Theory of General Price Level and Inflation : studying the economy as a whole, macro economic Macro Economics studies various components of analysis is needed. Nature of the economy, population, money supply and effect of them on the economy. total employment level, national income, production, Determination of wholesale price index and changes natural and human resources, savings, investment, in general price level (i.e., inflation and deflation) consumption in an economy all are to be studied are also studied in Macro Economics. in an economy which needs the help of Macro

3. Theory of Trade Cycle : Every economy faces the Economics. problems of ‘boom ’ and ‘depression ’ during the process 4. Helpful in Studying Micro Economics : Aggregative of its development. These phases are termed as trade economics and policies act as a guidelamp to or business cycles. The theories of trade cycles and individuals while designing their policies. An investor policies to control cyclical fluctuations come within may decline to an investment when an economy is the sphere of Macro Economics. passing through the phase of recession or contraction.

4. Theory of Economic Growth : Study of problems A proper appreciation of individual problems can only relating to economic growth or increase in per capita be made if an overview of the entire economic system real income forms part of Macro Economics. It studies is made.

the economic growth of underdeveloped economies. 5. International Comparisons : The factors related Various development policies are also studied therein. with the comparison of economic progress in different

5. Macro Theories of Distribution : Macro theories countries are the part of Macro Economics. Comparison of distribution deal with the distribution of income between national income, consumption, saving, among various factors. The analytical study of these investment become the basis for international comparison. theories help in equitable distribution of income and_{15.4. Limitations of Macro Economics constitutes a part of Macro Economics.}

15.3.

Importance of Macro Economics

The limitations of macro economic analysis are as follows :

In modern economic world, the importance of Macro 1. Macro Economic Paradoxes : Sometimes aggregates Economics is well-accepted. The following points show its provide misleading conclusions. What is true for

importance : individual may not be true for the entire group

1.Formulation of Economic Policies of the _{Two examples can be placed here :}

Government : Macro economic analysis is essential (a) Savings of Individual and Society : Fromfor formulating various economic policies. The objective individual point of view, saving is a virtue butof the state is to maximise the social welfare. The if all people in an economy start saving, it showsstate has to deal with various macro units like total the negative impact on the economy because More Savings ^Means Means

Less

Consumption and Less

Demand

Decrease in Production, Employment and Income

(b) Apprehension of Bank Deposit : If an individual withdraws money from bank, it creates no danger but if all people withdraw the amount simultaneously, the banking system will fail. The above situations signify macro economic paradoxes which implies

Micro Economics

1. It is concerned with an individual economic unit like a consumer, a firm, an industry or income of an individual.

2. It is based on the assumption of full employment.

3. It is based on the assumption of ‘ other things being equal’. This analysis is based on partial equilibrium .

4. Its objective is to study the theories related to optimum distribution of resources.

5. Its nature is comparatively easy.

6. It has main instruments of demand and supply.

7. It is also known as ‘‘Price Theory’’.

15.6. Mutual Dependence of Micro and Macro Economics

Micro and Macro Economics are two different systems of economic analysis. Both the systems are not competitive, rather they are complementary and dependent on each other.

According to Samuelson, ‘‘There is really no opposition between Micro and Macro Economics. Both are absolutely vital. And you are only half-educated if you understand the one while being ignorant of the other .’’

The mutual dependence of the two can be made clear with the following discussion :

(1) Dependence of Micro Economic Analysis on Macro Economic

Analysis : The study of micro economic analysis is essential for macro economic analysis. Various problems related to micro economic analysis can only be studied with the support of macro economic analysis.

For example :

(a) Rate of profit is determined in micro economic

analysis on the basis of degree of uncertainty bearing but the determinants of profit and causes of their changes can be understood only with macro economic analysis.

(b) Micro economic analysis presents partial equilibrium analysis for determining the rate of interest. General equilibrium analysis of interest has been ‘‘what is true for an individual is not necessarily true for the whole of economic system’’.

2. Individual Units are Ignored : Macro Economics puts an emphasis on the entire society while individual units, which make the society, are ignored.

15.5. Distinction between Micro and Macro Economics

Micro and Macro Economics are two main branches of Economics. Micro Economics deals with individual economic problems whereas Macro Economics is the study of aggregates or of entire economic system. These two approaches differ from each other in the following manner :

Macro Economics

1. It deals with aggregates of economy such as national income, aggregate expenditure, total employment, general price level, etc.

2. It is based on the assumption of under full employment of resources.

3. This is based on general equilibrium analysis.

4. Its objective is to study the theories related with full employment.

5. Its nature is comparatively complex.

6. Its main instruments are aggregate demand, aggregate supply, aggregate saving and investment.

7. It is also known as ‘‘Income & Employment Theory’’.

explained by Prof. J.M. Keynes on the basis of macro economic analysis.

(c) Price determination of a commodity depends not only on the relative forces of demand and supply but also depends upon demand and supply of other goods for which we need help of macro economic analysis.

(d) A consumption of goods by a consumer not only depends on the price of that goods and consumer's income but also on prices of other goods for which use of macro economic analysis is required.

(2) Dependence of Macro Economic Analysis on Micro Economics : Following examples explain the dependence of macro economic analysis on micro economics :

(a) Without the information of individual units,

economic conclusions cannot be withdrawn at macro level. For example, income of individuals has to be collected for measuring national income.

(b) For analysing general price level, the study of price theory is essential.

(c) The addition of activities made by individual units represents the activities of entire economy. Determination of consumption, saving, investment, employment is based on individual economic activities.

15.7. Some Basic Concepts of Macro Economics

Goods
↓
↓↓

Consumption Goods Producer Goods ↓↓ ↓↓ ↓ ↓ Durable Non-durable Goods
Goods
15.7.1. Consumption Goods

Consumption goods are those goods which are bought and used by consumers for their final consumption rather than using them in further production process.

Consumption goods are of two types :

(i) Durable Goods,

(ii) Non-durable Goods.

(i) Durable Goods : Durable goods are those that

last for a long time. These goods have long life and satisfy the consumer wants continuously for a long period.

Television sets, refrigerators, air-conditioners, car, scooter are examples of durable goods.

(ii) Non-durable Goods : Non-durable goods of consumption last for a short time and satisfy the human wants for a short period. Stationery items, food items, soap, toothpaste or vegetables are examples of non-durable goods.

15.7.2. Producer Goods

Producer goods refer to those materials which are used by a firm to produce consumer goods. Thus, producer goods help in satisfying human wants indirectly.

Producer goods are of two types :

Intermediate Capital Goods Goods

(i) Intermediate Goods, (ii) Capital Goods. (i) Intermediate Goods : Semifinished goods are

termed as intermediate goods. A firm’s product that is used as an input into the production process of either the same firm or another, rather than being directly available for final consumption, is called intermediate goods. In other words, intermediate goods are those which are purchased by one firm from the other firm as raw material or as goods for sale.

(ii) Capital Goods : Capital is one of the factors of production. ‘‘Capital consists of those kind of wealth, other than free gifts of nature which yield income.’’

Capital represents the stock of goods which are used

in production and which have themselves been

produced. In other words, capital indicates those

producer goods which are not used for consumption

but reinvested in the next production process.

Generally capital is classified into two parts : ‘fixed

capital’ and ‘circulating (or variable) capital’.

Fixed capital represents durable goods such as

building, plant and machinery while the circulating

(or variable capital) consists of raw material, semifinished goods etc.

Distinction between Final Goods and Intermediate Goods

Final goods refer to those commodities used by the consumers rather than by firms as inputs into production process. Final good is different with intermediate good because it is not used for producing another goods as input and directly become the part of consumption in household sector. Intermediate goods are such goods of a firm which are used in the production of other goods as raw material.

Only final goods are included in the estimation of national income in the country. Intermediate goods are not the part of national income estimation. Box 3

15.8. Stock and Flow

‘Stock’ is related to a ‘point of time’ while ‘flow’ is that quantity which is measured for a period of time.

Stock has no time dimension while flow has a time dimension.

For example, wealth of a person is stock because it shows the total quantity of goods (or money) at a particular time while the income of a person is a flow which is related for a time period e.g., one month etc.

A wealth of a person on July 1, 2016 is ` 5 lakh (It is an example of stock) but a person gets ` 10,000 per month income (It is an example of flow).

Examples of Stock and Flow Stock 1. Wealth

2. Distance between two places

3. Water in a Tank

4. Quantity of Money

5. Capital

6. Supply of Money in a Country

7. Labour force

8. Bank Deposits

9. Population of country

10. Stored wheat in godown

Flow

1. Income

2. Velocity of moving vehicle

3. Water in River

4. Expenditure of Money

5. Capital Formation

6. Change in Money Supply in a Country.

7. Interest on capital

8. Water Leakage from tank

9. Sale of Wheat

10. Number of children taking birth

11. Stock is a static concept.

12. Examples :

(a) Quantity of Money (b) Wealth

(c) The Amount of Wheat Stored (d) Water in a Reservoir. (e) Five Hundred rupee note

Difference between Stock and Flow Variables ¹

Stock Flow

1. Stock means that quantity of an economic variable

which is measured at a particular point of time.

2. Stock has no time dimension.

3. Flow is that quantity of an economic variable which is measured during the period of time. 2. Flow has time dimension as per hour, per day, per

month and per year.

3. Flow is a dynamic concept.

4. Examples :

(a) Consumption

(b) Investment

(c) Income

(d) Water in a River.

(e) Money Expenditure

15.9. Concept of Investment

Investment is a process of capital formation or a process that increases the stock of capital. Change in stock of capital is also called capital formation.

● Types of Investment

1. Fixed Investment

2. Inventory Investment

Fixed investment refers to increase in the stock of fixed assets (like machines etc.) with the producers during an accounting year. On the other hand, inventory investment of a producer refers to the change in inventory stock during the year.

15.9.1. Gross Investment and Net Investment

Gross investment represents the total expenditure incurred by a firm (or by economy) on productive equipments. If we deduct the depreciation from gross investment, we get net investment. Gross investment never becomes negative.

Net Investment = Gross Investment – Depreciation Gross Investment = Stock Investment (or Inventory Investment) + Gross Fixed Capital Investment

15.10. Depreciation

Depreciation is the reduction in the value of the fixed assets that takes place in the process of production. Depreciation percentage is calculated on the basis of lifetime of fixed assets. When we divide the value of the asset by the number of years (i.e., estimated life-time of the asset), we get the annual amount of depreciation. This depreciation amount is a part of business expenses which is deducted from the gross profit to obtain the net profit.

A QUICK REVIEW OF THE CHAPTER

● Macro Economics : Macro economics is defined as that branch of economics which studies economic activities (including economic issues or economic problems) at the level of an economy as a whole.

● Scope of Macro Economics :

(i) Income and Employment Theory, (ii) Theory of General Price Level and Inflation, (iii) Theory of Trade Cycle. (iv) Theory of Economic Growth. (v) Macro Theories of Distribution.

1. In the circular flow models we focus only on the flow variables, not the stock variables.

● Significance of Macro Economics :

(i) Necessary for studying the working of the economy, (ii) Helpful in formulating economic policies, (iii) Helpful in studying economic growth, (iv) Helpful in studying micro economics, (v) Helpful in studying international comparisons.

● Consumption Goods : Consumption goods are those goods which are bought and used by consumers for their final consumption rather than using them in further production process.

● Durable Goods : Durable goods are those that last for a long time. These goods have long life and satisfy the consumer wants continuously for a long period.

● Final Goods : Final goods refer to those commodities used by the consumers rather than by firms as inputs into production process.

● Intermediate Goods : Semi-finished goods are termed as intermediate goods. A firm’s product that is used as an input into the production process of either the same firm or another, rather than being directly available for final consumption, is called intermediate goods.

● ‘Stock’ is related to a ‘point of time’ while ‘flow’ is that quantity which is

measured for a period of time.

● Investment : Investment is a process of capital formation or a process that increases the stock of capital.

● Net Investment : Gross Investment – Depreciation.

● Depreciation : It is the reduction in the value of the fixed assets that takes place in the process of production.

QUESTIONS Very Short Answer Type Questions

1. What is Macro Economics ?

(B.S.E.B., 2012; U.S.E.B., 2012; JAC, 2018, 19)

2. Define Macro Economics. (J.A.C., 2011, 17)

3. Mention the features of Macro Economics.

(J.A.C., 2010; U.S.E.B., 2015,17; Raj. Board., 2015)

4. Define ‘‘Flow’’. (C.B.S.E ., 2011, 12, 16)

5. What is ‘‘Stock’’ ? (C.B.S.E ., 2011, 12; Raj. Board, 2015) Or Define Stock.

6. Define capital good.

Or

What are Capital goods ?

7. Define consumption good.

8. What is gross investment ?

9. Define Depreciation.

Short Answer Type Questions

(C.B.S.E ., 2016) (C.B.S.E ., 2012)

(C.B.S.E., 2012) (C.B.S.E ., 2012)

1. What do you mean by Macro Economics ? ( J.A.C., 2016)

2. What is the difference between Micro Economics and Macro Economics ? (J.A.C., 2011; B.S.E.B . (Comm .), 2016; Raj. Board 2017; J.A.C. (Comm. ) 2017; M.P. Board , 2017)

3. Give two illustrations of interdependence between Micro Economics and Macro Economics. (U.S.E.B., 2011)

4. National income belongs to which part of Economics Micro or macro ? (J.A.C., 2011)

5. State the meaning and importance of macro economics. (U.S.E.B., 2016)

6. Write any four features of macro economics.

(M.P. Board, 2017)

7. Explain the importance of macro economics in four points. [M.P. Board, 2016; B.S.E.B. (Comm. ), 2019]

8. Explain the interdependence of micro and macro economics. (M.P. Board, 2015)

9. Write limitations of macro economics.(M.P. Board, 2014) 10. Classify the following into ‘Stock’ and ‘Flow’ by mentioning the reasons :

(i) Capital, (ii) Savings, (iii) Gross Domestic Product, (iv) Property. (C.B.S.E., 2013) 11. Distinguish between ‘Stock’ and ‘Flow’ and give two examples for each. (Raj. Board, 2013; C.B.S.E., 2013; U.S.EB., 2017) 12. Distinguish between ‘stock’ and ‘flow’ Variables. (Raj. Board , 2016) 13. Distinguish between Gross Investment and Net Investment. (Raj. Board , 2016) 14. Distinguish between consumption goods and capital goods. (U.S.E.B., 2017)

Long Answer Type Questions

1. What is meant by Macro Economics ? Discuss its scope. (B.S.E.B ., 2013)

2. Explain the differences between Micro Economics and Macro Economics.

3. What do you mean by micro and Macro Economics ? Explain the importance of Macro Economics.

Objective Type Questions

(A) Multiple Choice Questions :

1. English letter ‘Macro’ has been taken from Greek word ‘Macros’ which means :

(a) Narrow (b) Broad

(c) Individual (d) None of the above

2. Which of the following is a characteristic of Macro Economics ?

(a) Macro Economics studies national income, full

employment, general price level, etc.

(b) Macro Economics studies the policies related to entire economy.

(c) Macro economic variables are the important subject

matter of Macro Economics.

(d) All the above

(a) Micro Economics (c) Both a and b

3. Which subject is included in the subject matter of Macro Economics ?

(a) Income and Employment Theory

(b) General Price Level and Inflation Theory

(c) Theory of Trade Cycle (d) All the above

4. Which one is the utility of Macro Economics ?

(a) Formation of Government Economic Policy

(b) Economic Growth

(c) International Comparisons

(d) All the above

5. Which one is the limitation of Macro Economics ? (a) Collective Economic Paradox

(b) Ignores Individual Units

(c) Both a and b (d) None of the above 6. The subject of the study of Macro Economics is : (a) The Principle of National Income

(b) The Principle of Consumer

(c) The Principle of Producer (d) None of these 7. Macro Economics Studies

[JAC , 2012; B.S.E.B. (Comm .), 2016, 19] (a) Employment opportunities in economy

(b) Consumption theory

(c) Elasticity of demand in scooter

(d) Price of wheat in market

8. General price level is studied in :

[J.A.C . 2012; B.S.E.B. (Comm .), 2016] (b) Macro Economics

(d) None of the above

9. Employment theory is related to : [B.S.E.B. (Arts), 2012] (a) Static Economics

(c) Macro Economics

(b) Micro Economics (d) None of the above 10. Increase in stock of capital is known as : (J.A.C., 2015)

(a) Capital Loss (b) Capital profit

(c) Capital Formation (d) None of the above 11. Which of the following is a stock ? (C.B.S.E., 2015)

(a) Wealth

(c) Export

12. Macro Economics studies :

(a) Full employment

(c) Gross National Product

(b) Savings

(d) Profit

[B.S.E.B., (Comm. ), 2018] (b) Aggregate price level (d) All the above 13. Which of the following is studied under macro economics ? [B.S.E.B.,

(Comm. ), 2019] (a) National Income (b) Full Employment

(c) Total Production (d) All of these

14. Macro Econmic studies : (M.P. Board, 2019)

(a) Individual economic units (b) Aggregative

(c) Individual units and aggregative both

(d) Burning problems

15. Which one of the following is included in ‘Stock’ ? (B.S.E.B. , 2019)

(a) Quantity of money (b) Wealth

(c) Quantity of wheat stored in warehouse

(d) All of these

16. Which one of the following is included in flow ? (B.S.E.B., 2017) (b) Investment

(d) All of these

(a) Consumption (c) Income

[Ans. 1. (b), 2. (d), 3. (d), 4. (d), 5. (c), 6. (a), 7. (a), 8. (b), 9. (c), 10. (c), 11.

(a), 12. (d), 13. (d), 14. (c), 15. (d), 16. (d)]

(B) Fill in the Blanks :

1. Income and Employment theory is a branch of ................

Economics.

2. Macro Economics is based on ................equilibrium analysis.

3. Theory of trade cycles comes under the scope of. ............... Economics.

4. Micro and Macro Economics are ............... to each other. (M. P. Board,

2015. [Ans. 1. Macro, 2. general, 3. Macro, 4. Complementary.] (C) State True/False :

1. The Principle of National Income is subject of study of Macro Economics.

2. English letter ‘Macro’ has been taken from Latin word ‘Makros’.

3. Employment theory is related to Micro Economics.

4. Fiscal policy and monetary policy are main macro tools.

5. Process of capital formation known as investment. [Ans. 1. True, 2. False,

6. False, 4. True, 5. True.] (D) Match the following Column : ‘A’

7. Macro Economic Variable

8. Macro Tool

9. Durable Good

10. Flow

11. Makros

12. Macro economic theories explain the problems

‘B’

(a) Income Policy

(b) Dynamic Concept

(c) Greek Language

(d) Aggregate Demand (e) Refrigerator

(f) of the whole economy

(M.P. Board, 2019) [Ans. 1. (d), 2. (a), 3. (e), 4. (b), 5. (c), 6. (f).]

(E) Answer in One Word :

1. What is called increase in capital stock ?

2. To which employment theory is related ?

3. Give one example of ‘Flow’.

4. In which branch analysis of national income is made ? [Ans. 1. Capital formation, 2. Macro Economics, 3. Income, 4. Macro Economics.]

HOTS High Order Thinking Skills Questions

1. Why does employment theory become a part of Macro Economics ? (See : Section 15.2)

2. Why saving is a virtue from individual point of view ? (See : Section 15.4, Point 1 (a)) VBQ Value Based Questions

3. Final product is the ultimate basis of measuring National Income. Why ? (See : Box 1)

4. Depreciation is related to fixed assets. How ? (See : Section 15.10) MDQ Case Study Based on Evaluation & Multi-disciplinary Questions

5. Micro and Macro Economics are complementary to each other. Discuss. (Sec : Section 15.6)

6. What relation time has with stock and flow ? (See : Section 15.8.) NCERT CORNER

Q. 1. What is the difference between Micro and Macro Economics ? Ans. See Section 15.5_❐

16

CIRCULAR FLOW OF INCOME

STUDY MATERIAL INCLUDED IN THE CHAPTER

16.1. Circular Flow of Income : Concept 16.2. Types of Circular Flow 16.3. Circular Flow of Income in Various Sectors 16.4. A Quick Review of the Chapter Questions

Questions (VBQ)

Leakages and Injections in the Circular Flow of Money 16.5. Importance of Circular Income Flows High Order Thinking Skills (HOTS) Questions Value Based Case Study Based on Evaluation & Multi-disciplinary Questions NCERT Corner. consumer, i.e. , income earned by the producer equals the income spent by the consumer.

2. Goods and services flow from buyers to sellers in one direction but the money payment for these goods and services flow in opposite direction i.e. it flows from buyers to sellers.

16.2. Types of Circular Flow

Circular Flow 16.1. Circular Flow of Income : Concept

Production is the result of collective efforts of various factors of production. Factors engaged in production process get their award—land, labour, capital and entrepreneurship get rent, wage, interest and profit respectively. Commercial firms make use of these factors

for producing goods and services. These factors of production are not only suppliers of factors to the producer, but they are consumers also. These factors earn their income on consumption. Commercial firms sell their product, earn income and again spend

Fig.

1 on completing production activity. Thus, flow of income

circulates. Production gives birth to income, income to consumption, consumption to expenditure and again expenditure to income and production. Thus, circular flow of income earning economic activities takes place in the economy.

Hence, the circular flow of income refers to flow of money income or the flow of goods and services across different sectors of the economy in a circular form. ● Definition

According to Lipsey, ‘‘The circular flow of income is the flow of payment and receipts between domestic firms and domestic households.’’

● Principles or Reasons of Circular Flow of Income Circular flow of income depends on two principles (or reasons) : 1. In the process of exchange, seller or the producer

gets that money which is spent by buyer or Real Flow Money Flow Flow of Goods Flow of Income and Services (i.e. , Money)

● Real Flow

Real flow of income implies the flow of factor Goods and services (like land, labour, capital, etc.) from the household sector to the producing sector and the corresponding flow of final goods and services from the producing sector to the household sector. Fig. 2 explains that household sector being the owners of factors of production supply factor service to the

Factor Goods and Service (Land, Labour, Capital etc.) Household Firms or Producer Sector Final Goods and Services Fig. 2 : Real Flow

producers and in return producers supply goods and ● Money Flow services to the household sector. Flow of income refers to money flow. Household gets In other words, flow of producer refers to the flow income from commercial firms for their services and of goods and services and this flow of product is termed firms get income from household which they spend as real flow in attaining goods and services. This cycle showing income flow is referred as money flow. Factor Payments (Rent, Wage, Interest, etc.) Household Firms or Producer Sector Consumption Expenditure on Goods and Services

Fig. 3 : Money Flow If Fig. 3, money flow model shows that household gets factor income (rent, wage, interest, etc.) for providing their factor goods and services and in return household 16.3. Circular Flow of Income in Various Sectors

sector incurs expenditure for acquiring final goods and services. Two Sector Model Three Sector Four Sector Model Model HouseProducer hold Sector or

Firm HouseProducer GovernForeign hold Sector or ment Sector

Firm

Household

16.3.1. Two Sector Model of Circular Flow of Income

In Two Sector Model of circular flow of income, there are only two sectors —‘Household Sector’ (i.e. , families) and ‘Producer Sector’ (i.e. , firms) and it deals with circular flow (both money and real flows) between these two sectors. ● Assumptions

(1) The economy consists of two sectors : (a) Household Sector : This sector provides its services to producer sector and consumes the goods and services finally produced by producer sector.

(b) Producer Sector : It produces final goods and services and makes use of the services of various factors like land, labour, capital, etc.

(2) Economic policies are not influenced by the government.

(3) Economy is ‘closed economy ’, i.e. , producer sector makes neither exports nor imports and household sector is fully dependent on domestic production. Producer Government

Sector or Firm

(4) Household sector spends its entire income and saves nothing.

● Structure of Two Sector Model

Two Sector Circular Flow Model Consumption Expenditure

Goods and Services (Real Flow)

Producers/Firms Households

Factor Goods and Services : Land, Labour, Capital, Entrepreneurship (Real Flow)

Factor Payments : Rent, Wages, Interest, Profits (Money Flow)

● Conclusions of the Model

Two sector Circular Flow Model concludes the following facts :

1. Total goods and services produced by the producer

sector equals the consumption of goods and services made by household sector.

2. Factor payment made by firms equals the factor income received by household sector.

3. Consumption expenditure of household sector equals the income of household sector.

4. Real flow of production and consumption of firms and households is equal to the money flow of income and expenditure of firms and households.

● Two Sector Model with Savings–Investment In real life both household sector (i.e. , family) and producer sector (i.e. , firm) save a part of their income. This saving is withdrawn from money flow and consequently money flow squeezes. Thus, saving is a leakage from money flow which becomes available in capital market for loaning purposes. Commercial firms borrow from capital market for investment. Investment has the opposite effect than that of saving. If the saving made by households returns back to money circulation through investment of commercial firms, money circulation remains stable.

Hence, in a two sector model, the equilibrium condition or the stability condition is :

Savings = Investment

S= I

Two Sector Circular Flow Model with Savings Investment (Financial System) Factor Payments (Money Flow)

Goods and Services (Real Flow)

Borrowings for Investment Household Savings

Producers/Firms

Money Market/ Financial System Households

Factor Services (Real Flow)

Consumption Expenditure (Money Flow) Fig. 5

16.3.2. Three Sector Model of Circular Flow of Income

In Three Sector Model of Circular flow of income, (iv) there are three sectors—Household (Family), Firms and Governmen t. In this model, government activities also affect the flow of income. Government activities can be classified into two categories—public expenditure and (i) public revenue.

unemployment allowance, scholarship, etc.) made to the household sector by the government. Subsidy given to industrial sector/consumer by the government.

Thus, there may be three possibilities related to public revenue and public expenditure : If public revenue (T) is equal to public expenditure (G), i.e. T = \mathbf { G } , budget will be balanced.

^{(a) Public Revenue (T) : Government earns revenue} (ii) If public revenue exceeds public expenditure from various sources. Tax is main source \mathrm { o f } _ { \mathrm { ( T > G ) } } , it will be a _{situation of surplus budget .} revenue. Thus, public revenue is the income_{This will} result in contraction of money flow.earned by the government mainly from taxes. Government savings will increase which will reach

(b) Public Expenditure (G) : Government spends_{capital market.} ^{its earned income in various ways which can be} (iii) If public revenue falls short of public expenditur ^ { \underline { { \mathbf { \delta } } } } _ { \mathrm { { c l a s s i f i e d } } } as : (T < G), it will be a situation of deficit budget .(i) Salaries given to households for their services. In this situation, government will borrow from (ii) Payments to firms for buying their products._{the capital market which will leave favourable} (iii) Transfer payments (like old age pension, impact on flow of income.

● Structure of Three Sector Model Structure of Three Sector Model Fig . 6 : Three Sector Circular Flow Model (Note : This model shows only money flow)

● Conclusion of the Model

The above Three-Sector Circular Flow Model explains that :

(i) Firms pay to households for their factor services and households pay to firms for getting goods for their use.

(ii) Household savings go to capital market and firms borrow from capital market for investment.

(iii) Government earns revenue by imposing taxes on

households and firms and spends on public activities which is called public expenditure.

In modern times, economy adopts the shape of open economy which includes exports and imports of goods and services. When an economy pays for imports, outflow of money takes place from that country to rest of the world and on the contrary when a country receives

(iv) The savings of the government, if any, comes to capital market and on the contrary government borrows from capital market in case of deficit.

(v) Government provides subsidy to firms and consequently money flows towards firms.

(vi) Government provides transfer payments like pension which results in the flow from government sector to household sector. Thus, circular flow of income in three sector economy continuously goes on.

● Condition of Equilibrium

16.3.3. Four Sector Model of Circular Flow of Income Four Sector Model of Flow of Income represents open economy which includes ‘foreign sector or rest of the world ’. Four Sectors of the Economy

1. Household Sector

2. Producer Sector

3. Government Sector

4. External Sector

Box 1

payment for the exports, inflow of money takes place to that country from rest of the world.

In open economy income flow includes the following five sectors : (i) Household Sector, (ii) Business Firm, (iii) Government Sector, (iv) Rest of the World Sector, (v) Capital Market.

With inclusion of rest of the world sector, import (M) and export (X) also affect the circular flow of income. Imports signify leakages from circular flow while exports indicate injection of income in circular flow.

Four sector economy in its circular flow of income possesses the following equilibrium condition : Y = C + I + G + (X – M)

Where, Y = Production or Income

C = Consumption Expenditure

I = Investment Expenditure

G = Government Expenditure

(X – M) = Net Export

(X stands for export and M for import)

● Structure of Four Sector Model

Fig. 7 : Money Flow of Income in Four Sector Modern Economy Features of Various Sectors of a Modern Economy

(I) Household Sector :

1. Household sector is the owner of factors of production.

2. This sector receives income in the form of wages, rent, interest and profits. They also get certain transfer payments from the government.

3. This sector spends money on the purchase of goods and services produced by the producing sector (or business sector) and also pays taxes to the government.

4. This sector saves a part of its income which goes to the financial market.

(II) Producing Sector (Firm) :

1. Producing sector (firms) produces goods and services which are consumed by the households and government. The firms in turn receive revenue from the sale of their goods and services. This sector also earns export income.

2. This sector hires factor services and makes them payments. It also makes payment to other countries for goods/services imported.

3. This sector also has to pay taxes to the government on sale and production of their goods. Certain firms receive subsidies from the government.

4. This sector also saves a part of its income.

(III) Government Sector :

1. Government receives revenue from taxes both on the household sector and the producer sector.

2. Government sector makes transfer payments to the household sector and gives subsidies to the firms (like food subsidy, fertilizer subsidy, etc.)

3. Like other sectors, this sector also saves which goes to the financial market.

(IV) Rest of the World Sector :

1. Rest of the world sector receives payments for exports. It also receives payments on government account.

2. It makes payments for the imports. It also makes payments on government accounts. (V) Capital Market :

3. All savings made by households, firms and government get accumulated in this sector.

4. This sector invests money by lending out to households, firms and the government.

5. Inflow and outflow in the capital market are equal.

Box 2

16.4. Leakages and Injections in the Circular Flow of Money

1. Leakage of Income : Leakage represents that income which is saved and not returned back to income flow. If factors of production do not spend their entire income on purchasing goods and services (i.e. , save a part of their income), it is called the leakage of income. Similarly, if firms do not spend their income and keep away a part of their income as undistributed income and profit, it will also be called leakage from income flow.

Thus, ‘‘ Leakage of income is that income which is not returned to circular flow as an expenditure and is kept away from the flow .’’

In other words, ‘‘Leakage gives the squeezing effect on national income .’’

2. Injection of Income : Injection of income is that income addition which takes place in circular flow from outsources other than circular flow.

Injection of income causes an increase in the process of income generation in the economy.

In other words, ‘‘Injection gives the expanding effect on national income ’’.

For the equilibrium in economy, leakages should be equal to injections. Or Injections = Leakages

Various sources of ‘Injections ’ and ‘Leakages ’ are :

(1) Two Sector Economy :

Leakages Injections (2) Three Sector Economy :

Leakages = Savings (S) = Investment (I)
= Savings + Tax = S + T
Injections = Investment + Government Expenditure = I + G
(3) Four Sector Economy :
Leakages = Savings + Tax + Import
= S + T + M
Injections = Investment + Government Expenditure + Export = I + G + X
Box 3 16.5. Importance of Circular Income Flows

In economic analysis circular income flow has a vital role to play. Salient points showing the importance of circular flow of income are as follows :

1. It helps in estimation of national income.

2. It gives the knowledge of working of the economy.

3. Equality between savings and investment becomes an important basis for monetary policy in the economy.

4. Its study also helps in fiscal policy from the 5. Its study helps in analysing the reasons of imbalance in the economy and making solutions to them.

5. Keynesian Theory of Income and Employment takes important note of elements associated with flow of money.

6. It also helps in studying the effects on imports and exports in the economy.

7. This circular flow explains that

Production ≡ Income ≡ Expenditure This identity becomes basis for the methods of economic point of view. calculating national income.

A QUICK REVIEW OF THE CHAPTER

● Circular Flow of Income : A continuous flow of production, income and expenditure is known as circular flow of income. It is circular because it has neither any beginning, nor an end.

● Why is it called a circular flow ? Income flow is a circular flow because

(i) Flow of receipts and payments of various sectors remain equal.

(ii) Every real flow has its money flow in its reverse direction.

● Difference between Stock and Flow : Stock measures the economic variable at a point of time while flow measures it at a period of time.

● Real Flow : It shows the flow of goods and services among the various sectors of the economy.

● Money Flow : It shows the flow of money among various sectors of economy.

● Conditions of Equilibrium :

(i) Two Sector Model :

S= I

Or C + S = C + I

(ii) Three Sector Model :

$C + S + T = C + I + G$

(iii) Four Sector Model :

$C + S + T + M = C + I + G + X$

● Leakage of Income : That part of income which is not returned back to circular flow is called leakage of income. Savings, tax or imports are examples of leakages.

● Injection of Income : Some additions made in the economy from outsources like investment, government expenditure and exports.

QUESTIONS Ultra Short Answer Type Questions

1. What is circular flow of income ?

2. What is real flow ?

3. What is money flow ?

4. Goods and services flow from which to which direction ?

5. Write the names of four sectors of a modern economy.

Very Short Answer Type Questions

1. What is meant by circular flow of national income ? (J.A.C. , 2011, 17)

2. What are the types of circular flow ?

3. Why money flows are opposite to real flows ?

4. What is a Closed Economy ? (Raj. Board , 2016)

5. What are ‘injections’ in the Circular Flow ?

(J.A.C., 2013)

6. What are ‘withdrawals’ in the Circular Flow ?

7. Define secondary sector of economy. (B.S.E.B . 2019)

8. Give any two examples of flow concept. (C.B.S.E ., 2019)

Short Answer Type Questions

1. Distinguish between Money Flows and Real Flows. (B.S.E.B. , 2012)

2. What are the three stages of Circular Flow of national Income ? (J.A.C. , 2017)

3. Explain the Circular flow of Income.

(C.B.S.E., 2013, 15; Raj. Board, 2013, 16; U.S.E.B ., 2016, 17, 19 B.S.E.B. , 2017, 18)

4. Why Flow of Income is called Circular Flow ? (U.S.E.B., 2013, 14)

5. Show the circular flow of income in a two sector economy. (B.S.E.B. , 2014)

6. Explain the circular flow of income and output in a three-sector economy. (B.S.E.B. , 2015)

Long Answer Type Questions

1. Circular Flow Models establish the equality between production, income and expenditure. Explain.

2. Explain in detail the circular flow of income. (U.S.E.B., 2015)

3. Explain the concepts of injections and leakages in Circular Flow of Income.

4. Explain the circular flow in four sector economy. [B.S.E.B (Arts ), 2011]

5. Explain the three steps of circular flow of national income. (J.A.C. , 2012)

6. Explain the circular nature of income effects. (U.S.E.B , 2012) 7. Explain the importance of circular income flows.

Objective Type Questions

(A) Multiple Choice Questions :

1. Which one of the following is included in circular flow ?

( B.S.E.B ., 2012) (a) Real Flow (b) Money Flow

(c) Both a & b (d) None of the above

2. Which one of the following is included in ‘Stock’ ? (B.S.E.B ., 2019) (a) Quantity of Money (b) Wealth

(c) Quantity of wheat stored in warehouse

(d) All the above

3. Which one of the following is included in flow ? (J.A.C ., 2019) (a) Consumption (b) Investment (c) Income (d) All the above

4. Which of the following is included in real flow ?

(a) Flow of Goods (c) Both a & b (b) Flow of Services (d) None of the above

5. Which services are provided by families to a firm ? (a) Land (b) Labour

(c) Capital and Enterprises (d) All the above

6. Which one is included in three-sector model ?

(B.S.E.B. , 2015) (a) Family (b) Firm

(c) Government (d) All the above

7. Which one is included in four-sector model ?

(a) Family, Firm, Industry

(b) Family, Firm, Government

(c) Family, Firm, Government, Foreign Sector

(d) None of the above

8. Which is the equilibrium condition of circular flow in four sector model ?

(B.S.E.B. , 2011) (a) C + I (b) C + I + G

(c) C + I + G + (X – M) (d) None of the above

9. Priority sector includes : (a) Agriculture

(c) Small Industries (B.S.E.B , 2012; J.A.C. , 2017) (b) Retail trading

(d) All the above

10. For a four sector or open economy the condition for equilibrium is : (B.S.E.B. , 2015) (a) Savings + taxes + Imports = Investment – govt,

expenditure + exports

(b) Total Leakages = Total Injections

(c) Aggregate output = Aggregate Expenditure (d) All of these

11. Which service is included in Tertiary Sector ? (B.S.E.B. , 2015) (a) Mining (b) Construction (c) Communication (d) Animal Husbandary

12. Which of the following is not a flow ? (C.B.S.E. , 2015) (a) Capital (b) Income

(c) Investment (d) Depreciation

13. Which of the following is included in secondary sector ? (B.S.E.B , 2017,

18. (a) Insurance (b) Banking

(c) Trade (d) Manufacturing

14. In an open economy which are the components of Aggregate Demand ?

(a) Consumption (b) Investment

(c) Consumption + Govt. Expenditure

(d) Consumption + Investment + Govt. Expenditure + Net

Export

15. Which sector is included in an economy ? (B.S.E.B. , 2019) (a) Primary

(c) Tertiary

(b) Secondary

(d) All of the above

[Ans. 1. (c), 2. (d), 3. (d), 4. (c), 5. (d), 6. (d), 7. (c), 8. (c), 9. (d), 10. (d), 11.

(c), 12. (a), 13. (d), 14. (d), 15. (d).]

(B) Fill in the Blanks :

1. ................has no time dimension.

2. Water in a reservoir is an example of.................

3. ................flow of income implies the flow of factor services.

4. ................is a leakage from money flow.

5. Every real flow has its................flow but in its reverse direction. [Ans. 1.

Stock, 2. stock, 3. Real, 4. Savings, 5. money] (C) State True/False

1. The Circular flow of income is the flow of payment and receipts between domestic firms and domestic households.

2. Condition of equilibrium is S = I in two sector model.

3. Mining is under tertiary sector.

4. Four sector model shows the closed economy.

5. Four sector circular flow model include the foreign sector rest of the world sector.

[Ans. 1. True, 2. True, 3. False, 4. False, 5. True.] (D) Match the following

Column :

‘A’

1. Money flow

2. Real flow

3. Two Sector Model

4. Public Revenue

5. Four Sector Model Sector

‘B’

(a) Flow of Goods & Services (b) Tax

(c) Open Economy

(d) Flow of Income

(e) Houshold and Producer

[Ans. 1. (d), 2. (a), 3. (e), 4. (b), 5. (c).]

(E) Answer in One Word :

1. Give an example of money flow.

2. Give an example of real flow.

3. What is called flow of goods and services ?

4. What is called flow of income (or money) ?

[Ans. 1. Expenditure on goods, 2. Flow of Labour, 3. Real flow, 4. Money flow.]

HOTS High Order Thinking Skills Questions 1. In what way ‘real flow’

and ‘money flow’ are associated ?

(See : Section 16.1 & 16.2)

2. Why does an injection give the expanding effect on national

income ?

(See : Point 2 of Section 16.4)

VBQ Value Based Questions

1. How is money flow opposite to real flow ?

(See : Section 16.2)

2. For the equilibrium in economy, injection of income should be equal to the leakage of income. Discuss.

(See : Section 16.4)

3. The four sector model of income indicates open economy.

(See : of Section 16.3.3)

MDQ Case Study Based on Evaluation & Multi-disciplinary Questions

1. What role does foreign sector play in four sector model of flow of income ?

(See : Section 16.3.3)

2. Savings squeezes money flow whereas investment make it extended. How ?

(See : Two sector model with saving-investment in Section 16.3.1)

3. 'Real flow' and 'Money flow' are complementary to each other. How ? (See : Section 16.2)

NCERT CORNER

Q. 1. Describe the four major sectors in an economy from Macro Economic point of view ?

Ans. Hint : See Section 16.3.3

Q. 2. Describe the Great Depression of 1929.

Ans. This depression took place due to fall in aggregate demand, in the economy. Classical view i.e ., supply creates its own demand (Say's law) stood false which was replaced by Keynesian view of ‘Effective Demand’. Keynes advocated for state intervention and criticised the classical view of ‘Laissez faire ’ i.e ., no state intervention.

Q. 3. What are the four factors of production and what are the remunerations to each of these called ? Ans. Following are the four factors of production and the remunerations of factors of production : Factors of Production Land Labour

Capital Entrepreneur

Remuneration Rent Wages Interest Profit.

Q. 4. Why should the aggregate final expenditure of an economy by equal to the aggregate factor payments ? Explain. Ans. See Section 16.3.1

Q. 5. Distinguish between stock and flow. Between net investment and capital which is a stock and which is a flow ? Compare net investment and capital with flow of water into a tank. Ans. See Section 16.1

Q. 6. What is the difference between planned and unplanned inventory accumulation ? Write down the relation between change in inventories and value added of a firm.

Ans. Planned inventory refers to changes in the stock of inventories which occurs in a planned way while on the contrary unplanned inventory signifies the change in the stock of inventories which occurs in an unexpected way. Value added may be defined as the contribution of the enterprise to the current flow of goods and services. Thus,

Gross Value Added = Value of Gross Output – Intermediate Consumption

Alternatively,

Gross Value Added = Sales + Value of Change in Inventories – Intermediate Consumption.

Here change in inventories means difference between opening inventories and closing inventories. Change in inventories affects the gross value added. If opening inventory is less than closing inventory, gross value added will be more and vice versa. _❐

CONCEPTS AND AGGREGATES RELATED TO NATIONAL INCOME

STUDY MATERIAL INCLUDED IN THE CHAPTER

17.1. Main Concepts and Aggregates of National Income 17.2. Gross Domestic Product at Market Price \left( \mathrm { G D P _ { M P } } \right)

17.3. Gross National Product at Market Price \left( \mathrm { G N P _ { M P } } \right) 17.4. Net National Product at Market Price \left( \mathrm { N N P _ { M P } } \right)

17.5. Net Domestic Product at Market Price \left( \mathrm { N D P _ { M P } } \right) 17.6. Net Domestic Income Or Net Domestic Product at Factor Cost ( \mathrm { N D P _ { F C } ) } 17.7. Gross Domestic Income Or Gross Domestic Product at Factor Cost ( \mathrm { G D P _ { F C } ) }

17.8. Net National Product at Factor Cost ( \mathrm { N N P _ { F C } ) } Or National Income 17.9. Gross National Product at Factor Cost ( \mathrm { G N P _ { F C } } ) ) 17.10. Private Income

17.11. Personal Income 17.12. Personal Disposable Income 17.13. National Disposable Income (NDI) 17.14. Numerical Illustrations A Quick Review of the Chapter Questions High Order Thinking Skills (HOTS) Questions Value Based Questions (VBQ) Case Study Based on Evaluation & Multidisciplinary Questions (MDQ) Numerical Questions NCERT Corner.

17.1. Main Concepts and Aggregates of National Income

Main aggregates of national income are as follows

(1) Gross Domestic Product at Market Price— { \bf G D P _ { M P } }

(2) Gross National Product at Market Price— { \bf G N P _ { M P } }

(3) Net National Product at Market Price— { \bf \cdot N N P _ { M P } }

(4) Net Domestic Product at Market Price— { \bf \cdot N D P _ { M P } }

(5) Net Domestic Product at Factor Cost or Net

Domestic Income— { \tt N D P } _ { \mathrm { F C } } or NDI

(6) Gross Domestic Product at Factor Cost or Gross

Domestic Income— { \bf G D P } _ { \mathrm { F C } } or GDI

(7) Net National Product at Factor Cost or National Income— \mathrm { \cdot N N P _ { F C } } or NI

(8) Gross National Product at Factor Cost or Gross National Income— \mathrm { \cdot G N P _ { F C } } or GNI

(9) Private Income

(10) Personal Income

(11) Personal Disposable Income

(12) National Disposable Income

17.2. Gross Domestic Product at Market Price (GDP _MP )

India, for example, there are many international banks as well as multinational companies which make production of goods and services in the country. Gross domestic product includes the market value of the final goods and services produced by all such producers.

Thus, Gross Domestic Product (GDP) is the market value of the final goods and services produced during a year within the domestic territory of a country.

● Features of Gross Domestic Product

1. It is a domestic concept rather than a national concept. Therefore, it does not include net factor income from abroad.

2. The gross refers to the cost of depreciation or consumption of capital goods which is included in GDP.

3. To avoid double counting, it includes the value of final goods and services only. The value of intermediate goods is not included in it.

4. GDP is a monetary concept and includes only market value of goods and services produced in the economy during a year.

5. It is a flow concept that measures market value of goods and services during a specific period and not on a point of time.

6. It does not include transfer payments, capital gains Gross Domestic Product (GDP) is the market value

of the final goods and services produced within the domestic territory of a country during one year inclusive of depreciation. There are both resident as well as foreign producers within the domestic territory of a country. In and incomes from illegal activities.

7. It is measured at prevailing price. If we calculate the value of GDP for 2019, only goods and services produced during 2019 will be included. Goods produced in 2018 and sold in 2019 will not be included in it. ^☞ Value of final goods and services { \mathrm { G D P } } _ { \mathrm { M P } } = produced within the territory of the country during a year

Box 1

17.3. Gross National Product at Market Price (GNP _MP )

Gross National Product is not only related to the value of final products produced by the residents of the country within the country’s territory but also adds net factor income from abroad. Thus, Gross National Product at market price \left( \mathrm { G N P _ { M P } } \right) ) is the market value of the final goods and services produced within the domestic territory of a country by the normal residents during an accounting year along with net factor income earned from abroad. (NFIA)

\mathrm { G N P } _ { \mathrm { M P } } = \mathrm { G D P } _ { \mathrm { M P } } + Net Factor Income from

Abroad (NFIA)

17.3.1. Net Factor Income from Abroad

Net factor income from abroad is the difference between factor income (rent, interest, profit and wages) earned by our residents from rest of the world and factor income earned by non-residents within our country.

The net factor income from abroad may be positive or negative. If net factor income from abroad is positive, gross national product would be greater than gross domestic product. On the other hand, if net factor income from abroad is negative, gross national product would be less than the gross domestic product.

Net Factor

Factor Income earned

● Components of Net Factor Income from Abroad

1. Net Compensation of Employees : It is the difference between compensation (of employees) received by resident workers, temporarily employed abroad and a similar payment made to non-resident workers who are employed temporarily within the domestic territory of a country.

2. Net Income from Property and Entrepreneurship (other than Retained Earnings of Resident

Companies of Abroad) : It is the difference between the income in the form of rent, interest and profit received by the residents of a country and similar payments made to the rest of the world.

3. Net Retained Earnings of Resident Companies Abroad : It is the difference between the retained earnings of resident companies located abroad and retained earnings of foreign companies located within the domestic territory of a country.

Difference between NFIA and Net Exports Net Factor Income from abroad (NFIA)

1. It refers to the difference between factor income earned by our normal residents from rest of the world and factor income earned by non-residents.

2. Net Factor Income from abroad = Factor Income from abroad earned by the Normal Residents – Factor Income of non-residents of the domestic territory.

3. It is a part of national income.

4. Its main components are :

(i) Net compensation of employees.

(ii) Net income from property and entrepreneurship.

Net Exports

1. It refers to the difference between exports and imports of goods and nonfactor services related to domestic territory of the country.

2. Net Exports = Total Exports – Total Imports

3. It is a part of domestic income.

4. Its main components are :

(i) Export and import of goods. (ii) Export-import of non-factor services.

(iii)Net retained earnings of residents companies.

Box 2

_{17.4. Net National Product at Market Price} used during production process and few of them are to (NNP

MP

be replaced. This depreciated value and replacement cost has to be deducted from gross national product for Capital instruments get depreciated while continuously obtaining Net National Product at market price (NNP_MP ).

\mathrm{NNP} _ {\mathrm{MP}} = \mathrm{GNP} _ {\mathrm{MP}} - \text {Depreciation}

Or

Net National Product at = Market Value of final goods and Market Price of services produced during a year + Net factor income from abroad – Depreciation or Capital Consumption

Box 3

Concepts and Aggregates Related to National Income (a) Normal Wear and Tear : It refers to those expenses which are borne on account of wear and tear of fixed capital like machines due to their continuous use.

(b) Obsolescence : It refers to those expenses which are incurred by the producers because of some capital equipment becoming obsolete or out of date with the introduction of latest machines and equipments.

(c) Accidental Breakdown of the Machinery : It includes expenses breakdown during

of meeting out machinery, the production process.

17.5. Net Domestic Product at Market Price (NDP _MP )

Net Domestic Product at Market Price is the market value of final goods and services produced by all the producers in the domestic territory of a country exclusive of depreciation during a year. It is obtained by deducting depreciation from gross domestic product.

It is exclusive of depreciation or capital consumption allowance because it is a loss in the value of capital assets, therefore, true or net domestic income does not include it.

In other words, Gross Domestic Product at Market Price \left( \mathrm { G D P _ { M P } } \right) includes depreciation while in Net Domestic Product at Market Price ( \mathrm { N D P _ { M P } } ) , depreciation is excluded.

Thus, Net Domestic Product at Market Price is the market value of final goods and services produced within the domestic territory of a country during a year exclusive of depreciation.

NDP_MP = GDP_MP – Depreciation Or

\mathrm{GDP} _ {\mathrm{MP}} = \mathrm{NDP} _ {\mathrm{MP}} + \text {Depreciation}

Box 4

17.6. Net Domestic Income Or

Net Domestic Product at Factor Cost ( { \bf N D P } _ { \bf F C } )

Net Domestic Product at Factor Cost can be defined as the total factor incomes earned by the factors of production while working within the domestic territory of a country in an accounting year. In other words, \mathrm { N D P _ { F C } } is the sum of domestic factor incomes.

Thus, Net Domestic Income or Net Domestic Product at Factor Cost (NDP _ { F C } ) is the sum total of factor incomes ( r e n t + p r o f i t + w a g e s + i n t e r e s t ) generated within the domestic territory of a country during a year.

\mathrm { N D P } _ { \mathrm { F C } } = \mathrm { N D P } _ { \mathrm { M P } } . – Net Indirect Taxes Or

\mathrm { N D P } _ { \mathrm { F C } } = \mathrm { N D P } _ { \mathrm { M P } } – Indirect Tax + Subsidy

Box 5

Why ‘Indirect Taxes’ are deducted and ‘Subsidy’ is added in \mathbf { N D P _ { M P } } for calculating \mathbf { N D P } _ { \mathrm { F c } } ?

(a) Why ‘Indirect Taxes’ are deducted ?

In the calculation of Net Domestic Product the value of goods and services at market prices are taken into consideration which includes production. So indirect taxes

(b) Why ‘Subsidy’ is added ?

indirect taxes. Hence, the entire market price is not received by factors of are deducted from market price for calculating the value of factor cost.

Generally, government provides subsidy ( i.e., economic assistance) to the producer or distributor, so that the commodity may be sold at lower prices. In this case, market price becomes lower to what factors of production actually get. Hence, for calculating the actual factor income, subsidy amount is added in market price.

Box 6

17.7. Gross Domestic Income Or Gross Domestic Product at Factor Cost ( \mathbf { G D P _ { F C } } )

Gross Domestic Product at Factor Cost ( G D P _ { F C } ) is the sum total of factor incomes ( r e n t + i n t e r e s t + p r o f i t + w a g e s ) generated within the domestic territory of a country, alongwith consumption of fixed capital during a year.

\mathrm{NDP} _ {\mathrm{FC}} + \text {Depreciation} = \mathrm{GDP} _ {\mathrm{FC} O r}

NDP_FC = GDP_FC – Depreciation

17.8. Net National Product at Factor Cost ( \mathbf { N N P } _ { \mathbf { F C } } ) Or National Income

Net National Product at Factor Cost ( \mathrm { N N P _ { F C } ) } is known as ‘National Income \mathrm { \ ' . N N P _ { F C } } is the sum total of net domestic product at factor cost and net factor income from abroad.

Net National Product at Factor Cost ( N N P _ { F C } ) or national income is the sum total of factor incomes ( r e n t + i n t e r e s t + p r o f i t + w a g e s ) generated within the domestic territory of a country, alongwith net factor income from abroad during a year.

Money GDP and Real GDP Gross National Income (GNP) and Gross

Domestic Income (GDP) calculation have two aspects :

1. GNP or GDP Calculation on Current Prices : It is called Money GNP or Money GDP.

2. GNP or GDP Calculation on Fixed Prices : It is called Real GNP or Real GDP.

Real GDP Or

GDP at Fixed Prices

GDP at Current Prices_{100= Price Index}

Box 7

Thus, NNP _FC is the sum total of factor incomes earned by normal residents of a country during a year. \mathrm { N I = R e n t + W a g e s + S a l a r y + I n t e r e s t + P r o f i t }

For converting ‘ domestic ’ variable into ‘national ’ variable, net factor income from abroad is added in domestic variable. Domestic income, i.e., \mathrm { N D P _ { F C } } is a domestic variable and hence, for converting it into { \mathrm { N N P } } _ { \mathrm { F C } } , net factor income from abroad is added in it.

\mathrm { N N P } _ { \mathrm { F C } } = \mathrm { N D P } _ { \mathrm { F C } } + Net Factor Income from Abroad NDP _FC

1. It is an addition of all factor income generated within domestic territory of a nation, whether generated by residents or non-residents

2. Net factor income from abroad is not included in it.

Distinction between \mathbf { N D P _ { F C } } and \mathbf { N N P _ { F C } }

\mathsf {N N P} _ {F C}

1. It is an addition of all factor income generated by residents of a country either within the territory or outside the territory.

2. It includes net factor income from abroad. Box 8

17.9. Gross National Product at Factor Cost ( \mathbf { G N P } _ { \mathbf { F C } } )

Gross National Product at Factor Cost \left( G N P _ { F C } \right) is the sum total of factor incomes earned by normal residents of a country, alongwith consumption of fixed capital during a year. If depreciation expenses are added to { \mathrm { N N P } } _ { \mathrm { F C } } we get \mathrm { G N P _ { F C } }

GNP

Gross National Product

is the total earned factor income by residents of a country during an accounting year which includes depreciation.

Box 9

☞

\mathrm { N N P _ { F C } } + Depreciation = GNP_FC Or

\mathrm { G N P _ { F C } } – Depreciation = NNP_FC

(A) Distinction between GDP and GNP : Gross Domestic Product ( GDP )

1. GDP refers to the money value of all the final goods and services produced within the domestic territory of a country.

2. GDP is a territorial concept as it is confined to domestic territory of a country.

3. It does not include net factor earning from abroad. GDP = GNP–NFIA

(NFI A indicates Net Factor Income from Abroad)

4. GDP is a smaller concept, limited to domestic territory.

(B) Distinction between NDP _MP and \mathbf { N N P } _ { \mathbf { \Lambda } \mathbf { M P } } : N D P _ { \mathbf { \Lambda } _ { M P } }

1. It refers to the market value of all final goods and services produced within the domestic territory of a country within a year.

2. It is a domestic concept as it does not include net factor income from abroad.

3. \mathrm { N D P _ { M P } = N N P _ { M P } - N F I A }

(C) Distinction between \mathbf { N D P _ { M P } } and \mathbf { N D P _ { F C } }

N D P _ {M P}

1. It refers to the market value of all final goods and services produced within the domestic territory of a country in an accounting year.

2. It is estimated at market price.

3. Net indirect taxes are included in it.

4. \mathrm { N D P } _ { \mathrm { M P } } = \mathrm { N D P } _ { \mathrm { F C } } + \tau r Net Indirect taxes Indirect taxes – Subsidies

Gross National Product ( GNP ) 1. GNP refers to market value of final goods and services produced by normal residents of a country.

2. GNP is a national concept as it is related to normal residents of a country.

3. It does include the income from net factor earning from rest of the world.

GNP = GDP + NFIA

4. GNP is a wider concept as it includes factor income received from abroad.

NNP MP

It refers to the net market value of all final goods and services produced by the national residents of a country in any part of the world.

2. It is a national concept as it includes the net factor income from abroad.

3. \mathrm { N N P _ { M P } = N D P _ { M P } + N F I A }

N D P _ {F C}

1. It is the income received by the factors of production while working within the domestic territory of a country in a year.

2. It is estimated at factor cost.

3. Net indirect taxes are not included in it.

4. \mathrm { N D P } _ { \mathrm { F C } } = \mathrm { N D P } _ { \mathrm { M P } } - \mathbf { 0 } \mathrm { r } net indirect taxes Indirect Taxes + Subsidies

17.10. Private Income

Private income refers to that income which accrues to private sector from all sources, both within domestic territory as well as from rest of the world. It is the income of all private enterprises and households in the private sector from whatever source either earned or unearned.

Private income includes both factor income and transfer income accruing to private households and private enterprises. It does not make any distinction between earned and unearned incomes, domestic and foreign income.

Private Income = Income Earned by Private Sector in Domestic Product + Net Factor Income from Abroad + Current Transfer from Government + Net Current Transfer from Rest of the World + Interest on National Debts

Transfer Earnings Transfer earnings refer to those earnings which accrued to household or private enterprises without providing any service. It is an unearned income accruing from Govt. or from abroad; Govt. pays it in the form of pension, unemployment allowance, subsidies, etc., gifts and grants as received from abroad.

Box 10 Box 11

● (A) Difference between National Income and Private Income National Income

1. It includes income of both public and private sectors.

2. It does not include transfer earnings.

3. Interest on national debt is not a part of national income.

Private Income

1. It includes income of only private sector.

2. It includes both factor income and transfer earnings.

3. Interest on national debt is a part of national income.

● (B) Difference between Income from Domestic Product accruing to Private Sector and Private Income

Income from Domestic Product accruing to Private Sector

1. It is purely a domestic concept that does not include income from abroad.

2. It includes only factor income.

3. It does not include interest on national debt.

4. Domestic income accrued to Private Sector = { \mathrm { N D P } } _ { \mathrm { F C } }

– Income from Domestic Product accruing to public sector.

17.11. Personal Income

Personal income is the income actually received by the individuals and households from all sources in the form of factor income and current transfers. Personal income is always less than national income because factors of production do not get that income which is generated by them. Many deductions are made from national income and a few items are added for getting personal income. ● Computation of Personal Income

For the computation of personal income the items to be deducted and to be added in national income are as follows :

(i) Items to be Deducted :

(a) Corporate Income Tax : Corporate sector has

to pay a part of its profit as tax to the government. So this part of income is not received by shareholders as personal income and hence, it is deducted from national income.

(b) Undistributed Corporate Profit : Corporate sector does not distribute the entire income Private Income

1. It is a national concept that includes domestic as well as income received from abroad.

2. It includes both factor income and transfer income.

3. It includes interest on national debts.

4. Private Income = Domestic Income accrued to Private Sector + All Transfers Incomes + Interest on National Debts + NFIA.

among shareholders. A part of the income is reinvested by them and hence, for computing personal income, this item is deducted from national income.

(c) Deductions for Social Security : Social security contributions like provident fund and pension fund are deducted from national income for computing personal income.

(ii) Items to be Included :

Transfer payments like pension, unemployment allowance, etc., are added in national income for computing personal income.

Thus,

Personal Income = National Income – Corporate Tax – Undistributed Corporate Profits – Social Securities Contributions + Transfer Payments.

22

Introductory Macro Economics

(A) Difference between Private Income and Personal Income

1. It is a because savings.

Private Income

broader concept than personal income it includes corporate tax and corporate 2. It is the total income of both private and households.

Income = Domestic Income enterprises

3. Private Private accrued to Sector + NFIA + All Transfer Payments Personal Income

4. It is a narrow concept than private income as it does not include corporate tax and corporate savings.

5. It is the actual income received by households and individuals.

6. Personal Income = Private Income – Corporate Tax

– Corporate Savings.

+ Interest on National Debts.

(B) Difference between National Income and Personal Income National Income

1. It is related to the generation of income by public and private sector.

2. It does not include

Personal Income

1. It is a receipt concept. It does not include the income of public sector. transfer income. 3. It does not include interest on national debts. 4. It includes corporate tax and corporate savings.

2. It includes individuals.

3. It includes

4. It neither savings.

transfer income of households and

interest on national debts.

includes corporate tax nor corporate

17.12. Personal Disposable Income

The entire personal income received by households and individuals is not available to them as disposable income. A part of personal income is paid by households and individuals to the government as direct tax (like income tax, house tax, etc.) Besides direct tax, individuals and households have to pay fines and fees which becomes

Hence,

the miscellaneous receipts of the government administrative department and it has also to be deducted from personal income for computing personal disposable income.

Personal Miscellaneous Disposable = Personal – Direct – Receipts of Income Income Tax the Government

Difference between Personal Income and Personal Disposable Income

Personal Disposable Income

It is the income remaining with indi-viduals and households after payment of all taxes levied against their income and their property by the government.

Box 12

Personal Income

1. It is a broader concept as it includes direct taxes and fines and fees of Govt. administration.

2. Whole of this income cannot be disposed of upon consumption and savings.

3. It includes direct taxes, income tax, wealth tax, etc.

17.13. National Disposable Income (NDI)

National Disposable Income

It is the income from all sources (earned income as well as transfer payments from abroad) available to residents of a country for c ons ump tion e xpe ndi tu re o r saving during a year.

Box 13

National disposable income refers to disposable income of the country as a whole. National disposable income is estimated as the sum total of net domestic income at factor cost, net indirect

Personal Disposable Income

1. It is a narrow concept and does not include both direct taxes and miscellaneous Govt. receipts.

2. It can be disposed of upon consumption expenditure and savings.

3. It does not include such taxes.

taxes, net factor income from abroad and net current transfers from rest of the world.

Hence,

National National Income (Net Domestic Income

Disposable = at Factor Cost + Net Factor Income Income from Abroad) + Net Indirect Tax + Net Current Transfer from Rest of the World

● Gross and Net Concepts of National Disposable Income

(i) For computing, Net National Disposable Income (NNDI), net indirect tax and net current transfers from rest of the world are added in national income. In short,

Net National Disposable =

Income (NNDI) National Income + Net Indirect Tax + Net Current Transfers from Rest of the World

(iii) When fixed capital consumption is added to NNDI, we get Gross National Disposable Income (GNDI) GNDI = NNDI + Fixed Capital Consumption

Difference between National Income (NI) and National Disposable Income (NDI) 1. National income is always computed at factor cost while national disposable income is calculated at market factor.

2. National income includes only factor income while national disposable income includes both factor income as well as net transfer from abroad.

Difference between National Disposable Income and Personal Disposable Income Personal Disposable

Income

1. It is the actual income received by households from all sources.

2. It does not include and direct taxes.

3. PDI = Personal Income – Direct Taxes – Misc. Govt. Receipts

National Disposable

Income

1. It is the income of whole national income, including income of public and private sector, transfer incomes and indirect taxes.

2. It includes both the taxes in it.

3. { \mathrm { N D I } } = { \mathrm { N N P } } _ { \mathrm { F C } } + Net Indirect Taxes + Net Current Transfers from Rest of the World.

Inter-relationship among Various Aggregates : At a Glance

• GNP_MP = GDP_MP + NFIA

\mathrm { G N P } _ { \mathrm { M P } } = \mathrm { G N P } _ { \mathrm { F C } } + Net Indirect Taxes

• GNP_MP = NNP_MP + Depreciation

\mathrm { G N P } _ { \mathrm { M P } } = \mathrm { G D P } _ { \mathrm { F C } } + Net Indirect Taxes + NFIA

• GDP_MP = GNP_MP – NFIA

\mathrm { G D P } _ { \mathrm { F C } } = \mathrm { G D P } _ { \mathrm { M P } } – Net Indirect Taxes

\mathrm { G N P } _ { \mathrm { F C } } = \mathrm { G N P } _ { \mathrm { M P } } – Net Indirect Taxes

• NNP_MP = GNP_MP – Depreciation

\mathrm{NNP} _ {\mathrm{MP}} = \mathrm{NDP} _ {\mathrm{MP}} + \mathrm{NFIA}

\mathrm { N N P } _ { \mathrm { M P } } = \mathrm { N D P } _ { \mathrm { F C } } + \mathrm { N F I A } + Net Indirect Taxes

• NNP_FC = NDP_FC + NFIA

\mathrm { N N P } _ { \mathrm { F C } } = \mathrm { G D P } _ { \mathrm { F C } } – Depreciation + NFIA

\mathrm { N N P } _ { \mathrm { F C } } = \mathrm { N N P } _ { \mathrm { M P } } – Net Indirect Taxes

\mathrm { N D P } _ { \mathrm { F C } } = \mathrm { G D P } _ { \mathrm { F C } } – Depreciation

\mathrm { N D P } _ { \mathrm { F C } } = \mathrm { N D P } _ { \mathrm { M P } } – Net Indirect Taxes

Box 14

Box 15

Final Goods And Intermediate Goods Final Goods — Final Goods are those goods which are used by the consumers as cell as producers. Final Goods may be classified into (i) final consumer goods, and (ii) final producer goods.

(i) Final consumer goods are those goods which are purchased by consumers or households for satisfaction of their wants (like clothes, shoes, anaments, milk etc.) (ii) Final Producer Goods are those goods which are purchased by procuress for using them as fixed assets in the production process.

Note : Final Goods are neither resold nor used for any further transformation in the process of production. Intermediate Goods

Intermediate Goods are those goods which are used either for resole or production of other goods in the same year for example, cotton is purchased by producer of cloth for production of clothes. Here, cotton is an intermediate good.

Distinction between Intermediate Goods and Final Goods

Intermediate Goods Final Goods

1. These goods are used for the production of other 1. Final goods are those goods which are purchased Goods or for resole in the firm. for final consumption i.e. these will be no further production would be made from those goods.

2. They are neither included in National Income nor 2. They are included in both national and domestic included in domestic Income. income.

3. They remain within the boundry line of production.

4. Sugar used by a sweet owner for production of 3. These goods are outside the boundry line of ^{production.sweets is a good example of intermediate good.} 4. Sugar used by Household for final consumption in c1 house is a perfect example for final good.

17.14. Numerical Illustrations

1. Calculate :

(a) Gross Domestic Product at Market Price

(b) Net Domestic Product at Market Price

Items ` (crores) (i) Operating Surplus 10000

(ii) Consumption of Fixed Capital 1250

(iii) Indirect Taxes 2600

(iv) Subsidy 2000

(v) Mixed Income 5550

(vi) Compensation of Employees 6620

Solution :

(a) { \mathrm { G D P } } _ { \mathrm { M P } }

GDP_MP = Operating Surplus + Indirect Taxes – Subsidies + Mixed Income +

Compensation of Employees + Consumption of Fixed Capital = 10000 + 2600 - 2000 + 5550 + 6620 + 1250 =` 24020 crores NDP$_{MP}$ = 24020 - 1250 = 22770 crores (b) N D P$_{MP}$ = GDP$_{MP}$ - Consumption of Fixed Capital = 24020 - 1250 = ` 22770 crores 2. Calculate Gross Domestic Product at Factor Cost from following data : Items ` (crores) (i) Value of Intermediate Consumption 250 (ii) Indirect Taxes 40 (iii) Consumption of Fixed Capital 50 (iv) Value of Output 700 Solution : GDP$_{FC}$ = Value of Output - Value of Intermediate Consumption - Indirect Taxes = 700 - 250 - 40 = ` 410 crores 3. Calculate Gross National Product at Market Price from the following data : Items ` (crores) (i) Mixed Income of Self-employed 250 (ii) Net Capital Formation 160 (iii) Net Indirect Taxes 70 (iv) Compensation of Employees 300 (v) Net Factor Income from Abroad (-)20 (vi) Changes in Stock 30 (vii) Gross Fixed Capital Formation 150 (viii) Operating Surplus 500 (ix) Exports 70 (x) Imports 100 Solution : GNP$_{MP}$ = Mixed Income of Self-employed + Net Indirect Taxes + Compensation of Employees + Net Factor Income from Abroad + Operating Surplus + Consumption of Fixed Capital Where Consumption of Fixed Capital = Changes in Stock + Gross Capital Formation - Net Capital Formation = 30 + 150 - 160 = ` 20 crores GNP$_{MP}$ = 250 + 70 + 300 + (- 20) + 500 + 20 =` 1120 crores

4. From the following data calculate : (a) Personal Income (b) National Income (c) Domestic Income Items ` (crores) (i) Disposable Income 59050 (ii) Corporate Tax 950 (iii) Net Factor Income from Abroad (-)280 (iv) Undistributed Profits 410 (v) Personal Tax 1820 (vi) Transfer Payments 1986 Solution : (a) Personal Income = Disposable Income + Personal Tax = 59050 + 1820 = ` 60870 crores (b) National Income = Personal Income + Corporate Tax – Transfer Payments + Undistributed Profits = 60870 + 950 – 1986 + 410 = ` 60,244 crores [Hint : Undistributed Profits means Corporate Savings] (c) Domestic Income = National Income – NFIA = 60244 – (-280) = ` 60524 crores 5. Gross National Product at Market Price in an economy is ` 180000 crores. The capital stock in the economy is worth ` 300000 crores and it depreciates at the rate of 10% per annum. Indirect taxes amount to ` 40000 crores and subsidies amount to ` 20000 crores. What is National Income ? Solution : National Income (NNP$_{FC}$ ) = GNP$_{MP}$ – Depreciation – Indirect Taxes + Subsidies Here, GNP$_{MP}$ = ` 180000 crores; Indirect Taxes = 40000, Subsidies = ` 20000 crores 10 Depreciation = 300000 × 100 = 30000 crores National Income = 180000 – 40000 + 20000 – 30000 = ` 130000 crores

6. Using the following information, calculate : (a) Income from Domestic Product accruing to Private Sector (b) Personal Disposable Income Items ` (crores) (i) Interest on National Debts 10 (ii) Savings of Private Corporate Sector 30 (iii) Corporate Tax 15 (iv) Net Current Transfers from Govt. Administrative Deptt. 20 (v) Net Domestic Product at Factor Cost 450 (vi) Savings of Non-departmental Enterprises 20 (vii) Net Current Transfers from Rest of the World 5 (viii) Direct Taxes paid by Households 15 (ix) Net Factor Income from Abroad (-5) (x) Income from Property and Entrepreneurship 25 accruing to Govt. Administrative Departments Solution : (a) Income from Domestic Product accruing to Private Sector = NDP$_{FC}$ – Income from Property and Entrepreneurship accruing to Govt. Administrative Departments – Savings of Non-departmental Enterprises = 450 – 25 – 20 = ` 405 crores (b) Personal Disposable Income : Private Income = Income from Domestic Sector accruing to Private Sector + Net Current Transfer from Govt. Administrative Departments + Net Current Transfers from Rest of the World + Net Factor Income from Abroad + Interest on National Debts = 405 + 20 + 5 – 5 + 10 = ` 435 crores Personal Income = Private Income – Corporate Savings – Corporate Tax = 435 – 30 – 15 = ` 390 Personal Disposable Income = Personal Income – Direct Taxes = 390 – 15 = ` 375 crores 7. You are given the following information, calculate GNP$_{MP}$ and National Income : Items ` (crores) (i) NDP$_{FC}$ 55000 (ii) Indirect Taxes 3000 (iii) Subsidies 1600 (iv) Depreciation 2000 (v) Net Factor Earnings (-)500 Also determine National Income from it.

Solution : GNP$_{MP}$ = NDP$_{FC}$ + Depreciation + Net Factor Earnings + Indirect Taxes – Subsidies = 55000 + 2000 + (−500) + 3000 – 1600 = ` 57900 crores National Income (NNP$_{FC}$ ) = NDP$_{FC}$ + Net Factor Earnings = 55000 + (−500) = ` 54500 crores 8. From the following data calculate : (a) Private Income (b) Personal Income (c) Personal Disposable Income Items ` (crores) (i) Savings of Private Corporate Sector (Net of Retained Earnings of Foreign Companies) 80 (ii) Direct Taxes paid by Households 30 (iii) Operating Surplus 200 (iv) Factor Income from Net Domestic Product accruing to Private Sector 750 (v) Corporate Tax 40 (vi) Current Transfers from Govt. Administrative Departments 20 (vii) Net Factor Income from Abroad (−)25 (viii) Capital Transfers from Rest of the World 60 (ix) Current Transfers from Rest of the World 45 (x) Savings of Non-departmental Enterprises 150 (xi) Income from Property and Entrepreneurship accruing to Govt. Administrative Departments 200 Solution : (a) Private Income = Factor Income from NDP accruing to Private Sector + Net Factor Income from Abroad + Current Transfers from Govt. Administrative Departments + Current Transfer from Rest of the World = 750 + (−25) + 20 + 45 = ` 790 crores (b) Personal Income = Private Income – Corporate Tax – Corporate Savings (Net of Retained Earnings of Foreign Companies) = 790 – 40 – 80 = ` 670 crores (c) Personal Disposable Income = Personal Income – Direct Taxes paid by Households = 670 – 30 = ` 640 crores 9. Following data relates to national income and other aggregate at

current prices in India for the year 2018-19 : Items ` (crores) (i) Net National Product at Factor Cost 1008188 (ii) Indirect Taxes 164902 (iii) Subsidies 37143 (iv) Other Current Transfers from Rest of the World 41,120 Calculate Net National Disposable Income for 2018-19. Solution : Net National Disposable Income = NNP$_{FC}$ + Indirect Taxes – Subsidies + Other Current Transfers from Rest of the World = 108188 + 164902 – 37143 + 41120 = ` 1177067 crores 10. Following figures relate to an economy calculate : (a) National Income (b) Net National Disposable Income (c) Gross National Disposable Income Items ` (crores) (i) Net Domestic Product at Factor Costs 155650 (ii) Net Indirect Taxes 4550 (iii) Operating Surplus 55430 (iv) Other Current Transfers from Abroad 26500 (v) Net Factor Income from Abroad 7460 (vi) Consumption of Fixed Capital 1000 Solution : (a) National Income (NNP$_{FC}$ ) = Net Domestic Product at Factor Costs + Net Factor Income from Abroad = 155650 + 7460 = ` 163110 crores (b) National Disposable Income = National Income + Net Indirect Taxes + Net Current Transfers from Abroad = 163110 + 4550 + 26500 = ` 194160 crores (c) Gross National Disposable Income = National Disposable Income + Consumption of Fixed Capital = 194160 + 1000 = ` 195160 crores 11. Determine the following from given information : (a) GDP$_{MP}$, (b) Private Income, (c) Personal Income. Items ` (crores) (i) Net Indirect Taxes 750 (ii) Net Factor Income from Abroad (–)20 (iii) Savings of Private Corporate Sector 280

(iv) GNP at Factor Cost 3950 (v) Income from Domestic Sector accrued to Private Sector 3100 (vi) Corporation Tax 220 (vii) Interest on National Debt 90 Solution : (a) GDP$_{MP}$ = GNP$_{FC}$ – Net Factor Income from Abroad + Net Indirect Taxes = 3950 – (-20) + 750 = ` 4720 crores (b) Private Income = Income from Domestic Sector accrued to Private Sector + Interest on National Debt + Net Factor Income from Abroad = 3100 + 90 – 20 = ` 3170 crores (c) Personal Income = Private Income–Corporate Tax – Savings of Private Corporate Sector = 3170 – 220 — 280 = ` 2670 crores 12. From the following data, estimate : (a) GDP at Market Price (b) Private Income (c) Personal Income Items ` (crores) (i) National Income 1200 (ii) Consumption of Fixed Capital 300 (iii) Net Factor Income and from Abroad (-)100 (iv) Net Indirect Taxes 400 (v) Income from Domestic Product accruing to Private Sector 800 (vi) Net Current Transfers from Govt. Administrative Departments 300 (vii) Net Other Current Trans. from Rest of the World 200 (viii) Savings of Private Corporate Sector 200 (ix) Corporate Tax 100 Solution : (a) GDP$_{MP}$ = National Income + Consumption of Fixed Capital + Net Indirect Taxes – Net Factor Income from Abroad. = 1200 + 300 + 400 – (-100) = ` 2000 crores (b) Private Income = Income from Domestic Product accruing to Private Sector + Net Current Transfers from Government Administrative Departments + Net Other Current Transfers from Rest of the World + NFIA = 800 + 300 + 200 + (-100) = ` 1200 crores (c) Personal Income

= Private Income – Savings of Private Corporate Sector – Corporate Tax = 1200 – 200 – 100 = `900 crores Calculate Net Domestic Product at Factor Cost from following information : Items ` (crores) (i) GNP at Market Price 35000 Net Indirect Taxes 4000 Consumption of Fixed Capital 1800 Net Factor Income from Abroad 200 Solution : Calculation of Net Domestic Product at Factor Cost involves the following three steps : (a) GNP$_{FC}$ = GNP$_{MP}$ – Net Indirect Taxes = 35000 – 4000 = `31000 crores NNP$_{FC}$ = GNP$_{FC}$ – Depreciation = 31000 – 1800 = `29200 crores NDP$_{FC}$ = NNP$_{FC}$ – Net Factor Income from Abroad = 29200 – 200 = `29000 crores From the following data estimate : (a) National Income (b) Personal Income (c) Private Income Items ` (crores) (i) Net National Product of Market Price 1015 (ii) Income from Entrepreneurship and Property accruing to Govt. Administrative Department 25 (iii) Indirect Taxes 150 (iv) Subsidies 20 (v) Savings of Non-departmental Enterprises 5 (vi) National Debt Interest 10 (vii) Current Transfers from Govt. 25 (viii) Current Transfers from Rest of the World 10 (ix) Savings of Private Corporate Sector 15 (x) Corporate Profit Tax 10 Solution : (a) National Income = NNP$_{MP}$ – Indirect Taxes + Subsidies = 1015 – 150 + 20 = `885 crores Personal Income = National Income – Income from Property and Entrepreneurship accruing to Govt. – Savings of Non-departmental Enterprises + Current Transfers

from Govt. + Current Transfers from Rest of the World + Interest from National Debt – Corporate Profit Tax – Savings of Private Corporate Sector = 885 – 25 – 5 + 25 + 10 + 10 – 10 – 15
=` 875 crores
(c) Private Income
= Personal Income + Corporate Profit Tax + Savings of Private Corporate Sector = 875 + 15 + 10 = ` 900 crores
15. With the help of following data calculate :
(a) Personal Disposable Income
(b) Personal Income
(c) Private Income
Items ` (crores) (i) Corporate Tax 1500
(ii) Direct Taxes paid by Households 6500
(iii) Household Final Consumption Expenditure 24500
(iv) Savings of Private Corporate Sector 3500
(v) Interest on National Debt 2000
(vi) Household Savings 7500
Solution :
(a) Personal Disposable Income
= Household Final Consumption Expenditure + Household Savings = 24500 + 7500 = ` 32000 crores
(b) Personal Income
= Personal Disposable Income + Direct Taxes paid by Households = 32000 + 6500 = ` 38500 crores
(c) Private Income
= Personal Income + Corporate Tax + Savings of Private Corporate Sector = 38500 + 1500 + 3500 = ` 43500 crores
16. From the following data find out :
(a) Net National Product at Market Price
(b) Private Income
(c) Personal Disposable Income
Items ` (crores) (i) Gross Domestic Product at Factor Cost 2570
(ii) Indirect Tax 850
(iii) Subsidies 125
(iv) Net Factor Income from Abroad (–)5
(v) Savings of Non-departmental Enterprises 15
(vi) Income from Property and Entrepreneurship accruing to Govt.

Administrative Departments 100 (vii) Consumption of Fixed Capital 290 (viii)Interest on Public Debt 60 (ix) Current Transfers from Govt. 245 (x) Other Current Trans. from Rest of the World 310 (xi) Corporate Tax 190 (xii) Savings of Private Corporate Sector 85 (xiii)Direct Taxes paid by Households 50 Solution : (a) NNP$_{MP}$ = GDP$_{FC}$ + Indirect Taxes – Subsidies + Net Factor Income from Abroad – Consumption of Fixed Capital = 2570 + 850 – 125 + (– 5) – 290 = ` 3000 crores (b) Private Income = GDP$_{FC}$ – Depreciation + Net Factor Income from Abroad – Savings of Non-departmental Public Enterprises – Income from Property and Entrepreneurship accruing to Govt. Administrative Department + Current Transfers from Govt. + Other Current Transfers from Rest of the World + Interest on Public Debts = 2570 – 290 + (– 5) – 15 – 100 + 245 + 310 + 60 =` 2775 crores (c) Personal Disposable Income = Private Income – Corporate Tax – Saving of Private Corporate Sector – Direct Taxes paid by Households = 2775 – 190 – 85 — 50 = ` 2450 crores 17. Calculate : (a) Private Income (b) Personal Disposable Income (c) GNP at Market Price Items ` (crores) (i) Consumption of Fixed Capital 195 (ii) Income from Entrepreneurship accruing to Govt. Administrative Deptts. 75 (iii) Net Domestic Product at Factor Cost 2700 (iv) Savings of Non-departmental Enterprises 9 (v) National Debt Interest 30 (vi) Current Transfers from Govt. Admn. Deptts. 72 (vii) Current Transfers from Rest of the World 27 (viii) Savings of Private Corporate Sector 48

(ix) Direct Personal Taxes 75 (x) Corporate Profit Tax 27 (xi) Net Factor Income from Rest of the World (-)45 Solution : (a) Private Income = NDP$_{FC}$ – Income from Entrepreneurship accruing to Govt. Administrative Deptt. – Savings of Non-departmental Enterprises + Current Transfers from Govt. Admn. Deptt. + Current Transfers from Rest of the World + Interest on National Debts + Net Factor Income from Abroad = 2700 – 75 – 9 + 72 + 27 + 30 + (-45) =` 2700 crores (b) Personal Disposable Income = Private Income – Savings of Private Corporate Sector – Corporate Profit Tax – Direct Personal Taxes = 2700 – 48 – 27 – 75 = ` 2550 crores (c) GNP$_{MP}$ = NDP$_{FC}$ + Consumption of Fixed Capital + Net Factor Income from Abroad = 2700 + 195 + (-45) = ` 2850 crores 18. Calculate NDP$_{FC}$ and NDP$_{MP}$ from the following information : Items ` (crores) (i) GNP$_{MP}$ 200000 (ii) Consumption of Fixed Capital 10000 (iii) Net Indirect Taxes 6000 (iv) Net Factor Income from Abroad (-)4000 Solution : NDP$_{MP}$ = GNP$_{MP}$ – Consumption of Fixed Capital – Net Factor Income from Abroad = 200000 – 10000 – (-4000) =` 194000 crores NDP$_{FC}$ = NDP$_{MP}$ – Net Indirect Taxes = 194000 – 6000 = ` 188000 crores 19. Determine the value GNP$_{FC}$ from the following data : Items ` (crores) (i) Net Domestic Product at Market Price 24000 (ii) Capital Stock of the Country (Depreciation @ 10%) 40000 (iii) Indirect Taxes 120 (iv) Subsidies 30 (v) Factor Income from Rest of the World 400 (vi) Factor Income to Rest of the World 600 Solution : GNP$_{FC}$ = NDP$_{MP}$ + Depreciation + Factor Income from Abroad –

Factor Income to Rest of the World – Indirect Taxes + Subsidies = 24000 + 4000 + 400 - 600 - 120 + 30 = 28430 - 720 = ` 27710 crores 20. From the data given below, estimate : (a) GNP at Market Price (b) Private Income (c) Personal Income Items ` (crores) (i) Gross Domestic Product at Factor Cost 370 (ii) Income from Domestic Product accruing to Private Sector 290 (iii) Net Current Transfers from Govt. 50 (iv) Net Indirect Taxes 60 (v) Net Other Current Transfers from Abroad 35 (vi) Net Factor Income from Abroad (–)30 (vii) Savings of the Private Corporate Sector 25 (viii) Corporate Tax 5 Solution : (a) GNP$_{MP}$ = GDP$_{FC}$ + Net Indirect Taxes + Net Factor Income from Abroad = 370 + 60 + (– 30) = ` 400 crores (b) Private Income = Income from Domestic Product accruing to Private Sector+ Net Current Transfers from Govt. + Net Other Current Transfers from Abroad + Net Factor Income from Abroad = 290 + 50 + 35 - 30 = ` 345 crores (c) Personal Income = Private Income – Corporate Tax – Savings of the Private Corporate Sector = 345 - 5 - 25 = ` 315 crores 21. Find out Personal Income from following data : Items ` (crores) (i) Income from Domestic Product accruing to Private Sector 224 (ii) Net Current Transfers from Rest of the World 3 (iii) Net Current Transfers from Govt. 9 (iv) National Debt Interest 8 (v) Undistributed Profit 1 (vi) Corporate Tax 3 Solution : Personal Income = Income from Domestic Product accruing to Private Sector + Net Current Transfers from Rest of the World + Net Current Transfers from Govt. + National Debt Interest – Undistributed Profits –

Corporate Tax = 224 + 3 + 9 + 8 - 1 - 3 = ` 240 crores Calculate GNP at Factor Cost from the following information : Items ` (crores) (i) Wages and Salaries 24500 (ii) Mixed Income 3000 (iii) Rent 4000 (iv) Interest 3000 (v) Profit 7000 (vi) Depreciation 2000 Solution : GNP$_{FC}$ = Wages and Salaries + Rent + Interest + Profit + Mixed Income Depreciation = 24500 + 4000 + 3000 + 7000 + 3000 + 2000 =` 43500 crores Note : It is understood that Net Factor Income from Abroad is already included in these incomes. 23. From the following imaginary figures, calculate GDP : Items ` (crores) (i) Net Domestic Product 50000 Depreciation 3200 (ii) Net National Product 46000 Net Foreign Earnings 3000 Consumption of Fixed Capital 3600 (iii) Gross National Product 100000 Net Income from Abroad 6000 Net Income Payable to Foreigners 2000 Depreciation 11000 Solution : (i) GDP = Net Domestic Product + Depreciation = 50000 + 3200 = ` 53200 crores (ii) GDP = Net National Product + Consumption of Fixed Capital – Net Foreign Earnings = 46000 + 3600 – 3000 = ` 46600 crores (iii) GDP = GNP – Net Income from Abroad + Net Income Payable to Foreigners = 100000 – 6000 + 2000 = ` 96000 crores 24. Following information relates to national incomes of a country. Calculate the following : (i) GNPMP (ii) NNP MP (iii) National Income

Items ` (crores) GNP$_{FC}$ 113882 Indirect Taxes 16744 Subsidies 2839 Depreciation 8048 Solution : (i) GNP$_{MP}$ : GNP$_{MP}$ = GNP$_{FC}$ + Indirect Taxes – Subsidies = 113882 + 16744 - 2839 = ` 127787 crores (ii) NNP$_{MP}$ : NNP$_{MP}$ = GNP$_{MP}$ – Depreciation = 127787 - 8048 = ` 119739 crores (iii) National Income : = NNP$_{MP}$ – Indirect Taxes + Subsidies = 119739 - 16744 + 2839 = ` 105834 crores 25. Calculate NDP at Market Price (NDP$_{MP}$) when Items ` (crores) Gross National Product at Market Price 6000 Depreciation 500 Net Factor Income from Abroad (-)100 Solution : NDP$_{MP}$ = GNP$_{MP}$ – Depreciation – Net Factor Income from Abroad = 6000 - 500 - (- 100) = ` 5600 crores 26. Calculate Net National Disposable Income from the following data : Items ` (crores) (i) National Income 985000 (ii) Indirect Taxes 35650 (iii) Subsidies 3000 (iv) Capital Consumption Allowance 25000 (v) Net Current Trans. from Rest of the World 12000 (vi) Net Capital Trans. from Rest of the World 10000 Solution : Net National Disposable Income = National Income + Indirect Taxes – Subsidies + Net Capital Transfers from Rest of the World = 985000 + 35650 - 3000 + 10000 =` 1027650 crores Note : While calculating Private or Personal Disposable Income, Net

Items ` (crores) (i) Wages and Salaries 500

(vii) Employer’s Contri. to Social Security Schemes 50

=` 1700 crores`

27. Calculate National Income from following information :

(ii) Mixed Income of Self Employed 300

(iii) Dividends 300

(iv) Corporate Tax 100

(v) Rent 200

(vi) Consumption of Fixed Capital 100

(viii)Undistributed Profits 200

(ix) Net Factor Income from Abroad (−)50

(x) Interest 100

Solution :

National Income (NNP$_{FC}$)

= Wages and Salaries + Mixed Income + Dividends + Corporate Tax + Rent

= 5 0 0 + 3 0 0 + 3 0 0 + 1 0 0 + 2 0 0 + 2 0 0 + 1 0 0 - 5 0 +

28. Calculate National Disposable Income from the following data :

Items ` (crores) (i) National Income 50000

(ii) Net Indirect Taxes 4000

(iii) Net Current Transfers from Abroad 3500

Solution :

National Disposable Income

\text {Abroad} = 5 0 0 0 0 + 4 0 0 0 + 3 5 0 0 = 5 7 5 0 0

A QUICK REVIEW OF THE CHAPTER

● Gross Domestic Product at Market Price : { \mathrm { G D P } } _ { \mathrm { M P } } is the total value of all goods and services produced within the domestic territory of the country in a year.

● Gross National Product at Market Price : It is a wider concept than the concept of gross domestic product. It is the gross money value of final goods and services produced by normal residents of a country in a year. It may be greater or lesser than GDP depending upon net factor income from abroad. We can calculate by using the following formula :

\mathrm { G N P _ { M P } = G r o s s } Domestic Product at Market Price + Net Factor Income from Abroad

● Net National Product at Market Price : It is the net money value of all final goods and services produced by the normal residents of a country within or outside the country. It can be calculated by using the following formula :

\mathrm { N N P } _ { \mathrm { M P } } = \mathrm { G N P } _ { \mathrm { M P } } – Depreciation

\mathbf { N D P _ { M P } } : \mathrm { N e t } domestic product at market price means the value of goods and services produced during a year at market price (i.e. , at prevailing current price). It does not include net factor income from abroad. \mathrm { N D P _ { M P } = } \mathrm { G D P } _ { \mathrm { M P } } \mathrm { - D e p r e c i a t i o n }

\mathbf { N D P _ { F C } } Or Net Demestic Income : It is the sum total of incomes earned by various factors of production within the domestic territory of a country. Factors of production receive income payments in the form of rent, wages, interest and profits for their services rendered.

Net domestic product at factor cost is also called net domestic income.

\mathrm { N D P } _ { \mathrm { F C } } = \mathrm { N D P } _ { \mathrm { M P } } – Indirect Tax + Subsidy Tax ● GDP at Factor Cost : Or

Gross Domestic Income

\mathrm { G D P } _ { \mathrm { F C } } = \mathrm { N D P } _ { \mathrm { F C } } + Depreciation

● GNP at Factor Cost Or Gross National Income : Net factor income from abroad is added to GDP_{FCfor getting GNPFC}

\mathrm { G N P } _ { \mathrm { F C } } = \mathrm { G D P } _ { \mathrm { F C } } + Net Factor Income from Abroad ● NNP at Factor Cost or National Income : Net factor income from abroad is added to \mathrm { N D P _ { F C } } for getting national income.

{ \mathrm { N N P } } _ { \mathrm { F C } } or \mathrm { N I } = \mathrm { N D P } _ { \mathrm { F C } } \cdot Net Factor Income from Abroad

● Private Income : Private income is the total of factor income from all sources and current transfers from the government and rest of the world accruing to private sector.

Private Income = Factor Income from Net Domestic Product accruing to Private Sector + Net Factor Income from Abroad + Interest on National Debt + Current Transfers from Government + Current Transfers from Rest of the World

● Personal Income : Personal income is the income actually received by the individuals and households from all sources in the form of factor income and current transfers.

Personal Income = Private Income – Undistributed Profits or Corporate Saving – Corporate Tax

● Personal Disposable Income : Personal disposable income is that part of personal income which the households can spend the way they like. It reflects purchasing power of the households. Disposable income is either spent or saved.

Personal Disposable Income

= Personal Income – Direct Personal Tax – Miscellaneous Receipts of the Government Administrative Department or Miscellaneous Fees and Fines paid by the Households.

● National Disposable Income : National disposable income is estimated as the sum total of net domestic income at factor cost, net indirect taxes, net factor income from abroad and net of current transfers from rest of the world.

● Different Concepts of National Income : At a Glance

1. Gross Domestic Product at Market = Market Value of Final Goods and Services Produced within the Price \left( \mathrm { G D P _ { M P } } \right) Domestic Territory of a country in an accounting year. 2. Gross National Product at Market = { \mathrm { G D P } } _ { \mathrm { M P } } + Net Factor Income from Abroad Price \left( \mathrm { G N P _ { M P } } \right)

2. Net National Product at Market Price \left( \mathrm { N N P _ { M P } } \right)

3. Net Domestic Product at Market Price ( \mathrm { N D P _ { M P } } )

4. Net Domestic Product at Factor Cost or Net Domestic Income ( \mathrm { N D P _ { F C } ) }

\mathbf { \Sigma } = \mathbf { G N P _ { M P } } – Consumption of Fixed Capital or Depreciation

= \mathrm{NNP} _ {\mathrm{MP}} - \text {Net Factor Income from Abroad}

= \mathrm{NDP} _ {\mathrm{MP}} - \text {Indirect Taxes} + \text {Subsidies}

6. Gross Domestic Product at Factor = \mathrm { N D P _ { F C } + } Depreciation Cost ( \mathrm { G D P _ { F C } } )

7. Gross National Product at Factor Cost ( \mathrm { G N P _ { F C } ) }

8. Net National Product at Factor Cost or National Income ( \mathrm { N N P _ { F C } ) }

9. Net National Disposable Income (often referred to as National Disposable Income)

= \mathrm { G D P _ { F C } + } Net Factor Income from Abroad

= \mathrm{GNP} _ {\mathrm{FC}} - \text {Depreciation}

= Net Domestic Income + Net Indirect Taxes + Net Factor Income from Abroad + Net Current Transfers from Rest of the World

10. Gross National Disposable Income = Net National Disposable Income + Current Replacement Cost 11. Factor Income from Net \mathrm { { D o m e s t i c } = \mathrm { { N D P } _ { F C } - } } Property and Entrepreneurial Income of the Product accruing to Private Sector Departmental Enterprises of the Government – Savings of Nondepartmental Enterprises

11. Private Income = Income from Domestic Product accruing to Private Sector + Net Factor Income from Abroad + Current Transfers from Government + Current Transfers from Rest of the World (Net) + Interest on National Debt

12. Personal Income = Private Income – Corporate Profit Tax – Undistributed Profits or Corporate Savings 14. Personal Disposable = Personal Income – Direct Personal Taxes – Miscellaneous Income Fees and Fines paid by the Households QUESTIONS Ultra Short Answer Type Questions

13. What is the difference between { \mathrm { N N P } } _ { \mathrm { F C } } and { \mathrm { G N P } } _ { \mathrm { F C } } \ ?

14. Whether personal income is less than national income or greater than

national income ?

3. What is net indirect tax ?

4. What is depreciation ?

Very Short Answer Type Questions

1. What do you mean by Gross Domestic Product ? (C.B.S.E., 2011, 17; J.A.C., 2018)

2. What do you mean by Net National Product ? (B.S.E.B., 2010, 12)

3. Define Net Domestic Product at Market Price.

4. Define Gross Domestic Product at Factor Cost or Domestic Income.

5. What is meant by Net Domestic Product at Factor Cost ?

6. What is meant by Gross National Product at Factor Cost ?

7. Define Gross National Disposable Income.

[B.S.E.B., (Arts ) 2018]

8. Define Net National Disposable Income.(Raj. Board , 2013)

9. What is Personal Disposable Income ?

[B.S.E.B., (Arts ) 2018] 10. What has to be deducted from Gross Product to get Net Product ?

11. Define National Income. [B.S.E.B., (Arts ) 2012, 16; J.A.C. , 2011, 15, 16] 12. What do you mean by GNP ?

[B.S.E.B. , (Comm .) 2011, 13, 18, 19] 13. What do you mean by transfer payment ? (J.A.C. , 2017) 14. What do you mean by Intermediate goods ? (J.A.C. , 2015) 15. What is persanal income ? (MP Board , 2019)

Short Answer Type Questions

1. Distinguish between National Income and Domestic Income. (U.S.E.B., 2015; B.S.E.B. (Comm.) , 2017, 18)

2. Distinguish between Gross Domestic Product and Gross National Product. [J.A.C., 2019; B.S.E.B. (Comm.), 2013; Raj. Board , 2017]

3. Distinguish between Gross Domestic Product at Market Price and Net National Product at Factor Cost. [U.S.E.B., 2013; B.S.E.B. (Arts ), 2018]

4. Define any two of the following : (U.S.E.B., 2015) (i) Gross National

Product at market price

(ii) Gross National Product at factor cost

(iii) Net National Product at factor cost.

5. Discuss the concepts of Gross National Product and Gross Domestic

Product. (Raj. Board., 2015) 6. Distinguish between Domestic Product and National Product. When can domestic product be more than national product?

7. A country’s population is 50 crores while national income is estimated at ` 60,000 crores. What is per capita income ? [Ans. ` 12,000 crores]

8. What are the uses of National Income Accounting ? (B.S.E.B. (Comm.), 2013) 9. What is the difference between { \mathrm { N N P } } _ { \mathrm { M P } } and \mathrm { N N P _ { F C } } ? 10. Give diagramatic representation of Gross Domestic Product by the three methods : Expenditure, Income and Product. (B.S.E.B. , 2014) 11. What do you mean by Net National Product of market price ? (U.S.E.B. , 2016) 12. What is meant by private income ? What is the difference between private income and personal income ?

[B.S.E.B. (Comm. ), 2018] 13. Disting with between National Income and Per Capital Income. (MP. Board , 2019) 14. Disting with between National Income and National wealth. (MP. Board , 2019) Long Answer Type Questions

1. Explain the concept of Domestic Product. Distinguish between Gross Domestic Product and Gross National Product.

[ B.S.E.B. (Comm.), 2019] 2. Explain the concept of the Net National Product at Market Price and Net National Product at Factor Cost. Differentiate between them.

3. Explain the various concepts of national income. [U.S.E.B., 2011; B.S.E.B. (Comm. ), 2018]

4. Explain the following concepts :

[B.S.E.B., 2014; Raj. Board , 2016] (i) Gross Domestic Product, (ii) Gross National Product, (iii) Net National Product, (iv) Net National Product at Factor Cost, (v) Personal Income, (vi) Personal Disposable Income.

5. "Every Increase in GDP is not the indicator of welfare." Clarify the statement on the basis of any three arguments. (Raj. Board ., 2015) 6. Distinguish between the following concepts :

(Raj. Board ., 2015) (i) Consumer goods and Capital goods

(ii) Intermediate goods and final goods

(iii) Gross Investment and Net Investment

7. What is the difference between National Income and Net National Disposable Income ? Clarify. (U.S.E.B ., 2016)

Objective Type Questions

(A) Multiple Choice Questions :

1. The market price of all final goods and services produced in the domestic territory of a country in a year is known as :

[ B.S.E.B., 20 11 (Comm .)] (a) { \mathrm { G D P } } _ { \mathrm { M P } } (b) \mathrm { G D P _ { F C } }

(c) { \mathrm { N N P } } _ { \mathrm { F C } } (d) None of the above

2. Which one is true ?

(a) GNP = GDP + Depreciation (b) NNP = GNP + Depreciation (c) NNP = GNP – Depreciation (d) GNP = NNP – Depreciation

3. \mathrm { G N P _ { M P } = ? }

(a) \mathrm { G D P _ { M P } - D e p r e c i a t i o n }

[B.S.E.B., 2012 (Arts )]

[B.S.E.B., (Comm. ) 2018]

(b) \mathrm { G D P _ { M P } + N e } t Factor Income from Abroad (c) GNP + Subsidy

(d) None of the above

4. \mathrm { N N P _ { M P } } = \uparrow

(a) { \mathrm { G N P } } _ { \mathrm { M P } } – Depreciation (c) { \mathrm { G N P } } _ { \mathrm { M P } } + Indirect Tax

5. Depreciation expenses are included in :

(B.S.E.B., 2015, 16, 18, 19) (a) { \mathrm { G N P } } _ { \mathrm { M P } } (b) { \mathrm { N N P } } _ { \mathrm { M P } }

(c) { \mathrm { N N P } } _ { \mathrm { F C } } (d) None of the above

6. { \mathrm { N D P } } _ { \mathrm { F C } } = ?

(a) { \mathrm { N D P } } _ { \mathrm { M P } } – Indirect Tax

(b) { \mathrm { G N P } } _ { \mathrm { M P } } – Indirect Tax + Subsidy

(c) { \mathrm { N D P } } _ { \mathrm { M P } } – Subsidy

(d) { \mathrm { N D P } } _ { \mathrm { M P } } – Depreciation

7. Net National Income at Factor Cost is called :

[B.S.E.B., (Comm. ), 2015] (b) Gross Investment

(d) None of the above

8. Which one is included in National Income ?

[B.S.E.B., (Comm. ), 2015, 16, 19] (a) Rent, Wage, Interest

(b) Rent, Wage, Salary

(c) Rent, Profit, Interest

(d) Rent, Wage, Salary, Interest, Profit

9. What is consumption of fixed capital called ? [B.S.E.B (Arts ), 2015, 18] (b) Depreciation

(d) All of these

10. Which of the following is correct ? [B.S.E.B (Arts ), 2015] (a) Disposable Income = Personal Income – Direct Taxes (b) Disposable Income = Private Income – Direct Taxes (c) Disposable Income = Personal Income – Indirect Taxes (d) Disposable Income = Private Income – Indirect Taxes

11. If for a country net factor income from abroad is negative then : (B.S.E.B (Arts ), 2015) (a) GDP < GNP (b) GDP > GNP (c) GDP > GNP (d) GDP = GNP

12. The market value of all final goods and services produced in an economy over a year is called : (B.S.E.B (Arts ), 2015) (a) Gross National Product (b) National Income (c) Gross Domestic Product (d) Net National Product

13. Goods purchased for the following purpose are final goods : (C.B.S.E (AI ), 2017) (a) For satisfaction of wants (b) For Investment in firms (c) Both (a) & (b) (d) None of the above

14. Which of the following affects national income ? (C.B.S.E., 2018)

( B.S.E.B., 2011) (b) { \mathrm { G N P } } _ { \mathrm { M P } } + Depreciation (d) None of the above (a) Goods & Service Tax (b) Corporate Tax (c) Subsidiaries (d) None of the above [Ans. 1. (a), 2. (c), 3. (b), 4. (a), 5. (a), 6. (b), 7. (a), 8. (d), 9. (b), 10. (a), 11. (b), 12. (c), 13. (d), 14. (d)]

(B) Fill in the Blanks : 1. \mathrm { G N P } _ { \mathrm { M P } } = \mathrm { G D P } _ { \mathrm { M P } } +

2. \mathrm { N N P } _ { \mathrm { M P } } = \mathrm { G N P } _ { \mathrm { M P } } -

3. \mathrm { N D P } _ { \mathrm { F C } } = \mathrm { N D P } _ { \mathrm { M P } } -

4. Both factor income and transfer earnings are included in................income.

5. Subsidy is................to \mathrm { N D P _ { F C } } calculation.

[Ans. 1. Net Income from Abroad, 2. Depreciation, 3. Net Indirect Tax, 4. private, 5. added.]

(C) State True/False

1. Net national income at factor cost is called domestic income.

2. GNP is a national concept.

3. Consumption of fixed capital is called depreciation.

4. Disposable income = Private income – Direct taxes.

5. Rent, salary, profit, interest and wages are included in National Income.

6. India’s per capital income is very low in comperison to that of developed nations. (MP, Board, 2019) [Ans. 1. False, 2. True, 3. True, 4. False, 5. True,

7. True.] (D) Match the following Column :

(a) National Income (c) Domestic Income

‘A’

1. Net Export

2. National Income

3. GDP

4. { \mathrm { N D P } } _ { \mathrm { M P } }

5. GNDI

‘B’

(a) \mathrm { N N P } _ { \mathrm { M P } } - \mathrm { N F I A }

(b) NNDI + Fixed Capital

Consumption

(c) Export-Import

(d) GNP–Net Foreign Fact (e) Net National Product at

Factor Cost

(a) Capital formation (c) Investment

[ Ans. 1. (c), 2. (e), 3. (d), 4. (a), 5. (b)]

(E) Answer in One Word :

1. What is called the difference between { \mathrm { N D P } } _ { \mathrm { M P } } and \mathrm { N D P _ { F C } } ? 2. What is called the difference between { \mathrm { G D P } } _ { \mathrm { M P } } and { \mathrm { N D P } } _ { \mathrm { M P } } ? 3. What is \mathrm { N N P _ { M P } - } NFIA ?

2. What is consumption of fixed capital called ?

[Ans. 1. Net Indirect Tax, 2. Depreciation, 3. { \mathrm { N D P } } _ { \mathrm { M P } } , 4. Depreciation.] HOTS High Order Thinking Skills Questions

1. Why are ‘indirect taxes’ deducted and ‘subsidy’ added in { \mathrm { N D P } } _ { \mathrm { M P } } ? (See : Box 6)

2. Can transfer earning be treated as subsidy ?

(See : Section 17.10)

VBQ Value Based Questions

1. Why is indirect tax deducted from { \mathrm { N D P } } _ { \mathrm { M P } } ?

(See : Box 6)

2. What is the difference between national income and national disposable income ? (See : Section17.13)

MDQ Case Study Based on Evaluation & Multi-disci plinary Questions

1. Concept of ‘personal income’ is a narrow concept as compared with the concept of ‘private income’, why ? (See : Table (A) after Section 17.11)

2. Is transfer payment included in personal income ? (See : Section 17.11) NUMERICAL QUESTIONS

1. Calculate (a) ‘Net Domestic Product at Factor Cost’ and (b) ‘Private Income’ from the following : (C.B.S.E., 2011) Items ` (crores) (i) Net factor transfers to abroad 30 (ii) Mixed income 600 (iii) Subsidies 20 (iv) Operating surplus 200 (v) National debt interest 70 (vi) Net factor income from abroad 10 (vii) Compensation of employees 1400 (viii) Indirect tax 100 (ix) Domestic product accruing to government 350 (x) Current transfers by government 50 [Ans. (a) { \mathrm { N D P } } _ { \mathrm { F C } } = { \bf \Phi } 1600 crores]

(b) Private Income = ` 1350 crores]

2. Calculate National Income from following data :

Items ` (crores) (i) Personal Income 2450 (ii) Savings of Private Corporate Sector 25 (iii) Corporate Tax 45 (iv) Current Transfers from Government Administrative Departments 60 (v) Current Transfers from Rest of the World 50 (vi) Income from Property and Entrepreneurship accruing to Govt. Administrative Departments 50 (vii) Savings of Non-departmental Government Enterprises 40 (viii) Net Indirect Taxes 390 (ix) Direct Taxes paid by Household 50 [Ans. National Income = ` 2500 crores] 3. Find (a) Private Income and (b) National Income : Items ` (crores) (i) Personal Disposable Income 350 (ii) Income from Property and entrepreneurship accruing to govt. Administrative Departments 50 (iii) Savings of Non-departmental Enterprise 25 (iv) Direct Personal Tax 10 (v) Net Factor Income from Abroad (–)5 (vi) Indirect Taxes 15 (vii) Current Transfer to Rest of the World 20 (viii) Savings of Private Corporate Sector 25 (ix) Corporation Tax 15 (x) Current Transfer from govt. 30 [Ans. (a) Private Income = ` 400 crore (b) National Income = ` 465 crore] 4. Calculate Gross Value Added at Factor Cost : (C.B.S.E., 2012) Items ` crores) (i) Units of output sold (units) 1,000 (ii) Price per unit of output 30 (iii) Depreciation 1,000 (iv) Intermediate cost 12,000 (v) Closing stock 3,000 (vi) Opening stock 2,000 (vii) Excise 2,500 (viii) Sales tax 3,500 [Ans. GVA$_{FC}$ = ` 13000 crores] (C.B.S.E., 2012) 5. From the following data, calculate : (a) National Income

(b) Personal Disposable Income

Items ` (crores) (i) Compensation to Employees 1200 (ii) Rent 400 (iii) Profit 800 (iv) Consumption of Fixed Capital 300 (v) Mixed Income of Self Employed 1000 (vi) Private Income 3600 (vii) Net Factor Income from Abroad (–)50 (viii) Net retained Earnings of Private Enterprises 200 (ix) Interest 250 (x) Net Indirect Taxes 350 (xi) Net Exports (–)60 (xii) Direct Taxes paid by Households 150 (xiii) Corporate Tax 100 [Ans. (a) ` 3600 crores, (b) ` 3150 crores]

6. Calculate GDP, Private Income and Personal Income from the following : Items ` (crores) (i) Gross Domestic Product at Factor Cost 12000 (ii) Net Foreign Income from Abroad (–)1000 (iii) Net Indirect Taxes 4000 (iv) Income from Domestic Product accrued to Private Sector 8000 (v) Net Current Transfers from Government

Administrative Department 3000 (vi) Net Current Transfers from Abroad 2000 (vii) Savings of Private Corporate Sector 2000 (viii) Corporate Tax 1000 [Hint : GDP means GDP at Market Price]

[Ans. GDP_MP = ` 16,000 crores, Private Income = ` 12,000 crores, Personal Income = ` 9,000 crores]

7. Calculate Personal Disposable Income from the following : Items (crores) (i) Retained Profits 10 (ii) NNP at Factor Cost accruing to Private Sector 400 (iii) Corporate Tax 60 (iv) Personal Tax 80 (v) National Debts Interest 50 (vi) Net Factor Income from Abroad (–)5 (vii) Net Current Transfers from Rest of the World (–)10 (viii) Current Transfers from Govt. 20

(ix) Savings of Non-department Enterprises 10

[Hint : Retained Profits means corporate savings or undistributed profits.] [Ans. ` 310 crores]

8. Calculate National Income and Personal Disposable Income : (C.B.S.E ., 2016) Items ` (crores) (i) Corporation Tax 100

(ii) Private Final Consumption Expenditure 900

(iii) Personal Income Tax 120

(iv) Government Final Consumption Expenditure 200

(v) Undistributed Profit 50

(vi) Change in Stocks (–)20

(vii) Net Domestic Fixed Capital Formation 120

(viii) Net Imports 10

(ix) Net Indirect Tax 150

(x) Net Factor Income from Abroad (–)10

(xi) Private Income 1000

[Ans. National Income = ` 1,030 crore, Personal Disposable Income = ` 730 crore]

9. Using following data determine Personal and Disposable Income :

Items ` (crores) (i) Net National Product 5450

(ii) Corporate Gain Tax 152

(iii) Undistributed Profits of Companies 350

(iv) Income from Domestic Product accruing to Govt. Sector 168

(v) National Debt Interest 70

(vi) Current Transfers :

(a) From Government 120

(b) From Rest of the World 30

(vii) Personal Income Tax 25

[Ans. (i) Personal Income : ` 5000 crores, (ii) Disposable Income : `4975 crores]

10. With the help of following data, calculate :

(a) Private Income

(b) National Income

Items ` (crores) (i) Interest on National Debts 1100

(ii) Income from Property and Entrepreneurship accruing to Govt.

Administrative Deptt.s 5900

(iii) Personal Disposable Income 36400

(iv) Corporation Tax 2300

(v) Direct Taxes paid by Household 3200

(vi) Savings of Private Corporate Sector 3700

(vii) Savings of Non-departmental Enterprises 1400

(viii) Net Other Current Transfers from Rest of the World 700

[Ans. (a) Private Income = ` 45600 crores, (b) National Income = ` 51100 crores]

11. Determine National Disposable Income from the following : Items (crores) (i) Gross Domestic Product at Factor Cost 40800

(ii) Indirect Taxes 500

(iii) Subsidies 200 (iv) Current Transfers from Rest of the World 640 (v)

Current Transfers to Rest of the World 560 (vi) Consumption of Fixed

Capital 250 (vii) Net Factor Income from Abroad 400 [Ans. National

Disposable Income ` 41330 crores] 12. Find National Income and Private

Income : (C.B.S.E ., 2016) Items ` (crores) (i) Wages and Salaries 1000 (ii) Net Current Transfers to Abroad 20 (iii) Net Factor Income paid to Abroad 10 (iv) Profit 400 (v) National Debt Interest 120 (vi) Social Security Contributions by Employers 100 (vii) Current Transfers from Government 60 (viii) National Income Accruing to Government 15 (ix) Rent 200 (x) Interest 300 (xi) Royalty 50 [Ans. National Income = ` 2,040 crore, Private Income = ` 2,050 crore]

13. Calculate \mathrm { N D P _ { F C } } from the following data :

(Raj. Board , 2015) Items ` (crores) (i) Private Income 10000 (ii) Income from Domestic Product accruing to Govt. Sector 925 (iii) Transfer Payments 125 (iv) Net Income from Abroad (–)200 (v) Net Indirect Taxes 300 [Ans. 11,000 crores]

[Hint : NDP_FC = Private Income + Income from Domestic Product accruing to Government Sector – Transfer Payments – Net Factor Income from Abroad.] 14. Find Net National Product at Market Price and Personal Disposable Income : (C.B.S.E. , 2016) Items ` (crores) (i) Personal Taxes 200 (ii) Wages and Salaries 1200 (iii) Undistributed Profit 50 (iv) Rent 300 (v) Corporation Tax 200 (vi) Private Income 2000 (vii) Interest 400 (viii) Net Indirect tax 300 (ix) Net Factor Income to Abroad 20 (x) Profit 500 (xi) Social Security Contributions by Employers 250 [Ans. \mathrm { N N P _ { M P } } = \mathrm { \Omega } ^ { \cdot } 2 { , } 9 3 0 crore, PDI = ` 1,550 crore] 15. Calculate value added by firm X from the following data : Items ` (crores) (i) Sales 600 (ii) Purchase of Raw Material 200 (iii) Import of Raw Material 100 (iv) Import of Machines 200 (v) Closing Stock 40 (vi) Opening Stock 10 [Ans. ` 330 crores] 16. Calculate Gross National Disposable Income from the following data : Items (i) Net Factor Income from Abroad (ii) National Income (iii) Net Indirect Taxes (crores) (–)10 1000 80

(iv) Net Current Transfers from Rest of the World 150

(v) Consumption of Fixed Capital 100

[Ans. ` 1320 crores]

17. Calculate National Income from the following data : Items ` (crores) (i)

Profits 220 (ii) Compensation to Employees 350 (iii) Interest 100 (iv) Consumption of Fixed Capital 50 (v) Opening Stock 30 (vi) Subsidies 20 (vii) Closing Stock 50 (viii) Mixed Income of Self Employed 150 (ix) Employer's Contribution to Social Security Schemes 30 (x) From Abroad Net Factor Income 10 (xi) Indirect Taxes 90 [Ans. ` 830 crores] 18. Calculate Private Income from the following : Items ` (crores) (i) Net National Product at Factor Cost 200 (ii) Savings of Non-departmental Enterprises 10 (iii) Net Factor Income from Abroad 3 (iv) Income from Property and Entrepreneurship accruing to Government Administrative Deptts. 15 (v) Net Current Transfers from Rest of the World (–)10 (vi) Current Transfers from Government (vii) Interest on Public Debt (viii) Corporate Tax [Ans. ` 220 crores] 5 50 20

19. Find out (a) National Income and (b) Net National Disposable Income : (CBSE, 2012) Items ` (crores) (i) Factor income from abroad 15 (ii) Private final consumption expenditure 600 (iii) Consumption of fixed capital 50 (iv) Government final consumption expenditure 200 (v) Net current transfers to abroad (–)5 (vi) Net domestic fixed capital formation 110 (vii) Net factor income to abroad 10 (viii) Net imports (–)20 (ix) Net indirect tax 70 (x) Change in stocks (–)10 [Ans. (a) \mathrm { N N P _ { F C } } or National Income = ` 840 crores

(b) Net National Disposable income = ` 915 crores] 20. Calculate Gross National Disposable Income from the following data :

Items ` (crores) (i) National Income 2000

(ii) Net Factor Income from Abroad (–)50

(iii) Consumption of Fixed Capital 200

(iv) Net Current Transfer from Rest of the World 150

(v) Net Indirect Taxes 250

[Ans. ` 2550 crores]

21. Calculate from following :

(a) GNP at Market Price (b) Private Income (c) Personal Income Items ` (crores) (i) Gross Domestic Product at Factor Cost 300

(ii) Income from Domestic Product accruing to Private Sector 200

(iii) Net Current Transfers from General Govt. 50

(iv) Net Indirect Taxes 50

(v) Net Current Transfers from Rest of the World 40

(vi) Net Factor Income from Abroad (–)30

(vii) Savings of Private Corporate Sector 25

(viii) Corporate Tax 5

[Ans. (a) GNP_MP = ` 320 crores

(b) Private Income = ` 260 crores

(c) Personal Income = ` 230 crores]

22. With the help of the following data calculate : (a) Income from Domestic

Product accruing to Private Sector

(b) Personal Disposable Income

Items ` (crores) (i) Interest on National Debt 25

(ii) Savings from Private Corporate Sector 50

(iii) Corporate Tax 25

(iv) Net Domestic Product at Factor Cost 1000

(v) Savings of Non-departmental Enterprises 40

(vi) Net Current Transfers from Govt. Administrative Deptt. 30

(vii) Direct Taxes paid by Households 35

(viii) Net Current Transfers from Rest of the World 10

(ix) Net Factor Income from Abroad (–)15 (x) Income from Property and Entrepreneurship accruing to Govt. Admn. Deptt.) 60

[Ans. (a) Income from Domestic Product accrued to Private Sector = ` 900 crores, (b) Personal Disposable Income = ` 840 crores]

23. Find out National Income from the following data : Items ` (crores) (i)

Operating Surplus 200

(ii) Wages and Salaries 700 (iii) Net Factor Income from Abroad (–)10 (iv) Contribution to Social Security Schemes by Employees 100 (v) Rent and Royalty 50 [Ans. ` 890 crores] 24. Calculate Net Value Added at Market Price from the following : Items (i) Subsidy (ii) Sales (iii) Opening Stock (iv) Intermediate Cost (v) Net Indirect Tax (vi) Depreciation (vii) Closing Stock [Ans. ` 22 crores] ` (crores) 2 50 4 20 8 4 0

25. Calculate Personal Disposable Income from following : Items

(i) Corporation Tax (ii) Miscellaneous Receipts of Government (iii) Undistributed Profits of Corporation (iv) Direct Taxes

(v) Private Income ` (crores) 680 340

80 880 55960 [Ans. Personal Disposable Income ` 53980 crores] 26. Find (a) National Income and (b) Gross National Disposable Income : Items ` (crores) (i) Net Current Transfer from Abroad 5 (ii) Private Final Consumption Expenditure 200 (iii) Subsidies 20 (iv) Net Domestic fixed Capital Formation 40 (v) Net Factor Income to Abroad 10 (vi) Govt. final Consumption Expenditure 50 (vii) Change in Stocks (–)10 (viii) Net Imports (–)20 (ix) Consumption of Fixed Capital 30 (x) Indirect Tax 60

(xi) Exports 100

[Ans. (a) ` 250 crore, (b) ` 325 crore]

27. Following information relates to a country. Determine Personal Disposable Income :

Items ` (crores) (i) Personal Income 664160

(ii) Personal Direct Taxes 19360

(iii) Fees, Fine etc. 1730

(iv) Social Security Contributions by Employees 5000

[Ans. Personal Disposable Income = ` 638070 crores] [Hint : Social security contribution paid by employees no longer remains at the disposal of the households, therefore it should be deducted from the personal income.] 28. Calculate from following data :

(a) Gross Domestic Product at Market Price (b) Private Income

(c) Personal Income

Items ` (crores) (i) Gross National Income at Factor Cost 66000

(ii) Net Factor Income from Abroad (–)1500

(iii) Consumption of Fixed Capital 6000

(iv) Income from Property accruing to Government Admn. Deptt. 5000

Transfers from Rest of the World 1000 (x) Interest on National Debt 1500

[Ans. (a) { \mathrm { G D P } } _ { \mathrm { M P } } = { \dot { \mathbf { \theta } } } 70000 crores, (b) Private Income = ` 57500 crores, (c)

Personal Income = ` 54000 crores] 29. Calculate Net National Disposable Income from the following data :

Items ` (crores) (i) Gross National Product at Factor Cost 800 (ii) Net Current Transfers from Rest of the World 50 (iii) Net Indirect Taxes 70 (iv) Consumption of Fixed Capital 60 (v) Net Factor Income from Abroad (–)10 [Ans. ` 860 crores]

30. From the following data, calculate :

(a) Net National Disposable Income

(b) Private Income

(c) Personal Disposable Income

Items ` (crores) (i) National Income 900 (ii) Net Factor Income from Abroad (–)20 (iii) Net Indirect Taxes 80 (iv) Income from Property and Entrepreneurship accruing to Government Administrative Departments 100 (v) Savings of Non-departmental Enterprises 50 (vi) Direct Taxes paid by Households 60 (vii) Savings of Private Corporate Sector (Not

included Net of Retained Earnings of Foreign Companies) 120 (viii) Dividends 130 (ix) Current Transfers from Rest of the World 10 (x) Current Transfers from Government Administrative Departments 30 (xi) Corporate Tax 50 [Ans. (a) Net National Disposable Income :` 990 crores, (b) Private Income :` 790 crores, (c) Personal Disposable Income :` 560 crores] 31. Calculate National Income with the help of following data ? (Raj. Board, 2015) Items ` (crores) (i) Gross National Product at market price` 1000 crore (ii) Depreciation ` 200 crore (iii) Indirect Taxes ` 150 crore (iv) Subsidy ` 250 crore [Ans. NNP$_{FC}$ = ` 900 crores] 32. Calculate Value Added at Factor Cost from the following : Items ` (crores) (i) Purchases of Materials 30 (ii) Depreciation 12 (iii) Sales 200 (iv) Excise Duty 20 (v) Opening Stock (vi) Intermediate Consumption (vii) Closing Stock 15 (vi) Net Current Transfers from Government 48 Administrative Departments 15 10 (vii) Net Other Current Transfers from Rest of [Ans. (i) Gross Value Added = ` 117 crores, (ii) Net Value the World 10 Added = ` 105 crores] 33. Determine GNP from following : Items (i) Net Domestic Product of Factor Cost (ii) Indirect Taxes (iii) Economic Subsidies (iv) Depreciation (v) Net Factor Income from Abroad [Hint : GNP means GNP at market prices.] [Ans. ` 150900 crores] (viii) Savings of Private Corporate Sector 10 (ix) Corporate Tax 5 ` (crores) [Ans. (a) GDP$_{MP}$ = ` 100 crores, (b) Private Income = $^{150000}$ ` 60 crores, (c) Personal Income = ` 45 crores] $^{1000}$ 37. Determine Personal Disposable Income from the following$_{200}$ data : 50 Items ` (crores) $^{50}$ (i) Personal Taxes 6 (ii) Corporation Taxes 4 (iii) Miscellaneous Receipts of Government 34. Calculate National Income from following data : Administrative Department 2 Items ` (crores) (iv) Private Income 331(i)

Rent 80 (v) Undistributed Profits of Private Corporate Sector 2(ii) Interest 100 (vi) National Debts Interest 12(iii) Profits 210 (vii) Misc. Receipts of Government Deptt. 2(iv) Tax on Profits 30 Ans. 317 crores Employee’s Contribution to Social Security 38. Using following data calculate the following :Schemes 25 (a) National Income(vi) Mixed Income of Self-employees 250 (c) Disposable Income(vii) Net Indirect Taxes 60

(b) Personal Income (d) Domestic Income ^Items (viii) Employer’s Contribution to Social Security Schemes 50^{(i) Rent}

(ix) Compensation to Employees 500^{(ii) Interest}

(x) Net Factor Income Abroad (–)20^{(iii) Dividend}

` (crores) 4000

150

200

_{[ Ans.} ` _{1120 crores]} (iv) Net Income from Abroad 500

35. Find net domestic product at factor cost and personal (v) Corporate Gain Tax 200

income : (C.B.S.E ., 2016) (vi) Transfer Payments 300

` (crores) (vii) Value of Consumer Goods 4000

(i) Rent 200 (viii) Mixed Income 2000

(ii) Net Current Transfers to Abroad 10 (ix) Surplus Profits 150

(iii) National Debt Interest 60 (x) Direct Personal Taxes 200

(iv) Corporate Tax 100 (xi) Contribution to Social Security 300

(v) Compensation of Employees 900 (xii) Wages 6000

(vi) Current Transfers from Government 150 [Ans. (a) National Income = ` 13500 crores, (b) Personal (vii) Interest 400 Income = ` 13300 crores, (c) Disposable Income = ` 13100

(viii) Undistributed Profits 50 crores, (d) Domestic Income = ` 13000 crores]

(ix) Dividend 250 39. Determine GNP at Market Price from the following :

(x) Net Factor Income to Abroad (–)10 Items ` (crores) (xi) Income Accruing to Government 120 (i) Mixed Income of Self employed 2500

[Ans. Net Domestic Product at Factor Cost = ` 1,900 crore, (ii) Net Capital Formation 1600

Personal Income = ` 1,840 crore]_{(iii) Net Indirect Taxes 700}

36. From the data given below, estimate :_{(iv) Compensation of Employees 3000}

^{(a) GDP at Market Price} (v) Net Factor Income from Abroad (–)200 (b) Private Income (vi) Changes in Stock 300(c) Personal Income (vii) Gross Fixed Capital Formation 1500 Items ` (crores) (viii) Operating Surplus 5000(i) National Income 60 (ix) Exports 700(ii)

^{Consumption of Fixed Capital 15 (x) Imports 1000(iii) Net Factor Income from Abroad (–)5} [Hint :

Depreciation = Changes in Stock + Gross Fixed_{(iv) Net Indirect Taxes 20 Capital}

Formation – Net Capital Formation](v) Income from Domestic Product accruing to [ Ans. ` 11200

crores]Private Sector 40

40. Determine from the following data :

(a) Private Income

(b) Personal Disposable Income

(c) Net National Disposable Income

Items ` (crores) (i) National Income 1500

(ii) Savings of Private Corporate Sector 15

(iii) Corporate Tax 40

(iv) Current Transfers from Govt. Administrative Deptt. 30

(v) Income from Property and Entrepreneurship accruing to Govt.

Administrative Department 75

(vi) Current Transfers from Rest of the World 25

(vii) Savings of Non-department Govt. Enterprises 20

(viii) Net Indirect Taxes 125

(ix) Direct Taxes paid by Households 50

(x) Net Factor Income from Abroad (–)5

[Ans. (a) Private Income = ` 1460 crores, (b) Personal Disposable Income =

` 1355 crores, (c) Net National Disposable Income = ` 1650 crores]

41. Determine Personal Disposable Income from the following data : Items

(i) Direct Taxes paid by Households (ii) Misc. Receipts of Govt.

Administrative Departments

(iii) National Debt Interest

(iv) Savings of Private Corporate Sector (v) Corporate Tax

(vi) Private Income

[Ans. ` 188 crores]

` (crores) 3

42. Find Gross Value Added at Market Price : (C.B.S.E., 2016) Items (Lakh) (i) Depreciation 20 (ii) Domestic Sales 200 (iii) Net change in Stocks (–)10 (iv) Exports 10 (v) Single use Producer Goods 1 2 0 [ \mathrm { A n s . G V A _ { M P } = \Delta } ^ { \mathrm { { \backprime } } } 80 lakh]

43. With the help of the following data, calculate : (a) { \mathrm { G D P } } _ { \mathrm { M P } }

(b) Private Income

(c) Personal Income

Items ` (crores) (i) Net Indirect Taxes 7500

(ii) Net Factor Income from Abroad (–)200

(iii) Savings to Private Corporate Sector 2800

(iv) Gross National Product at Factor Costs 39500

(v) Income from Domestic Product accruing to Private Sector 31000

(vi) Corporate Tax 2200

(vii) Interest on National Debts 900

[Ans. (a) \mathrm { G D P _ { M P } = \Delta ^ { \circ } 4 7 2 0 0 } crores, (b) Private Income = ` 31700 crores, (c)

Personal Income = ` 26700 crores] 44. From the following data, calculate :

(a) Private Income

(b) Personal Income

(c) Personal Disposable Income

Items ` (crores) (i) Income from Property and Entrepreneurship accruing to the Govt. Administrative Departments 100 (ii) Savings of Non-departmental Enterprises 80 (iii) Factor Income from Net Domestic Product accruing to Private Sector 500 (iv) Corporate Tax 30 (v) Savings of Private corporate Sector (Net of Retained Earnings of Foreign Companies) 65 (vi) Direct Taxes paid by Household 20 (vii) Current Transfers from Government Administrative Departments 10 (viii) Factor Income from Abroad 5 (ix) Current Transfers from Rest of the World 20 (x) Operating Surplus 150 (xi) Factor Income to Abroad 15 [Ans. (a) Private Income = ` 520 crores, (b) Personal Income = ` 425 crores, (c) Personal Disposable Income = ` 405 crores]

45. Calculate National Income and Gross National Disposable Income from the following : (C.B.S.E., 2011) Items ` (crores) (i) Net current transfers to the rest of the world (–)5 (ii) Private final consumption expenditure 500 (iii) Consumption of fixed capital 20 (iv) Net factor income from abroad (–)10 (v) Government final consumption expenditure 200 (vi) Net indirect tax 100 (vii) Net domestic fixed capital formation 120 (viii) Net imports 30 (ix) Change in stocks (–)20 [Ans. NNP = 660 crores Gross National Disposable Income = 765 crores]

Trade Deficit = (I - S) + (G - T)
= 2000 - 1500 = 500 crores

NCERT CORNER

Q. 1. Define budget deficit and trade deficit. The excess of private investment over savings of a country in a particular year was `2000 crores. The amount of budget deficit was (–) ` 1500 crores. What was the volume of trade deficit of that country ?

Ans. Budget deficit means the excess of the government expenditure over tax revenue.

Budget Deficit = Government Expenditure (G) – Tax Revenue (T) Trade deficit means the excess of import expenditure over the export revenue earned by the economy.

Thus,

Trade Deficit = Imports (M) – Exports (X) Given, G – T = (–) 1500 I – S = 2000

Q. 2. Suppose the GDP at market price of a country in a particular year was ` 1100 crores. Net Factor Income from Abroad was ` 100 crores. The value of Indirect taxes – subsidies was ` 150 crores and National Income was ` 850 crores. Calculate the aggregate value of depreciation. Ans. ` (crores) GDP at Market Price 1100 Net Factor Income from Abroad 100 Net Indirect Taxes (Indirect Taxes – Subsidies) 150 National Income

National Income =
850 GDP at Market Price + Net Factor Income from Abroad
– Net Indirect Taxes
– Depreciation

$850 = 1,100 + 100 - 150 - Depreciation$

Depreciation = GDP at Market Price + Net Factor Income from Abroad

- Net Indirect Taxes

– National Income

$= 1100 + 100 - 150 - 850 = 1200 - 1000$ $= \text{`} 200$ crores.

Q. 3. Net National Product at Factor Cost of a particular country in a year is ` 1900 crores. There are no interest payments made by the households to the firms/ government or by the firms/government to the households. The Personal Disposable Income of the households is ` 1200 crores. The personal income taxes paid by them is ` 600 crores and the value of retained earnings of the firms and government is valued at 200 crores. What is the value of transfer payments made by the government and firms to the households ? Ans.

Personal Income Taxes

Retained Earnings

Personal Disposable Income ` (crores) 1900 1200

600 200

= Net National Product at Factor Cost– Retained Earnings

– Personal Income Taxes + Transfer Payments from the Government and the Firms.

1,200 = 1,900 – 200 – 600 + Transfer Payments

1,200 = 1,100 + Transfer Payments Transfer Payments = 1,200 – 1,100 = ` 100 crores.

Q. 4. From the following data, calculate Personal Income and Personal Disposable Income : (U.S.E.B., 2012) ` (crores) (a) Net Domestic Product at Factor Cost 8000 (b) Net Factor Income from Abroad 200 (c) Undisbursed Profit 1000 (d) Corporate Tax 500 (e) Interest Received by Households 1500 (f) Interest Paid by Households 1200 (g) Transfer Income 300 (h) Personal Tax 500 Ans. Personal Income = Net Domestic

Product at Factor Cost
+ Net Factor Income from Abroad
- Undisbursed Profit
- Corporate Tax
+ Interest Received by Households + Transfer Income
- Interest Paid by Households = 8000 + 200 - 1000 - 500 + 1500 + 300 - 1200
= 10000 - 2700
= `7300 crores.

Personal Disposable Income

= Personal Income - Personal Tax = 7300 - 500

= ` 6800 crores

Q. 5. In a single day Raju, the barber, collects ` 500 from haircuts; over this day, his equipment depreciates in value by ` 50. Of the remaining 450, Raju pays sales tax worth ` 30, takes home ` 200 and retains ` 220 for improvement and buying of new equipment. He further pays ` 20 as income tax from his income. Based on this information, compute Raju's contribution to the following measures of income (a) Gross Domestic Product, (b) NNP at Market Price, (c) NNP at Factor Cost, (d) Personal Income, (e) Personal Disposable Income.

Ans. Total Collection =`500

Depreciation = ` 50 Indirect Taxes (Sales Tax) =` 30 Dividend =` 200 Retained Earnings =` 220 (a) Gross Domestic Product at Market Price =` 500

Gross Domestic Product at Factor Cost = 500 – 30 =` 470 (b) NNP at Market Price = GDP at Market Price –

$= 500 - 50$

=`450

(c) NNP at Factor Cost = NNP at Market Price

- Indirect Taxes

$= 450 - 30$

=`420.

(d) Personal Income = NNP at Factor Cost
- Retained Earning = 420 - 220
=` 200

(e) Personal Disposable Income = Personal Income – Personal

Taxes
= 200 - Nil
=` 200.

❐

18

MEASUREMENT OF NATIONAL INCOME

STUDY MATERIAL INCLUDED IN THE CHAPTER

18.1. National Income Measurement : Introductions 18.2. Product or Value Added Method 18.3. Income Method

18.4. Expenditure Method 18.5. Reconciliation of the Three Measures of National Income 18.6. Nominal National Income and Real National Income 18.7. GNP and Economic Welfare 18.8. Miscellaneous Illustrations A Quick Review of the Chapter Questions High Order Thinking Skills (HOTS) Questions Value Based Questions (VBQ) Case Study Based on Evaluation & Multi-disciplinary Questions (MDQ) Numerical Questions NCERT Corner

Thus,

18.1. National Income Measurement : Introductions

It is already explained in circular flow of income that ‘Production ’, ‘Income ’ and ‘Expenditure ’ make the circular flow of economic activities. Production of goods and services is the result of collective efforts of factors of production. Factors of production during the production process get income

in terms of rent, wage, interest and profit. The factor owners with this earned income demand goods and services for satisfying their wants. This demand creates an incentive for producers to produce more and circular flow of economic activity becomes complete.

Fig. 1 Fig. 2

In short, as a result of economic activities in the economy, a regular cycle of production, income and expenditure goes on moving and all these three elements provide base for the calculation of national income.

National Income Measurement

Production Income Expenditure ↓↓ ↓

Product/Value Added Method Income Expenditure Method Method

Box 1

18.2. Product or Value Added Method

Product Method or Value Added Method is that method which measures the national income by estimating the contribution of each producing enterprise to production in the domestic territory of the country in an accounting year.

● Value of Output

It refers to market value of the goods (or services) produced by a firm during an accounting year. If the entire output of the year is sold during the year, value of output = sales.

Values of Output = Sales, if entire output of the year is sold during the year

If some output remains unsold, it is added to the firm’s inventory-stock. It is expressed as change in stock (∆ stock) during the year. In such a situation, value of output is measured as the sum total of ‘sales during the year ’ and ‘change in stock during the year’ .

What is Value Added ? Value added is the difference between value of output and intermediate cost. A few points to be rememberd : ● It is calculated at market price.

● Exports are a part of value of output and imports are deducted from it. ● Production of self-consumption is also a part of value of national output. ● Purchase of machinery is not a part of intermediate consumption.

Box 2

18.2.1. Measurement of National Income : Three Steps of Value Addition What is Intermediate Consumption ?

Value of Output = Sales + Change in Stock, if some output remains unsold during the year

It refers to value of non-factor inputs (all inputs other than factor inputs of land, labour, capital and entrepreneurship). Basically, it includes the value of raw material used in the process of production. Box 3

● First Step : Identification and Classification of Productive Enterprise At the very first step, we are to identify and classify various productive enterprises of an economy. Broadly speaking, we can classify the economy into the following three sectors :

(i) Primary Sector, (ii) Secondary Sector, (iii) Tertiary Sector.

(i) Primary Sector : It is that sector which produces

goods by exploiting natural resources like land, water, forests, mines, etc. It includes all agricultural and allied activities, such as fishing, forestry, mining and quarrying.

(ii) Secondary Sector : This sector is also known

as manufacturing sector . It transforms one type of commodity into another, using men, machines and materials. For example, manufacturing of cloth from cotton or sugar from sugarcane.

(iii) Tertiary Sector : This sector is also known as service sector which provides useful services to primary and secondary sectors. It consists of banking, insurance, transport, communication, trade and commerce etc.

Difference between Primary, Secondary and Tertiary Sector Primary Sector

1. It is known as agriculture and allied sector.

2. It is that sector which exploits natural resources and produces goods and services.

3. It includes all agricultural and allied activities such as forestry, mining, quarrying, fishing, animal husbandry, etc.

4. Unorganised and Traditional techniques.

5. No possibility of division of labour.

Secondary Sector

1. It is known as manufacturing sector.

2. It is that sector which transforms one goods into another for creating more utility from it.

3. It includes manufacturing units, small scale units, large firms, big corporates, multinational corporations.

Tertiary Sector

1. It is known as service sector .

2. It provides useful services to primary and secondary sectors that smoothen their working.

3. It consists of services such as banking, insurance, trade, communications, etc.

4. Organised techniques.

5. Complex division of labour can be used for production.

6. Organised and modern techniques.

7. Complex and geographical division of labour is applied.

Box 4 Second Step : Calculation of Net Value of Output To estimate the net value added in each identified enterprise in first step the following estimates are calculated :

(a) Value of Output,

(b) Value of Intermediate Consumption,

(c) Consumption of Fixed Capital, i.e., Depreciation. Value of output is worked out by multiplying the amount of goods and services by each enterprise with their market prices. Value of intermediate consumption is calculated by using the prices paid by the enterprise. Consumption of fixed capital is also estimated as per rules and regulations.

To arrive at the net value added by the enterprise, we have to deduct the following items from the value of output :

(a) Value of Intermediate Consumption

(b) Consumption of Fixed Capital

(c) Net Indirect Taxes.

In short,

Net Value Added = Value of Output – Intermediate Consumption –Net Indirect Taxes

By adding the net value added by all the producing enterprises in an industrial sector, we obtain net value added to that industrial sector. The sum total of net values added by all the industrial sectors in the domestic territory of the country, gives us the Net Domestic Product at Factor Cost.

Hence,

Net Value Added = Value Added by Primary Sector + Value Added by Secondary Sector + Value Added by Tertiary Sector

Calculation of Value of Output

Final Product Method Value Added Method

This method includes only final goods and services. Final goods and services are not resold by the buyers but the buyers themselves consume them. In this method, the value of intermediate goods is deducted from the value of output. Example : Bread is the final product of the value of ` 3,600. Only `3,600 will be included in national income. Used wheat in making flour costs ` 1,600. Flour which costs ` 2,400 goes to bakery making bread of value ` 3,200. Hence, total value of output will be 1,600 + 2 , 4 0 0 + 3 , 2 0 0 + 3 , 6 0 0 = 1 0 , 8 0 0 . The value of intermediate goods for final bread, i.e., 1,600 + 2,400 + 3 { , } 2 0 0 = 7 { , } 2 0 0

The value of final product will be

= Value of Total Product – Value of Intermediate Goods = 10,800 – 7,200 = 3,600 Various steps in value added method are as follows : (i) The farmer does not bear any cost as he works himself (and does not pay for seed and fertilizers). Hence, value added at farmer stage is ` 1,600.

(ii) Flour making mill buys wheat for ` 1,600 and mate flour which is sold for ` 2,400. Hence, value added at flour stage is 2 , \dot { 4 } 0 0 - 1 , 6 0 0 = \dot { ~ } 8 0 0

(iii) Baker buys flour for ` 2,400 and makes bread of ` 3,200. Hence, value added at baker stage is 3 , 2 0 0 - 2 4 0 0 = \cdot 8 0 0 . \mathrm { ( i v ) } Shopkeeper bought bread for ` 3,200 and sold it to consumers for ` 3,600. Hence, value added at sale of bread stage is 3 , 6 0 0 - 3 , 2 0 0 = \dot { ~ } 4 0 0

Hence, Total Value Added = 1,600 + 800 + 800 + 400 = ` 3,600 Stage of Production

Wheat Flour Bread Sale of Bread

Total

Both the methods give product value of ` 3,600 is called GDP at Market Price .

Illustration

Value of Output Cost of Intermediate Goods Value Added

1,600 — 1,600 2,400 1,600 800 3,200 2,400 800 3,600 3,200 400

10,800 7,200 3,600 Box 5

● Third Step : Calculation of Net Factor Income _{NNPFC = NDPFC + NFIA from}

Abroad OrThe third and final step in the estimation of national Net National

income is to estimate the net factor income earned^{☐ ☐} from abroad and add it to the net domestic product ☐ ☐☐ ☐☐ ☐

☐ ☐☐ ☐☐ ☐ at factor cost. This gives us the national income. ☐ ☐☐ ☐☐ ☐ ☐ ☐ ☐ ☐☐ ☐

In short, ☐ ☐

48

Introductory Macro Economics

A Brief Review of Calculation of National Income by Product/Value Added Method Gross Value (i) Added or GDP =

at Market Price Value of Production in all Primary, Secondary and Tertiary Sectors at Market Price Value of

– Intermediate Consumption

(ii)

NDP at

Market Price = GDP at Market Price – Depreciation

(iii)

NDP at Factor cost = NDP at Market Price – Indirect Tax + [Subsidy]

(iv)

NNP at Factor Cost₌ NDP at₊ Net Factor Income_{= National IncomeFactor Cost from} Abroad

Box 6

18.2.2. Precautions regarding Product Method or Value Added Method

Following precautions should be taken while estimating national income from product method :

(A) Items to be included :

1. Commission and brokerage earned on sale and purchase of second-hand goods are added in national income.

2. Own account of production of goods of producing unit should be added while estimating value added.

3. The value of goods retained for self-consumption should be included in national income. 4. Imputed rent of owner-occupied buildings should be included in national income.

(B) Items not to be included :

1. Value of intermediate goods should not be included in the estimation of national income. 2. The sale and purchase of second-hand goods and property should not be included in national income.

2. Services of self-consumption are not included in national income.

18.2.3. Problem of Double Counting

‘‘Double counting means counting of the value of the same product (or expenditure) more than once in calculating the national income.’’

While estimating national income with value added method, there may arise the problem of double counting. The problem of double counting is the problem of estimating the value of goods and services more than once . As the original goods goes into different processes and passes many stages so there is always danger that its value may be included at every stage and result may be double, triple or manifold counting.

For example, a farmer produces wheat and sells it for` 3,000 in the market to a flour mill . As far as the farmer is concerned, the sale of wheat is a final sale and he gets ` 3,000 for it. If he does not incur any expenditure on the cultivation of wheat,`3,000 becomes the value of his contribution or value added by him. The purchase of wheat by the flour mill is an intermediate goods. It converts wheat into flour and sells it for`5,000 to a baker . The flour mill treats the flour as a final product, but the baker uses it as an intermediate goods and manufactures bread. The baker sells bread to the shopkeeper for ` 6,500. For the baker, the bread is a final goods but, for the shopkeeper, it is an intermediate goods. The shopkeeper sells the entire stock of bread to the final consumers for ` 8,000. Thus,

\text {Value of Output} = 3, 0 0 0 + 5, 0 0 0 + 6, 5 0 0 + 8, 0 0 0 = \text {`} 2 2, 5 0 0

But in this calculation, value added at every stage includes the value added of previous stage because the value of flour contains the value of wheat and the value of bread manufactured contains the value of wheat and value of services of the miller, baker and shopkeeper. Now, the value of the wheat is counted four times, the value of services of the miller thrice and the value of services by the baker twice. In other words, the value of wheat and value of services of the miller and baker have been counted more than once.

=` 22,500 - ` 14,500
=` 8,000

The counting of the value of commodity more than once is called double counting. This leads to overestimation of the value of goods and services produced.

How to Avoid Double Counting ?

For avoiding double counting in product method two methods are used : (I) Final Product Method,

(II) Value Added Method.

(I) Final Output Method : According to this method, for avoiding double counting, the value of intermediate

goods is deducted from the value of output. In other words, the value of final goods and services only is included in national income. In the above example, the bread sold to the consumers is the final output. Only the value of final output, i.e., ` 8,000 will be included in national income. The value of wheat, flour and baking-bread, i.e., ` 3,000, `5,000 and ` 6,500 = ` 14,500 are the values of intermediate goods. The value of the final output can be calculated by deducting the value of intermediate goods from the value of output. In other words,

Value of Final Output =Value of Output – Value of Intermediate Goods

(II) Value Added Method : Value Added refers to the difference between value of output and the value of intermediate consumption of each producing unit in the country. Sum total of value added by all the producing units within the domestic territory of the country is equal to Domestic Product .

In the above example :

(i) Value Added at Wheat Production Level = ` 3,000

(ii) Value Added at Flour Making Stage = ` 5,000 – 3,000

= ` 2,000

(iii) Value Added at Baker Level = ` 6,500 – 5,000

= ` 1,500

(iv) Value Added at Sale of Bread = ` 8,000 – 6,500

= 162895 - (-681) = `163576 crores

= 132470 + 19183 = `151653 crores

= 151653 + 11242 = `162895 crores

(i) $NNP_{FC} = NDP_{FC} + Net Income from Abroad$

(v) $GDP_{FC} = GDP_{MP} - Net Indirect Tax$

= ` 1,500
Total Value Added = ` 3,000 + 2,000 + 1,500 + 1,500
= ` 8,000
Box 7
18.2.4. Numerical Illustrations of Product/Value Added Method

1. Calculate \mathrm { N N P } _ { \mathrm { \tiny ~ F C } } , \mathrm { N N P } _ { \mathrm { \tiny ~ M P } } , \mathrm { G N P } _ { \mathrm { \tiny ~ M P } } , \mathrm { G D P } _ { \mathrm { \tiny ~ M P } } , \mathrm { G D P } _ { \mathrm { \tiny ~ F C } } , \mathrm { G N P } _ { \mathrm { \tiny ~ F C } } NDP _MP , from the following data :

Items ` (crores) NDP _FC 133151 Depreciation 11242 Net Indirect Tax

19183 Net Income from Abroad (–)681 Solution :

= 133151 + (-681) = `132470 crores

(ii) $NNP_{MP} = NNP_{FC} + Net Indirect Tax$

(iii) $GNP_{MP} = NNP_{MP} + Depreciation$

(iv) GDP $_{MP}$ = GNP $_{MP}$ - Net Income from Abroad

(vi) GNP $_{FC}$ = GDP $_{FC}$ + Net Income from Abroad

50 Introductory Macro Economics 2. Calculate the value added by firm A and B from the following data :

Items

(i) Final Stock of Firm A

(ii) Final Stock of Firm B

(iii) Initial Stock of Firm A

(iv) Initial Stock of Firm B

(v) Sale by Firm A

(vi) Purchase by Firm A from B
(vii) Purchase by Firm B from A
(viii) Sale by Firm B
(ix) Import of Raw Material by Firm A
(x) Export by Firm B
Solution :
For Firm A
(i) Production Value of Firm A
= Sale + Change in Stock (Final Stock – Initial Stock) = 1050 + (120 – 30) = `1140 lakhs
(ii) Value added by Firm A
= Production Value – Purchase by Firm B – Import of Raw
Material by Firm A
= 1140 – 450 – 180 = `510 lakhs
For Firm B
(i) Production Value of Firm B
= Sale + Change in Stock (Final Stock – Initial Stock) = Sale + Export by Firm B + Change in Stock = 900 + 150 + (60 – 30) = `1080 lakhs
(ii) Value Added by Firm B
= Production Value – Purchase from Other Firms = 1080 – 300 (Purchase from Firm A)
= `780 lakhs
3. Calculate the value added by Industry C on the basis of following data :
Items
(i) Sale by Industry A to B
(ii) Value Added by Industry B
(iii) Value Added by Industry D
(iv) Sale by Industry C to D
(v) Final Sale
Solution :

Value Added by Industry A (20 – 0) Value Added by Industry B (given) Value Added by Industry D (given) Total value Added by Industries A, B and D Total Value Added by All Industries (A, B, C and D) So, Value Added by Industry C = 130 – 90 = ` 40 thousand

4. There are two firms in an economy. Calculate the following on the basis of given information : (a) Value Added by firm A and firm B (b) Gross Value Added or GDP at Factor Cost

Items ` (lakhs) (i) Sale by firm A 100

(ii) Purchase by A from B 40

(iii) Purchase by B from A 60

(iv) Sale by Firm B 200

(v) Final Stock of Firm A 20

(vi) Final Stock of Firm B 35

(vii) Initial Stock of Firm A 25

180

150

` (thousand) 20 40 30 70 130 ` (thousand) 20 40

30 90 130

(viii) Initial Stock of Firm B 45 (ix) Indirect Tax Payment by both firms 30 Solution : (a) Value added by Firm A = Sale by Firm A – Purchase by Firm A from Firm B + Change in Stock (i.e., Final Stock of Firm A – Initial Stock of Firm A) = 100 – 40 + (20 – 25) = ` 55 lakhs. Value added by Firm = Sale by Firm B – Purchase by Firm B from Firm A

• Change in Stock (i.e., Final Stock of Firm B – Initial Stock of Firm B) = 200 – 60 + (35 – 45) = 130 lakhs. (b) Gross Value Added or GDP $_{FC}$ = Value added by Firm A + Value added by Firm B – Indirect Tax = 55 + 130 – 30 = 155 lakhs. Ans. (a) Value added by Firm A = 55 lakhs Value added by Firm B = 130 lakhs (b) Gross Value added at Factor Cost = ` 155 lakhs

5. Calculate the value added by firm X from the following data : Items (i) Sale (ii) Purchase of Raw Material (iii) Import of Raw Material (iv) Import of Machines (v) Final Stock (vi) Initial Stock Solution : ` (lakhs) 600 200 100

200
40
10
Value Added by Firm X
Intermediate Consumption
(ii) Raw Material bought (iii) Import of Raw Material
Total
Value of Production
` in lakhs ` in lakhs
200 (i) Sale 600
100 (ii) Change in Stock (v–vi) 30
(40 – 10) 630
300
Value Added = Value of Production – Intermediate Consumption
= 630 – 300 = ` 330 lakhs
6. Calculate the value of added by firm A and Firm B—
Items ` (crores) (i) Domestic Sale by Firm A 4000 (ii) Export by Firm A
1000 (iii) Purchase by firm A 200 (iv) Sale by firm B 2940 (v) Purchase
by Firm B 1300 Solution :
Value added by Firm A
= Domestic sale by firm A + Export by firm A — Purchase by firm A 4000
+ 1000 — 200 = ```` 4800 crore
Value added by Firm B
= Sale by firm B — Purchase by Firm B
= 2940 — 1300
= `` 1640 crore
52
Introductory Macro Economics

7. Firm A sold building wood to firm B for `1,000 and wood for burning to individual consumers for ` 500, firm B made wood platforms and sold them to firm C for ` 800 and consumers for ` 700. Firm C made wooden furniture and sold it for ` 1,000 to individual consumers and for ` 500 to government office. Calculate the value added by firm A, B and C. Calculate the value of gross production. Solution :

S.No. Details of Transactions 1. A sold building wood to B

A sold wood to consumers 2. B sold platforms to C

B sold platforms to consumers 3. C sold furniture to consumers C sold furniture to government office Total Sale Value Intermediate Value Added (`) Cost (`) 1,000 1,500 Zero 500 800_1,000 1,500 – 1,000 700 (from A) = 500

$1,000_{800}\ 1,500 - 800$ (from B) = 700 500

4,500 1,800 2,700 Value added by A, B and C are ` 1,500, ` 500 and ` 700 respectively. Value of Gross Production is ` 4,500.

18.3. Income Method

In the process of production, different factors like land, labour, capital and organisation co-ordinate with each other and produce goods. These factors belong to household sector and get factor income like rent, wages, interest and profit in return of their services. The sum total of factor’s income is known as national income with income method. This method is also called Factor Payment or Distributed Share Method .

National Income = Wage + Rent + Interest + Dividend + Undistributed Profit + Corporate Profit Tax + Surplus of Public Sector + Mixed Income + Net Income from Abroad.

Components of National Income with Income Method (a) Compensation of Employees :

Wages/salaries in cash

Wages/salaries in kind

Employers contribution to social security

Pension after retirement (b) Operating Surplus :

Rent

Interest

Profit

(c) Mixed Income of self–employed

(d) Net factor income from abroad.

Box 8

Wage :

Rent :

Reward given to labour for his work.

Reward given to the landlord or owner of building.

It includes imputed rent. Rent of owner occupied houses should be imputed on the basis of prevailing market price and be included in the national income.

Interest : Reward on the capital given as loan.

Profit : Rewards to firms for bearing uncertainties and risks in the production process. Components of Profit :

(i) Dividend : A part of the profit which is distributed by the company among shareholders. (ii) Undistributed Profit : The remaining profit income of the company after paying profit tax and dividend is called the reserve fund which is also known as undistributed profit. (iii) Corporate Profit Tax : It is a direct tax which government imposes on the profit income of the company.

● Operating Surplus : It refers to income from property and enterpreneurship. It includes : (i) Rent, (ii) Interest, (iii) Profit

● Mixed Income : Mixed income refers to the incomes of the self-employed persons using their labour, land, capital and entrepreneurship to produce goods and services. These incomes are mixed in terms of wages, rent,

● Surplus of Public Sector : Income earned by public enterprises is also a part of national income.

Box 9

Factor Income is different from Transfer Income

A factor income refers to income earned by a person as a reward for rendering his factor service. It may be in the form of wage salary for his labour, rent for his land, interest for his capital or profit for his entrepreneurship. It must be noted that factor incomes are only ‘ earned ’ incomes. It does not include any income which is ‘not earned ’ or for which a factor service has not been rendered. Transfer income , on the other hand, is ‘not earned ’ income against which no service is rendered in the economy. old age pension received by the senior citizens is not the earned income. It is just a help by the government for which no service has been rendered. Such receipts or payments are called transfer receipts or transfer payments. These are not factor incomes and therefore not included in the estimation of national income. Thus,

(i) Factor incomes are earned incomes and transfer payments are unearned.

(ii) Factor incomes are rewards for rendering factor services. Transfer payments are just one sided payments.

No service is rendered in return for the transfer payments.

Box 10

18.3.1. A Brief Review of Calculating National Income from Income Method

^{NNPFC or} Wage + (Operating^{Net Factor} National = _{Surplus) + Mixed Income} + Income from Income Abroad Operating Surplus = Rent + Interest + Profit

18.3.2. Precautions related to Income Method

1. Income from Sale of Second-hand Goods : Any income from the sale of second-hand goods and property is not included in national income. But any commission paid on such a transaction becomes the part of national income.

2. Transfer Payments or Incomes : Transfer payments like old age pension, scholarships, unemployment allowance, student’s pocket allowance are unilateral payments and they are not included in national income.

3. Sales of Shares and Bonds : The sale proceeds of shares and bonds are not included in national income, as these transactions do not relate to a flow of goods and services.

4. Income from Illegal Activities : Income from black marketing, robbery, corruption, etc., is not included in national income because no services are provided for such incomes.

5. Windfall Gains : Income from lotteries or capital gains are not included in national income as income arises without any effort.

6. Imputed Rent : Income or rent from self-occupied houses is included in national income.

7. Indirect Taxes : Indirect taxes are commodity taxes which raise market price of the commodity. Therefore, it becomes a part of GNP at market prices, but not included in national income.

8. Corporation Tax and Income Tax : These are a part of profits therefore they become a part of factor income.

9. Death Duties, Gift Tax, Wealth Tax, etc. These are not included in national income, because these are paid out of past income or savings. 10. Production for Self-consumption : Estimated income of goods produced for self-consumption are included in national income but production of domestic services for self-consumption is not included in it. 11. Travelling Allowances : Not included in national income because it is reimbursement of expenses already spent.

$NNP_{MP} = (i) + (iii) - (viii) - (ii)$

$NNP_{FC} = NNP_{MP} - Indirect Tax$

12. Contribution to Social Security Schemes Paid by Employees : It should not be included in national income because these have already been included in factor income.

18.3.3. Numerical Illustrations of Income Method

1. Calculate the national income from the following data by value added method and income method : Items ` (crores) (i) Sale 15000 (ii) Depreciation 200 (iii) Increase in Stock 2000 (iv) Wages and Salaries 3500 (v) Rent 1600 (vi) Interest 1300 (vii) Profit 3000 (viii) Value of Intermediate Goods 7000 (ix) Indirect Tax 400 Solution : Calculation of National Income :

(i) By Value Added Method :

= `15000 + 2000 - 7000 - 200 = `9800 crores

= 9800 - 400 = `9400 crores

(ii) By Income Method :

$NNP_{FC} = (iv) + (v) + (vi) + (vii)$

= 3500 + 1600 + 1300 + 3000 = `9400 crores

2. Determine the following from the given data :

(a) Gross Domestic Product at Market Price (GDP $_{MP}$ )

(b) Gross National Product at Market Price \bf ( G N P _ { M P } )

(c) Net National Product at Factor Cost (NNP _FC )

Items ` (crores) (i) Fixed Capital Consumption 34 (ii) Contribution of Employers in Social

Security Schemes 30 (iii) Rent 10 (iv) Interest 20 (v) Profit 25 (vi) Royalty 5 (vii) Wages & Salaries 170 (viii) Net Indirect Tax 38 (ix) Net Factor Income from Abroad (–)3 Solution : (a) GDP _MP = Wages & Salaries + Rent + Interest + Profit + Royalty + Contribution of Employers in Social Security Schemes + Fixed Capital Consumption + Net Indirect Tax = 1 7 0 + 1 0 + 2 0 + 5 + 2 5 + 3 0 + 3 4 + 3 8 = ` 332 crores (b) \mathbf { G N P } _ { \mathrm { \mathbf { M P } } } = \mathbf { G D P } _ { \mathrm { M P } } + Net Factor Income from Abroad = 332 – 3 = ` 329 crores (c) \mathbf { N N P } _ { \mathbf { F C } } = \mathbf { G N P } _ { \mathbf { M P } } - – Fixed Capital Consumption – Net Indirect Tax = 3 2 9 - 3 4 - 3 8 = \dot { } 2 5 7 crores 3. Calculate the following : (a) NDP _FC by Product Method (b) NNP _FC by Income Method Items ` (crores) (i) Value of Production 800 (ii) Value of Intermediate Consumption 400 (iii) Economic Subsidy 10 (iv) Indirect Tax 60 (v) Factor Income from Abroad 10 (vi) Factor Income given to Abroad 20 (vii) Mixed Income from Self-employed 120 (viii) Rent and Royalty 40 (ix) Interest and Profit 20 (x) Wages and Salary 110 (xi) Consumption of Fixed Capital 50 (xii) Employer’s Contribution in Social Security Schemes 10 Solution : (a) NDP _FC (By Product Method) \mathbf { \Sigma } = ( \mathrm { i } ) - ( \mathrm { i i } ) + ( \mathrm { i i i } ) - ( \mathrm { i v } ) - ( \mathrm { x i } )

= 800 - 400 + 10 - 60 - 50 = ` 300 crores
(b) NNP FC (By Income Method)
= (x) + (ix) + (viii) + (vii) + (v) - (vi) + (xii)
= 110 + 20 + 40 + 120 + 10 - 20 + 10
= ` 290 crores
4. Calculate the following by Expenditure Method :
(a) Net Domestic Income
(b) Gross Domestic Income
(c) Net National Income
(d) Net National Product at Market Price
Items ` (crores) (i) Indirect Tax 3000
(ii) Economic Subsidy 600
(iii) Mixed Income of Self Employment 9000
(iv) Depreciation 500
(v) Operation Surplus 3000
(vi) Net Factor Income from Abroad 100
(vii) Compensation to Employees 8000
Solution :
(a) NDI = Mixed Income from Self Employment + Operation Surplus +
Compensation to Employees = 9000 + 3000 + 8000 = ` 20000 crores
(b) GDI = Net Domestic Income + Depreciation
= 20000 + 500 = ` 20500 crores
(c) NNI = Net Domestic Income + Net Factor Income from Abroad
= 20000 + 100 = ` 20100 crores
(d) NNP MP = Net National Income + Indirect Tax - Subsidy
= 19900 + 3000 - 6000 = ` 22300 crores
5. Calculate the National Income from the following data by Income
Method and Value Added Method : Items ` (crores) (i) Sale 40000
(ii) Increase in Stock 5000
(iii) Wage and Salary 20000
(iv) Rent 10000
(v) Interest 4000
(vi) Dividend 6000
(vii) Undistributed Profit 1000
(viii) Company Tax 1200
(ix) Indirect Tax 800
(x) Depreciation 2000

Solution : Calculation of National Income (a) By Value Added Method : NNP$_{MP}$ = (i) + (ii) - (x) = 40000 + 5000 - 2000 = ` 43000 crores NNP$_{FC}$ = NNP$_{MP}$ - Indirect Tax = 43000 - 800 = ` 42200 crores (b) By Income Method : NNP$_{FC}$ = (iii) + (iv) + (v) + (vi) + (vii) + (viii) = 20000 + 10000 + 4000 + 6000 + 1000 + 1200 = ` 42200 crores 6. Calculate the National Income from the following data : Items ` (crores) (i) Rent and Royalty 30 (ii) Salary and Wages 500 (iii) Net Factor Income from Abroad (-)5 (iv) Contribution of Employees in Social Security Schemes 60 (v) Operating Surplus 120 Solution : National Income = (ii) + (iii) + (v) = 500 + (-5) + 120 = ` 615 crores 7. Calculate the following from the information of an economy : (a) Domestic Income, (b) National Income. Items ` (crores) (i) Rent 4000 (ii) Wage 8000 (iii) Dividend 2000 (iv) Interest 300 (v) Undistributed Profit 200 (vi) Mixed Income 300 (vii) Contribution in Social Security 500 (viii) Corporate Profit Tax 300 (ix) Net Factor Income from Abroad 1100 Solution : (a) Domestic Income = Wage + Rent + Interest + Dividend + Mixed Income + Undistributed Profit + Contribution in Social Security + Corporate Profit Tax = 8000 + 4000 + 300 + 2000 + 300 + 200 + 500 + 300 = ` 15600 crores

(b) National Income = Domestic Income + Net Factor Income from Abroad = 15600 + 1100 = ` 16700 crores

18.4. Expenditure Method

Expenditure method is the third method for calculating national income under this method, national income is estimated by aggregating all the final expenditure in an economy during a year.

● Definition

‘‘Expenditure Method is the method which measures the final expenditure on gross domestic product at market price during an accounting year. This total final expenditure is equal to the gross domestic product at market price.’’ ☞

In expenditure method only final expenditure is taken into consideration. In this method, domestic product is measured as a flow of final expenditure on final goods and services produced in an economy in a year. This final expenditure is termed as ‘Gross Domestic Product at Market Price’ (GDP _MP ).

Box 11

18.4.1. What is ‘Final Expenditure’ ?

The expenditure on final goods and services in an accounting year is termed as final expenditure.

‘Final Expenditure’ differs from ‘Intermediate Expenditure’ and this difference depends on the nature of demand. If an enterprise uses the goods purchased from other enterprises for resale or as raw material, the expenditure on such goods will be intermediate expenditure. On the other hand, if goods and services are purchased for final consumption or capital formation, the expenditure on them is final expenditure. In this method, final expenditure alone is considered.

In India, expenditure method is to estimate national income in secondary (manufacturing) sectors. 18.4.2. Steps of Expenditure Method

Following steps are included in expenditure method in calculating national income :

1. Identification of economic units incurring final expenditure.

2. Classification of final expenditure.

3. Estimation of final expenditure.

4. Estimation of net factor income from abroad.

5. Estimation of national income.

Step 1. To Identify Economic Units incurring

Final Expenditure : Various economic units which incur final expenditure within the domestic territory of a country can be grouped under the following categories :

(a) Household Sector,

(b) Producing Sector,

(c) Government Sector and

(d) Rest of the World Sector.

Step 2. Classification of Final Expenditure : The final expenditure is classified in the following five main categories :

(a) Private Final Consumption Expenditure, (b) Government Final Consumption Expenditure, (c) Gross Fixed Capital Formation (or Gross Fixed Investment Expenditure),

(d) Change in Stocks (or Inventories),

(e) Net Exports.

Step 3. Estimation of Final Expenditure : To get value of gross final expenditure on domestic product, we require two types of data for this purpose : (i) Volume of Gross Sales, (ii) Retail Prices. By multiplying volume of sales with their respective retail prices and then by adding them all, we get { \mathrm { G D P } } _ { \mathrm { M P } }

Step 4. Estimation of Net Factor Income from Abroad : Finally, value of net factor income from abroad (NFIA) is estimated which is added to { \mathrm { G D P } } _ { \mathrm { M P } } to get { \mathrm { G N P } } _ { \mathrm { M P } }

Step 5. Estimation of National Income : For obtaining national income at factor cost, cost of depreciation and net indirect taxes have to be subtracted.

In short,

(i) \mathrm { G D P _ { M P } = P r i v a t e } Final Consumption Expenditure + Govt. Final Consumption Expenditure + Gross Fixed Capital Formation + Change in Stock + Net Acquisition of Valuables + Net Exports

(ii) GNP$_{MP}$ = GDP$_{MP}$ + NFIA (iii) NNP$_{FC}$ = GNP$_{MP}$ - Depreciation - Net Indirect Taxes = National Income

Box 12 Measurement of National Income by Expenditure Method 1. Final Consumption

Expenditure
2. Gross Domestic Capital Formation 3. Net Exports= (X-M)

Private Final Consumption Expenditure Gross Domestic Fixed Capital

Formation
Exports
+- +

Change in Stock (Closing Stock – Opening Stock) Imports

Government Final
Consumption
Expenditure Commercial Fixed Investment + Govt. Fixed Investment + Investment on Residential Construction by Households GDPMP
↓ Minus Depreciation ↓ =
NDPMP
↓ Minus Net Indirect Tax ↓ =
NDPFC
↓ Plus Net Factor
Income
from Abroad ↓ =
NNPFC or
National
Income

Box 13 18.4.3. Precautions related to Expenditure Method

The following precautions are to be taken while using expenditure method : (1) Only Final Expenditure is to be taken into account for avoiding error of double counting. Final expenditure is to be interpreted as expenditure on final goods and services.

(2) The Intermediate Expenditure is not included in the calculation of national income because the (3)

(4) value of intermediate expenditure is already reflected in the value of final expenditure. Expenditure on second -hand goods is not included because,

value of second-hand goods has already been accounted during the year of their production. Hence, expenditure on old goods should not be included in current year’s expenditure. Expenditure on shares and bonds is not included in total expenditure, as these are mere paper claims and are not related to the flow of final goods and services. Such expenditures do not cause any value addition.

(5) Expenditure on transfer payments e.g., old age pension, scholarship, etc., by the government is 18.4.4. Numerical Illustrations of Expenditure Method 1. Calculate the following by Expenditure Method :

not included in total expenditure because transfer payments do not cause any value addition in the economy.

(a) Gross National Product at Market Price (b) Gross National Product at Factor Cost (c) Net National Product at Factor Cost

Items ` Private Consumption Expenditure 1,000 Govt. Expenditure on Goods and Services 500 Rent 50 Interest 20 Indirect Tax 50 Social Security Contribution 25 Personal Income Tax 120 Undistributed Profit 125 Dividend 100 Wages and Salary 1,200 Corporate Tax 100 Net Domestic Investment 200 Net Foreign Investment 50 Transfer Payments 50 Depreciation 75 Solution : (a) GNP$_{MP}$ = Govt. Expenditure on Goods & Services + Private Consumption Expenditure + Net Domestic Investment + Net Foreign Investment + Depreciation = 500 + 1,000 + 200 + 50 + 75 = ` 1,825 (b) GNP$_{FC}$ = GNP$_{MP}$ - Indirect Tax

= 1,825 - 50 =` 1,775 (c) NNP$_{FC}$ = GNP$_{FC}$ - Depreciation = 1,775 - 75 =` 1,700 2. Calculate Net Domestic Product at Market Price from following data : Items ` (crores) (i) Gross Fixed Capital Formation 1000 (ii) Net Factor Income from Abroad (-)200 (iii) Net Export of Goods and Services (-)100 (iv) Personal Disposable Income 3000 (v) Personal Savings 350 (vi) Net Indirect Tax 200 (vii) Change in Stock 300 (viii) Consumption of Fixed Capital 250 (ix) Government Final Consumption Expenditure 500 Solution : Net Domestic Product at Market Price = (iv) - (v) + (ix) + (i) + (vii) + (iii) - (viii) = 3000 - 350 + 500 + 1000 + 300 + (- 100) - 250 = ` 4100 crores (Private Final Consumption Expenditure = Personal Disposable Income - Personal savings) 3. Calculate GNP at Market Price from the following data : ` (i) Private Consumption Expenditure 50,000 (ii) Govt. Consumption Expenditure 15,000 (iii) Gross Fixed Capital Formation 10,000 (iv) Increase in Stock 2,000 (v) Export of Goods and Services 5,000 (vi) Import of Goods and Services 7,000 (vii) Capital Consumption Allowance 6,500 (viii) Net Indirect Tax 5,000 Solution : NNP$_{FC}$ = (i) + (ii) + (iii) + (iv) + (v) - (vi) + (viii) = 50,000 + 15,000 + 10,000 + 2,000 + 5,000 - 7,000 + 5,000 = ` 80,000 4. Calculate the following by expenditure method : (a) Gross National Product at Market Price (b) Net National Product at Factor Cost Items ` (crores) (i) Government Final Consumption Expenditure 47 (ii) Net Export (-)6

(iii) Gross Capital Formation 94 (iv) Net Indirect Tax 43 (v) Private Final Consumption Expenditure 260 (vi) Net Change in Stock 11 (vii) Net Factor Income from Abroad (−)3 (viii) Consumption of Fixed Capital 39 Solution : (a) Gross National Product at Market Price = (v) + (i) + (iii) + (ii) + (vii) = 260 + 47 + 94 + (−) 6 + (−) 3 = ` 392 crores (b) Net National Product at Factor Cost = GNP$_{MP}$ – (viii) – (iv) = 392 – 39 – 43 = ` 310 crores Note : Change in stock is included in gross capital formation.GNP GNI 18.5. Reconciliation of the Three Measures of National Income Three methods of measuring national income give us three measures of national income : Gross National Product ≡ ≡ Gross National Expenditure ≡ GNE Methods of Measuring National Income : At a Glance Product Method Income Method Or Value Added Method Expenditure Method Compensation of Employees Gross Value Added in the + Primary Sector at Market Price Operating Surplus Private Final Consumption Expenditure + Government Final Consumption Expenditure ++ + Gross Value Added in the Mixed Income of the Secondary Sector at Market Price Self-employed Gross Domestic Fixed Capital Formation ++ Gross Value Added in the Tertiary Sector at Market Price ↓ Gross Domestic Product at Market Price (−) Depreciation

↓ Net Domestic Income ₍ + ₎ Net Factor Income from Abroad

↓ Net Domestic Product at Market Price ( – )

↓

National Income (NNP _FC ) Change in Stock or Inventory Investment +

Net Exports (Exports– Imports) ↓ Gross Domestic Product at Market Price ( – ) Net Indirect Taxes

Introductory Macro Economics

Net Indirect Taxes Depreciation Net Domestic Product at Factor Cost +

( + ) Net Factor Income from Abroad

National Income (NNP _FC ) National Income (NNP _FC ) Box 14 18.6. Nominal National Income and Real National Income 18.6.1. Nominal National Income or National Income at Current Prices

National income at current prices, which signifies money or nominal national income, represents money value of all final goods and services measured at current prices produced by the residents of a country during one year.In other words, nominal national income is defined as the value of current output at current year prices, i.e. , national product multiplied by the current market prices.

Nominal or monetary national income estimates cannot be treated as reliable index of economic growth of a nation because during inflation in the nation current prices go up which unnecessarily increase the value of national income.Hence, the increase in national income at current prices does not signify economic growth in the country.

18.6.2. Real National Income or National Income at Constant Prices

Real national income or the national income at constant prices represents the value of all final goods and services at constant (i.e., some base year) prices, produced by the residents of a nation during one year.It is obtained by multiplying the goods and services produced in the current year with the prices prevailed in the base or constant year.

Real national income is the true and reliable index of economic growth in the country. This real national income will show an increase only when production of goods and services during current year is increased and such increase will imply economic growth.

18.6.3. Difference between Real and Nominal National Income Real National Income

1. It is termed as national income at base year constant price.

2. It is the value of current year's output at base year's prices.

3. It shows an increase only when current year's output of goods and services increases.

4. It is a reliable index of economic growth.

Nominal National Income

1. It is termed as national income at current year’s prices.

2. It is the value of current year's output at current year's prices.

3. It can also show an increase in case of no increase in production in current year (due to inflationary prices in the economy)

4. It is not a reliable index of economic growth.

Conversion of National Income at Current Prices into National Income at Constant Prices Or Conversion of Nominal National Income into Real National Income

For converting national income at current prices into National Income at Constant Prices, the following formula can be used : National Income at Constant Price

= National Income at Current Prices

Price Index of the Current Year ×Price Index of the Base Year

or National Income at Constant Price

= National Income at Current Prices

Price Index of the Current Year × 100

(because price index of the base year is always taken to be 100)

Measurement of National Income

Example :

National Income at current prices is`320000 crore and the current year price index is 160. Calculate the National Income at constant prices.

Solution :

National Income at Constant Price

National Income at Current Prices _{× Price Index of the Base YearPrice Index of the}

Current Year

Hence,

National Income at Constant Price = 320000_{160 × 100}

= `200000 crores

Box 15

18.6.4. GNP Deflator

GNP deflator is measured as the ratio of nominal GNP to real GNP multiplied by 100. It measures the average level of prices of all the goods and services which make GNP.

GNP Deflator = Nominal GNP_{× 100}

Real GNP

Similarly,

1. GDP Deflator = Nominal GDP_{× 100}

Real GDP

2. GDP Deflator (at Current Price)

= Nominal GDP for Current Year

Real GDP for Current Year × 100

18.7. GNP and Economic Welfare

Gross National Product (GNP) or Gross Domestic Product GDP if not taken in real terms, can not be taken as a measuring rod of economic welfare in the country. As a matter of fact, increase in real national income of a country leads to increase in per capita income. On the contrary per capita income cannot increase without increase in real national income.

GNP cannot be taken a true indicator of economic welfare. Increase in GNP cannot assure about a corresponding increase in economic welfare.

Following are some of the practical limitations of using GNP or GDP as the indicator of economic welfare in the country :

An increase in GNP may not necessarily ensure a higher standard of living in the economy. Higher population growth may not establish higher standard of living even though GNP goes up.

GNP or GDP ignores equitable distribution of income. Econom ic w elfa re can not be i mprov ed if the distribution of GNP or GDP is not equitable in the society.

Many activities (like barter transactions) are not evaluated in monetary terms which make GNP or GDP under-estimated and hence it cannot be a true indicator of economic welfare.

GNP and GDP do not take note of externalities which refer to positive and negative impact of an activity. GNP figures ignores social cost like environmental pollution, excessive exploitation of mineral resources etc. The impact of these externalities remains out of the scope of GNP or GDP and hence they can not be the true indicator of economic welfare from the point of view of the society.

Green GNP

Green GNP denotes sustainable economic growth. GNP at constant prices or current prices does not take note of environmental pollution and decay of natural resources. The increase in GNP with excessive use of natural resources and environmental pollution, fails to denote sustainable economic development. Hence ‘Green GNP ’ signifies that GNP which helps in attaining the sustainable use of natural resources with a check on environmental pollution.

“Estimating GNP with parameters like excessive use of natural resources and environmental pollution is called Green GNP.”

Box 16

Calculation of Gross National Product Or National Income

Items to be Included

• New final goods and Services.

• Production of goods for self-consumption.

• Imputed value of owner occupied houses.

Self-account production of fixed assets (as they are part of final investment expen-diture).

Items not to be Included

Purchase and sale of old goods (as no value addition takes place in current Year).

Intermediate goods (as they are already included in final goods. If included, problem of double counting takes place).

• Transfer payments (as no value addition in the economy).

• Housing services (as these are services of self-consumption).

• Workers’ services employed on wages.

• Free fooding given to labours.

Broker’s commission (as it is production service which creates new income).

• Bonus (as it is a part of labour’s work).

• Interest rebates on loans given to labourers by employer.

• Singing or dancing with remuneration.

• Pension on retirement.

Expenditure on road construction (as it is a part of permanent gross capital forma-tion).

• Expenses made by foreign tourists.

• Fare payment by passenger (as it comes under category of final private consumption).

• Security expenses (as it is a part of government final consumption expenditure).

• Fees paid by the students (as it is a payment against Examples of transfer payments : Old age pension, scholarships, unemployment allowance, etc.

• Sale and purchase of bonds and shares and financial transactions (as they do not contribute to the production of goods and services).

Income earned from illegal activities (as this income is unaccounted).

• Black money (as it is also unaccounted money).

• Capital Gain (e.g., gains accruing to the individuals on account of increase in prices of land, shares etc.

• Unexpected gain such as lottery gain.

increase the market price of goods).

• Capital loss (loss occurring due to floods, earthquake etc.)

• Services rendered by housewives (as they are not paid for it).

received services.) Box 17

18.8. Miscellaneous Illustrations

1. Use following information of an economy to determine Gross National Product at Market Price applying Value Added Method :

Items ` (crores) (i) Sales of Output 50000

(ii) Increase in Stock 5000

(iii) Intermediate Cost 10000 (iv) Consumption of Fixed Capital 9000 (v) Economic Subsidies 500 (vi) Payment of Excise Duties 735 Solution : GNP _MP = Sales of Output + Increase in Stock – Intermediate Cost = 50000 + 5000 – 10000 = ` 45000 crores 2. On the basis of following data determine : (a) Gross Value Added at Market Price for Primary, Secondary and Tertiary Sectors (b) National Income Items ` (crores) (i) Gross Value of Output : Primary Sector 48000 Secondary Sector 12000 Tertiary Sector 18000 (ii) Value of Intermediate Inputs Purchased : Primary Sector 24000 Secondary Sector 6000 Tertiary Sector 3000 (iii) Indirect Taxes paid by all the Sectors 3000 (iv) Consump. of Fixed Capital by all the Sectors 4800 (v) Factor Income received from Rest of the World 600 (vi) Factor Income paid to Non-Residents 1200 (vii) Subsidies received by all the Sectors 1200 Solution : (a) Gross Value Added by (i) Primary Sector = Gross Value of Output by Primary Sector – Value of Intermediate Cost of Primary Sector (ii) Secondary Sector = Gross Value of Output by Secondary Sector – Value of Intermediate Cost of Secondary Sector = 12000 – 6000 = ` 6000 crores (iii) Tertiary Sector = Gross Value of Output by Tertiary Sector – Value of Intermediate Cost of Tertiary Sector = 18000 – 3000 = ` 15000 crores

(b) National Income (NNP _FC )

= Gross Value Added by Primary Sector + Gross Value Added by Secondary Sector + Gross Value Added by Tertiary Sector (–) Consumption of Fixed Capital (–) Indirect Taxes + Subsidies + Net Factor Earnings from Abroad

= 24000 + 6000 + 15000 – 4800 – 3000 + 1200 + (600 – 1200)

= 46200 – 7800 – 600 = ` 37800 crores

3. From following data calculate net value added at factor cost by each sector : `(Crores)

Items Primary Sector

(i) Intermediate Consumption 200

(ii) Change in Stock 40

(iii) Production for Self–consumption 60

(iv) Consumption of Fixed Capital 40

(v) Value of Output 400

(vi) Net Indirect Taxes 50

(vii) Purchase of Machinery 40

Solution :

Net Value Added by Primary Sector

Secondary Sector Tertiary Sector 400 250 60 — 80 —

100 60

1000 600

120 60

200 80

= Value of Output – Intermediate Consumption – Net Indirect Taxes –

Consumption of Fixed Capital

= 400 – 200 – 50 – 40 = ` 110 crores

Net Value Added by Secondary Sector

= Value of Output – Intermediate Consumption – Net Indirect Taxes –

Consumption of Fixed Capital

= 1000 – 400 – 120 – 100 = ` 380 crores

Net Value Added by Tertiary Sector

Administrative Departments 150
(vi) Current Transfers from Rest of the World 50
(vii) Savings of Non-departmental Government Enterprises 40
(viii) Net Indirect Taxes 250
(ix) Direct Taxes paid by Households 100
(x) Net Factor Income from Abroad (−)10
Solution :
Net National Disposable Income
= National Income + Net Indirect Taxes + Current Transfers from Rest of the World = (i) + (viii) + (vi)
= 3000 + 250 + 50 = `3300 crores

= Value of Output – Intermediate Consumption – Net Indirect Taxes – Consumption of Fixed Capital
= 600 - 250 - 60 - 60 = `230 crores
4. Calculate Net National Disposable Income from the following data :

Items ` (crores) (i) National Income 3000 (ii) Savings of Private Corporate Sector 30 (iii) Corporate Tax 80 (iv) Current Transfers from Govt. Administrative Departments 60 (v) Income from Property and Entrepreneurship accruing to the Government

5. From the following data, calculate Gross National Product at Market Price by (i) Income Method and (ii) Expenditure Method :

Items ` (crores) (i) Mixed Income of Self-employed 400

(ii) Compensation to Employees 500

(iii) Private Final Consumption Expenditure 900

(iv) Net Factor Income from Abroad (–)20

(v) Net Indirect Taxes 100

(vi) Consumption of Fixed Capital 120

(vii) Net Domestic Capital Formation 280

(viii) Net Exports (–)30

(ix) Profits 350

(x) Rent 100

(xi) Interest 150

(xii) Government Final Consumption Expenditure 450

Solution :

(a) Gross National Product at Market Price (by Income Method) = Mixed Income of Self-employed + Compensation to Employees + Net Factor Income from Abroad + Net Indirect Taxes + Consumption of Fixed Capital + Profits + Rent + Interest = 400 + 500 + (−) 20 + 100 + 120 + 350 + 100 + 150 = ` 1700 crores (b) Gross National Product at Market Price (by Expenditure Method) = Private Final Consumption Expenditure + Net Factor Income from Abroad + Consumption of Fixed Capital + Net Domestic Capital Formation + Government Final Consumption Expenditure + Net Exports = 900 + (−) 20 + 120 + 280 + 450 - 30 = ` 1700 crores 6. From the following data calculate National Income by : (a) Income Method, (b) Expenditure Method. Items ` (crores) (i) Private Final Consumption Expenditure 350 (ii) Mixed Income of Self-employed 35 (iii) Gross Domestic Fixed Capital Formation 70 (iv) Opening Stock 15 (v) Compensation of Employees 250 (vi) Closing Stock 25 (vii) Government Final Consumption Expenditure 100 (viii) Operating Surplus 200 (ix) Consumption of Fixed Capital 10 (x) Net Factor Income from Abroad (−)5 (xi) Exports 10 (xii) Imports 20 (xiii) Net Indirect Taxes 25 Solution : (a) National Income (NNP$_{FC}$) (Income Method) = Compensation of Employees + Operating Surplus + Mixed Income + Net Factor Income from Abroad = 250 + 200 + 35 + (− 5) = 485 - 5 = ` 480 crores (b) National Income (NNP$_{FC}$) (Expenditure Method) = Private Final Consumption Expenditure + Govt. Final Consumption Expenditure + Gross Domestic Fixed Capital Formation + Changes in Stock + Net Exports + Net Foreign Income from Abroad

-Consumption of Fixed Capital - Net Indirect Taxes
= 350 + 100 + 70 + (25 - 15) + (10 - 20) + (-5) - 10 - 25
= 520 + 10 - 10 - 5 - 10 - 25

7. Find out personal disposable income from the following data :

Items ` (crores) (i) Corporate Tax 3 (ii) Miscellaneous Receipts of Govt. Administrative Departments 1 (iii) Direct Taxes paid by Households 4 (iv) Savings of Private Corporate Sector Net of Retained Earnings of Foreign Companies 1 (v) Private Income 218 Solution : Personal Disposable Income

= Private Income – Corporate Tax – Corporate Savings – Miscellaneous Receipts of Government Administrative Departments – Direct

Taxes paid by Households
= 218 - 3 - 1 - 1 - 4
= ` 209 crores

8. From the following information, calculate Gross National Income by (a) Income Method, (b) Expenditure Method :

Items ` (crores) (i) Factor Income from Abroad 10
(ii) Compensation of Employees 150
(iii) Net Domestic Capital Formation 50
(iv) Private Final Consumption Expenditure 220
(v) Factor Income to Abroad 15
(vi) Change in Stock 15
(vii) Employee's Contribu. to Social Security Schemes 10
(viii) Consumption of Fixed Capital 15
(ix) Interest 40
(x) Exports 20
(xi) Imports 25
(xii) Indirect Taxes 30
(xiii) Subsidies 10
(xiv) Rent 40
(xv) Government Final Consumption Expenditure 85
(xvi) Profit 100

Solution :
(a) Income Method :
GNI = Factor Income from Abroad + Compensation of Employees – Factor Income to Abroad + Consumption of Fixed Capital + Interest + Rent + Profit 10 + 150 - 15 + 15 + 40 + 40 + 100 = `340 crores
(b) Expenditure Method :
GNI = Factor Income from Abroad + Net Domestic Capital Formation + Private Final Consumption Expenditure – Factor Income to Abroad + Consumption of Fixed Capital + Exports – Imports – Indirect Taxes + Subsidies + Government Final Consumption Expenditure 10 + 50 + 220 - (-15) + 15 + 20 - (-25) - (-30) + 10 + 85 = `340 crores
9. From the following data calculate :
(a) Value of Output by Government, (b) Net Value Added by Government
Items ` (crores) (i) Value of Services Supplied 500
(ii) Compensation of Employees 400
(iii) Intermediate Consumption 150
(iv) Value of Services Sold 50
Solution :
(a) Value of Output by Government
= Value of Services Supplied + Value of Services Sold
= 500 + 50 = `550 crores
(b) Net Value Added by Government
= Value of Output by Govt. – Intermediate Consumption
= 550 - 150 = `400 crores
10. Find out Personal Income from the following data :
Items ` (crores) (i) Income from Domestic Product accruing to Private Sector 224 (ii) Net Current Transfers from Rest of the World 3 (iii) Net Current Transfers from the Government 9 (iv) Interest on National Debt 8 (v) Undistributed Profits 1 (vi) Corporate Tax 3 (vii) Direct Tax 2
Solution :
Personal Income

= Income from Domestic Product accruing to Private Sector + Net Current Transfers from Rest of the World + Net Current Transfers from the Government + Interest on National Debt – Undistributed Profits – Corporate Tax

= 224 + 3 + 9 + 8 - 1 - 3 = ` 240 crores

11. Use expenditure method to calculate : (a) NDP${FC}$, (b) NNP${FC}$, (c) Private Income.

Items (crores) (i) Net Domestic Capital Formation 250 (ii) Net Exports (-)50 (iii) Private Final Consumption Expenditure 900 (iv) Consumption of Fixed Capital 80 (v) Net Indirect Taxes 120 (vi) Government Final Consumption Expenditure 100 (vii) Net Factor Income from Abroad (-)20 (viii) Current Transfers 100 (ix) Interest on National Debts 20 Solution : (a) NDP$_{FC}$ = Private Final Consumption Expenditure + Government Final Consumption Expenditure + Net Domestic Capital Formation + Net Exports – Net Indirect Taxes = 900 + 100 + 250 + (-50) - 120 = 1250 - 170 = 1080 crores (b) NNP${FC}$ = NDP${FC}$ + Net Factor Income from Abroad = 1080 + (-20) = 1060 crores (c) Private Income = NNP$_{FC}$ + Current Transfers + Interest on National Debts = 1060 + 100 + 20 = 1180 crores

12. Find out private income from the following data : Items ` (crores) (i) Current Transfers from Government Administrative Departments 18 (ii) Savings of Non-departmental Government Enterprises 1 (iii) Net National Product at Factor Cost 473 (iv) Net Factor Income from Abroad (-)7 (v) Income from Property and Entrepreneurship accruing to the Government Administrative Departments 9

(vi) Net Current Transfers from the Rest of the World 4

(vii) National Debt Interest 28

Solution :

Private Income

= Net National Product at Factor Cost – Savings of Non-departmental

Enterprises – Income from Property and Entrepreneurship accruing to

Government Administrative Enterprises + Current Transfers from

Government Administrative Departments + Net Current Transfers from Rest

of the World + National Debt Interest

$= 473 - 1 - 9 + 18 + 4 + 28$

= ` 513 crores

13. Calculate GNP at Market Price by Income Method and Expenditure

Method from the following data : [B.S.E.B ., (Arts ) 2012] Items ` (crores)

(i) Rent 40

(ii) Private Final Consumption Expenditure 800

(iii) Net Exports 20

(iv) Interest 60

(v) Profit 120

(vi) Government Final Consumption Expenditure 200

(vii) Net Domestic Capital Formation 100

(viii) Compensation of Employees 800

(ix) Consumption of Fixed Capital 20

(x) Net Indirect Taxes 100

(xi) Net Factor Income from Abroad (–)20

Solution :

(a) Income Method

GNP = Rent + Interest + Profit + Compensation of Employees +

Consumption of Fixed Capital + Net Indirect Taxes + Net Factor Income from Abroad

$= 40 + 60 + 120 + 800 + 20 + 100 + (-20)$

= ` 1120 crores

(b) Expenditure Method

GNP = Private Final Consumption Expenditure + Net Exports +

Government Final Consumption Expenditure + Net Domestic Capital

Formation + Consumption of Fixed Capital + Net Factor Income from

= 800 + 20 + 200 + 100 + 20 (– 20) = ` 1120 crores

14. From the following data estimate :
(a) Personal Income, (b) Private Income, (c) Personal Disposable Income
Items ` (crores) (i) National Income 1300
(ii) Corporate Profit Tax 15
(iii) Direct Personal Taxes 40
(iv) Savings of Private Corporate Sector 25
(v) Income from Property and Entrepreneurship accruing to Government 35
(vi) Current Transfers from Government Administrative Deptt. 30
(vii) National Debt Interest 10
(viii) Savings of Non-departmental Public Enterprises 5
(ix) Current Transfers from Rest of the World 15
Solution :
(a) Personal Income
= National Income – Income from Property and Entrepreneurship accruing to Government Administrative Departments – Savings of Non-departmental Public Enterprises + National Debt Interest + Current Transfers from the Government Administrative Departments + Current Transfers from Rest of the World – Corporate Profit
Tax – Savings of Private Corporate Sector = 1300 – 35 – 5 + 10 + 30 + 15 – 25 – 15
(b) Private Income
= Personal Income + Corporate Profit Tax + Savings of Private Corporate Sector = 1275 + 15 + 25
= ` 1315 crores
(c) Personal Disposable Income
= Personal Income – Direct Personal Taxes
= 1275 – 40
= ` 1235 crores
15. Calculate ‘Net Domestic Product at Factor Cost’ and ‘Gross National Disposable Income’ from the following data :
(` (crores) (i) Net Current Transfers from Abroad (–)5
(ii) Private Final Consumption Expenditure 250

(iii) Net Factor Income from Abroad 15 (iv) Government Final Consumption Expenditure 50 (v) Consumption of Fixed Capital 25 (vi) Net Exports (−)10 (vii) Subsidies 10 (viii) Net Domestic Capital Formation 30 (ix) Indirect Tax 20 Solution : $\text{NDP}_{\text{FC}} = (\text{ii}) + (\text{iv}) + (\text{viii}) + (\text{vi}) - [(ix) - (vii)]$ $= 250 + 50 + 30 + (-10) - (20 - 10)$ $= \text{` }310 \text{ Crores.}$ Gross National Disposable Income = $\text{NDP}_{\text{FC}} + \text{NIT} + \text{NFIA} + \text{CFC} + \text{Net}$ Current transfers from abroad = $310 + (20 - 10) + 15 + 25 + (-5)$ $= \text{` }355 \text{ Crores.}$ 16. From the following data calculate National Income by (a) Income Method and (b) Expenditure Method Items ` (crores) (i) Private Final Consumption Expenditure 2000 (ii) Government Final Consumption Expenditure 1000 (iii) Compensation to Employees 1200 (iv) Net Exports (−)20 (v) Net Indirect Taxes 370 (vi) Net Domestic Capital Formation 800 (vii) Consumption of Fixed Capital 100 (viii) Net Factor Income from Abroad (−)10 (ix) Interest 310 (x) Rent 200 (xi) Mixed Income of Self-employed 900 (xii) Profits 800 Solution : (a) National Income (by Income Method) = Compensation to Employees + Net Factor Income from Abroad + Interest + Rent + Mixed Income of Self-employed + Profit = $1200 + (-) 10 + 310 + 200 + 900 + 800$ = ` 3400 crores (b) National Income (by Expenditure Method) = Private Final Consumption Expenditure + Government Final Consumption Expenditure + Net Domestic Capital Formation + Net Exports + Net Factor

Income from Abroad – Net Indirect Taxes = 2000 + 1000 + 800 + (–) 20 + (–) 10 – 370

17. Calculate Gross Domestic Product at Market Price by

(a) Product Method and (b) Income Method

(a) Primary Sector 500 (b) Secondary Sector 400 (c) Tertiary Sector 300

(ii) Value of Output :

(a) Primary Sector 1000

(b) Secondary Sector 900

(c) Tertiary Sector 7

(iii) Rent 10

(iv) Compensation to Employees 400

(v) Mixed Income 650

(vi) Operating Surplus 300

(vii) Net Factor Income from Abroad (–)20

(viii) Interest 5

(ix) Consumption of Fixed Capital 40

(x) Net Indirect Tax 10

(a) Gross Domestic Product at Market Price by Income Method

(b) National Income by Expenditure Method.

Items ` (crores) (i) Mixed Income of the Self-employed 280

(ii) Compensation to Employees 240

(iii) Net Factor Income from Rest of the World (–)5

(iv) Imports 60

(v) Exports 50

(vi) Government Final Consumption Expenditure 75

(vii) Indirect Taxes 90

(viii) Change in Stock 35

(ix) Private Final Consumption Expenditure 510

(x) Consumption of Fixed Capital 40

(xi) Gross Fixed Capital Formation 130

(xii) Subsidies 10

(xiii) Rent, Interest and Profit 100

(xiv) Interest on National Debt 10

Solution :

(a) Gross Domestic Product at Market Price (by Income Method)

= Compensation to Employees + Rent, Interest and Profit + Mixed Income + Consumption of Fixed Capital + Indirect Taxes – Subsidies = 240 + 100 + 280 + 40 + 90 – 10

(b) National Income (By Expenditure Method)

= Private Final Consumption Expenditure + Government Final Consumption Expenditure + Gross Fixed Capital Formation + Change in Stock + Exports – Imports + Net Factor Income from Abroad – Indirec Taxes + Subsidies – Consumption of Fixed Capital.

= 510 + 75 + 130 + 35 + 50 – 60 – 5 – 90 + 10 – 40

= ` 615 crores

19. Calculate from the following data Net National Product at Market Price by (a) Income Method, (b) Expenditure Method :

Items ` (crores) (i) Compensation to Employees paid by the Govt. 40

(ii) Mixed Income of the Self-employed 50

(iii) Wages and Salaries 400

(iv) Employer’s Contribution to Social Security Schemes 80

(v) Operating Surplus 300

(vi) Indirect Taxes 30

(vii) Subsidies 10

(viii) Net Capital Formation 150

(ix) Net Factor Income to Abroad 10

(x) Government Final Consumption Expenditure 230

(xi) Private Final Consumption Expenditure 500

(xii) Exports 15

(xiii) Imports 45

(xiv) Consumption of Fixed Capital 20

(xv) Profits 130

Solution :

(a) Net National Product at Market Price (Income Method)

= Wages and Salaries + Employer’s Contribution to Social Security Schemes

+ Operating Surplus + Mixed Income of Self Employed + Indirect Taxes –

Subsidies – Net Factor Income to Abroad

(b) NNP _MP (Expenditure Method)

Expenditure + (Exports

– Imports) + Net Capital Formation – Net Factor Income to Abroad = 500 +

230 + (15 – 45) + 150 – 10

20. Calculate :

(a) Net Domestic Product at Factor Cost by Expenditure Method

(b) Net National Product at Factor Cost by Value Added Method

Items ` (crores) (i) Domestic Capital Formation 250

(ii) Net Export (–)50

(iii) Private Final Consumption Expenditure 900

(iv) Value of Output of

(a) Primary Sector 900

(b) Secondary Sector 800

(c) Tertiary Sector 400

(v) Value of Intermediate Consumption :

(a) Primary Sector 400

(b) Secondary Sector 300

(c) Tertiary Sector 100

(vi) Consumption of Fixed Capital 80

(vii) Indirect Taxes 100

(viii) Government Final Consumption Expenditure 100

(ix) Subsidies 10
(x) Net Factor Income from Abroad (−)20
Solution :
(a) Net Domestic Product at Factor Cost (Expenditure Method)
= Private Final Consumption Expenditure + Government Final Consumption Expenditure + Domestic Capital Formation + Net Exports – Consumption of Fixed Capital – Indirect Taxes + Subsidies = 900 + 100 + 250 + (− 50) − 80 − 100 + 10
= 1260 − 230 = ` 1030 crores
(b) Net National Product at Factor Cost (Value Added Method)
= Value of Output of Primary Sector + Value of Output of Secondary Sector + Value of Output of Tertiary Sector – Intermediate Consumption of Primary Sector – Intermediate Consumption of Secondary Sector – Intermediate Consumption of Tertiary Sector – Consumption of Fixed Capital – Net Indirect Taxes + Net Factor Income from Abroad
= 900 + 800 + 400 − 400 − 300 − 100 − 80 − (100 + 10) + (− 20)
= 2100 − 880 − 90 − 20
= 2100 − 990
= ` 1110 crores
21. Calculate Gross National Disposable Income from the following data :
Items ` (crores) (i) National Income 2000
(ii) Net Current Transfers from Rest of the World 200
(iii) Consumption of Fixed Capital 100
(iv) Net Factor Income from Abroad (−)50
(v) Net Indirect Taxes 250
Solution :
Gross National Disposable Income
= National Income + Consumption of Fixed Capital +Net Current Transfers from Rest of the World + Net Indirect Taxes
= 2000 + 100 + 200 + 250
= ` 2550 crores
22. Calculate Private Income from the following data :
Items ` (crores) (i) Income from Domestic Product accruing to Private Sector 254
(ii) Net Current Transfers from Government Administrative Departments 10

(iii) Net Current Transfers from Rest of the World 4

(iv) Interest on National Debt 10

(v) Net Factor Income from Abroad (–)3

Solution :

Private Income

= Income from Domestic Product accruing to PrivateSector + Net Current Transfers from Government Administrative Departments

– Net Current Transfers to Rest of the World + Interest on National Debt + Net Factor Income from Abroad

= 254 + 10 – 4 + 10 + (– 3)

= ` 267 crores

Note : ‘Net current transfers to rest of the world’ are to be read carefully.

These are ‘to’ and not ‘from’ Rest of the World. Hence, these are deducted to find Private Income.

23. From the following data, calculate Personal Disposable Income : Items ` (crores) (i) Personal Income 70000

(ii) Direct Taxes 500

(iii) Miscellaneous Receipts of the Government (Fees, Fines, etc.) 800 Solution :

Personal Disposable Income

= Personal Income – Direct Taxes – MiscellaneousReceipts of the Government = 70000 – 500 – 800

A QUICK REVIEW OF THE CHAPTER

● Product Method or Value Added Method : Product Method or Value Added Method is that method, which measures the national income by estimating the contribution of each producing enterprise to production in the domestic territory of the country in the accounting year.

Following components are estimated for calculating national income by this value added method : (i) \mathbf { N D P _ { M P } } : (Net Domestic Product at Market Price)

\mathrm { N D P _ { M P } = } Value added by the Primary Sector + Value added by the Secondary Sector + Value added by the Tertiary Sector

(ii) \mathbf { N N P _ { F C } } (Net National Product at Factor Cost) or National Income \mathrm { N N P } _ { \mathrm { F C } } = \mathrm { N D P } _ { \mathrm { M P } } – Net Indirect Tax + Net Income from Abroad

● Precautions regarding Value Added Method :

(A) Items to be included :

(i) Value of goods retained for self-consumption.

(ii) Imputed rent of owner-occupied building.

(iii) Commission and brokerage earned on sale and purchase of second-hand goods. (iv) Production retained for self-consumption.

(B) Items not to be included :

(i) Value of intermediate goods.

(ii) Sale and purchase of second-hand goods.

(iii) Services for self-consumption.

● Value Added : Value added is the difference between value of output of an enterprise and the value of its intermediate consumption.

● Double Counting : It is the problem of estimating the value of goods and services more than once. It unnecessarily increases the size of national product.

● Income Method : Income Method is that method which measures national income in terms of payments made in the form of wages, rent, interest and profit to the primary factors of production i.e ., labour, land, capital and enterprise respectively for their productive services in an accounting year. According to this method, national income is estimated as the sum total of factor incomes of normal residents of a country during an accounting year. In short

(i) \mathbf { N D P _ { F C } } or Net Domestic Income = Wages of Employees + Operating Surplus + Mixed Income (ii) \mathbf { N N P _ { F C } } or National Income = \mathrm { N D P _ { F C } + } Net Factor Income from Abroad

● Expenditure Method : Expenditure method is the method which measures final expenditure on gross domestic product at market price during an accounting year. Final expenditure is equal to the gross domestic product at market price. This is also called ‘Income Disposal Method ’ or Consumption and Investment Method .

(i) \mathbf { G D P _ { \ M P } } = \mathrm { P r i v a t e \ F i n a l } Consumption Expenditure + Government Final Consumption Expenditure + Gross Fixed Capital Formation + Net Exports (ii) National Income ( \mathbf { N N P } _ { \mathbf { \mathrm { F C } } } ) = \mathbf { G N P } _ { \mathbf { \mathrm { M P } } } – Depreciation – Net Indirect Tax

+ Net Factor Income from Abroad

QUESTIONS

Ultra Short Answer Type Questions

1. Does the income caused by sale and purchase of shares and bonds included in national income ?

2. Write three components of primary sector.

3. Write down the components of profits.

Very Short Answer Type Questions

1. What are the three sectors of an economy ?

2. Distinguish between national income on current prices and constant prices. (B.S.E.B. , 2011) 3. What is transfer payment ? (B.S.E.B., 2012) 4. Give two examples of intermediate goods. (C.B.S.E., 2013) 5. Give two examples each for consumption goods and capital goods. (Raj. Board, 2013) 6. What is meant by Income Method of measurement of national income ? 7. What is meant by Production Method of measuring National Income ? (Raj. Board, 2017) 8. Define Primary Sector of the economy.(Raj. Board, 2017) 9. How could error of double counting be avoided ?

Short Answer Type Questions

1. Explain the value added method of National Income measurement. (Raj. Board , 2016)

2. How national income is calculated by expenditure method ? (B.S.E.B. , 2018)

3. Distinguish between Primary Sector and Secondary Sector. (B.S.E.B., 2011,13; J.A.C. , 2016)

4. Give the meanings of Primary, Secondary and Tertiary Sectors of an economy. (B.S.E.B., 2013)

5. What any four precautions should be taken in the estimation of National Income with the help of Income Method. (C.B.S.E., 2015; B.S.E.B. , 2018)

6. What precautions are taken while measuring National Income by Expenditure Method ? (C.B.S.E., 2015)

7. Describe the expenditure method of calculating GDP at market price. (C.B.S.E., 2015)

8. What is the importance of estimating National Income ?

9. What are the items excluded from GNP's calculation ? Give reasons.

(J.A.C ., 2011) 10. Explain how distribution of “gross domestic product” is a limitation in taking gross domestic product as an index of welfare. (C.B.S.E., 2011, 19) 11. Explain how “non-monetary exchanges” are a limitation in taking GDP as an index of welfare. (C.B.S.E., 2011) 12. What is the difference between final good and intermediate good ? (J.A.C., 2012, 19 ; C.B.S.E., 2015)

Long Answer Type Questions

1. Explain the method to estimate National Income by Product Method with an example. (Raj. Board, 2013)

2. How National Income is estimated by Value Added Method. (U.S.E.B., 2013, 19; B.S.E.B. , 2016, 18)

3. Explain the Income Method for calculating National Income. (J.A.C., U.S.E.B., 2012; B.S.E.B. , 2019)

4. Explain briefly four precautions required to be taken in estimating National Income by Income Method.

5. Define National Income. What is the role of national income in economic development ? (U.S.E.B ., 2019)

6. Explain income and expenditure methods of calculating national income. (J.A.C. , 2011, 13, 15; U.S.E.B ., 2017; B.S.E.B. , 2018)

7. How will you treat the following while estimating national income of India ? Give reasons for your answer : (i) Dividend received by a foreigner from investment in shares of an Indian company.

(ii) Profits earned by a branch of an Indian bank in Canada. (iii) Scholarship given by Indian students studying in India by a foreign company. (C.B.S.E. , 2010)

8. Explain the problem of double counting in estimating national income, with the help of an example. Also explain two alternative ways of avoiding the problem.

(C.B.S.E. , 2010, 19)

9. What do you mean by double counting ? How the problems can be solved ? (J.A.C., 2010; B.S.E.B. , 2018) 10. What do you mean by national income ? How is it measured ? Or (U.S.E.B. , 2011) What is National Income ? Discuss the methods of measuring national income. (B.S.E.B., 2017; J.A.C ., 2016, 18) (a) Production Method (c) Expenditure Method 11. Giving reasons classify the following into intermediate products and final product : (C.B.S.E. , 2011) (i) Furniture purchased by a school.

(ii) Chalks, dusters, etc, purchased by a school. 12. Giving reasons classify the following into intermediate products and final products : (C.B.S.E. , 2011) (i) Computers installed in an office.

(ii) Mobile sets purchased by a mobile dealer.

13. Giving reasons, explain the treatment assigned to the following while estimating national income : (C.B.S.E. , 2011) (i) Family members working free on the farm owned by the family.

(ii) Payment of interest on borrowings by general government.

14. Giving reasons, explain the treatment assigned to the following while estimating national income : (C.B.S.E. , 2011) (i) Social security contributions by employees. (ii) Pension paid after retirement.

15. Giving reasons, explain the treatment assigned to the following while estimating national income :

(C.B.S.E. , 2011) (i) Expenditure on maintenance of a building. (ii) Expenditure on adding a floor to the building. 16. Discuss the various methods of measuring national income. (B.S.E.B. , 2012) 17. Giving reason explain how should the following be treated in estimating national income : (C.B.S.E. , 2012) (i) Expenditure on fertilizers by a farmer.

(ii) Purchase of tractor by a farmer.

18. While calculating national income, what will you do with the following ? Give reasons : (C.B.S.E. , 2012) (i) Imputed rent of self residing houses

(ii) Interest earned on bonds

(iii) Economic help of flood victims.

19. Give the suggestions to increase the national income in India. What are the difficulties in calculation of national income in India ? (MP. Board , 2017)

Objective Type Questions

(A) Multiple Choice Questions :

1. Which method is adopted in measuring National Income ?

( B.S.E.B. , 2012, 15) (b) Income Method

(d) All the above

2. Which sector is included in an economy ? (J.A.C., 2016) (a) Primary (b) Secondary

(c) Tertiary (d) All the above

3. Which service is included in Tertiary Sector ? (B.S.E.B., 2016) (a) Mining (b) Construction (c) Communication (d) Animal Husbandry

4. Which one is included in Secondary Sector ?

(a) Insurance (c) Trade

( B.S.E.B. , 2011) (b) Manufacturing

(d) Banking

5. Which one is included in Primary Sector ? (B.S.E.B., 2016) (a) Land (b) Forest

(c) Mining (d) All these

6. To include the value of goods or services more than one time while calculating National Income is called : (a) Single Counting (b) Double Counting (c) Multiple Counting (d) None of the above

7. Which one is a component of profit ? (B.S.E.B. , 2011; B.S.E.B ., 2016) (a) Dividend (b) Undistributed Profit (c) Corporate Profit Tax (d) All the above

8. Which one is included in National Income ? ( B.S.E.B. , 2018) (a) Transfer Earnings

(b) Sale proceeds of Shares and Bonds

(c) Black Money

(d) None of the Above

9. Which one is included in the calculation of National Income ? (a) New Final Goods and Services

(b) Earned Income of Indian Companies in Abroad (c) Expenses made by Foreign Tourists in the country (d) All the above

10. Which of the following is not included in the calculation of Gross National Product ? (J.A.C. , 2017) (a) Purchase and Sale of Old commodities (b) Intermediate Commodities

(c) a and b both (d) None of the above [Ans. 1. (d), 2. (d), 3. (c), 4. (b), 5. (d), 6. (b), 7. (d), 8. (d), 9. (d), 10. (c).]

(B) Fill in the Blanks :

1. Tertiary sector is known as................sector.

2. Only................goods are included to avoid double counting in national income.

3. Factor income is different from................income.

4. Value added = ................ – Intermediate Consumption – Net Indirect Tax.

5. Dividend is a component of................

6. ............. goods are not included in calculating gross national product.

[Ans. 1. service, 2. final, 3. transfer, 4. Value of output, 5. profit, 6.

(C) State True/False

1. National income is measured by income method, expenditure method and product method.

2. Product method is also known as value added method.

3. Secondary sector is also known as service sector.

4. To include the value of goods or services more than one time while calculating National Income is known as double counting.

5. Intermediate commodities is included in calculation of Gross National Product.

[Ans. 1. True, 2. True, 3. False, 4. True, 5. False] (D) Match the following

Column :

‘A’

1. Measurement of National Income

2. Primary Sector

3. Secondary Sector

4. Tertiary Sector)

5. Factor Income)

‘B’

Agriculture and related Sector

Service Sector

Value Added Method Earned Income

Manufacturing Sector

(E) Answer in One Word :

1. What is included in tertiary sector ?

2. To which sector manufacturing belongs ?

3. What item is used for old age pension ?

4. On which prices nominal national income is shown ? [Ans. 1. Services, 2. Secondary Sector, 3. Transfer Payments, 4. Current Prices]

HOTS High Order Thinking Skills Questions 1. How does double counting make value added higher ?

(See : Section 18.2.3)

2. In what way factor income is different from transfer income ?

(See : Box 10)

3. Green GNP indicates sustainable economic growth Explain.

(See : Box 16)

VBQ Value Based Questions

1. Do the final product method and value added method in calculating product value give the same result ? Why ? (See : Box of second step in Section 18.2.1)

2. Which items should not be included in the value added method of measuring national income ? (See : Section 18.2.2)

3. What is Green GNP ?

(See : Box 16)

MDQ Case Study Based on Evaluation & Multi-disci plinary Questions

1. ‘Final expenditure’ differs from ‘intermediate expenditure’. Do you agree ? Give reasons. (See : Section 18.4.1)

2. What is GNP Deflator ?

(See : Section 18.6.4)

NUMERICAL QUESTIONS

1. From the following data, calculate :

(a) National Income and (b) Personal Disposable Income

Items ` (crores) (i) Profit 500

(ii) Rent 200

(iii) Private Income 2000

(iv) Mixed Income of Self-employed 800

(v) Compensation to Employees 1000

(vi) Consumption of Fixed Capital 100

(vii) Net Factor Income from Abroad (–)50

(viii) Net Retained Earnings of Private Enterprises 150

(ix) Interest 250

(x) Net Exports (–)40

(xi) Corporate Tax 200

(xii) Net Indirect Tax 160

(xiii) Direct Taxes paid by Households 120 [Ans. (a) National Income = ` 2700 crores, (b) Personal Disposable Income = ` 1530 crores]

2. In an economy S = – 50 + 0.5 Y is the saving function (where S = saving and Y = national income) and investment expenditure is 7,000. Calculate : [Ans. 1. (c), 2. (a), 3. (e), 4. (b), 5. (d)] (i) Equilibrium level of national income.

(ii) Consumption expenditure at equilibrium level of national income. [Ans. (i) 32,000, (ii) 3,000]

3. Calculate Private Income, Personal Income and Personal Disposable Income from the following data : Items ` (crores) (i) Net National Product at Factor Cost 52500 (ii) Corporate Profit Tax 1500 (iii) Undistributed Profit of Corporation 2500 (iv) Portion of National Income accruing to Government Sector 1700 (v) Interest on National Debt 700 (vi) Current Transfers Income 200 (vii) Personal Income Tax 300 [Ans. Private Income = ` 51700 crores, (ii) Personal Income = ` 47700 crores, (iii) Personal Disposable Income = ` 47400 crores.]

4. From the following data calculate Gross National Product at Market Price by (i) Income Method and (ii) Expenditure Method :

Items ` (crores) (i) Net Domestic Capital Formation 375 (ii) Compensation to Employees 600 (iii) Net Indirect Taxes 150 (iv) Profits 450 (v) Rent 200 (vi) Private Final Consumption Expenditure 1100 (vii) Consumption of Fixed Capital 115 (viii) Government Final Consumption Expenditure 700 (ix) Interest 250 (x) Mixed Income of Self-employed 500 (xi) Net Factor Income from Abroad (–)15 (xii) Net Exports (–)25 [Ans. (i) ` 2250 crores, (ii) ` 2250 crores]

5. From the following data calculate National Income by (i) Income Method and (ii) Expenditure Method : Items ` (crores) (i) Private Final Consumption

Expenditure 900 (ii) Net Domestic Capital Formation 200 (iii)

Compensation to Employees 500 (iv) Mixed Income of Self-employed 400

(v) Government Final Consumption Expenditure 400 (vi) Net Factor Income from Abroad (–)10 (vii) Profits 220 (viii) Rent 90 (ix) Net Exports (–)25 (x) Interest 100 (xi) Net Indirect Tax 165 (xii) Net Current Transfers from Rest of the World 50 [Ans. National Income by Income and Expenditure Method = ` 1300 crores]

6. Calculate National Income from the following data : (C.B.S.E., 2013)

Items ` (in crores) (i) Private final consumption expenditure 900 (ii) Profit

100 (iii) Government final consumption expenditure 400

(iv) Net Indirect Taxes 100

(v) Gross domestic capital formation 250

(vi) Change in stock 50

(vii) Net factor income from abroad (–) 40

(viii) Consumption of fixed capital 20

(ix) Net imports 30

[Ans. ` 1440 crores]

7. Calculate Personal Disposable Income on the basis of following data : Items ` (crores) (i) Different Receipts of Government Administrative Deptt. 5

(ii) Undistributed Profits of Private Corporate Sector 4

(iii) National Debt Interest 18

(iv) Personal Taxes 10

(v) Private Income 400

(vi) Corporate tax 6

[Ans. Personal Disposable Income = ` 375 crores] 8. From the following data calculate National Income by (i) Income Method and (ii) Expenditure Method : Items ` (crores) (i) Compensation to Employees 600

(ii) Government Final Consumption Expenditure 550

(iii) Net Factor Income from Abroad (–)10

(iv) Net Exports (–)15

(v) Profits 400

(vi) Net Indirect Tax 60

(vii) Mixed Income of Self-employed 350

(viii) Rent 200

(ix) Interest 310

(x) Private Final Consumption Expenditure 1000

(xi) Net Domestic Capital Formation 385

(xii) Consumption of Fixed Capital 85

[Ans. National Income by (Income and Expenditure Method) = ` 1850 crores]

9. Calculate (i) Gross Domestic Product at Factor Cost by Expenditure Method and (ii) National Income by Income Method :

Items ` (crores) (i) Private Final Consumption Expenditure 85

(ii) Net Domestic Capital Formation 25

(iii) Consumption of Fixed Capital 2

(iv) Closing Stock 10

(v) Opening Stock 5

(vi) Government Final Consumption Expenditure 10

(vii) Net Exports (–)5

(viii) Wages and Salaries 80

(ix) Contribution of Employers towards Social Security Schemes 10

(x) Operating Surplus 20

(xi) Net Factor Income received from Rest of the World (–)5

(xii) Net Indirect Taxes 10

[Ans. (i) Gross Domestic Product at Factor Cost (By Expenditure Method) = ` 107 crores

(ii) National Income (By Income Method) = ` 105 crores] 10. Calculate ‘‘Sales’’ from the following data :

Items ` (in lakhs) (i) Net value added at factor cost 560 (ii) Depreciation 60 (iii) Change in stock (–) 30 (iv) Intermediate cost 1000 (v) Exports 200 (vi) Indirect taxes 60 [Ans. ` 1710 Lakh] (C.B.S.E., 2013) 11. Given the following information about Indian economy for the year 2018-19. Find out Private Income : Items ` (crores) (i) National Income 2580 (ii) National Debt Interest 100 (iii) Current Transfers from Government Administrative Departments 100 (iv) Income from Property and Entrepreneurship accruing to Government Administrative

Departments 40 (v) Savings of Government Departmental Enterprises 20 (vi) Current Transfers from Rest of the World 30 [Ans. Private Income = 2750 crores]

12. Calculate Net National Disposable Income from the following data : Items ` (in crores) (i) Gross domestic product at market price 2000 (ii) Net current transfers to rest of the world (–) 200 (iii) Net Indirect Taxes 150 (iv) Net factor income to abroad 60 (v) National debt interest 70 (vi)

Consumption of fixed capital 200 (vii) Current transfers from Government 150 (C.B.S.E., 2013) [Ans. ` 2060 crores] 13. Calculate Gross National Disposable Income from the following data : Items ` (crores) (i) Net Current Transfers from Rest of the World 100 (ii) National Income (iii) Consumption of Fixed Capital (iv) Net Factor Income from Abroad (v) Net Indirect Taxes 1600 150 20 180 [Ans. Gross National Disposable Income = ` 2030 crores] 14. Calculate Net National Disposable Income from the following data : Items ` (crores) (i) Gross National Product at Market Cost 1000 (ii) Net Factor Income from Abroad (–)20 (iii) Net Indirect Tax 120 (iv) Consumption of Fixed Capital 100 (v) Net Current Transfer from Abroad 50 [Ans. Net National Disposable Income = ` 930 crores] 15. Given the following data, calculate Net Domestic Product at Factor Cost : Items ` (crores) (i) Net Factor Income from Abroad 30 (ii) Depreciation 170 (iii) Gross National Product at Market Price 4000 (iv) Net Indirect Taxes 900 [Ans. Net Domestic Product at Factor Cost = ` 2900 crores] 16. Find Gross National Product at Market Price and Private Income : (C.B.S.E., 2016) Items ` (in crores) (i) Private Final Consumption Expenditure 800 (ii) Net current transfers to Abroad 20 (iii) Net Factor Income to Abroad (–)10 (iv) Government Final Consumption Expenditure 300 (v) Net Indirect Tax 150 (vi) Net Domestic Capital Formation 200 (vii) Current Transfers from Government 40 (viii) Depreciation 100 (ix) Net Imports 30 (x) Income Accruing to Government 90 (xi) National Debt Interest 50 [Ans. GNP_MP = ` 1,380 crores, Private Income = ` 1,120 crores] 17. From the following data, calculate : (a) Personal Disposable Income and (b) National Income Items ` (crores) (i) Private Income 3000

(ii) Compensation to Employees 800

(iii) Mixed Income of Self-employed 900

(iv) Net Factor Income from Abroad (–)50

(v) Net Retained Earnings of Private Enterprises 600

(vi) Rent 350

(vii) Profit 600

(viii) Consumption of Fixed Capital 200

(ix) Direct Taxes paid by Households 300

(x) Corporate Tax 350

(xi) Net Indirect Taxes 250

(xii) Net Exports (–)70

(xiii) Interest 450

[Ans.

(a) Personal Disposable Income = ` 1750 crores, (b) National Income = ` 3050 crores.]

18. With the help of following data, calculate : (i) Personal Disposable Income, (ii) Personal Income and (iii) Private Income :

Items ` (crores) (i) Corporate Tax 1500

(ii) Direct Taxes paid by Households 6500

(iv) Savings of the Private Corporate Sector 3500

(v) Interest on National Debt 2000

(iii) Household Final Consumption Expenditure 24500

(vi) Household Savings 7500

[Ans. (i) Personal Disposable Income = ` 32000 crores, (ii) Personal Income = ` 38500 crores, (iii) Private Income = ` 43500 crores]

19. From the following data calculate National Income by (a) Income Method, and (b) Expenditure Method : Items ` (crores) (i) Compensation of Employees 800 (ii) Private Final Consumption Expenditure 1200 (iii) Profits 500 (iv) Rent 200 (v) Government Final Consumption Expenditure 800 (vi) Interest 150 (vii) Net Factor Income from Abroad 20 (viii) Net Indirect Taxes 190 (ix) Mixed Income of Self-employed 630 (x) Net Exports (–)30 (xi) Net Domestic Capital Formation 500 (xii) Consumption of Fixed Capital 150 [Ans. National Income by (a) Income Method = ` 2300 crores, (b) Expenditure Method = ` 2300 crores] 20. Calculate (i) Gross Domestic Product at Market Price, (ii) Gross National Product at Market Price from the following data by Expenditure Method :

Items ` (crores) (i) Personal Final Consumption Expenditure (ii) Government

Final Consumption Expenditure (iii) Gross Domestic Fixed Capital Formation (iv) Increase in Stock (v) Exports of Goods and Services (vi) Imports of Goods and Services (vii) Consumption of Fixed Capital (viii) Net Factor Income from Abroad (ix) Net Indirect Taxes 50 50 45 5 8 6 6 5 20 [Ans. (i) Gross Domestic Product at Market Price = 152 crore, (ii) Gross National Product at Market Price = ` 157 crore] 21. Calculate Net Value Added at factor cost from the following data : (i) Depreciation (ii) Intermediate Cost (iii) Subsidy (iv) Sales (v) Exports (vi) Change in Stock (vii) Import of Raw Materials [Ans. ` 25 lakh] (lakhs) 20 90 5 140 7 (–)10 3

22. Calculate Net National Disposable Income from the following data :

Items ` (crores) (i) Gross National Product at Market Cost 1500 (ii) Net Factor Income from Abroad (–)20 (iii) Consumption of Fixed Capital 100 (iv) Net factor income form rest world (–)30 (v) Indirect Taxes 120 [Ans. Net National Disposable Income = ` 1350 crores] 23. Find out Gross Domestic Product at Factor Cost from the following data : Items ` (crores) (i) Value of Intermediate Consumption 250 (ii) Indirect Taxes 40 (iii) Consumption of Fixed Capital 50 (iv) Value of Output 700 [Ans. Gross Domestic Product at Factor Cost = ` 410 crores]

24. Calculate ‘‘Gross National Disposable Income’’ from the following data

Items ` (in crores) (i) Net domestic product at factor cost 3000

(ii) Indirect taxes 300

(iii) Net current transfers from rest of the world 250

(iv) Current transfers from the government 100

(v) Net factor income to abroad 150

(vi) Consumption of fixed capital 200

(vii) Subsidies 100

[Ans. ` 3500 crores] (C.B.S.E., 2013) 25. Calculate ‘‘Gross National Product at Market Price’’ from the following data : (C.B.S.E., 2013) Items ` (in

crores) (i) Compensation of employees 2,000

(ii) Interest 500

(iii) Rent 700

(iv) Profits 800

(v) Employer’s contribution to social security schemes 200

(vi) Dividends 300

(vii) Consumption of fixed capital 100

(viii) Net indirect taxes 250

(ix) Net exports 70

(x) Net factor income to abroad 150

(xi) Mixed income of self-employed 1,500

[Ans. ` 5350 crores]

26. From the following data calculate Gross National Product

at Market Price by (i) Income Method and (ii) Expenditure Method :

Items ` (crores) (i) Compensation of Employees 400

(ii) Profits 250

(iii) Mixed Income of Self-employed 300

(iv) Rent 80

(v) Interest 70

(vi) Private Final Consumption Expenditure 700

(vii) Net Domestic Capital Formation 120

(viii) Consumption of Fixed Capital 100

(ix) Net Exports (–)10

(x) Government Final Consumption Expenditure 350

(xi) Net Indirect Taxes 60

(xii) Net Factor Income from Abroad (–)10

[Ans. (i) Income Method = ` 1250 crores, (ii) Expenditure Method = ` 1250 crores]

27. From following data, calculate ‘national income’ by (a) income method and (b) expenditure method :

Items ` (in crores) (i) Interest 150 (ii) Rent 250 (iii) Government Final Consumption Expenditure 600 (iv) Private Final Consumption Expenditure 1,200 (v) Profit (vi) Compensation of Employees (vii) Net Factor Income to Abroad (viii) Net Indirect Taxes (ix) Net Exports (x) Consumption of Fixed Capital (xi) Net Domestic Capital Formation [Ans. ` 2,010 crores] 640 1,000 30 60 (–) 40 50 340

28. From the following data estimate : (i) GNP at Market Price, (ii) Private Income and (iii) Personal Income : Items ` (crores) (i) Gross Domestic Product at Factor Cost 750 (ii) Income from Domestic Product accruing to the Private Sector 590 (iii) Net Other Current Transfers from General Government 110 (iv) Net Indirect Taxes 130 (v) Net Other Current Transfers from Abroad 80 (vi) Net Factor Income from Abroad (–)70 (vii) Savings of the Private Corporate Sector 60 (viii) Corporate Tax 20 [Ans. (i) Gross National Product at Market Price = ` 810 crores, (ii) Private Income = ` 710 crores, (iii) Personal Income = ` 630 crores] 29. From the following data calculate National Income by (i) Income Method and (ii) Expenditure Method : Items ` (crores) (i) Compensation of Employees 1200 (ii) Net Factor Income from Abroad (–)20 (iii) Net Indirect Tax 120 (iv) Profits 800 (v) Private Final Consumption Expenditure 2000 (vi) Net Domestic Capital Formation 770 (vii) Consumption of Fixed Capital 130 (viii) Rent 400 (ix) Interest 620 (x) Mixed Income of Self-employed 700

(xi) Net Exports (–)30

(xii) Government Final Consumption Expenditure 1100

[Ans. National Income by : (i) Income Method = ` 3700 crores (ii) Expenditure Method = ` 3700 crores] 30. Calculate National Income from the following data by Income and Expenditure Method :

Items ` (crores) (i) Compensation of Employees

(ii) Government Final Consumption Expenditure (iii) Net Indirect Taxes

(iv) Operating Surplus

(v) Net Exports

(vi) Gross Fixed Capital Formation

(vii) Private Final Consumption Expenditure (viii) Net Increase in Stock

(ix) Net Factor Income from Abroad

(x) Consumption of Fixed Capital

(xi) Mixed Income

[Ans. National Income = ` 140 crores] 52

15

14

20

25

(–)4

120

10

64

31. On the basis of following data calculate GNP at market price. (U.S.E.B, 2017) Items ` (in crores) (i) GDP at market price 50,720 (ii) Net factor Income from abroad 2400 [Ans. \mathrm { G N P _ { M P } = 5 0 7 2 0 + 2 4 0 0 = \Delta ^ { \circ } 5 3 1 2 0 . } \mathrm { ] }

32. From the following data, calculate the Gross Domestic Product at Market Price :

Items ` (crores) (i) Value of Output in Primary Sector 3000 (ii) Intermediate Consumption of Secondary Sector 900 (iii) Intermediate Consumption of Primary Sector 1000 (iv) Net Factor Income from Abroad (–) 30 (v) Net Indirect Taxes 300 (vi) Value of Output of Tertiary Sector 1400 (vii) Value of Output of Secondary Sector 1800 (viii) Intermediate Consumption of Tertiary Sector 600 [Ans. Gross Domestic Product at Market Price = ` 3700 crores]

33. Find out Gross National Product at Market Price and Net National Disposable Income from the following : (C.B.S.E., 2011) Items ` (Arab) (i) Opening stock 50 (ii) Private final consumption expenditure 1,000 (iii) Net current transfers to abroad 5 (iv) Closing stock 40 (v) Net factor income from abroad (–) 10 (vi) Government final consumption expenditure 300 (vii) Consumption of fixed capital 30 (viii) Net imports 20 (ix) Net domestic fixed capital formation 150 [Ans. \mathrm { G N P _ { M P } } = \mathrm { \Omega } ^ { \cdot } 1 \mathrm { { , } } 4 2 0 crore, Net National Disposable Income = ` 1,405 crore]

34. Calculate Net National Disposable Income from the following data : Items ` (crores) (i) Gross National Product at Factor Cost 800 (ii) Net Current Transfers from Rest of the World 50 (iii) Net Indirect Tax 70 (iv) Consumption of Fixed Capital 60 (v) Net Factor Income from Abroad (–)10 [Ans. Net National Disposable Income = ` 860 crores] 35. Given the following information, calculate : (1) Factor Income from Domestic Product accruing to the Private Sector, (2) Personal Disposable Income : Items ` (crores) (i) Interest on National Debt 10 (ii) Corporate Saving 30 (iii) Corporate Tax 15 (iv) Current Transfers from the Government Administrative Departments 20 (v) Net Domestic Product at Factor Cost 450 (vi) Savings of Non-departmental Enterprises 20 (vii) Current Transfers from Rest of the World 5 (viii) Payment of Direct Taxes by the Households 15

Measurement of National Income

(ix) Net Factor Income from Rest of the World (x) Property and Entrepreneurial Income of the Government Administrative Departments (–) 5

25 [Ans. (i) Factor Income from Domestic Product accruing to the Private Sector =`405 crores, (ii) Personal Disposable Income = ` 400 crores]

36. Calculate Gross National Income from the following data : Items (i) Net Factor Income from Abroad (ii) National Income

(iii) Net Indirect Taxes `(crores) (–)10 1000

(i) Net Value Added at Factor Cost (ii) Intermediate Consumption (iii) Excise Duty (iv) Subsidy

(v) Depreciation [Ans. ` 200 lakhs]

(iv) Net Current Transfers from Rest of the World 150 (v) Consumption of Fixed Capital 100 [Ans. Gross National Income = ` 1330 crores] 37. Calculate ‘value of output’ from the following data : ` (lakhs) 100 75 20 5 10

38. Find National Income on the basis of the following data : Items `(crores) (i) Rent and Royalty 15 (ii) Wages and Salary 700 (iii) Net Factor Income from Abroad (–)10 (iv) Contribution of Employer’s to Social Security 50 (v) Operating Surplus 60 [Ans. National Income ` 800 crores]

39. If Real GDP is ` 500 and Price Index (Base = 100) is 125. Calculate Nominal GDP. (MP Board, 2019) [Ans. ` 625]

40. Given the following data, find the missing value of ‘Government final Concunption Expenditwe’ and ‘Mixed Income of Self-Employed.’ (CBSE, 2019)

(i) National Income 71000

(ii) Gross Domestic Capital Formation 10,000 (iii) Government Final Consunption Expenditure ? (iv) Mixed Income of Self-employed ? (v) Net Facter Income from Abroad 1,000 (vi) Net Indirect Taxs 2,000 (vii) Profits 1,200 (viii) Wages & Salaries 15,000 (ix) Net Exports 5,000 (x) Prival Final consumption Expenditwe 40,000 (xi) Consumption of Fixed Capital 3,000 (xii) Operating Surplus 30,000 [Ans.

Mixed Income of self Employed =`25,000 crores; Go vernm ent Fi na l Co ns umption Ex penl itu e = `20,000 crores)

NCERT CORNER

Q. 1. Write down the three identities of calculating the GDP of a country by the three methods. Also briefly explain why each of these should give us the same value of GDP. Ans. See Section 18.5

Q. 2. The value of the nominal GNP of an economy was ` 2500 crores in a particular year. The value of GNP of that country during the same year, evaluated at the prices of same base year, was `3000 crores. Calculate the value of the GNP deflator of the year in percentage terms. Has the price level risen between the base year and the year under consideration ? Ans. The value of nominal GNP of an economy is calculated on the basis of current year's prices. The value of GNP evaluated at the prices of same base year is called real GNP. GNP deflator is the ratio of nominal GNP to real GNP multiplied by 100.

Thus,

GNP Deflator = Nominal GNP_{× 100}

Real GNP

= 25003000 × 100 = 2503 = 83.33%

Since the GNP deflator is less than 100%, price level has not risen; price level has declined between the base year and the year under consideration.

Q. 3. Write down some of the limitations of using GDP as an index of welfare of a country. Ans. See Section 18.7

STUDY MATERIAL INCLUDED IN

MONEY : MEANING, EVOLUTION AND FUNCTIONS

THE CHAPTER

19.1. Barter System : Meaning 19.2. Evolution of Money 19.3. Meaning and Definitions of Money 19.4 . Functions of Money 19.5. Classification of Money 19.6. Merits of a Good Money 19.7. Importance of Money 19.8. Evils of Money 19.9. Money Supply 19.10 Demand for Money A Quick Review of the Chapter Questions High Order Thinking Skills (HOTS) Questions Value Based Questions. (VBQ) Case Study Based on Evaluation & Multi-disciplinary Questions (MDQ) NCERT Corner.

19.1. Barter System : Meaning

Barter means direct exchange of goods and services. Under barter system, both sale and purchase of goods and services take place without the use of money. In other words, barter system of exchange is a system in which goods are exchanged for goods and no general acceptable medium of exchange is available. ● Definitions

1. According to Kent, "Barter is the direct exchange of goods for goods without the use of money as a medium of exchange."

2. According to Thomas, "Direct exchange of one commodity for another is termed as barter." 19.1.1. Barter System : Necessary Conditions ● Barter : Illustration : Illustration

A farmer in a village has excess of wheat to his requirement and a weaver has excess cloth with him. If farmer needs cloth and weaver needs wheat. This double coincidence of wants becomes the basis for barter exchange. If 50 kgs. of wheat is exchanged for 5 metre cloth, barter exchange (i.e., exchange of goods by the goods gives cloth to farmer and wheat to weaver and hence both of them fulfil their requirements.

1. Limited Requirements

2. Limited Exchange Area Necessary 3. Economically Backward Society Conditions 4. Lack of Money

3. Double Coincidence of Wants

4. Lack of Transportation Facilities

19.1.2. Barter System : Advantages

1. Simple System Advantages of 2. Promotes Mutual Co-operation Barter System 3. No Economic Disparities

C–C Economy Commodity–Commodity Economy (C–C Economy) is that economy where barter system is used and money does not perform the function of exchange.

Box 1

4. Relief from Evils of Economic Fluctuations—Inflation or Deflation 5. Easy Foreign Trade Possible

19.1.3. Barter System : Difficulties

1. Lack of Double Coincidence

2. Difficulty in Store of Value

Difficulties of 3. Lack of Common Acceptable Unit of Value Barter System 4. Difficulty of Divisibility in Commodities 5. Lack of Transfer of Value 6. Lack of Standard of Deferred Payments

1. Lack of Double Coincidence : The barter system requires a double coincidence of wants on the part of those who want to exchange goods or services. It is necessary for a person who wishes to trade his goods or service to find some other person who is not only willing to buy his goods or services, but also possesses that goods which the former wants. For example, suppose a person possesses rice and wants to exchange it for cloth. In the barter system, he has to find out a person who not only have excess cloth but also wants rice. But, such a double coincidence is a rare possibility. The person would most likely have to undertake some intermediate transactions rice for wheat, wheat for sugar, sugar for wood and finally wood for the desired cloth or he would have to accept something less useful than the cloth.

(But with the development of money this difficulty is removed because every person can sell his excess commodity and get money with which he can buy anything he wants.)

2. Difficulty in Store of Value : A major difficulty in barter system appears because store of purchasing power for future cannot be made due to perishable nature of most of the goods. Consequently, capital formation is not made and large scale production does not become possible. (Development of money has also removed this difficulty. Money can now be saved and can buy anything in future.)

3. Lack of Common Acceptable Unit of Value : Due to lack of common acceptable unit of value, it becomes difficult to determine the value of commodity to be exchanged. For example, how will it be determined that how much wheat will be exchanged for one metre of cloth and vice versa . (Money solves this problem also because the value of each commodity is expressed in money, i.e., cloth ` 50 per metre, wheat ` 1,000 per quintal etc.)

4. Difficulty of Divisibility in Commodities : Another difficulty of barter system relates to the fact that all commodities can not be divided or subdivided. If the commodity is divided, its utility is lost, e.g., living animal. For example, if a person has a goat and he wants both wheat and cloth which are available from different persons. If he cuts he got for getting both goods, he incurs losses.

(With money this problem is also solved because the person can sell his goat and can buy both wheat and cloth with the attained money.)

5. Lack of Transfer of Value : Barter system faces the problem of transfer of value. Suppose we have a house at Agra and want to get it shifted in Allahabad. Barter system does not allow this shifting but in present day with development of money, we can sell the house at Agra and buy a new one in Allahabad.

6. Lack of Standard of Deferred Payments : Many goods are sold but payment is made on some future date. Barter system does not allow such transactions because problem of price stability arises in barter system. Hence, exchange of goods was essential from both the parties at the time of transaction. (Money also solves this problem. Deferred payments are made in money because money has got some stable value.)

19.2. Evolution of Money

It is difficult to trace the origin of money. The history of the evolution of money is extremely interesting and meaningful. There have been times in the monetary history when worthless commodities like clay, cowry shells, stones and whale-teeth have circulated as money in the primitive societies. More recently, during World War II cigarettes and cigars were used as means of payment in Germany. Through history, wide range of commodities belonging to the animal and vegetable kingdoms and minerals were adopted as medium of exchange. Although some of these defied any proper classification, a common idea ran through all of them in their being used as money in society by commanding general acceptability as means of payment.

After barter, primitive money was first used as commodity money. Later on with the progress of society people aboundoned the use of commodity money and adopted metal money which was used due to its durability, portability, etc. Basically gold and silver were accepted for metal money. With the problems associated with gold standard, paper money came into existence. Written documents were being accepted because people were confident that these could be readily exchanged for money

82

Introductory Macro Economics

on demand. With the passage of years, people became document accustomed to these written documents because paper documents possessed certain natural advantages over actual metallic money which they represented. Again with the passage of time, bank note which was secondary or convertible money came into use. In present days, bank note is a full– fledged money and carries with it no obligation on the part of central bank to convert it into specie-gold or silver. Banks today gave birth to credit money.

Evolution of Money

Commodity Money Metal Money

(Gold &

Silver) Paper Money Credit Money (Cheques and

Drafts)

Consumption Goods (Rice, Salt, Corn, Fish, Cattle, etc.) Capital Goods (Knives, Nails, Metals) Ornamental Articles (Shells and Precious Metals)

19.3. Meaning and Definitions of Money

Representative Paper Money (Bank Note) Convertible

Paper Money (Bank Note) Inconvertible Paper Money (Bank Note)

Money is a commodity which has a common acceptability as a means of medium of exchange, measure of value and store of value. Definitions of Money

Descriptive or Functional Definitions Legal

Definitions Common Acceptability Definitions

Definitions of Hartley Withers , Coulborn , Thomas , etc.

Definition of Knapp

Definitions of Seligman, Cole , Keynes etc.

(A) Descriptive or Functional Definitions Definitions related to this category explain the functions of money. Definitions given byCoulborn, Hartley Withers, Thomas , etc., are included in this category. (i) According toCoulborn ,‘‘Money may be defined

as the means of valuation and payment.’’ (ii) According toHartley Withers ,‘‘Money is what

money does.’’

(iii) According toThomas ,‘‘It is a means to an end not for its own sake but as a means of obtaining other articles or of commanding the service of others.’’

(B) Legal Definitions

According to this category, money is that commodity which has legal sanction with it.

This category includes the definitions given by Knapp and Hawtrey.

According toKnapp , “Anything which is declared by state as money, becomes money.”

(C) Common Acceptability Definitions

Definitions of this category give emphasis on general acceptability of money. Definitions given by Seligman, Cole, Keynes, etc., belong to this category. (i) According toSeligman ,‘‘Money is one thing that

possesses general acceptability.’’

(ii) According to G.D.H. Cole , ‘‘Money is simply

purchasing power—something which buys thing,

it is anything which is habitually or widely used

as a means of payment and is generally acceptable

in the settlement of debts. ’’

(iii) According toKeynes ,‘‘Money is that by delivery

of which debt contracts and price contracts are

discharged and in the shape of which a store

of general purchasing power is held.’’

On the basis of above definitions we may conclude that money is that commodity which is generally accepted by the people as a medium of exchange, measure of value, store of value and transfer of value.

● Broad Definitions

These definitions include all forms of money. Any goods, which helps in performing the functions of money, is called money.

According to Hartley Withers , ‘‘Money is what money does.’’

According to these definitions, not only coins and currency notes but cheques, Hundies, exchange bill, etc., are also included in money.

● Narrow Definitions

These definitions signify the feature of general acceptability of money. According to Robertson, ‘‘A commodity which is used to denote anything which is widely accepted in payment of goods or in discharge of other business obligations.

This definition makes the scope of money narrow because this definition includes only coins issued by the government as money.

● Reasonable Definitions

The definitions of this category adopts the middle view between narrow and broad definition categories. According to Ely , ‘‘Money is anything that passes freely from hand to hand as medium of exchange and is generally received in final discharge of debts.’

According to Marshall , ‘‘All those things which are (at any time and place) generally acceptable without doubt or special enquiry, as a meaning of purchasing commodities and services and of defraying expenses are included in the definition of money.’’

These definitions include both coins and paper currency in the scope of money.

Box 2

19.4. Functions of Money

Functions of Money

(A) Primary Functions

Medium of Exchange Measure of Value (B) Secondary Functions Standard of Store of Value Transfer of Deferred Payments Value

(C) Contingent Functions

(1) Basis of Credit

(2) Basis of Distribution of Social Income

(3) Basis of Maximum Satisfaction and Production (4) Helpful in Making

Capital Liquid and Mobile (5) Guarantee of Solvency (6) Bearer of Option

Box 3 (A) Primary Functions of Money : Primary functions of money are also called prime functions. These functions are of prime importance and common to all countries during all the periods. Money has two prime functions :

(1) Medium of Exchange : Money acts as a medium of exchange. In modern days, exchange is the basis of entire economy and money makes this exchange possible. At present, money is the most liquid means of exchange. It has considerably extended the size of market is modern days. In old age, barter system was in practice in which goods were exchanged for goods but due to lack of double coincidence, exchange was difficult. But the use of money has removed this difficulty. In modern times, money performs all functions of exchange in the economy.

(2) Measure of Value : Money acts a unit of measure of value. In other words, it acts as a yardstick of standard measure of value to which all other things can be measured. In barter system, the general measurement of value was absent and consequently it was difficult to measure the value of exchange. In modern times, the value of every commodity can be measured in money. With the use of money, economic calculations for measuring value have become simplified.

(B) Secondary Functions : These functions are supplementary to primary functions. There are following three secondary functions as follows :

(1) Standard of Deferred Payments : Deferred payments mean those payments which are to be made in future. Money performs this function successfully because of following reasons : (i) Its value remains more or less stable as

compared to other commodities. (ii) It has the merit of general acceptability. (iii) It is more durable as compared to other

commodities.

It is because of this function of money that there has been significant

expansion of domestic and international trade.

(2) Store of Value : Human being has a tendency to save a part of his income for future to fulfil his future requirements. Store of value can take place only when person becomes confident to use his savings as per his requirements in future. Money has this merit because its utility is never lost. Moreover, it contains purchasing power in future also with which a person can buy goods and services.

(3) Transfer of Value : Money is a liquid means of exchange. Hence, purchasing power of money can easily be transferred from one person to another or one place to the other. Thus, in modern times, money has become the best means of transferring the value of money.

(C) Contingent Functions : Besides, primary and secondary functions, money also performs contingent functions which are as follows :

(1) Basis of Credit : In modern times credit has a vital role in the economy. At present credit is used as money on the basis of money, credit is issued, i.e., bank or financial institutions create credit on the basis of money. Thus, money is the basis of credit.

(2) Basis of Distribution of Social Income : In modern times production is done on collective basis in which various factors of production—land, labour, capital, organisation perform their assigned role. Every factor of production should properly be rewarded. With the use of money, reward of every factor can be determined and can be paid in money.

(3) Basis of Maximum Satisfaction and Production : Money helps consumers in maximising their satisfaction. A consumer maximises his satisfaction by equating the prices of each commodity (expressed in terms of money) with its marginal utility.

(4) Helpful in Making Capital Liquid and Mobile : In modern times, capital is kept in the form of money and consequently liquidity and mobility of capital increases. One can refuse to accept capital in the form of houses, land, etc., but not in the form of money. Thus, money makes capital liquid and mobile.

(5) Guarantee of Solvency : Money serves as a guarantee of solvency for an individual or institution. For retaining its solvency, every individual or institution prefers to keep some money ready as cash deposits. Money deposits serve as a guarantee against solvency.

(6) Bearer of Option : Money serves as a bearer of option which implies that accumulating wealth in the form of money, we can change our decisions regarding the goods and services as and when the situation demands.

19.4.1. Static and Dynamic Functions of Money

Paul Einzig has classified functions of money into two broad groups viz ., (A) Static Functions.

(B) Dynamic Functions.

(A) Static Functions : Static functions are those which help the operation of the economy but these do not create movement in the economy. In this respect, the functions of money like medium of exchange, measure of value, store of value and measure of deferred payment are the static functions of money because these functions do not create any movement in the economy. Performing these static functions, money helps in regulating the economic system.

Static functions in fact are the traditional functions of money. These functions are also known as technical or passive functions of money.

(B) Dynamic Functions : The dynamic functions are those by which money actively influences the economic system through its impact on price level, interest rates, volume of production, distribution of wealth and income, etc.

Important dynamic functions of money are listed below :

(i) Money influences the general price level. (Higher money supply increases the general price level and vice versa ).

19.5. Classification of Money

(ii) Money influences income, production and employment levels.

(Higher money supply reduces interest rate which induces investment and consequently income, production and employment increase and vice versa ).

(iii) Money serves as a basis for determination and operation of monetary policy and fiscal policy.

(iv) Money is the basis of specialisation and division of labour.

Classification of Money

(A) (B) (C) On the Basis of Nature

Classification on the Basis of General Acceptability or Legality Classification on the Basis of Physical Form

(A) Classification on the Basis of Nature : Prof. J.M. Keynes has divided money into segments on the basis of nature : (ii) Money of Account : Money of account is that

(i) Actual or Real Money. in which debts and prices and general purchasing _{(ii) Money of Account.} power are expressed. It is that form of money

(i) Actual or Real Money : Actual money is that^{in which the accounts are maintained and the} money which circulates in a country as a medium^{value is measured. Benham has called money} of exchange. It is that form of money in which^{of account as ‘unit of account’ and Seligman} the price contracts and debt contracts are considers it as ‘ideal money’ . In India, rupee is used as money of account. discharged. In India, all coins and paper currency notes are actual money.

Distinction between ‘Actual Money’ and ‘Money of Account’ Actual Money

1. It actually circulates in the economy. 2. Its features, size etc., can change. Money of Account 1. It has only theoretical importance. 2. Its status is not changed.

Box 4

(B) Classification on the Basis of General (ii) Optional Money : It is that money for the Acceptability or Legality : On the basis of legality, acceptance of which a person cannot be forced. money can be classified into two segments : It has no legal sanctions behind it. Credit

(i) Legal Tender Money, instruments like cheques, drafts, bills of exchange, (ii) Optional Money. etc., are optional money. (i) Legal Tender Money : It is also called ‘Legal (C) Classification on the Basis of Physical

Money’ . A person cannot refuse the payment in Form : On the basis of physical form of money, there legal tender money in fulfilment of a general are three kinds of money :

monetary obligation. In India, all coins and (i) Metallic Money, (ii) Paper Money, (iii) Credit currency notes are all legal tender money. Legal Money. tender money can further be classified as : (i) Metallic Money : Metallic money is made of (a) Unlimited Legal Tender Money : Standard metal, for example, coins of gold, silver or copper.

coins and currency notes of varrying denomiMetallic coins are of two types :

nations are unlimited legal tender money. (a) Standard Coin : It is the prime money (b) Limited Legal Tender Money : Subsidiary_{of a country. It}

measures the value of goodscoins of smaller denominations are legal and services in a country. A _{standard cointender money for only limited amounts. is that coin whose face value is equal to} its intrinsic value. It is an unlimited tender money and has generally free coinage. It is also known as ‘full bodied coin’. (b) Token Money : This money is generally

used as a supplementary money. It is a limited tender money. Its face value exceeds its intrinsic value.

Difference between Standard and Token Money Standard Money

1. It is the prime coin in a country. 2. It is an unlimited legal tender money.

2. Its face value is equal to its intrinsic value.

3. It has free coinage.

4. It is made of pure metal.

Token Money

1. It is a subsidiary form of standard money.

2. It is a limited tender money.

3. Its face value exceeds its intrinsic value.

4. It has limited coinage.

5. It is not of pure metal.

Box 5

(ii) Paper Money : It refers to the currency printed on paper. Such money is issued by the government or by the Central Bank of the country. Paper money is a legal tender money which circulates in every part of the nation.

(iii) Credit Money : Credit money is issued by commercial banks on the basis of their demand liabilities or deposits which are transferable by cheques.

19.6. Merits of a Good Money

A good money must possess the following merits : 1. Utility : The metal with which coin is made, must bear the feature of utility. The metal must easily be accepted. Gold and silver are such metals which possess utility.

2. Portability : The metal, with which coin is made, can easily be transferred from one place to another. Gold and silver coins bear this feature also.

3. Durable : Money is saved by people and hence, coin should be made of such metal which is durable from saving purpose.

4. Divisibility : Money metal should be divisible without any loss in its value. Gold and silver are such metals having the feature of divisibility.

5. Homogeneity : All units of money should be homogeneous.

6. Economy : Minting cost of coin should be minimum and the depreciation in the coin should be least.

7. Stability of Value : Money metal should be stable in value, i.e., price fluctuation in the metal of coin should be minimum.

8. Liquidity : Money metal should be liquid in nature. Metal should easily be converted into coins and coins can again be converted into metal easily.

9. Cognisibility : Metal should easily be identified. Fake coins can easily be traced out if metal of money is cognisible. Gold and silver are such metals having full cognisibility.

19.7. Importance of Money

Money plays an instrumental role in shaping economic life in the country. According to Marshall , ‘‘Money is a pivot around which the economic science clusters.’’

The significance of money can be explained as follows :

1. Importance of Money in the Field of Consumption : Money is of great importance in consumption :

(i) To Attain Maximum Satisfaction : A consumer can maximise his satisfaction by using money according to the Law of Equi-marginal Utility.

(ii) To Facilitate Deferred Payments : Consumer sometimes takes loan for his present consumption which is repaid on some future date. Money makes such payments possible.

(iii) To Make Savings : A person spends a part of his present income on present consumption and saves the remaining part for the future. Hence, money makes savings possible for future.

(iv) To Purchase Various Goods : With money, a consumer can buy any goods of his requirement, i.e., money enables a consumer to exercise his freedom of choice in consumption.

2. Importance of Money in the Field of Production : Money has facilitated production in following ways :

(i) Large Scale Production : With the use of money, large scale production has become possible in modern days. Production is the result of collective efforts of all factors of production which get reward in terms of money.

(ii) Division of Labour and Specialisation Possible : Money has facilitated division of labour and specialisation which has accelerated the pace of production in the economy.

(iii) Assembling of Factors of Production Possible : Money is the instrument which assembles all the factors of production at one place. Producer substitutes the factor having lesser productivity by the factors having higher productivity and it becomes possible with the use of money.

3. Importance of Money in the Field of Exchange : (i) Removal of Barter Difficulties : Money has removed the inconveniences of barter, as a medium of exchange, money to be acceptable by everyone. Money has also removed the difficulty in store of value which was present in barter.

(ii) Development of Banks and Credit Institutions : Money has opened the doors for developing banks and credit institutions. Use of cheques and exchange bill has made exchange easier.

(iii) Capital Formation Possible : People save money and transfer it to productive uses. It accelerates capital formation.

(iv) Makes Capital Mobile : Money makes capital mobile. With use of money capital can be transferred from one place to the other.

4. Importance of Money in the Field of Distribution : Money helps in the distribution of income among different factors of production ideally. Applying marginal productivity theory, money distributes national income into wages, rent, interest and profits properly.

5. Importance of Money in Public Finance : Public expenditure and income are calculated in terms of money. Imposed tax is also paid in money and public expenditure is also made in money. With the use of money, government succeeds in attaining the Principle of Maximum Social Advantage.

19.8. Evils of Money

Evils of Money

Economic Evils Moral Evils Social Evils 1. Economic Evils

(i) Promotes Credit System which makes availability of loans easier and extravagance is promoted.

(ii) Promotes over–capitalisation and over– production because traders easily get loans for extending their production. This leads to economic crisis.

(iii) Instability in the value of money takes place because of change in price level which adversely affects the business and other economic activities in the country.

(iv) Inequality in income distribution promotes capitalistic tendencies in the economy. It centralises wealth of the country in a few hands and the poor class becomes more poor in the society.

(v) Appearance of Class Struggle : Money power makes few people stronger in the society who exploit the poor people and consequently class struggle appears in the society.

2. Moral Evils : Money is the root of all evils from moral point of view. Money makes people to fall below the normal social ethics. People indulge in corruption, smuggling, black marketing, thefts and in other immoral activities.

3. Social Evils :

(i) Promotes Materialism : Money has promoted materialism in the society. Man has lost the peace of his mind.

(ii) Promotes Greediness : Money has created the atmosphere of greediness in the society. Even a person is murdered for money.

(iii) Generates Exploitation Tendency : Money has been the supporting factor for generating exploitation factor in the society. A person is exploited by another person for earning more money.

19.9. Money Supply

The money supply in a country means “ the total stock of money in circulation .” Money supply takes into account only that stock of money which is held by the public in a spendable form. Cash balances held by the Central Government, Central Bank or the Commercial Banks are not the part of money supply since they are not in circulation in the country. The money supply in a country comprises two items : (i) Currency (i.e. , coins and paper notes) and (ii) Deposits (i.e. , demand deposits withdrawable by cheques).

Important

1. Supply of Money does not include (i) stock of money held by the government and (ii) stock of money held by the banking system of a country. The government and the banking system of a country are suppliers of money. Hence, money held by them is not a part of stock of money held by the people.

2. Only Net Demand Deposits are included in Money Supply :

Distinction may be drawn between gross demand deposits and net demand deposits with the commercial banks. Gross demand deposits include interbanking claims : claims of one bank against the other. Net demand deposits do not include inter-banking claims. Inter-banking claims are not a part of demand deposits of the people. Hence, only net demand deposits are taken as a part of money supply.

Box 6

19.9.1. Money Supply Measures in India

On the basis of recommendations given by its second working group on money supply, RBI has adopted four measures of money supply :

1. \mathbf { M } _ { 1 } Measurement

M \mathbf { \Phi _ { 1 } } = \mathbf { C } + \mathbf { D D } + \mathbf { O D }

88

Introductory Macro Economics

C : It refers to currency and includes coins and paper notes held by the public.

DD : It refers todemand deposits of the people with the commercial banks. These are chequeable deposits which can be withdrawn or transferred on demand.

OD : These are other deposits which include :

(i) Demand deposits with RBI of public financial institutions like IDBI (Industrial Development Bank of India).

(ii) Demand deposits with RBI of foreign central banks and of the foreign governments.

(iii) Demand deposits of international financial institutions like IMF and World Bank.

OD does not include : (i) deposits of the government of the country with RBI, (ii) deposits of the country's banking system with RBI.

2.M ₂ Measurement

It is a broader concept of the supply of money compared to \mathbf { M } _ { 1 } . Besides all the components of \mathbf { M } _ { 1 } , it also includes savings of the people with the post offices. Thus,

M { \bf \Lambda } _ { 2 } = { \bf M } { \bf \Lambda } _ { 1 } + { \bf \Lambda } Savings of the People with Post Offices 3.M ^ 3 Measurement

{ { \bf { M } } _ { 3 } } is also a broader concept of money supply compared to \mathbf { M } _ { 1 } . Besides all the components of \mathbf { M } _ { 1 } , it includes, net time deposits (or fixed deposits /or term deposits) of the people with the commercial banks. Thus,

M { \bf \Phi _ { 3 } } = { \bf M \Phi _ { 1 } } { \bf \Phi ^ { + } } Net Time Deposits with the Commercial Banks 4 . \mathbf { M _ { \lambda 4 } } Measurement

\mathbf { M } _ { 4 } concept of money supply is still broader—it is broader than evenL 3 . Besides all the components of { { \bf { M } } _ { 3 } } , it also includes savings with the Post Offices (excluding NSC). Thus,

M { \bf \Phi _ { 4 } } = { \bf M \Phi _ { 3 } } + { \bf \Phi } Savings with the Post Offices (excluding NSC)

Box 7 High Powered Money

High powered money signifies the total liability of the monetary authority of the country.

It consists of currency (notes + coins) with the public and deposits held by government and commercial banks with RBI.

H = C + R

Where, H = High Powered Money

C = Currency with the Public (notes + coins)

R = Total Reserves of Banks

Box 8

19.10 Demand for Money

Prof. J.M. Keynes associated the demand for money with the term ‘Liquidity Preferenc e ' . In Keynesian terminology liquidity preference means the demand for money to hold cash by the public. According toKeynes, the demand for money ,i.e., liquidity preference arises because of three motives :

(i) Transaction Motive : Individuals hold cash in order to ‘‘bridge the interval between the receipt of income and day–to–day expenditure.’’ Income is received after a certain interval but expenditure goes on day–by– day. So every individual has to keep some money in liquid form to meet his day–to–day requirements.

(ii) Precautionary Motive : Every individual keeps a certain amount of money in liquid form to meet any unforeseen emergency that may arise like accidents, illness, etc.

(iii) Speculative Motive : This motive relates to the desire to hold the resources in liquid form in order to take advantage of market movements regarding the future changes in the rate of interest (or in bond prices).

Demand for money for transaction and precautionary motive is interest–inelastic but the demand for money for speculative motive is interest–elastic. Demand for money for speculative motive is a diminishing function of the rate of interest.

Liquidity Preference

Liquidity preference is the desire to keep money in cash rather than investing in other forms of wealth such as stock, bonds or property. It refers to the demand for money. Prof. J. M. Keynes has mentioned three motives of liquidity preference : (i) Transactive Motive (demand to hold cash for current transactions), (ii) Precautionary Motive (demand to hold cash for unforeseen contingencies) and (iii) Speculative Motive (demand to hold cash for buying bonds and securities so as to earn profit.)

Box 9

19.10.1. Liquidity Trap

It is a situation in which speculative demand for money

becomes perfectly elastic. It is a situation of absolute liquidity

preference. This term was coined by Prof. J. M. Keynes.

Liquidity trap appears at a very low rate of interest r _ { 0 } (in

Fig. 1) in which people prefer to hold cash rather than invest

in bonds. The fear of loss due to minimum rate of interest

may induce the public to refrain from further security

purchases; the alternative is simply to hold the additional_{Fig. 1cash as an idle asset.} \cdot F i g .

A QUICK REVIEW OF THE CHAPTER

● Meaning of Barter System : Barter system is a system in which goods are exchanged for goods and no general acceptable medium of exchange is available.

● Difficulties of Barter :

(i) Lack of Double Coincidence.

(ii) Difficulties in Store of Value.

(iii) Lack of Common Acceptable Unit of Value. (iv) Difficulty of Divisibility in Goods.

(v) Lack of Transfer of Value.

(vi) Lack of Standard of Deferred Payments.

● Definitions of Money :

Descriptive Definitions

Definitions of this category are based on functions of money. (Crowther, Coulborn, Hartley Withers, Thomas, etc.)

Legal Definitions Any goods which is declared by state as money becomes money. (Knapp)

Common Acceptability Definitions

Definitions of this category gives emphasis on general acceptability of money. (Seligman, Cole, Keynes and Kent)

● Suitable Definition of Money : Money is that commodity which is generally accepted by the people as a medium of exchange, measure of value, store of value and transfer of value.

● Functions of Money :

(A) Primary Functions :

(i) Medium of Exchange. (ii) Measurement of Value.

90 Introductory Macro Economics

(B) Secondary Functions :

(i) Standard of Deferred Payments.

(ii) Store of Value.

(iii) Transfer of Value.

(C) Contingent Functions :

(i) Basis of Credit.

(ii) Basis of Distribution of Social Income.

(iii) Basis of Maximum Satisfaction and Production.

(iv) Helpful in Capital Mobility.

(v) Indicator of Solvency.

(vi) Bearer of Option.

● Static and Dynamic Functions of Money :

(i) Static functions help in operation of the economy but do not create movement in the economy. Functions of money like medium of exchange, measure of value, store of value and measure of deferred payments are the static function of money.

(ii) Dynamic functions of money influence the economic system through its impact on price level, interest rates, volume of production, distribution of wealth, etc.

● Supply of Money : It is a stock concept. It refers to stock of money available with the public/people at a point of time.

● Stock of money with the money issuing authorities (the government and the banking system of the country) is not considered as a part of money supply.

● Measures of Money Supply : \mathbf { M } _ { 1 } , \mathbf { M } _ { 2 } , \mathbf { M } _ { 3 } and \mathbf { M } _ { 4 } are the four measures of money supply in India. \mathbf { M } _ { 1 } = \mathbf { C u r r e n c y } with Public + Demand Deposits +

Other Deposits with the Reserve Bank

{ \bf { M } } _ { 2 } = { \bf { M } } _ { 1 } + Post Office Savings Bank Account

\mathbf { M } _ { 3 } = \mathbf { M } _ { 1 } + Time Deposits with Banks

\mathbf { M } _ { 4 } = \mathbf { M } _ { 3 } + Total Deposits with Post Offices

\mathbf { M } _ { 4 } measure of money supply is most comprehensive but is least liquid.

\mathbf { M } _ { 1 } measure of money is most liquid but is least comprehensive.

● High Powered Money : It includes currency (notes + coins) with the public and cash reserves with the banks.

QUESTIONS Ultra Short Answer Type Questions

1. What term is used to express direct exchange of one commodity for another ?

2. Write one primary function of money.

3. “Money is what money does.” Who said this ?

4. By whom credit money is created ?

5. State any two functions of money.

(U.S.E.B., 2014, Raj. Board, 2017)

6. Give any two deficiencies of barter system.

(B.S.E.B., 2014, U.S.E.B., 2017)

7. Give two demerits of money. (U.S.E.B., 2016)

Very Short Answer Type Questions

1. Define Barter System of Economy.

2. What is Barter System of Exchange ?

3. What do you mean by ‘Double Coincidence of Wants’ ? (U.S.E.B., 2013)

4. What are the Primary Functions of Money ?

(U.S.E.B., 2012, 15)

5. Mention two Secondary Functions of Money.

6. Mention two Contingent Functions of Money.

7. What are Static Functions of Money ?

8. What are Dynamic Functions of Money ?

9. What is the meaning of money supply ?

(J.A.C. 2019; C.B.S.E., 2011, 18) 10. State the components of money supply. (C.B.S.E., 2013; C.B.S.E., 2010, 15) 11. Name the functions of money. (B.S.E.B. , 2010) 12. What is \mathbf { M } _ { 3 } measurement of money supply ?

(Raj. Board, 2013) 13. Write the main components of High Powered Money. (Raj. Board , 2016) 14. Suggest two measures to remove the difficulties of barter system. (Raj. Board , 2017) 15. Money is good servant, but a bad master. Explain (M.P. Board , 2017)

Short Answer Type Questions

1. State any four shortcomings of Barter System of Exchange. (B.S.E.B., 2011; J.A.C., 2013; Raj. Board, 2013)

Or

What are the drawbacks of Barter system ? (J.A.C. , 2016) 14. State the qualities of good money. 15. Explain the properties of money. 16. What is

Liquidity Trap ?

2. Explain exchange function of Money.

3. State the four functions of Money. Describe any one of these.

( J.A.C., 2012)

4. Explain the main evils of money. (U.S.E.B., 2011)

5. Explain the Primary Functions of Money. (B.S.E.B. , 2018)

6. What are the Secondary Functions of Money ? (J.A.C., 2011, 13)

7. Explain the Static and Dynamic Functions of Money. (B.S.E.B., 2015)

8. Mention the functions of Money.

(C.B.S.E., 2015; B.S.E.B. , 2012, JAC , 2017, 18)

9. State the main functions of money. Explain any two of them. (J.A.C.,

2015. 10. Explain any two functions of money.

(C.B.S.E., 2016; Raj. Board, 2013, B.S.E.B. , 2017) 11. ‘‘Money is a medium of exchange.’’ Explain it.

(C.B.S.E., 2013, 16) 12. Explain the importance of “store of value” of money. (C.B.S.E., 2012, 16) 13. Explain the function “standard of deferred payment of money.” 3. Which one is the difficulty of Barter System ?

(a) Lack of Double Coincidence

(b) Difficulty of Division of the Goods

(c) Lack of General Acceptable Measure of Value (d) All the above

4. Which is the correct order of money evolution ?

(B.S.E.B. , 2018, 19) (a) Commodity Money, Paper Money, Metal Money (b)

Commodity Money, Metal Money, Paper Money, Credit Money

(c) Credit Money, Metal Money, Paper Money

(d) None of the above

5. ‘‘Money is what money does.’’ Who said it ?

(a) Hartley Withers (c) Thomas

( B.S.E.B., 2010, 11, 15, 16) (b) Hawtrey

(d) Keynes

6. Which one is included in the primary function of money ?

( C.B.S.E., 2012, 16) (B.S.E.B . 2016, 19) (B.S.E.B., 2014) (B.S.E.B., 2014)

(a) Medium of Exchange (c) Both (a) & (b)

( J.A.C. , 2019) (b) Measure of Value

(d) Store of Value

17. Explain the four major components of supply of money. (Raj. Board , 2016)

18. State any two components of \mathbf { M } _ { 1 } measure of money supply. (C.B.S.E., 2019)

Long Answer Type Questions

1. What is Barter System ? Mention its difficulties.

(B.S.E.B. , 2013, 17)

2. What are the main functions of Money ?

(U.S.E.B., 2010; B.S.E.B ., 2013; U.S.E.B., 2019; J.A.C., 2013; B.S.E.B., 2011, 13, 15)

3. Explain the Static and Dynamic Functions of Money.

4. Explain the importance of Money.

5. Explain the problems faced in the barter system. How has money solved this problem?

(J.A.C. , 2012; C.B.S.E., 2013; B.S.E.B. , 2018)

6. “Money is a pivot around which the economy clusters”. Explain.

7. Explain the evils of money.

8. What are difficulties of barter system ? Explain how money has removed these difficulties ? (J.A.C., 2014, 17)

Objective Type Questions

(A) Multiple Choice Questions :

1. What are the necessary conditions of Barter System ? (a) Limited Needs

(b) Limited Exchange Area

(c) Economically Backward Society

(d) All the above

2. What are the advantages of Barter System ?

[B.S.E.B. (Comm. ), 2019] (a) Simple System

(b) More Mutual Co-operation

(c) No Economic Disparities (d) All the above 7. Which one is included in the secondary function of money ?

(a) To make Deferred Payments

(b) Store of Value

(c) Transfer of Value

(d) All the above

8. ‘‘Money is a pivot around which the whole economy clusters.’’ Who said it ? (a) Keynes (c) Marshall

( B.S.E.B., 2018) (b) Robertson

(d) Hawtrey

9. The function of money is : ( B.S.E.B., 2012, 16; J.A.C., 2018) (a) Medium of Exchange

(c) Store of Value

(b) Measure of Value (d) All the above

(c) Means of exchange

11. Money is matter which is :

(a) a measure of value

(b) Store of value (d) All the above

(B.S.E.B. , 2015)

(a) Medium of exchange (c) Store of value

(b) accepted as a means of exchange

(c) used to store wealth

(d) All the above

12. By supply of money we mean : (B.S.E.B., 2015) (a) Money deposited in bank

(b) Money available with the public

(c) Deposits with post office savings bank

(d) All of these

13. Which of the following is not a function of money ? (C.B.S.E., 2015) (b) Price stability

(d) Unit of account

14. RBI has presented four measures of money supply, namely \mathbf { M } _ { 1 } \mathbf { M } _ { 2 } , \mathbf { M } _ { 3 } and \mathbf { M } _ { 4 } . \mathbf { M } _ { 1 } includes : (B.S.E.B. , 2018) (a) C = currency held by public

(b) DD = net demand deposit of the bank

(c) OD = other deposits held with the RBI

(d) All of the above

92

Introductory Macro Economics

15. Through which method can we withdraw money from bank ? (J.A.C.,

2018. (a) Withdrawal form (b) Cheque

(c) ATM (d) All of these

16. Who classified static and dynamic functions of money ?

(a) Ragnar Frisch (c) Marshall

( B.S.E.B. , 2018) (b) Paul Einzig

(d) None of these

[Ans. 1. (d), 2. (d), 3. (d), 4. (b), 5. (a), 6. (c), 7. (d), 8. (c), 9. (d), 10. (d), 11.

(d) 12. (d), 13. (b), 14. (d), 15. (d), 16. (b).]

(B) Fill in the Blanks :

1. Double coincidence of wants was required in................system.

2. Measure of value is the................function of money.

3. Standard of deferred payment is a................function of money.

4. Static and dynamic functions of money were classified by................

5. Medium of exchange is a ................. function of money. (B.S.E.B., 2010)

[Ans. 1. Barter, 2. Primary, 3. Secondary, 4. Paul Einzig, 5. Primary]

(C) State True/False

1. According to Coulborn money is what money does.

2. Check, hundi, bill etc are the examples of credit money.

3. Medium of exchange and measure of value are included in the primary function of money.

4. Paul Einzing classified functions of money in three parts. 5. Static functions is also known as active function.

[Ans. 1. False, 2. True, 3. True, 4. False, 5. True]

(D) Match the following Column : ‘A’

1. First step of Money Development 2. Credit Money 3. Legal Definition of Money

‘B’ (a) Guarantee of Solvency

(b) Commodity Money (c) Medium of Exchange 4. Contingent Function of Money (d) Cheque 5. Static Function (e) Knapp

[Ans. 1. (b), 2. (d), 3. (e), 4. (a),

(E) Answer in One Word 1. Who said, “Money is what money does” ? 2. Mention any one primary function of money.

3. Mention any one secondary function of money. 4. What type of elasticity liquidity trap has ?

[Ans. 1.

Hartley Withers,

Medium of Exchange, 3. Transfer to Value, 4. Infinite] High Order Thinking Skills Questions 1. How did barter system suffer with ‘lack of double coincidence’ ?

(See : Section 19.1.3; Point 1) 2. “In modern times, dynamic functions of money activity influ ence the economic system.” How ? (See : Point B of Section 19.4.1) 3. “Money is a bad master.” Do you agree ? (See : Section 19.8)

1. Money is a liquid medium of exchange. How ?

[See : Point 3 of Section 19.4 (B)]

2. The dynamic functions of money affect the pace of economy. How ? (See : Point B of Section 19.4.1)

Case Study Based on Evaluation & Multi-disci plinary Questions

1. "Money is a dynamic factor for the economy." Explain. (See : Section 19.4.1 B)

2. Demand of money for speculative motive in interest is elastic. How? (See : Section 19.10)

3. What are not included in money supply ?

(See : Box 6)

NCERT CORNER

Q. 1. What is a barter system ? What are its drawbacks ? Ans. See : Section 19.1.

Q. 2. What are the main functions of money ? How does money overcome the shortcomings of a barter system ?

Ans. See : Section 19.2.

Q. 3. What is transaction demand for money ? How is it related to the value of transactions over a specified period of time ? Ans Soo oction 19.10

Ans. See : Section 19.10.

Q. 4. Suppose a bond promises `500 at the end of two years with no intermediate return. If the rate of interest is 5 percent per annum, what is the price of the bond ?

Ans. Let Price of Bond = A

Rate of Interest = 5%

A 5 5A + ~ \mathrm { A } + 1 0 0 \times ^ { 5 } Total Interest =_{100 100} = 20 + 21A

41A 400 41A ^Thus, 400 = 500 A = 500 400 41 A = `4,878 (approx.) Hence, Price of Bond = ` 4,878. Q. 5. Why is speculative demand for money inversely related to the rate of interest ? Ans. See : Section 19.10. Q. 6. What is ‘liquidity trap’ ? Ans. See : Section 19.10.1. Q. 7. What are the alternative definitions of money supply in India ? Ans. See : Section 19.9.1. Q. 8. What is a ‘legal tender’ ? What is ‘paper money’ ? Ans. See : Section 19.5. Q. 9. What is high powered money ? Ans. See : Box 7.

□

20

COMMERCIAL BANKING SYSTEM AND CREDIT CREATION

STUDY MATERIAL INCLUDED IN THE CHAPTER 20.1. Commercial Bank : Origin and Growth 20.2. Commercial Bank : Definitions 20.3. Functions of Commercial Banks 20.4.

High Order Thinking Skills (HOTS) Questions

& Multi-disciplinary Questions (MDQ) NCERT Corner.

Money (or Credit) Creation by Commercial Banks A Quick Review of the Chapter Questions Value Based Questions (VBQ) Case Study Based on Evaluation

20.1. Commercial Bank : Origin and Growth

The word ‘bank’ seems to have originated from Italy. The word ‘bank ’ is supposed to have been derived from German word ‘Banck’, meaning a mound or heap, from which Italians adopted ‘Banco’. A few believe that the word bank has been derived from bancus or banc or banque which means a bench at which the money changers or bankers used to change one kind of money into another and transact their banking business. The Bank of Venice, in venice (Italy) founded in 1157 was the first public banking institution. Modern banking was developed in Europe and later on it extended to other nations.

Modern banking is supposed to be initiated in 17th century when Bank of Amsterdom, Holland (1609), Bank of Hamburg, Germany (1619) and Bank of England, England (1694) were established. Later on, banking extension took place.

The present day commercial bank has three ancestors of particular note—‘The Merchant’, ‘The Moneylender’ and ‘The Goldsmith’.

20.2. Commercial Bank : Definitions

Commercial banks perform general banking functions. A commercial bank is an institution which deals with money and credit. It accepts deposits from the public, makes the funds available to those who need them and helps in remittance of money from one place to another.

(i) According to Banking Regulation Act , ‘‘Banking means the accepting for the purpose of lending and investment of deposits of money from the public, repayable on demand or otherwise, and withdrawable by cheque, draft, order or otherwise.’’

(ii) According to Horace White , ‘‘Bank is a manufacturer of credit and a machine for facilitating exchanges.’’

(iii) According to Crowther , ‘‘A banker is a dealer in debts—his own and other people’s. The banker’s business is then to take the debts of other people, to offer his own in exchange and thereby to create money.’’

(iv) According to Webster’s Dictionary , ‘‘An institution with trades in money, establishment for the deposit, custody and issue of money as also for making loans and discount and facilitating the transmission of remittance from one place to another.’’

In short, commercial banks deals in trading of money

and credit for earning profit.

● Features of Commercial Bank Commercial bank has following features : (1) Commercial bank makes money transactions. (2) Bank accepts deposits from the public for loaning purpose.

(3) Bank has profit earning motive. (4) Commercial bank deals with credit and have ability of credit creation. (5) Commercial bank is such financial institution which has totally commercial nature. (6) Commercial bank as commercial institution generates demand deposits which are used as medium of exchange.

20.3. Functions of Commercial Banks Functions of Commercial Banks

Main or Primary Functions

Secondary Social Functions Functions

Or

Role of Banks in Economic Development

I. Main or Primary Functions

Primary Functions of Commercial Bank

(A) Accepting Deposits (B) Granting Loans (C) Credit Creation

1. Current Deposits 1. Cash Credit

2. Saving Deposits 2. Overdraft

3. Fixed Deposits 3. Loans and Advances

4. Recurring Deposits 4. Discounting the Bills of Exchange

5. Investment in Government Securities

● (A) Accepting Deposits

The primary function of the commercial bank is to accept deposits from bank.

The various types of deposits accepted by the (3) commercial bank are as follows :

(1) Current Deposits : Deposits in current account are termed as current deposits. A depositor can deposit the amount any number of times he likes and can also withdraw the amount any number of times he wants. Generally, bank does not grant any interest on such accounts, rather bank may take some charges from the depositor.

Banks provide cheque facility to the depositors for the withdrawal of money. Such accounts promote capital formation.

Fixed Deposits : In fixed accounts, account is deposited for a certain fixed period (which may be 46 days or more). Depositor gets deposit receipt while depositing cash in such accounts. The receipt indicates the name of the depositor, amount of deposit, rate of interest and period of deposit. This receipt is non-transferable, i.e., the amount written on the receipt can be paid only to the depositor, not to anyone else. Such account are useful for traders who need (4) Recurring Deposits : Recurring deposits are money for daily transactions many times in a certain type of fixed deposit. Depositor deposits day. a certain amount every month in this account. (2) Saving Deposits : Such accounts generally The amount cannot be withdrawn before expiry belong to the people having small savings and of given period except under exceptional

who do not require withdrawal of money many circumstances. Such accounts generally give

times. Interest rate in such accounts is low. higher interest rate. Depositor gets deposited

Savings account is generally opened by households amount with interest after expiry of the

salaried class and people having average income. period.

Saving Deposits

1. Demand deposits can be withdrawn by their depositors at any time without notice.

2. These deposits have low rate of interest.

3. They are chequeable, i.e. , demand deposits are withdrawable through cheques.

4. These deposits constitute a part of money supply.

Fixed Deposits

1. These deposits can be withdrawn only after the expiry of certain fixed time period.

2. These deposits carry high rates of interest.

3. They are not chequeable.

4. They fall under the category of near money assets.

Box 1 ● (B) Granting Loans

The second important primary function of commercial banks is advancing of loans. After keeping certain cash reserves, the banks lend their deposits to needy borrowers. However these advances are given for productive purposes against an approved security, with the motive of earning interest. Various types of loans granted by banks are as follows :

(1) Cash Credit : In cash credit system, bank provides loans to the borrower against bonds or some other types of securities. Businessmen deposit securities with the bank and take the amount of loan as per requirement. The entire loan is not granted at one time, rather an account is opened in the name of borrower and bank allows them a certain limit for withdrawal. Interest is charged only on the amount actually withdrawn from the account.

(2) Overdraft : Customers having current account with the bank are granted the facility of withdrawing more money than the amounts lying in their accounts. Bank decides the limit of overdraft and the borrower pays the interest on only overdrawn amount. Banks consider customers credit while giving permission of overdraft.

Difference between Cash Credit and Overdraft

1. Overdraft is permitted to those customers who have current account with the bank while cash credit can be granted to anyone.

2. Cash credit is granted after acquiring full security while overdraft is generally given against personal security because current accountholders are old and reliable customers of banks.

3. Overdraft is given for very short period (generally 3 months) while cash credits are granted for a fixed period (generally a year).

4. Interest rates charged on overdrafts are higher than interest rate charged on cash credit .

(3) Loans and Advances : A particular amount is given by banks as loan and advances which is deposited in customer’s account. Customers can withdraw any amount at any time. Banks charge interest on the entire amount sanctioned.

(4) Discounting the Bills of Exchange : Banks discounts the bills of exchange, i.e., after making some marginal deductions, it pays the value of the bill to the holder. Discount rate is generally equal to interest rate. When bill of exchange matures, the bank gets its payments from the party.

(5) Investment in Government Securities : Banks also grant loan to the government. The buying of government securities by banks is termed as ‘loaning to the government’. Investment in government securities is more safe and hence, banks prefer such investments.

● (C) Credit Creation ¹

In present times, credit creation has become the prime function of commercial banks. Banks invite primary deposits from the public and grant loan many times than these primary deposits on the basis of credit multiplier. All loans are in the form of demand deposits. II. Secondary Functions

(A) Functions as an Agent

1. Collection and Payments of Various Items : Banks collect cheques, rent, interest, etc., on behalf of their customers and also make payment of taxes, insurance premium, etc., on their customer’s behalf.

2. Purchase and Sale of Securities : Bank buy, sell and keep in safe custody the securities on behalf of their customers.

3. Remittance of Money : Banks remit money at distant places through bank drafts, cheques, etc.

4. Trustee and Executor : Banks also act as trustees and executors of the property of their customers on their advice.

5. Purchase and Sale of Foreign Exchange : Banks also buy and sell foreign exchange, promoting international trade. This function is mainly discharged by Foreign Exchange Banks.

6. Letter of Reference : Banks also give information about economic position of their customers to domestic and foreign traders and likewise provide information about economic position of domestic and foreign traders to their customers.

1 Detailed process of credit creation has been explained in Section 20.4 of this Chapter.

Secondary Functions of Commercial Bank

(A) Function as (B) General Utility Functions (C) Social Functions an Agent

1. Collections and Payments 1. Locker Facilities of Various Items

2. Purchase and Sale of

Securities

3. Remittance of Money

4. Trustee and Executor

5. Purchase and Sale of Foreign Exchange 6. Letter of Reference

Informations and Statistics 5. Help in Transportation of Goods

Box 2

2. Traveller’s Cheque and Letters of Credit

3. ATM and Credit Card Facilities

4. Collecting Business

(B) General Utility Functions

(1)Locker Facilities : Banks provide locker facilities to their customers. People can keep their valuable or important documents in these lockers. Their annual rent is very nominal.

(2) Traveller’s Cheque and Letters of Credit : Banks issue traveller’s cheque and letters of credit to their customers so as to avoid their risk of carrying cash during journey.

(3) ATM and Credit Card Facilities : In modern times, banks are providing ATM (Automatic Teller Machine) services to their customers for withdrawing the cash round 24 hours. Moreover, banks are providing credit card facility to its customers by which customers can purchase goods throughout the world for a limited amount and no cash payment is required.

(4) Collecting Business Information and Statistics : Being familiar with the economic situation of the country, the banks give advice to their customers on financial matters on the basis of business information and statistical data collected by them.

(5) Help in Transportation of Goods : Big businessmen or industrialists after consigning goods to their retailers send railway receipt (consignment note) to the bank. The retailers get this receipt from the bank on payment of the value of the consignment to it and take their consignment from the railway. In this way, banks help in the transportation of goods from the production centres to the consumption centres.

(C) Social Functions Or

Contribution of Banks in Economic Development In modern times, banks also provide various services related to social welfare and economic development in the country. Banks also provide help in trade, industry, etc., which accelerates the pace of economic development. Such functions of banks are :

(1) Increase in Capital Productivity : Bank collects surplus money from the public and grants loans for productive services which increases the productivity of capital, production and national income in the economy.

(2) Investment Promotion : In modern times, big industries need huge amount of fixed and working capital which is met by banking system and this promotes investment in the country.

(3) Encouragement to Capital Formation : Commercial banks mobilise idle savings of the people and invest the same in productive activities. Thus, they help in promoting capital formation and accelerating the rate of economic development.

(4) Increase in Employment : Banking development not only provides employment in banking sector but due to increased investment in trade and industry through bank loaning also increases employment level in the economy.

(5) Facility in Payments : Extending use of cheques, bank makes the payments easier which has removed the fear of cash loss.

(6) Elasticity of Monetary System : Banks extend or contract credit as per requirement of the economy. It maintains elasticity in monetary system.

(7) Encouragement to Foreign Trade : Banks help in promoting foreign trade by arranging foreign currency for the traders and providing various assistance to foreign trade.

(8) Development of Entrepreneurs : In modern times, commercial banks are also providing assistance in development an entrepreneurship in the economy by providing loans to them.

20.4. Money (or Credit) Creation by Commercial Banks

In modern times, credit creation is one of the essential function of commercial banks. In modern times, banks not only make transactions but also create credit. According toSayers , ‘‘Banks are not merely surveyors of money but also manufacturers of money.’’

Credit Creation Process Primary Deposits or Cash Deposits Bank

Derived Demands or

Derived Deposits are result of Credit Deposits Primary Deposits—it is Credit Creation by Bank

Box 3

Primary Deposits or Cash Deposits

According toHalm , banks have two types of deposits : (A) Primary Deposits : Primary deposits are those

deposits which people deposit in cash in their accounts with the bank. In other words, cash deposits received by the bank from the public are called primary deposits.

For example, if a customer of a bank Mr. Dinesh deposits ` 10,000 in cash in his saving account or other account with State Bank of India, these ` 10,000 becomes the primary or cash deposits for State Bank of India.

(B) Derived Deposits : When the bank gives loan to a person, it deposits that sanctioned amount in his account and such amount is termed as ‘derived deposits ’. Derived deposits are the result of primary deposits because banks grant the loans ( i.e., credit) on the basis of its primary deposits. Thus, derived deposits are also called credit deposits.

According to Halm , ‘‘The creation of derived deposits is identical with what

is commonly called the creation of credit.’’

Higher the loans given by banks, greater will be the credit deposits. Thus, credit creates deposit and deposit creates credit.

Credit Creation : Explanation with Illustration

Credit creation process of banks can be understood with the following examples :

1. If a customer deposits` 10,000 in bank A. These ` 10,000 becomes the primary deposits for bank A.

2. Bank has the experience that the customer will not withdraw the entire amount at a time, so bank does not maintain `10,000 in cash in the customer's account. 3. If cash reserve ratio (i.e., ratio of cash reserves to deposits) is 20%, Bank A will keep cash of `2,000 (i.e., 20% of deposit of `10,000) and the balance`8,000 will be given to someone else as loan.
4. Now bank gives this `8,000 to Dinesh and deposits `8,000 in his account and hence, bank creates derived deposits of `8,000.
5. Now Dinesh makes payment to Suresh and gives this `8,000 to Suresh through cheque. 6. Suresh deposits this cheque in Bank B, which keeps `1,600 (20% of `8,000) in Suresh account

in cash and gives ` 6,400 to some other person Shyam, i.e., bank will deposit` 6,400 in Shyam’s account.

7. `6,400 is received by Mohan from Shyam through cheque who deposits it in Bank C. ` 6,400 will become primary deposit for bank C. Agrain Bank C gives loan of ` 1,280 (i.e., 20% of ` 6,400) and this process continues till basic primary deposit of ` 10,000 becomes 5 times.

Cash Reserve Ratio (CRR) Vs. Legal Reserve Ratio (LRR)

CRR refers to the percenta ge of to ta l dema n d deposits of the commercial banks which they must keep as cash reserves with the Central Bank of the country.

LRR is legally compulsory for the banks to keep a certain minimum fraction of the deposits as cash with them. This fraction is called Legal Reserve Ratio (LRR). LRR is fixed by the Central Bank which has two components :

(i) Cash Reserve Ratio (CRR) (ii) Statutory Liquidity Ratio (SLR) Box 4

This process can be understood with the following table :

Table 1 : Process of Credit Creation

New Deposits i.e. Cash Amount Loan Bank Primary Deposits kept by Bank (Derived Deposits) (`) (`) (`) A 10,000 2,000 8,000

B 8,000 1,600 6,400

50,000 10,000 40,000

Credit Multiplier

Credit multiplier is reciprocal of the ratio of cash reserves to deposits of banks. (i.e. CRR) Credit multiplier tells how much credit can be created by commercial bank.

Credit Multiplier =

Ratio of Cash Reserves to Deposits

For example,

If Ratio of Cash Reserves to Deposits is 20%

Credit Multiplier = 20% = 10020 = 5

i.e., primary deposits of` 10,000 will become 5 times to` 50,000 which include derived deposits of` 40,000. Box 5 Limitations of Credit Creation

Credit creation by commercial banks has following limitations :

1. Volume of Money in the Country : Currency is the basis of credit. Higher the currency money in the economy, greater will be the credit creation by banks and vice-versa .

2. Liquidity Preference of Money : If people want to keep their money in cash with them, bank deposits will decline and consequently credit creation is contracted.

3. Banking Habits : Higher the banking habits among the people, more will be the credit creation. Banking habits leads to more demand for bank loans and consequently more credit creation will take place.

4. Ratio of Cash Reserves to Deposits : Every bank has to maintain a certain ratio of cash reserves to deposits. If this ratio rises, credit creation is contracted and vice-versa.

5. Interest Rate : Credit creation is also influenced by rate of interest. At higher interest rate, less credit creation will take place and vice-versa.

6. Banks Deposits with the Central Bank : Every bank has to keep some deposits against their liabilities with the central bank. If central bank raises this ratio (which is called CRR), credit creation gets squeezed and viceversa.

7. Credit Related Policy of Central Bank : Credit Policy of Central Bank also affects credit creation. Central Bank can adopt various measures of credit control or expansion, as required.

A QUICK REVIEW OF THE CHAPTER

Commercial Bank : A commercial bank is an institution which deals with money and credit. It accepts deposits from the public for granting loans.

Functions of Commercial Banks :

I. Primary Functions :

(i) Accepting Deposits,

(ii) Granting Loans,

(iii) Credit Creation.

II. Secondary Functions :

(i) Functions as an Agent,

(ii) General Utility Functions,

(iii) Social Functions.

III. Social Functions or Contribution of Banks in Economic Development.

● Meaning of Credit Creation : Credit creation signifies that power of commercial banks with which

they create derived deposits on the basis of primary deposits.

● Primary Deposits : Primary deposits are those deposits which people deposit in cash in their accounts

with the bank.

● Derived Deposits : Derived deposits are the result of primary deposits because banks provide credit

on the basis of primary cash deposits. Derived deposits are also called credit deposits.

QUESTIONS Ultra Short Answer Type Questions

1. What type of relationship do CRR and credit multiplier have ? (B.S.E.B. , 2014)

2. What is the basis of derived deposits ? (B.S.E.B. , 2014)

3. What is Credit Card ?

4. What is meant by credit creation ?

5. What are time deposits ?

6. What are demand deposits ?

( B.S.E.B., 2014) (U.S.E.B., 2015) (C.B.S.E., 2015) (C.B.S.E., 2015)

7. What is meant by Cash Reserve Ratio ?( U.S.E.B ., 2016)

8. Mention the formula of Credit multiplier.

9. Write an example of credit money. (U.S.E.B ., 2019) Very Short Answer Type Questions

1. Define Commercial Bank. (B.S.E.B. , 2017)

2. Mention the characteristics of Commercial Bank. (U.S.E.B. , 2017,

B.S.E.B., 2017, 18)

3. Explain any two functions of Commercial Bank.

4. What do you mean by ‘overdrafting’ ?

5. What do you mean by Demand Deposits ? (C.B.S.E., 2012, 13)

6. What is Current Deposit Account ?

7. What is the difference between Primary Deposits and Derived Deposits ?

8. What is meant by Credit Creation ?

9. Who creates credit in the economy ? 10. What is time deposit ?

10. What are deposits ?

Short Answer Type Questions

( J.A.C., 2010) (C.B.S.E., 2012) (B.S.E.B., 2014)

1. What is a Commercial Bank ? Explain any function of Commercial Bank. (B.S.E.B., 2010)

2. Explain the functions of Commercial Banks.

(B.S.E.B. , 2011; J.A.C. , 2013, 16; Raj. Board., 2015)

3. Explain the various types of deposits in the bank. [B.S.E.B., 2011]

4. What is the relationship between Primary Deposits and Derived Deposits. (B.S.E.B. ,2014)

5. Explain the impact of increase in bank rate on the credit creation by commercial banks.

6. Explain the process of money creation by commercial banks (C.B.S.E. , 2010)

(a) Accepting Deposits (c) Credit Creation

7. Write primary and secondary functions of commercial banks. (U.S.E.B. , 2010)

8. Explain the meaning of commercial bank. (J.A.C. , 2011)

9. If the cash reserve ratio is 20% and new deposits ` 1000, explain the process of credit creation by commercial banks. (C.B.S.E. , 2017) (Hints : See Example of section 20.4)

Long Answer Type Questions

1. Define Commercial Bank and mention its main Functions. (J.A.C., 2010, 14, 19; B.S.E.B., 2013, 14)

2. Explain the role of Commercial Bank in the economic development of an economy.

Or

Discuss the developmental functions of commercial banks. (B.S.E.B. , 2015)

3. How does a Commercial Bank create credit ? Explain with an example. (C.B.S.E., 2011, 13; B.S.E.B., 2014)

4. Explain the various functions of Commercial Bank. (J.A.C., 2012;

B.S.E.B. , 2018)

5. What do you mean by commercial bank ? What are the limitations of its credit creation? (B.S.E.B., 2012, 14)

6. Explain briefly the primary functions of a commercial bank.

7. Define credit multiplier. What role does it play in determining the credit creation power of the banking system ? Use a numerical illustration to explain. (C.B.S.E ., 2019) Objective Type Questions

(A) Multiple Choice Questions :

1. Which one is the Bank of the Public ? (B.S.E.B ., 2016, 18) (a)

Commercial Bank (b) Central Bank (c) Both (a) & (b) (d) None of the above

2. Which is the primary function of Commercial Banks ? (B.S.E.B., 2015)

(b) Advancing Loans

(d) All the above

3. Deposits accepted by the Commercial Banks :

(a) Current Deposits (c) Time Deposits

( B.S.E.B., 2019) (b) Saving Deposits

(d) All the above

4. What type of loan is advanced by Commercial Banks ? (a) Cash Credit (b) Overdraft (c) Loan and Advance (d) All the above

5. Which function is the Secondary Function of Commercial Banks ?

(a) Agency Function (c) Social Function (b) General Utility Function (d) All

the above

6. Which is the Agency Function of Banks ? (a) Advancing Loans (c) Act as Trustee

7. Credit Multiplier is : ^{1 (a)} CRR (c) Cash × CRR (b) Accepting Deposits (d) Locker Facility

(B.S.E.B. , 2018) ¹ (b) Cash ×_CRR

(d) None of the above 8. Credit money is increased when CRR : (B.S.E.B., 2011, 17) (a) Falls (b) Rises (c) Both (a) & (b) Possible (d) None of the above

9. The full form of ATM is : (B.S.E.B., 2015, 19; J.A.C. , 2017) (a) Any Time Money (b) All Time Money (c) Automated Teller Machine (d) Both (a) & (b)

10. The main function of commercial bank is : ( B.S.E.B. , 2018) (a) Credit control (b) Loaning to other banks (c) Accept deposits from customers (d) All the above

11. What is Central Bank of India ? (J.A.C., 2018) (a) Commercial Bank (c) Private Bank

12. Commercial banks : (a) Issue currency notes (d) Central Bank (d) None of these

(B.S.E.B. , 2015)

(d) Accepts deposits from customers

(c) Provide loans to customers

(d) Only (b) & (c)

13. Through with which method can we withdraw money from bank ?

(a) Withdrawal form (c) ATM

14. The Commercial Banks : (a) Accept deposit

(c) Provide locker facility (J.A.C ., 2016)

(d) Cheque

(d) All of these

( J.A.C ., 2016) (b) Advance loans

(d) All of these

[Ans. 1. (a), 2. (d), 3. (d), 4. (d), 5. (d), 6. (c), 7. (a), 8. (a), 9. (c), 10. (c), 11.

(a), 12. (d.), 13. (d), 14. (d)]

(B) Fill in the Blanks :

1. In credit creation, banks create................deposits.

2. ..............multiplier tells how much credit can be created by commercial banks.

3. When CRR falls, credit creation.................

¹ 4. Credit multiplier =_..

5. To act as a trustee is the................function of banks. [Ans. 1. derived, 2. credit, 3. increases, 4. CRR, 5. agency.]

(C) State True/False :

1. Central bank is the bank of public.

2. Accepting deposit is the agency function of bank. 3. Central Bank of India is a Commercial bank. 4. When cash reserve ratio falls, credit money is increased. 5. The full form of ATM is any time money.

[Ans. 1. False,

2. False, 3. True, 4. True, 5. False]

(D) Match the following Column :

1. Bank of Venus

2. Starting of Modern Banking

‘B’

(a) Seventeenth Century (b) Automated Teller

3. Primary Function of Commercial

4. Secondary Function of Commercial Bank

5. ATM

(c) Machine

Remittance of Money

(d) Italy

(e) Credit Creation [Ans. 1. (d), 2. (a), 3. (e), 4. (c), 5. (b)]

(E) Answer in One Word :

1. What is called to cash deposit by public in bank ?

2. What is the formula of credit multiplier ?

3. Which one is the bank of public ?

4. Which bank makes credit creation ?

[Ans. 1. Primary Deposit, 2.

CRR , 3. Commercial bank, 4. Commercial bank]

High Order Thinking Skills Questions 1. Commercial bank is credit creator. How ?

(See : Section 20.4)

2. Derived deposits are generated from primary deposits. Why ?

(See : Point B of Section 20.4)

3. What is the role of cash reserve ratio in credit creation of banks ?

VBQ

(See : Table 1 & Box 5)

Value Based Questions

1. Banks are also money creator. How ?

(See : Section 20.4)

2. What are the factors affecting the credit creating efficiency of banks ?

MDQ

(See : Section 20.4)

Case Study Based on Evaluation & Multi-disci plinary Questions

1. CRR has inverse relationship with credit multiplier. Explain with an example.

(See : Box 5)

2. What is the relation between primary deposits and derived deposits ? (See : Section 20.4) NCERT CORNER

Q. 1. Explain the functions of a commercial bank. Ans. See : Section 20.3.

Q. 2. What is money multiplier ? How will you determine its value ? What ratios play an important role in the determination of the value of the money multiplier ?

Ans. Money multiplier may be defined as the ratio of the stock of money to the stock of high powered money in an economy. It is determined by following formula :

^M Money Multiplier =_H

Where M = Stock of Money.

H = Stock of High Powered Money. Since stock of money is always greater than high powered money, the value of money multiplier is greater than 1 (one).

Fo l lowi n g ra tio s pl ay a n im po rta nt role in the determination of the value of the money multiplier.

(i) Currency Deposit Ratio

CU

DD

Where CU = Currency held by the public.

DD = Net demand deposits held by commercial banks. (ii) Reserve Deposit Ratio : Reserve deposit ratio is a proportion (ratio) of total deposits which commercial banks keep as reserves.

Q. 3. Do you consider a commercial bank ‘creator of money’ in the economy ? Ans. See : Section 20.4.

STUDY MATERIAL INCLUDED IN

21

CENTRAL BANK : MEANING AND FUNCTIONS

THE CHAPTER

21.1. Meaning of Central Bank 21.2. Distinction between Central Bank and Commercial Bank 21.3. Functions of Central Bank 21.4. Credit Controls 21.5. Difficulties in Credit Control 21.6. Reserve Bank of India A Quick Review of the Chapter Questions High Order Thinking Skills (HOTS) Questions Value Based Questions (VBQ) Case Study Based on Evaluation & Multi-disciplinary Questions (MDQ) NCERT Corner.

21.1. Meaning of Central Bank According to De Kock , ‘‘A Central Bank is a bank

Central Bank of a country is the apex monetary institution which works as a pivot for the entire banking system in the economy. Central Bank as an apex monetary institution not only plays the leadership role in banking system but also puts a control on commercial banks. Central Bank frames and executes the monetary policy and is responsible for maintaining stability and economic growth in the economy.

● Definitions

According to Samuelson , ‘‘Central Bank has one

function. It operates to control economy, supply of

money and credit.’’

which constitutes the apex of the monetary and banking structure of its country.’’

According to R. P. Kent , ‘‘Central Bank is an institution, charged with the responsibility of imaging the expansion and contraction of volume of money in the interest of general public welfare.’’ In modern times, a proper definition of Central Bank can be given as follows :

‘‘Central Bank is an apex institution in a country's monetary and banking system which develops, regulates and controls the currency and credit in the country with the objective of economic development and economic stability.’’

21.2. Distinction between Central Bank and Commercial Bank Basis of Distinction Central Bank Commercial Bank 1. Place in Banking System

2. Motive

3. Number

4. Ownership

(Subordination)

It is the apex bank in the country which controls all other banks. Its main objective is to operate banking system in national interest. It does not work with profit earning profit. Leaving USA (where 12 Central Banks are working), every country has only one Central Bank. It is subordinate to the government.

5. Public Dealing

6. Banker

7. Note Issue

Apart from a few specific situation, it has no direct dealing with the public. It is a banker to the government. It has monopoly right of note issue. It is a part of banking system and works under the control of Central Bank. Its main objective is to earn maximum profit with banking operations.

A country has a number of commercial banks.

These banks are basically banks of shareholders. It may or may not be state owned.

It directly deals with general public.

It is a banker to the public. It cannot issue notes.

Central Bank : Meaning and Functions 103 8. Loan

9. Competition

10. Foreign Exchange

11. Advisory Body

It is the lender of last resort and provides facility to Commercial Banks for encashment of bills.

It has no competition with Commercial Banks.

It is the custodian of a country’s foreign exchange.

It acts as an agent, adviser to the government on monetary and fiscal matters.

It acts like a customer to Central Bank.

Different commercial banks compete with each other.

It can deal with foreign exchange on the permission of Central Bank. It has no advisory responsibility towards the state.

21.3. Functions of Central Bank

→ (A) Monopoly in Note Issue

(B) Banker, Agent and Financial Advisor to the Government

→ (C) Bank of Banks

→ (D) Lender of the Last Resort

→ (E) Custodian of Foreign Exchange Reserves

→ (F) Function of Clearing House

→ (G) Credit Control

^→ (H) Development related Functions → (I) Other Functions Collection of Statistics (A) Monopoly in Note Issue

Relations with International Financial Institutions Survey of Banks Arranging Seminars

In modern times, central bank alone has the exclusive right to issue notes in every country of the world. The notes issued by the central bank are unlimited legal tender throughout the country.

According to De Kock , ‘‘Almost everywhere the privilege of note issue is associated with the origin and development of central banking. ’’

Central Bank of the country enjoys monopoly right of note issue which has following merits : 1. It imparts uniformity in monetary system. 2. Control on paper currency becomes simple. 3. Central bank can change money supply, i.e.,

maintain the flexibility in money system. 6.

4. It raises public confidence in the monetary system in the economy. 5. Central bank can easily control the credit creation in the economy. It becomes successful in maintaing internal or external price stability.

(B) Banker, Agent and Financial Advisor to the Government Like general public government also needs various services and the central bank performs the same functions as banker to the government as a commercial bank provides to its customers. As a ‘Banker, Agent and Financial Advisor ’ to the government central bank performs the following functions :

104

(1) As a Banker to the Government : As a banker to the government, central bank peforms following functions : (i) Accounts : It maintains accounts of

government transactions and submits the details to the government from time to time.

(ii) Payments : It makes payments of all government expenses from government account.

(iii) Debt and Loans : It arranges loans from national-international level and deposit them in government account.

(iv) Payments of Debt and Interest : It arranges and makes payments of interest and the amount of matured debts on behalf of the government.

(v) Loan to Government : It provides shortterm loans to the government whenever it is required.

(2) As an Agent to the Government : It acts as an agent to the government. All dealings of economic transactions are performed by government on behalf of the central bank. Besides, central bank represents the government in various international institutions and conferences.

(3) As a Financial Advisor to the Government : Central bank advises to the government on various economic policies like deficit financing, devaluation, trade policy, foreign exchange, etc.

(C) Bank of Banks

It performs the functions of a banker to all other banks in the country. Central bank has almost the same relation with all other banks as a commercial bank has with its customers. Central bank keeps part of the cash balances of all commercial banks as deposit with a view to meeting liabilities of these banks in times of crises. Due to this act of the central bank, it is also called ‘custodian of cash reserves ’. These cash balances are kept by the commercial banks in two ways : (a) part of the cash balances with themselves and (b) another part with the central bank as deposit. The balances kept with the central bank are also treated as cash balances by the commercial banks.

(D) Lender of the Last Resort

As banker to the banks, the central bank acts as the lender of the last resort. In other words, in case the commercial banks fail to meet their financial requirements from other sources, they can, as a last resort, approach to the central bank for loans and advances. The central bank assists such banks through discounting of approved securities and bills of exchange.

Introductory Macro Economics In reality, due to this discounting function, central bank is also called as ‘banker of banks ’. Central bank converts ‘liquid securities ’ of commercial banks into cash and provides liquidity to commercial banks through its discounting facility.

(E) Custodian of Foreign Exchange Reserves Central bank also acts as custodian of foreign exchange reserves. It is helpful in eliminating difficulties of balance of payments and in maintaining stable exchange rate. For minimising fluctuations in foreign exchange rate, central bank buys or sells foreign exchange in the market.

(F) Function of Clearing House

Central bank also performs the function of a clearing house. By clearing house function of central bank we mean settling the claims of various banks against each other with least use of cash. Since all the banks have their reserves and accounts with the central bank, therefore, it is an easy and logical step for it to act as a settlement or clearing house for the other banks. The clearing house function of central bank has following advantages : (i) It economises the use of cash by banks while

settling their claims and counter–claims. (ii) It increases the commercial relations with bank. (iii) It keeps central bank fully informed about

liquidity position of each bank.

(G) Credit Control

The most important function of the central bank is to control the credit activities of the commercial banks. Credit control refers to the increase or decrease in the volume of credit money in accordance with the monetary requirement of the country. More expansion of credit money than necessary leads to the situation of inflation. Greater contraction of credit money, on the other hand, might create a situation of deflation. Central bank seeks to contain credit money within reasonable limits. With central bank keeping credit under proper control, stability in general price level and increase in output and employment can be achieved in the country. For credit control,

central banks applies various measures which can be classified as ‘quantitative controls ’ and ‘qualitative controls ’.¹

(H) Development Related Functions

For promoting economic development, central bank performs following functions :

(i) It extends organised banking system and establishes

new financial institutions.

(ii) It ensures sufficient money supply for development activities.

(iii) Adopts cheap money policy for inducing investment. (iv) With management of agriculture credit, it ensures the fulfilment of loan requirements of the farmers.

1 Quantitative and qualitative credit controls have been explained in Section 21.4.1. of this chapter.

Central Bank : Meaning and Functions

(v) It manages sufficient amount of industrial finance for accelerated industrial development.

(I) Other Functions

(1) Collection of Statistics : Being a supreme financial authority, central bank arranged a variety of statistics concerning finance, banking, currency, prices and foreign exchange. These statistics help in formulating policies at macro level. In modern times, the major function of the central

(2) Relations with International Financial bank is ‘‘to control credit with proper monetary Institutions : Central bank of the country management in the economy ’’. Central bank applies maintains relation with various international credit control for fulfilling various objectives. Credit financial institutions like IMF, IBRD,etc ., Central control refers to the regulation of credit by the central bank sends its representative in annual conferences bank for achieving some definite objectives : of these institutions. (i) Maintaining price stability.

(3) Survey of Banks : Central bank makes survey (ii) Maintaining foreign exchange stability. operation and control of commercial banks. (iii) Making economic planning successful. Central bank issues licenses to banks and grants (iv) Promoting production and employment.

21.4.1. Methods of Credit Controls

permission of their extension, mergers and liquidation.

(4) Arranging Seminars : Central Bank arranges seminars from time to time for transferring its policies and guidelines to banks and also invites suggestions from banks for future policy making.

21.4. Credit Controls

Methods of Credit Control

(I) (II) Quantitative Methods Qualitative or Selective Methods

(A) Bank Rate Policy (A) Rationing of Credit

(B) Open Market Operations (B) Regulation of

Consumer’s Credit

(C) Change in Cash Reserve Ratio (C) Change in Margin Requirements

(D) Change in Statutory Liquidity Ratio (D) Direct Action
(F) Moral Suasion Publicity

(E)

(I) Quantitative Methods

Q u a n t i t a t i v e methods refer to those methods of credit control which are used by the central bank to influence the total volume of credit without regard for the purpose fo r which the credit

Difference between Bank Rate and Interest Rate Bank rate is different frommarket interest rate .Interest rate is the rate on which commercial banks and other financial institutions becomes ready to provide loans to their customers. Bank rate is the rate of discount of central bank at which central bank is prepared to discount the first class bills of exchange and grant

loans to commercial banks. Box 1

is put. Thus, with its quantitative methods of central bank directly affects the cash reserves of commercial banks.

Quantitative credit control methods are : (A) Bank Rate Policy : Bank rate policy is the

indirect important method for controlling credit money. The bank rate is the rate at which the central bank is prepared to discount the first class bills of exchanges and grant loans to commercial banks. This rate is also called ‘discount rate ’.

Change in bank rate brings change in rate of interest. (i) With the rise in bank rate, commercial banks get loan at higher rate and consequently commercial banks make their interest rate high. At dearer interest rate, demand for loans declines, and

106

Introductory Macro Economics

‘ contraction of credit ’ takes place. It is called‘dear money policy ’. Government raises bank rate to control inflation in the economy.

(ii) Contrary to it, with fall in bank rate, commercial banks get loan at cheaper rate and consequently grant loans of lower interest rate which increases the loan demand and ‘expansion of credit ’ takes place. It iscalled cheap money policy .Government decreases bank rate to promote investment in the economy.

Role of Increase in Bank Rate

by Central Bank Bank Rate Rise in in

Interest Rate by Commercial Banks

Fall in Interest Rate by Commercial Banks

Contraction Low Credit of Credit Creation by
Credit Creation Loan Availability from Commercial
i.e., Increase in Bank Rate indicates ‘Dear

Money Policy’

Loan Availability from Commercial Banks become cheaper

More Credit creation by Higher Loan Demand by public

Box 2 What Type of Bank Rate should be adopted in ‘Inflation’ and ‘Deflation’ ?

(i) If the economy faces the state of ‘inflation’, central bank raises bank rate and consequently commercial banks will make loans dearer by increasing the interest rate. At higher interest rate people will take lesser loans and contraction of credit will take place and it will put a control on inflation.

(ii) Contrary to it, if the economy faces the situation of deflation, central bank reduces bank rate which also makes commercial bank’s interest rate lower. People will demand for more loans and expansion of credit takes place Consequently it increases investment and minimises the pressure of deflation in the economy.

Box 3

Conditions for the Success of Bank Rate Policy For making bank rate policy successful, the following conditions should be followed : 1. Economy of the nation should be flexible. 2. Interest rates prevailing in money market should

change according to the change in bank rate.

3. Commercial banks should be dependent on central bank. 4. Investment attitude of entrepreneur and business class should change according to changed bank rate.

Repo Rate and Reverse Repo Rate

Repo Rate is that rate at which Central Bank of the country provides shortterm loan to scheduled commercial banks. Central bank raises repo rate to curtail the inflationary pressure with economy.

Reverse Repo Rate is that rate which is paid by Central Bank to Commercial banks when they park their surplus funds with the Central Bank. Currently reverse repo rate is tagged with repo rate.

Reverse repo rate remains 0.25% lower to repo rate. Reverse repo automatically increases with every increase in repo rate and vice versa.

Box 4 (B) Open Market Operations : Open market operations means —“purchase or sale of government and other approved securities by the central bank in money and capital market.” In other words, central bank buys and sells securities in open market which directly affects the quantity of money in open market. When central banks sells the securities, money size contracts in the market and on the contrary when central bank buys the

securities, money size expands. Thus, open market operations affect the cash reserves of commercial banks. Consequently credit creation by commercial bank increases or decreases and money supply expands or contracts respectively.

● Sale of Securities in Open Market —For Contraction of Credit When money market has excess money supply (i.e., case of inflation), central bank starts selling of securities in open market. People start purchasing of these securities from their savings and as a result, cash with people decreases. Cash deposits in the bank also decreases which contracts the credit creation by banks and consequently inflationary pressure gets reduced.

● Purchase of Securities in Open Market —For Expansion of Credit When money supply decreases (i.e., deflationary situation), central bank starts buying securities and transfers cash money to the buyers of these securities. People get cash in their hands and deposit a part of it in banks. With this additional deposits, bank expands credit creation which puts a check on deflationary tendencies in the economy.

What action should be taken under open market operations for checking ‘Inflation’ and ‘Deflation’ ?

● Central Bank has to adopt credit contraction measures for checking inflation and for it central bank sells securities in open market. Cash reserves decreases with the public and banks and consequently credit creation and money supply contracts which puts a check on inflation.

● In situation of deflation, central bank has to adopt credit expansion measures and for it central bank purchases securities in open market. Cash reserves increases with the public and banks and consequently credit creation and money supply expands which puts a check on deflation.

Box 5

● Basic Conditions for Success of Open Market Operations The success of open market operations for credit control depends on following conditions : 1. Demand and supply of securities should remain

present in the market.

2. Money market should be developed.

3. Cash reserves of banks should be affected by open market operations of the central bank.

4. Loaning policy of the commercial banks should not change.

5. Central bank should have unlimited power of buying and selling of securities.

6. Price of government securities should not fluctuate. (C) Change in Cash Reserve Ratio

Every commercial bank has to maintain a certain ratio of its deposits with the central bank. Central bank can affect cash reserves of commercial bank by making a change in cash reserve ratio. For credit contraction, central bank raises cash reserve ratio. Consequently, cash reserves with the banks decreases and credit creation will be reduced. Contrary to it, for credit expansion, cash reserve ratio is reduced. Consequently, cash reserve of bank increases and more credit creation takes place.

For example, if the cash reserve

Difference Between CRR and SLR

Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR) are different. Amount of CRR is kept with central bank by commercial banks while the amount of SLR has to be kept by commercial bank with themselves.

Box 6

ratio is 5 percent and total deposits of a certain bank is ` 200 crores, it will have to keep ` 10 crores with the central bank. If the cash reserve ratio is raised to 10 percent, the bank will have to keep ` 20 crores with the central bank. Thus, when the cash flow or credit is to be increased, cash reserve ratio is reduced and when the cash flow or credit is to be reduced, cash reserve ratio is increased.

(D) Change in Statutory Liquidity Ratio Every bank is required to maintain a fixed percentage of its assets in the form of cash or other liquid assets, called SLR. With a view to reducing the flow of credit in the market, the central bank increases this liquidity ratio and for expansion of credit, the liquidity ratio is reduced.

However the success of both Cash Reserve Ratio (CRR) and Statutory Liquidity Ratio (SLR), depends on the maintenance rigidity of these ratios by the commercial banks.

II. Qualitative or Selective Method

Qualitative or selective methods are those methods which are used by the central bank to regulate the flow of credit into particular directions of the economy. It does not affect the credit size but aims to control only the direction of credit use.

The important qualitative methods of credit control are :

(A) Rationing of Credit : Central bank is the lender of last resort. So it can adopt the measure of credit rationing for credit control. Central bank can adopt rationing of credit in four ways :

(i) Central bank may reduce the size of the loans to be given to commercial banks.

(ii) Central bank may fix a quota of credit to be given to commercial banks. (iii) Central banks may refuse to give credit to a particular bank.

(iv) Central bank can fix the credit limits for different business activities. Thus, by adopting rationing of credit, central bank controls the credit.

Consequently, credit size decreases. (B) Regulation of Consumer’s Credit : In this method the credit given to durable consumer goods is controlled.

Durable consumer goods are purchased under ‘Hire Purchase System ’ and payment is made in instalments. In the days of inflation, consumer’s credit is squeezed and in the days of deflation, credit is expanded. For checking inflation, hire purchase system is made limited. Initial instalment amount is increased and repayment period is reduced. The opposite actions are made in deflationary tendencies. (C) Change in Margin Requirements : Marginal requirement is the difference between the current value of physical security offered for loans and the value of loans granted. Central bank determines marginal requirement ratio for different commodities. When it wants to expand credit against a particular commodity, it reduces marginal requirement ratio by which customers get more loans against this commodity. Suppose marginal requirement ratio for rice is 10%, it means a rice-miller would get 90% advances against his stock of rice. Now if this ratio is reduced to 5%, he would get 95% loans against such stocks and credit would expand. Similarly, credit can be contracted against physical

securities by raising marginal requirement ratio.

(D) Direct Action : Central bank can take direct action against any commercial bank if the latter do not follow central bank’s direction. It can charge penal interest against advances or can order for a shut down of defaulter banks.

(E) Moral Suasion : Moral suasion means persuasion, request and appeal by the central bank to the member banks to expand or contract credit, as the situation demands. Through this method, the central bank merely uses its moral influence on the commercial banks to follow its policies. For example, the central bank may request the commercial banks not to grant loans for speculative purposes.

(F) Publicity : In modern times, central bank seeks active co-operation of the public by informing its various policies to the public.

Monetary Policy

Central bank of the country determines the monetary policy. Monetary policy aims at regulating the flow of currency, credit and other money substitutes in an economy with a view to affect the stock of such assets as well as to influence the demand of the community for such assets.

Central bank makes changes in the tools of monetary policy (i.e., Bank Rate, Repo Rate, Cash Reserve Ratio, Statutory Liquidity Ratio) time to time as per requirement of the economy.

During depression, Central Bank adopts cheap money policy for creating additional liquidity in the market. Contrary to it, Central Bank adopts Dear Money Policy with the aim to reduce total money supply in the economy.

Box 7

21.5. Difficulties in Credit Control

In spite of adopting various measures, central bank may not control the credit in fully desired way. Central bank may face many difficulties while going for credit control which are as follows :

1. Credit other than Bank Credit : Central bank can only control bank credit, not other credits like exchange bills, promissory notes, etc.

2. Lack of Control on all Banks : Central bank has no direct control on all banking institutions in the country. Central bank does not have that much control on foreign banks as it has on domestic banks.

3. Lack of Control on Ultimate Use of Credit : Central bank cannot put a control on the ultimate use of credit. People may use the credit for speculation, while it is taken for productive business activity.

4. Lack of Control on Non-monetary Factors : Economic fluctuations (inflation or deflation) appear due to both monetary and non-monetary factors. Central bank can control only monetary factors with its policies.

21.6. Reserve Bank of India

It is the Central Bank of the country. The Reserve Bank of India was established in 1935 with a capital of ` 5 crore. This capital of ` 5 crore was divided into 5 lakh equity shares of ` 100 each. In the beginning the ownership of almost all the share capital was with the non-government shareholders. In order to prevent the centralisation of the equiy shares in the hands of few people, the Reserve Bank of India was nationalised on January 1, 1949.

Functions of Reserve Bank of India

1. Issue of Notes : The Reserve Bank has the monopoly of note issue in the country. It has the sole right to issue currency notes of various denominations except one rupee note. The Reserve Bank acts as the only source of legal tender money because the one rupee note issued by Ministry of Finance are also circulated through it. The Reserve Bank has adopted the Minimum Reserve System for the note issue. Since 1957, it maintains gold and foreign exchange reserves of ` 200 crore, of which atleast ` 115 crore should be in gold.

2. Banker to the Government : The second important function of the Reserve Bank is to act as the Banker, Agent and Adviser to the Government. It performs all the banking functions of the State and Central Government and it also tenders useful advice to the Government on matters related to

economic and monetary policy. It also manages the public debt for the Government.

3. Banker’s Bank : The Reserve Bank performs the same function for the other banks as the other banks ordinarily perform for their customers. It is not only a banker to the commercial banks, but it is the lender of the last resort.

4. Controller of Credit : The Reserve Bank undertakes the responsibility of controlling credit created by the commercial banks. To achieve this objective it makes extensive use of quantitative and qualitative techniques to control and regulate the credit effectively in the country.

5. Custodian of Foreign Reserves : For the purpose of keeping the foreign exchange rates stable the Reserve Bank buys and sells the foreign currencies and also protects the country’s foreign exchange funds.

6. Other Functions : The bank performs a number of other developmental works. These works include the function of clearing house arranging credit for agriculture, (which has been transferred to NABARD) collecting and publishing the economic data, buying and selling of Government securities and trade bills, giving loans to the Government buying and selling of valuable commodities etc. It also acts as the representative of Government in I.M.F. and represents the membership of India.

A QUICK REVIEW OF THE CHAPTER

● Central Bank : It is the apex monetary institution which controls the entire monetary and banking system of the country. Central bank is the maker and executor of monetary policy in the country.

● Functions of Central Bank :

(i) Monopoly in note issue.

(ii) Banker, lgent and financial advisor to the government.

(iii) Bank of Banks.

(iv) Lender of the last resort.

(v) Custodian of foreign exchange reserves.

(vi) Function of clearing house.

(vii) Credit control.

(viii) Development related function.

(ix) Other functions.

● Methods of Credit Control : Various methods of credit control can be grouped into two categories :

(a) Quantitative Methods,

(b) Qualitative or Selective Methods.

● Quantitative Instruments of Credit Control : These methods includes :

(a) Bank Rate Policy (b) Open Market Operations, (c) Cash Reserve Ratio (CRR), (d) Statutory Liquidity Ratio (SLR).

● Bank Rate Policy : The bank rate is the minimum rate at which the central bank of a country (as a lender of last resort) is prepared to give credit to the commercial banks.

● Open Market Operations : Open market operations refer to the sale and purchase of securities in open market by the central bank.

● Cash Reserve Ratio (CRR) : It refers to the minimum percentage of bank’s total deposits required to be kept with the Central bank.

● Statutory Liquidity Ratio (SLR) : SLR refers to that deposit ratio which every bank is required to maintain in cash against its total assets.

● Qualitative or Selective Credit Control : Qualitative methods or selective methods are those methods which are used by the central bank to regulate the flow of credit into particular directions of the economy. Unlike quantitative methods these methods affect the types of credit given by the commercial banks. It is because of this specific use of credit, they are called ‘Selected Controls ’.

QUESTIONS Ultra Short Answer Type Questions

1. Who is known as banker's bank ?

2. What is bank rate ? (J.A.C., 2019; Raj. Board, 2013)

3. What is the name of India’s Central Bank ?

4. Which bank is at the apex of the banking system in India ?

5. What is the full form of SLR ? (B.S.E.B., 2014)

6. Who issues currency in India ? (U.S.E.B., 2014)

7. When Indian Reserve Bank nationalised ?

8. What is the meaning of Cash Reserve Ratio ? (U.S.E.B., 2016)

9. What is meant by open market operations ?

(Raj. Board, 2017)

10. Who controls the credit in the economy ?

Very Short Answer Type Questions

1. What is the meaning of Central Bank ?

2. What is the meaning of Credit Control ? (B.S.E.B., 2019)

3. Explain the meaning of ‘Quantitative Credit Control’.

4. Explain the meaning of Cash Reserve Ratio (CRR). [C.B.S.E., 2011, 15; J.A.C., 2011)] Or

Define CRR. (Raj. Board , 2015)

5. What is Statutory Liquidity Ratio (SLR) ? (C.B.S.E., 2011)

6. What is the difference between ‘Bank Rate’ and ‘Interest Rate’ ?

7. Define ‘Clearing House’. (B.S.E.B., 2014)

8. What type of bank rate is adopted by the Central Bank in inflationary conditions ?

Short Answer Type Questions

1. How is the Central Bank different from Commercial Bank ? (B.S.E.B., 2015, 17)

2. State any two methods by which a Central Bank controls the quantity of credit. (C.B.S.E . 2013, 19; J.A.C., 2013)

3. What is the difference between CRR and SLR ?

4. State the main functions of a Central Bank. (J.A.C., 2017; B.S.E.B., 2012) Or

Give four main functions of a Central Bank.

(C.B.S.E. , 2015, J.A.C., 2012)

5. How does a Central Bank control the availability of credit by Open Market Operations? (C.B.S.E., 2013, 16)

6. What is meant by Bank Rate Policy ? Briefly describe their effect on credit creation by Commercial Banks. (U.S.E.B. , 2010)

7. Discuss the ‘Issue of Currency’ function of Central Bank. (J.A.C., 2011)

8. Explain the role of Central Bank as government’s agents and advisor.

9. Explain the last resort function of the central bank. (C.B.S.E. , 2010, 12,

13; J.A.C., 2013; B.S.E.B., 2015; Raj. Board, 2015) 10. Explain the banker to the government function of the central bank. (C.B.S.E. , 2010, 12, 13) 11.

(C.B.S.E. , 2010, 12) 12. What is Selective Credit Control ? (B.S.E.B. , 2011)

13. What is meant by open market operations ? What are the basic

conditions for its success ?

14. What is the role of bank rate in credit control ?

(B.S.E.B., 2014) 15. Write four instruments of monetary policy of RBI. (B.S.E.B., 2014) 16. What is Monetary Policy ? (B.S.E.B. , 2019; JAC., 2015) 17. Who suplies money ? (B.S.E.B. , 2016) 18. Explain how ‘Repo Rate’ can be helpful in controlling credit creation ? (C.B.S.E., 2016) 19. Explain the role of Reverse repo rate in increasing money supply. (C.B.S.E., 2017) 20. Explain the role of open market operations in reducing money supply. (C.B.S.E., 2017) 21. Write the names of main measures of monetary policy. (B.S.E.B. , 2018) 22. Distinguish between central Bank and Commercial Bank ? (MP Board , 2019) 23. Distinguish between Bank Rate and Repo Rate. (MP Board , 2019)

Long Answer Type Questions

1. Define Central Bank and explain its functions. (J.A.C., 2013; B.S.E.B ., 2016) Or

Explain important functions of a central bank.

( B.S.E.B., 2014, 15, JAC , 2017, U.S.E.B, 2017) 2. What do you mean by Credit Control ? How does the Central Bank control the credit ? (B.S.E.B ., 2017) 3. With which methods the Central Bank of a country control the supply of money in an economy ?

( B.S.E.B ., 2013) 4. Explain how the Bank Rate Policy controls the flow of credit in the economy ? State the factors that determine its success. 5. Discuss the main functions of RBI as Central Bank.

(U.S.E.B., 2014)

6. Explain the role of Cash Reserve Ratio and Interest Rate to decrease aggregate demand in an economy.

7. Discuss the methods of credit control by Central Bank of a country. (U.S.E.B. , 2011; B.S.E.B. , 2011; J.A.C. , 2016)

8. Explain how do “open market operations” by the Central Bank affect money creation by commercial banks. (C.B.S.E. , 2010)

9. Describe in brief the various quantitative methods employed by central bank to control credit. (U.S.E.B., 2015) 10. Explain the following function of Central Bank : (J.A.C., 2019; C.B.S.E. , 2011) (i) Bank of Issue, (ii) Bank of

Banks

11. Distinguish between Central Bank and Commercial Banks. (B.S.E.B. , 2013; J.A.C. , 2016) 12. Describe any three quantitative methods of credit control of central bank. (B.S.E.B., 2015) 13. How do changes in Bank Rate affect the money supply in an economy ? Explain. (C.B.S.E., 2015)

Objective Type Questions

(A) Multiple Choice Questions :

1. What is true for the Central Bank ?

(a) Apex Bank of the Country

(b) Ownership of the Government

(c) Regulates the entire banking system in the country (d) All the above

2. Which is the Central Bank in India ? (B.S.E.B ., 2011, 12, 17) (a) Reserve Bank of India

(c) Central Bank of India

(b) State Bank of India (d) Bank of India (b) Restriction on consumer credit

(c) Open market operations

(d) Variation in bank rate

14. The major objectives of monetary policy is/are : (B.S.E.B ., 2015) (a)

Increase in output and employment

(b) Stability in foreign exchange rate

(c) Price stability

(d) All of these

15. Who regulates money supply ?

16. Which of the following is the function of Central Bank ? (B.S.E.B. , 2018)

(a) Monopoly of Note Issue

(b) Banker of the Government

(c) Custodian of Foreign Exchange Reserves

(d) All the above

4. Which type of currency is issued by the Central Bank ? (B.S.E.B ., 2015, 17, 18, 19) (a) Currency (b) Credit Money (c) Coins (d) All the above

5. Which is the major objective of credit control ?

(a) Govt. of India

(c) Commercial Bank

( C.B.S.E. , 2015, B.S.E.B. , 2017) (b) Reserve Bank of India (d) Planning Commission

(a) Reserve Bank of India (c) Unit Trust of India

16. Credit money is increased when CRR : (B.S.E.B. , 2016) (a) Falls (b) Rises

(c) Both (a) & (b) (d) None of these

17. Who is the custodian of Indian Banking System ? (B.S.E.B. , 2016) (b) State Bank of India (d) LIC of India

( B.S.E.B ., 2019) (a) To maintain Price Stability (b) To stabilize Exchange Rate (c) To promote Production and Employment

(d) All the above

6. Which one is true ?

(a) Bank rate is a rate at which Central Bank is ready to give credit to commercial banks

(b) Bank rate and interest rates are different

(c) Bank rate is the discount rate of the Central Bank

(d) All the above

7. Which is not a quantitative method of credit control ? (B.S.E.B., 2011)

(a) Bank Rate (b) Moral Suasion

(c) Open Market Operations (d) Change in CRR 8. Every bank is required to maintain a fixed percentage of its assets in the form of cash is called :

18. The Central Bank can increase the availability of credit by : (a) Raising Repo Rate

(b) Raising Reserve Repo Rate

(c) Buying Govt. Securities

(d) Selling Govt. Securities

19. Main function of Central Bank is :

(a) The Banker, Agent, Advisor of Central Bank (b) Bank of Banks

(c) Issuing Currency Notes (d) All of these

20. Reserve Bank of India is : (a) Central Bank

(c) Co-operative Bank (b) Commercial Bank (d) None of these

(a) Cash Reserve Ratio (c) Both (a) & (b)

(b) Statutory Liquidity Ratio (d) None of the above

9. Reserve Bank of India was established in :

(B.S.E.B ., 2012, 15, 16, 17, J.A.C. , 2017) (a) 1947 (b) 1935

(c) 1937 (d) 1945

10. Monetary policy is related with :

(a) Public Expenditure (c) Public Debt

( B.S.E.B ., 2016, 17; J.A.C. , 2017) (b) Taxes

(d) Open market operations

11. Which of the following issue paper currency in the country ? (a)

Commercial Bank (c) World Bank

(b) Central Bank (d) Industrial Bank

12. Central bank controls credit through : (B.S.E.B ., 2012, 17) (a) Bank rate

(b) Open market operations (c) CRR (d) All the above

13. Which of the following is a qualitative method of credit control ? (B.S.E.B ., 2015) (a) Variation in cash reserve ratio of banks [Ans. 1. (d), 2. (a), 3. (d), 4. (a), 5. (d), 6. (d), 7. (b), 8. (b), 9. (b), 10. (d), 11. (b), 12. (d), 13. (b), 14. (d), 15. (b), 16. (a), 17. (a), 18. (d), 19. (d), 20. (a).]

(B) Fill in the Blanks :

1. ................is the bank of banks.

2. Central Bank is a................of the government.

3. Bank rate is a................method for controlling credit creation.

4. Bank rate is also known as................rate.

5. ................refers to the minimum percentage of bank's total deposits required to be kept with the Central Bank.

6. Reserve Bank of India is .................. (B.S.E.B ., 2010)

7. The interest rate at which loan is given by Reserve Bank of India to

commercial bank is ..... ......

[Ans. 1. Central Bank, 2. banker, 3. quantitative, 4. discount, 5. cash reserve ratio, 6. Central Bank, 7. Bank Rate.] (C) State True/False :

1. Central Bank regulates the entire banking system in the country.

2. Credit money is issued by the Central Bank.

3. Reserve Bank of India was established in 1935.

4. Commercial Bank regulates money supply.

5. Head office of Reserve Bank of India in Delhi.

[Ans. 1. True, 2. False, 3. True, 4. False, 5. False]

(D) Match the following Column : ‘A’

1. Central Bank

2. Quantitative Method of

Credit Control

3. Qualitative Method of

Credit Control

4. Contraction of Credit 5. Expansion of Credit

‘B’

(a) Rationing of Credit (b) Dear Money Policy

(c) Apex Bank

(d) Cheap Money Policy (e) Bank Rate Policy

[ Ans. 1. (c), 2. (e), 3. (a), 4. (b), 5. (d)]

(E) Answer in One Word :

1. Which one is Central Bank of India ?

2. Which one is called Bank of Banks ?

3. What is the second name of Bank Rate ?

4. Which makes Credit Control ?

[Ans. 1. Reserve Bank of India, 2. Central Bank, 3. Discount Rate, 4. Central Bank.] HOTS High Order Thinking Skills Questions 1. “Central bank is custodian of foreign reserves.” How ?

[See : Section 21.3(E)]

2. In what way interest rate is associated with bank rate ?

3. Distinguish between CRR and SLR. What role they have in credit control ? (See : Box 6)

VBQ Value Based Questions

1. In what way central bank is the lender of last resort ? (See : Point D of Section 21.3)

2. A change in bank rate brings the change in interest rate. How ? (See : Box 1)

MDQ Case Study Based on Evaluation & Multi-disci plinary Questions

1. “Increase in bank rate indicates dear money policy.” Why ? (See : Box 2)

2. What should the Central Bank do for credit expansion ? (See : Section 21.4.1)

3. Central bank changes its monetary policy as per requirement. Explain. (See : Box 7)

NCERT CORNER

Q. 1. What are the instruments of monetary policy of RBI ? How does RBI stabilize money supply against exogeneous shocks ? Ans. See : Section 21.4.

Q. 2. What role of RBI is known as ‘lender of last resort’ ? Ans. See : Section 21.3 (D).

❐ STUDY MATERIAL INCLUDED

IN THE CHAPTER

22.1. Reforms in Banking Sector : Introduction 22.2. Narsimham Committee on Banking System (1991) 22.3. Goiporia Committee (1990) 22.4. Narsimham Committee Second (1998) 22.5. Verma Committee (1999) 22.6. Reforms in Banking Sector (1992-2017) 22.7. Private Sector Banks : New Guidelines Questions High Order Thinking

Case Study Based on Evaluation & Multi-disciplinary

report to the Finance Minister in November 1991 which was placed on the table of Parliament on December 17, 1991. Skills (HOTS) Questions Value Based Questions (VBQ) Questions (MDQ) NCERT Corner

22.1. Reforms in Banking Sector : Introduction After the first phase of nationalisation of banks in 1969, banking system has played a deep positive role _{in economic development of the country but this} 22.2.1. Narsimham Committee : Basic Viewpoint

nationalised banking system also became associated Regarding financial reforms, the basic viewpoint of with negative aspects and consequently profitability the committee was based on the following three facts : and efficiency of banking system started diminishing. (i) For ensuring competitive efficiency in financial It was realised to re-examine the present banking sectors of the economy, attempts should be made organisation and its policies so as to make banking on the lines as adopted for real sectors. system more efficient and result-oriented. In the (ii) For promoting competitive efficiency, financial sector decade of 1990, emphasis was given on consolidation should be made healthy and profitable. of banks. Under the phase of liberalisation, it was (iii) Financial sector should be left free and be allowed

realised to adopt some structural reforms in banking to work without any interference.

^● Suggestions system for improving financial efficiency of banks, adopting balanced approach in branch expansion, The salient

recommendations of the Narsimham expanding computerised banking network and making Committee under the above basic viewpoints are : banking organisation more strong and capable. With 1. 4-tier banking system should be introduced in the this motive, a few committees for suggesting banking country.

reform were constituted : I tier 3 or 4 International Banks, ● Narsimham Committee (1991), II tier 8 or 10 National Banks, ● Goiporia Committee (1991), III tier Regional Banks,

● Second Narsimham Committee (1998),^{IV tier Rural Banks.}

_{● Verma Committee (1999).} 2. Branch licensing system for opening new bank

22.2.

Narsimham Committee on Banking System

branches should be abolished. 3. A liberal view should be adopted for allowing foreign_{(1991) banks in the country. Both foreign and domestic banks}

The Government of India constituted a 9-member should be treated at par. committee under the chairmanship of Mr. M. 4. SLR for banks should be curtailed to the level of Narsimham, retired RBI Governor, on Aug. 14, 1991 25% within next 5 years. CRR should also be curtailed for making recommendations on existing financial in various phases.

system and to give suggestions for improving the 5. Banks should be given more autonomy and the existing structure. The committee submitted its directed credit should be abolished.

* Note —This Chapter is not for CBSE students.

6. Primary targets for credit should be redefined and such credit should not be more than 10% of total credit.

7. Computerisation in banks should be promoted.

8. Banks should be authorised to appoint banking official at their own discretion.

9. The dual control of RBI and Finance Ministry on banks should be abolished and RBI should function only as a regulatory authority of banking system in the economy.

10. RBI's representative should not be included in the management boards of banks. Only Government representative should be there.

11. Granting resources to development finance institutions on concessional rates of interest should be abolished in phases within next three years. These institutions should be allowed to mobilise resources from open market on competitive rates.

12. Quick and effective liberal attitude should be adopted in the policy related to capital market. System of getting prior permission by the companies for their new share issues should also be abolished.

22.2.2. Reforms adopted with reference to Suggestions

Government adopted many reforms on the lines of the suggestions put forward by Narsimham Committee in August 1991. Phase of financial reforms was initiated in 1992-93 and the reforms were intensified since 1993-94.

Important reforms adopted with reference to suggestions are as follows :

1. Statutory Liquidity Rates (SLR) was reduced from high level of 38.5% in 1992 to 25% in 1997 which was the minimum ceiling in Banking Regulation Act, 1949.

Presently this minimum ceiling of 25% has also been removed. At present (as per status of october 2017), SLR stands at 20 percent.

2. Action of repos for bills and securities was permitted since 1992-93 for associating the interest rates on government securities with the market.

3. Bank rate was made more active and changes were made in it from time to time for making interest rates more meaningful.

4. Suggestion related to ‘Capital Adequacy Ratio’ was accepted.

5. Debt Recovery Tribunals were established for accelerating the debt recovery.

6. Norms for establishing private banks were simplified and private banking was promoted in banking system.

7. Banking Ombudsman Scheme was started in 1995 for the rapid solutions of banking complaints.

8. For strengthening the weak Regional Rural Banks (RRBs), government initiated the phase of decentralised banking in the country.

9. Rational criterion were framed for financial institutions and non-banking financial institutions.

10. For improving the operating efficiency and customer service, computer and information technology have been associated with banking system. In spite of adopting above banking reforms on the lines of suggestions put forward by Narsimham Committee, NPAs (Non-Performing Assets) of banks could not be reduced.

Banking Ombudsman Scheme

RBI introduced a Banking Ombudsman Scheme in the country on June 14, 1995, for giving a solution for customer's complaints. 15 ombudsmen have already been appointed for different regions. These regions are—New Delhi, Bhopal, Bengaluru, Kolkata, Chandigarh, Hyderabad, Mumbai, Patna, Jaipur, Kanpur, Guwahati, Bhuvaneshwar, Chennai, Ahmedabad and Tiruvanatpuram. Bank customers can send their complaints to these ombudsman if concerned banks fail to satisfy them. These Ombudsman will take necessary action and will ensure a relief to customers.

According to a circular issued by the RBI, all scheduled primary cooperative banks and commercial banks have been brought under purview of this banking ombudsman scheme. Regional Rural Banks (RRBs) have not been included under the scheme. The matter should be reported by grieved customer to ombudsman within the period of one month after getting final reply from concerned bank. Ombudsman will not act upon the complaints having received after this time limit.

Box 1

22.3. Goiporia Committee (1990)

RBI constituted a committee under the chairmanship of Sri M. N. Goiporia, then the President of SBI, in September 1990 on making recommendations for consumer service improvements in banks. The committee submitted its report on December 5, 1991. The main recommendations of the committee were following :

1. Extension of banking hours for all works excluding cash payment.

2. Re-adjustment of bank opening time for staff so as to ensure start of work at bank counters well in time.

3. Spot deposit of outstation cheques of ` 5,000 (instead of existing ` 2,500) in bank accounts.

4. Increase in bank interest rates on saving accounts.

5. Providing tax benefit on bank deposit amounts.

6. To ensure optimum use of powers available with bank staff.

7. Outstation cheques collection should be speed up.

8. Duties of letter should be expanded.

9. Bank computerisation should be adopted for modernisation of banking system.

10. Banks should provide restricted holidays. 22.4. Narsimham Committee Second (1998)

Government adopted a member of reforms in financial and banking system on the basis of recommendations made by Narsimham Committee (1991). For making appraisal of these reforms, the government constituted the Second Narsimham Committee on December 26, 1997. This new committee was asked to review the progress of banking sector reforms to date and chart a programme on financial sector reforms necessary to strengthen India's financial system. The committee submitted its report on April 22, 1998.

● Suggestions

The salient recommendations of the second Narsimham Committee are as follows :

1. Three-tier banking system in public sector should be adopted :

(i) 2 or 3 International Level Banks.

(ii) 8 to 10 National Level Banks.

(iii) A few local level Banks.

2. Merger of banks for 3-tier banking system.

3. Narrow banking concept to be adopted for weak banks and the close them after the failure of this attempt.

4. The third-tier (i.e., local banks) should limit their working area within state or a group of few districts.

5. A quick review of RBI Act, Banking Regulation Act, Nationalisation Act, SBI Act is needed.

6. Extension of computerisation in banks.

7. Asset Reconstruction Fund to be constituted for acquiring bad assets of banks.

8. Capital Adequacy Ratio (CAR) should be increased.

9. Banks to be made free from political interference. 10. Voluntary

Retirement Scheme to be adopted in case of excess employees.

● Steps Adopted by the Government

Accepting the recommendations of Narsimham Committee (1998), government made many related declarations. Few important among them are as follows :

1. To strengthen Debt Recovery Tribunals.

2. On trial basis Asset Restructuring Companies to be established for loan recovery of banks having excess of unproductive assets.

3. Capital Adequacy Ratio to be raised upto 10%.

4. A task force to be established for suggesting the outlines for reviewing various Banking Acts for ensuring banking reforms and modernisation. 22.5. Verma Committee (1999)

RBI constituted Verma Committee for suggesting the revival and restructure of weak public sector banks. The Committee submitted its suggestions on October 4, 1999.

1. A strategy to be adopted for re-organising and

restructuring the working of weak banks like UCO Bank, Indian Bank and United Bank of India so as to enhance their profitability and reducing the cost. Committee suggested these banks to reduce their NPAs and reduce the employees cost.

2. Committee recommended to weak banks for the development of information technology on the basis of BOOT (Build, Own, Operate, Transfer).

3. NPAs of above ` 50 lakhs in these identified weak banks should be transferred to the newly constituted ‘Asset Reconstruction Fund ’.

4. Committee recommended 25% employees reduction. 22.6. Reforms in Banking Sector (1992-2017) Various important reforms which took place during 1992-2017 are as follows :

5. Statutory Liquidity Ratio (SLR) : SLR has been reduced from the high level of 38.5% to 20% in October 2017. Recently a new Act has removed this minimum ceiling of 25% for SLR.

6. Cash Reserve Ratio (CRR) : CRR which was at the height of 10% was processed to be reduced. In october 2017, CRR stood at 4 percent. The purpose of reducing CRR was to release funds locked up with RBI for lending purpose by the commercial banks.

7. Reduction in Interest Rate Slabs : These slabs were gradually reduced from 20 to 2 by 1994-95. The important changes in interest rates since 1991- 92 are as follows :

(a) Interest rate on domestic term deposits has been

decontrolled.

(b) The prime lending rate of SBI and most other banks on general advances of over ` 2 lakhs has been reduced.

(c) Rate of interest on bank loans above ` 2 lakh has been fully decontrolled.

(d) The interest rates on deposits and on advances

of all co-operative banks (except urban cooperative banks) have been deregulated. The purpose of deregulation of interest rate on the high slab of bank advances was to stimulate healthy competition among the banks and encourage their operational efficiency.

4. Capital Adequacy Ratio Criteria : For commercial banks capital adequacy ratio criteria was adopted and the ratio was fixed at 8 per cent by RBI in April 1992 and banks had to comply with them over a three year period. By the end March 1996, all public sector banks had attained capital to risk weighted assets ratio of 8 per cent.

5. Other Reforms :

(i) For giving a solution for consumer's complaint

Banking Ombudsman were appointed. (ii) Banking Companies Act was modified to enable

the nationalised banks to access the market for capital funds through public issues.

(iii) Scheduled commercial banks have now been given freedom to open new branches and upgrade extension counters. They are also permitted to close non-viable branches other than in rural areas.

(iv) Required norms for establishing new private

banks were liberalised.

(v) Six Special Recovery Tribunals have been set up

at Kolkata, New Delhi, Jaipur, Ahmedabad,

Bengaluru and Chennai to facilitate quicker

recoveries of loan arrears (within six months)

and an Appellate Tribunal has also been set up

in Mumbai.

22.7. Private Sector Banks : New Guidelines

In the process of banking reforms and liberalisation, RBI declared the new guidelines for the first time on January 22, 1993 for issuing the licence to new banks in private sector. RBI, under these guidelines also gave licence to 10 private banks.

RBI on January 3, 2001 again declared new guidelines for issuing licence to private sector banks which are as follows :

1. The paid-up capital of banks to be raised from ` 100 crores to ` 200 crores.

2. Within three years of starting business, paid-up capital to be raised upto ` 300 crores.

3. Minimum 40% of paid-up capital to be given by promoters of the bank and the rest to be collected through public issues.

4. Restriction on big industrial houses for becoming direct promoter of the bank.

5. Non-Banking Financial Companies (NBFCs) having strong economic base were allowed to be changed in banks (but only to those NBFCs which contain capital adequacy ratio at minimum 12%).

6. 40% of total credit to be granted to priority sector, to maintain 10% capital adequacy ratio and to open 25% branches in rural and semi-urban areas.

QUESTIONS Ultra Short Answer Type Questions

1. Write the name of the committee constituted in 1990 to recommend improved customer services.

2. In which year the First Narsimham Committee was constituted ?

3. For what purpose Goiporia committee was constituted ?

4. For what purpose Second Narsimham Committee constituted ? (B.S.E.B., 2014)

Very Short Answer Type Questions

1. What is meant by reforms in banking sector ?

2. What is Banking Ombudsman Scheme ?

3. Mention two conclusions of Goiporia Committee.

4. When the second Narsimham Committee was appointed ?

5. Write any two recommendations recommended by First Narsimham Committee.

Short Answer Type Questions

1. Mention two main recommendations of first Narsimham Committee. (B.S.E.B., 2019)

2. When was the second Narsimham Committee appointed ? What are its main recommendations ?

3. What are the new guidelines of RBI for private sector banks ?

4. Write any two recommendations of Verma Committee, 1999.

Long Answer Type Questions

1. Mention the salient Recommendations of first Narsimham Committee.

2. What measures did the government adopt on recommendations of second Narsimham Committee ?

3. What are the major reforms in banking sector during the period 1992– 2015 ?

4. What are the new guidelines released by RBI for new private banks ?

5. When was first Narsimham Committee constituted ? Discuss its recommendation in brief.

6. What reforms were brought in banking sector after Narsimham Committees recommendations in 1991 ?

7. Why and when Goiporia Committee was constituted ? What were its recommendations ?

8. What was the purpose of constituting of Verma Committee ? When was it constituted ? What were its recommendations ? When was it constituted ? What were its recommendations ? 2017 ?

Objective Type Questions

(A) Multiple Choice Questions :

1. With which Narsimham Committee is related to ? ( B.S.E.B., 2011, 17) (a) Tax Reforms (b) Banking Reforms (c) Agriculture Reforms (d) Infrastructure Reforms

2. In which year the second Narsimham Committee was constituted ? (B.S.E.B. , 2011) (a) 1978 (b) 1991 (c) 1997 (d) 1998

3. Banking Ombudsman Scheme was announced in the year : (B.S.E.B. , 2016, 17, 19) (a) 1990 (b) 1995 (c) 1997 (d) 2000

4. Which was included in the purview of Banking Ombudsman Scheme ? (a) All Scheduled Banks (c) Commercial Banks (b) Co-operative Banks (d) All the above

5. Which committee was constituted for suggesting consumer service improvements in banks ? (a) Raja Chelliah Committee (b) Goiporia Committee (c) Verma Committee (d) Chakrabarty Committee

6. For revival and restructure of weak banks of public sector, which committee was constituted ? (a) Verma Committee (c) Rekhi Committee (b) Goiporia Committee (d) Narsimham Committee

7. RBI announced the guidelines to issue licences to new banks of private sector on : (a) January 22, 1993 (c) April 1, 1999

( B.S.E.B., 2015) (b) March 15, 1995 (d) None of the above

8. Who is the custodian of Indian Banking System ? (a) Reserve Bank of India (c) Unit Trust of India (b) State Bank of India (d) LIC of India 9. Banking Sector Reforms in India began in : (B.S.E.B., 2015) (a) 1969 (b) 1981 (c) 1991 (d) 2001

9. 14 big scheduled commercial banks in India were nationalised in : (B.S.E.B. , 2012; 2018) (a) 1949 (b) 1955 (c) 1969 (d) 2000

10. Which is associated with reforms in the banking sector ? (B.S.E.B. , 2015, 18) (a) Year 1991 (b) Narsimham Committee (c) Y.V. Reddy Committee (d) Only (a) & (b) [Ans. 1. (b), 2. (d), 3. (b), 4. (d), 5. (b), 6. (a), 7. (a), 8. (a), 9. (c), 10. (c). 11. (d).]

(B) Fill in the Blanks :

1. Second Narsimham Committee had suggested............tier structure for public sector banks.

2. The name of India's Central Bank is............ .

[Ans. 1. three, 2. Reserve Bank of India.]

(C) State True/False :

1. Narsimham Committee is related to banking reforms.

2. Gaiporia Committee was constituted in 1990.

3. Chakrabarty Committee was constituted for reforms in consumer service in Banks.

4. Banking Ombudsman scheme was announced in 1995. 5. Ten big scheduled commercial banks in India were nationalised in 1969.

[Ans. 1. True, 2. True, 3. Fase, 4. True, 5. False] (D) Match the following Column :

‘A’ ‘B’

1. Verma Committee (a) 1991

2. Goiporia Committee (b) 1998

3. Narsimham Committee (c) 1990

4. Narsimham Committee Second (d) 1995

5. Banking Ombudsman Scheme (e) 1999

[Ans. 1. (e), 2. (c), 3. (a), 4. (b), 5. (d)

(E) Answer in One Word :

1. When was first Narsimham Committee constituted ? 2. When was

Goiporia Committee constituted ?

3. To which Narsimham Committee related ?

4. What was the subject of verma Committee ?

[Ans. 1. 1991, 2. 1990, 3. Banking Reforms, 4. Rehabilitation of weak banks.]

HOTS High Order Thinking Skills Questions 1. What are the objectives of Banking Ombudsman Scheme ? (See : Box 1) VBQ Value Based Questions 1. What is the working scope of Banking Ombudsman ?

(See : Box 1)

2. When was second Narsimham Committee constituted ? What duties were assigned to this committee ? (See : Section 22.4)

MDQ Case Study Based on Evaluation & Multi-disci plinary Questions

1. What reforms were adopted in banking sector during 1990s decade ? (See : Section 22.6)

❐

AGGREGATE DEMAND, AGGREGATE SUPPLY23

AND RELATED CONCEPTS (PROPENSITY STUDY MATERIAL INCLUDED IN TO CONSUME, PROPENSITY TO SAVE AND INVESTMENT) THE CHAPTER

23.1. Introduction 23.2. Aggregate Demand 23.3. Aggregate Supply 23.4. Two Components of Aggregate Demand

23.5. Consumption and Consumption Function 23.6. Investment and Investment Function 23.7. Full Employment and Involuntary Unemployment A Quick Review of the Chapter Questions High Order Thinking Skills (HOTS) Questions Value Based Questions (VBQ) Case Study Based on Evaluation & Multi-disciplinary Questions (MDQ) Numerical Questions NCERT Corner.

23.1. Introduction

J.B. Say , belonging to Adam Smith’s classical school, propounded the Law of Market, i.e., (Supply creates its own demand ) which is called as Classical Theory of Employment .

According to this law,

(i) Economy is always at full employment level, (ii) There is no possibility of ‘over-production ’ or

‘under-production ’ in the economy.

The great depression of thirties proved this law impractical and false. In his book ‘General Theory of Employment, Interest & Money ’, published in 1936, Prof.

J.M. Keynes used the concepts of ‘ aggregate demand ’ and ‘aggregate supply ’ for determining the employment level. ● Starting Point of Keynesian Theory of Employment :

Effective Demand

According to Keynesian employment theory in short period, total production, i.e., national income in capitalist economy depends on the level of employment because in short period other factors of production such as capital, technique, etc., remain constant. Employment level depends on effective demand. That level of aggregate demand at which it becomes equal to aggregate supply is called effective demand .

23.1.1. Effective Demand : Determining Factors

Income Level ≡ Output Level ≡Employment Level Y ≡ O ≡ N Determined by Effective Demand Determining Factors Aggregate Demand Aggregate Supply Consumption Demand Investment Demand

Income Level Propensity to Consume Marginal Rate of Efficiency Interest of Capital

Multiplier Money Demand Money Supply 23.2. Aggregate Demand

The total demand of goods and services in an economy is termed as ‘aggregate demand ’ which is expressed in terms of total expenditure made in the economy. Thus, aggregate demand in an economy is measured in terms of total expenditure on goods and services.

In other words, aggregate demand refers to total expenditure that the residents of a country are ready to incur on the purchase of goods and services at given level of income.

Aggregate Demand = Consumption Expenditure + Investment Expenditure AD = C + I

23.2.1. Characteristics of Aggregate Demand

Demand of goods and services are of two types : (i) Consumption Demand, (ii) Investment Demand.

● Demand for goods and services by individual people for consumption is called ‘private consumption ’ while the demand by the government for consuming goods and services become ‘public consumption ’. The addition of both private consumption and public consumption is called ‘consumption demand ’.

● Investments demand comes from both individuals and government. Investments made by individuals and government are termed as ‘private investment ’ and ‘public investment ’ respectively. The addition of both, ‘private investment ’ and ‘public investment ’ is called ‘investment demand ’. Thus, the addition of both consumption demand and

investment demand becomes ‘aggregate demand’. Aggregate Demand
↓ ↓
Consumption Demand
↓↓ ↓
Private Public
Consumption Consumption ↓

Investment Demand ↓_↓↓

Private Public Investment Investment

When households, enterprises and the government demand goods and services, they have to spend on these goods and services. Hence, the aggregate demand of a community can also be expressed as ‘aggregate expenditure ’. A part of this aggregate expenditure goes on consumption and other one to investment.

In Short,

Aggregate = Aggregate =Consumption+ Investment

Demand Expenditure Expenditure Expenditure Y = C + I

Where, Y = Total Production or Total Expenditure

C = Consumption Expenditure

I = Investment Expenditure

Box 1

Aggregate demand or aggregate expenditure depends on the employment level in the economy. Generally, there is a direct positive relationship between employment level in the economy and its aggregate expenditure. In other words, employment increases with increase in aggregate demand in the economy and vice versa.

Difference between ‘ Market Demand ’ and ‘ Aggregate Demand ’

● Market demand refers to the demand of goods in the market but aggregate demand refers to the total demand of goods and services in the economy.

● Market demand is a ‘micro concept ’ while aggregate demand is a ‘macro concept ’.

● Market demand curve is negatively sloped which shows the inverse relationship between price and demand while aggregate demand curve is positively sloped which establishes positive relationship between income and demand.

120 Introductory Macro Economics

Market Demand Curve Aggregate Demand Curve

Box 2 23.2.2. Aggregate Demand Schedule

By adding consumption expenditure and investment expenditure at various levels of income, we can get aggregate demand schedule.

(1) Aggregate Consumption Expenditure : This expenditure depends on income level. As income increases, consumption expenditure also increases but not in that proportion in which income rises. The increase in aggregate consumption due to increase in income is referred as propensity to consume. Hence, propensity to consume refers to the relation between income level and consumption level.

(2) Aggregate Investment Expenditure : Total investment in the economy may adopt two forms : (i) Autonomous Investment : It is also called

independent investment as it is not related to income level.

(ii) Induced Investment : Investment made with profit motive is called induced investment which is related to income level.

In making aggregate demand schedule, it is assumed that the economy has only autonomous investment. It means that the change in income brings no effect on investment.

Thus, aggregate demand schedule is made by adding consumption schedule and investment schedule. Table 1 : Aggregate Demand Schedule Income Level (Y) Consumption (C) Investment (I) Aggregate Demand

Expenditure (AD = C + I) 040 40 80
20 50 40 90
40 60 40 100
60 70 40 110
80 80 40 120
100 90 40 130
120 100 40 140
140 110 40 150
160 120 40 160
180 130 40 170
200 140 40 180

The above Table shows that even at zero level of income consumption demand is not zero but is maintained at a minimum level because a person has to consume the essentials for his survival even at zero level of income. Such consumption of essentials is made either with past savings or by borrowing from others.

23.2.3. Measurement of Aggregate Demand

Or

In closed economy (where the foreign trade element is absent)

Aggregate Demand = Consumption + InvestmentFig. 3AD = C + I
(B) In Open Economy
Aggregate Demand = Consumption + Investment + Export - Import AD = C + I + (X - M)
Or AD = C + I + G + (X - M)
Where, C = Domestic Consumption Expenditure I = Private and Public Investment G = Government Consumption Expenditure (X - M) = Net Exports (Exports - Imports)

↓ (C) Household Consumption Expenditure

Determinants of Aggregate Demand
↓(I)

Investment ↓ ↓(G) ↓(X–M) Government Net Exports Consumption (Exports-Imports) Expenditure

● Household Consumption Expenditure (C) : Household consumption expenditure mainly depends on income, i.e.,

C = f(Y)
or consumption is a function of income.
The relation between consumption and income is called ‘consumption function’.

● Investment (I) : Expenditure made on capital goods like machines, equipments, building, etc., is termed as investment. Thus, increase in the capital goods is known as investment.

● Government Consumption Expenditure (G) : It includes the expenditure made by the government on public works, power, water supply, roads, hospitals, etc.

● Net Exports (X–M) : Imports (M) are subtracted from exports (X) to obtain net exports (i.e., X–M). It signifies the foreign demand of goods and services produced in the economy. If net export is positive (i.e., X > M) aggregate demand increases and vice versa .

Box 3

23.3. Aggregate Supply

The concept of aggregate supply is related to the total supply of goods and services made available by all producers in the economy. It means that aggregate supply depends on the production made by producers.

The money value of goods and services produced in an economy is termed as gross domestic product and this GDP is equal to the total factor income in the economy because the production is distributed among various factors of production as factor income.

Thus,

Aggregate Supply = Gross Domestic Product = Total Factor Income = Rent + Interest + Wage + Profit

● In Keynesian View

Aggregate Supply = Consumption + Saving

Income earned by the factors is either consumed or saved. So aggregate supply can also be defined as a sum total of consumption (C) and saving (S). Firm has to incur cost for employing various factors of production, i.e., land, labour, capital and enterprise. A firm will maintain that employment level where it may earn that much amount of income from its production which becomes equal to the total payment made to production factors. Hence, according to Keynes , “Aggregate supply price of the output of a given

amount of employment is the expected proceeds which will just make it worthwhile for the entrepreneurs to give that employment.”

☞ Aggregate supply can be expressed in three forms :

● Money value of all goods and services produced in the economy in an accounting year, i.e., national income.

● A sum of consumption (C) and saving (S), i.e., total income.

● Minimum income to be obtained by the firms by selling their products.

Box 4

Introductory Macro Economics

23.3.1. Aggregate Supply Schedule

Aggregate supply can be expressed in aggregate supply schedule which can be obtained by taking sum of consumption and saving at various levels of income.

Table 2 : Aggregate Supply Schedule

Income Level Consumption Savings (Y) (C) (S)

0 40 -40
20 50 -30
40 60 -20
60 70 -10
80 80 0 100 90 10
120 100 20
140 110 30
160 120 40
180 130 50
200 140 60
Aggregate Supply Expenditure (AS = C + S)
0
20
40

100 120 140 160 180 200

Table 2 shows that initially consumption is more than

200

\begin{array}{c} \text {Y = C + S} \\ / \end{array}

income and hence, past savings are used. As income level

\begin{array}{c} 1 8 0 \\ 1 6 0 \end{array}

increases, aggregate supply increases. Aggregate supply

\begin{array}{c} \text {nptior} \\ \text {& AS} \end{array} \begin{array}{c} 1 4 0 \\ 1 2 0 \end{array} \begin{array}{c} \text {—} \\ \text {—} \end{array}

is obtained by making sum of consumption (C) and savings (S) at various levels of income. Fig. 4 represents aggregate

\begin{array}{c} \text {onsur} \\ \text {saving} \end{array} \begin{array}{c} 1 0 0 \\ 8 0 \end{array} \begin{array}{c} \text {上} \\ \text {上} \end{array}

supply curve which starts from origin and makes 4 5 ^ { \circ } with

Fig . 4
Determination of Income, Employment and Output Levels in the Economy

According to Keynes, income, employment and output are determined at that point. Aggregate demand equals aggregate supply,i.e., the point, where aggregate demand and aggregate supply are equal, is called the point of effective demand.

That’s the reason to call effective demand as a starting point of Keynesian Employment Theory.

Fig. 5

Box 5 23.4. Two Components of Aggregate Demand 23.5. Consumption and Consumption Function

Consumption

Investment

Consumption : Meaning

Consumption Function That part of income in the economy which is spent on goods and services is called ‘consumption ’ and

Investment Function which is not consumed becomes ‘savings ’. The addition of consumption (C) and savings (S) is called ‘income ’.

Income = Consumption + Savings Y = C + S

● Consumption Function

According to Keynes, consumption expenditure in an economy depends on income or ‘consumption is a function of income ’.

☞ Fig. 6 shows that :

Thus, relation between consumption and income is called consumption function .

Consumption function tells that consumption expenditure directly increases with increase in income but increase in consumption is less than increase in income, i.e., consumption does not increase at the same rate as income does. Keynes named this consumption tendency as ‘Psychological Law of Consumption ’.

Y Even at zero income level, consumption level is OC because minimum consumption of necessary goods are essential for life. Y Point A is breakeven point where consumption expenditure equals_{+S C}

^{income. A Y > C} At income level OY₂ (i.e., left of point A) income is less than^C1 _{Y = C} consumption (i.e., Y < C). This situation shows ‘negative saving ’ in C –S

which past savings are consumed. Y< C

^{At income level OY3 ( i.e., right of point A) income is greater than O Y 2 Y 1 Y3 X} consumption (i.e. Y > C), this situation shows positive saving in which_{In co m e (Y )} savings increases. Fig. 6 Box 6 23.5.1. Propensity to Consume

According to Keynes , propensity to consume signifies the increase in consumption with increase in income. Similarly, increase in savings with increase in income is termed as ‘propensity to save ’. Keynes used the term ‘propensity to consume ’ for consumption function.

According to Dillard, “A schedule showing various amounts of consumption which correspond to different levels of income is known as the propensity to

consume. ,,

Schedule of Propensity to Consume The schedule expressing the functional relation between income and consumption at various levels of income is known as ‘Schedule of the propensity to consume ’.

Table 3 shows an imaginary table showing the schedule of propensity to consume.

Table 3 : Schedule of Propensity to Consume Income (Y) Consumption (C)

Types of Propensity to Consume

I. Average Propensity to Consume

The part of income which is spent on consumption is called average propensity to consume. It is the ratio between total consumption (C) and total income (Y).

According to Kurihara, “The average propensity to consume is the ratio of consumption expenditure to any particular level of income.”

According to Peterson, “The average propensity to consume is the ratio between consumption and income at a particular level of income.”

Average Propensity to Consume (APC)

Total Consumption (C)_{= Total Income (Y)}

Introductory Macro Economics

Illustration

If income level is`150 crores out of which`100 crores is spent on

consumption, then APC = C 100 0.66 Y 150

i.e., in economy 66% of income is spent on consumption. APC : Table and Diagram

Table 4

Income (Y) Consumption Expenditure (C)

3 0 0 1 8 0 ^ {1 0 0} = 0. 6 7 _ {1 5 0}

In Fig. 7 CC is consumption curve. At point A of this curve

APC = C 100 0.67
Y 150
Similarly, at point B of this curve
APC = C 180 0.60
Y 300

II. Marginal Propensity to Consume The ratio between the change in consumption and change in income is termed as marginal propensity to consume.

According to Kurihara, “Marginal propensity to consume is the ratio of a change in consumption to a change in income.”

According to Keiser, “The ratio of the change in aggregate consumption to the change in aggregate income is called the marginal propensity to consume.” Symbolically,

M arginal Propensity

to Consume (MPC) Illustration

Change in Consumption ( C) Change in Income ( Y)

If income of a country increases from `200 crores to`400 crores and consumption expenditure increases from ` 160 crores to ` 240 crores, it means that change in income by `200 (i.e., 400 – 200) crores has caused change in consumption expenditure by ` 80 (i.e ., 240 – 160) crores. The Ratio of Change in Consumption to Change

_{in Income, i.e.} MPC will be 80 0.4

MPC : Table and Diagram

^{Fig. 7} Table 5 : Marginal Propensity to Consume Income Change in Income Consumption Change in Consumption (Y) ( Y) (C) ( C) (`crore) (`crore) (`crore) (`crore)

100 200 – 100 80 120 – 80 = 100 = 40 200 120

300 – 200 150 – 120 300 = 100 150 = 30 200

Marginal Propensity to Consume
MPC
=
C
Y
—
40
100 = 0.4
30
100 = 0.3

In Fig. 8, CC is consumption curve. When income

\mathrm{MPC} = \frac {3 0}{\text {}} = 0. 3

increases from `100 crores to`200 crores, consumption

increases from `80 crores to ` 120 crores.

3 0 0 _ {F i g}

Aggregate Demand, Aggregate Supply and Related Concepts.....

23.5.2. Propensity to Save

According to Keynes, saving is a function of income,

i.e., saving depends on income.

\mathrm{S} = f (\mathrm{Y})

Or “Saving is a Function of Income.”

Thus, Propensity to save is the ratio of saving to income at different levels of income.

According to Peterson, “Propensity to save may be defined as a schedule showing amounts that will be saved at different levels of income.”

Types of Propensity to Save

I. Average Propensity to Save (APS) According to Keiser, “The average propensity to save Average propensity to save is the ratio between total is the ratio of savings to income.” savings and total income at a given level of output So, Average Propensity to Save (APS) =Total Savings and employment in the economy.

Total Income

_Or APS S

Y

When does savings become negative ? Negative saving is termed as ‘dissaving ’ which signifies the situation

where consumption (C) exceeds income (Y).

Propensity to Save Curve

C > Y

as a result, component ‘S’ becomes negative in Y = C + S. In other words, past-savings are used in consumption.

Propensity to save has been shown in Fig. 9. SS shows the propensity

の

to save curve. Left to point A, SS curve is negative because people

do not save before income level OA. At point A, saving is zero ( i.e.,

^{at point A, income is equal to consumption) Beyond income level Fig . 9} OA, saving increases because people save more with increased income.

Box 7

Illustration In Fig. 10, SS line shows the average propensity to If income is`100 crores and saving is`50 crores, save. then

Average Propensity to Save S 50_{= 0.5}

This indicates that at the given level of income in

an economy, 50% of the income is saved and the

rest 50% income is consumed.

Average Propensity to Save : Table and Dia

\mathrm{APS} = \frac {6 0}{3 0 0} = 0. 2 \mid

^{Income Saving} Propensity to Save

$^{00}$ |S (`Crores) (`Crores) (APS) Fig . 10 At point A, 300 60 60 300 = 0.2 APS = SY = 60300 = 0.2 600 240 240 = 0.4 Similarly, at point B, 600 APS = SY = 240600 = 0.4

Introductory Macro Economics

II. Marginal Propensity to Save

The ratio between change in saving ( S) caused by change in income ( C) is termed as marginal propensity to save.

Thus, ‘‘The marginal propensity to save is the ratio of change in saving to a change in income.’

Marginal Propensity to Save = Change in Savings Change in Income = S Y ●

Illustration

If the income increases to `400 crores from`200 crores, income change ( Y) becomes Y = 400 – 200 = `200 crores. And hence, saving increases from `50 crores to 100 crores, i.e., increase in saving, ( S) becomes S = 100 – 50 = ` 50 crores.

$S = 80 - 20 = 60$

So, MPS = S = 50 Y 200 = 0.25

i.e., 25% of the increased saving is saved. MPS : Table and Diagram Table 7 : Marginal Propensity to Save Change in Income Change in Income Savings Income Marginal Propensity to (Y) ( Y) (S) ( S) Save (`crore) (`crore) (`crore) (`crore) MPC = S Y 100 --20 ----200 – 100 80 – 20 200 = 100 80 = 60⁶⁰ = 0.6 300 – 200 150 – 80¹⁰⁰ 300 = 100 150 = 70⁷⁰ = 0.7₁₀₀

In Fig. 11, SS is the saving function which represents

Y←

marginal propensity to save

At point A,

and Y = 200 – 100 = 100

Fig. 11

Relation between APC and APS

The addition between average propensity to consume (APC) and average propensity to save (APS) is equal to one.

\mathrm{Y} = \mathrm{C} + \mathrm{S}

\texttt {Y C S C S Y Y Y Y}

1 = \mathrm{CS}

\mathrm{YY}

1 = \mathrm{APC} + \mathrm{APS}

APS can be calculated when APC is given. APS = 1 – APC (because APS + APC = 1)

Similarly, APC can be calculated when APS is given. APC = 1 – APS (because APS + APC = 1)

Box 8

Aggregate Demand, Aggregate Supply and Related Concepts.....

Relation between MPC and MPS

The addition between marginal propensity to consume (MPC) and marginal propensity to save (MPS) is equal to one.

MPC + MPS = 1 because

\mathrm{Y} = \mathrm{C} + \mathrm{S}

\mathrm{Y} _ {\mathrm{=}} \mathrm{CSCS}

\texttt{YYYY}

\mathrm{Or} 1 = \mathrm{MPC} + \mathrm{MPS}

MPC is less than unity but more than zero.

MPS can be calculated when MPC is known.

MPS = 1 – MPC (because MPC + MPS = 1) Similarly, MPC can be calculated when MPS is known. MPC = 1 – MPS (because MPC + MPS = 1)

Box 9

23.6. Investment and Investment Function According to Peterson, “Investment expenditure _{Investment refers to those expenditures which are} includes expenditure for producer’s durable equipment, new

incurred by the producer on the purchase of capital goods^{construction and the change in inventories.”} such as machinery, instrument, raw material for manufacturing^{23.6.1. Types of Investment} etc.

(A) Induced Investment

Induced investment in the economy depends on income and profit. Higher income level increases consumption expenditure which induces the higher possibilities to producers. There is positive relationship between induced investment and level of income. Higher expectation of income and profit increases induced investment and vice versa . In Fig. 12, I I line represents induced investment which rises from left to right. This I I line represents the positive relationship between

Fig . 12

income and investment when income rises to \mathrm { O Y } _ { 2 } from \mathrm { O Y } _ { 1 } investement also increases from \mathrm { O K } _ { 1 } to \mathrm { O K } _ { 2 }

(B) Autonomous Investment

Autonomous investment is independent of income level, i.e., autonomous investment remains uneffected with change in income. Even high expected profit does not affect this autonomous investment. Autonomous investment is such government investment which is done in the economy for increasing aggregate demand level in the economy.

Autonomous

In Fig. 1 3 \mathrm { I _ { a } I _ { a } } is a line showing autonomous investment which is parallel to X-axis. This line shows that autonomous investment remains constant even if income changes. When income increases to \mathrm { O Y } _ { 2 } from \mathrm { O Y } _ { 1 } , investment remains constant at OK ( i . e . , \mathrm { O K } = \mathrm { A Y } _ { 1 } + \mathrm { B Y } _ { 2 } )

Induced Investment Vs. Autonomous Investment

Induced Investment

1. It is guided by profit motive.

2. It is income elastic. (As income increases induced investment also increases.)

3. Its curve slopes upward as it is income elastic.

4. It is generally done by private sector.

Automomous Investment 1. It is done for social welfare.

2. It is independent of income level.

3. Its curve is parallel to X-axis as it is income inelastic.

4. It is done by the government sector.

Box 10

23.6.2. Determining Factors of Investment

I. Marginal Efficiency of Capital

The expected profitability from addition investment is the called ‘marginal efficiency of capital ’.

In other words,‘‘Marginal efficiency of capital is the expected rate of return of an additional unit of capital goods over its cost.’’

Marginal efficiency of capital can be understood with an example. If the supply price of one additional unit of capital is `10,000 and the expected profit from this invesment is `1,000 per annum, marginal efficiency of capital (MEC) will be

1, 000 100 10%

10, 000

The rate of expected profit is termed as the marginal efficiency of capital which is represented in percentage.

The formula determining the MEC is

MEC = Expected Income (Y)

Cost or Supply Pr ice (P)

When represented in percentage,

^{Expected Income (Y) 100MEC} Cost (or Supply Price) P With the above formula MEC is calculated with expected income and supply price at different levels.

(A) Prospective Yield

The prospective yield of an asset is the aggregate net return expected from it during its whole life. The term ‘Net Return ’ is calculated by deducting present cost of the asset from total yields. Prospective yield can be expressed as follows :

\mathbf { P } _ { \mathrm { Y } } = \mathbf { Q } _ { 1 } + \mathbf { Q } _ { 2 } + \mathbf { Q } _ { 3 } + \ldots + \mathbf { Q } _ { n } Where \mathrm { P _ { Y } } represents prospective yield and \mathrm { Q } _ { 1 } , \mathbf { Q } _ { 2 } \ldots \mathbf { Q } _ { n } represent net annual returns.

(B) Supply Price

The expenditure made on capital goods at the time of initial investment is known as supply price. For example, investment made on purchase of new machinery is supply price or cost of investment. It is also known as ‘replacement cost ’.

Estimation of Marginal Efficiency of Capital (MEC)

Having known the values of ‘prospective yield and supply price ’, marginal efficiency ofcapitalcanbeestimated as the rate of discount that equates these two values. Thus,

^{Py1 Py2 Py3 ...... Py n SP =} (1 m) (1 m) (1 m)³ (1 m)ⁿ Here, SP = Supply Price; \mathrm { P _ { y } }

= Prospective

Yield; m = Marginal Efficiency of Capital II. Rate of Interest

The second factor determining the invstment size

is rate of interest. Rate of interest is determined

by demand for money and supply of money. Demand

for money is related to liquidity preference. People

have liquidity preference (i.e., desire to keep cash

money) due to three motives :(i) Transactive Motive,

(ii) Precautionary Motive and (iii) Speculative Motive.

Aggregate Demand, Aggregate Supply and Related Concepts.....

According to Keynes, interest is the reward for parting with liquidity for a specified period.

Money supply being constant in short period, rate

129

of interest is basically dependent on liquidity preference. Higher the liquidity preference level, more will be the rate of interest.

MEC and Rate of Interest

The decisions of investors are influenced by both Marginal Efficiency of Capital (MEC) and rate of interest (r ). As long as the MEC is greater than the rate of interest, the investors will be induced to increase investment till the point where MEC becomes equal to rate of interest, i.e., when MEC is equal to rate of interest, the effect on investment will be passive. If MEC is greater than rate of interest, the investor will increase the investment and on the other hand, if MEC is less than rate of interest, investment will be reduced. Thus, (i) If MEC = r

Passive effect on investment (i.e., investment will neither increase nor decrease). (ii) If MEC > r

Favourable effect on investment (i.e., investment will be increased).

(iii) If MEC < r

Adverse effect on investment (i.e., investment will be reduced.)

^{Box 11} Table 8 shows that at ` 100 crores investment, MEC is 20%. MEC declines as investment increases. At ` 600 crores, MEC declines to 10%.

● Investment Demand Curve

Invesment in a particular capital asset depends on MEC. Marginal efficiency of the capital (MEC) of investment made in all capital assets can be expressed in a schedule which is known as Investment Demand Schedule . Investment demand schedule shows the relationship between investment and MEC. This schedule tells that ‘‘MEC decreases with every increase in investment’’ . There are two reasons of inverse relations between investment and MEC :

(i) Prospective yield declines as more similar machines

are installed.

(ii) Machines become dearer with increased demand which raises the cost.

Table 8 : Diminishing Marginal Efficiency of Capital

Investment Marginal Efficiency of Capital (`crores) (Annual Percentage)
100 20
200 18
300 16
400 14

500 12 600 10 Fig . 14

In Fig. 14 ID is investment demand curve which shows the declining tendency of MEC. This curve also shows that fall in interest rate promotes investment.

☞ Ex-ante and Ex-post Concepts I. Ex-ante Saving and Ex-ante Investment

☞

Investment demand schedule is also affected by existing rate of interest with fall in interest rate, investment demand increases. Thus, when investment demand increases, both MEC and rate of interest decline and become equal to each other. But Keynes presented rate of interest to be independent of investment while according to him MEC is a function of investment.

Box 12

Ex-ante saving and investment refer to the planned saving and investment or desired saving and investment. Ex-ante saving is what the savers plan to save (or intend to save) at different levels of income in the economy. Similarly, ex-ante investment is what the investors plan to invest (or intend to invest) at different levels of income in the economy. Since savers and investors in an economy are different persons and guided by a different set of factors, the level of ex-ante saving may or may not be equal to ex-ante investment corresponding to any level of income.

II. Ex-post Saving and Ex-post Investment

Ex-post saving and investment refer to realised saving and investment in the economy. Ex-post saving and expost investment have identical definition, i.e., ‘‘The ‘excess of income flow over consumption flow in economy during the period of one year. ’’ Accordingly, ex-post saving is always equal to expost investment. In fact, ex-post saving and ex-post investment form an accounting identity and are, therefore, bound to be equal to each other at all levels of income and employment in the economy.

Thus, Saving≡ Investment

S I

(Sign signifies ‘identity’) Box 13 23.7. Full Employment and Involuntary Unemployment

23.7.1. What is Full Employment ?

In Macro Economics, ‘ full employment ’ means a situation in which at a given level of real wage, demand for labour is equal to its available supply. Thus, the term full employment is used to signify a situation in which ordinarily all those people who are willing to work at the prevailing wage rate get work.

In other words, “Full employment is a situation in which all those persons who are able and willing to work, get work, i.e., employment at the prevailing wage rate.”

Full Employment : Definition

In the words of Spencer , “Full employment is a situation in which everyone who wants to work is working except for those who are frictionally and structurally unemployed.”

Box 14

Full employment is not a situation of zero employment. It does not mean lack of unemployment. It simply means that situation in which employment opportunities and qualified job–seekers get equilibrium but some sort of unemployment cannot do denied in this equilibrium. This sort of unemployment may be referred as natural rate of unemployment.

In short, the situation of full employment does not imply a situation of zero unemployment. It is a situation compatible with natural rate of unemployment.

In the words of Ward, “Full employment is a level of employment associated with a normal level of unemployment.” 23.7.2. Involuntary Unemployment

Involuntary unemployment is that situation in which able persons are ready to work at existing wages but jobs are not available to get them absorbed.

Constituents of Aggregate Demand : Aggregate demand has two constituents : (i) Consumption,
(ii) Investment.
Hence,
AD = Consumption Expenditure + Investment Expenditure
AD = C + I
In Open Economy,

Thus, involuntary unemployment is a compulsion to remain unemployed because jobs are not available in the market, although persons are willing to work at the prevailing rate of wages.

According to Hanson, “Involuntary unemployment is a situation in which people are able to work and willing to work at existing rate of wages but do not work.”

Only involuntary unemployment is included in the total estimates of unemployment in the economy. Voluntary unemployment is not considered while estimating

unemployment situation in the country. Voluntary unemployment refers to the situation when a person is unemployed because he is not willing to work at the existing wage rate, even when work is available.

A QUICK REVIEW OF THE CHAPTER

Effective Demand : It signifies that point where aggregate demand equals aggregate supply. Thus, that aggregate demand which equals to the aggregate supply is called effective demand. Aggregate Demand : The total demand for goods and services in an economy is termed as ‘aggregate demand ’ which is expressed in terms of total expenditure made in the economy.

Aggregate Demand = C + I + G + (X – M) = Consumption + Investment + Government Consumption Expenditure + Net Export Aggregate Supply : Aggregate supply can be presented in three forms :

(i) Money value of goods and services produced in an economy, i.e., national income. (ii) Addition of consumption and saving, i.e., C + S.

(iii) Minimum level of income obtained by the firm for continuing their production process.

Aggregate Supply Schedule : This schedule represents the addition of consumption expenditure and saving at various levels of income.

Aggregate Supply = Consumption + Saving

AS = C + S

Aggregate Demand, Aggregate Supply and Related Concepts.....

Consumption Function : This function explains the relationship between income and consumption expenditure.

C = f (Y)

i.e., Consumption is the function of income.

Propensity to Consume : It denotes the consumption levels at various levels of income. Average Propensity to Consume (APC) : It is the ratio of consumption expenditure to any particular level of income.

APC

C Total Consumption

Y Total Income

Marginal Propensity to Consume (MPC) : Marginal propensity to

consume is the ratio of a change in consumption to a change in income.

Marginal Propensity to Consume Change in Consumption

Change in Income

^C MPC_Y

Saving Function : It denotes the relation between saving and income. It shows the desire of savings at various levels of income.

Average Propensity to Save (APS) : It is the ratio of saving to income.

^{S SavingAPS} Y Income

Marginal Propensity to Save (MPS) : It is the ratio of change in saving to a change in income :

^{S Change in SavingMPS} Y Change in Income

Relation between MPC and MPS

MPC + MPS = 1

Or MPC = 1 – MPS

MPS = 1 – MPC

Investment : The expenditure made on the additional at capital goods like machine, equipment, raw material for manufacturing, etc., is called investment.

Investment Function : It refers to the behaviour of investment corresponding to different levels of income/ employment.

Induced Investment : Induced investment in the economy depends upon income and the profit. Investment made with expectation of profit is called induced investment. It depends on (i) marginal efficiency of capital and (ii) rate of interest.

Autonomous Investment : This investment is independent of income and employment. Such investment is made by the government with the motive of social welfare.

Marginal Efficiency of Capital (MEC) : Prospective yield of additional investment is called marginal efficiency of capital.

MEC

Pr ospective Yield

Cost (or Supply Price)

Prospective Yield : Prospective yield of an asset is the aggregate net return expected from it during its whole life-time.

Supply Price : The expenditure made on capital goods at the time of initial investment is known as supply price.

Full Employment : It refers to a situation in which all those who are able to work and are willing to work at the existing wage rate get employment.

Involuntary Unemployment : It occurs in a situation when some people are not getting jobs even when they are able to work and are willing to work at the existing wage rate.

Ex-ante Saving and Investment : Saving and investment as planned by the savers and investors.Exante saving may or may not be equal to ex-ante investment.

Ex-post Saving and Investment : Actual saving and investment as in national income accounting.Expost S = Ex-post I as a matter of accounting identity.

QUESTIONS Ultra Short Answer Type Questions

1. What is the meaning of propensity to consume ?

2. What is the title of Keynes' book published in 1936 ? (J.A.C., 2012)

3. What is APS ? (U.S.E.B., 2014)

4. What is closed economy ? (B.S.E.B., 2014)

5. What is savings function ? (U.S.E.B., 2015)

6. Define full employment. (C.B.S.E./U.S.E.B., 2015; J.A.C ., 2016, 17)

7. Define autonomous investment.

(U.S.E.B ., 2016; J.A.C ., 2016)

8. Explain the meaning of investment.

(Raj. Board , 2016; J.A.C., 2018, 19)

9. What is meant by Gross Investment ?(Raj. Board , 2017) 10. Mention two components of aggregate demand. (Raj. Board , 2017) Very Short Answer Type Questions

10. What is effective demand ? [C.B.S.E. (A.I. ), 2017] Or

Define effective demand.

2. What is the relationship between consumption and income.

( J.A.C., 2015)

3. What is meant by aggregate supply ?

4. What is average propensity to consume ?

5. Define marginal propensity to consume.

(C.B.S.E., 2010; J.A.C., 2012)

6. Why can the value of marginal propensity to consume be not greater than one ?

7. What is meant by aggregate demand ? (U.S.E.B., 2013)

8. Define marginal propensity to save. (J.A.C., 2010)

9. Express the relationship between marginal propensity to save and marginal propensity to consume.

10. What is the value of marginal propensity to consume when marginal propensity to save is zero ? (J.A.C., 2017) 11. Define investment. (Raj. Board, 2013; J.A.C. , 2011, 15) 12. What is induced investment ?

11. What is autonomous investment ?

12. What is Marginal Propensity to Invest ?

13. Give the meaning of Investment Function. (J.A.C. , 2012) 16. What is Involuntary Unemployment ? Define. 17. Give the meaning of ex-ante saving.

14. Give the meaning of ex-ante investment. (C.B.S.E., 2010; U.S.E.B., 2013) 19. Give the meaning of aggregate demand. (C.B.S.E., 2010, J.A.C., 2017) (J.A.C. , 2012) (C.B.S.E. , 2015)

15. Define saving function.

16. Give the meaning of :

(a) Autonomous Consumption (b) Full employment

22. Why does consumption curve not start from origin ? (C.B.S.E., 2018)

Short Answer Type Questions

1. What is the meaning of Aggregate Demand ? Explain the components of Aggregate Demand.

( J.A.C. , 2012, 16; C.B.S.E ., 2016, 18; U.S.E.B., 2019)

2. What is Aggregate Supply ? What are its main components ?

3. Explain Consumption Function. (J.A.C, 2017; B.S.E.B. , 2019)

4. Explain the relationship between Marginal Propensity to Consume and Marginal Propensity to Save. (C.B.S.E. 2015, 17; J.A.C ., 2016)

5. What is the relationship between Average Propensity to Consume and Marginal Propensity to Consume ? Can the value of APS be negative ? If yes, when ?

6. Explain MPC with the help of diagram. (J.A.C. 2016)

7. Distinguish between direct investment and portfolio investment.

8. Savings and investment are always equal. Explain. (B.S.E.B., 2011)

9. Distinguish between voluntary and involuntary unemployment. (C.B.S.E. ,

2011; B.S.E.B., 2013, 18; J.A.C. , 2015, 19] 10. What is meant by average propensity ? Explain marginal propensity to consume and average propensity to consume. (U.S.E.B., 2011) 11. What is the theory of Effective Demand ?

(Raj. Board, 2013, 17) 12. Write the meaning of APC and MPC. Can APC be zero ? (Raj. Board, 2013) 13. Explain AD and AS with the help of a diagram. 14. What is the difference between MPS and APS ?

(B.S.E.B. , 2014) 15. What is liquidity trap ? Explain with the help of diagram. (B.S.E.B., 2014) 16. State and discuss the components of Aggregate demand in a two sector economy. (C.B.S.E., 2019) 17. Define marginal propensity to consume. Why is its value greater than zero but less than one ? (B.S.E.B., 2015) 18. What is the relation between MPS and investment multiplier ? (C.B.S.E. 2015) 19. Which of the following cannot have a negative value ? Give reasons. (C.B.S.E., 2015) (i) Average Propensity to save

(ii) Marginal Propensity to save.

20. Distinguish between marginal propensity to consume and average propensity to consume. Give numerical example. (C.B.S.E ., 2016) 21.

Define the concept of full employment. (U.S.E.B. , 2016) 23. Discuss the working of adjustment mechanism in the following situations :

(a) Aggregate demand is greater than supply.

(b) Ex-Ante investments are lesser than Ex-ante savings. (C.B.S.E., 2019)

Long Answer Type Questions

1. What do you understand by the concept of Full Employment ? Does it refer to a situation of zero unemployment ?

( J.A.C. 2019)

2. Explain Voluntary and Involuntary Unemployment.

3. Explain the concept of effective demand. (U.S.E.B., 2010)

4. Explain the salient points of Keynesian concept of income and employment theory. (U.S.E.B., 2011)

5. What is meant by Involuntary Unemployment ? Explain its causes.

(U.S.E.B., 2011, 13, 17, 19)

Aggregate Demand, Aggregate Supply and Related Concepts.....

6. What do you mean by aggregate demand ? Make a distinction between market demand and aggregate demand.

( B.S.E.B., 2012) 7. Explain the concepts of aggregate demand and aggregate supply with diagrams. (U.S.E.B., 2012) 8. What is Average Propensity to consume ? Explain with the help of table and diagram.

9. What is principle of Effective Demand ? (B.S.E.B., 2015)

10. Explain the changes that take place when aggregate demand aggregate supply are not equal. (C.B.S.E., 2015, 17)

11. Discuss the main features of Keynesian Theory of Employment. (J.A.C ., 2016; J.A.C. , 2018)

12. Explain with the help of diagram how equilibrium level of income is determined by aggregate demand and aggregate supply. (J.A.C ., 2017)

13. Explain the determination of equilibrium level of nataional income using saving and investment approach. Use deiagram. Also explain the effects of saving is greater than investment. (C.B.S.E. , 2017)

Objective Type Questions

(A) Multiple Choice Questions :

1. ‘‘Supply creates its own Demand.’’ Who gave this law ?

( B.S.E.B., 2015, 16) (a) J.B. Say (b) J.S. Mill

(c) Keynes (d) Ricardo

2. Who is the writer of the book ‘General Theory of Employment,

(b) Malthus (d) Marshall

Interest & Money ’ ? (a) Pigou

(c) J.M. Keynes

3. Which of the following is true for Classical Theory of Employment ?

(a) State of full employment in the economy

(b) No possibility of over–or under–production in the economy (c) Both (a) & (b)

(d) None of the above

4. On which factor Keynesian Theory of Employment depends ? (B.S.E.B., 2015, 16, 17;J.A.C., 2018) (a) Effective Demand (b) Supply

(c) Production Efficiency (d) None of the above

5. Which is the determining factor for investment ? (B.S.E.B., 2017, 18, 19)

(a) Marginal Efficiency of Capital

(b) Interest Rate

(c) Both (a) & (b)

(d) None of the above

6. For Keynes, investment implies : (B.S.E.B., 2017) (a) Financial Investment

(c) Both (a) & (b)

(b) Real Investment (d) None of the above

7. With increase in investment, MEC :

(a) Rises (b) Falls

(c) Remains Constant (d) None of the above

8. Which of the following is a Real Investment ?

(a) Purchasing of a Share

(b) Purchasing of Old Factory

(c) Construction of Buildings

(d) Opening Deposit Account in the Bank

9. APC + APS = ? (B.S.E.B. , 2018) (a) 0 (b) 1

(c) (d) None of these 10. MPC + MPS = ?

(a) (b) 2 11. Which one is true ?

(a) MPC + MPS = 0

(c) MPC + MPS = 1

(B.S.E.B., 2011,J.A.C , 2015) (c) 1 (d) 0

( B.S.E.B., 2012, 16, 19) (b) MPC + MPS < 1

(d) MPC + MPS > 1

12. The main component of aggregate demand is : (J.A.C., 2012) (a) Individual consumption (b) Public consumption (c) Investment (d) All the above 13. Who is the writer of the book, "Traited Economic Politique " ? (B.S.E.B., 2015, 16) (a) Pigou (b) J.B. Say

(c) Keynes (d) Ricardo

14. If MPC = 0.5, then Multiplier (k ) will be : (B.S.E.B., 2015)

(a) { \bf \tau } ^ { 1 } \left( { \bf b } \right) = 0 \left( { \bf c } \right) 1 \left( { \bf d } \right) 2 _ { 2 }

15. On which concept does classical viewpoint depend ? (B.S.E.B., 2015) (a) Say's law of Market (b) Perfect Flexibility of Wage Rate (c) Perfect Flexibility of Interest Rate (d) All of these

16. British Economist JM Keynes famous book ‘‘The General Theory’’ was published in which year ? (B.S.E.B. , 2018) (a) 1926 (b) 1936 (c) 1946 (d) 1956

17. Which of the following is known as the state of deficient demand and Keynesian Economy ? (B.S.E.B. , 2018) (a) Full Employment Equilibrium (b) Under full Employment Equilibrium (c) Both (a) and (b) (d) None of these

18. Which of the following is MPC ? (B.S.E.B. , 2018) (a) Y (b) C C Y (c) Y (d) None of these I

19. The Great Depression came in which year ? ( B.S.E.B. , 2018) (a) 1949 (b) 1939 (c) 1930 (d) 1919

20. Suppose in a hypothetical economy, the income rises from ` 5,000 crore to ` 6,000 crore. As a result consumption expenditure rises from` 4,000 crore to` 4,600 crore. Marginal propensity to consume in this case would be : (CBSE, 2019) (a) 0.8 (b) 0.4 (c) 0.2 (d) 0.6 [Ans. 1. (a), 2. (c), 3. (c), 4. (a), 5. (c), 6. (b), 7. (b), 8. (c), 9. (b), 10. (c), 11. (c), 12. (d), 13. (a), 14. (d), 15. (d), 16. (b), 17. (b), 18. (b), 19. (c), 20. (d).]

(B) Fill in the Blanks : 1. ................investment is not related to income level. ^C 2. .... \mathbf { \equiv _ { Y } } 3. APC + ................ = 1 4. ................=Savings Income

5. The expected profitability from additional investment is called.................

6. Law of market is given by ............... .

[Ans. 1. Autonomous, 2. MPC, 3. APS, 4. APS, 5. Marginal Efficiency of Capital, 6. J. B. Say]

134

Introductory Macro Economics

(C) State True/False :

1. Keynesian theory of employment depends on effective demand.

2. Ricardo propounded that supply creates its own demand.

3. Relation of consumption and income known as consumption function.

4. With increase in investment marginal efficiency of capital rises.

5. State of deficient in Keynesian economy is known as under full employment equilibrium.

[Ans. 1. True, 2. False, 3. True, 4. False, 5. True]

(D) Match the following Column :

‘A’

1. J. B. Say

2. Aggregate Demand 3. Market Demand 4. Aggregate Supply

‘B’

(a) Micro Concept

(b) J. B. Say

(c) Consumption + Saving (d) Classical Theory of

Employment
5. Traited Economic Politique (e) Macro Concept [Ans. 1. (a),
2. (e),
3. (a),
4. (c),

[Ans. 1.
J.B. Say,
2.
Induced Investment,
3.
MPC + MPS = 1, 4.
C = f(Y).]

HOTS

High Order Thinking Skills Questions

1. How does the interest rate affect investment demand schedule ? (See : Investment Demand Curve in Section 23.6.2)

2. Why does ‘effective demand’ become a starting point of Keynesian employment theory ?

3. Why did Keynes give preference to aggregate demand in his viewpoint?
(See : Section 23.2)

Income ()
) Savings (

Value Based Questions

VBQ

1. Can savings be negative ?

(See : Box 6)

2. In what way marginal propensity to consume affect the size of multiplier ? (See : Section 23.5.1)

3. What are the determinants of induced investment ? (See : Section 23.6.2)

MDQ

Case Study Based on Evaluation & Multi-disci plinary Questions

1. Can MPC become greater than one ? Why ?

(See : Box 8)

2. Why does consumption function line not originate from origin ?

(See : Box 5)

3. When does saving become negative ?

(See : Box 6)

Numerical Questions

1. An economy is in equilibrium. Calculate MPC.

(C.B.S.E ., 2016)

National Income = 1000 Autonomous Consumption Expenditure = 200 Investment Expenditure = 100 [Ans. MPC = 0·7]

2. C = 100 + 0.4 Y is the Consumption Function of an economy where C is Consumption Expenditure and Y is National Income. Investment expenditure is 1100. Calculate :

( C.B.S.E., 2013) (i) Equilibrium level of National Income. (ii) Consumption expenditure at equilibrium level of

[Ans. S - 40, - 20, 0, 30, 50; APC -,1.2 ,1 , 0.8,0.75 ; MPC -,0.6 , 0.6,0.4, 0.6 ]

4. In an economy investment increases from `1,000 crores to `1,200 crores and as a result, its total income increases by `800 crores. Calculate the marginal propensity to consume. (MPC) [Ans. MPC = 0·75] (J.A.C., 2015)

5. In an economy, S = – 100 + 0.6 Y is the saving function, where S is Saving and Y is National Income. If investment expenditure is 1100, Calculate : (C.B.S.E., 2013) (i) Equilibrium level of National Income. (ii) Consumption expenditure at equilibrium level of Na tional Income.

[ Ans. (i) Y = 2,000; (ii) C = 900.] 6. Given that national income is`80 crores and consumption expenditure is`64 crores, find out average propensity to save. When income rises to`100 crores and consumption expenditure to`78 crores, what will be the average propensity to consume and the marginal propensity to consume ?

(C.B.S.E., 2011) [Ans. APS = 0·2; APC = 0·78; MPC = 0·70]

7. If national income is `50 crores and Saving`5 crores, find out average propensity to consume. When income rises to` 60 crores and saving to`9 crores, what will be the average propensity to consume and the marginal propensity to save ? (C.B.S.E. , 2011) [Ans. APC = 0·9; APC = 0·85; MPC = 6]

Aggregate Demand, Aggregate Supply and Related Concepts.....

8. Complete the following table:
Income Marginal Saving Propensity to Consume
0 — — 100 0·6 — 200 0·6 — 300 0·6 —
[Ans. S = 90, 40, 80, 120; APS = -, 0.4, 0.4, 0.4]
9. Complete the following table:
Income (
)
Consumption Marginal proExpenditure (
)
'pensity to Save 0 80 — 100 140 0.4 200 — — — 240 — — 260 0.8
Average Propensity to Save
—
—
—
—
( C.B.S.E., 2013) Average Propensity to Save
—
—

0 0.25 0.35

[Ans. Y 0, 100, 200,320, 400 ; C 80, 140, 200, 240, 260; MPS –, 0.4,0.4, 0.67 , 0.8; APS –, – 0.4 , 0, 0.25, 0.35] NCERT CORNER

Q. 1. What is marginal propensity to consume ? How is it related to marginal propensity to save ? Ans. See, Box 9.

Q. 2. What is the difference between ex-ante investment and ex-post investment ? Ans. See, Box 13.

Q. 3. Measure the level of ex-ante aggregate demand when autonomous investment and consumption expendi ture (A) is `50 crores and MPS is 0.2 and level of in come (Y) is `4,000 crores. State whether the economy is in equilibrium or not (cite reasons).

Ans. Level of Income (Y) =`4,000 crores Autonomous Expenditure =`50 crores

MPS = 0.2

Hence, MPC = 1 – 0.2 = 0.8

Y = A+c .Y = 50 + 0.8 × 4,000 = 50 + 3,200 =`3,250 crores Thus, the level ofex-ante aggregate demand =`3,250 crores. Sinceex-ante aggregate demand falls short of the level of income (output), there is excess supply. Hence Y = 4,000 is not the equilibrium of output in the economy.

□

24

SHORT RUN EQUILIBRIUM OUTPUT

STUDY MATERIAL INCLUDED IN THE CHAPTER

24.1. Income and Production Equilibrium Analysis : Meaning 24.2. Equilibrium Analysis of Income/Output : Classical Viewpoint 24.3. Short-Run Equilibrium : Keynesian Viewpoint A Quick Review of the Chapter Questions High Order Thinking Skills (HOTS) Questions Value Based Questions (VBQ) Case Study Based on Evaluation & Multi-disciplinary Questions (MDQ) NCERT Corner.

24.1. Income and Production Equilibrium Analysis : Meaning

In Macro Economics, equilibrium levels of income, production and employment are treated as synonyms. In other words, Macro Economics does not accept any difference between ‘income ’, ‘employment ’ and ‘production ’ and hence, income equilibrium implies ‘production equilibrium ’ and ‘production equilibrium ’ implies ‘employment equilibrium ’.

Equilibrium Level = of Income

Equilibrium Level = of Production

Equilibrium Level of Employment Y= O = N

The identity among the above three can be understood as follows : (i) National Income, implies ‘value addition ’ and in an economy ‘value addition’ equals, ‘income generation’. In other words, production and income are two faces of the same coin, i.e. , they do not have any difference. (ii) Keynesian analysis is short-term analysis which assumes no change in production technique. As a result, production increases only when employment increases. In other words, production increases in the same proportion in which employment increases. Hence, no difference appears between level of production and level of employment.

Above analysis shows that income, employment and production—all three are same and have identity among them.

☞ Income/production level in the economy can be studied from two viewpoints : 1. Aggregate Demand and Aggregate Supply Approach in which

Aggregate Demand = Aggregate Supply AD = AS 2. Saving and

Investment Approach in which Saving = Investment S= I Box 1 24.2. Equilibrium Analysis of Income/Output : Classical Viewpoint

Classical economists (Ricardo, J.B. Say, J.S. Mill, etc.) put the view that the equilibrium among income, production and employment can be analysed from two viewpoints :

(i) When aggregate demand equals aggregate supply, (ii) When savings equal investment.

According to the classical views, in a free economy, equality between aggregate demand and aggregate supply is a general equilibrium condition which is attained at full employment level in the economy.

The above conclusion of the classicals, is based on the following three concepts:

1. Say’s Law of Market.

2. Perfect Flexibility in Wage Rate.

3. Perfect Flexibility in Interest Rate.

4. Say’s Law of Market

J. B. Say in his book ‘Traited Economic Politique ’ propounded a law which is known as ‘Say’s Law of Market ’.

According to this law, ‘‘ Supply creates its own demand .’’

It implies that production increases supply on one hand and brings increase in demand via more income earning by factors of production. Hence, additional income earned by factors in production process is spent on produced goods and as a result, increased supply is automatically demanded.

☞ Working of Say’s Law

Collective Efforts of Factors Production of Additional Supply worth of ` 200 crores `200 crores

Additional Income earned by Factors ` 200 crores Additional

Demand of Demand = Supply ` 200 crores i.e. , No overproduction and state of full employment

Box 2 2. Perfect Flexibility in Wage Rate According to Pigou , ‘flexibility in wages ’ or the ‘wage cuts ’ maintains the full employment state in the economy in a natural way. If the economy faces some unemployment, wages will be reduced and this fall in wages will ensure employment to more labours by the producers. Hence, unemployment will automatically be eliminated.

3. Perfect Flexibility in Interest Rate Interest rate is influenced by saving and investment. In short period, if saving exceeds investment, interest rate falls which will induce more investment and again savings will be equal to investment. Hence, flexibility in interest rate maintains equality between saving and investment.

Conclusions of Classical Viewpoint

● Every economy works at full employment level.

● Economy has a capacity of self-adjustment. Whatever is produced in an economy, is automatically consumed, i.e. , supply creates its own demand. ● Over-production is impossible in an economy because every additional production generates additional income and as a result, total income equals total saving.

● General unemployment in the economy is not possible because no possibility of over-production arises in the economy.

Box 3 24.3. Short-Run Equilibrium : Keynesian Viewpoint

Income (or production) equilibrium implies that level of income/production at which aggregate demand (AD) becomes equal to aggregate supply (AS) in the economy.

Aggregate supply denotes the flow of goods and services in the economy and it can be measured in terms of ‘value added ’ or income generation.

Income (Y) has two components—(i) Consumption and (ii) Saving.

Hence, Aggregate Supply = Income

= Consumption + Saving AS = Y

= C + S ...(1)
Aggregate demand denotes the total demand of goods and services in the economy. It can be measured in terms of total expenditure made on buying goods and services.
Expenditure includes two components—(i) Consumption Expenditure and (ii) Investment Expenditure.
Hence,
Aggregate Demand = Consumption Expenditure + Investment Expenditure
AD = C + I ...(2)
Combining both equations (1) and (2)
AD = AS
C + I = C + S
⇒ I = S
i.e., aggregate investment equals aggregate savings in the economy. Hence, income equilibrium level can also be explained with alternative viewpoint or 'equality of saving and investment'.
Thus,
(i) If AD = AS
or C + I = AS = C + S
or I = S
Output level will be in equilibrium.
(ii) If AD > AS
i.e., I > S
or S < I
Output level will be increasing.
(iii) If AD < AS
i.e., S > I
or I < S
Output level will be decreasing.
Determination of Equilibrium Level of Income under Keynesian Framework
(I)
Aggregate Demand and Aggregate Supply Viewpoint or Effective Demand Viewpoint (II)
Saving and Investment Viewpoint

I. Keynesian Viewpoint of Aggregate Demand and Aggregate Supply According to Keynes, an economy obtains the equilibrium at that level of income and employment where aggregate demand equals aggregate supply (i.e. , Saving = Investment). The point where aggregate demand equals aggregate supply, is called point of ‘Effective Demand ’. Fig . 1

Hence, according to Keynes, there are two important determinants of income and employment : (i) Aggregate Demand, (ii) Aggregate Supply. (i) Aggregate Demand ¹ : Aggregate demand refers

the total demand of goods and services in an economy during a year. Aggregate demand is expressed in terms of total expenditure in the economy which includes both consumption and investment expenditures, i.e. , Aggregate Demand = Consumption Expenditure

+ Investment Expenditure AD = C + I

(ii) Aggregate Supply ¹ : Aggregate supply denotes total production of goods and services in the economy. In other words, aggregate supply is equal to national income.

Hence, AS = Y

In Fig. 2, AS is the aggregate supply curve which is a straight line starting from origin and making 45° angle with the axis.
Aggregate supply changes in the same ratio in which employment changes in the Fig. 2 economy.
- Determination of Equilibrium Income

In an economy, income equilibrium is determined at a point where the elements of aggregate demand schedule and aggregate supply schedule become equal.

Aggregate demand schedule denotes the total demand of goods and services (or consumption and investment) in the economy while aggregate supply schedule represents total production of goods and services. Both the schedules have been shown in Table 1.

Table 1 : Aggregate Demand and Aggregate Supply Schedules (

Crore)) Income Level Aggregate Demand Aggregate Supply (Y) AD = C + I AS = Y = C + S 0 150 0

100 200 100 AD > AS
200 250 200
300 300 300 AD = AS
400 350 400
500 400 500 AS > AD

1 For detailed explanation of ‘Aggregate Demand ’ and ‘Aggregate Supply ’ please refer Chapter 23.

Table 1 shows that at income level ` 300 crores, aggregate demand equals aggregate supply. Hence, ` 300 crores will be the level of income equilibrium. It is also called equilibrium employment level and point of effective demand.

● If Aggregate Demand is not equal to Aggregate Supply

At the point of income (or employment) equilibrium, AD becomes equal to AS. But we can also find two situations of inequality between AD and AS. 1. What happens if AD > AS ?

In this situation, firm will employ more factors

to match AD with AS and it will result an increase in employment and income which brings equality between AD and AS.

2. What happens if AS > AD ?

In this situation, firms have to cut down the production level which makes a few factors unemployed. Income level will fall and consequently production or aggregate supply falls till the point where AD becomes equal to AS.

Thus, an economy may face fluctuations in employment level but economy has a tendency to remain at equilibrium where AD = AS.

A necessary condition of equilibrium (income level or employment level) in an economy is Aggregate Demand = Aggregate Supply

C + I = C + S

or I = S

Keynesian equilibrium process is as follows :

Equilibrium in Employment

Aggregate Demand AD = Aggregate Supply AS (A) (B)

If AS > AD Increase in employment of factors

^{If AD > AS} →Increase in Decrease in employment of factors→Decrease in production of goods and services and at last production of goods and services and at last AD = AS AD = AS Box 4

● Determination of Equilibrium Income : Diagrammatical Representation

Fig. 3 shows the determination of equilibrium level.

(i) AD curve (C + I) cuts AS curve (Y = C + S) at point E where the equilibrium

income level is `300 crores.

(ii) If income falls short of ` 300 crores, aggregate supply will be less than aggregate demand. For increasing supply, firms will employ more factors and as a result, employment and income level rise. Consequently,

equilibrium

is re-established at the level of ` 300 crores.

(iii) If income exceeds ` 300 crores, aggregate demand will be more than aggregate

supply. Firms will cut down the employment and production level.

Consequently

income level falls and equilibrium is re-established at point E._{Fig . 3}

Change in Equilibrium Income appears only due to Change in Aggregate Demand

Income and employment equilibrium level is established in the economy where

aggregate demand (AD) and aggregate supply (AS).

Aggregate supply is affected by technological conditions of production. As technological condition cannot be changed in short period, aggregate supply remains

constant in short period.

Hence, Keynes accepts aggregate demand as a sole responsible factor in determination of employment level. That’s why, Keynesian employment theory is

also called as ‘Theory of Aggregate Demand ’.

Thus, according to Keynes, only change in aggregate demand brings change in equilibrium level of income. As aggregate demand curve moves upward,

income_{Fig . 4and employment level increase, in the economy (as shown in Fig. 4).} \dot { \cdot } F i g

In Fig. 4 AD and AS curves cut each other at point E where income and employment level is OY. AS aggregate demand increases AD curve shifts upwards to \mathrm { A D } _ { 1 } which cuts AS at point \mathrm { E } _ { 1 } . At new equilibrium, income and employment level increase to \mathrm { O Y } _ { 1 } from OY.

Box 5 II. Keynesian Saving-Investment Viewpoint According to Keynes, income-employment equilibrium is determined at a point where saving is equal to investment.

Or Saving = Investment

An economy has two types of investments : 1. Planned Investment,

2. Unplanned Investment.

The real investment in the economy is the addition of planned investment and unplanned investment.

\mathrm{I} _ {\mathrm{R}} = \mathrm{I} _ {\mathrm{P}} + \mathrm{I} _ {\mathrm{U}}

where, \mathrm { { I _ { R } } = } Real Investment.

I_P = Planned Investment. Table 2 Income Consumption

0 100 100 150 200 200 300 250 400 300 500 350 600 400 $I_{U}$ = Unplanned Investment. It can be concluded from the above equation that real investment can be equal to planned investment only when unplanned investment becomes zero. But it does not mean that real investment and planned investment are always equal in the economy. Thus, when we say $Y = C + I$ we actually mean $Y = C + I_{R}$ and $Y = C + S$ Hence, on combining both equations $C + S = C + I_{R}$

Or S = I_{R} Thus, savings are always equal to real investment. Saving Investment (Y - C) (I)

-100 100 -50 100 0 100 +50 100 +100 100 +150 100 +200 100

Table 2 shows that when income is determined at the level 400, saving and investment both become equal to 100.

i.e. , at income level 400,

S = I = 100

Fig. 5 represents saving investment viewpoint of income equilibrium. In Fig. 5, II is investment curve and SS is saving curve. II is horizontal to X-axis as it represents autonomous investment. SS curve originates from the point below origin O which shows that till point A saving is negative. At point A, saving has become zero and beyond it become positive. Point E stands as point of equilibrium where II and SS cut each

Fig.

5

other. At this equilibrium point, the determined income level is ` 400 crores.

Income Equilibrium level in Keynesian Viewpoint Represents ‘under full Employment’ Situations.

● Classical viewpoint explains the income equilibrium level at full employment level, i.e. , aggregate demand can equal aggregate supply only at a point of full employment.

● Contrary to it, according to Keynesian viewpoint aggregate demand equals aggregate supply at the point before full employment level (i. e. , takes place at underfull employment level). Aggregate demand has to be increased for increasing employment in the economy.

i.e. , in Keynesian viewpoint, underfull employment equilibrium can be converted to full employment equilibrium only by increasing aggregate demand.

According to Keynes, ‘‘Under employment equilibrium is a situation in which aggregate demand (which is less than full employment aggregate demand) is equal to aggregate supply so that there is equilibrium but some resources remain unemployed.’’

In this situation, factors are not fully employed and all labourers do not get employment. According to Keynes, under employment situation appears due to deficient aggregate demand but not due to deficiency of aggregate supply. In Fig. 6, at \mathrm { O N } _ { 1 } employment level, AD = AS but it is a situation of underfull employment. When aggregate demand AD increases to \mathrm { A D } _ { 1 } , full employment level ON is obtained.

Fig. 6 Box 6

A QUICK REVIEW OF THE CHAPTER

● In an economy, Income Equilibrium Level = Output Equilibrium Level = Employment

Equilibrium Level Y= O = N ● Equilibrium Analysis of

Income/Output/Employment : It implies that situation in which

(i) Aggregate Demand = Aggregate Supply

AD = AS

Or (ii) Consumption + Saving = Consumption + Investment

$C + S = C + I$

Or (iii) Saving = Investment

S= I

● Classical Concept of Equilibrium :

(i) Every economy works at full employment level.

(ii) Economy has a capacity of self-adjustment. Whatever is produced in an economy, is automatically consumed, i.e. , supply creates its own demand.

(iii) Over-production is impossible in an economy because every additional production generates additional income and as a result, total income equals total saving.

(iv) General unemployment in the economy is not possible because no possibility of over-production arises in the economy.

(v) Wage flexibility helps in eliminating unemployment in the economy.

(vi) Interest flexibility maintains the equality between saving and investment.

● Keynesian Concept of Equilibrium : Keynesian analysis of

Income/Output/Employment equilibrium can

be studied from two viewpoints :

(A) AS = AD Approach

According to this approach, employment level is determined at a point where AS = AD

(B) S = I Approach

According to this approach, income and employment level is determined at the point where S = I

● Effect of Increase in Aggregate Demand : When aggregate demand rises the level of income and

employment increases in the economy and vice versa .

QUESTIONS Very Short Answer Type Questions

1. What does Say’s law state ?

2. Who determines S and I in the classical model ?

$5,100=25,500_{Y=0.2}$

3. Write an equation for C function in the Keynesian framework.

4. Write an equation for S function in the Keynesian framework.

Short Answer Type Questions

1. Explain determination of equilibrium level of income using ‘consumption plus investment’ approach. Use diagram.

2. Explain determination of equilibrium level of income using ‘savinginvestment’ approach. Use diagram.

3. Outline the steps taken in deriving consumption curve from the saving curve. Use diagram. (C.B.S.E., 2012) 4. Calculate the equilibrium level of income in the economy : (C.B.S.E., 2015) C = 500 + 0.9Y

Investment Expenditure = 3000

[ \text {Ans.} \mathrm{Y} = \mathrm{C} + \mathrm{I}

\mathrm{Y} = 5 0 0 + 0. 9 \mathrm{Y} + 3, 0 0 0 \mathrm{Y} - 0. 9 \mathrm{Y} = 3, 5 0 0

0. 1 \mathrm{Y} = 3, 5 0 0

$\mathrm{Y}=35,000]$

5. S = – 100 + 0.2 Y is the saving function in an economy. Investment expenditure is 5,000. Calculate the equilibrium level of income. (C.B.S.E., 2015) [Ans .Y=C + S

$Y=C+I$

\Rightarrow \mathrm{S=I}

- 1 0 0 + 0. 2 \mathrm{Y} = 5, 0 0 0

6. Explain the meaning of under-employment equilibrium. (C.B.S.E., 2015) Long Answer Type Questions

7. Explain the equilibrium level of income with the help of saving and investment curves. (J.A.C. , 2016)

8. Why should Planned Savings and Planned Investment be equal at equilibrium level of income ? Explain with the help of a diagram. Or

‘‘There is an obvious identity between saving and investment.’’ Examine the statement critically. (J.A.C., 2018)

3. Explain the concept of Unemployment Equilibrium with the help of a diagram. Show on the same diagram the Additional Investment Expenditure required to reach Full Employment Equilibrium. (J.A.C. , 2011)

4. Explain J. B. Say’s Market Law.

5. How employment is determined by saving and investment ? (B.S.E.B. , 2019)

6. Explain all the changes that will take place in an economy when aggregate demand is not equal to aggregate supply. (C.B.S.E., 2013)

7. Explain briefly the different methods of determining income and employment. (J.A.C., 2013)

8. Explain the main points of Keynesian Theory of Income and Employment. (B.S.E.B., 2014)

9. How are income and employment determined in two-sector economy ? (B.S.E.B., 2014) 10. How is the classical concept of Aggregate supply is different from the Keynesian concept of Aggregate supply ? Explain. (U.S.E.B., 2015) 11. The value of m.p.c. is 0.6 and initial income in the economy is ` 100 crores. Prepare a schedule showing Income, Consumption and Saving. Also show the equilibrium level of income by assuming antonomous investment of ` 80 crores. (C.B.S.E., 2018) Objective Type Questions Questions

(A) Multiple Choice Questions :

1. Who is the writer of ‘Traited Economic Politique ’ ?

( B.S.E.B. , 2015, 16) (a) Pigou (b) J.B. Say

(c) J.M. Keynes (d) Ricardo

2. On which concept, classical viewpoint depends upon ?

(a) Say’s Law of Market

(b) Perfect Flexibility of Wage Rate

(c) Perfect Flexibility of Interest Rate

(d) All the above

3. “Wage cut maintains full employment in the economy.” Who put forward this view ?

(a) Pigou (b) Keynes

(c) Marshall (d) None of the above

4. Which one of the following is the determining factor of Equilibrium Income in Keynesian Viewpoint ?

(a) Aggregate Demand (c) Both (a) & (b)

( B.S.E.B. , 2011) (b) Aggregate Supply

(d) None of the above

5. In Keynesian viewpoint, the equilibrium level of income and employment in the economy will be established where : (a) AD > AS (b) AS > AD (c) AD = AS (d) None of the above

6. According to saving-investment viewpoint, incomeemployment equilibrium will be determined at a point where : (a) S > I (b) I > S (c) S = I (d) None of the above

7. Increase in aggregate demand of equilibrium level of income and employment causes increase in : (B.S.E.B ., 2016) (b) Production

(d) All the above (a) Employment

(c) Income

8. Which one is correct ? (a) Y = C + I

(c) C + S = C + I

9. On which of the following Keynesian theory of employment depends upon ? (B.S.E.B., 2011) (a) Effective demand (b) Supply

(c) Production efficiency (d) None of the above (b) Y = 0 = N

(d) All the above

10. Keynes theory is associated with : (a) Effective demand

(c) Propensity to save

[Ans. 1. (b), 2. (d), 3. (a), 4. (c), 5. (c), 6. (c), 7. (d), 8. (d), 9. (a), 10. (d)]

(B) Fill in the Blanks :

1. In an economy, national income implies value additions which equals...............

2. In classical viewpoint................cut can eliminate unemployment.

3. Effective demand concept was given by................

4. If AD > AS,................in employment will take place.

5. Keynes presented the concept of................employment equilibrium.

[Ans. 1. income generation, 2. wage, 3. Keynes, 4. increase, 5. under]

(C) State True/False :

1. According to Pigou wage cut maintains full employment in the economy.

2. Increase in aggregate demand of equilibrium level of income and production causes increase in employment, production and income.

3. According to classical viewpoint wage cut can increase unemployment.

4. In an economy, national income implies value addition which is equal to income generation.

[Ans. 1. True, 2. True, 3. False, 4. True]

( B.S.E.B., 2012) (b) Propensity to consume (d) All the above

(D) Match the following Column : ‘A’

1. Classical Economist

2. Aggregate Demeand

3. Equilibrium Level of Income

4. Wage Cut

[Ans. 1. (b), 2. (d), 3. (a), 4. (c)] (E) Answer in One Word : ‘B’

(a) Equilibrium Level of Production

(b) J.S. Mill

(c) Elimination of Unemployment

(d) C + I

1. Who gave the concept of effective demand ?

2. According to classical viewpoint, which factor can eliminate unemployment ?

3. Who gave the concpt of eliminating unemployment by wage cut ?

4. Which employment level is shown by Keynesian concept at Income Equilibrium level ?

[Ans. 1. J.M. Keynes, 2. Wage cut, 3. Pigou, 4. Under full employment.]

HOTS High Order Thinking Skills Questions

1. What happens if AD > AS prior to the full employment level of output ? (See : Heading ‘‘What happens if AD > AS ?’’ in Section 24.3)

2. Why did classical economists present the view of “no situation of over production” ? (See : Box 3)

3. On what basis did Keynes present ‘under-full employment’ situation ? (See : Box 6)

VBQ Value Based Questions

1. What is the relation of aggregate demand with employment level ? (See : Box 6)

2. What is the Keynesian Saving-Investment Viewpoint ? (See : Part II of Section 24.3)

3. Classical economists treated perfect flexibility in interest rate. This perfect flexibility maintains the equality between savings and investment. How ? (See : Section 24.2)

MDQ Case Study Based on Evaluation & Multi-disci plinary Questions

1. Who gave the view of no possibility of general unemployment in the economy and on what grounds ?

(See : Box 3)

2. How does a wage cut maintain full employment in classical viewpoint ? (See : Perfect Flexibility in Wage Rate in Section 24.2)

3. Income equilibrium level of Keynesian concept does not represent full employment level. Explain.

(See : Box 6)

NCERT CORNER

Q. 1. What do you understand by ‘parametric shift of a line’ ? How does a line shift when its (i) slope decreases and (ii) its intercept increases ?

Ans. Let consumption function be
C = a + b Y
or C = 4 + 0.5Y
Two Situations
When a change from 4 to 5 When b changes from 0.5 to 1 Parallel Shift in the Curve Parametric Shift in the Curve
Fig. 7 Fig. 8

Hence, when intercept changes Hence, when slope changes there is there is parallel shift in the curve. parametric shift in the curve.

Q. 2. What is ‘effective demand’ ? How will you derive the autonomous expenditure multiplier when price of final goods and the rate of interest are given ?

Ans. See Chapter 24, Section 24.3 and Chapter 25, Section 25.1.

1

INVESTMENT MULTIPLIER AND

ITS MECHANISM

STUDY MATERIAL INCLUDED IN THE CHAPTER

25.1 Investment Multiplier25.2 Relation between Multiplier and MPC25.3 Mechanism or Working of Multiplier

25.4 Numerical Illustrations A Quick Review of the Chapter Questions High Order Thinking Skills (HOTS) Questions Value Based Questions (VBQ) Case Study Based on Evaluation & Multi-disciplinary Questions (MDQ)

25.1 Investment Multiplier

The concept of multiplier is an important concept

of Keynesian Theory of income, production and employment.

According to Keynes, when some autonomous investment

is made in the economy, income increases but increase

in income is not exactly the same as increase in

investment, rather it is many times more than the

increased investment. The number of times it increases

is calledmultiplier .

According toDillard ,“Investment multiplier is the ratio of an increase of income to given increase in investment.”

Thus, the multiplier is the ratio of change in income to the change in investment. So, Keynesian multiplier is known as investment or income multiplier.

Investment Multiplier : Formula The formula of investment multiplier can be expressed as follows :

Keynesian concept of multiplier establishes a relationship between additional investment and additional income. That is why it is called Investment Multiplier. It is the ratio between change in income and change in investment. It shows that with an increase in investment, there is initially an increase in consumption and finally many times more increase in income. For example, if by increasing investment by`10 crores, ultimate increase in income is`60 crores,

then multiplier will be 60 10 = 6. In short,it can be said that multiplier is that number which when multiplied by the amount of change in investment gives us the value of consequent change in income.

Investment Multiplier : Definitions

According toKeynes , “Investment multiplier tells us that when there is an increment of aggregate investment, income will increase by an amount which is K times the increment of investment .”

Where, K = Multiplier Y = Change in Income

I = Change in Investment Investment multiplier can be illustrated with an example. If the government makes an investment of ` 20 crores in the economy and as a result, additional income of ` 100 crores is created in the economy, then Investment Multiplier (K)

20

Multiplier refers to change in income due to change in investment and it is the ratio of change in income to the change in investment.

Multiplier (K) =
Y
I
Change in Income Y

$^{=}$ Change in Investment I Box 1 Investment Multiplier and its Mechanism

K =
Y
I
Y = C + I Similarly Y = C + I Or I = Y - C ... (1)

25.2 Relation between Multiplier and MPC Table 1 : MPC and Value of Multiplier

Keynesian investment multiplier depends on marginal propensity to consume (MPC). Higher the marginal propensity to consume, greater will be the size of multiplier. On the contrary, lower the MPC, smaller will be the size of multiplier.

So, there is direct relation between multiplier and marginal propensity to consume. ¹ Multiplier (K) =_{1 MPC} We know that

...(3) (Here I = Change in Investment, Y = Change in Income and C = Change in Consumption). Putting the value of I in equation (1), we have Y

Dividing right hand side of the equation by Y, Y (Here K = Multiplier, MPC = Marginal Propensity to Consume, MPS = Marginal Propensity to Save).

Or
1
K 1 MPC
MPC C Y
Or
1 1
K 1 MPC MPS
( MPS = 1- MPC)

It is clear that by knowing the value of either MPC or MPS, the value of multiplier can be calculated. Higher the MPC, greater will be the value of multiplier. On the other hand, higher the MPS, smaller will be the value of multiplier. Thus, MPCand multiplier are directly related while MPS and multiplier are inversely related.

If MPC = 13, then
Multiplier (K) = 1 1 1 3 1.5 1 MPC 1 2 21 3 3
Marginal Propensity to Multiplier MPC
C
1
Consume Y K 1 MPC
1 1 10 K = 1 MPC 1 0
1 K = 1 1 1.5 3 1 21 3 3
1 K = 1 1 2 2 1 11 2 2
2 K = 1 1 3 3 2 11 3 3
3 K = 1 1 4 4 3 11 4 4
8 K = 1 1 5 10 8 2 1 10 10
1 11 K = 1 1 0

Thus, when MPC is zero, multiplier is one. Similarly, when MPC is unity (i.e., one), multiplier is infinity ( ). Between these two extremes, value of multiplier may be determined depending on the size of MPC.

Some Important Conclusions

(1) MPC and Multiplier have direct relationship, i.e. , multiplier increases with increase in MPC and decreases with decreases in MPC.

(2) MPS and multiplier have inverse relationship, i.e. , multiplier decreases with increase in MPS and increases with decrease in MPS.

(3) Generally, MPC is not zero but when the consumer saves his entire income, MPC becomes zero and with zero MPC, multiplier becomes unity (i.e. , one).

(4) When MPC is unity, i.e. , entire income is spent, value of multiplier becomes infinity.

(5) Generally, the value of multiplier is neither unity, nor infinity. It ranges between unity and infinity because in real life neither consumes his entire income, nor he saves the entire income. In real life, the value of MPC is less than one and greater than zero.

Box 2

146

Introductory Macro Economics

25.3 Mechanism or Working of Multiplier

Process of Multiplier

(I) (II)

Forward Action Backward Action

Many times multiplication in income due to increase in investment Many times reduction in income due to decrease in investment

I. Forward Action of Multiplier

Forward action of multiplier indicates that as a result of increase in initial investment, there are several times more increase in ultimate income. For instance, supposing investment increases by`100 crores and MPC is 0.5, then income will increase to`200 crores because

^{Multiplier = 1 1 1 2} 1 MPC 1 0.5 0.5

^Y Hence, K =_I

Or Y = K. I

$= 2 \times 100 = 200$

This process of multiplier can be explained with following example :

Due to initial increase in investment by `100 crores, in the first round additional income of ` 50 crores will be created because first group of consumers will consume only 50% of their income (as MPC = 0.5). Again in second round`25 crores will be added (which is 50% of`50 crores). Similarly`12.5 crores in third round and ` 6.25 crores additional income will be created in fourth and in fifth round ` 3.12 crores respectively. This process will continue till total additional income of ` 200 crores is created, i.e. , first two times of initial investment. Table 2 shows how income increases by`200 crores with investment of ` 100 crores.

Table 2 : Working of Multiplier

(Let MPC=0.5) (` crores)

^{Initial Increase in Increase in Increase inRound} Investment I Income Y Consumption C

Saving S 1 100 50 50 50

2

50 25 25

3 25 12.50 12.50

4 12.50 6.25 6.25

5 6.25 3.12 3.12

0 0 0 At Last 100 200 100 100

Above table 2 shows that with initial investment of ` 100 crores, total income will be increased by ` 200 crores and saving will also increase by ` 100 crores.

It proves that

Multiplier =

Change in Income 200 2 Change in Investment 100

Investment Multiplier and its Mechanism

Diagrammatic Representation

Multiplier working is also shown in Fig. 1. With given MPC = 0.5, multiplier will be 2.

Fig. 1
In Fig. 1, II and SS represent investment and saving curves which cut each other at point E where equilibrium income level is OY. Supposing, investment is increased by`100 crore ( i . e . , \mathrm { { I } } = 1 0 0 ) , investment curve moves to \mathrm { I } _ { 1 } \mathrm { I } _ { 1 } which cuts saving curve at point A where new equilibrium income level is \mathrm { O Y } _ { 1 } . Thus, increase in investment ( \mathrm { ~ I ~ } = 1 0 0 ) brings increase in income ( { \mathrm { ~ Y ~ } } = 2 0 0 ) with MPC being equal to 0.5. Fig. clearly shows that income increases more than initial investment made in the economy.

II. Backward Action of Multiplier

Multiplier is a double-edged instrument. It also works in reverse direction. Backward action of multiplier shows that as a result of decrease in initial investment, there is several times more decrease in final income. It is also called reverse action of the multiplier. Supposing in an economy, investment falls from ` 200 crores to`100 crores,i.e. , investment decreases by`100 crores. If multiplier is 2, then income will finally decrease by`100 crores × 2 =`200 crores. According toProf. Samuelson ,“The multiplier is a two-edged sword. It will cut for you or against you. It will amplify new investment as we have seen. It will amplify downward decrease in investment.”

Multiplier Process

The working of the multiplier assumes the following process :

Change in investment causes change in income. As a result, there is change in consumption. Consumption expenditure of one person is an income of the other. Hence, change in consumption leads to change in income. This process continues till C falls to zero. Process of multiplier works in two ways. With increase in investment, multiplier increases income many times more. It is called forward action of the multiplier. On the contrary, with decrease in investment, multiplier decreases income many times more. It is called backward action of the multiplier .

Box 3 25.4 Numerical Illustrations ` 500 crores × 0.7

Illustration 1

If an economy wants to generate additional income of `500 crores, what amount of initial

investment will be required
if MPC = (i) 0·3, (ii) 0·4 ?
Solution :
We know that
= `350 crores Ans. In I = `500 crores × (1 - 0·4) `500 crores × 0·6 = `300 crores Ans.

Illustration 2

How much additional income will be generated in the economy if additional investment is `100

crores with MPC = 1 2 ?Solution :
K =
Y
I
1= MPS
1= 1 MPC
1
Y = I1-MPC
Or I = Y (1 - MPC)
(i) In I = `500 crores × (1 - 0·3) Y = K I 1 I 1 MPC
1 ` ` 100 crores=1
1 2
= 1 ` `100 crores
1
2
= 2 × ` 100 crores = ` 200 crores Ans.
1/8
Introductory Macro Economics
Illustration 3

In an economy investment expenditure is increased by `400 crores and marginal propensity to consume is 0·8. Calculate total increase in

income and saving.

Solution :
Multiplier (K) =
1 1 1 MPC 1 0 8 0 2. MPS = 1 - MPC = 1 - 0·8 = 0·2 Increase in Income = K × I
= 5 × 400 = `2000 crores Increase in Saving = MPS × Y
= 0·2 × 2000 =`400 croresAns.

Illustration 4

As a result of increase in investment by `125 crores, national income increases by `500 crores. Calculate marginal propensity to consume.

Solution:
I =` 125 Crores
Y =` 500 Crores

K = Y = 1
I 1 MPC
= 500
125 =
1
1 MPC
= 500 (1 - MPC) = 125 500 - 500 MPC = 125
375 = 500 MPC
MPC = 375500 = 0·75 Ans.

Illustration 5
If MPC adopts the following values, what will be the multiplier :
(i) 0 (ii) 0.4 (iii) 1 (iv) 0.9

Solution :
(i) MPC = 0
K =
1
1 MPC K = Multiplier 1
1 1
Y = Increase in =101 Income (ii) MPC = 0.4

I = Increase in Investment
K = 1 1 1 1.67 1 MPC 1 0.4 0.6
(iii) MPC = 1
15.
K =
1 1 1
1 MPC 1 1 0
(iv) MPC = 0.9
K = 1 1 1 10 Ans. 1 MPC 1 0.9 0.1
Illustration 6
Suppose in an economy MPC = 0.8. Investment is increased by `400 crores. Calculate total increase in income, consumption expenditure and saving expenditure.
Solution :
Here, MPC = 0.8; I = `400 crores
1 1 1 5 Hence, K = 1 MPC 1 0.8 0.2
(i) Increase in income
(Y) = K × I = 5 × 400 = `2000 crores Ans. (ii) Increase in consumption expenditure
(C) = Y × MPC = 2000 × 0.8 = 2000 × 8
10 = `1600 crores Ans.
(iii) Increase in saving expenditure
(S) = Y × MPS × (1 - MPC) = 2000 (1 - 0.8)
= 2000 × 0.2 = `400 crores Ans.
Illustration 7
If an economy wants to generate additional income of `8000 crores, what amount of initial investment will be required,
if MPS = (i) 0·5, (ii) 0·4 ?
Solution :
We know that
K = Y¹

I MPS
1
Y = IMPS

Or I = Y × MPS
(i) In I =`8000 crores × 0·5 =`4000 crores (ii) In I =`8000 crores × 0·4 =`3200 crores

Ans. Illustration 8

If initial investment is `100 crores and additional income generation is `500 crores, calculate the value of MPS and MPC.

Solution : We know that K = Y$^{1\ 1}$ I MPS 1 MPC 1 Y = IMPS Or I = Y × (MPS) 100 = 500 (MPS) MPS = 100 . Or 0 2 500 MPC + MPS = 1 MPC = 1 - MPS = 1 - 0·2 = 0·8 Ans.

Illustration 9

In an economy, the actual level of income is `500 crores, whereas the full employment level of income is ` 800 crores. The MPC is 0.75. Calculate the increase in investment to achieve the full employment level of income.

Investment Multiplier and its Mechanism

Solution : Solution :
Actual Level of Income = ` 500 crores (i) MPS = 0.6
Full Employment Income Level = ` 800 crores1 1 1.67 Ans. Warranted increase in
Income = ` 300 crores K = MPS 0.6MPC = 0·75 (ii) MPS = 0.5We know that Y = K. I 1 1 2 Ans. and
K = 1 K = MPS 0.51 MPC (iii) MPS = 0.75
=
1. 1
1 0 75 0 25.⁴ K =¹¹ 1.33 Ans. MPS 0.75
Y 300= 75 croresAns. (iv) MPS = 0.125 Thus, I = D =
K 4
Illustration 10 K = 1 1 1000 8 Ans. Calculate multiplier if MPS value is as
follows : 0.125 125 125 1000 (i) 0.6 (ii) 0.5 (iii) 0.75 (iv) 0.125
A QUICK REVIEW OF THE CHAPTER
● Investment Multiplier : It establishes the relation between investment

and income. It is the ratio of ● change in income and change in investment.
K =
Y
I
(where K = Multiplier, Y = Change in Income and I = Change in Investment)
-
Relation between MPC and Multiplier :

(i) Investment multiplier depends on MPC. Multiplier has positive relation with MPC and negative relation

with MPS. Higher the marginal propensity to consume, greater is the size of multiplier. On the contrary, lower the marginal propensity to consume, smaller is the size of multiplier.

Hence,

K =

1 1

1 MPC MPS

(ii) When MPC = 0, multiplier will be unity. When MPC = 1, multiplier will be infinity. Hence, the value of multiplier ranges between these two extremes.

Forward and Backward Action of Multiplier : Multiplier is two-edged instrument and hence, it works

in both directions :

(i) Additional investment creates income many times — Forward Action .

(ii) Withdrawal of investment decreases income many times — Backward Action .

QUESTIONS

Ultra Short Answer Type Questions

1. What type of relationship do MPC and multiplier have ?

2. If MEC is greater than rate of interest then how the investment will be affected ?

3. Give the formula of investment multiplier in terms of MPC. (U.S.E.B., 2017)

4. When multiplier value becomes infinite ?

5. When multiplier value becomes unity ?

Very Short Answer Type Questions

1. Define Investment Multiplier. Or

What is an Investment Multiplier ? (J.A.C., 2017) 2. If the value of multiplier is 5, what will be the effect on the income of an economy if investment increases by`200 crores ?

[Ans. Income will increase by ` 1000 crores] 3. If Marginal Propensity to Consume is 0.5, what will be the value of the multiplier ?

[Ans. K = 2] (C.B.S.E., 2017) 4. If MPC and MPS are equal, calculate the value of multiplier.

[Ans. Multiplier 2] (U.S.E.B., 2012, 19) 5. What will be the effect on the income of an economy if there

is a decrease in its investment by ` 100 crores provided

the value of multiplier is 4 ?

[Ans. Income will decrease by ` 400 crores]

Short Answer Type Questions

1. What is meant by Investment Multiplier ? Explain with the help of suitable examples.

( B.S.E.B., 2013;J.A.C., 2013, 15, 19) 2. Explain the relationship between Marginal Propensity to Consume and Investment Multiplier. (B.S.E.B. , 2018) 3. Explain briefly the process of investment multiplier.

(Raj. Board. , 2015,U.S.E.B. , 2017)

Introductory Macro Economics

4. Explain the working of the Multiplier with the help of a diagram.

5. National income increases by`2500 crore when an additional investment of `500 crore is made. Calculate the value of investment multiplier. (C.B.S.E. , 2017) [Ans. K = 5]

6. As a result of increase in investment by`60 crores, national income rises by`240 crores. Calculate marginal propensity to consume. (C.B.S.E. , 2011) [Ans. MPC = 0·75]

7. Giving reasons, state whether the following statements are true orfalse :

(i) Average propensity to save is always greater than zero. [Ans. False]

(ii) Value of investment multiplier varies between zero and infinity.

(C.B.S.E., 2010) [Ans. True]

8. In an economy 75 percent of the increase in income is spent on consumption. Investment is increased by`1,000 crores. Calculate :

(a) total increase income.

(b) total increase in consumption expenditure. (C.B.S.E., 2010) [Ans. (a) ` 4000 crores (b) ` 3000 crores]

9. In an economy Marginal Propensity to Consume is 0·75. If investment expenditure is increased by`500 crores, calculate the Increase in Income and Consumption Expenditure. [Ans. Y = 2000, C = 1500]

10. Giving reasons, state whether the following statements are true orfalse : (C.B.S.E., 2010) (i) If the ratio of marginal propensity to consume and marginal propensity to save is 4 : 1, the value of investment multiplier will be 4.

[Ans. False; Multiplier = 5]

(ii) Sum of average propensity to consume and marginal propensity to consume is always equal to 1.

[Ans. False]

11. Giving reasons, state whether the following statements are true orfalse : (C.B.S.E., 2010) (i) When marginal propensity to consume is zero, the value of investment multiplier will also be zero.

[Ans. False]

(ii) Value of average propensity to save can never be less than zero.

[Ans. True] (C.B.S.E., 2010) 12. In an economy the marginal propensity to consume is 0·75. Investment expenditure in the economy increases by`75 crore. Calculate the total increase in national income. (C.B.S.E., 2011) [Ans. ` 300 crores]

13. Calculate the national income : Autonomous consumption =`100.

Marginal Propensity to Consume = 0.80. Investment =`50. (C.B.S.E., 2012) [Ans. National Income = ` 750]

14. In an economy the marginal propensity to save is 0·4. National income in the economy increases by`200 crores as a result of change in investment. Calculate the change in investment. (C.B.S.E., 2011) [Ans. ` 80 crores]

15. What do you mean by multiplier ? Explain the favourable and unfavourable working of multiplier.

16. In an economy, 20 percent of increased income is saved. How much will be the increase in income if investment increases by 10,000 ? Calculate. (C.B.S.E., 2015) [Ans. MPS = 0.2

1 YK = MPS=
1 V
0.2 10,000

Y = 50,000]
17. In an economy, investment increases from 300 to 500. As a result of this equilibrium level of income increases by 2000. Calculate the marginal propensity to consume.

(C.B.S.E., 2015) [Ans. = 500 - 300 = 200
G = 2000
Y = 1 1K = MPS 1 MPC
2000 1 200 = 1 MPC
10 - 10 MPC = 1
MPC = 90.9 ]
10
18. In an economy investment is increased by ` 300 crore. If MPC is 2 3, calculate increase in income. (C.B.S.E., 2016)
[Ans. I = 300 crore
2 MPC =3
2 1
MPS = 1 3 3
K = 1 3MPS 1
3
Y = K I = 3 × 300 = ` 900 crore]

19. Define Multiplier. What is the relation between MPC and multiplier ? Calculate the MPC if the value of multiplier is 4. (C.B.S.E., 2018)

1 [Ans. K =1 MPC
14 = 1 MPC
or (1 - MPC) = 1 = 0.254
MPC = 0.75]
20. If the value of multiplier is 5, calculate the value of marginal propensity to consume. (J.A.C., 2017)
1 1[ Ans. K = MPS 1 MPC

$^{1}$ 1 0.2 $_{MPS = K 5}$ So MPC = 1 - MPS = 1 - 0.2 = 0.8] Investment Multiplier and its Mechanism

(a) Investment and Income (c) Saving and Investment 2. Which one is correct ? (a) K =
1
MPC
(c) K =
1
1 MPS
21. If I = `400
Y = `1600
Find the value of MPC. (J.A.C. , 2016)
Y 1 1[ Ans. K = I MPS 1 MPC 1600 = 1
400 1 MPC
4 (1 - MPC) = 1
4 - 4MPC = 1
4MPC = 3
MPS = 3.75]
4
22. If in an economy change in Initial Investment ( I) = `1,200 crore
MPS = 0.2
Find the values of :
(a) Investment Multiplier,
(b) Change in final income. (C.B.S.E., 2019) [Ans. (a) K = 5, (b) Y = `6,000 crore.
Long Answer Type Questions

(b) K = 1
MPS

(B.S.E.B., 2011, 12,J.A.C., 2017)
(a) K = S (b) K = Y
I I

1. Explain the working of Investment Multiplier with the help of an example. (B.S.E.B. , 2018)

2. Define Investment Multiplier. How is it related with Marginal Propensity to Consume ? (J.A.C. , 2017)

3. Explain the relationship between Marginal Propensity to Save and Multiplier. (C.B.S.E., 2011)

4. Explain with the help of numerical examples how an increase in investment in an economy affects its level of income ?

5. Explain the ‘Forward’ amd ‘Backward’ action of Multiplier with suitable examples.

6. What is multiplier? How is it calculated? Explain with an example. (U.S.E.B. , 2014)

7. In an economy, the level of income is`2000 crore and marginal propensity to consume is 0.75. Calculate the total increase in gross income if investment increases by ` 200 crore. (J.A.C. , 2017)

$^{1}$ [Ans. K = 1 - MPC

$1 = 14 = 10.750.25$

\mathrm{Y} _ {\mathrm{K}} = _ {\mathrm{I}}

Y4 = 2000

$\mathrm{Y}=8000\mathrm{crore}$

Objective Type Questions

(A) Multiple Choice Questions :

1. Keynesian multiplier establishes relationship between :

( B.S.E.B. , 2019) (b) Income and Consumption (d) None of the above

(d) K =

1 MPS 3. Multiplier can be expressed as :

(c) K = I – S (d) None of the above 4. Keynes derived Investment Multiplier from Kahn’s :

(a) Income Multiplier

(c) Employment Multiplier (b) Consumption Multiplier (d) None of the above

5. The value of Keynesian Investment Multiplier depends on :

(a) Income Level

(b) Marginal Productivity of Capital

(c) Marginal Propensity to Consume

(d) Investment Level

6. Which factor affects Keynesian Multiplier ?

(a) Marginal Propensity to Save

(b) Marginal Propensity to Consume

(c) Both (a) & (b)

(d) None of the above

7. Which of the following is correct ?

(a) MPC and multiplier have direct relationship

(b) MPS and multiplier have inverse relationship

(c) Both (a) & (b)

(d) None of the above

8. The value of MPC is :

(a) 1 (b) 0

(c) Greater than 0 but less than 1

9. If MPC = 0·5, then multiplier (K) will be :

(B.S.E.B., 2011, 18)

(a) 1/2 (b) 1 (c) 2 (d) 0 10. If MPC = 0·5 and initial investment is ` 100 crores, the

income generation in the economy will be :

(a)` 5 crores (b) ` 100 crores

(c) ` 200 crores (d) ` 500 crores

11. The theory of employment multiplier was propounded by : (B.S.E.B. , 2015)

(a) Keynes (b) Kahn

(c) Hansen (d) Marshall

[Ans. 1. (a), 2. (b), 3. (b), 4. (c), 5. (c), 6. (c), 7. (c), 8. (c), 9. (c), 10. (c),

11. (b).]

(B) Fill in the Blanks :

1. Multiplier (K) = ......

2. Multiplier (K) = 1

3. If MPC = 0·6, multiplier will be................

4. MPC and multiplier have................relationship.

5. When MPC is unity, multiplier becomes................ [Ans. 1. Y, 2. MPS, 3.

2·5, 4. direct, 5. infinite.] (C) State True/False :

1. Keynes multiplier theory establishes relationship between investment and income.

2. Keynes derived investment multiplier from Kahn’s income multiplier.

3. The value of Keynesian investment multiplier depends on marginal propensity to consume.

4. The propounder of theory of employment multiplier is Marshall.

[Ans. 1.
True,
2.
False,
3.
True,
4.
False]
152
Introductory Macro Economics
152

(D) Match the following Column :

1. Multiplier (a) Kahn

2. Originator of Employment (b) Relation between Multiplier Investment and Income Theory

3. Keynesian Multiplier Theory (c) Direct Relationship Change in Income

4. MPC and Multiplier (d)_{Change in Investment}

[Ans. 1. (d), 2. (a), 3. (b), 4. (c)]

(E) Answer in One Word :

1. What will be the value of multiplier when MPS is unity ?

2. What type of relation between MPC and multiplier ?

3. Who was the originator of employment multiplier ?

4. Who gave the concept of investment multiplier ?

[Ans. 1. Unity, 2. Inverse, 3. Kahn, 4. J.M. Keynes.]

High Order Thinking Skills Questions HOTS

1. Why does MPC have direct relationship with multiplier ?

(See : Section 25.2)

2. In what way multiplier behaves when MPC becomes unity ? Give reasons.

(See : Table 1)

3. Explain the process how income changes as a consequence of change in investment. (See : Box 3)

Value Based Questions

1. MPC and multiplier are inversely related. How ? (See : Section 25.2)

2. Does the multiplier, also work in reverse direction ? (See : Part II of Section 25.3)

3. What will be the value of multiplier when there is no savings ?

(See : Box 2)

Case Study Based on Evaluation & Multi-disciplinary Questions

1. Is there any backward action of multiplier ?

(See : Part II of Section 25.3)

2. In what way multiplier is double-edged instrument ? (See : Section 25.3)

3. Why does multiplier have direct relation with MPC but inverse relation with MPS?

(See : Section 25.2)

NCERT CORNER

Q. 1. Explain ‘Paradox of Thrift’.

Ans. The classical economists considered savings as a virtue and the thrift (i.e. , the act of non-spending) as a virtuous act. They believe that whatever is saved is automatically invested. An all round increase in individual saving will lead to an increase in national saving.Prof. Keynes partially accepted this view. He regarded, saving as a ‘private virtue ’ but a ‘social vice ’. Keynes put the view that “if the community as a whole decides to save more, it will bring down the level of income and the community will actually save less.” This is the paradox of thrift.

STUDY MATERIAL INCLUDED IN

26

PROBLEMS OF DEFICIENT AND EXCESS DEMAND

THE CHAPTER

26.1. Full Employment Equilibrium and Under-Employment Equilibrium 26.2. Deficient Demand : Meaning 26.3. Excess Demand : Meaning 26.4. Difference between Deficient Demand and Excess Demand 26.5. Cyclical Fluctuations Or Cyclical Impact on Output, Employment and Prices A Quick Review of the Chapter Questions High Order Thinking Skills (HOTS) Questions Value Based Questions (VBQ) Case Study Based on Evaluation & Multi-disciplinary Questions (MDQ)

26.1 Full Employment Equilibrium and UnderEmployment Equilibrium

Full employment equilibrium refers to that situation in the economy when aggregate supply become equal to aggregate demand (AS = AD) or savings equals investment (S = I) along with full utilisation of resources. In such a situation there is no excess capacity or unemployment in the economy.

Under-employment equilibrium refers to that situation in the economy when AS = AD (or S = I) but without full utilisation of resources. In such a situation, economy comes in the state of equilibrium but has unutilised capacity or excess capacity which remains in the economy. In other words, some people who want to work at existing wage rate are not getting employment and remain unemployed.

26.2 Deficient Demand : Meaning

If the economy attains income equilibrium level before full employment level, it is called to be ‘Situation of Deficient Demand ’. Keynes called this situation as ‘under– employment equilibrium’ .

“Deficient demand refers to a situation in which aggregate demand remains short of aggregate supply corresponding to full employment.”

Deficient Demand

↓

\mathrm{AD} <   \mathrm{AS}

Aggregate Demand is short of Aggregate Supply corresponding to Full Employment Level

Box 1

Thus, the situation of deficient demand appears due to attaining equilibrium level below full employment level in the economy. The existing aggregate demand falls short of required aggregate demand at full employment level and as a result, situation of deficient demand arises. Due to this deficiency in aggregate demand, full employment level is not obtained. Hence, when the level of aggregate demand happens to be short of its full employment level, situation of deficient demand arises.

● Characteristics of Deficient Demand

(i) In deficient demand, the level of aggregate demand falls short of its full employment level, i.e., for making factors fully employed and utilising full capacity of production, entrepreneurs expect aggregate demand to a desired level, but actual aggregate demand level falls short of it. In such situation (i.e., when resources are not fully utilised and aggregate demand level falls short) production remains at lower level and involuntary unemployment appears.

(ii) The aggregate demand level fails to match with aggregate supply level upto the point of full employment in the economy, i.e., in case of deficient demand, ‘under–employment equilibrium level’ is found in the economy.

154

Introductory Macro Economics

IVT

Deficient Demand : Diagrammatical Representation

In Fig. 1, AS represents aggregate supply curve. AD is aggregate demand curve at deficient demand level and \mathrm { A D } _ { 1 } is aggregate demand curve at full employment level. At full employment level, deficiency in demand becomes AC which is the difference between \mathrm { A D } _ { 1 } and AD.

Diagrammatically,

Deficient Demand = AN – CN = AC

Fig. 1
Deflationary Gap Deficient Demand Implies Deflationary Gap Deflationary gap is the shortfall in aggregate demand from the level of aggregate supply required to maintain the level of full employment equilibrium.
In other words, The difference between aggregate supply and aggregate demand is termed as ‘Deflationary Gap. Or

(i) Deficient Demand = Deflationary Gap

= Desired Aggregate Demand – Actual Aggregate Demand \mathrm { a t } _ { \mathrm { ( i i ) } } Deflationary at

Full Employment Level Under Employment LevelGap

Thus, Deflationary gap is a measure of deficient demand.

Greater the deficiency of aggregate demand, greater will be the deflationary gap, i.e., deflationary gap is the measurement of deficient demand. This deflationary gap indicated that if effective demand is increased for covering this deflationary gap, the equilibrium point may shift to full employment level. It will eliminate involuntary unemployment in the economy (See Fig. 1).

Box 2

Illustration of Deficient Demand

Table 1 : Deficient Demand (` In Crore) Aggregate Demand Aggregate

Supply National Income 2000

Less : Tax 20% 400

Disposable Income 1600

Less : Saving 25% 400

Aggregate Demand 1200

National Production 1600 Less : Consumption on Net Income 240 Aggregate Supply or Expected

Production Quantity 1360

Hence, Deficiency in Demand = 1360 – 1200 = ` 160 crores

Reasons of Arising Deficient Demand

The main causes of deficiency of demand are as follows :

(1) Squeeze in money supply (either by withdrawing some currency by the Govt. or less credit creation by banks).

(2) Decrease in investment demand due to rise in bank rate.

(3) Reduction in disposable income and consumption demand due to rise in taxes.

(4) Reduction in public expenditure.

(5) Reduction in consumption demand due to increase in propensity to save.

(6) Reduction in export demand.

Problems of Deficient and Excess Demand

Effects of Deficient Demand Deficient Demand (A)

Effects on Production (B) (C) Effects on Employment Effects on Prices (A) Effects on Production (i) Reduction in production of goods and services due to deficient demand.

(ii) Full capacity of production will not be utilised. (iii) Factors of production will remain under-utilised. (iv) A few firms may stop their production due to losses.

(v) Production cost will be increased.

(B) Effects on Employment

Due to deficiency in demand, producers have to cut down their production of goods and services which will curtail down the employment level.

(C) Effects on Prices

The price level in the country falls due to deficient demand and as a result, profit margin will come down for the producers. Consumers will also get goods and services at lower level.

Illustration 1

Calculate deficient demand on the basis of following information :

Items ` Crores

(i) National Income at Full Employment 320

(ii) Commodities for Net Consumption 40 300 48 32

(iii) National Income (iv) Taxes (v) Savings

Solution : Deficient Demand = Available

– Production Anticipated

Expenditure Anticipated Expenditure (` In Crores)

National Income Less : Taxes 48 Savings 32 Aggregate Demand 300

– 80 220

Available Production (` In Crores) National Income at Full Employment 320 Less : Goods for Net Consumption 40

Aggregate Supply 280 Deficiency in Demand = 280 – 220 = ` 60 crores 26.3. Excess Demand : Meaning

If aggregate demand and aggregate supply attain equilibrium at the point beyond full employment, the situation of excess demand appears. In other words, when aggregate demand exceeds aggregate supply at full employment level, excess demand arises.

Thus, ‘‘Excess demand refers to a situation in which aggregate demand becomes excess of aggregate supply corresponding to full employment in the economy .’

Excess Demand

AD > AS

Aggregate Supply corresponding to Full Employment Level is short of required Aggregate Demand Box 3

In situation of excess demand, the aggregate demand exceeds the required demand, hence, increased demand will not put any reaction on employment and production levels because factors are already at full employment level. In this situation of excess demand (in which aggregate demand exceeds aggregate supply) the prices of goods and services rise and situation of inflation arises in the economy.

Characteristics of Excess Demand

1. When existing aggregate demand exceeds aggregate supply of full employment level, it becomes the situation of excess demand.

2. When aggregate demand exceeds required demand, there is no effect on employment and production level and they remain constant.

3. The difference between aggregate demand and aggregate supply is termed as ‘Inflationary Gap ’.

Thus, inflationary gap is measured as the difference, between ‘aggregate demand beyond full employment’ and ‘aggregate demand at full employment’. i.e., Inflationary Gap

Aggregate Demand ^{= beyond Full –} Employment

Aggregate Demand at Full Employment

4. Higher the inflationary gap, more will be the excess demand, i.e., inflationary gap is the measurement of excess demand.

156

Introductory Macro Economics

100

Excess Demand : Diagrammatic Representation In Fig. 2, the situation of excess demand has been shown. Aggregate

AS 11

demand curve AD refers the situation of full employment. At full

Excess Demand = FY – EY = EF

employment level Y, required aggregate demand is EY. Aggregate demand

beyond full employment is shown by \mathrm { A D } _ { 1 } line where aggregate demand becomes FY. Existing aggregate demand FY exceeds required aggregate

demand EY and the difference EF becomes excess demand.

Diagrammatically,

Full Employment

0 Y Income/Output/Employment

Fig. 2 Inflationary Gap

Excess Demand Implies Inflationary Gap

‘‘Inflationary gap is the measure of the amount by which aggregate demand exceeds the level of aggregate

demand required to maintain full employment equilibrium.’’

In other words, the difference between aggregate demand and aggregate supply is called ‘Inflationary Gap ’.

In situation of inflationary gap, production in the economy does not increase, only prices rise, i.e., at the point

of full employment, production becomes constant and prices start rising.

Inflationary pressure emerges in the

economy.

(i) Excess Demand = Inflationary Gap

(ii) Excess Demand = Actual Aggregate

– Aggregate Demand Necessary

Demand for Full Employment

Thus, Inflationary gap is a measure of excess demand.

Inflationary pressure is proportionate to excess demand. Greater the excess demand, greater is the inflationary pressure. Accordingly, a situation of excess demand is often identified as a situation of inflationary gap in the economy. (See Fig. 2)

Box 4 Illustration of Excess Demand

Table 2 : Excess Demand (` In Crore) Aggregate Demand Aggregate Supply

1600 320 = 1280 320

National Production 1280 Less : Consumption on Net Income 400 Available Production 880

= 960 = 960 – 880 = ` 80 crores

National Income Less : Tax 20% Disposable Income Less : Savings 25%

Aggregate Demand and Expected Consumption Expenditure Hence, Excess Demand

Reasons of Arising Excess Demand The situation of excess demand in an economy may appear due to following reasons :

1. Government demand for goods and services due to increase in public expenditure.

2. Increase in disposable income and consumption demand due to fall in taxes.

3. Addition in money supply due to deficit financing.

4. Increase in demand due to credit extension.

5. Increase in investment demand.

6. Increase in consumption demand due to increase in propensity to consume.

7. Increase in demand for export goods.

Effects of Excess Demand

(A)

Effects on Production

Excess Demand

Effects

(B) (C) Effects on Effects on Employment Prices (A) Effects on Production : In situation of excess demand, production remains constant, excess demand only puts excess pressure on existing supply.

Problems of Deficient and Excess Demand

(B) Effects on Employment : In situation of excess demand, employment remains unaffected because the economy is already at full employment level and hence, there is no possibility of employment increase due to increased demand.

(C) Effects on Prices : The economy being already working at full employment level, no possibility of production increase appears in case of excess demand. Hence, supply falls short of excess

Solution :

Fig. 3

demand and as a result, prices of goods and services start rising. In Fig. 3, OL is the production level at full employment level which remains constant even if aggregate demand increases to \mathrm { A D _ { E } } from \mathrm { A D } _ { \mathrm { F } } . In this situation of excess demand, only price level rises from \mathrm { O P } _ { 1 } to \mathrm { O P } _ { 2 }

Illustration 2

Calculate the excess demand from the following data :

Items ` Crores

(i) Available Production 400 (ii) War Expenditure 36 (iii) National Income 660 (iv) Taxes 60 (v) Savings 64

Excess Demand = Anticipated Expenditure – Available Production Anticipated Expenditure (` In crores)

National Income Less : Taxes 60 Savings 64 Aggregate Demand

Available Production (` In crores)

660 Available Production 400 Less : War Expenditure 36 124

= 536 Aggregate Supply = 364 Hence, Excess Demand = 536 – 364 = ` 172 Crores

26.4 Difference between Deficient Demand and Excess Demand Deficient Demand

1. It refers to that level of demand which falls short of what is required to maintain full employment equilibrium in the economy.

2. Aggregate demand is less than aggregate supply corresponding to full employment in the economy.

3. It creates deflationary gap.

4. Employment, output and price levels tend to fall.

26.5 Cyclical Fluctuations

Cyclical Impact on Output, Employment and Prices

After detailed study of the concepts of excess demand and deficient demand alongwith their impact on output, employment and prices, it is clear that the ideal situation in any economy would be the one when aggregate demand (AD) is equal to aggregate supply (AS) corresponding to fuller utilisation of the resources including labour. In this ideal situation, there should be no involuntary unemployment and any tendency to change remains absent. But it is only a theoretical situation . But in real life, aggregate demand (AD) tends to fluctuate becoming higher or lower than what is required to maintain full employment equilibrium in the economy. Fluctuations (i.e ., increase or decrease) in aggregate demand generate fluctuations in business activity, popularly known as trade cycle. This

Excess Demand

1. It refers to that level of demand which becomes surplus to what is required to maintain full employment equilibrium in the economy.

2. Aggregate demand is greater than aggregate supply corresponding to full employment.

3. It creates inflationary gap.

4. Only prices tend to rise but no change in employment and output because the economy is already at full employment level.

trade cycle refers to ups and downs

of business activity

which take place in the economy at

Δ

A to B → Denression

a regular interval.

B to C → Recovery at C → Full Emplovment

In Fig. 4, FF line represents full

B

C to D → Prosperity D to E → Recession

employment level.

ABCDE denotes a trade cycle which Fig. 4 has five stages :

1. Depression

_{2. Recovery} Due to Deficient Demand 3. Full Employment

4. Prosperity or Boom

_{5. Recession} Due to Excess Demand In situation of deficient demand, phase of depression

appears in which prices fall and output is adversely affected. If depression is not checked, it converts into great depression. On adopting the checking measures of depression, economy revives and enter into the phase of recovery . This recovery phase continues and enters in the phase of prosperity (or boom) after crossing the phase of full employment . In this phase of prosperity, excess demand arises because output cannot be increased after full employment level. When the inflationary pressure is checked, the economy enters into the phase of recession which again takes the economy to the phase of depression and trade cycle again continues.

Thus, an economy faces cyclical fluctuations due to deficient demand and excess demand.

A QUICK REVIEW OF THE CHAPTER

● Deficient Demand : It occurs when aggregate demand falls short of aggregate supply corresponding to the full employment level. Deficient Demand = AD < AS (at full employment level).

● Deflationary Gap or Measurement of Deficient Demand :

Deflationary gap is the measurement of deficient demand and is equal to the difference between aggregate demand at full employment ( \mathrm { A D _ { F } } ) and actual aggregate demand (AD).

Or Deflationary \mathrm { G a p } = \mathrm { A D } _ { \mathrm { F } } - \mathrm { A D }

● Reasons of Deficient Demand :

(i) Reduction in supply of currency,

(ii) Squeeze in credit creation,

(iii) Increase in Bank Rate,

(iv) Increase in Taxes,

(v) Fall in public demand,

(vi) Increase in propensity to save,

(vii) Fall in export demand.

● Effects of Deficient Demand :

(i) Fall in production level,

(ii) Increase in unemployment,

(iii) Fall in price level.

● Excess Demand : It occurs when aggregate demand is greater than aggregate supply corresponding to the full employment level. Excess demand : AD > AS (at full employment level).

● Inflationary Gap or Measurement of Excess Demand :

Inflationary gap is the measurement of excess demand and is equal to the difference between aggregate demand beyond full employment (AD) and aggregate demand at full employment ( \mathrm { A D } _ { \mathrm { F } } )

^{Inflationary Gap = AD – ADF} ● Reasons of Excess Demand :

(i) Increase in public expenditure,

(ii) Reduction in taxes,

(iii) Deficit financing,

(iv) Extension of credit facilities,

(v) Increase in investment demand,

(vi) Increase in propensity to consume,

(vii) Increase in export demand.

● Effects of Excess Demand :

(i) Production cannot be increased beyond full employment level.

Consequently, pressure increases on production.

(ii) No effect on employment because the economy is already at full employment level. (iii) Price rise in goods and services.

● Cyclical Fluctuations : In real life, aggregate demand does not match aggregate supply. Consequently, economy faces economic fluctuations like, Depression → Recovery → Boom → Recession → Again Depression → Process Continues.

Problems of Deficient and Excess Demand 159 QUESTIONS Very Short Answer Type Questions

1. What is meant by Deficient Demand ?

2. What is meant by Excess Demand in an economy ?

3. What is meant by Under Employment Equilibrium ?

4. What is meant by Deflationary Gap ? (C.B.S.E. , 2010)

5. Define Inflationary Gap. (J.A.C. , 2010, 12; C.B.S.E., 2010, 15)

6. Give the meaning of Excess Demand in an Economy. Short Answer Type Questions

7. What is Excess Demand ? Explain with a diagram.

8. What is Deficient Demand ? Explain the concept of Deficient Demand with the help of a diagram. (B.S.E.B., 2011)

9. Explain the meaning of Inflationary Gap with the help of a diagram.

10. Explain the meaning of Deflationary Gap with the help of a diagram.

(U.S.E.B. , 2014; C.B.S.E. 2015; B.S.E.B. , 2015)

5. Distinguish between Inflationary and Deflationary Gap. (B.S.E.B., 2014; 2018; C.B.S.E. 2015)

6. Explain the concept of ‘Inflationary Gap’. (U.S.E.B., 2009; J.A.C. , 2015; B.S.E.B. , 2015; B.S.E.B , 2016)

7. “Excess demand shows inflationary gap” Clarify.

8. What is meant by under employment equilibrium and full employment equilibrium ? (B.S.E.B., 2018) Long Answer Type Questions

9. What is deficient demand in an economy ? What is its impact on production and employment? (J.A.C. , (Comm.) 2017)

10. What is Excess Demand ? What is its impact on production and prices ? (J.A.C. , 2017)

11. Explain the concept of Inflationary Gap with the help of a diagram. What is its impact on prices and employment ?

12. Explain the concept of Deflationary Gap with the help of a diagram. What is its impact on production and prices ?

13. Distinguish between Inflationary Gap and Deflationary Gap. Show Deflationary Gap on a diagram.

(C.B.S.E. (O.D.), 2013)

6. What do you mean by inflationary gap ?

7. What do you mean by deflation ? Does it affect price and output ? Give reasons.

8. Explain the problem of “Excess Demand” with the help of diagram. (U.S.E.B. , 2016) Or

Explain the problems of ‘‘Excess Demand’’ in an economy with help of diagram. (C.B.S.E., 2019)

Objective Type Questions

(A) Multiple Choice Questions :

1. If income equilibrium level in the economy is determined at the level before full employment, it is known as the state of : (b) Surplus Demand (d) None of the above (a) Deficit Demand (c) Partial Demand

2. In Keynesian economics, the state of Deficit Demand is called as : (B.S.E.B., 2019) (a) Full Employment Equilibrium

(b) Under Full Employment Equilibrium

(c) Both (a) & (b)

(d) None of the above

3. What are the characteristics of Deficit Demand ?

(a) Aggregate Demand falls short of Aggregate Demand required at full employment

(b) Aggregate Demand remains short of Aggregate Supply required of full employment level

(c) Both (a) and (b)

(d) None of the above

4. Deflationary Gap shows the measurement of :

(a) Deficit Demand (b) Surplus Demand (c) Full Employment (d) None of the above 5. Which one is the reason of appearing Deficit Demand condition ?

(a) Fall in the money supply in the country

(b) Fall in investment demand as a result of rise in bank rate.

(c) Fall in disposable income and consumption demand due to increase in taxes

(d) All the above

6. Which of the following is true ?

(a) Employment level declines due to decrease in demand

(b) Price level falls due to deficient demand in the country

(c) Production level falls deficient demand

(d) All the above

7. The difference between the Aggregate Demand at above full employment and Aggregate Demand at full employment is known as :

(a) Inflationary Gap

(c) Both (a) & (b) (b) Deflationary Gap (d) None of the above

8. Which of the following is a reason of appearing Surplus Demand ?

(B.S.E.B., 2011, 16, 18) (a) Increase in Public Expenditure

(b) Increase in Money Supply

(c) Fall in Taxes

(d) All the above

9. In the situation of deflationary gap :

(a) Demand increases rapidly

(b) Supply increases rapidly

(c) Both demand & supply are equal

(d) None of the above

the Blanks :

1. In.................demand, the level of aggregate demand falls short of its full employment level.

2. Deficient demand implies.................gap.

3. The difference between aggregate demand and aggregate supply is termed as.......

4. ................gap is a measure of excess demand.

5. In deficient demand, employment, output and price levels tend

to................

6. Deflationary gap is a measure of ............ demand. (B.S.E.B., 2010) [Ans.

7. deficient, 2. deflationary, 3. inflationary gap, 4. inflationary, 5. fall, 6. deficient.]

(C) State True/False :

1. Deflationary gap shows the measurement of surplus demand.

2. In the situation of deflationary gap supply increases rapidly.

3. If income equilibrium level it is the economy is determined at the level before full employment, it is known as state of deficit demand.

4. The state of deficit demand in economy is called by Keynes as under full employment equilibrium.

5. The difference between aggregate demand at above full employment and agreegate demand at full employment is known as inflationary gap.

[Ans. 1. False, 2. False, 3. True, 4. True, 5. True] (D) Match the following Column :

‘A’ ‘B’

1. Measurement of Deficit Demand (a) Fall in Production

2. Difference between aggregate demand and supply

3. Cause of Deficit Demand

4. Effect of Deficit Demand [Ans. 1. (c), 2. (d), 3. (b), 4. (a)] (E) Answer in One Word :

(b) Increase in Bank

Rate

(c) Deflationary

(d) Inflationary gap

1. What measurement deflationary gap does ?

2. What does excess demand show ?

3. What effect appears on employment in case of excess demand ?

4. What happens when aggregate demand exceeds aggregate supply ?

[Ans. 1. Deficit Demand, 2. Inflationary Gap, 3. No effect, 4. Excess Demand.]

HOTS High Order Thinking Skills Questions

1. Why and how does a deficient demand create deflationary gap ? (See : Section 26.2)

2. In what way inflationary gap becomes a measure of excess demand ? (See : Section 26.3)

3. What situation arises when we take difference between ‘aggregate demand beyond full employment’ and ‘aggregate demand at full employment’ ? (See : Section 26.3)

VBQ Value Based Questions

1. Deficient demand creates deflationary gap. Why ? (See : Section 26.2)

2. What is the effect of excess demand on price level ? (See : Section 26.3)

3. What are the two main reasons of appearing excess demand ? (See : Section 26.3)

MDQ Case Study Based on Evaluation & Multi-disciplinary Questions

1. In what way prices react in case of excess demand ? [See : Section 26.3 (Effects of Surplus Demand)]

2. Excess demand generates inflationary gap. How ? (See : Section 26.3)

3. Deficient demand and excess demand generate economic fluctuations. How ?

(See : Section 26.2 & 26.3)

❑

27

MEASURES TO CORRECT DEFICIENT AND EXCESS DEMAND

STUDY MATERIAL INCLUDED IN THE CHAPTER

27.1. Introduction 27.2. Measures to Correct Deficient Demand 27.3. Measures to Correct Excess Demand

27.4. A Comparative Look at Measures of Correcting Deficient Demand and Excess Demand A Quick Review of the Chapter Questions High Order Thinking Skills (HOTS) Questions Value Based Questions (VBQ) Case Study Based on Evaluation & Multi-disciplinary Questions (MDQ) NCERT Corner

27.1. Introduction

In the last chapter we have studied that full employment equilibrium is the state of economic stability which is an ideal situation for the entire situation.

Any deviation from this equilibrium creates the situations of ‘deficient demand ’ or ‘excess demand’ . Deficient demand and excess demand generate deflationary and inflationany tendencies respectively in the

27.2. Measures to Correct Deficient Demand

economy which give birth to ‘trade cycles’ in the economy . Both the phases of economic fluctuations (inflationary as well as deflationary) related to trade cycles are harmful for an economy. These economic fluctuations deeply hit the weaker section of the society. Hence, for the economic growth with justice, it is required to control these economic fluctuations by suitable adjustments in fiscal measures, monetary measures and other measures like foreign trade policy, wage and policy, etc.

Measures to Correct Deficient Demand

(I) (II) (III) Fiscal Measures Monetary Measures Other Measures

I. Fiscal Measures

Measures related to public expenditure, taxation and public debt are termed as fiscal measures and policy related to these measures is called ‘fiscal policy ’ which

is also called ‘ Budget Policy ’ because fiscal policy works through the budget.

In the words of Dalton , “Fiscal Policy is the policy concerning the revenue, expenditure and debt of the government for achieving definite objectives.”

Fiscal Measures of Correcting Deficient Demand (A)

Public Expenditure (B)

Taxation (C)

Public Debt (D)

Deficit Financing

Increase in

Public Expenditure Decrease in Tax Burden Decrease in Public Debt Budget of Big Deficit

Box 1 (A) Public Expenditure

The expenditure made by the government is called public expenditure. According to Keynes , the most important measure for correcting deficient demand is the ‘increase in public expenditure’.

Government can increase public expenditure in following ways :

(i) Expenditure in public construction works like construction of roads, bridges, dams, etc.

(ii) Expenditure on public welfare programmes like education and public health.

(iii) Expenditures on defence and administration and for maintaining law and order in the country.

(iv) Expenditure on providing subsidies to producers for encouraging production.

(v) Expenditure of transfer payment like unemployment allowance, social security and social insurance. The increase in public expenditure for correcting deficient demand is also termed as ‘pump priming’ which implies that as government increases initial doses of public expenditure, private sector gets inducement for investment and as a result total investment in the economy increases.

(B) Taxation

Tax is such a compulsory payment to the government in return of which taxpayer does not expect any direct benefit from the government.

Taxes are of two types :

(a) Direct Taxes : Direct taxes are those taxes which are levied on income and property of the persons. The burden of these taxes is borne by those persons on whom these are levied. Income tax, gift tax, wealth tax are some examples of direct taxes.

(b) Indirect Taxes : Indirect taxes are those taxes which are levied on goods and services. The burden of these taxes may be transferred to other persons. Sales tax, excise duty, custom duty, etc., are examples of indirect taxes.

For correcting deficient demand, government should cut down the direct taxes like income tax, corporation tax, etc. The tax reduction will leave more purchasing power with households and the public will be induced to increase consumption and promote investment. Consequently, aggregate demand in the economy will increase which will correct the deficiency of the demand.

(C) Public Debt : It refers to the debt or loan borrowed by the government from the public.

In the state of deficient demand, government should curtail the public borrowings and also return the amount of previous debts taken from the public. It increases the quantity of money in circulation and people have more purchasing power in their hands. Consequently, aggregate demand will increase.

(D) Deficit Financing : Keynes advocated for ‘deficit budget’ for correcting deficient demand. Government should go with deficit budget in case of deficit demand. In such budget, public expenditure exceeds public revenue. The budget deficit is covered by increasing the money supply which further increases purchasing power with the public and aggregate demand in the economy. Hence, deficit budget becomes an important instrument for correcting deficit demand.

Role of Fiscal Policy in Correcting Deficient Demand or Deflationary Gap : At a Glance

Following measures should be adopted for correcting deficient demand : (i) More public expenditure by the government should be done on public works.

(ii) Taxes should be curtailed; Direct taxes like income tax, corporation tax should be reduced. (iii) Reduction in public debt, return of previous debts back to the public.

(iv) Deficit budget should be adopted, i.e., public expenditure should exceed public revenue.

Box 2

II. Monetary Measures

Measures related to monetary policy are termed as monetary measures. The Central Bank of a country makes and operates monetary policy in the economy. Central Bank with its monetary policy controls the following three elements for ensuring economic stability in the economy :

● Supply of Money.

● Rate of Interest.

● Availability of Money.

According to Auston , “Monetary policy involves the influence on the level and composition of aggregate demand by the manipulation of interest rate and the availability of credit.”

Measures to Correct Deficient and Excess Demand

Monetary Measures of Correcting Deficient Demand (II) A (II) B Quantitative Measures Qualitative Measures Quantitative Credit Control Qualitative Credit Control

(A) Marginal Rqurentof Looans

Reduction in Bank Rate

Reduction in Liquidity Ratio

Box 3 IIA. Quantitative Monetary Measures Or

Quantitative Credit Control

(CRR). Reduction in CRR leaves more cash reserves with the commercial banks for extending credit creation.

These measures refer to those controls by which supply of credit in the economy is controlled. Central Bank applies the following measures for controlling the quantity of credit :

(A) Bank Rate

The bank rate is the rate at which the central bank gives loan or credit to the commercial banks. In situation of deficient demand or deflationary tendencies, bank rate should be reduced which in relation will reduce the

rate of interest in the economy and the credit availability will become cheaper. Demand for loans will be more and additional credit creation will take place which will increase the money supply and consequently aggregate demand will increase.

(B) Open Market Operations

These operations refer to the purchase and sale of securities in the open market by the central bank. In the situation of deficit demand, central bank should buy securities in open market which increases the cash reserves with the banks and their capacity of credit creation increases. Consequently, aggregate demand increases due to increased purchasing power in the economy.

(C) Change in Cash Reserve Ratio

Every commercial bank has to deposit a fix percentage of its total deposits with the central bank. This percentage or ratio is termed as cash reserve ratio (CRR).

Central bank can increase the credit creation by commercial banks by reducing cash reserve ratio

(D) Change in Liquidity Ratio

Every commercial bank is required to maintain a fixed percentage of its assets in the form of cash or other liquid assets and this percentage or ratio is known as ‘liquidity ratio’.

By reducing this liquidity ratio, central bank attempts for more credit creation in the situation of deficient demand.

IIB. Qualitative Monetary Measures

Or

Qualitative Credit Control

Qualitative measures aim at controlling the flow of credit for certain specific or selective activities in the economy. These measures are also called ‘selective credit control’.

These are as follows :

(A) Change in the Margin Requirement of Loans Business class obtains loans from the bank on the basis of security of commodity stocks. Banks do not provide loans cent percent equal to the value of security but cuts a margin on the security for giving loans. When bank has to promote credit flow for a few specific commercial activities, margin is reduced. Hence, for controlling deficient demand, margin requirement of loan is reduced.

(B) Rationing of Credit

Rationing of credit refers to fixation of credit quotas for different business activities. For controlling deficient demand rationing of credit is removed.

(C) Direct Action

Central bank has got the right of taking direct action against the member banks in case they do not comply with its direction. Central bank stops granting loans to such defaulter banks and may even cancel their

(D) Moral Pressure

Sometimes central bank applies moral pressure to make banks agree to expand credit creation in situation of controlling deficient demand.

license. Role of Monetary Policy in Controlling Deficient Demand or Deflationary Gap : At a Glance

Monetary policy tools may be useful in controlling deficient demand in the following ways : (i) Bank rate is reduced for more credit creation and increasing aggregate demand.

(ii) Central bank purchases securities in open market which increases the purchasing power in the economy. (iii) Cash reserve ratio is reduced for credit expansion.

(iv) Liquidity ratio is reduced and consequently more credit creation takes places.

(v) Margin requirements of loan is reduced for making more availability of loans.

(vi) Credit rationing is abolished.

(vii) Commercial banks are advised by central bank for expanding credit creation.

The above explanation shows that in situation of deficient demand central bank adopts cheap money policy for expanding credit creation and

controlling deficient demand.

Cheap money policy implies that situation in which loans are easily available at lower rate of interest.

Box 4

III. Other Measures

Other Measures to Correct Deficient Demand

(A)

Export–Import Policy (B) (C) Support Price Policy Wage Policy

Attempts of Curtailing Imports and Boosting Exports Govt. Purchasing at Stable High Support Price Wage

Box 5 (A) Export-Import Policy In situation of deficient demand, a policy of curtailing imports and boosting exports should be adopted. Rising various goods. It will increase the aggregate demand in the economy which helps in controlling deficient demand.

exports increases the foreign demand for domestic goods (C) Wage Policy which helps in solving the problem of deficient demand. Government should adopt the stable wage policy in (B) Support Price Policy situation of controlling deficient demand. Government should announce the support prices of

27.3. Measures to Correct Excess Demand

Measures to Correct Excess Demand

(I) (II) (III) Fiscal Measures Monetary Measures Other Measures I. Fiscal Measures ¹

Fiscal Measures of Correcting Excess Demand

(A) (B) (C) (D) Public Expenditure Taxation Public Debt Surplus Budget Decrease in Public Expenditure Increase in Tax Burden Increase in Public Debt Budget of Big Surplus Box 6

1 The meaning of various fiscal measures has already been explained in the section of deficient demand.

(A) Public Expenditure

For controlling excess demand, the government should reduce the public expenditure on public works like constructing roads, dams, bridges, schools, hospitals, etc. and also curtail investments in public enterprises. It will make aggregate demand decline in the economy.

(B) Taxation

In situation of excess demand, government should impose heavy direct taxes (like income tax) specially on rich class of the society. Besides, taxes on goods used by rich people should also be increased.

(C) Public Debt

In situation of excess demand, government should take more and more loans from the public and collected money should be spent only on productive activities. Consequently, purchasing power with the public will decline and production increase which help in controlling excess demand.

II. Monetary Measures ¹

(D) Surplus Budget

Government should make surplus budget in situation of excess demand. Surplus budget implies a situation where public revenue exceeds public expenditure. Policy of surplus budget will trasnfer public’s purchasing power to the government which will reduce aggregate demand and control excess demand in the economy.

Role of Fiscal Policy in Correcting Excess Demand or Inflationary Gap : At a Glance The various monetary measures for controlling excess demand or inflationary gap are as follows : (i) Public expenditure should be reduced by the government by curtailing public works.

(ii) Taxes should be increased.

(iii) Public debt should be encouraged.

(iv) Government should adopt surplus budget, i.e., public

revenue should exceed public expenditure. Box 7

Monetary Measures of Correcting Excess Demand

(II)A (II)B Quantitative Measures

or

Quantitative Credit Control

^(A) Bank Rate

Qualitative Measures or Qualitative Credit Control (A) Margin Requirement of Loans Increase in Bank Rate ^(B) Open Market Operations Increase in Margin

^(B) Rationing of Credit Sale of Shares and Debentures by Central Bank in Open Market

^(C) Cash Reserve Ratio

Promotion of Credit Rationing

Increase in Cash Reserve Ratio ^(D) Liquidity Ratio

Increase in Liquidity Ratio

Box 8 IIA. Quantitative Monetary Measures Or Quantitative Credit Control

Various quantitative monetary measures for controlling excess demand are as follows :

(A) Bank rate is increased. Consequently interest rate on which commercial banks grant loan becomes costlier and as a result people demand less credit and aggregate demand declines.

(B) Securities are sold in open market which reduces the purchasing power in the hands of the public.

(C) Cash reserve ratio is increased which limits the credit expansion.

(D) Liquidity ratio is increased which limits the credit creation efficiency of banks.

IIB. Qualitative Monetary Measures Or Qualitative Credit Control Various Qualitative monetary measures for controlling excess demand are as follows :

(i) Margin requirement of loan is increased. Consequently, less loans are granted. (ii) Rationing of credit is made more strict for putting a check on credit flow.

1 The meaning of various Monetary Measures has already been explained in the section of deficient demand.

166

Introductory Macro Economics

1W

The Role of Monetary Policy in Controlling Excess Demand or Inflationary Gap : At a Glance

Excess demand or inflationary gap situation can be controlled by following monetary measures : (i) Bank rate to be increased for squeezing the credit creation and consequently aggregate demand.

(ii) Central Bank should sell securities in open market for reducing the purchasing power in the economy. (iii) Cash reserve ratio should be increased for controlling the credit expansion.

(iv) Liquidity ratio should be raised to put a check on credit creation by banks.

(v) Margin requirement should be raised so as to curtail the size of the loans. (vi) Rationing of credit should be adopted.

(vii) Commercial banks are advised by the central bank for credit contraction.

Hence, ‘Dear Money Policy’ is adopted for controlling excess demand and by various methods. Availability of credit is made difficult and expensive which stops people from taking more loans. Consequently, aggregate demand falls and the problem of excess demand is controlled.

Box 9

III. Other Measures

Other Measures of Correcting Excess Demand

(A) Export–Import Policy

Attempts of Promoting Imports and Curtailing Exports

^(B) Wage Policy

(C) Increase in Production (D) Price Control and Rationing Maintaining

Box 10

(A) Export–Import Policy

When the country faces the problem of excess demand, policy of boosting imports and checking exports should be adopted. Increase in imports will not affect domestic production but will put a control on inflationary tendencies in the economy.

(B) Wage Policy

Money wages should be kept stable in the state of excess demand. Increase in demand can be checked only if wages are increased when productivity increases.

(C) Increase in Production

For controlling excess demand production should be increased. With full utilisation of existing resources, production can be increased and the gap between aggregate demand and aggregate supply can be reduced.

(D) Price Control and Rationing

Government should sell the commodities through rationing for putting a check on excess demand. The maximum price ceiling of commodities should be fixed. Stockholding and speculation should be prohibited.

Difference between Fiscal Policy and Monetary Policy Fiscal Policy

1. It is related with government budget ( i.e., public expenditure, revenue and debt).

2. It is determined by Finance Ministry of the Government.

3. Main components of fiscal policy are : (i) Revenue from taxes, public debt deficit financing. (ii) Public expenditure on public works, welfare works, security,

Monetary Policy

1. It is related with money supply, availability of credit and its cost.

2. It is determined by central bank of the country.

3. Main components of monetary policy are : bank rate, sale or purchase of securities in open market operations, change in cash reserve ratio, change in

subsidy, etc. liquidity ratio and change in margin requirement of money.

Box 11

27.4. A Comparative Look at Measures of Correcting Deficient Demand and Excess Demand

Measure For Correcting Deficient Demand For Correcting Excess Demand

I. Fiscal Measures

• Public Expenditure

• Tax

• Public Debt

• Budget

II. Monetary Measures

• Money Policy

• Bank Rate

Should be raised

Tax burden should be reduced Should be reduced.

Deficit budget should be adopted. Should be curtailed.

Tax burden should be raised.

Should be raised.

Surplus budget should be adopted.

Cheap money policy should be adopted. Should be reduced.

• Open Market Operations Securities should be purchased.

• Cash Reserve Ratio

• Liquidity Ratio

III. Other Measures

• Foreign Trade Policy

• Rationing

• Price Control

Should be reduced Should be reduced. Dear money policy should be adopted. Should be raised.

Securities should be sold.

Should be raised.

Should be raised.

Policy of less import and more export. Should not be adopted.

Price supportive policy required.

Policy of more import and less export. Should be adopted.

Price control policy required.

A QUICK REVIEW OF THE CHAPTER

● Fiscal Policy : Government measures related to public expenditure, taxation and public debt are referred as fiscal measures and the policy related to these measures is called fiscal policy.

● Instruments of Fiscal Policy : (i) Public Expenditure, (ii) Taxation, (iii) Public Debt, (iv) Deficit Financing.

● Monetary Policy : A policy, which controls the money supply, credit availability and its cost, is termed as monetary policy. Central bank of the country makes this policy and ensures its execution.

● Measures of Monetary Policy : (1) Quantitative : (i) Bank Rate, (ii)

Open Market Operations, (iii) Cash Reserve Ratio, (iv) Liquidity Ratio.

(2) Qualitative : (i) Moral Pressure, (ii) Margin Requirement of Money, (iii) Credit Rationing.

● Bank Rate Policy : Bank rate is the rate at which the central bank of the country gives loans to commercial banks.

● Open Market Operations : Open market operations refer to the purchase and sale of securities in open market by the central bank.

● Change in Cash Reserve Ratio : It refers to the minimum percentage of a

bank’s total deposits which is essential to be kept with the central bank.

● Qualitative or Selective Credit Control : These controls aim at controlling the flow of credit for certain specific or selective activities in the system.

● Measures of Correcting Deficient Demand and Excess Demand :

Deficient Demand (Deflationary Gap) 1. Fiscal Policy :

(i) Increase in Public Expenditure

(ii) Reduction in Tax Burden

(iii) Reduction in Public Debt

(iv) Deficit Budget

2. Monetary Policy :

(i) Reduction in Bank Rate

(ii) Purchase of Securities in open Market (iii) Reduction in Cash Reserve Ratio (iv) Reduction in Liquidity Ratio

Excess Demand (Inflationary Gap) 1. Fiscal Policy :

(i) Reduction in Public Expenditure

(ii) Increase in Tax Burden

(iii) Increase in Public Debt

(iv) Surplus Budget

2. Monetary Policy :

(i) Rise in Bank Rate

(ii) Sale of Securities in open Market (iii) Rise in Cash Reserve Ratio (iv) Rise in Liquidity Ratio

168 (v) Reduction in Margin Requirement of Money

(vi) Abolition of Credit Rationing 3. Others

(i) Less Import, More Export

(ii) Declaration of High Supportive Price (iii) Constant (Stable) Wages

(iv) Price Control and Rationing

Introductory Macro Economics (v) Increase in Margin Requirement of Money

(vi) Credit Rationing

3. Others

(i) More Import, Less Export

(ii) Wage like according to increased production

(iii) Increase in Production

(iv) Price Control and Rationing

QUESTIONS Ultra Short Answer Type Question

1. What type of credit policy should be adopted by central bank of a country

in case of excess demand ?

2. What is bank rate policy ?

3. Who determines monetary policy ?

4. Which policy contains money supply ?

Very Short Answer Type Questions

1. What is meant by Fiscal Policy ?

2. What measures are included in Fiscal Policy ?

3. What is meant by Monetary Policy ?

4. What measures do we find in Monetary Policy ?

5. Define Trade cycles.

6. Explain how controlling money supply is helpful in reducing excess

demand ? (C.B.S.E. , 2016) Short Answer Type Questions

1. What is Monetary Policy ? What are its main instruments ?

2. What is Fiscal Policy ? What are its various instruments ?

3. Explain methods of correcting the situation of Excess Demand ? (C.B.S.E., 2018)

4. What is Bank Rate ? How it affects the availability of loans ?

5. What are Open Market Operations ? How do these affect the availability of credit ? (B.S.E.B. , 2011)

6. What is Excess Demand ? Would you advocate expansion or contraction of credit supply in a situation of Excess Demand ?

7. State any two fiscal measures by which Excess Demand in an economy can be reduced.

8. State any three fiscal measures for reducing Inflationary Gap.

9. In the given figure, what does the gap ‘KT’ represent ? State any two fiscal measures to correct the situation. (C.B.S.E., 2019)

Fig. 1

Long Answer Type Questions

1. Explain the various monetary measures by which Excess Demand in an economy can be checked. (B.S.E.B., 2011)

2. Explain the role of the following in correcting ‘deficient demand’ in an economy : (C.B.S.E., 2011,12) (i) Open market operations (ii) Bank rate.

3. Explain the role of the following in correcting ‘excess demand’ in an

economy : (C.B.S.E., 2011,12) (i) Bank rate (ii) Open market operations.

4. Explain the role of the following in correcting the inflationary gap in an

economy : (C.B.S.E., 2011) (i) Legal reserves (ii) Bank rate

5. Explain the role of the following in correcting the deflationary gap in an economy : (C.B.S.E., 2011) (i) Open market operations

(ii) Margin requirements.

6. What do you mean by monetary measures of central bank ? Explain the monetary measures of correcting deficient demand. (B.S.E.B., 2012)

7. Explain the meaning of unemployment equilibrium. Explain two measures by which full employment equilibrium can be reached. (C.B.S.E., 2013)

8. What is Monetary Policy ? How is it used during the situations of Excess Demand and Deficient Demand ? (B.S.E.B. , 2018)

9. What is excess demand ? How can it be controlled ? (C.B.S.E. , 2018)

Objective Type Questions

(A) Multiple Choice Questions :

1. Which of the following causes the appearance of a Trade Cycle ?

(a) Deflationary Conditions (c) Both (a) & (b)

(b) Inflationary Conditions (d) None of the above

2. Which one is the corrective measure for Deficient Demand ? (a) Fiscal Measures (c) Both (a) & (b) (b) Monetary Measures (d) None of the above

3. Which measure is included in Fiscal Measures ? (a) Public Expenditure

(b) Taxation

(c) Public Debt (d) All the above

4. Which fiscal measure should be adopted for correcting

Deficient Demand ?

(a) Government should spend more in public works (b) Taxation should be reduced

(c) Public debt should be reduced

(d) All the above

5. With which component of Monetary Policy, Central Bank tries to attain economic stability in the country ?

(a) Supply of Money (b) Interest Rate (c) Availability of Money (d) All the above

6. Which method Central Bank adopts for controlling quantitative of credit ?

(a) Bank Rate

(b) Open Market Operations

(c) Change in Cash Reserve Ratio

(d) All the above

7. Which is a qualitative method of controlling credit ? (a) Change in Margin Requirements of Loans

(b) Credit Rationing

(c) Direct Action

(d) All the above

8. Which monetary measure may be adopted to correct Deficient Demand ?

(B.S.E.B. , 2019) (a) Reduction in Bank Rate

(b) Buying Securities in Open Market

(c) Reducing Cash Reserve Ratio

(d) All the above

9. Which fiscal measure is to be adopted in correcting Inflationary Gap ?

(a) Reduction in Public Expenditure

(b) Selling Securities in Open Market

(c) Increase in Cash Reserve Ratio

(d) All the above

10. Which monetary measure is to be adopted in correcting Inflationary Gap

? (B.S.E.B. , 2011) (a) Increase in Bank Rate

(b) Selling of Securities in Open Market

(c) Increase in Cash Reserve Ratio

(d) All the above

[Ans. 1. (c), 2. (c), 3. (d), 4. (d), 5. (d), 6. (d), 7. (d), 8. (d), 9. (d), 10. (d).]

(B) Fill in the Blanks :

1. To correct................demand, Govt. should make more public expenditure.

2. Deficient demand can be corrected by adopting.............budget in the economy.

3. In situation of excess demand, central bank should adopt.............money policy.

4. For controlling inflationary gap bank rate should be................

5. Price................policy is required for correcting deficient demand.

[Ans. 1. deficient, 2. deficit, 3. dear, 4. increased, 5. supportive.]

(C) State True/False :

1. To correct deficient demand fiscal and monetary measures are used.

2. The policy concerning the revenue, expenditure and debt of the government for achieving definite objectives known as monetary policy.

3. Public expenditure, taxation, public debt etc. are the fiscal measures of correcting deficient demand.

4. Monetary policy involves the influence on the level and composition of aggregate demand by the manipulation of interest rate and availability of credit.

5. Export-import policy, support price policy, wage policy etc. are the monetary measures to correct deficient demand. [Ans. 1. True, 2. False, 3.

True, 4. True, 5. False] (D) Match the following Column :

‘A’

1. Fiscal Policy

2. Taxation

3. Rationing of Credit

4. Support Price policy

[Ans. 1. (c), 2. (d), 3. (b), 4. (a)] (E) Answer in One Word :

‘B’

(a) Other Measure (b) Monetary Measure (c) Budget Policy

(d) Fiscal Measure

1. Mention one fiscal measure of correcting deficient demand.

2. Which type of demand deflationary gap shows ?

3. What type of budget should be adopted to correct excess demand ?

4. What type of Export-Import policy be adopted to correct deficit demand ? [Ans. 1. Increase in Public Expenditure, 2. Deficient demand, 3. Budget of saving, 4. Increase in Export & decrease in Imports.]

HOTS High Order Thinking Skills Questions 1. “Deficient demand's correction needs deficit budget.” Why ?

(See : Point D of Section 27.2)

2. “Cheap money policy is essential to control the situation of

(See : Box 4)

3. Are ‘surplus budget policy’ and ‘dear money policy’ complementary in controlling inflationary gap ? Give reasons to your

(See : Section 27.3)

VBQ Value Based Questions

1. What change should be made in cash reserve ratio (CRR) for correcting inflationary pressure ?

(See : Part II A of Section 27.2)

2. What should be done regarding public debt in excess demand ? (See : Point C of Section 27.3)

MDQ Case Study Based on Evaluation & Multi-disciplinary Questions 1. In what circumstances do we need expansion methods of public expenditure and why ?

(See : Point A of Section 27.2)

2. What type of budget should be made for correcting deficient demand and why ?

(See : Part I of Section 27.2)

GOVERNMENT BUDGET AND ECONOMY

THE CHAPTER

28.1. Budget : Meaning 28.2. Components of Budgets Or Structure of Budget 28.3 Kinds of Budget 28.4. Budget Deficits 28.5. Fiscal Policy and its Role A Quick Review of the Chapter Questions High Order Thinking

Case Study Based on Evaluation & Multi-disciplinary Skills (HOTS) Questions Value Based Questions (VBQ) Questions (MDQ) NCERT Corner 28.1. Budget : Meaning

The word ‘ Budget ’ is said to have its origin from the French word Bougett which means ‘a small leather bag ’. Budget is a detailed economic statement which includes the details of income (i.e., revenue) and expenditure of the government. A budget is a document which contains estimates of government receipts and expenditure during a financial year (In India, financial year runs between April 1 to March 31).

● Budget : Important Definitions

(i) According to Rene Stourn , ‘‘The budget is a document containing a preliminary approval plan of public revenue and expenditure.’’

(ii) According to Findlay Shirras , ‘‘A budget in short includes a statement of the receipts and expenditure of the previous year, an estimate of the receipts and expenditure of the ensuring financial year and proposals as to meet ways and means for meeting a deficit or distributing a surplus, if any. (iii) According to P. E. Taylor , ‘‘Budget is a master financial plan of the government. It brings together estimates of anticipated revenue and proposed expenditures for the budget year.

28.1.1. Objectives of the Budget

Budget is not only an annual statistical statement of government revenue and expenditure but it also reflects government policies and a set of objectives which the government has to fulfil through budget. Thus, government budget is a statement of receipt and expenditure estimates during the period of coming financial year. Budget reveals the fiscal policy measures of the government focusing on growth and stability in the economy. Government tries to fulfil the following objectives through budget :

1. Encouragement to Economic Development : The basic objective of the budget is to accelerate the pace of economic development in the country. For accelerating the pace of economic development (i) government may grant tax rebates to productive activities, (ii) government may develop infrastructure like roads, canals, power, bridges etc. by increasing public expenditure and (iii) government may establish public enterprises.

2. Balanced Regional Development : Through budget, government may promote the development in backward areas for ensuring balanced regional development in the economy. Government may grant tax rebates to these areas, may establish public enterprises in these areas and may allocate more funds for infrastructural development in these backward areas.

3. Re-distribution of Income and Property : Budget plays a vital role in reducing the economic disparities in the economy. Many steps can be taken in the budget for reducing the economic disparities in the economy. For example, (i) heavy taxes on higher income group, (ii) tax exemption to lower income group, (iii) higher taxes on goods consumed by higher income group.

4. Economic Stability : Economy faces the cycles of boom and depression and the budget aims to put a control on these cycles. Government may adopt ‘surplus budget ’ during boom and ‘deficit budget ’ during depression.

5. Creation of Employment : Employment creation is one of the important objectives of government budget. Government may promote labourintensive techniques in public works programmes and may also initiate various employment generation programmes in the economy.

6. Management of Public Enterprises : Government may establish public enterprises for ensuring social justice in the economy because the aim of public enterprises is to ensure social welfare and not earning profit.

Government Budget and Economy

Characteristics of a Budget in a Planned Economy

Budget plays a decision-making role in planned economy. The goals of economic development in a planned economy may be achieved with the basic instruments of budget. A budget in a planned economy may contain the following features :

1. In a planned economy budget is based on the broad objectives of national planning.

2. In initial phase of economic development, planning is supported by deficit budget which is brought to near balanced budget in the later stage of development.

3. In a planned economy a policy of ‘justice in taxation ’ is adopted while making budget and for it the policy of progressive taxation is adopted.

4. Budget also plays a positive role in performing the economic activities in the country.

Box 1

28.2. Components of Budgets Or Structure of Budget

Budget has two components :

(A) Budget Receipts, (B) Budget Expenditure.

Components of Budget : At a Glance

Budget Receipts Budget Expenditure

Revenue Receipts Capital Receipts Revenue Expenditure Capital

Expenditure Box 2

28.2.1. Budget Receipts example, is a revenue receipt because it does not involve any corresponding liability for the government.

Budget receipts refer to estimated money receipts Tax is a unilateral or one-sided compulsory

^{paymentof the government from all sources during the fiscal to the government.year.} (ii) These

Receipts do not cause any Reduction in _{Budget receipts are classified into two parts :}

Assets of the Government : For example, when(I) Revenue Receipts, the government sells its shares of public companies,(II) Capital Receipts. it causes reduction in the assets of the government. (I) Revenue Receipts : Those money receipts of the These are, therefore, not to be treated as revenuegovernment are known as revenue receipts which receipts.satisfy two related characteristics : In short, Revenue Receipts of the government are

(i) These Receipts do not Create any Corresponding those money receipts which do not either create a Liability for the Government : Tax receipt, for liability or lead to reduction in assets. Constituents of Revenue Receipts

Tax Receipts

Income Tax

Corporate Tax

Estate Duty

(A) (B) Non-Tax Receipts Fees, License and Permits Fines and Penalties

Income from Public Enterprises

Gifts and Grants

(A) Tax Receipts

● Definitions of Tax

(i) According to Dalton , ‘‘A tax is a compulsory

contribution imposed by a public authority irrespective of an exact amount of service rendered to the taxpayer in return and not imposed as a penalty for any legal offence.’’

(ii) According to Buehler , ‘‘It is a compulsory contribution, although it may be paid willingly enough, but it is not a penalty for legal offences.’’

(iii) According to De Marco , ‘‘The tax is the price which citizen pays to the state to cover his shares of the cost of the general public services which will

consume.’’

(iv) According to Bastable , ‘‘Tax is compulsory contribution of the wealth of a person or body of persons for the service public power.’’

Thus, A Tax is a compulsory payment made by a person or a firm to a government without reference to any benefit, the payer may drive from the government.

● Characteristics of Tax

(i) A tax is a compulsory contribution. Everyone has to pay a tax upon whom it is levied by the state. Refusal to pay a tax is subject to punishment.

(ii) It is the duty of the tax payer to pay the tax if he is liable to pay it.

(iii) Revenue received from tax payers may not be incurred for their benefit alone, but for the general and common benefit.

(iv) Since public expenditure is done for the common benefit and the benefit may not be in proportion of payment of tax.

(v) A tax may be imposed on an individual or property or commodities, but it is actually paid by individuals.

(vi) It is a legal collection.

● Types of Taxes

1. Direct and Indirect Taxes,

2. Proportional, Progressive and Regressive Taxes,

3. Specific Tax and Ad –valorem Tax.

4. Direct and Indirect Taxes

● Direct Tax

Direct taxes are those taxes which are paid by the same person on whom they are levied. The person on whom direct tax is levied cannot shift its burden to others. It has to be borne by the tax-payer himself. In other words, when impact and incidence of tax fall on the same person, it is called direct tax. For example, income tax, property tax, profession tax, wealth tax, etc., are regarded as direct taxes.

● Indirect Tax

Indirect taxes are those taxes whose burden can be shifted, i.e. , indirect tax is one which is imposed on one person but it is paid partly or wholly by another person. For example, union excise duties, sales tax, custom duties, etc. When we buy goods from a shopkeeper, we have to pay trade tax with the price of the goods. Shopkeeper pays tax on his sale to the government and diverts it on his consumer. Due to this shifting of the tax, trade tax is

called indirect tax.

Distinction between Direct Tax and Indirect Tax

Direct Taxes

1. They are directly paid to the government by the person on whom it is imposed.

2. They are generally progressive. The rate of tax increases with increase in income.

3. They cannot be shifted on to others.

Indirect Taxes

1. They are paid to the government by one person but their burden is borne by another person.

2. They are generally regressive. The rate of tax decrease as income increases.

3. They can be shifted on to others.

Box 4

A New Indirect Tax : Goods & Service Tax (GST)

Goods and Services Tax (GST) is a newly created national sales tax which included all indirect taxes of the country. All states of the country possess the uniform tax rate. GST has one slogan—One Tax, One Nation, One Market.

GST is compulsorily a tax imposed on value added which includes the entire chain of production activities between producer and consumers.

Box 5

2. Proportional, Progressive and Regressive Taxes (i) Proportional Tax : Taxes in which the rate of tax remains constant whatever the size of the tax base may be. For example, if the rate of income tax remains 20 percent whatever the size of income is, it will be a proportional tax.

Table 1 : Proportional Tax

Income (Y) Tax Rate Tax Amount (`)% (`)

(ii) Progressive Tax : Taxes in which the rate of tax increases with the increase in the size of tax base, are called progressive taxes. In India, income tax is a progressive tax.

Table 2 : Progressive Tax

Income (Y) Tax Rate Tax Amount (`)% (`)

1,000 20 200
2,000 30 600
3,000 40 1,200
4,000 50 2,000

(iii) Regressive Tax : When the rate of tax decreases as the tax base increases the taxes are called regressive taxes. The burden of such taxes falls, more heavily on the poor than on the rich.

Table 3 : Regressive Tax

Income (Y) Tax Rate Tax Amount (`)% (`)

1,000 30 300 2,000 20 400 3,000 14 320 4,000 12 480

3. Specific and Ad-valorem Tax

According to method of assessment, taxes on commodities may be classified into two groups—specific and advalorem.

(i) Specific Tax : Specific taxes are those taxes which are based on specific qualities or attributes of goods such as weight, number or volume of the commodity taxed. For example, tax on the sugar on the basis of units of weight

Distinction between Specific Tax and Ad-valorem Tax

Specific tax is levied on the basis of attributes of goods like weight, units, size, etc., while ad–valorem tax is levied on the basis of money value of the goods.

Box 6

and on the cloth on the basis of length units are specific taxes.

Merits : (i) It is easy and convenient in collection as it is collected on the basis of weight or volume. (ii) Tax evasion is difficult in specific taxes.

Demerits : It put heavy burden on poor as it is based on proportional tax system.

(ii) Ad-valorem Tax : Whereas taxes are levied entirely on the basis of money-value of the goods they are called ad–valorem taxes. For example, import or export duties are levied in terms of value. Imported or exported goods have nothing to do with their size, length and weight. Merits : It falls heavily on rich and hence, it establishes maximum social justice.

(B) Non-Tax Receipts

Non-Tax Receipts are those receipts which are received from sources other than taxes like interest, dividend, etc. Some important non-tax receipts are as follows :

(1) Fees, License and Permit : One of the main sources of non-tax revenue of the government is fees, license and permit.

(a) Fees : A fee is a payment to the government for the services that it renders to the people, e.g., land registration fees, birth and death registration fees, passport fees, court fees, etc. Main Features of Fees :

(i) Fee is a compulsory payment to be made by a person for availing a service.

(ii) Fee provides specific benefit to the payer and it also implies general advantage.

(iii) Fee is not a payment (price) for commercial service but it is a payment for administrative and judicial services provided to the people.

(iv) Generally, amount of fee is equivalent to the cost of service provided .

(b) License and Permit : The amount that government charges for allowing the people to perform a given job, is called license or permit fees. ‘‘License fees are charged to

Difference between Fees and License License fees are paid when a person is permitted to do some specific job by the government. No service is provided to the licenseholder. On the contrary, in case of fees , the payer receives some service from the government. When the government is not willing to authorise some persons to do a particular job, it refuses license to them. By issuing license to liquor vendors, government controls the sale of liquor.

Box 7

give permission for something by the government.’’ Its examples are : driving license, import license. (2) Escheat : Escheat refers to that income of the state which arises out of the property that comes to it for want of a legal heir. Such a property has no claimant and the State alone has the legal right over it.

(3) Fines and Penalties : Fines and penalties are those payments which are made by the law breakers to the government by way of economic punishment. The aim is not to earn revenue. Its actual aim is to force the people to be law abiding (follow the rules and regulations).

(4) Income from Public Enterprises : Government earns profit income from the sale of the products made by public enterprises. This income is a nontax revenue source of the government.

(5) Gifts and Grants : Gifts received by the government are also a source of revenue. In the event of some natural calamities (like earthquake, floods, famines) or during wars, citizens of the country often give large gifts and donations to the government. Such gifts are also received by the government from rest of the world.

II. Capital Receipts : Capital receipts of the government are those monetary receipts which satisfy the following two characteristics :

(1) These receipts create a liability for the government.

For example, loans by the government are a liability. These are to be paid back. These are, therefore, the capital receipts of the government.

(2) These receipts cause reduction in assets of the government. As stated earlier, money received by the government by selling its shares in a public enterprise causes reduction in assets of the government. These are, therefore, to be treated as capital receipts. In short, capital receipts are those monetary receipts which either create liability for the government or cause reduction in the assets of the government.

Constituents Capital Receipts

1. Recovery of Loans 2. Loans and Borrowings 3. Disinvestment of Shares of Public Sector Enterprises

Domestic

● Constituents of Capital Receipts

Foreign Box 8

1. Recovery of Loans : The Central Government offers loans to the state governments, union territories, local bodies, etc., to cope with their financial requirements. The loans are recovered by the Central Government from the borrowers and they form a part of capital receipts. These recoveries reduce financial assets of the government.

2. Loans and Borrowings : Sometimes the government borrows funds from different sources to meet its financial requirements. These borrowings create liabilities for the government. The government may borrow funds from general public, Reserve Bank of India, foreign governments and other bodies.

3. Disinvestment of Equity Holding in Public Sector Enterprise :

Disinvestment is an opposite concept of investment. Disinvestment means the funds received by the government from the sale of the part or the whole of equity shares of the public enterprises to others. Such receipts are called capital receipts because it causes reduction in assets of the government.

28.2.2. Budget Expenditure

Budget expenditure refers to the estimated expenditure of the government during a financial year. Budget expenditure can be classified into two parts :

I. Revenue Expenditure,

II. Capital Expenditure.

I. Revenue Expenditure : Revenue expenditures of the government are those expenditures which have the following two characteristics :

(i) Revenue Expenditures do not create Assets for the government. For example, expenditure by the government on old-age pensions, salaries and scholarships are to be treated as revenue expenditure. Because these are just routine expenditures, not creating assets of any sort.

(ii) Revenue expenditures do not cause any Reduction in Liability of the Government. Expenditure on the repayment of loans, for example, causes reduction in government liability. Accordingly, this is not to be treated as revenue expenditure.

In short, revenue expenditure refers to estimated expenditure of the government in a fiscal year which neither creates assets nor cause a reduction in liabilities. II. Capital Expenditure : Those expenditures of the government are capital expenditures which (i) Create Assets for the Government . Equity (or shares) of the domestic or multinational corporations purchased by the government may be cited as an example. (ii) Cause Reduction in Liabilities of the Government . Repayment of loans certainly reduces liability of the Government. Accordingly, this is to be treated as capital expenditure.

In short, capital expenditure refers to the estimated expenditure of the government in a fiscal year which either creates assets or causes a reduction in liabilities.

28.2.3. Other Types of Public Expenditure Public Expenditure

(I) Developmental and Non-developmental Expenditure

(II) Plan Expenditure and Non-plan Expenditure

Box 9 I. Developmental and Non-developmental Expenditure

(i) Developmental Expenditure : Developmental expenditure is that expenditure which is incurred on economic and social development of the country. Expenditures on the development of agriculture, industries, health, education, environment, transport and communication, etc., are included in this group.

(ii) Non-developmental Expenditure : Non-developmental expenditure is that expenditure which does not promote economic development such as expenditure on administrative services like police, defence, administration of justice, general administration, grants to states government for nondevelopmental purposes.

II. Plan Expenditure and Non-plan Expenditure (i) Plan Expenditure : It refers to that expenditure which is made by the Government on various projects, programmes and schemes included in the central plans . It includes both the consumption and investment expenditure of the Government. It includes expenditure on agriculture and allied activities, irrigation, energy, transport, communication, general economic and social services, etc.

Plan expenditure can further be divided into two parts :

(a) Revenue Expenditure,

(b) Capital Expenditure.

(ii) Non-plan Expenditure : It includes all those expenditures which are not covered or included in the plan. It includes both developmental and nondevelopmental expenditure, like education, health, roads, rural development, interest on loans, pensions, etc. Non-plan expenditure can again be divided into two parts : (a) Revenue Expenditure, (b) Capital Expenditure.

Box 10

+ Capital Expenditure

Total Expenditure = Plan Expenditure + Non-plan Expenditure

Total Expenditure = Development Expenditure + Non-development

Expenditure

Box 11

Introductory Macro Economics

Structure of Government Budget : At a Glance

Budget Receipts

Revenue Capital Receipts Receipts Borrowings Plan Plan Tax Receipts Recovery of Loans Budget Expenditure

Revenue Expenditure Non-plan

Development

Non development Non-Tax Receipts

Other Sources of Disinvestment According to the Capital

Expenditure

Non-plan

Development

Box 12 28.3 Kinds of Budget

Non

development

traditional approach, a budget is

Budgets

Balanced Budget Unbalanced Budget

Surplus Budget Deficit Budget

deemed a balanced budget if revenue of the government is sufficient for meeting its expenditure over the period under consideration . A general view of the concept of balanced budget is that over a fixed interval of time the total receipts are equal to total expenditure. Traditional economists favoured balanced budget but due to great depression of 1930 the concept of balanced budget was criticised. Prof. Keynes opposed balanced budget for underdeveloped countries.

Performance Budget

A budget made on the basis of performance in activities is called performance budget. This budget does not put stress on sources of achievements, rather stress is given on achievements itself. In centre point of the budget, those targets and aims do appear which government wants to fulfil.

Gender Budget

Government initiated gender budget with the objective of women empowerment. An amount of funds are allocated by the government every year in the budget for various plans and programmes associated with the development, welfare and empowerment of the women.

28.3.1. Balanced Budget

Balanced budget is that budget in which government receipts are equal to government expenditure.

Balanced Budget

[Government Expenditure]

28.3.2. Unbalanced Budget

Unbalanced budget is the budget in which the anticipated revenue and estimated expenditure are not equal. Unbalanced budget may of two types :

I. Surplus Budget,

II. Deficit Budget.

I. Surplus Budget

Surplus budget is a budget in which estimated income of the government exceeds estimated expenditure of the government.

Surplus Budget

[Estimated Income of > Government]

[Estimated Expenditure of Government]

[Government = Receipts]

(i) Surplus Budget : Desirable in Inflation : In inflationary tendencies, surplus budget is desirable tendencies. Surplus budget is desirable because surplus budget decreases the level of aggregate demand in the economy which helps in reducing the inflationary gap in the economy.

Surplus budget brings reduction in aggregate demand due to two reasons :

(i) Government collects more revenue by higher taxes which leaves less purchasing power in the hands of people. Consequently, demand comes down.

(ii) Less public expenditure gives less income to the public which again reduces the public demand.

(ii) Surplus Budget : Undesirable in Depression : In surplus budget, public expenditure falls short of public revenue and hence, it becomes undesirable in conditions of depression in the economy because :

Low Public Expenditure ↓ Less Economic Activities ↓ Less Investment ↓ Less Employment ↓ Less Income ↓ Less Savings and Consumption ↓

Contraction in the Economy

II. Deficit Budget

Deficit budget is that budget in which estimated income of the government falls short of estimated expenditure.

Deficit Budget

[Estimated Income of

Government]

< [Estimated Expenditure

of Government]

Deficit budget implies the supply of more money in the economy than its absorption capacity. Consequently, extension forces appear in the economy.

● Deficit Budget : Helpful in Depression Prof. Keynes advocated for deficit budget for coming out from the phase of depression in the economy. Deficit budget is helpful in depression because

Deficit Budget ↓ More Public Expenditure ↓ More Investment ↓ More Employment ↓ More Income ↓ More Saving and Consumption ↓ Extension in the Economy 28.4. Budget Deficits

Budget deficit refers to a situation in which budget expenditure of the government exceeds budget receipts. Budget deficit represents excess of all expenditures on both revenue and capital accounts over all receipts on revenue and capital accounts including borrowings by the Central Government.

Budget Deficit = [Total Expenditure] – [Total Receipts] = [Revenue Expenditure + Capital Expenditure] – [Revenue Receipts + Capital Receipts]

Box 13

● Budget Deficit : Types and Measurement In annual budget of union government following three types of deficits are included : 1. Revenue Deficit, 2. Fiscal Deficit, 3. Primary Deficit.

28.4.1. Revenue Deficit

Revenue deficit is the excess of revenue expenditure over revenue receipts. Revenue receipts include both tax revenue and non-tax revenue. Similarly, revenue expenditures also include both plan and non-plan expenditures on revenue account. Revenue deficit does not include items of capital receipts and capital expenditure.

[Revenue Deficit]
[Revenue Deficit] = [Revenue Expenditure] - Or
= Plan Expenditure on

[Revenue Receipts] Tax Revenue + Revenue Account + Non-Plan – Non-Tax Revenue Expenditure on Revenue Account Box 14

● Importance of Revenue Deficit

For economic development government should put a control on revenue deficit. A high revenue deficit warns the government either to cut its expenditure or increase its tax and non-tax receipts. But in a country like India, where people are poor, it is difficult to force them to pay more taxes. In such a situation, revenue deficit can be made up either through borrowing or disposal of assets, i.e., disinvestment. While borrowing creates liability for the government, disinvestment reduces her assets. A government should try to strike a proper balance between its assets and liabilities otherwise the financial system of the economy will be destablished.

178

Introductory Macro Economics

28.4.2. Fiscal Deficit

It is an important measure of deficit in the budget. Fiscal deficit refers to the excess of all the anticipated government expenditure (both on revenue and capital account) over the anticipated government receipts in the year both on revenue and capital account except borrowings .

Fiscal deficit is the excess of total expenditure (revenue + capital) over total receipts other than borrowing (Revenue Receipts + Capital Receipts other than borrowings.)

Fiscal deficit is, in fact, equal to the total borrowings and other liabilities of the government.

Box 15

The point to be noted in case of fiscal deficit is that it does not take into account borrowings which is a part of capital receipts . Total Receipts means

Revenue Receipts + Non-debt Capital Receipts (i.e., capital receipts less borrowings). Non-debt capital receipts indicate recoveries of loans and disinvestment proceeds.

Fiscal Deficit = Budgetary_+Deficit

= Total

Expenditure Borrowing and

other Liabilities

Revenue Receipts

– + Debt Recovery

+ Other Receipts

Plan Expenditure Tax Revenue + Non-tax Revenue = + –

Non-Plan Expenditure + Debt Recovery + Other Receipts

Plan Expenditure on Revenue Account

+ Plan Expenditure on Capital Account

= + Non-plan Expenditure on Revenue Account –

+ Non-plan Expenditure on Capital Account

Tax Revenue + Non-tax Revenue + Debt Recovery + Other Receipts

Financing of Fiscal Deficit

Fiscal deficit can be financed by three ways :

(i) Borrowing from Internal and External Sources : Fiscal deficit can be met by borrowing both from internal market and external sources.

(ii) Disinvestment : Fiscal deficit can be met by selling the shares of public enterprises, i.e., disinvestment. (iii) Borrowing from the R.B.I. : Fiscal deficit can be met by borrowing by the Govt. from RBI against its own securities. The RBI in turn issues new currency money which is called ‘monetising the deficit’ . In other words, that part of the fiscal deficit which is financed by printing of new currency notes is called ‘monetised deficit ’. It is generally called deficit financing in India. Monetised deficit indicates the level of support extended by the Reserve Bank of India to the Government’s Borrowing programmes.

Box 16

Importance of Fiscal Deficits

Fiscal deficit is an useful instrument for giving a direction to the economy because :

(i) It helps in increasing the amount of capital expenditure in the economy. (ii) Government can collect more resources for meeting out its expenditures.

Dangers of Fiscal Deficit

Fiscal deficit contains a few dangers also : (i) Fiscal deficit may lead to inflationary pressure on the economy.

(ii) High fiscal deficit generally leads to wasteful and unnecessary expenditure by the government. So fiscal deficit should be kept as low as possible.

(iii) The entire amount of fiscal deficit, i.e., borrowings is not available for meeting expenditure because a part of it is used for interest payment. Only primary deficit (fiscal deficit-interest payment) is available for financing expenditure.

Due to above dangers of fiscal deficit, it is necessary to keep it within limits.

28.4.3. Primary Deficit

Primary deficit is the difference between fiscal deficit and interest payment. ^{Primary Deficit or = [Fiscal Deficit]} Gross Primary Deficit

– [Interest Payment] Primary deficit indicates how much government borrowing is going to meet expenses other than interest payment. It reflects the extent to which future burden is increasing.

Zero Primary Deficit : Indicator of Fiscal Discipline

The zero primary deficit signifies that the government has to resort to borrowing only to fulfil its earlier commitments of interest payments. In other words, the government is not adding to the existing loans for the purpose other than meeting its existing obligation of interest payment. It is a sign of fiscal discipline or fiscal responsibility on the part of the government. High primary deficit, on the other hand, reflects fiscal irresponsibility of the government.

Box 17

Distinction between Various Deficits : At a Glance Revenue Deficit

1. It is an excess of revenue expenditure over the revenue receipts.

2. Revenue Deficit = Revenue Expenditure – Revenue Receipts

3. It indicates the reasons of borrowings by the government.

Fiscal Deficit

It is an excess of all anticipated Govt. expenditure over the anticipated Govt. receipts in the year.

Fiscal Deficit = Total Expenditure

– Revenue Receipts – Capital Receipts excluding borrowings It increases the liability of the Govt. in the form of repayment of loan with interest.

Primary Deficit

Primary deficit is the difference between fiscal deficit and interest payment. It is known as gross primary deficit.

Primary Deficit =Fiscal Deficit

– Interest Payment

It indicates borrowing requirement of the Govt. to meet fiscal deficit excluding interest payment.

Box 18

28.5. Fiscal Policy and its Role

Fiscal policy at present is a powerful instrument of promoting and accelerating economic development. According to Arthur Smithies, ‘‘Fiscal policy is a policy under which government uses its expenditure and revenue programmes to produce desirable effects and avoid undesirable

effects on the national income, production and employment.’’ Objectives of Fiscal Policy in Underdeveloped Countries The salient objectives of fiscal policy in developing or underdeveloped economies are :

(i) To accelerate investment rate (i.e. , to promote capital formation),

(ii) To mobilise resources for investment,

(iii) To redistribute the growing national income, (iv) To maintain economic stability.

Thus, in a developing economy, the government through fiscal policy plays the four roles mentioned below :

(a) Role of Investor,

(b) Role of Resource Management,

(c) Role of Income Redistributor,

(d) Role of Economic Stabiliser.

(a) Role of Investor

Fiscal Policy and Capital Formation

Fiscal policy can affet investment quantitatively and qualitatively. The quantitative aspect is concerned with increasing investment. Fiscal policy is a means of expanding the volume of investment in the public sector and also encouraging investment in the private sector. In its qualitative aspect, it changes the pattern of investment in such a way as to encourage socially desirable and productive investment and discourage unproductive and nonessential investment.

(b) Role of Resource Management Or

Fiscal Policy and Resource Mobilisation Domestic financing of economic development requires an increase in savings (voluntary saving and taxation) and investment (private sector and public sector investment). The level of voluntary savings being very low, the mobilisation of investible resources needed for the economic development of the country becomes very difficult.

To increase the volume of development finance from internal sources, the government may adopt the following methods :

(1) Direct physical controls,

(2) Increase in the rates of existing taxes,

(3) Imposition of new taxes,

(4) Surplus from public enterprises,

(5) Public borrowing and

(6) Deficit financing.

(c) Role of Income Redistributor

Or

Fiscal Policy and Income Redistribution Underdeveloped or developing economies do have disparities of income and wealth. A few people are very rich and a vast majority live in extreme poverty. Fiscal policy is helpful in reducing this income disparities. Progressive taxation helps in reducing income disparities. Exemption of poor people from taxes and high taxation on higher income group do help in reducing income disparities.

(d) Role of Economic Stabiliser Or

Fiscal Policy and Economic Stability The objective of fiscal policy in underdeveloped economies also ‘‘prevention of economic fluctuations’’ in the economy. Development project need high investment which gives results after long gestation period. This results in inflationary pressure on the economy. For checking this pressure, government promotes saving and impose higher taxation. Thus, fiscal policy plays vital role in the economic development of developing economy.

A QUICK REVIEW OF THE CHAPTER

● Budget : It is a statement of expected revenue and expenditure of the government over the period of a financial year (April 1—March 31 in India). ● Objectives of the Budget : (a) Redistribution of income and wealth with a view to increasing equality, (b) Reallocation of resources with a view to maximising social welfare, (c) Achieve economic stability and (d) To accelerate growth through public sector enterprises.

● Structure of the Budget : It includes (a) revenue budget showing revenue receipts and revenue expenditure of the government, and (b) capital budget showing capital receipts and capital expenditure of the government.

● Revenue Receipts : (a) Which do not cause any reduction in assets and (b) which do not create any corresponding liability of the government [Example : tax receipts of the government].

● Capital Receipts : (a) Which create corresponding liability for the Government (Example : loans by the government) and (b) which cause reduction in assets of the government (Example : disinvestment).

● Tax : It is a compulsory payment made by an individual, household or a firm to the government without receiving anything in return.

● Progressive Tax : It increases with increase in income. It implies greater real burden of tax on the rich than the poor.

● Regressive Tax : It decreases with increase in income. It implies greater real burden of the tax on the poor than the rich.

● Proportional Tax : It remains constant at all income levels.

● Ad-valorem Tax : It relates to the value of the goods and services.

● Specific Tax : It relates to unit(s) of the goods, not the value of goods.

● Direct Tax : It is the tax in which final burden of the tax falls on the person who pays. It cannot be shifted on others.

● Indirect Tax : It is a tax on goods and services. It is to be initially paid by the producers/traders but its final burden can be passed on to the final buyers by way of increase in price of the taxed commodity. Sales tax is an example of it.

● Revenue Expenditure : It is that expenditure by the government (a) which does not cause increase in government assets, and (b) which does not cause any reduction in government liability.

● Capital Expenditure : It is that expenditure by the government (a) which causes increase in government assets, and (b) which causes reduction in government liability.

● Plan Expenditure : It is incurred in accordance with planned development programmes of the country.

● Non-plan Expenditure : It is not incurred in accordance with planned development programmes of the country.

● Development Expenditure : It is directed towards development programmes of the country. And, which directly contributes to the flow of goods and services in the economy.

● Non-development Expenditure : It is not directly related to development programmes of the country. And, which does not directly contribute to the flow of goods and services in the economy.

● Balanced Budget :

● Deficit Budget :

● Surplus Budget :

● Revenue Deficit :

Total Expenditure = Total Revenue

Total Expenditure > Total Revenue

Total Expenditure < Total Revenue

Revenue Receipt < Revenue Expenditure

● Fiscal Deficit : (Revenue Expenditure + Capital Expenditure) – Revenue

Receipts + Capital Receipts (other than Government Borrowing)

● Primary Deficit : Fiscal Deficit – Interest Payment

QUESTIONS Ultra Short Answer Type Question

1. What type of tax is income tax ? Direct or Indirect ?

2. What type of budget is made during economic depression ?

3. What is revenue receipt in budget ? (C.B.S.E ., 2016, 17)

4. What is meant by primary deficit ?

5. What is meant by fiscal deficit ?

( C.B.S.E., 2019) (C.B.S.E., 2019) 6. Who presents the government Budget ?

(MP Board, 2019) Very Short Answer Type Questions

1. Define Government Budget. (C.B.S.E. , 2013; J.A.C., 2018) Or

What do you mean by Budget ?

Or

Define Budget. (J.A.C. , 2016) 2. Name the two parts of a Government

Budget. 3. Define Balanced Budget.

4. What is meant by Deficit Budget ?

(U.S.E.B. , 2011; B.S.E.B. , 2018) 5. Explain the objectives of government budget. 6. Define Revenue Expenditure. (C.B.S.E. , 2016) 7. Define Revenue Receipts.

8. Define fiscal deficit. (J.A.C. , 2010; C.B.S.E., 2016) 9. Define the term

Tax. (J.A.C. , 2011, 19; C.B.S.E. , 2010,12, 19) 10. What is a Direct Tax ? (U.S.E.B. , 2015; J.A.C. 2015, 17) Or

Define Direct Tax. (MP Board , 2019) 11. Give two examples of Direct Tax. (C.B.S.E. , 2010; U.S.E.B. , 2015; B.S.E.B. , 2019) 12. Define Indirect Tax. (J.A.C. , 2015; U.S.E.B. , 2015; MP Board , 2019) 13. Give two examples of Indirect Tax.

(C.B.S.E. , 2013; U.S.E.B. , 2015) 14. Define Proportional Tax. (B.S.E.B ., 2014) 15. Define Progressive Tax. (J.A.C. , 2013; B.S.E.B ., 2014) 16. What is Regressive Tax ? (J.A.C. , 2013, 19) 17. Define Capital Receipts. (Raj. Board , 2013; C.B.S.E. , 2016, 17) 18. Give two examples of Capital Receipts.

19. Define Capital Expenditure. (Raj. Board , 2013) 20. Define Capital Budget.

20. Define Plan Expenditure.

21. Define Non-plan Expenditure.

22. Define Development Expenditure.

23. Give two examples of Development Expenditure. 25. What is Nondevelopment Expenditure ?

24. What is meant by Revenue Deficit ? (C.B.S.E. , 2010, 13) 27. Why are taxes received by the government not capital receipts?

25. What is meant by a financial year in India? 29. What is Budget ? Explain performance Budget and Gender Budget. (B.S.E.B., 2014) 30. Sales tax and Entertainment tax are examples of which tax ? (MP Board , 2016)

Short Answer Type Questions

1. What is Government Budget ? What are the main features of a Government Budget ?

( U.S.E.B., 2010; B.S.E.B., 2009, 11, 13, 14 18; J.A.C. , 2016, 18; Raj . Board , 2017) 2. Explain briefly any two objectives of Government Budget. (B.S.E.B., 2009; 2018; C.B.S.E., 2013; J.A.C., 2013) 3. What is Government Budget ? Name two sources each of Non-tax Revenue Receipts and Capital Receipts.

( U.S.E.B., 2015) 4. Distinguish between Revenue Receipts and Capital Receipts in a Government Budget. Give two examples of each.

8. Distinguish between Progressive, Regressive and Proportional Taxes. 9. What is budget ? Distinguish between balance and deficit budget.

How are capital receipts different from revenue receipt ? Discuss briefly. (C.B.S.E., 2019)

5. What do you mean by Capital Receipts ? What are the main components of the Capital Receipts ? (Raj. Board, 2015)

6. What is meant by Revenue Receipts ? Explain the components of Revenue Receipts of the government.(Raj. Board , 2017)

7. Explain the allocation function of a government budget. (C.B.S.E. , 2010,11)

(U.S.E.B., 2017) 10. What is meant by Capital Expenditure and Revenue Expenditure ? Give an example of each. (J.A.C. , 2017) 11. Distinguish between Development and Non-development Expenditure.

12. Differentiate between Plan and Non-plan Expenditure. (J.A.C., 2012) 13. Distinguish between Revenue Expenditure and Capital Expenditure. Give an example of each.

(C.B.S.E. , 2012, 13; U.S.E.B ., 2014) Or

Distinguish between Capital Expenditure and Revenue Expenditure. (M.P. Board, 2017; J.A.C. , 2019) 14. What is meant by Revenue Deficit ? What are its effects ? (J.A.C., 2011; C.B.S.E., 2012) 15. How is Revenue Deficit measured ? (Raj. Board, 2013) 16. Distinguish between : (J.A.C., 2015) (i) Direct and Indirect Tax

(B.S.E.B., 2011, 13; J.A.C., 2013, 18) (ii) Revenue Receipts and Capital Receipts

(U.S.E.B., 2011; C.B.S.E. , 2012; J.A.C., 2013; MP Board 2019) 17. What do you mean by Fiscal Deficit ? What are its effects ? (B.S.E.B., 2010; J.A.C., 2010; U.S.E.B., 2012) 18. Distinguish between ‘Fiscal deficit and Revenue Deficit’. (U.S.E.B ., 2017) 19. Define Government Budget. Write any four objectives of government budget. (B.S.E.B., 2010; J.A.C., 2013) 20. What is the meaning of revenue deficit? What problems arise due to this ? (J.A.C., 2012; B.S.E.B., 2013) 21. Classify public expenditure. (J.A.C., 2019) 22. What is Tax ? State its two main features.

(U.S.E.B., 2013; MP Board , 2017)

23. What is a deficit budget? Describe its merits and demerits. (U.S.E.B., 2019)

24. How can government budget be helpful in altering distribution of income in an economy ? Explain. (C.B.S.E., 2010)

25. Give reasons classify following into direct & indirect tax– wealth tax and value added tax. (C.B.S.E., 2010)

26. Define direct tax. Explain its merits and demerits. (U.S.E.B., 2011; MP Board , 2017)

27. Explain the re-distribution objective of govt. budget. (C.B.S.E., 2011)

28. Explain the economic stability objective of govt. budget. (C.B.S.E., 2011)

29. Is fiscal deficit essentially inflationary in nature ? Explain.

30. What do you understand by deficit budget ?

(U.S.E.B., 2014)

31. Explain the concept of revenue deficit in a government budget. (J.A.C . , 2016)

32. Write two examples of tax revenue and non-tax revenue. (Raj. Board , 2016)

33. Explain revenue receipts in government budget with suitable example. (U.S.E.B ., 2016)

34. Clarify the effects of fiscal deficit on the economy. (U.S.E.B ., 2016)

35. Describe the importance of government budget. (U.S.E.B ., 2016)

36. State any four objectives of Government Budget. (J.A.C. , 2017, Raj. Board , 2017)

37. Explain the effect of deficiate budget. (M.P. Board, 2017)

38. Explain the following :

(a) Fiscal Deficit

(b) Balanced Budget (U.S.E.B., 2019) Long Answer Type Questions

1. Distinguish between Balanced Budget and Unbalanced Budget. (J.A.C. , 2010)

2. Distinguish between Direct Tax and Indirect Tax. (J.A.C., 2013; C.B.S.E , 2016)

3. Explain the significance of Government Expenditure in the modern economies. (B.S.E.B., 2012)

4. What is meant by Budget ? What are the objectives of Budget ? (J.A.C. , 2012)

5. Distinguish between : (C.B.S.E., 2010, J.A.C., 2017) (i) Capital

expenditure and Revenue expenditure. (ii) Fiscal deficit and Primary deficit. 6. What is called Government Budget ? What are its characteristics ? (B.S.E.B., 2011)

7. What are the components of aggregate expenditure ? (J.A.C. , 2012)

8. Explain the balanced budget, surplus budget and deficit budget. (U.S.E.B., 2012; J.A.C., 2013, 16)

9. From the following data about a Government budget, find out : (a) Revenue deficit, (b) Fiscal deficit and (c) Primary deficit : (C.B.S.E., 2011)

(` Arab ) (i) Capital receipts other than borrowings

(ii) Revenue expenditure

(iii) Interest payments

(iv) Revenue receipts

95 100 10 80 (v) Capital expenditure 110 [Ans. (a) 100 – 80 = 20 Arab

(b) (100 + 110) – (95 + 80) = 35 Arab

(c) 35 – 10 = 25 Arab]

10. Explain the following concepts prevalent in the budget of Govt. of India. (B.S.E.B., 2014) (i) Revenue Deficit, (ii) Fiscal Deficit, (iii) Primary Deficit. 11. Distinguish between progressive and regressive taxation in terms of their effect on the rich and the poor. (J.A.C., 2014) 12. What is progressive tax ? Explain its merits and demerits. (B.S.E.B., 2015; J.A.C., 2019) 13. Explain the need for reduction inequalities of income and wealth. Explain any two budgetary measures by which it can be done. (C.B.S.E., 2015) 14. What is the difference between revenue expenditure and capital expenditure ? Explain how taxes and government expenditure can be used to influence distribution of income in the society ? (C.B.S.E. , 2016) 15. What is government budget ? Explain how taxes and subsidies can be used to influence allocation of resources ? (C.B.S.E ., 2016) 16. Explain the meaning of following : (C.B.S.E., 2018) (a) Revenue Deficit, (b) Fiscal Deficit, (c) Primary Deficit. 17. Explain the following objectives of government budget : (C.B.S.E., 2018) (a) Allocation of Resources, (b) Reducing Income Inequalities.

Objective Type Questions

(A) Multiple Choice Questions :

1. Financial Year in India is : (B.S.E.B. , 2011, 17) (a) April 1 to March 31 (b) January 1 to December 31 (c) October 1 to September 30 (d) None of the above

2. Which objectives government attempts to obtain by Budget ? (a) To Promote Economic Development (b) Balanced Regional Development (c) Redistribution of Income and Wealth (d) All the above

3. Which is a component of Budget ? (J.A.C. , 2017) (a) Budget Receipts

(c) Both a & b

(b) Budget Expenditure (d) None of the above

4. Which is a component of Budget Receipt ?

(a) Revenue Receipt (c) Both a & b

( B.S.E.B. , 2011, 17) (b) Capital Receipt

(d) None of the above

5. Tax revenue of the Government includes : (a) Income Tax (c) Excise Duty (b) Corporate Tax (d) All the above

6. Which is included in the Direct Tax ? (B.S.E.B., 2018 ; J.A.C ., 2016, 18) (a) Income Tax (b) Gift Tax (c) Both a & b (d) Excise Duty

7. Which is included in Indirect Tax ? (B.S.E.B. , 2019) (a) Excise Duty (b) Sales Tax

(c) Both a & b (d) Wealth Tax government is called : (a) Revenue Expenditure (c) Both a & b

9. Direct tax is :

(a) Income Tax

(c) Both a & b

8. The expenditures which do not create assets for the

( B.S.E.B., 2010, 17; 18) (b) Capital Expenditure (d) None of the above.

( B.S.E.B., 2019) (b) Gift Tax

(d) None of these

(c) Deficit is covered by loans or printing of notes (d) Only (b) & (c)

22. Which is included in indirect tax ? (B.S.E.B. , 2015; C.B.S.E. , 2017; J.A.C., 2019) (a) Income tax (c) Excise Duty (b) Wealth tax (d) Gift tax

23. In India one rupee note is issued by : (B.S.E.B., 2010; 18) (a) Reserve Bank of India (b) Finance Ministry of Government of India (c) State Bank of India (d) None of these

24. Capital budget consist of : (B.S.E.B., 2018) (a) Revenue Receipts and Revenue Expenditure (b) Capital Receipts and Capital Expenditure (c) Direct and Indirect Tax (d) None of these

25. Which of the following is an indirect tax ? (B.S.E.B., 2018) (a) Excise Duty (c) Custom Duty (b) Sales Tax (d) All of the above

26. Which type of expenditure is made in bridge construction ? (a) Capital Expenditure (c) Both (a) & (b)

( B.S.E.B., 2019) (b) Revenue Expenditure (d) None of the above

14. Which of the following budget is suitable for developing economies ? (a) Deficit Budget (c) Surplus Budget (b) Balanced Budget (d) None of the above 15. What is the duration of a Budget ? (MP Board, 2017; B.S.E.B., 2017) (a) Annual (b) Two Years (c) Five Years (d) Ten Years 16. Which of the following is included in fiscal policy ? (a) upto Feb. 28 (c) upto March 15

15. Primary Deficit is :

16. Which one of the following is a pair of direct tax ? (C.B.S.E., 2015) (a) Excise duty & Wealth Tax

(b) Service Tax & Income Tax

(c) Excise Duty & Service Tax

(d) Wealth Tax and Income Tax

24. Which of the following is not a revenue receipt ? (C.B.S.E ., 2015) (a) Recovery of Loans (b) Foreign Grants (c) Profits of Public Enterprise

(d) Wealth Tax

25. Which of the following is a correct measure of primary deficit ? (C.B.S.E ., 2015) (a) Fiscal deficit minus revenue deficit

(b) Revenue deficit minus interest payments

(c) Fiscal deficit minus interest payments

(d) Capital expenditure minus revenue expenditure

26. Fiscal deficit equals : (C.B.S.E ., 2017) (a) Primary Deficit – Interest Payment

(b) Primary Deficit + Interest Payment (c) Total Budget Expenditure – Total Budget Receipt (d) None of the above 27. Indian Parliament generally approves budget by :

(a) Public Expenditure (c) Public Debt

( B.S.E.B., 2012, 17) (b) Tax

(d) All the above

( B.S.E.B. , 2018; MP Board , 2016) (b) upto March 1

(d) upto March 31

(B.S.E.B. , 2018)

17. Which of the following is capital expenditure of the government ?

(a) Interest Payment (c) Expenses on Machinery

18. Budget may include : (a) Revenue Deficit

Deficit

(b) Purchase of House

(d) All of the above

( B.S.E.B., 2012, 16) (b) Fiscal Deficit (c) Primary (d) All the above

(a) Fiscal Deficit – Interest Payment

(b) Fiscal Deficit + Interest Payment

(c) Both (a) and (b)

(d) None of above

29. Budgets are of the following types : (B.S.E.B. , 2018) (a) Balanced Budget

(c) Deficit Budget

(b) Surplus Budget (d) All of the above

30. Which of the following is danger of Fiscal Deficit ?

31. Which of the following statement is true ? (C.B.S.E., 2015)

(a) Fiscal deficit is the difference between total expenditure and total receipts.

(b) Primary deficit is the difference between total receipt and interest payments

(c) Fiscal deficit is the sum of primary deficit and interest payment

20. Budget : (B.S.E.B., 2015)

(a) is a description of income-expenditure of government.

(b) is a document of economic policy of government.

(c) is a description of non-programmes of the government.

(d) All of these

21. In an unbalanced budget : (B.S.E.B., 2015)

(a) Income is greater than expenditure

(b) Expenditure is higher relative to income

(a) Deflationary Pressure (c) Both (a) and (b)

( B.S.E.B. , 2018) (b) Inflationary Pressure (d) None of these

31. Which of the following indicates the reason of borrowing by the government ?

(a) Fiscal Deficit (b) Revenue Deficit

( B.S.E.B. , 2018) (b) Primary Deficit

(d) All the above

32. Which of the following is correct measure of Primary Deficit ? (B.S.E.B.

, 2018) (a) Fiscal Decifit – Revenue Deficit

(b) Revenue Deficit – Interest Payment

(c) Fiscal Deficit – Interest Payment

(d) Capital Expenditure – Revenue Expenditure

33. Which of the following word is ‘‘Budget’’ ? (B.S.E.B. , 2018) (a) Latin

(b) German

(c) French (d) None of these

184

Introductory Macro Economics

34. Benefit of income tax is received by : (U.S.E.B., 2019) (a) Central Government

(b) State Government

(c) Both of Central & State Govt.

(d) None of the above

[Ans. 1. (a), 2. (d), 3. (c), 4. (c), 5. (d), 6. (c), 7. (c), 8. (a), 9. (c), 10. (b), 11. (b), 12. (d), 13. (a), 14. (a), 15. (a), 16. (d), 17. (a), 18. (d), 19. (c), 20. (d), 21. (d), 22. (c). 23. (d), 24. (a), 25.(c), 26. (b), 27. (d), 28. (a), 29. (d), 30. (b), 31. (a), 32. (c), 33. (c), 34. (c).]

(B) Fill in the Blanks :

1. ................is a document of the government containing estimates of government receipt and expenditure.

2. ................receipts do not create any corresponding liability for the government.

3. Income tax is a................tax.

4. ................taxes can be shifted on others.

5. ................tax is levied on the basis of money value of the goods. [Ans. 1.

Budget, 2. Revenue, 3. direct, 4. Indirect, 5. Advalorem .]

(C) State True/False :

1. Budget is a document of the government containing estimates of government receipt and expenditure.

2. Financial year of India commences from 1st January.

3. Expenses on machinery is capital expenditure of the government.

4. One rupee note is issued by finance ministry of Government of India.

5. Fiscal deficit is the sum of primary deficit and interest payment.

[Ans. 1. Tru), 2. False, 3. False, 4. True, 5. True]

(D) Match the following Column :

‘A’

1. Surplus Budget 2. Deficit Budget

2. Direct Tax

3. Indirecct Tax

4. Zero Primary Deficit

‘B’

(a) Property Tax

(b) Boom Period

(c) Indicator of Fiscal Discipline (d) Depression Period

(e) Sales Tax

[Ans. 1. (b),

2. (d),

3. (a),

4. (e),

5. (c)]

(E) Answer in One Word :

1. Income tax belongs to which category of tax ?

2. What is GST ?

3. When tax rises with rise in income, which tax appears. 4. What is the indicator of fiscal discipline ?

[Ans. 1. Direct Tax, 2. Indirect Tax, 3. Progressive Tax, 4. Zero Primary Deficit.]

HOTS

High Order Thinking Skills Questions 1. When we need a policy of progressive taxation ?

(See : Progressive Tax in Section 28.2.1)

2. Revenue receipts do not create any corresponding liability for the government. Why ?

(See : Part I of Section 28.2.1)

3. Why do capital receipts cause reduction in assets of the government ? (See : Part II of Section 28.2.1)

4. What type of budget do we need in inflationary situation in the country ?

(See : Part I in Section 28.3.2)

Value Based Questions

1. Which receipts do not create any liability on the government ? (See : Section 28.2.1)

2. The impact and incidene of taxation in direct taxes fall on the same person. Why ?

(See : Direct tax in Section 28.2.1)

MDQ

Case Study Based on Evaluation & Multi-disciplinary Questions

1. Why do we treat zero primary deficit as an indicator of fiscal discipline ? (See : Box 16)

2. Is disinvestment a source of financing deficit financing ? (See : Box 15) 3. Capital expenditure reduces the liability of the government. How ? (See : Section 28.2.2)

NCERT CORNER

Q. 1. Explain why public goods must be provided by the government.

Ans. Public goods must be provided by the government because public goods are collectively consumed. Since it is not possible to collect fees for the use of such goods, private enterprises will not be motivated to provide these goods. Hence, public goods must be provided by the government.

Q. 2. Distinguish between revenue expenditure and capital expenditure. Ans. See, Section 28.2.2.

Q. 3. “The fiscal deficit gives the borrowing requirement of the government.” Elucidate.

Ans. See, Section 28.4.2.

Q. 4. Give the relationship between the revenue deficit and the fiscal deficit.

Ans. See, Section 28.4.2.

Q. 5. Suppose that for a particular economy, investment is equal to 200, government purchases are 150, net taxes (that is lump-sum taxes minus transfers) is 100 and consumption is given by \mathbf { C } = \mathbf { 1 0 0 } + \mathbf { 0 . 7 5 Y } (a) What is the level of equilibrium income ? (b) Calculate the value of the government expenditure multiplier and the tax multiplier. (c) If government expenditure increases by 200, find the change in equilibrium income.

Ans. Consumption = C = 100 + 0.75 Y

\mathrm{C} = 1 0 0

c = 0. 7 5

\mathrm{T} - \mathrm{TR} = 1 0 0

I = 200
G = 150
(a) Y = C + c [Y - (T - T R)] + I + G = 100 + 0.75 [Y - 100] + 200 + 150 = 100 + 0.75Y - 75 + 350 = 0.75Y + 375
Y - 0.75 Y = 375
0.25Y = 375

Y = 375 100
25
Y = 1,500
Thus, Equilibrium income is 1,500
(b) Government expenditure multiplier
=
1 c 1 0.75
1 = 1 = 1 0.25 = 4
Tax multiplier
= 1 c = 0.75 = 0.75 = -3 c 1 0.75 0.25
(c)
Y =
1
1 c G
= Government expenditure multiplier ×
Change in government expenditure = 4 × 200
= 800

Increase in equilibrium income due to increase in government expenditure is 800.

Q. 6. Consider an economy described by the following functions : C = 20 + 0.80Y, I = 30, G = 50, TR = 100 (a) Find the equilibrium level of income and the autonomous expenditure multiplier in the model. (b) If government expenditure increases by 30, what is the impact on

equilibrium income ? (c) If a lumpsum tax of 30 is added to pay for the increase in government purchases, how will equilibrium income change ?
Ans. C = 20 + 0.80Y
I = 30
G = 50
TR = 100
(a) Y = C + c [Y - (T - TR)] + I + G
= 20 + 0.80 [Y - (-100)] + 30 + 50 = 20 + 0.80 [Y + 100] + 80
= 20 + 0.80 Y + 80 + 80
= 0.80 Y + 180
Y - 0.80 = 180
0.20Y = 180
Y = 900
Thus, equilibrium level of income is 900
Autonomous expenditure multiplier
=
1 c 1 0.80
1 = 1 = 10.20 = 5
(b) Increase in equilibrium income (Y)
= AE × Expenditure multiplier = 30 × 5 = 150
(c) Tax multiplier = c = 0.80 = 0.80 = -4 1 c 1 0.80 0.20
Decrease in equilibrium income
= T × Tax multiplier
= 30 × -4 = -120.
Q. 7. In the above question, calculate the effect on output of a 10 per cent increase in transfers and a 10 percent increase in lump-sum taxes. Compare the effects of the two.
Ans. Transfer multiplier = 1 c = 0.80^0.80 c = 0.20 = 4
1 0.80
Increase in transfers = 10%

Therefore, increase in output = 10% × 4 = 40% Increase in lump-sum taxes = 10%

Decrease in output = 10% × 4 = 40% Here, we find that effect of change in transfers and change in taxes are equal. It is because their size of changes as well as multipliers are equal.

Q. 8. We suppose that C = 70 + 0.70 Y D, I = 90, G = 100, T= 0.10 Y (a) Find the equilibrium income. (b) What are tax revenues at equilibrium income? Does the government have a balanced budget ?

Ans. (a) C = 70 + 0.70 YD
I = 90
G = 100

T = 0.10 Y
Y = C + c [Y - (T - T R)] + I + G = 70 + 0.70 [Y - 0.10 Y] + 90 + 100 = 70
+ 0.70 [Y - 0.10 Y] + 190
Y = 260 + 0.70 Y - 0.07 Y
= 260 + 0.63 Y
Y - 0.63 Y = 260
0.37 Y = 260
Y = 703 (approx.)
Thus, equilibrium income is 703.
(b) Tax Revenues = 0.10 Y = 0.10 × 703 = 70 (approx.) Since tax revenues are 70 and government spending is 100, government does not have a balanced budget. For a balanced budget, it is essential that government spending must be equal to government revenues (taxes). Q. 9. Suppose marginal propensity to consume is 0.75 and there is a 20 percent proportional income tax. Find the change in equilibrium income for the following (a) Government purchases increase by 20, (b) Transfers decrease by 20.
Ans. MPC = 0.75
Proportional tax (t) = 20%
(a) Increase in government purchases (G) = 20 (b) Decrease in transfers (TR) = -20
(a) Government expenditure multiplier

1 = 1 = 1 c (1) 1 0.75 (1 0.20)
=
0.25 0.80
1 = 10.20 = 5

Increase in equilibrium income
= G × Govt. expenditure multiplier = 20 × 5 = 100

1 1 1 4(b) Transfer multiplier1 c 1 0.75 0.25 Decrease in equilibrium income
= Decrease in transfer
× Transfer multiplier = 20 × 4 = 80

Introductory Macro Economics

Q. 10. Explain why the tax multiplier is smaller in absolute value than the government expenditure multiplier.

Ans. The tax multiplier is smaller in absolute value than the government expenditure multiplier because

$^{c}$ Tax multiplier = 1 $_{c}$ Government expenditure multiplier = 1 1 c

An increase in government expenditure directly affects total expenditure whereas taxes enter the multiplier process through their impact on disposable income which influences household consumption (which is a part of expenditure.)

Q. 11. Explain the relation between government deficit and government debt.

Ans. The government deficit and the government debt are closely related. The government deficit is a flow concept but it adds to the stock of debt. Government's continuously borrowing will increase the debt burden which ultimately increases the burden of interest payment. It implies that

government has to pay more and more by way of interest. These interest payments themselves contribute to the debt. Hence, deficit is the cause and effect of debt.

Q. 12. Does public debt impose a burden ? Explain.

Ans. A public debt imposes a burden in the following circumstances : (i) Govt. debt transfers the burden on future generation. To pay off debt burden in future, Govt. raises taxes which reduce the savings and capital formation and growth. Thus, the debt acts as a burden on future generations.

(ii) Any external debt involves a burden since corresponding interest payments is regularly paid. (iii) Aggregate demand in the country increases which in result raises inflationary pressure.

Q. 13. Are fiscal deficits necessarily inflationary ?

Ans. All fiscal deficits are not necessarily inflationary. If the fiscal deficit results in higher demand and greater output, the fiscal deficit will not be inflationary. But in opposite circumstances, it becomes inflationary.

Q. 14. Discuss the issue of deficit reduction.

Ans. Following measures may be adopted for deficit reduction : (i) Increase in Taxes : Deficit reduction is possible by increasing the tax in a progressive manner. (ii) Disinvestment in PSUs : The government may raise receipts through the sale of shares in Public Sector Undertakings (PSUs).

(iii) Reduction in Publi c Expenditure : The government should reduce its expenditure for deficit reduction in the country.

29

FOREIGN EXCHANGE RATE

STUDY MATERIAL INCLUDED IN THE CHAPTER

29.1. Foreign Exchange Rate : Meaning 29.2. Exchange Rate : Fixed and Flexible 29.3. Determination of Flexible Exchange Rate Or Demand-Supply Theory of Exchange Rate 29.4. Foreign Exchange Market 29.5. Factors Influencing Exchange Rates Or Causes of Changes in Exchange Rates 29.6. Recent Systems of Exchange Rate–Co-ordination between Fixed Exchange

Rate System and Flexible Exchange Rate System 29.7. Managed Floating Exchange Rate System 29.8. Recent Issues related to Exchange Rate A Quick Review of the Chapter Questions

High Order Thinking Skills (HOTS) Questions Value Based Questions (VBQ) Case Study Based on Evaluation & Multi-disciplinary Questions (MDQ) NCERT Corner.

29.1. Foreign Exchange Rate : Meaning

Foreign exchange rate refers to the rate at which one unit of currency of a country can be exchanged for the number of units of currency of another country. In other words, it is the price paid in domestic currency in order to get one unit of foreign currency. In other words, exchange rate expresses the ratio of exchange between the currencies of two countries. Hence, exchange rate is the price of a currency expressed in terms of another currency.

● Important Definitions

(i) According to Sayers , “The price of currencies in terms of each other are called foreign exchange rate.”

(ii) According to Crowther , “The rate of exchange measures number of units of one currency which is exchanged in the foreign market for one unit or another.”

● Illustration

If we get ` 80 for a pound, then exchange rate between pound and ` will be :

1 Pound = `80
Exchange rate can be expressed in two ways : (i) In units of domestic currency;
1 Pound = `80
(ii) In units of foreign currency;
1
`1= 80 Pound = 0.125 Pound.
Favourable and Unfavourable Exchange Rates
Exchange rate may be favourable or unfavourable :

(A) In Domestic Currency : When exchange rate is expressed in terms of domestic currency, then falling exchange rate will be favourable and increasing exchange rate becomes unfavourable.

For example, let us assume that 1 Pound = ` 80. If exchange rate decreases to ` 78, it will be favourable for India because now we have to give less money for 1 pound. On the contrary if 1 pound = ` 82, exchange rate will be unfavourable for India because we have to give more money for one pound.

(B) In Foreign Currency : When exchange rate is expressed in terms of foreign currency, increasing exchange rate will be favourable for domestic currency and decreasing exchange rate will be unfavourable for the domestic country.

For example : Suppose ` 1 = 4 cent. If ` 1 becomes equal to 5 cent, it will be favourable for our country as we will get 5 cent for ` 1. On the contrary, if exchange rate becomes ` 1 = 3 cent, then exchange rate will be unfavourable because now less goods could be purchased in lieu of ` 1.

Box 1

29.2. Exchange Rate : Fixed and Flexible

● Types of Exchange Rate : Exchange rate is mainly of two types :

(i) Fixed Exchange Rate,

(ii) Flexible Exchange Rate.

Fixed Rate of Exchange refers to that rate of exchange which is fixed by the government. It generally does not change or the changes can take place within a fixed limit only.

Flexible Exchange Rate is that rate which is determined by market forces. Change in flexible exchange rate occur on account of change in market demand and supply. Flexible exchange rate is also called Floating Exchange Rate.

In foreign money market, the greater supply of money of a country makes its value decline and vice-versa . Government has got no interference in determining the flexible exchange rate.

29.2.1. Fixed Exchange Rate

In gold standard, exchange rate was fixed because changes in exchange rate could take place within certain limits and these limits were called ‘gold points ’. Historically, the two forms of fixed exchange rate were :

(i) Gold Standard System of Exchange Rate, (ii) Bretton Woods System of Exchange Rate.

Or, Adjustable Peg System of Exchange Rate. ● (i) Gold Standard System of Exchange Rate

According to this system (prevalent in most countries prior to 1920) gold was taken as the common unit of parity between currencies in circulation of different countries. Each country was to define value of its currency in gold. Therefore, value of one currency in terms of the other currency was fixed considering, the gold value of each currency.

Example : In UK £ (Pound) = 4 gms. of gold and US $ (Dollar) = 1 gm. of gold. Then 1 UK £ = 4 USA $. Exchange rate or exchange ratio between UK £ and US $ = 1 : 4. Four dollars would be exchanged for one UK pound. This system of exchange was also known as mint par value of exchange gold value of that currency.

● (ii) Bretton Woods System of Exchange Rate Or Adjustable Peg System of Exchange Rate

Bretton Woods System, though being a fixed system

of exchange rate, allowed some adjustment in

exchange rate within limits. So, it was called

‘Adjustable Peg System of Exchange Rate’ .

According to this system :

(i) Different currencies were pegged (or related to) to

one currency, i.e., US dollar.

(ii) US dollar was assigned gold value of fixed rate. (iii) Value of one currency in terms of U.S. dollar ultimately implied value of that currency in terms of gold.

(iv) Gold continued to be the ultimate unit of parity between any two currencies.

(v) Adjustment in the parity value of a currency was possible but only if allowed by IMF (International

Monetary Fund).

● Arguments in favour of Fixed Exchange Rate 1. Increase in International Trade : When all the

nations adopt fixed exchange rate, international trade increased because this type of exchange rate contains an element of certanity.

2. Incentives to Foreign Capital : This exchange rate ensures a regular flow of long-term foreign capital as there is no fear of currency appreciation or depreciation.

3. Acceleration in Capital Formation : Fixed exchange rate ensures internal price stability which promotes capital formation.

4. Economic Planning Possible : In fixed exchange

rate expenditures on public project do not variate

which makes economic planning possible and easy. 5. Helps in Maintaining

Favourable Balance of

Payments : Fixed exchange rates attract foreign

capital which ensures more industriations, employment

generation and more production. All these results

in favourable balance of payments.

● Arguments against Fixed Exchange Rate 1. Ignores National Interest :

Fixed exchange rate

ignores national interests for gaining international benefits because national elements like national income, price level and other national interests are placed at secondary level for maintaining fixed exchange rate with other countries.

2. Controls in Various Sectors : For maintaining fixed exchange rate various types of controls have to be applied on industrial sector, banking section and foreign trade. These controls lead to corruption and immoral activities in the economy. 3. Sudden Fluctuations in

Exchange Rate : Fixed exchange rate cannot persist for long. Balance of payment problems and fluctuations in commodity prices in the world market may force the countries to bring about changes in exchange rates. 29.2.2. Flexible Exchange Rate It refers to the system of exchange rate in which the value of a currency is allowed to adjust freely

or to float as determined by demand for and supply of exchange. Thus, flexible rate is free to fluctuate according to the changes in the demand and supply of foreign currency.

Hence, R = f (D, S) i.e. Exchange rate is a function of demand and supply. (where R = Exchange Rate, D = Demand for various currencies in the international market and S = Supply of various currencies in international market). The exchange rate, at which demand for foreign exchange becomes equal to supply of foreign exchange, is called ‘Par Exchange of Rate’ . It is also termed as ‘Normal Rate of Exchange’ or ‘Equilibrium Rate of Exchange’.

● Merits of Flexible Exchange System (i) Simple System : It is a simple system in its operation where exchange rate is determined at a point where the demand and supply forces of exchange rate become equal, Hence, it does not need any outside intervention.

(ii) Continuous Adjustments : There is always a possibility of adjustment in flexible exchange rate and hence, adverse effects of long–term disequilibrium can be avoided.

(iii) Improvement in Balance of Payment : Adjustments in balance of payments in flexible exchange rate are smoother as compared with the fixed exchange rate adjustments.

(iv) Optimum Use of Resources : Flexible exchange rate ensures optimum use of resources which consequently increases the level of efficiency in the economy.

● Demerits of Flexible Exchange Rate : The main demerits of flexible exchange rate are as follows :

(i) Bad Effects of Less Elasticity : Less elasticity in exchange rate makes foreign exchange market unstable and consequently BOP situation becomes worse as a result of depreciation in scarce money.

(ii) Uncertainty : Flexible exchange rate generates uncertainty and frequent changes in exchange rate discourages international trade and capital movements.

(iii) Instability in International Trade : Instability in international money market generates instability in international trade. Consequently, formulation of long run policies related to import and export becomes difficult.

Distinction between Fixed and Flexible Exchange Rates Fixed Exchange Rate

1. It is decided and declared by the government and it is kept stable.

2. In this system, the central bank becomes ready to buy or sell its currencies at a fixed rate.

3. No fluctuation takes place.

Flexible Exchange Rate

1. It is determined by demand and supply forces in international market.

2. Exchange rate is freely dependent on the working of foreign exchange market and the central bank has nothing to do with it.

3. Fluctuations appear.

Box 2 29.3. Determination of Flexible Exchange Rate Or Demand-Supply Theory of Exchange Rate

Like price of goods, exchange rate is determined by demand and supply forces working in the exchange market. All nations of the world make transactions of goods, services and capital and for it they need foreign exchange. When payment is made in foreign exchange, demand for foreign exchange appears. Similarly, receipt of foreign exchange refers to the supply of foreign exchange. Demand and supply factors of foreign exchange determine the rate of exchange.

● Demand for Foreign Exchange

Demand for foreign exchange arises mainly due to import of goods, investing in foreign countries and giving loans to other nations. Demand for foreign exchange signifies the functional relationship between exchange rate and demanded quantity of foreign exchange. There is an inverse relationship between price of foreign exchange (i.e., rate of exchange) and demand for

foreign exchange, e.g., more foreign exchange is demanded at lower exchange rate and vice-versa . That is why demand curve for foreign exchange slopes downward from left to right. The following factors cause demand for foreign exchange, i.e., foreign exchange is demanded by domestic residents for the following reasons :

(a) To purchase goods and services from foreign countries.

(b) To purchase financial assets ( i.e., to invest in bonds and equity shares) in a foreign country.

(c) To invest directly in shops, factories, buildings in foreign countries.

(d) To speculate on the value of foreign currencies.

(e) To send gifts abroad.

(f) To undertake foreign tours and

(g) Remittances to their families by foreigners working say in India.

Fig. 1 shows that \mathrm { { a t } ^ { Y D } }

exchange rate OR, OQ_{R2dollar is demanded.}

When dollar’s price_{R( i.e., exchange rate)}

^{increases to OR2, R1} demand for dollar comes down to \mathrm { O Q _ { 2 } . o 0 2 Q Q ^ { X } } 1Similarly,

^{when price Demand for Foreign Exchange} of dollar falls to OR1, Fig . 1the demand of dollar

increases to \mathrm { O Q } _ { 1 } . Hence, the inverse relationship between exchange rate and demand for foreign exchange is established which makes the foreign exchange demand curve sloping downward from left to right.

● Supply of Foreign Exchange

Supply of foreign exchange represents the functional relationship between foreign exchange rate and supply of foreign exchange. There is a direct positive relationship between foreign exchange rate and supply of foreign exchange, e.g., with rise of foreign exchange rate, supply of foreign exchange increases and vice-versa .

The supply of foreign exchange comes from :

(a) The domestic exporters who receive payments of foreign currency,

(b) The foreigners who invest and lend in the home country,

(c) Domestic residents who repatriate capital funds previously sent abroad,

(d) The domestic residents who receive gifts from foreign countries,

(e) Direct purchases by the non-residents in the domestic market. The supply curve SS indicates that at higher exchange rates larger amount of foreign exchange are offered for sale. For example, when rate of exchange goes up from OR to \mathrm { O R } _ { 2 } , supply of foreign exchange increases from OQ to \mathrm { O Q } _ { 2 } and on the other hand, when exchange rate comes down to \mathrm { O R } _ { 1 } supply of foreign exchange also declines to \mathrm { O Q } _ { 1 } . The positive slope of supply curve shows that when exchange rate of dollar in terms of rupees rises (which also means that exchange rate of Thus, OR is the equilibrium market rate of exchange where the demand for and supply of foreign exchange are equal.

● Disequilibrium in Demand and Supply : Selfadjustment

1. If the prevailing exchange rate \left( \operatorname { O R } _ { 1 } \right) becomes greater than market equilibrium rate (OR), the dollar’s supply exceeds its demand by AB which makes exchange rate decline from \mathrm { O R } _ { 1 } to OR.

2. On the contrary, if prevailing exchange rate \left( \mathrm { O R } _ { 2 } \right) becomes less than market equilibrium rate (OR), the dollar’s supply falls short of its demand by CD which makes exchange rate rise from \mathrm { O R } _ { 2 } to OR. Thus, through selfadjustment between demand and supply forces, market equilibrium rate appears at the point where demand for and supply of foreign exchange are equal.

29.3.1. Change in Exchange Rate Or

Effects of Change in Demand and Supply on Exchange Rate

Exchange rate is determined by demand and supply forces of foreign exchange. Hence, change in demand and supply conditions bring change in exchange rate.

(A) When the demand for foreign exchange increases, demand curve shifts upward and consequently exchange rate rises. It is called depreciation of domestic currency.

Fig. 2 rupee in terms of dollar’s falls), the Indian exporters will increase the supply of dollars and vice-versa .

● Determination of Equilibrium Exchange Rate Equilibrium exchange rate is determined at the point where demand and supply curves of foreign exchange (DD and SS respectively) cut each other. In Fig. 3, equilibrium exchange rate is determined at the point E, where both demand and supply of foreign exchange are equal to OQ.

Fig . 4

(B) Similarly, when the supply of foreign exchange increases, supply curve shifts to the right and consequently exchange rate falls. It is called appreciation of domestic currency.

Fig. 3 Fig . 5

29.4. Foreign Exchange Market

Foreign exchange market refers to the market of trading for different currencies of the world. Buyers and sellers in foreign exchange market wish to buy foreign exchange or sell foreign exchange.

29.4.1. Functions of Foreign Exchange Market

Foreign exchange market performs the following functions :

(1) Transfer Function : It implies transfer of purchasing power in terms of foreign exchange across different countries of the world.

(2) Credit Function : It implies provision of credit in terms of foreign exchange for the export and import of goods and services

Spot Exchange Rate and Forward Exchange Rate

● Spot Exchange Rate (i.e., Current Exchange Rate) is that rate of exchange which prevails in the market at that time when transactions are made.

● Forward Exchange Rate is that rate of exchange at which forward transactions are honoured. It is a ‘‘contracted’’ exchange rate which becomes operational on some future date.

Box 3

across different countries of the world.

(3) Hedging Function : It implies protection against the risk related to variations in foreign exchange rate. Demand for and supply of foreign exchange is committed at some commonly agreed rate of exchange even when the commitments are to be honoured on some future date.

29.4.2. Operation of Foreign Exchange Market

Foreign exchange market consists of two types of foreign exchange—Spot Exchange Rate and Forward Exchange Rate. On the basis of it, foreign exchange market may be classified into two : (i) Spot Market, and (ii) Forward Market .

(1) Spot Market

Spot market for foreign exchange is that market which handles only spot transactions or current transactions. Such market does not deal with future transactions and it contains the nature of daily market. It is also called ‘Effective Exchange Rate’ .

● Principal Characteristics

Its principal characteristics are that :

(i) In terms of ‘period of transactions’, spot market is

of ‘daily nature’ . It does not trade in future deliveries. (ii) The rate of

exchange which is determined in the

spot market is known as spot rate of exchange. The

spot rate of exchange or current rate of exchange

is that rate which happens to prevail at the time

when transactions are incurred.

(2) Forward Market

Forward market for foreign exchange is that market which handles such transactions of foreign exchange as are meant future delivery. Such transactions are signed today but are to materialise (or are to be honoured) on some future date.

In this market, foreign exchange is made available in future. So forward exchange rate is that one at which transactions are made on some future date.

● Principal Characteristics

Principal characteristics of forward market are that : (i) It only caters to forward transactions; it does not

deal with spot transactions in foreign exchange. (ii) It defines (or

determines) forward exchange rate—

the exchange rate at which forward transactions are

to be honoured.

Why are Forward Transactions Contracted ? Forward transactions are contracted for two reasons :

(i) To avoid the risk of any adverse change in exchange rate, and

(ii) To make speculative gains.

Box 4

29.5. Factors Influencing Exchange Rates Or

Causes of Changes in Exchange Rates

The market or the current rate of exchange is subject to fluctuations due to changes in demand and supply of foreign exchange in the foreign exchange market. Some of the important factors which cause fluctuations in the rate of exchange are given as following :

1. Change in Trade : The demand and supply of foreign exchange is influenced by changes in exports and imports. If exports exceed imports, demand for domestic currency increases so that rate of exchange moves in its favour. But, if imports exceed exports, the demand for foreign exchange increases and the rate of exchange will move against the country.

2. Capital Movements : Short-term or long-term capital movements also influence the exchange rate. For example, if there is a capital flow from USA for investment in India, the demand for Indian Currency will increase in the foreign exchange market. As a result, the rate of exchange of Indian rupee in terms of US dollar will rise.

3. Sale and Purchase of Securities : The stock exchange transactions, i.e. , the sale and purchase of foreign securities, debentures, shares, etc., influence the demand for foreign exchange, and thereby, the exchange rate.

4. Bank Rate : The bank rate also influences the exchange rate. If bank rate is raised, more funds will flow into the country from abroad to earn high interest rate. As a result supply of foreign currency increases and the rate of exchange moves against the foreign exchange. Converse will be the case if the bank rate falls.

5. Speculative Activities : Speculation in the foreign exchange market also influences the exchange rate. If the speculators expect a fall in the value of foreign currency, they will sell that currency. As a result, rate of exchange will move against foreign currency and in favour of home currency.

6. Political Conditions : If there is political stability, strong and efficient administration foreign investment increases in the country. The demand for domestic currency will increase and the exchange rate will move in favour of the country.

29.6. Recent Systems of Exchange Rate—Co-ordination between Fixed Exchange Rate System and Flexible Exchange Rate System

Hybrid Systems of Exchange Rate

I. Wider II. Crawling III. Managed Bands Peg Floating

(I) Wider Bands : Wider Bands is a system that allows wider adjustment in the fixed exchange rate system. It allows adjustment upto 10 percent around the ‘parity’ between any two currencies in the international money market. Example : If one British Pound is fixed as equal to 80 Indian rupees, 10 percent revision (upward or downward) is to be allowed in this exchange rate of 1 : 80. Exchange rate may be revised as

$1:80 + 10\% = 1:88$

Or

as 1:80 - 10% = 1:72

This is to help the member countries to correct their BOP (balance of payments) status. In the event of deficit BOP, India, for example, may depreciate its currency (upto 10 percent). So that, purchasing power of other currencies in India increases by 10 percent (from 80 to 88 rupees a pound). This is expected to increase demand for India's products. Export earnings are expected to rise. Accordingly, BOP status is expected to improve.

(II) Crawling Peg : Crawling Peg allows ‘small’ but regular adjustments in the exchange rate for different currencies. Not more than (±) 1 percent adjustment is allowed at a time. Indeed it is small adjustment. But it can crawl : it can be repeated at regular intervals.

How Wider Bands differ from Crawling Peg ?

Both the system allow adjustment in the exchange ratio. But, Wider Bands allow wider adjustment as compared to Crawling Peg. Crawling Peg is a system of a ‘narrow bands’ as compared to ‘wider bands’.

Box 5

(III) Managed Floating : Managed Floating is a system that allows adjustments in exchange rate according to a set of rules and regulations which are officially declared in the foreign exchange market. There is no pre-defined range of adjustment. Also, there is no pre-defined time of adjustment. Adjustment is allowed entirely on the merits of a case. Managing authority may allow or reject an appeal for adjustment.

29.7. Managed Floating Exchange Rate System

International trade and the flow of foreign investments are adversely affected by fluctuation of exchange rates. For solving this very problem,

Smithsonian Agreement was made on December 18, 1971. This agreement raised the fluctuation range of exchange parity at both ends by 1 percent to 2.25 percent.

On February 12, 1973, after the devaluation of American dollar Smithsonian Agreement was broken. After Jamaica Agreement in January 1976, floating exchange rate system was launched under International Monetary Fund.

In fact, floating exchange rate system was not a free flexible exchange rate system but it is a managed floating exchange rate system in which the

monetary authority of the nations were given the responsibility to eliminate short-run fluctuations of exchange rates without affecting the long-run trends of the exchange rates. Thus, in this managed floating exchange rate system, countries were given opportunities to enjoy the benefits of fixed exchange rates on one hand and also to maintain flexible exchange rate for adjusting imbalances in balance of payments on the other.

In managed floating exchange rate, short-term fluctuations of exchange rates are controlled with the use of foreign exchange funds without affecting the long-term inclination of exchange rates.

Clean Floating and Dirty Floating Systems

(i) In Clean Floating System, exchange rate is allowed to be determined by two free forces of demand and supply in the market. In this system, monetary authority is not allowed to interfere and foreign exchange market re-adjusts itself by demand and supply forces without any intervention.

(ii) In Dirty Floating System, the monetary authority of the country makes intervention to check fluctuations of exchange rate. The basic aim of this intervention is to favour domestic nation. Thus, in clear floating system exchange rate stability is obtained with flexibility to some extent but in dirty floating system, there is no flexibility in exchange rate.

Box 6

29.8. Recent Issues related to Exchange Rate

● Convertibility of Money

During gold standard, countries were having gold currencies in which face value and the actual value of the coin were same. In gold standard, the currency in circulation was allowed to get converted either in gold or in other currencies based on gold standard. Such currency was called convertible money. After the fall of gold standard, countries adopted paper currency which is ‘non-convertible ’.

In existing money standards convertibility of money has different meanings. Presently, convertibility of money implies such a system in which country’s currency becomes convertible in foreign exchange and vice versa .

● Liberalised Exchange Rate Management System (LERMS)

With an object of improving country’s Balance of With an object of improving country’s Balance of 93 introduced a new system of foreign exchange management which was named as LERMS—Liberalised Exchange Rate Management System.

With this new system, named as LERMS, double exchange rate system was adopted since March, 1992 which had the basic objective to discourage nonessential imports.

Following provisions were made in this new system :

(i) The exporters were allowed to sell 60% of their foreign exchange earnings to authorised foreign exchange dealers on open market exchange rate.

(ii) The remaining 40% of their foreign exchange earnings was made compulsory for the exporters to sell on exchange rates decided by the RBI.

(iii) Authorised exchange rate was made applicable for providing foreign exchange by the government for the most essential imports while the importers of other items were asked to manage foreign exchange themselves in the open market.

● Full Convertibility of Rupee in Current Account LERMS, introduced in 1992, showed good results which induced the government to adopt full convertiblity of rupee in current account since 1993-94. By adopting full convertibility of rupee in current account, the government abolished double exchange rate system for exports and imports and ‘Unified Exchange Rate System’ based on open market exchange become applicable. RBI made rupee full convertible in current account w.e.f. August 19, 1994.

● Full Convertibility of Rupee in Capital Account : Tarapore Committee

After making Indian rupee full convertibility in current account, government gave a thought also to make Indian rupee full convertible in capital account. Tarapore Committee was constituted by the government on March 20, 2006 for suggesting road map of full convertibility of rupee in capital account. Committee submitted its report on July 31, 2006.

Tarapore Committee suggested three phases of adopting full convertibility of rupee in capital account which are as follows :

(i) First phase since 2006-07 (50% convertibility was suggested).

(ii) Second phase between 2007-08 and 2008-09 (75% convertibility was suggested).

(iii) Third phase between 2009-10 to 2010-11 (100% convertibility was suggested).

Later on, RBI had set up a task force headed by Mr. Salim Gangadharan on September 1, 2006 for examining the report and extending suggestions on the implemented proposals of the Tarapore Committee. Meaning of Devaluation & Depreciation of Domestic Currency

● Devaluation is a process in which the government deliberately cheapens the exchange value of its own currency in terms of other currency by giving it a lower value. The objective of devaluation is to improve the adverseness of balance of payment. Devaluation is helpful in increasing exports and decreasing imports in the country.

● In depreciation of domestic currency, the demand and supply forces in international market reduces the value of domestic currency in terms of foreign currency. Government has no role in this process.

Box 7

A QUICK REVIEW OF THE CHAPTER

● Foreign Exchange Rate : It refers to the price of one currency in relation to other currencies in the international money market.

●● Fixed Exchange Rate : Gold exchange rate and adjustable peg system of exchange rate are the two important types of fixed exchange rate system. Adjustable Peg System (also called Bretton Woods system) allows some adjustment in exchange rate; it is not as rigid as the gold exchange rate system.

● Floating or Flexible Exchange Rate : It is associated to that system in which foreign exchange rate is determined by the prices of demand and supply of different currencies in foreign exchange market.

● Determination of Exchange Rate Or Demand and Supply Theory of

Exchange Rate ( i.e., Equilibrium Exchange Rate) : In foreign exchange market equilibrium exchange rate is determined at the point where demand for and supply of foreign exchange are equal. When demand for foreign exchange increases foreign exchange rate rises. On the contrary if supply of foreign exchange increases, foreign exchange rate declines.

● Foreign Exchange Market : It refers to the market for national currencies of different countries of the world. Its main functions are : (i) transfer function, (ii) credit function, (iii) hedging function.

● Spot Market : It deals with current sale and purchase of foreign exchange. It defines spot rate of exchange.

● Forward Market : It deals with such sale and purchase of foreign exchange which are contracted today but are implemented sometimes in the future. It defines forward rate of exchange.

QUESTIONS Ultra Short Answer Type Question

1. Name the exchange rate which is determined by the demand supply of money in international market.

2. What type of exchange rate was there in gold standard ?

3. What is foreign exchange rate ?

4. What is fixed exchange rate ?

5. What is called spot market ?

6. What is forward market ?

(B.S.E.B. , 2014) (J.A.C. , 2019)

Very Short Answer Type Questions

1. Define Rate of Exchange.

(MP Board, 2017; C.B.S.E., 2011; J.A.C. , 2019) Or

What is meant by Foreign Exchange Rate ? (C.B.S.E., 2011, J.A.C., 2015, 16, 17] 2. What is meant by System of Fixed Rate of Exchange ? 3. What is meant by Flexible Rate of Exchange ?

( U.S.E.B., 2011)

4. At what point equilibrium rate of exchange is determined ?

5. What are Favourable and Unfavourable Exchange Rates ?

6. State two sources of supply of foreign exchange. (C.B.S.E. , 2010)

7. State two sources of demand for foreign exchange. (C.B.S.E. , 2010)

8. Explain the meaning of managed floating exchange rate. (C.B.S.E. , 2012)

9. What is meant by foreign exchange market ? (U.S.E.B. , 2013) 10. Explain favourable foreign exchange rate with example. (U.S.E.B ., 2016) Short Answer Type Questions

10. State four sources each of demand for and supply of Foreign Exchange. (B.S.E.B. , 2015; C.B.S.E ., 2015)

11. Explain Fixed Rate of Exchange. (C.B.S.E. , 2012)

12. Explain Flexible Rate of Exchange. (Raj. Board , 2016)

13. Distinguish between Fixed and Flexible Rate of Exchange. (U.S.E.B ., 2017)

14. When exchange rate of foreign currency rises, its supply rises. How ? Explain. (C.B.S.E., 2011)

15. When exchange rate of foreign currency falls, its demand rises. Explain, how ? (C.B.S.E., 2011)

16. Giving two examples explain the relation between the rise in price of a foreign currency and its demand. (C.B.S.E. , 2010) 8. Explain the meaning of the managed flexible foreign exchange rate. (C.B.S.E. , 2010) 9. When price of a foreign currency falls, the demand for that foreign currency rises. Explain, why ? (C.B.S.E. , 2011) 10. When price of a foreign currency falls, the supply of that foreign currency also falls. Explain, why ? (C.B.S.E. , 2011) 11. Discuss the economic effects of favourable and unfavourable rates of exchange. (U.S.E.B. , 2014) 12. Explain the meaning of foreign exchange market. Mention any two participants of the market. (B.S.E.B. , 2014) 13. Give the meaning of devaluation and depreciation of domestic currency. (C.B.S.E. , 2015) 14. What is meant by exchange rate ? Explain briefly the determination of the exchange rate in flexible exchange rate system. (Raj. Board , 2017) 15. Distinguish between the fixed exchange rate and floating exchange rate. If exchange rate falls, explain its effects on exports and imports. (C.B.S.E. , 2017) 16. Describe the four elements effecting the rate of foreign exchange. (MP Board , 2016) 17. Explain the causes of fluctuations in Rate of Foreign Exchange. (MP Board , 2017)

Long Answer Type Questions

1. What is exchange rate ? How is it determined ? (B.S.E.B. , 2016)

2. How is Equilibrium Rate of exchange determined ? (U.S.E.B., 2013; Raj.

Board, 2013; C.B.S.E., 2013; J.A.C., 2013)

3. Explain the types of Rate of Exchange. How does Fixed and Flexible Rate of Exchange differ ? (B.S.E.B., 2010, 13)

4. Describe the merits and demerits of flexible exchange rate system.

(J.A.C., 2018; B.S.E.B. , 2011)

5. Explain two merits each of flexible foreign exchange rate and fixed foreign exchange rate.

6. What is meant by rate of foreign exchange ? How it is determined under free market ? (U.S.E.B., 2012, 19)

7. What is exchange rate ? Explain the favourable and unfavourable exchange rate ?

(U.S.E.B., 2011; B.S.E.B. , 2012; JAC , 2012) Or

What is exchange rate ? How it becomes favourable or unfavourable ? 8. Explain the meaning of foreign exchange and foreign exchange rate. Giving reasons, explain the relation between foreign exchange rate and demand for foreign exchange. (C.B.S.E., 2012) 9. Discuss the methods of exchange rate determination. (B.S.E.B., 2012) 10. Write a note on exchange rate management in India. (B.S.E.B., 2014) 11. Explain three sources each of demand and supply of foreign exchange. (C.B.S.E., 2017) Objective Type Questions

(A) Multiple Choice Questions :

1. Which one is a kind of exchange rate ? (B.S.E.B. , 2018) (a) Fixed Exchange Rate

(c) Both (a) & (b)

(b) Flexible Exchange Rate (d) None of the above 10. The forms of foreign exchange market is/are :

(a) Spot market (c) Both (a) & (b)

( B.S.E.B. , 2011) (b) Forward market

(d) None of these

11. Foreign exchange rate is determined by : (B.S.E.B. , 2012) (a)

Government (b) Barganing

(c) World Bank (d) Demand & Supply forces

12. By exchange rate we mean : (B.S.E.B. , 2015)

(a) How much local currency we have to pay for a foreign currency.

(b) How much of a foreign currency we have to pay for another foreign currency.

(c) The rate at which foreign currency is bought and sold.

(d) All of these.

13. The process of foreign exchange :

14. Which of the following is true ?

(a) Fixed exchange rate is determined by the government (b) Flexible exchange rate is determined by market forces

(demand and supply of foreign exchange)

(c) Both (a) & (b)

(d) None of the above

3. Which one is a kind of fixed exchange rate ?

(a) Gold Standard System of Exchange Rate

(b) Bretton Woods System of Exchange Rate

(c) Both (a) and (b) (d) None of the above

4. Which one is a merit of fixed exchange rate ?

(B.S.E.B. , 2018) (a) Promotes Foreign Trade

(b) Induces Foreign Capital

(c) Increases Capital Formation

(d) All the above

5. Which one is a demerit of fixed exchange rate ?

(a) Ignores National Interests

(b) Restricted Movement of Capital

(c) Sudden Fluctuations in Exchange Rates

(d) All the above

6. Which one is a merit of flexible exchange rate ?

(a) Simple System

(b) Continuous Adjustments

(c) Improves Balance of Payments

(d) All the above

7. Which one is a demerit of flexible exchange rate ? (B.S.E.B. , 2018) (a) Bad Results of Low Rate (b) Uncertainty (c) Instability in Foreign Exchange (d) All the above

8. Which one is a source of the demand of foreign exchange ? (a) Imports of Goods and Services from Abroad (b) Investment in Foreign Nations (c) Gift Scheme to Foreign Nations (d) All the above

9. Foreign exchange is determined by : (B.S.E.B. , 2016) (a) Demand of foreign currency

(b) Supply of foreign currency

(c) Demand & supply in foreign exchange market (d) None of the above (a) between the countries (c) within the countries (b) between the states (d) within the states

14. During Bretton Woods System most countries had :

(a) Fixed Exchange Rate (c) Both (a) and (b)

( B.S.E.B. , 2018) (b) Pegged Exchange Rate (d) None of the above

[Ans. 1. (c), 2. (c), 3. (c), 4. (d), 5. (d), 6. (d), 7. (d), 8. (d), 9. (c), 10. (c), 11.

(d), 12. (d), 13. (a), 14. (a).]

(B) Fill in the Blanks :

1. In gold standard, exchange rate was................

2. Bretton Woods System of Exchange Rate was called ........... Peg System.

3. ............exchange rate is determined by demand and supply forces in international market.

4. There is a...........relationship between the foreign exchange rate and supply of foreign exchange.

5. When supply of foreign exchange increases with no change in demand, exchange rate................

[Ans. 1. fixed, 2. Adjustable, 3. flexible, 4. direct, 5. falls.] (C) State True/False :

1. The rate of exchange measures number of units of one currency which is exchanged in the foreign market for one unit of another.

2. Spot market for foreign exchange is that market which handles only spot transactions or current transactions.

3. Three main forms of exchange rate are fixed, dynamic and flexible.

4. Forward market for foreign exchange is that market which handles much transaction of foreign exchange as are meant for future delivery.

5. Fixed exchange rate is determined by demand and supply forces in international market.

[Ans. 1. True, 2. True, 3. False, 4. True, 5. False] (D) Match the following Column :

‘A’

1. Bretton Woods System

2. Forward Market

3. Determination of fixed exchange rate

4. Determination of flexible exchange rate

5. Floating Exchange Rate

‘B’

(a) By Market Forces

(b) Flexible Exchange Rate (c) Adjustable Peg System

(d) By Government

(e) Form of Foreign Exchange Market

[Ans. 1. (c), 2. (e), 3. (d), 4. (a), 5. (b)]

Introductory Macro Economics

(E) Answer in One Word :

1. What is called market of current transaction of foreign exchange ?

2. Which Committee was constituted for full convertibility of rupee in capital account ?

3. Which system is known as Adjustable Peg System ?

4. Who determines flexible exchange rate ?

[Ans. 1. Spot Market,

2. Tarapore Committee, 3. Bretton Wood System, 4.

Market Forces.]

High Order Thinking Skills Questions

1. Flexible exchange rate has bad effects of less elasticity. Why ? (See : Demerits of Flexible Exchange Rate System in Section 29.2.2)

2. Define convertibility of money ? How is it associated with exchange rate ? (See : Section 29.8)

3. What is the difference between devaluation and depreciation of domestic currency ? (See : Box 7)

Value Based Questions VBQ

1. What is Managed floating system ?

(See : Section 29.6)

2. Why is flexible exchange rate called free exchange rate ? (See : Section 29.2.2)

MDQ

Case Study Based on Evaluation & Multi-disciplinary Questions

1. How does ‘Wider Band’ differ from Crawling Peg ? (See : Box 5)

2. What is the effect of increase in demand of foreign exchange on exchange

Real Exchange Rate = $e\mathrm{P}_{f}$ P where P = Price level of domestic country

rate ?

(See : Section 29.3.1)

NCERT CORNER

Q. 1. Distinguish between the nominal exchange rate and the real exchange rate. If you were to decide whether to buy domestic goods or foreign goods, which rate would be more relevant? Explain.

Ans. Nominal exchange rate refers to the number of units of domestic currency to be given up to get an unit of foreign currency. In other words, nominal exchange rate is the price of foreign currency in terms of domestic currency. On the other hand, real exchange rate is the relative price of foreign goods in terms of domestic goods, i.e., real exchange rate is the ratio of foreign prices to domestic prices, measured in the same currency. Thus,

P_f = Price level of foreign country e = Nominal exchange rate, i.e. , rupee price of foreign exchange. Hence, nominal exchange rate is based on current prices while real exchange rate is based on constant prices.

Q. 2. Suppose it takes 1.25 yen to buy a rupee and the price level in Japan is 3 and the price level in India is 1.2. Calculate the real exchange rate between India and Japan (the price of Japanese goods in terms of Indian goods). (Hint : First find out the nominal exchange rate as a price of yen in rupees.)

^{e P f} Ans. Real Exchange Rate =_P

where P = Price level of domestic country

P_f = Price level of foreign country e = Nominal exchange rate, i.e., rupee price of foreign exchange. Here P = 1.2

\mathrm{P} f = 3

^{e =} 1.25 = 0.8

Real Exchange Rate = 0.8³ = 2.4

_ {1. 2} 1. 2 = 2.

Q. 3. Explain the automatic mechanism by which BOP equilibrium was achieved under the gold standard.

Ans. See, Section 29.2.1.

Q. 4. How is the exchange rate determined under a flexible exchange rate regime ?

Ans. See, Section 29.3.

Q. 5. Differentiate between devaluation and depreciation.

Ans. Depreciation of a currency means a decrease in the price of the domestic currency in terms of the foreign currency. Depreciation of a currency takes place due to working of demand and supply forces in foreign exchange market. Devaluation also signifies a loss of value of the currency of a country relative to other foreign currency but it is a process in which government deliberately cheapen its own currency in terms of other currency.

Q. 6. Would the central bank need to intervene in a managed floating system ? Explain, why ?

Ans. Managed floating system is a mixture of flexible exchange rate system and a fixed rate system. Under managed floating system, the central bank allows the exchange rate to be determined by market forces but it intervenes at times to influence the rate. The central bank would need to intervene to moderate exchange rate movements whenever it feels that such actions are appropriate.

Q. 7. Are the concepts of demand for domestic goods and domestic demand for goods the same ?

Ans. No, the concepts of demand for domestic goods and domestic demand for goods are not the same. Domestic demand for goods is equal to the domestic demand for domestic goods in an open economy. Domestic demand for goods consists of the following :

(i) Consumption (C),

(ii) Government Expenditure (G),

(iii) Domestic Investment (I).

Demand for domestic goods in an open economy is equal to the domestic demand for goods plus net exports (exports minus imports), i.e. , demand for domestic goods is demand for goods made by both domestic and foreign countries.

Q. 8. What is the marginal propensity to import when M = 60 + 0.06Y? What is the relationship between the marginal propensity to import and the aggregate demand function ?

Foreign Exchange Rate

Ans. M = 60 + 0.06Y (given)

$M=M+mY$

Hence, m = 0.06

where m = marginal propensity to import

There is a positive relationship between the marginal propensity to import and the aggregate demand function. Marginal propensity to import (m ) is the fraction of an extra rupee of income spent on imports. Thus,

\mathrm{M} _ {m = \mathrm{Y}}

Whenever there is an increase in aggregate demand, income increases many times of the increase in aggregate demand due to multiplier effect. This increased income will create demand for imports. That is why when demand increases, a major portion of this increased demand goes to higher imports. As a result, there is an increase in marginal propensity to import.

Q. 9. Why is the open economy autonomous expenditure multiplier smaller than the closed economy one ?

Ans. Open economy multiplier is smaller than the closed economy multiplier because closed economy multiplier depends only on marginal propensity to consume (c) but open economy multiplier depends on marginal propensity to consume as well as marginal propensity to import (m ). Thus,

1 Open Economy Multiplier =_{1 c m}

$^{1}$ Closed Economy Multiplier = $_{1}$ c

Let us take an example. If c = 0 . 8 and m = 0 . 3 , we would have following multipliers :

1 Open Economy Multiplier = _ { 1 0 . 8 0 . 3 } = 2 . . 1 Closed Economy Multiplier = _ { 1 } _ { 0 . 8 } = 5

Q. 10. Calculate the open economy multiplier with proportional taxes, T =t Y, instead of lump-sum taxes as assumed in the text.

Ans. Open economy multiplier (in case of lump-sum taxes) ^ { 1 = } 1 c m

Open economy multiplier (in case of proportional taxes)

^ { 1 = } 1 c ( 1 t ) m STUDY MATERIAL INCLUDED IN

30

BALANCE OF PAYMENTS ACCOUNT : MEANING AND COMPONENTS

THE CHAPTER

30.1. Balance of Trade : Meaning 30.2. Balance of Payments 30.3. Balance of Payment : Structure or Components

30.4. Balance of Payments is always Balanced 30.5. Causes of Disequilibrium in Balance of Payments A Quick Review of the Chapter Questions High Order Thinking Skills (HOTS) Questions Value Based Questions (VBQ) Case Study Based on Evaluation & Multi-disciplinary Questions (MDQ) NCERT Corner

30.1. Balance of Trade : Meaning

Balance of trade is related to only visible items.

Difference between the value of total visible exports and imports of a country is called ‘Balance of Trade ’ of that country. Visible items include physical goods as machine, cloth, cement, etc.

Balance = [Export of – [Import of of Trade Visible Items] Visible Items] 30.2. Balance of Payments

Balance of payments is a broader concept as compared to Balance of Trade. ‘Balance of Trade’ includes only visible items, while ‘Balance of Payment’ includes three types of economic transactions/items :

1. Visible Items, 2. Invisible Items, 3. Capital Transfers. (1) Visible Items : Visible items include import and export of all types of physical goods. These are termed as visible items because they are made from some matter.

(2) Invisible Items : It includes all types of services. These are termed as invisible because services (like shipping, banking, etc.) are not made of matter or material.

(3) Capital Transfers : It includes capital receipts and capital payments. 30.2.1. Balance of Payments : Meaning and Definitions

Balance of payments refers to the statement of accounts recording all economic transactions of a given country with rest of the world. Each country enters into economic transactions with other countries of the world. As a result of such transactions, it receives payments from and makes payments to other countries. Balance of Payments is a statement of accounts of these receipts and payments. Balance of payments is thus an overall record of all economic transactions of a country, in a given period, with rest of the world.

Definitions : Few definitions of balance of payments are following :

(i) According to Benham , ‘‘Balance of payments of a country is a record of the monetary transactions over a period with the rest of the world.’’

(ii) According to Kindelberger , ‘‘The balance of payments of a country is a systematic record of all economic transactions between its residents and residents of foreign countries.’’

(iii) According to James Ingram , ‘‘The balance of payments is a summary record of all economic transactions between the residents of one country and the rest of the world during a given period of time.’’

30.2.2. Balance of Payments : Features

Main characteristics of ‘Balance of Payments’ are : (1) Systematic Record :

It is a record of payments

and receipts of a country related to its import and

export with other country.

(2) Fixed Period of Time : It is an account of a fixed period of time generally a year.

(3) Comprehensiveness : It includes all types of visible

items, invisible items and capital transfers. (4) Double Entry System :

Payments and receipts are

accounted on the basis of double entry system. (5) Self-balanced : Double entry system itself keeps

balance of payments as balanced.

(6) Adjustment of Differences : Whenever difference

arises between total receipts and payments, this

disequilibrium needs to be adjusted.

Difference between Balance of Trade and Balance of Payments Balance of Trade

1. Balance of trade refers to the difference between exports and imports of goods by a country in a year.

2. It is a narrow concept as it is a compo-nent of balance of payments.

3. It is only a partial record. Hence, it is not a true indicator of economic relations with other countries.

Balance of Payments

1. Balance of payments is a statement of all economic transactions between the residents of a country and rest of the world during a year.

2. It is a wider concept.

3. It is a complete record of economic transactions with the rest of the world. Hence, it provides a true picture of the economy of a country with the rest of the world.

4. It may be favourable or unfavourable. 4. From accounting viewpoint, it is always balanced. Box 1

30.3. Balance of Payment : Structure or Components

Balance of payment structure includes two types of account :

(a) Current Account, (b) Capital Account.

30.3.1. Current Account

Current account is that account which records imports and exports of goods and services and unilateral transfers. Current account records export and import of goods, export and import of services and unilateral transfers from one country to the other. Only real behaviours are included in current account.

● Components of Current Account

Current Account records the following transactions :

(1) Exports and Imports of Visible Items : Exports and imports of visible goods is the biggest item of current account. Exports are kept under credit side, while imports under debit side.

(2) Invisible Items : Different types of invisible items included in current account are :

(a) Expenditure on Travel : It is an invisible item. There could be many reasons for travel—business, education, health, entertainment, etc. Expenditure done by foreigners in our country is similar to exports because we get income (i.e., foreign exchange) by it. Expenditure done by an Indian in other country is similar to import as it is similar to our expenditure.

(b) Services rendered by Commercial Undertakings : (1) Transport : International transport of goods is another invisible item of current account. Use of domestic transport by foreigners in our country is a credit item, while use of foreign transport services by our businessmen is included in debit item.

(2) Insurance : Payment of claims and instalments of insurance is also an invisible item of current account. Insurance policy sold to foreigners is the credit item while policy bought from foreign countries is included in debit item.

(3) Services of Experts : Services of experts are available to all the countries of the world, services obtained are called imports and services given are called exports. These services are part of the current account of balance of payment.

(4) Investment Income : It includes rent, interest, profit and dividend. Income obtained from investment in foreign countries is termed as credit while income obtained by foreigners in our country is termed as debit.

(5) Government Transactions : Every country opens embassies, high commissions, etc., in foreign countries. Expenses done by a country on these institutions are listed in debit side and payment obtained from the foreign countries is included in credit side.

(3) Unilateral Tranfers : Gifts and aids obtained from foreign countries are kept in credit side, while aids and gifts given to foreign countries are kept in debit side.

● Features of Current Account Items : Important points related to current account of BOP are :

(i) All exports (of goods and services) are recorded as positive (+) items as these result in the flow of foreign exchange into the country.

(ii) All imports (of goods and services) are recorded as negative (–) items as these cause the flow of foreign exchange out of the country.

(iii) Balance occurring on account of export and import of goods is regarded as balance of visible trade.

(iv) Balance occurring on account of export and import of goods is regarded as balance of invisible trade. (v) Receipts of unilateral transfers are recorded as positive items.

(vi) Payments of unilateral transfers are recorded as positive items.

(vii) Net value of the three balances (1) balance of visible trade, (2) balance of invisible trade, (3) balance of unilateral transfers] is recorded as balance on current account.

Disequilibrium in BOP arises on account of balance on current account. If credit is greater than debit, then balance will be favourable and if credit is less than debit, then balance will be unfavourable.

30.3.2. Capital Account

Capital account is that account which records all such transactions between residents of a country and rest of the world which cause a change in the asset or liability status of the residents of a country or its government. In short, it is a record of capital transactions, Govt. and private capital, transfers and banking capital flow. Capital account tells us about debts and claims.

● Components of Capital Account

Main components of capital account are :

(i) Official Transactions : These are related to those international transactions which affect asset and liability status of the Govt. of a country or its agencies, e.g., Borrowing by country B from country A.

(ii) Non-official or Private Transactions : Non-official entities refer to non-government entities. It includes individuals, households and private business enterprises. e.g., Investment by an individual of country A in country B.

(iii) Foreign Direct Investment : Purchase of production units or investment of capital in any company or industry by a foreigner is called foreign direct investment, e.g., Acquisition of assets of a company in country A by another company in country B.

(iv) Portfolio Investment : It refers to purchase of assets abroad, but without any control over them. If any foreign investor buys shares of Reliance Company Ltd. from Indian Stock Exchange, it is called portfolio investment.

● Important Features of Capital Accounts (i) All capital transactions causing flow of foreign exchange into the country are recorded as positive items in the capital account of BOP, e.g., Loans from rest of the world or direct investment by the nonresidents in our country.

(ii) All capital transactions causing flow of foreign exchange out of the country are recorded as negative items in the capital account of BOP, e.g.,

Purchase of a firm by TATA in rest of the world. (iii) The net value of balances on account of (a) direct investment, and (b) portfolio investment is recorded as balance on capital account.

30.3.3. Other Items of BOP : Other than the Items of Current and Capital Account

(1) Errors and Omissions : Owing to a large variety of transactions, it is often not possible to record all of them with cent percent accuracy. Errors and omissions account for inaccuracies in recording transactions.

(2) Official Reserve Transactions : Official reserve transactions are different from all other transactions in balance of payment (BOP) accounts. These transactions are distinct because :

(a) These are carried out only by the government or the central, bank of the country on behalf of the government and

(b) These transactions are undertaken keeping in mind the international economic policy.

Consequently, official reserve transactions always have an impact on BOP status of a country or its exchange rate with rest of the world. It includes the following :

(i) Official Reserves of the Country : These can be decreased or increased with a view to financing government expenditures abroad. Reduction in reserves implies purchase of foreign exchange while increase in reserves implies sale of foreign exchange. By changing official reserves the Govt. is changing its supply/demand status of foreign exchange. This may be done with a view to affect the exchange rate in international money market.

(ii) Official Asset of Rest of the World in our Country : Increase in these assets generally implies increase in rupee reserves. Non-residents have to spend foreign exchange to increase their rupee reserves, causing flow of foreign exchange into the country. Accordingly, increase in such reserves is reflected as positive (+) item in BOP accounts. On the other hand, decrease in such reserves causes flow of foreign exchange out of the country and is, therefore, recorded as negative (–) item in BOP accounts.

☞ Decrease in official reserves are shown as positive item (+) in the BOP accounts, because their sales (through foreign exchange) causes the flow of foreign exchange into the country. On the other hand, increase in official reserves are shown as negative items (–) in the BOP accounts, because their purchases (through foreign exchange) causes flow of foreign exchange out of the country.

Distinction between Current Account and Capital Account of Balance of Payments

(i) Current account includes import-export of goods and services and unilateral transfers from one country to other, while capital account includes all such transactions between residents of a country and rest of the world which cause a change in the assets or liability status of the residents of a country and its residents.

(ii) Transactions in current account take place in the form of flow, while in capital account it takes place as stock.

(iii) Transactions related to current account bring change in current income of the country, while transactions related to capital account affect capital stock of the country.

Box 2 Box 3 Items of Balance of Payments : At a Glance

Receipts or Credit Payments or Debit (A) Items or Components of Current Account 1. Exports of goods.

2. Export of services :

(a) Services of domestic experts.

(b) Services of domestic commercial companies.

3. Income from foreign investments.

4. Expenditure by foreign tourists.

5. Receipts from transportation services.

6. Income from expenditure by foreign governments.

7. Gifts and donations received from abroad.

8. Mixed expenditure by foreigners.

9. Import of goods.

10. Import of services

(a) Services of foreign experts

(b) Services of foreign commercial companies

3. Income to foreigners from investment made at home.

4. Expenditure by country’s tourist abroad.

5. Payment of transportation services.

6. Government expenditure in foreign countries.

7. Payment of gifts and donations to the foreigners.

8. Mixed expenditure in foreign countries. (B) Items or Components of Capital Account 9. Foreign private loans.

9. Inflow of banking capital.

10. Reserves and monetary gold inflow. 12. Loans received by the government. 13. International sale of gold.

11. Capital receipts.

12. Repayment of private loans.

13. Outflow of banking capital.

14. Reserves and monetary gold transfer payment. 12. Loans repayment by the government. 13. Purchase of gold from international market. 14. Capital payments.

Box 4 30.4. Balance of Payments is always Balanced

Balance of payments of a country is always balanced because entries in BOP account are done on the basis of Credit (or Receipt) and Debit (or Payment) in dual entry system. After filling all the entries in the record, total credit and debit become equal to each other because both the sides are equal in transactions and recorded in opposite direction. That is why, BOP is always balanced.

BOP may be Disequilibrium in Operational Sense

From practical point of view, it is not possible that BOP always remains in equilibrium. BOP may be in disequilibrium. Balance of payments is also called economic balance. When there is a deficit or surplus in current account, equilibrium it is attained with the help of capital account, i.e., deficit in current account is removed by surplus of capital account and surplus in current account is utilized to remove deficit of capital account. In this way, BOP is brought in equilibrium by transfer of capital and current account. It can be concluded that, balance of payments of current account is not always balanced. It can be favourable or unfavourable but, overall it is seen that overall balance of payments is balanced or made balanced.

Box 5
- Illustration
Following Table 1, explain the items of balance of payments :
Table 1. Balance of Payments ` crore Assets (Credits) Liabilities (Debits)

1. Export of Goods 650
2. Export of Services (Banking, Shipping, Insurance, Tourism, etc.)
3. Transfer Payments from Rest of the World (Gifts, Aid, etc.)
4. Capital Receipts (Loans, Sales of Assets to Foreigners, Receipt of Capital)
1. Import of Goods 900 2. Import of Services (Banking, Shipping, 200 Insurance, Tourism, etc.) 75 3. Transfer Payments to Rest of the World 125 (Gifts, Aid, etc.) 90 4. Capital Payments (Loans to Foreigners, 225 Buying of Assets from Foreigners, Payment of Capital of Foreigners) 135 Total Receipts 1200 Total Payments 1200

● Explanation (1) From accounting point of view, it is clear from Table

1 that BOP is balanced because :
Total Credit = Total Debit
` 1200 crores =` 1200 crores

Balance of Trade = Exports of Goods – Import of

Goods
= 650 - 900
= (−) ` 250 crores

or there is deficit in balance of trade and this is the indicator of adverse balance of trade. In other words, this situation expresses disequilibrium in balance trade.

(3) Balance of Trade in Current Account : Balance on = [Balance of Trade] + [Balance of

=-`90 crores

Current Account Services] + [Transfer Balance] = [Goods Export – Goods Import] + [Service Export – Service Import] + [Transfer Receipts – Transfer Payments]

= [ 6 5 0 - 9 0 0 ] + [ 2 0 0 - 7 5 ] + [ 1 2 5 - 9 0 ]

$= -250 + 125 + 35$

Above equation reveals that balance of payments of current account is in disequilibrium and shows deficit of ` 90 crores.

(4) Balance of Payments of Capital Account : Balance of Payments = [Capital Receipts] – [Capital of Capital Account Payment] = 225 – 135

=` 90 crores

Above equation reveals that balance of payments of capital account has surplus of ` 90 crores. (5) Deficit in current account is equal to surplus in capital account or surplus of capital account compensates deficit of current account and balance of payments remains in equilibrium.

30.5. Causes of Disequilibrium in Balance of Payments

Reasons for imbalances in BOP can be divided into four group :

(I) Natural Causes,

(II) Economic Causes,

(III) Political Causes,

(IV) Social Causes.

● (I) Natural Causes

Natural causes like flood, famine, drought, etc., cause imbalances in BOP. Affected economy or economy prove to these natural disaster becomes dependent on imports which adversely affects BOP.

● (II) Economic Causes

(1) Development Expenditure : Huge development expenditure by the Govt. owing to which there are large scale imports in the country. It may cause a deficit in BOP or disequilibrium in BOP.

(2) Business Cycle : These occur in the form of recession, depression, recovery and boom. A period of boom may witness large scale exports of a country. Accordingly, disequilibrium with a surplus in BOP may occur.

(3) Rising Prices : Due to high domestic prices, exports are discouraged. This drives the economy towards ‘deficit BOP disequilibrium’.

(4) Import Substitution : Imports decline due to import substitution and deficit in BOP (i.e., disequilibrium) is narrowed.

(5) Other Economic Factors : New sources of supply in other countries discovery of new competitive goods bring decrease in exports of country. As a result of it, BOP is in disequilibrium.

● (III) Political Causes

(1) More Defence Expenditures : If due to political tension or war, defence expenditure increases, then BOP is in disequilibrium because Govt. has to increase defence expenditure to purchase war related requirements.

(2) International Relationship : International relations of a country can be sweet or bitter. It affects the BOP of a country.

(3) Expansion of Embassies and Higher Upkeep : Expenses done on expansion of embassies and higher upkeep are similar to import and affects BOP adversely.

(4) Political Instability : Due to political instability, BOP of a country is adversely affected.

● (IV) Social Causes

Due to change in social structure and social parameter, taste, interest, fashion of people change. This affects propensity to consume, imports and exports. It thereby affects BOP of a country.

A QUICK REVIEW OF THE CHAPTER

● Balance of Trade : Balance of trade is related to only visible items. Difference between the value of total visible exports and imports of a country is called Balance of Trade.

● Balance of Payments : Balance of payments is an overall record of all economic transactions of a country, in a given period, with the rest of the

world.

● Economic Transactions : Economic transactions of Balance of Payments include three items : (i) Visible Items,

(ii) Invisible Items,

(iii) Capital Transfers.

● Difference between Balance of Trade and Balance of Payments : There is difference between Balance of Trade and Balance of Payments. Balance of Trade includes only visible items, while in Balance of Payments visible items, invisible items as well as capital transfers are taken into account.

● Current Account and Capital Account of Balance of Payments :

(i) Current account is that account which records imports and exports of goods and services and unilateral transfers.

(ii) Capital account is that account which records all such transactions between residents of a country and rest of the world which cause a change in the asset or liability status of the residents of a country or its government.

● Other Items of Balance of Payments : Other items included in BOP are : (i) Errors and Omissions, (ii) Official Reserve Transactions, etc.

● Structure of Balance of Payments : There are following factors in structure of BOP : (a) Current Account : Which includes visible balance of trade, invisible balance of trade and capital transfers. (b) Capital Account : Which includes transactions, private transactions, direct investment and portfolio investment.

● Causes of Disequilibrium in BOP :

(1) Natural Causes.

(2) Economic Causes : (i) Development Expenditure, (ii) Trade Cycle, (iii) Rising Prices, (iv) Import Substitution, (v) Other Economic Causes.

(3) Political Causes : (i) More Development Expenditure, (ii) International Relations, (iii) Expansion of Embassies, (iv) Political Instability, (v) Social Causes.

QUESTIONS Ultra Short Answer Type Question

1. Trade balance includes what type of items ?

2. Who said this, “The Balance of payments of a country is a record of the monetary transactions over a period with the rest of the world” ?

3. Write the name of two invisible items. (U.S.E.B ., 2016)

4. What is open economy ? (B.S.E.B., 2019) 5. What is closed economy ? (J.A.C., 2019) 6. What are imports and exports ? (J.A.C., 2019) 7. What do you understand by favourable balance of payments ? (U.S.E.B., 2019) Very Short Answer Type Questions

5. Define Balance of Payments. Or

What is meant by Balance of Payments Account ?

2. Define Balance of Trade. Or What is Balance of Trade ? 3. What is Trade Surplus ? (J.A.C. , 2010)

( J.A.C. , 2019) (Raj. Board, 2013) 4. Which two transactions determine Balance of Trade ? 5. What does the deficit of Balance of Trade signify ? 6. Calculate the value of imports when Balance of Trade

(merchandise) is ` 400 crores and value of exports is ` 300 crores. [Ans. 700 crores] 7. The Balance of Trade shows a deficit of ` 300 crores. The value of exports are ` 500 crores. What is the value of exports ? [Ans. ` 800 crores] 8. What is meant by Balance of Payment Account ?

9. Define Capital Account. 10. What is the purpose of trade ? (MP Board, 2019) 11. Which items are included in balance of trade ?

( MP Board, 2019) Short Answer Type Questions

1. What is meant by Balance of Trade ?

( B.S.E.B. , 2016, J.A.C. , 2017) 2. What is meant by Balance of Payments ? (B.S.E.B. , 2012, J.A.C., 2015) 3. List four items each of Current Account and Capital Account of the Balance of Payments Account. (U.S.E.B., 2009) 4. Balance of payments always balances. Why ? (J.A.C., 2017) 5. State the difference between Direct Investment and Portfolio Investment. 6. Distinguish between Balance of Payment and Balance of Trade. (B.S.E.B. , 2015; U.S.E.B., 2014, 15; Raj. Board., 2015) 7. Name the main components of Current Account of Balance of Payments Account. (C.B.S.E., 2011) 8. What is meant by Visible and Invisible Items in the Balance of Payments Account ? Give two examples of Invisibile Items. (U.S.E.B., 2015, 17, 19) 9. Distinguish between balance of trade and balance on current account. (C.B.S.E., 2011, 13, 15) 10. Explain the meaning of deficit in balance of payments. (C.B.S.E. , 2010, 18) 11. Distinguish between autonomous &

accommodating transactions of balance of payments account. (C.B.S.E. , 2010, 12, 15) 12. What are the salient features of balance of payments ? (B.S.E.B., 2011) 13. State the components of capital account of balance of payments. (C.B.S.E. , 2011) 14. What does balance of payment account show ? Name the two parts of the balance of payments account. (C.B.S.E. , 2011) 15. Which transactions determine the balance of trade ? When is balance of trade in surplus ? (C.B.S.E. , 2011) 16. In the context of balance of payments account, state whether the following statements are true or false. Give reasons of your answer : (C.B.S.E. , 2015) (i) Profits received from investments abroad is recorded in capital account.

(ii) Import of machines is recorded in current account. 17. What are the components of Balance of Payments. (B.S.E.B. , 2018) 18. Discuss the monetary measures of correcting disequilibrium in Balance of payments. (MP Board , 2019) 19. Discuss the non-monetary measures of correcting disequilibrium in Balance of Payaments. (MP Board , 2019) Long Answer Type Questions

1. What is meant by Disequilibrium in the Balance of Payments ? Explain its types and causes.

( J.A.C. , 2010, 19; U.S.E.B., 2012; B.S.E.B., 2012) 2. Explain the items of Current Account and Capital Account of Balance of Payments. (J.A.C. , 2010; B.S.E.B., 2014) 3. What is Balance of Payments? Describe any four methods to correct adverse Balance of Payment. (B.S.E.B., 2015) 4. Explain the reasons of adverse balance of payments.

( U.S.E.B., 2010, B.S.E.B., 2012; J.A.C., 2010, 17, 16, 19) 5. Distinguish between balance of payments and balance of trade. (J.A.C., 2011) 6. Define balance of payment. State its main components.

( U.S.E.B., 2011) 7. “Balance of Payment is always in equilibrim.” Explain. (B.S.E.B., 2012) 8. What is Balance of Trade ? Distinguish between Current Account and Capital Account in Balance of Payments. (B.S.E.B., 2014) 9. (a) Define ‘Trade surplus’. How is it different from “Current Account Surplus” ?

(b) “Indian rupee (`) plunged to all time low the economic of ` 74.48 against US dollar ($).”

In the light of above report, discuss the impact of the situation on Indian Imports. (C.B.S.E., 2019) Objective Type Questions

(A) Multiple Choice Questions :

1. Balance of Trade = ? (B.S.E.B. , 2018) (a) Export of Visible Items – Imports of Visible Items (b) Export of both Visible and Invisible Items – Import of

both Visible and Invisible Items

(c) Import of Visible Items – Export of Visible Items (d) None of the above

2. Which items are included in Balance of Payments ?

(a) Visible Items (c) Capital Transfers

( B.S.E.B. , 2018) (b) Invisible Items

(d) All the above

3. Which one is the visible item of Balance of Payments ? (a) Machine (b) Cloth

(c) Cement (d) All the above

4. Which one is the invisible item of Balance of Payments ? (B.S.E.B., 2019; J.A.C. , 2019)

(a) Banking (b) Shipping (c) Communication (d) All the above 5. Which one is the feature of Balance of Payments ?

(a) Systematic Accounts (c) Comprehensiveness

( B.S.E.B. , 2018) (b) Fixed Time Period

(d) All the above

6. Which account is included in the composition of Balance of

(D) Match the following Column : ‘A’

1. Blanca of Trade

2. Balance of Payments 3. Capital Transfers 4. Visible Item

3. Invisible Item

‘B’

(a) Machine

(b) Visible items

(c) Banking

(d) Visible and Invisible Items (e) Capital Receipts and Payment

(b) Capital Account (d) None of the above

7. Which one is the item of Current Account ? (B.S.E.B., 2015, 19) (a) Import of Visible Items (b) Expenses of Tourists (c) Exports of Visible Items (d) All the above

8. Which one is the item of Capital Account ? ( B.S.E.B. , 2018) (a) Government Transactions (b) Private Transactions (c) Foreign Direct Investment (d) All the above

(d) None of these

(a) Current Account (c) Both (a) and (b)

10. Which items are included in balance of trade ? (a) Invisible Item (c) Visible Item

(d) All the above

(B.S.E.B., 2015, 16, 18, 19) (b) Import & export of goods

(d) All the above

12. The reason of imbalance in balance of payment is : (a) Natural Reasons (b) Economic Reasons (c) Political Reasons (d) All the above [Ans. 1. (a), 2. (d), 3. (d), 4. (d), 5. (d) , 6. (c), 7. (d), 8. (d), 9. (c), 10. (c), 11. (b), 12. (d).]

(B) Fill in the Blanks :

1. Balance of trade includes only................items of the trade.

2. From accounting point of view, balance of................is always balanced.

3. Foreign direct investment is a part of................account in balance of

payments.

4. Repayment of private loans comes in the debit side of................account.

5. Balance of payments structure contains both............. and............... accounts.

[Ans. 1. visible, 2. payments, 3. capital, 4. capital, 5. current, capital.]

(C) State True/False :

1. Current account and capital account are included in the composition of balance of payments.

2. Balance of Payments is a narrow concept in comparision of Balance of Trade.

3. Visible items, invisible items and capital transfers are included in balance of payments.

4. Cement cloth and machine are included in invisible items.

5. Visible items are included in balance of trade.

[Ans. 1. True, 2. False, 3. True, 4. False, 5. True] Payments ?

(a) Current Account (c) Both (a) and (b) [Ans. 1. (b), 2. (d), 3. (e), 4. (a), 5. (c)]

(E) Answer in One Word :

1. Which items are included in Balance of Trade ? 2. Which items are included in Balance of Payments ? 3. To which account of Balance of Payment, Portfolio investment belongs ?

2. To which account of Balance of Payments, unilateral transfer belongs ? [Ans. 1. Visible items, 2. Visible and invisible items, 3. Capital Account, 4. Current Account.]

HOTS High Order Thinking Skills Questions

1. Why is balance of payments always balanced from accounting point of view ?

(See : Section 30.4)

2. “Capital account of BOP tells us about debts and claims.” How ? (See : Section 30.3.2)

VBQ Value Based Questions

1. The scope of balance of payment is broader than that of balance of trade. How ?

Ans. C = 40 + 0.8YD

(See : Section 30.2)

2. What is portfolio investment ? To which account it becomes a component in balance of payment structure ?

(See : Section 30.3.2)

MDQ Case Study Based on Evaluation & Multi-disciplinary Questions

1. “BOP may be disequilibrium in operational sense.” Explain. (See : Box 5)

2. Equal dual entry keeps balance of payment always in equilibrium on the view of accounts. How ?

(See : Section 30.4)

NCERT CORNER

Q. 1. Differentiate between balance of trade and balance of payment. Ans. See, Box 1.

Q. 2. What are official reserve transactions ? Explain their importance in the balance of payments.

Ans. Official reserve transactions are the transactions relating to sale and purchase of foreign currency in the foreign exchange market. Official reserve transactions help in solving the problem of BOP. In case of a deficit BOP of a country should sale foreign currency in the foreign exchange market. The official reserve transactions are more relevant under a regime of pegged exchange rates.

206

Introductory Macro Economics

Q. 3. Suppose C = 40 + 0.8Y D, T = 50, I = 60, G = 40, X = 90, M = 50 + 0.5Y (a) Find equilibrium income. (b) Find the net export balance at equilibrium income. (c) What happens to equilibrium income and the net export balance when the government purchases increase from 40 and 50 ?

\mathrm{T} = 5 0

\mathrm{I} = 6 0

G = 40
X = 90
M = 50 + 0.05Y
(a) Equilibrium Income (Y)
= C + C (Y - T) + I + G + X - M = 40 + 0.8 (Y - 50) + 60 + 40 + 90 - (50 + 0.05 Y) Y = 40 + 0.8Y - 40 + 60 + 40 + 90 - 50
- 0.05Y Y = 0.8Y - 0.05Y + 40 - 40 + 60 + 40 + 90
- 50 = 0.75Y + 230 - 90
= 0.75Y + 140
Y - 0.75Y = 140
0.25 Y = 140
Y = 560
(b) Net Exports = X - M
= 90 - (50 + 0.05Y)
= 90 - (50 + 0.05 × 560)
= 90 - (50 + 28)
= 90 - 78
= 12
1 (c) Y = 1 cm G
= 1 × 10 1 0.8 0.05
1
= 0.25 × 10
= 40.
Increase in equilibrium income due to increase in government purchase of 10 = 40
New Income = 560 + 40 = 600
Change in Net Exports = X1 - M1
= 90 - (50 + 0.05 × 600)
= 90 - (50 + 30)
= 90 - 80
= 10.
Q. 4. In the above question, if exports change to X = 100, find the change in equilibrium income and the net export balance.

1 Ans. Y = 1 cm X
= 1 × 10 1 0.8 0.05
1
= 0.25 × 10
= 40
New Income = 560 + 40
= 600

Change in Net Exports = X₁ - M₁
= 100 - (50 + 0.05 × 600) = 100 - 80
= 20.

Q. 5. Explain why G - T = (S g - I) - (X - M). Ans. G - T = (Sg - I) - (X - M)
Here G = Government Expenditure T = Taxes
G - T = Net Government Expenditure S_g = Savings of the Government

I = Investment
S_g - I = Net Savings
X = Exports
M = Imports
X - M = Balance of Trade
The given equation states that net government expenditure equals net government savings and balance of trade. It implies that net government expenditure is financed by government savings and trade deficit. Hence, the given equation is correct.

Q. 6. If inflation is higher in country A than in country B and the exchange rate between the two countries is fixed, what is likely to happen to the trade balance between the two countries?

Ans. If inflation is higher in country A than in country B and the exchange rate between the two countries is fixed, country A will have deficit trade while that of country B have surplus trade. In case of inflation in country A and prices of country B remaining constant, imports of country A will rise or exports of country A will decline. As a result, trade balance of country A will be unfavourable and trade balance of country B will be favourable.

Q. 7. Should a current account deficit be a cause for alarm ? Explain.
Ans. A current account deficit need not be a cause for alarm because deficit

in current account is carried over by capital account.

Q. 8. Suppose \mathbf { C } = \mathbf { 1 0 0 } + \mathbf { 0 . 7 5 } \mathbf { Y } \mathbf { D } , \mathbf { I } = 5 \mathbf { 0 0 } , \mathbf { G } = 7 5 \mathbf { 0 } , taxes are 20 percent of income, X = 150, M = 100 + 0.2Y. Calculate equilibrium income, the budget deficit or surplus and the trade deficit or surplus.

Ans. C = 100 + 0.75YD

\mathrm{I} = 5 0 0

\mathrm{G} = 7 5 0

Proportional Taxes (t )

= 20\%

\mathrm{X} = 1 5 0

\mathbf {M} = 1 0 0 + 0. 2 \mathbf {Y}

(a) Equilibrium Income (b) Budget Decifit = Government Expenditure – Tax \mathbf { Y } = \mathbf { C } + c \left( 1 - t \right) \mathbf { Y } + \mathbf { I } + \mathbf { G } + \left( \mathbf { X } - \mathbf { M } \right) . = 7 5 0 - 2 0 \% 0 9 2 3 3 3 = 1 0 0 + 0 . 7 5 \left( \mathbf { X } - \mathbf { M } \right) . 1 - 0 . 2 ) \mathrm { Y } + 5 0 0 + 7 5 0 + = 7 5 0 - 4 6 7 = 2 8 3 \left( 1 5 0 - 1 0 0 - 0 . 2 \mathrm { Y } \right) _ { \mathrm { M } = 1 0 0 + 0 . 2 \mathrm { Y } } = 0 . 2 5 7 5 \mathrm { a m } + 0 . 2 5 7 5 \mathrm { a m } 1 0 0 + 0 . 7 5 ( 0 . 8 ) \mathrm { Y } + 5 0 0 + 7 5 0 + 5 0 = 1 0 0 + 0 . 2 \times 2 3 3 3

= 1 4 0 0 + 0. 4 \mathrm{Y} = 1 0 0 + 0. 2 \mathrm{Y} - \mathrm{X} ^ {\mathrm{Y} - 0. 4 \mathrm{Y} = 1 4 0 0} = 1 0 0 - 0. 2 \times 2 3 3 3 - 1 5 0 ^ {0. 6 \mathrm{Y}} =

MODEL PAPER

Bihar School Examination Board (Senior Secondary), Patna Economics-XII

Time : 3Hours 15Minutes ] [Max. Marks :100

Instructions to the Candidates :

1. Candidates are required to give their answers in their own words as far as, possible.

2. Figures in the right hand margin indicate full marks.

3. 15 Minutes of extra time has been allotted for the candidates to read the questions carefully.

4. This question paper is divided into two sections :Section A andSection B

5. InSection A , there are60 Objective Type Questions (each carrying1 mark ), out of which any 50 questions are to be

answered. Darken the circle with blue/black ball pen against the correct option on OMR Sheet provided to you.Do not use Whitener/Liquid/Blade/Nail on OMR Paper, otherwise the result will be invalid.

6. In Section-B, there are 27 Short Answer Type Questions (each carrying2 marks ), out of which any 15 questions are to be answered. Apart from this, there are8 Long Answer Type Questions (Each carrying5 marks ), out of which 4 questions are to be answered.

7. Use of any electronic device is prohibited.

Section-I

Objective Type Questions

Instruction : For Question Nos.1 to60 there are four alternatives of which only one is correct. Choose the correct alternative and mark it in the answer sheet. Out of which any50 questions are to be answered. 50 × 1 = 50

1. Which of the following is not a factor of production ? (a) Land (b) Labour (c) Money (d) Capital

2. According to whom, Economics is a science of human welfare ? (a) A. Marshall (c) J.S. Mill

(b) Paul Samuelson (d) Adam Smith

3. The word ‘micro’ was firstly used by : (b) Boulding

(d) Ragnar Frish (a) Marshall (c) Keynes

4. Who gave the definition of Economics related to welfare ? (b) Marshall

(d) Samuelson (a) Adam Smith (c) Robbins

5. “Economics is a science of logic.” Who said it ?

(a) Hicks (b) Keynes (c) Robbins (d) Marshall

6. How we calculate marginal utility ?

7. The ability of satisfying human want in a goods is called its : (b) Satisfaction (d) Profitability (a) Productivity (c) Utility

8. Slope of budget line or price line is :

P P

(a) –P y x x ^(b) –P ^{P P x P yy} (c)_{P y} (d)_{P x}

9. Goods, which can alternatively be used, are called : (a) Complementary Goods (b) Substitutes (c) Comforts (d) None of these

10. Law of Demand is a :

(a) Qualitative Statement (b) Quantitative Statement (c) Both (a) and (b) (d) None of these

11. Elasticity of demand for necessities is : (a) Zero (b) Unlimited (c) Greater than unity (d) Less than unity

12. If the demand for a goods changes by 60% due to 40% change in price, the elasticity of demand is : (a) 0.5 (b) –1.5 (c) 1 (d) zero

13. Long-run production function is related to :

(a) Law of Demand (b) Law of Increasing Returns (c) Laws of Returns to Scale (d) Elasticity of Demand

14. In which stage of production a rational producer likes to operate in shotrun production ? (a) First Stage (c) Third Stage (b) Second Stage (d) None of these

15. The cycle which increases first and after being constant starts to reduce is called : (a) APP (b) MPP (c) TPP (d) All these

16. Law of variable proportion is related to : (a) Both short-run and long run (b) Long-run (c) Short-run (d) Very Long-run

17. Which of the following is not fixed cost ? (a) Insurance Premium (b) Interest (c) Cost of Raw Material (d) Rent of the Factory

18. Supply is associated with : (a) A Time Period (b) Price (c) Both (a) and (b) (d) None of these

19. If the price of goods rises by 60% but supply increases by only 5%, the supply of goods will be : (a) Highly Elastic (b) Elastic (c) Inelastic (d) Perfectly Inelastic

20. The elasticity of a straight line supply curve originating from the centre of origin is : (a) Less than unity (c) equal to unity (b) greater than unity (d) equal to zero

21. Which one is a feature of monopoly ? (a) Single Seller and Many Buyers (b) Lack of Close Substitutes (c) Restrictions of New Firm entry (d) All of these

22. A market in which there is free entry and exit, the market is : (a) Monopolistic Competitive Market (b) Imperfect Competitive Market (c) Perfectly Competitive Market (d) None of these

23. Which of the following is the feature of pure competition? (a) Perfect knowledge of the market (b) Perfect mobility of factors (c) Homogenity by products (d) All of these

24. Market situation where there is only one buyer is : (a) Monopoly (b) Monopsony (c) Duropoly (d) None of these

25. Price of a commodity is determined at a point where : (a) Demand exceeds (b) Supply exceeds (c) Demand equals supply (d) None of these

26. Which one is included in flow ? (b) Investment (d) All of these (a) Consumption (c) Income

27. Which one is included in three-sector model ? (a) Family (b) Firm (c) Government (d) All of these

28. The market price of all final goods and services produced in the domestic territory of a country in a year is known as : (a) { \mathrm { G D P } } _ { \mathrm { M P } } (b) \mathrm { G D P _ { F C } }

(c) { \mathrm { N N P } } _ { \mathrm { F C } } (d) None of these

29. Which one is true ?

(a) GNP = GDP + Depreciation

(b) NNP = GNP + Depreciation

(c) NNP = GNP – Depreciation

(d) GNP = NNP – Depreciation

30. Net National Income at Factor Cost is called :

(b) Gross Investment (d) None of these

(a) National Income (c) Domestic Income

31. Which of the following is not a function of money ? (a) Medium of exchange (b) Price stability (c) Store of value (d) Unit of account

32. Which is the Agency Function of Commercial Banks ? (b) Accepting Deposits (d) Locker Facility (a) Advancing Loans (c) Act as Trustee

33. Which of the following is the function of Central Bank ? (a) Monopoly of Note Issue

(b) Banker of the Government

(c) Custodian of Foreign Exchange Reserves (d) All of these

34. Which type of currency is issued by the Central Bank ? (a) Currency (b) Credit Money (c) Coins (d) All of these

35. Which is not a quantitative method of credit control ? (a) Bank Rate (b) Moral Suasion (c) Open Market Operations

(d) Change in CRR

36. Reserve Bank of India was established in :

(a) 1947 (b) 1935 (c) 1937 (d) 1945

37. According to Keynes, investment implies :

(a) Financial Investment (b) Real Investment (c) Both (a) and (b) (d) None of the above

38. Which of the following is a Real Investment ?

(a) Purchasing of a Share

(b) Purchasing of Old Factory

(c) Construction of Buildings

(d) Opening Deposit Account in the Bank

39. If MPC = 0.5, then Multiplier (K) will be :

(a)¹ (b) = 0 (c) 1 (d) 2₂

40. Which one of the following is the determining factor of Equilibrium Income in Keynesian Viewpoint ?

(a) Aggregate Demand (c) Both (a) and (b) (b) Aggregate Supply (d) None of these

41. In the situation of deflationary gap : (a) Demand increases rapidly

(b) Supply increases rapidly

(c) Both demand and supply are equal (d) All of these

42. Which is a component of Budget Receipt ? (a) Revenue Receipt (c) Both

(a) and (b) (b) Capital Receipt (d) None of these

43. Tax revenue of the Government includes : (a) Income Tax (c) Excise

Duty (b) Corporate Tax (d) All of these

44. Which is included in the Direct Tax ?

(a) Income Tax (b) Gift Tax

(c) Both (a) and (b) (d) Excise Duty

45. The expenditures which do not create assets for the government is called

(a) Revenue Expenditure (b) Capital Expenditure (c) Both (a) and (b) (d) None of these

46. Which of the following statement is true ?

(a) Fiscal deficit is the difference between total expenditure and total receipts.

(b) Primary deficit is the difference between total receipt and interest payments

(c) Fiscal deficit is the sum of primary deficit and interest payment 47. By exchange rate we mean :

(a) How much local currency we have to pay for a foreign currency.

(b) How much of a foreign currency we have to pay for another foreign currency.

(c) The rate at which foreign currency is bought and sold. (d) All of these.

48. Which one is the invisible item of Balance of Payments ? (a) Banking (b) Shipping

(c) Communication (d) All of these

49. During Bretton Woods System most Countries had : (a) Fixed Exchange

50. The average product curve in the input-output plane, will be (a) an ‘S’ shaped curve (b) an inverse ‘S’ shaped curve (c) a ‘U’ shaped curve (d) an inverse ‘U’ shaped curve

51. An active factor of production is : (a) capital (b) labour (c) land (d) None of these

52. When the total fixed cost of producing 100 units is `30 and the average variable cost is`3, total cost is : (a)`3 (b)`30 (c)`270 (d)`330

53. With which condition, firm will get maximum profit ? (a) Marginal Revenue = Marginal Cost (b) Marginal Cost Cuts Marginal (c) Both (a) & (b) (d) None of these

54. “Supply creates its own demand”. Who said it ? (a) Prof. J.B. Say (b) Ricardo (c) Prof. Pigou (d) Keynes 56. Which of the following is a stock ? (a) Wealth (b) Savings (c) Export (d) Profit

55. Which of the following is not a flow ?

(a) Capital (b) Income

(c) Investment (d) Depreciation

58. In an open economy which are the components of Aggregate Demand ?

(a) Consumption (b) Investment

(c) Consumption + Govt. Expenditure

(c) Consumption + Investment + Govt. Expenditure + Net Export

59. Which of the following affects national income ? (a) Goods Service Tax

(c) Subsidiaries

60. Credit Multiplier is :

^{1 (a)} CRR

(c) Cash × CRR

(b) Corporate Tax (d) None of these

1

^(b) Cash ×CRR

(d) None of these

ANSWERS

1. (c), 2. (a), 3. (d), 4. (b), 5. (c), 6. (a), 7. (c), 8. (a), 9. (b), 10. (a),

2. (a), 12 . (b ), 1 3. (c), 1 4. (b), 15. (d), 16 . (c),

3. (c), 18. (c), 19. (c), 20. (c), 21. (d), 22. (c), 23. (d),

4. (b), 25. (c), 26. (d), 27. (d), 28. (a), 29. (c), 30. (a),

5. (b), 32. (c), 33. (d), 34. (a), 35. (b), 36. (b), 37. (b),

6. (c), 39. (d), 40. (c), 41. (d), 42. (c), 43. (d), 44. (c),

7. (a), 46. (c), 47. (d), 48. (d), 49. (a), 50. (d), 51. (d), 52. (b), 53. (d), 54. (c), 55. (a), 56. (a), 57. (a), 58. (d), 59. (d), 60. (a).

Section-II

Non-Objective Type Questions Short Answer Type Questions 15 × 2 = 30 1. Why is Production Possibility Curve concave towards origin

? Explain.

2. Mention the assumptions of Production Possibility Curve.

3. Suppose there are 20 consumers for a goods and they have identical demand functions :d ( p ) = 1 0 - 3 p for any price less than or equal to103 and d _ { 1 } ( p ) = 0 at any price greater than

10

3. What is the market demand function ?

4. What are the assumptions of Law of Demand ?

5. State the relation between Marginal Production and Average Production.

6. When the price of a commodity falls from`10 per unit to`9 per unit, its quantity supplied falls by 20% Calculate price elasticity of supply.

7. What is the difference between monopoly and monopolistic competition ?

8. Firm is a price maker in monopoly. Explain.

9. How national income is calculated by expenditure method ? 10. What precautions are taken while measuring National Income by Expenditure Method?

10. Explain the primary functions of money.

11. Explain ‘difficulty in storing wealth’ problem faced in the barter system of exchange.

12. Explain the Induced Investment and Autonomous Investment with the help of diagram.

13. In an economy investment increases from`1,000 crore to `1,200 crore and as a result, total income increased by`800 crore. Calculate MPC.

14. Distinguish between Direct Taxes and Indirect Taxes. 16. What is meant by foreign exchange market? Explain its main functions.

15. What is economic problem ?

16. Explain the Geometrical method of price elasticity of demand with diagram.

17. What is Production Function ?

18. The price elasticity of supply of commodity Y is half, the price elasticity of supply of commodity X. 16% rise in the price X results in a 40% rise in its supply. If the price of Y falls by 8%, calculate the percentage fall in its supply. 21. What is the relationship between market price and normal price ? 22. What is circular flow of income ?

19. State two qualities of good money.

20. When does savings become negative ?

21. What do you mean by Balance of Payment ?

22. Define the term ‘tax’.

23. Which two transactions determine Balance of Trade ? Long Answer Type Questions 4 × 5 = 20 28. Discuss the different types of economic system. 29. Explain the geometrical method of price elasticity of demand with diagram.

24. Define supply mention the causes which determine the supply of a commodity.

25. What is meant by market ? Explain its features. 32. Explain the various concepts national income.

26. How does a commercial bank create credit ? Explain with an example. 34. What do you mean by aggregate demand ? Distinguish between market demand and aggregate demand. 35. Explain progressive, proportional and regressive tax with examples.

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MODEL PAPER

Jharkhand Academic Council, Ranchi

Economics-XII

Time % 3 Hours ] [Maximum Marks % 100

Instructions to the Candidates :

(i) Candidates are required to give their answers in their own words as far as practicable.

(ii) Figures in the margin indicate full marks.

(iii) All questions in both the Groups are compulsory.

(iv) Question Nos. 1 to 5 and 17 to 21 are Multiple Choice type carrying 1 mark each.

(v) Question Nos. 6 to 10 and 22 to 26 are Short Answer I type carrying 3 marks each. Answers of these questions should not exceed 60 words each. (vi) Question Nos. 11 to 13 and 27 to 29 are Short Answer II type questions