Unit 1: Elasticity of Demand and its Measurement income, it is the positive income elasticity of demand.

he positive income elasticity of demand. For most goods, the income Normally, rich consumers do not respond to small changes in price. So, the price
What is elasticity of demand ? explain its types elasticity is positive. Such goods are called normal goods. It can be explained in a elasticity of demand for rich will be low. But poor people quickly respond to even
Elasticity of demand is defined as the percentage (proportionate) change in table as : small changes in prices of commodities. So, the price elasticity of demand for poor
quantity demanded of a goods due to the percentage (proportionate) change in the Income in rupees Demand in Kg people will be high.
price of the goods, income of the consumer, prices of related goods or other 5000 10 3.Habit and custom goods
determinants of demand. 6000 15 People who have been habituated in certain goods will not easily change their
There are 3 types of elasticity of demand In the table, when the income increases from rupees 5000 to rupees 6000, the demand due to changes in price. So, the price elasticity of demand for habitual
1. Price elasticity of demand demand also increases from 10 Kg to 15 Kg and vice-versa. This is positive income goods will be less. Similarly, many goods are demanded due to custom and
2. Income elasticity of demand elasticity of demand. It can be shown in a diagram tradition. The demand for such goods also do not change due to changes in their
3. Cross elasticity of demand as below: prices. So, the price elasticity of demand for custom goods will also be low.
1. Price elasticity of demand: Price elasticity of demand is defined as the 4.Time period
percentage ( proportionate) change in quantity demanded of a goods due to the In the diagram, DD is the positively sloping demand If the consumer has sufficient time to buy a commodity, the price elasticity of
percentage (proportionate) change in its price. curve. When the income of the consumer increases demand will be high as the consumers can search other commodities or make
There are five types / Degrees of Price elasticity of demand: They are: from I to I1, the demand also increases from Q to bargaining. But if there is less time to buy any commodity, the demand will be
1. Perfectly elastic demand (Ep =∞) Q1 and vice –versa. The positive income elasticity of relatively inelastic as the consumer cannot search for other commodities or make
When a negligible increase in price will bring down the demand to zero and a demand can be further divided into three types as: bargains.
negligible decrease in price will increase the demand to infinity, it is known as the Income elasticity of demand more than unity (Ey˃1) 5.Durability of goods
perfectly elastic demand. This type of change in demand is only theoretical and not 2.Negative income elasticity of demand (Ey˂0): When the demand for a Durable goods like furniture, houses, radios, television, etc will have less price
seen in real life. The perfectly elastic demand can be shown in a table as below: commodity increases with a decrease in income and decreases with an increase in elasticity of demand. But non-durable and perishable goods like fruits, vegetables,
income, it is negative income elasticity of demand. The income elasticity will be meat etc. will have high price elasticity of demand.
Price in rupees Demand in Kg negative in the case of low quality or Giffen goods. It can be explained in a table as
10 100 below:
10.01 0 Income in rupees Demand in Kg
9.99 ∞ 5000 10
In the table when the price is rupees 10, the demand is 100 Kg. When there is a 6000 5
negligible increase in price from rupees 10 to rupees 10.01, the demand decreases Types /degrees of price elasticity of supply
to zero and a negligible decrease in price from rupees 10 to 9.99 rupees, the There are five types or degrees of price elasticity of supply as:
In the table, when the income increases from rupees 5000 to rupees 6000, the
demand increases to infinity. This is a perfectly elastic demand. It can be shown in Perfectly elastic supply (Es =∞)
demand decreases from 10 Kg to 5 Kg and vice-versa. This is negative income
a diagram as below: When a negligible increase in price will bring down the supply to zero and a
elasticity of demand. It can be shown in a diagram as below:
negligible decrease in price will increase the supply to infinity is called perfectly
In the diagram, DD is the perfectly elastic elastic supply. This concept is only hypothetical and rarely found in the world. It can
In the diagram, DD is the negatively sloping
demand curve which is a horizontal straight be explained din a diagram as below:
demand curve. When the income of the
line and parallel to X-axis. This means that a consumer decreases from I to Io, the
negligible increase in price will bring down In the diagram, s is the perfectly elastic supply curve
demand for the commodity increases from
the demand to zero and a negligible decrease which is a horizontal straight line and parallel to X axis.
Q to Q1.
in price will increase the demand to infinity. The change in price cannot be shown and a negligible
increase or decrease in price will make the demand zero
or infinity.
3.Zero income elasticity of demand (Ey=0):
2. Perfectly inelastic demand (Ep=0) When the demand for a commodity does not change whatever increase or
Whatever increase or decrease in price, the demand remains constant is a perfectly Perfectly inelastic supply (Es = 0)
decrease in the income of the consumer, it is the zero income elasticity of demand.
inelastic demand. This can be shown in a table as below: Whatever increase or decrease in price, the supply remains constant is called
This type of elasticity is seen in case of necessity for life goods. It can be explained
Price in rupees Demand in Kg perfectly inelastic supply. It can be explained in a diagram as below:
with a table as below:
10 100 Income in rupees Demand in Kg In the diagram, the vertical curve is the perfectly inelastic
50 100 5000 10 supply curve. It is a vertical straight line and parallel to Y-axis.
2 100 10000 10 This means whatever increase or decrease in price, the
In the table, when the price is rupees 10, the demand is 100 Kg. When the price 2000 10 supply remains constant.
increases to rupees 50, the demand is constant at 100 Kg and when the price
decreases to rupees 2, the demand is constant at 100 Kg. This can be shown in a In the table, when the income increases from rupees 5000 to rupees 10,000 or
diagram as below: decreases to rupees 2000, the demand remains constant as 10 Kg. This is zero Unitary elasticity of supply (Es =1)
elasticity of demand. It can be shown in a diagram as: When the percentage change in supply is equal to the percentage change in price,
In the diagram, DD is the perfectly inelastic it is called unitary elasticity of supply. It can be explained in a diagram as below:
demand curve which is a vertical straight line and
parallel to Y-axis. This means that whatever In the diagram, DD is a demand curve vertical straight In the diagram SS is the unitary elastic supply curve. It is positively sloping with a
increase or decrease in price of the goods, the line and parallel to Y-axis. When the income of the gentle slope. The 5 change in supply (10%) is equal to the % change in price(10%).
demand remains constant. consumer increases from I to I1 or decreases to Io,
the demand remains constant at OQ. Relatively elastic supply (Es˃1)
When the % change in supply is more than the % change in price, it is called
Cross Elasticity of Demand relatively elastic supply. It can be explained in a diagram as shown below:
Cross elasticity of demand is defined as the percentage (proportionate) change in
3. Unitary Elastic demand (Ep=1) quantity demanded of x goods due to percentage (proportionate) change in price
When the percentage change in price is equal to the percentage change in demand, of Y goods (X and Y are substitutes or complementary goods). In the diagram ss is the relatively elastic supply
it is unitary elastic demand. The change in price is equal to change in demand. This Types of cross elasticity of demand curve. It is positively sloping with a flat slope. The %
can be shown in a table as below: There are two types of cross elasticity of demand: Positive cross elasticity and increase in supply from Q to Q1 is more than the %
Price in rupees Demand in Kg Negative cross elasticity. increase in price from P to P1.
10 200 1. Positive cross elasticity of demand:
15 100 When the X and Y goods are substitutes, the cross elasticity of demand will be
In the table the change in price from rupees 10 to rupees 15 is by 50% and the positive. The increase in the price of Y good will lead to the increase in the quantity
change in demand from 200 Kg to 100 Kg is also by 50%. This is a unitary elastic demanded of X good and a decrease in price of Y good will lead to a decrease in Relatively inelastic demand (Es˂1)
demand. It can be shown in a diagram as below: demand of X good. For example: When the price of tea(X goods) increases, the When the % change in supply is less than the % change in price, it is called relatively
demand for coffee(Y goods) also increases and when the price of tea decreases, the inelastic supply. It can be explained in a diagram as shown below:
demand for coffee also decreases.
In the diagram, DD is the unitary elastic demand The positive cross elasticity of demand can be shown in a table as:
curve which has a gentle slope. The decrease in Price of Y good in rupees Demand for X good in Kg In the diagram S is the relatively inelastic supply curve. It is
price from P to P0 is equal to the increase in 100 10 positively sloping with a steep slope. The % increase in
demand from Q to Q0. 150 15 price from Po to P1 is more than the % increase in supply
In the table , when the price of Y good increases fro rupees 100 to rupees 150, the from Qo to Q1.
demand for X good also increases from 10 Kg to 15 Kg. This is positive cross
elasticity of demand. It can be shown in a diagram as: Unit 2: Theory of Consumer's Behaviour
4. Relatively elastic demand (Ep˃ 1) Law of Diminishing Marginal Utility
When the percentage change in demand is more than the percentage change in The law of diminishing marginal utility was first introduced by a German engineer
price , it is a relatively elastic demand. A small change in price will bring a bigger named Hermann Henriech Gossen in 1854. So, the law is also known as the First
change in demand. This can be shown in a table as : In the diagram, DD is the positively slopping Law of Gossen. Later, the law was further modified by Marshall in 1890.
Price in rupees Demand in Kg demand curve. When the price of Y good According to Marshall, the law of diminishing marginal utility states,
10 200 increases from P to P1, the demand for X 'The additional benefit which a person derives from a given increase of the stock of
15 50 good also increases from OM to OM1 and a thing diminishes with every increase in the stock that he already has'. Similarly,
In the table the change in price from rupees 10 to rupees is by 50% and the change vice-versa. Watson and Getz say, ' The more you have of anything, the less important to you is
in demand from 200 Kg to 50 Kg is by 75%. The change in demand is more than the any one unit of it'. In other words, when a consumer consumes more and more
change in price. This is a relatively elastic demand. It can be shown in a diagram as units of a commodity, he/she gets less and less utility from the additional unit of
below: 2. Negative cross elasticity of demand consumption.
When the X and Y goods are complement, the cross elasticity of demand will be Assumptions of the law of diminishing marginal utility
In the diagram, DD is the negative. The increase in price of Y goods will lead to a decrease in demand of X -The consumer is rational
demand curve which has a flat slope. The goods and decrease in price of Y goods will lead to an increase in demand for X -The utility obtained from the consumption of goods can be measured in utils.
decrease in demand from Q1 to Q2 is more than goods. -The price of the good and the value of money are constant
the increase in price from P1 to P2. For example: When the price of car increases, the demand for petrol will decrease -The taste, habit and fashion of the consumer does not change
and when the price of car decreases, the demand for petrol increases. The negative -The goods consumed are homogenous in proper sizes and with no time gap in the
cross elasticity of demand can be shown in a table as below: units of good consumed.
5. Relatively inelastic demand (Ep˂ 1) Price of Y good in rupees Demand for X good in Kg The law of diminishing marginal utility can be explained in a table as below:
When the percentage change in price is more than the percentage change in 100 10
Units of goods consumed Marginal utility
demand, it is a relatively inelastic demand. A big change in price will bring about a 150 8 1 8
smaller change in demand. It can be shown in a table as: In the table, when the price of Y good increases from rupees 100 to rupees 150, the 2 6
3 4
Price in rupees Demand in Kg demand for X good decreases from 10 Kg to 8 Kg. This is negative cross elasticity of 4 2
10 100 demand. It can be shown in a diagram as: 5 0
6 -2
20 50
In the table, when the consumer consumes the first unit of the good, he/she
In the table the increase in price from rupees 10 to rupees 20 is by 100 % and the obtains 8 utils as the utility. When the consumer consumes the second, third,
decrease in demand from 100 Kg to 50 Kg is by 50 %. The change in price is more fourth, unit of the good, the marginal utility obtained from the good by the
than the change in demand. This can be shown in a diagram as below: consumer goes on diminishing as 6, 4, 2, utils respectively. On consumption of the
In the diagram, DD is a negatively slopping
demand curve. When the price of Y good fifth unit, the marginal utility obtained is 0. On further consumption of the sixth
increases from P to P1, the demand for X good unit of the good, the marginal utility becomes negative as -2. This is the disutility
decreases from OM to OM1 and vice-versa. obtained from the good. The above
schedule can be shown in a curve form as:
In the diagram, DD is the demand curve which has a steep slope. The increase in Factors affecting/Determinants of price elasticity of demand
price from P1 to P2 is more than the decrease in demand from Q to Q1. The price elasticity of demand to be more elastic or less elastic depends upon the In the diagram, the marginal utility is
2.Income Elasticity of Demand following factors: shown in Y-axis and the units of good
Income elasticity is defined as the percentage (proportionate) change in quantity 1. Nature of the commodity: consumed are shown in X-axis. The AB is
demanded due to the percentage (proportionate) change in the income of the Commodities can be necessities, comforts or luxuries. In case of necessity goods, the diminishing Marginal Utility curve
consumer. the price elasticity will be relatively less but in case of comforts and luxuries the derived from the schedule given above.
Types of Income Elasticity of Demand price elasticity will be relatively more. Existence of substitutes Law of Substitution
1.Positive income elasticity of demand (Ey˃0): When the demand for a 2.Economic status of the consumers The law of substitution was first introduced by Hermann Henreich Gossen. So it is
commodity increases with increase in income and decreases with a decrease in also known as the Second Law of Gossen. The law was later modified by Marshall.
The law of substitution is also known as the Law of Equi-Marginal Utility and the
Law of Maximum Satisfaction. Human wants are unlimited but the resources to Law of Variable Proportions percentage increase in factor inputs, it is decreasing returns to scale.
fulfill the wants are limited. So, every rational consumer will try to make the best The Law of Variable Proportions was developed by economists like Marshall, It can be shown in a table as below:
use of the available resources to obtain the maximum satisfaction or utility. Benham, Robinson and Samuelson. The law is an example of short-run production Factor inputs Total output/ returns
Assumptions of the law function where labour as a variable factor and other factors like land, capital and 2K +2L 100 KGs
-The consumer is rational organization are constant. 4K+4L 150 KGs
-The satisfaction obtained from the consumption of the goods can be measured . The law of variable proportions states, 'As the proportion of one factor in the In the table, when the factor I puts increases from 2K+2L to 4K +4L, the total output or returns
-The income or the resources of the consumer is limited and given combination of other factors is increased, after a point, first the marginal and then increase from 100 KGs to 150 Kgs by less than 100 %.
-The prices of the goods consumed are constant and given the average product of that factor will diminish.' The decreasing returns to scale can be explained in an isoquant diagram as shown
-The law of diminishing marginal utility is applicable. The law says that the marginal and average product will ultimately decrease when below:
According to the law, consumers go on substituting by units of the goods that give more and more labour as a variable factor is added to given fixed factors.
more marginal utility in place of the units of good that give less marginal utility. As Assumptions of the law In the diagram, OR is the product line. 1oo, 200 and 300 are the Isoquants
they proceed in this manner, they will arrive at a level where the marginal utilities -Labour is a variable factor producing equal quantities. The
derived from the last units of all the goods consumed are equal and the maximum -The other factors like land, capital, organization, etc. are fixed. successive isoquants of 100, 200 and 300
satisfaction is obtained. The law of substitution can be explained with a schedule. -The state of technology is given and constant. lie at an increasingly greater distance.
Let us assume that there are 2 goods consumed as X and Y and the consumer has a The Law of Variable Proportions can be explained in a table as shown below: This means that more and more factor
limited income of only 70 rupees to spend on X and Y goods. The price of each unit Fixed Variable Total Average Marginal Stage of inputs of labour and capital are needed to
of both X and Y goods is rupees 10. factors Product Product Product Production produce equal amount of output.
Units of goods Marginal Utility from X good Marginal Utility from Y good factors Alternative method of explain the laws
1 10 Utils 9 Utils 5 1 10 10 10 Stage 1: of Returns to Scale in diagram:
2 9 Utils 8 Utils Increasing The increasing returns to scale, constant
3 8 Utils 7 Utils Returns returns to scale and the decreasing
4 7 Utils 6 Utils 5 2 30 15 20 „ returns to scale can be explained in a diagram as shown below
5 6 Utils 5 Utils 5 3 60 20 30 „ In the diagram, there are three segments of the Laws of returns to Scale curve.

5 4 80 20 20 „ The first segment shows the increasing returns to scale curve which is positively or
In the table, the consumer gets maximum satisfaction from his limited income by 5 5 90 18 10 Stage II: upward sloping curve. This means that the increase in output or returns is more
consuming 4 units of X good and 3 units of Y good. The total utility from 4 units of X Decreasing than the increase in factor inputs.
and 3 units of Y goods= 10+9+8+7+9+8+7=58 utils. Returns The next segment shows the constant returns to scale curve. It is a horizontal
No other combination of X and Y goods can give this much high satisfaction or 5 6 90 15 0 „ straight line and parallel to X-axis. This means that the increase in total
utility. output/returns is equal to the increase in factor inputs.
5 7 80 11.4 -10 Stage III:
Suppose the consumer consumes 3 units of X good and 4 units of Y good. The total Unit 4: Market, Revenue and Cost Curves
Negative
utility from 3 units of X and 4 units of Y goods will be= 10+9++9+8+7+6=55 utils 4.1. Concept of Market: Perfect Competition, Monopoly and Imperfect
Returns
only. Similarly, no other combinations of X and Y goods can give as high satisfaction Competition. Market is a place or a process where buyers and sellers interact to
as 4 units of X and 3 units of Y goods. Therefore, the maximum satisfaction is buy or sell goods and services.
obtained at the equi-marginal utility of the last units of the goods consumed as There are different types of markets on different basis.
shown above in 4 units of X and 3 units of Y goods. -On the basis of area, markets can be local, regional, national or international
markets.
-On the basis of time, markets can be short-run and long-run markets.
The law of substitution can be explained in a diagram as below: -On the basis of volume of transaction, markets can be big and small markets.
-On the basis of competition, markets can be perfect, imperfect and monopoly
markets as discussed below:
In the above diagram, the consumer 1. Perfect competition
gets maximum satisfaction from 2 It is a type of market structure where there are a large number of buyers and
units of tea and 3 units of cigarette sellers selling homogeneous products at same price and there are no restrictions to
goods. The consumer is in the entry of new firms into the market. Both the buyers and the sellers have
equilibrium at E in tea and at N in perfect knowledge about the price and the quality of products in the market.
cigarette. No other combination of 2. Monopoly
tea and cigarette goods, given the Mono means single and poly means seller. Monopoly is a market structure where
limited income can give as high satisfaction as 2 units of X and 3 units of Y goods. there is a single seller selling heterogeneous products at different prices and there
When the consumer consumes 2 units of tea, and 4 units of cigarette, he will be in The law of variable proportions can be explained in a diagram as shown below: are restrictions to the entry of new firms into the market. The monopolist has
equilibrium at E1 for tea and at N1 for cigarette. But this combination of tea and complete control on the supply and price of products in the market.
cigarette cannot give the maximum satisfaction to the consumer because the loss The Law of Variable Proportions can be explained in three stages as below: 3. Imperfect competition
in utility shown by the shaded area 12EE1 is greater than the gain in utility shown Stage I: Stage of Increasing Returns The imperfect competition is in between perfect completion and monopoly
by the shaded area NN134. Similarly, in any other combinations of tea and In this stage, the total product goes in increasing, first faster and then slowly due to markets. When a market is not perfect or a monopoly, it is an imperfect market.
cigarette, the loss in utility will be greater than the gain in utility. Therefore, in the economies of scale. Both average and marginal products increase in the beginning, There are three types of Imperfect markets as:
above example, 2 units of tea and 3 units of cigarette gives the maximum but the marginal product begins to decrease. This stage ends when marginal 4.Monopolistic competition: It is a type of imperfect market where there are many
satisfaction or utility to the consumer. product is equal to average product. buyers and sellers selling differentiated product at different prices. The products
Stage II: Stage of Decreasing Returns are close substitutes to each other but not homogenous.
Limitations or Exceptions of law of substitution In this stage, the total product goes on increasing, but slowly. Both average and There exits the elements of both monopoly and perfect competition in this market.
The law of substitution has the following limitations: marginal products decrease continuously throughout this stage. This stage ends This type of market is more realistic in the world.
1. The consumer cannot be always rational: In reality, consumers may not be when total product becomes maximum and marginal product becomes zero.
always rationable to tell the utility derived from the consumption of goods. They Stage III: Stage of negative Returns Features of Monopolistic competition
may also be ignorant about the maximum satisfaction derived from the units of the In this stage, there will be over-crowdedness and mis-management of factors. -There are a large number of buyers and sellers in the market
goods. There will be diseconomies of scale. The total product will decrease. Both the -The firms sell differentiated products at different prices
2. The utility or satisfaction derived cannot be measured in utils: The satisfaction or average and the marginal products will decrease but the marginal product will be -There are no restrictions to the entry and exit of firms in the market
the utility derived from the consumption of goods is psychological and cannot be negative. -There will be many firms in the market producing different products which are
measured in exact numbers as utils. Stage II or the stage of decreasing returns is most suitable for production in any closely related but not perfect substitutes.
3. Unlimited resources: The law is applicable only in the consumption of limited production unit and the producers should stop production f it enters the third stage b. Duopoly: It is a type of market where there are only two sellers in the market
resources but not applicable in the consumption of unlimited resources like the when the marginal product of factor becomes negative. selling differentiated products at different prices. The sellers have control over the
free gifts of nature. The Law of Variable Proportions is applicable both in agriculture and industry. supply and prices of products in the market.
4. Changes in prices of goods and services: In reality the prices of goods and In agriculture, land is the fixed factor and when more and more number of labour Features of Duopoly
services change very frequently as against the assumption of this law. When the as a variable factor is added continuously, the marginal product of labour increases -There are only two sellers of the product in the market
prices change the marginal utility of money also change and the law cannot be in the beginning, then decreases and ultimately becomes negative. -The products are differentiated and not perfect substitutes
applicable. 3.4: Laws of returns to Scale -The prices of the products are different
5. The law of diminishing marginal utility is not always applicable: The law of The laws of Returns to Scale are examples of long-run production function where -The sellers control the supply and price of the products in the market
diminishing marginal utility is not applicable for all goods at all times and for all all factors of production are variable. c. Oligopoly
consumers. When the law of diminishing marginal utility is not applicable, the law There are three returns to scale as: It is a type of market structure where there are a few sellers selling differentiated
of substitution will also not be applicable. products at different prices in the markets. The sellers have some control on the
Consumer's Surplus 1.Increasing Returns to Scale supply and price of the products in the market.
The concept of consumer's surplus was first introduced by Dupit and later further When the percentage increase in total output or Features of Oligopoly
modified by Marshal and Boulding. Consumer's surplus is the difference between returns is more than the percentage increase in -The products sold in the market are differentiated without perfect substitutes
what a consumer is willing to pay for a commodity and what he/she actually pays factor inputs, it is called increasing returns to -The prices of the products are different.
for it. scale. -The sellers have control on the supply and price of the products
Consumer's Surplus = Willing to Pay -- Actually paid (Price). It can be shown in a table as below: -There is a great importance of advertisement of the products
For example: I want to buy a new mobile set and I have rupees 10,000 with me and Factor inputs Total output/ returns
I am willing to spend it to buy a mobile. I went to the market and bought the 2L+2K 100 KGs 4.2: Concept of Total, average and marginal revenue
mobile set of my choice at rupees 8,000. Here, I was willing to pay rupees 10,000 Derivation of average and marginal revenue curves from total revenue under
4L+4K 300 KGs
and I actually paid was rupees 8,000. Therefore my consumer's surplus= 10,000- perfect competition
In the table, the factor inputs increases from 2K+2L to 4K+4L by 100 % and the
8,000=2000 rupees. Under perfect competition, the goods bought or sold are homogeneous. So, the
total output or returns increases from 100 KGs to 300 KGs by more than 100 %.
Assumptions of the concept of Consumer's surplus. price or the average revenue remains same and constant for all the units of the
The increasing returns to scale can be explained in an isoquant diagram as shown
- Willing to pay is more than actually paid price. goods.
below:
-Consumer is rational As all the units are sold at the same price, the addition to total revenue is also
In the diagram, OA is the product line and 10, 20 and 30 are the Isoquants
-The law of diminishing marginal utility is applicable same. So, the marginal revenue also remains same and constant for all the units of
produced by the combination of labour and capital factor inputs. The successive
-Price of good and the value of money remain constant goods. The average and marginal revenue of all the goods remains same and
Isoquants lie at a comparative shorter distance. This means that the equal number
The concept of consumer's surplus can be explained with a schedule as below: constant as shown in a table below:
of labour and capital produces more and more amount of output or returns
Units of Willing to pay Actually paid Consumer's Surplus Units of goods sold Average revenue Total revenue Marginal revenue
goods in Rs. (Price) in Rs in Rs. 1 10 10 10
1 20 4 20-4=16 2.Constant Returns to scale 2 10 20 10
2 16 4 16-4=12 When the percentage increase in total output or returns is equal to the percentage
3 12 4 12-4=8 increase in factor inputs, it is constant returns to scale.
4 8 4 8-4=4 It can be shown in a table as below:
5 4 4 4-4=0 Factor inputs Total output/returns
Total 60 20 60-20=40 2K+2L 100 KGs
goods= 5 4K+4L 200 KGs

In the schedule, the consumer buys 5 units of the good. In the table , when the factor inputs increases from 2k+2L to 4K+4L by 100%, the
The total willing to pay of 5 goods= 60 total output or returns also increases from 100
The total price actually paid for 5 goods=20 KGs to 200 KGs by 100 %.
The Consumer's Surplus for 5 goods=Willing to pay - Actually paid Price = 60-20=40 The constant returns to scale can be shown in
The above table can be shown in a diagram as below: isoquants as below:

In the diagram, the willing to pay is shown

in the Y-axis and the units of goods are In the diagram, OE is the product line. The q1, q2
shown in the X-axis, The shaded portion of and q3 are the isoquants producing equal
the diagram is the consumer's surplus of 5 quantity using the labour and capital factor
units of the good consumed. The non- inputs. The successive isoquants of Iq1, Iq2 and
shaded below the price is the actual price the Iq3 lie at a equal distance. This means that equal amount of factor inputs
paid by the consumer for the 5 units of the good. produce equal amount of returns or output

Unit 3: Theory of Production 3.Decreasing Returns to Scale

When the percentage increase in
output or returns is less than the
3 10 30 10 Average Variable Cost (AVC): It can be calculated by dividing total variable cost by MC = Marginal cost and MR= Marginal revenue
4 10 40 10 the number of output. Under MC = MR approach, for a firm to be in equilibrium, the following two
5 10 50 10 AVC = TVC/ N where, conditions of equilibrium should be fulfilled.
In the table, AR and MR are constant and equal to each other and TR increases AVC = Average Variable Cost TVC = Total Variable Cost First-order condition/ necessary condition where marginal revenue is equal to
continuously at a constant rate. N = Number of output Marginal cost
The above table can be shown in a diagrams as shown below: Average Cost / Total Average Cost (TC/ TAC): It is the sum of average fixed cost and Second order condition/sufficient condition where marginal cost curve cuts the
average variable cost marginal revenue curve from below
It can be calculated by dividing total cost by thye number of output. The equilibrium of a firm under MC-MR approach in perfect competition can be
In the diagram (a), TR is the total revenue curve. It is positively sloping with a AC/TAC = AFC +AVC where, explained in a diagram as shown below:
constant slope. This means that the total revenue increases at a constant rate AC/ TAC = Average Cost/ Total Average Cost
under perfect competition. AFC = Average Fixed Cost AVC = Average Variable Cost In the diagram, both the conditions of equilibrium are fulfilled at point Q2, where,
In the diagram (b), AR = MR is average revenue and marginal revenue curve. It is a AC/TAC = TC/ N where, Marginal cost = Marginal revenue
horizontal straight line and parallel to X-axis. This means that under perfect AC/TAC = Average Cost/ Total Average Cost Marginal cost curve has cut
competition, AR and MR are constant and equal to each other. TC = Total Cost Marginal revenue curve from
below
Derivation of AR and MR curves from TR curve under Monopoly Market So, point Q2 is the equilibrium of
Under Monopoly market, the goods bought and sold are not homogeneous. The the firm and Q2L2 is the
prices of the products bought or sold are different. The monopolist follows sales equilibrium output at OP price.
maximization policy and will reduce the price of additional units of products to sell At point Q1, the firm cannot be in
more. So, the average revenue will go on decreasing. equilibrium as only one condition
As the additional units of products are sold at reduced price, the addition to total of equilibrium is fulfilled here
revenue will also go on decreasing. This will make marginal revenue to go on MC = MR but MC curve has cut MR
decreasing with every additional units of products sold. curve from above and not below.
Thus, under Monopoly market, both average and marginal revenue will go on So, Q1 cannot be the equilibrium of the firm.
decreasing as shown in the table below: The equilibrium of a firm by MC= MR approach under monopoly market can be
explained in a diagram as shown
Units sold Total revenue Average revenue Marginal revenue below:
1 10 10 10 N = Number
of output. In the diagram, both the
2 18 9 8
Marginal Cost (MC) conditions of equilibrium of a firm
3 24 8 6
It is the addition to total cost due to one more unit of output produced. under MC=MR approach is
4 28 7 4 fulfilled at point E where,
It is the cost for one particular unit of output produced.
5 30 6 2 MC= ∆TC/∆N where, Marginal cost = Marginal revenue
6 30 5 0 MC = Marginal cost ∆TC = Change in Total cost Marginal cost curve has cut the
7 28 4 -2 ∆N = Change in unit of output marginal revenue curve from
In the table, the total revenue first increases, reaches the maximum and then MCn = TCn – TCn-1 where, below
declines. Both average and marginal revenues decline but at different rates. The MCn = Marginal cost of n unit of output So, it is the equilibrium point of
average revenue is always positive nut marginal revenue becomes zero and even TCn = Total cost of N-1 unit of output the firm and EQ2 is the
negative. The derivation of average and marginal revenue curves from total TCn-1 = Total cost of n-1 unit of output. equilibrium output of the firm.
revenue curve can be explained in a diagram as shown below: The concepts of AFC, AVC, AC/TAC and MC can be explained in a table as shown
below: Meaning and features of perfect competition
In the diagram, TR is the total revenue curve. It first increases, reaches the Unit of output TFC TVC TC AFC AVC AC/TAC MC Meaning: Perfect competition is a market structure characterized by the absence of
maximum point and declines. AR is the average revenue curve. It decreases 0 20 0 20 - - - - rivalry among individual firms. There are a large number of buyers and sellers
continuously but remains positive. producing homogeneous products with free entry and exit of firms into or out of
1 20 20 40 20 20 40 20
MR is the marginal revenue curve. It decreases continuously, reaches zero and even the market.
2 20 30 50 10 15 25 10
becomes negative.
When TR is maximum, MR is zero. When TR declines, MR becomes negative. 3 20 50 70 6.6 16.6 23.3 20
Features of perfect competition
Costs and Cost Curves 4 20 80 100 5 20 25 30 1.Large number of buyers and sellers: In perfect competition, there are a large
Cost refers to the expenditure incurred in the production of goods and services in 5 20 140 160 3.3 28 31.3 60 number of buyers and sellers. A single seller is like a drop in the ocean and cannot
paying rent to land, wages to labourers, interest to capital and profit to influence the price and are the price-takers. The price is determined by market
entrepreneurs for their contribution in the production process. In the table, AFC decreases continuously, first faster and then slowly. The AVC first demand and supply.
There are different types of costs as: decreases, reaches the minimum and again increases. The AC is the sum of AFC and 2.Homogeneous products: The products bought and sold in the market are
Fixed costs: It refers to the cost incurred on the foxed factors of production like AVC which first decreases, reaches minimum and again increases. The MC also first homogeneous and identical in shape, size, colour, design, weight, quality, quantity,
land, buildings, machines, furniture, insurance, etc. This cost remains constant at all decreases, reaches the minimum and again increases. etc. They are perfect substitutes to one another. So, the prices of the products are
levels of production. Even at zero production, there is fixed cost and it remains The AFC, AVC, AC AND MC can be shown in a diagram as below: same.
valid only in the short-run as in the long- run all costs become variable. 3.Free entry and free exit of firms: The firms/ individual sellers can enter or leave
Variable cost: It refers to the cost incurred on the variable factors of production In the diagram, AFC is the the industry/ market without any restrictions.
like labour, raw-materials, fuel, transport, etc. This cost increases with increase in average fixed cost curve. It 4.Perfect knowledge: All the buyers and sellers have perfect knowledge or
production. At zero production, there will be no any variable cost. decreases continuously, first information about the price and quality of products bought and sold in the market.
Short-run cost: In the short-run, as the time is short and not sufficient, some faster and then slowly. AVC is So, the sellers cannot charge more price and the buyers will not pay more price. So,
factors of production like land, buildings, capital, machines, etc. cannot be changed the average variable cost. It is the price of the products remain same within the market.
and are fixed costs. Only labour, raw-materials, fuel, transport, etc. can be changed U-shaped, which decreases 5.Perfect mobility of factors: All the factors of production are perfectly mobile
and are the variable factors. So, in the short-run there are both fixed and variable first, reaches the minimum within the market and can be taken to any parts of the market/industry.
factors of production. The expenditures incurred on both the fixed factors and the and again increases. AC is the No transport cost added: In perfect competition, the transport cost will not be
variable factors of production is called short-run costs. average cost curve which is added to the price of the products. So, the price remains the same all throughout
Lon-run costs: In the long-run, as the time is long and sufficient, all factors of the summation of AFC and the market.
production like land , labour, capital, organization, fuel, transport, insurance, etc. AVC curves. It is also U- 6.No government interference: There is no government interference in the market.
can be changed and are all variable factors. So, in the long-run all factors of shaped. MC is the marginal It stands only as a supervisor. The market demand and supply determine the price
production are variable and the expenditure incurred on these variable factors is cost curve. It is also U-shaped but both the rise and fall of MC curve is faster than of products.
called long-run costs. AC curves. The marginal cost curve cuts the average cost curves at their minimum
points. Unit 6: Theory of Factor Pricing
According to David Ricardo, "Rent is that portion of the produce of the earth which
Relation between Average and Marginal costs is paid to the landlord for the use of the original and indestructible power of the
The relation between average and marginal costs can be explained with the help of soil".
The concept of the various short-run costs are: a diagram as shown below: Types of rent
Total Cost: There are three short-run total costs as: In the beginning, both AC and MC decreases but MC decreases faster than AC. 1.Contract Rent: The rent paid by the tenant to the landlord for the use of land as
Total Fixed Cost (TFC): It refers to the total expenditure incurred on fixed factors of MC curve reaches its minimum point and starts to rise earlier than AC curve. determined by the contract (agreement) between them is called contract rent. The
production. Both AC and MC costs increase after reaching their minimum points but marginal contract rent may be equal to, less than or greater than economic rent. The
TFC = TC - TVC where, cost increases faster than average cost. Both average and marginal costs are U- demand and supply of land determines the rate of contract rent. If the supply of
TFC= Total Fixed Cost, TC = Total Cost, TVC = Total Variable Cost shaped but the marginal cost has a steeper slope and average cost has a flatter land is more than the demand for land, there will be competition among landlords
Total Variable Cost (TVC): It refers to the expenditure incurred on the variable slope. to give their land on rent.
factors of production. When average cost is minimum, it is equal to marginal cost. 2. Economic / Net/Pure Rent: It is the rent paid purely and exclusively for the use
TVC = TC – TFC where, Marginal cost curve cuts the average cost curve at the minimum points from below. of land only by the tenant to the landlord. It is the amount paid for the use of the
TVC = Total Variable Cost, TC = Total Cost, TFC = Total Fixed Cost productivity of the land. The modern economists define economic rent as the
excess amount paid by any factor of production of which the supply is perfectly
Total Cost (TC): It is the sum of total fixed cost and total variable cost. inelastic.
TC = TFC + TVC where, Unit 5: Theory of Price and Output Determination
TC = Total Cost, TFC = Total Fixed Cost, TVC = Total Variable Cost. The equilibrium of a firm by TR-TC approach under perfect competition can be Ricardian Theory of Rent
The concepts of TFC, TVC and TC can be explained in a table as shown below: explained in a diagram as shown below: The Ricardian theory of rent was propounded by David Ricardo, a classical
Units of output TFC TVC TC economist. This theory is also known as the Classical or Traditional Theory of Rent.
0 20 - 20 According to Ricardo, "Rent is that portion of the produce of the earth which is paid
-In the diagram, before point B to the landlord for the use of the original and the indestructible power of the soil".
1 20 20 40
and after point D (before OL The Ricardian theory of rent is based on the concept of differential rent. Rent arises
2 20 30 50
and after ON outputs), the firm due to differences in the fertility of the soil. Some lands are more fertile while
3 20 45 65 incurs loss because total cost is
4 20 80 100 others are less fertile. So, fertile lands pay more rent. Rent would not arise if all
greater than total revenue. lands were equally fertile. The Ricardian theory of rent is based upon the following
5 20 150 170 -At points B and D (at OL and assumptions:
ON output), the firm neither -Land differs in fertility. Some lands are more fertile while others are less fertile.
In the table, the TFC remains constant at all levels of production. Even at zero earns profit nor incur loss -The cultivation of the new land is done from the most fertile to the least fertile in
output, the TFC is constant. The TVC increases with increase in output. At zero because total revenue is equal order.
output TVC is also zero. The TC is the sum of TFC and TVC. It increases continuously to total cost. These points B and -Rent is obtained from the agricultural cultivation of land.
with increases in output. D are called the break-even -The total supply of land is fixed.
The concept of TFC, TVC and TC can be points. The Ricardian Theory of rent can be explained with the help of a schedule and
explained in a diagram as shown below: -Between B and D points (between OL and ON outputs), the firm earns profit example as below:
In the diagram TFC is the total fixed cost because total revenue is greater total cost.
curve. It is a horizontal straight line and Grades of land Total production in Kg. Rent paid in Kg.
-At OM output, the firm earns maximum profit or the point of equilibrium of the
parallel to X-axis. This means that the TFC A 100 100-40=60
firm because the distance between total revenue and total cost is the maximum
remains constant at all levels of production. (this shown by CE in the diagram). B 80 80-40=40
The equilibrium of the firm by TR – TC approach under monopoly market can be C 60 60-40=20
explained in a diagram as shown below: D 40 40-40=0(No rent paid)

-In the diagram, before Points A and after point B (before OQ1 and after OQ3 Suppose there are 4 grades of land as A,B, C and D of different fertility. Grade A is
TVC is the total variable cost curve. It starts from the point of origin and increases outputs), the firm incurs loss because total cost is more than total revenue. most fertile and grade D is the least fertile land.
continuously, slowly first and then faster. -At points A and B (at OQ1 and OQ3 outputs), the firm nether earns profit nor Grade A land will be cultivated first and produces 100 Kg of wheat. There is no rent
TC is the total cost curve runs parallel to the TVC curve. It is the summation of TFC incurs loss because the total revenue is equal to total cost. These are the break- paid. When grade A land finishes, people cultivate grade B land and produce 80 Kg
and TVC curves. even points of the firm. of wheat. Now grade A land pays 100-80= 20 Kg as rent as it is surplus production
Average cost: There are three short-run average costs as: -Between points A and C (between OQ1 and OQ3 outputs), the firm earns profit than grade B land. Grade B land does not pay rent. When grade B land finishes,
Average Fixed Cost (AFC) : It can be calculated by dividing total fixed cost by because the total revenue is more than total cost. people cultivate grade C land and produce 60 Kg of wheat. Now, Grade A land pays
number of output. -The firm earns maximum profit and is in equilibrium at OQ2 output because the 100-60=40 Kg as rent and Grade B pays 80-60=20 Kg as rent and Grade C land does
AFC = TFC/N where, difference between total revenue and total cost is maximum (This is shown by MN not pay any rent. When grade C land finishes, people cultivate grade D land and
AFC= Average Fixed Cost TFC = Total Fixed Cost in the diagram). produce 40 Kg of wheat. Now grade A land pays 100-40=60 Kg, grade B pays 80-
N= Number of output Equilibrium of a firm under MC = MR approach 40=40 Kg and grade C pays 60-40=20 Kg as rent as they earn surplus production
over grade D land. Grade D land does not pay any rent as it does not have surplus -There will be only three sectors as household, business and government sectors In distribution: The different factors of production are paid remuneration for their
production. So, it is Marginal Land or No Rent Land. The above table can be shown contribution in production in money. Land is paid rent, labour is paid wages, capital
in a diagram as below: Open Economy is paid interest and entrepreneur is paid profit. All these is done in money.
In the diagram, A, B, C and D are An economy which participates in trade relations with other countries of the world In exchange: People use money to buy and sell goods and services they need. All
the four grades of land different is an open economy. There are exports and imports of the country. Such an transactions are done with money.
fertilities. The four rectangles show the economy is realistic and exists in the world but the degree of openness vary from In public finance: The income and expenditure of the government is called public
total production of each grade of the country to country. finance. The government collects revenue in the form of tax, fees, fines, permits,
land. The shaded area of the rectangle is The Gross Domestic Product of an open economy can be expressed as: C+I+G+(X- etc. in money. This revenue is spent as government expenditure in money terms
the amount of rent paid by each grade of M) Where, through budget and make development works and welfare of the people.
the land. Grade D land does not pay any GDP=Gross Domestic Product C=Consumption In international trade: All international trade and transactions are done in money.
rent and is called No rent Land or expenditures of individual and households A country exports goods and receives the value in money. It imports goods from
Marginal Land. I=Investment expenditures of business G=Government outside and pays in money.
expenditures on both consumption and investment Thus, money is used in all spheres of human life and activities as production,
Criticisms of Ricardian Theory of rent X= The value of total exports of the country M= The value of total consumption, distribution, exchange, public finance and international trade.
The Ricardian theory of rent is criticized by the modern economists mainly on the imports of the country Value of Money
following grounds: (X-M) = Net exports Value of money refers to the purchasing power of money. It is the amount of goods
1. No original and indestructible power of the soil: Ricardo opined that rent is Main features of open economy and services a unit of money can buy at any particular time.
paid due to original and indestructible power of the soil. But the critics argue that -There is trade relations with other countries of the world There is a direct relation between quantity of money and the prices of goods and
land has neither original nor indestructible power because the fertility of the soil -There is exports and imports of goods and services services but an indirect relation between quantity of money and value of money.
will decrease over time due to continuous cultivation and can be increased by the -There is inflow and outflow of capital and investment When the quantity of money increase, the prices of goods andserviceswill increase
use of fertilizers. -The country receives foreign aid and provides foreign aid to other countries and vice-versa. Similarly, when the quantity of money decreases, the prices will be
2. Wrong order of land cultivation: According to Ricardo, the cultivation of land is -The Gross Domestic Product and the Gross National Product of the country are high and vice-versa.
done from the most fertile to the least fertile in order. But in practice, land different there are exports and imports of the country
cultivation is done in the order of availability and accessibility of land. -There are four sectors as household, business, government and foreign sectors. The quantity Theory of Money can be explained in diagrams as shown below:
3. The concept of rent has been narrowed and limited: To Ricardo, rent arises only Macro-economic variables
from land. But for the critics, rent arises not only from land but from all factors The macro-economic variables are the indicators of the economic performance of In the diagrams above (A), when the
which are limited and inelastic in supply. the country. Looking at these variables, we can tell whether a country is quantity of money or the supply of money
4. Ignores the different uses of land: Ricardo says that land can be used only for progressing economically or not. increases from M to M, the price level also
cultivation of crops. But the critics say that besides cultivation, land can also be 1.National income: It is the market value of all final goods and services produced in increases from P to P1 and when the money
used for other purposes like making houses, industries, growing forests, etc. a country in a year. It can be calculated by adding the incomes of all the individuals supply decreases from M to M2, the price
5. No existence of marginal land: Ricardo has stated the existence of marginal land of a country earned in a year. There are various concepts of national income as level dec4reases from P to P2. There is a
or no rent land. But in reality, land without rent is impossible now due to increasing GDP, GNP, NNP, PI, DPI, PCI, etc. direct relation between price level and
population and limited supply of land. Even if it is an inferior land, it has to pay An increase in the national income continuously in real terms means that the money supply.
some rent, however less it may be. country is making a good progress economically. In the diagram below (B), when the supply
Despite all these criticisms leveled against it, the Ricardian theory of rent is one of 2.Unemployment: It is the situation where people are willing or ready to work at or the quantity of money increases from M
the most accepted and important theories of rent in Economics. the existing wages but are not getting any work. There are various types of to M1, the value of money decreases from
unemployment as open, disguised, seasonal, frictional, cyclical, structural, 1/P to 1/P1 and when the supply or
Wages educated, voluntary, involuntary, etc. quantity of money decreases from M to M2, the value of money increases from
Wage is the reward paid to the labourers for both physical and mental work. A high rate of unemployment in the country means that the country is not making a 1/P to 1/P2. There is an indirect relation between supply or quantity of money and
According to Benham, "Wage may be defined as a sum of money paid under good progress economically. value of money.
contract by an employer to a worker in exchange for services rendered". 3.Inflation: A sustained, continuous and an appreciable increase in the prices of Assumptions of Quantity Theory of Money
Types of Wages goods and services in the economy is called inflation. There are mainly two types of The main assumptions theory of money are as follows:
1. Money Wage or Nominal Wage inflation as demand-pull inflation and cost-pish inflation. A high and regular The velocity of money (V) and the transaction remains constant.
2. Real Wage inflation in a country means that are economic instabilities. Money is used in all transactions and there is no barter system.
4.Deflation: It is the opposite of inflation where the prices of goods and services The ratio of cash money and credit money remains constant
Determinants of / Factors affecting real wage decrease continuously. Deflation is worse than inflation as it decreases the Price (P) is passive and depends on other variables like velocity (V) and transaction
The following factors affect the real wage of the labourers economic activities causing widespread unemployment in the economy. and quantity of money (M).
1. The purchasing power of money: 5.Economic growth: It is the continuous increase in the real GDP or the national Criticisms of Quantity Theory of Money
2. Fringe benefits and facilities: income of a country. A continuous increase in the GDP means that the country is The quantity Theory of Money has been criticized mainly on its unrealistic
3. Working conditions: making a good progress. assumptions as:
4. Nature of work: 6.Trade/Business cycle: It is the fluctuation in the economic activity characterized -It is wrong to assume velocity (V) and transactions (T). It is unrealistic in the real
5. The future prospect of the work: by the phases of prosperity and depression in the economy. It is just like the ebb world.
6. Extra earning: and flow of waves in the ocean. A very fluctuation in the economy in the economy - In developing countries like Nepal, many goods and services do not get exchanged
7. Social prestige:. means that there are economic instabilities caused by inflation and deflation. in money but are done in barter. So, it is wrong to assume that all transactions are
7.Monetary policy: It is the policy adopted by the central bank of the country to done in money and there is no barter system.
Subsistence Theory of Wages control and regulate the money supply in order to control inflation and deflation -The ratio of cash money to credit money cannot remain constant as assumed by
This theory is one of the earliest theories of wages first introduced by Quesnay and and maintain economic stability. The main monetary policies are changing the cash the theory. The ratio will change every now and then in reality.
later developed by David Ricardo. This theory is also as the Iron Law of Wages as reserve ratio, changing the margin requirements, open market operations, etc. -The theory assumes that price (P) is a passive ad depends on other variables like
the theory is rigid and unbending like an iron in providing wages only of subsistence 8.Fiscal policy: It is the policy adopted by the government to control and regulate velocity (V), transaction (T) and quantity of money supply (M).
level to labourers. its revenue and expenditures in order to control inflation and deflation and But the critics argue that price (P) is not passive in reality. It is in fact very active
According to this theory, in the long run, the wages paid to the workers remain at maintain economic stability in the economy. The main fiscal policies are changing and other variables like T (Transaction), V (Velocity) and M (Supply of money)
the subsistence level or the minimum level of existence. In other words, the wages the tax and tax rates, changing the government expenditures and borrowings, etc. depend upon price (P).
paid to labourers will be just able to maintain the basic necessities of life. If the 9.Consumption: Consumption is the part of the income which is spent on goods -The theory takes into account only the supply of money but completely ignores
wage rate increases to more than the subsistence level, it will lead to the increase and services to satisfy wants. C= Y-S, Where, C=Consumption, Y=Income, S=Saving the demand of money. In reality, both demand and supply of money are equally
in population as the increased prosperity of labourers will encourage them to 10.Saving: Saving is that part of income which is not spent on current consumption. important to determine the price level.
produce more children. This will increase the supply of labourers leading to S=Y-C, Where, Despite all these severe criticisms labelled against it, the Quantity theory of money
competition among the workers for employment causing to a fall in the wage rate S= Saving, Y=income, C=Consumption is one of the most important theories in Economics.
to the subsistence level. On the other hand, if the wage rate falls below the 11.Investment: Investment is the buying of goods and services for further
subsistence level, workers will be unable to meet their basic needs resulting in production of goods and services or earn income. Deflation
malnutrition, starvation and deaths of workers. This will reduce the supply of Deflation is the opposite of inflation where the price of goods and services
labourers leading to increase in wage rate to the subsistence level. Unit 9: Money fall continuously, leading to increase in the value or the purchasing power of
Thus, in the long run the wage rate will always remain at the subsistence level, not Meaning money
less, not more. In the words of Crowther, ' Anything that is generally accepted as a means of It is the deficiency of aggregate demand to aggregate supply in the
exchange and at the same time acts as a measurement and the store of value is economy or rather it occurs when the aggregate demand is less than aggregate
Criticisms of the theory called money'. supply.
The subsistence theory of wages has been criticized on the following grounds: Functions of Money Causes of deflation
1. The Iron Law of Wages: There are three functions of money as: Primary functions, secondary functions and -Decrease in the supply of money and credit into the economy by the banks
2. Ignores the demand of labourers to determine wage rate contingent functions. -Increase in the taxes by the government as it will decrease the disposable income
3. Wrong concept of population growth: 1.Primary functions: These are the main functions performed by money which are of the people
4. Exploiting tendency of the theory as follows: -Decrease in the government expenditures as it will decrease the disposable
5. Discouraging Theory a.Medium of exchange: Money is used as a medium of exchange in all transactions income of people
6. Ignores the role of trade unions to determine wage rate of goods and services. We earn money by doing different works and spend it in -Sudden increase in the production of goods and services, agricultural or industrial
buying goods and services we need. production.
Part B Macro Economics b.Measure of value: Money is used to measure the value of all goods and services. -Excessive credit control by central bank.
Unit 7: Basic Concepts For example: The value of a pen = 50 rupees, the value of labour for a day's work is Consequences/ Effects of inflation
Meaning of Macro Economics 1000 rupees. Deflation may appear advantageous to the consumers in the short –run but it is
The word Macro is derived from the Greek word Makros meaning large. Macro 2.Secondary functions: These functions are performed due to the primary worse than inflation in the long-run as it will decrease the investment, production
Economics deals with large parts and about the economy as a whole. It deals with functions of money which are as follows: and there will be widespread unemployment.
the economy in totality or in aggregates. a.Store of value: Money can be easily stored for future use as it has durability and The main effects of deflation are as follows:
According to K.E Boulding, ‘Macro Economics deals not with individual quantities can last long time into the future. -Decrease in production in the economy due to loss to the producers
but with the aggregate of these quantities, not with individual incomes but with b.Transfer of value: Money can be easily transferred from one populace to -Increase in unemployment
national income, not with individual prices but with price level, not with individual another or from one person to another. -Decrease in investment
output but with national output.’ c.Standard of deferred payments: Money has made lending and borrowing of -Decrease in government revenue
Thus, Macro Economics studies about the total economy. It is the bird’s eye view of money very easy. People take loans and repay together with interest after a certain -Decrease in banking activities
the economy as a whole. period in money. -The economy may plunge into depression.
The main scope or the subject matter of Macro Economics are national income, 3.Contingent functions: These functions are the emergency functions and arise any
employment, poverty, price-level, money, banking, economic growth and time as per the need and necessity. The main contingent functions are as follows: Unit 10:
development, public finance, international trade, etc. a.Basis of credit/ bank money: The different credit money like drafts, cheques, Banking
Closed Economy ATM, Visa card, debit card, etc. are issued by banks and financial institutions on the A bank is a financial institution which deals with money. The word 'Bank' is believed
An economy which not participate in trade relation with other countries of the basis of money deposits. These credit money is becoming increasingly popular to have been derived from the Italian word 'Banco' meaning a bench, which traces
world is a closed economy. The trade is done within the domestic boundary of the these days. its origin to the ancient Roman Empire where the money lenders would set up their
country and there are no exports and imports. Such an economy is only b.Distribution of resources/ national income: The factors of production are paid stalls in an enclosed courtyard on a long bench called banco
hypothetical and does not exist in the real world. remuneration in the form of rent, wages, interest and profit in money. Role of banking system in economy
The Gross Domestic Product of a closed economy can be expressed as; GDP=C+I+G, c.Liquidity and uniformity: The value of all wealth and property is done in money A well- developed banking system is a pre-requisite for economic development of a
Where, terms. This brings uniformity in all the wealth and resources and makes it easy for country .Banks are the financial wheels of economic development. They accelerate
GDP= Gross Domestic Product economic comparison among individuals and even economies. the pace of trade and commerce, improve the living standard of the people and
C=Consumption expenditure of individuals and household sector The functions of money can be summed up and expressed in a couplet as: thereby develop the economy. The roles of the banking system in any economy are
I= Investment expenditure of business sector Money is a matter of functions four, discussed as follows:
G= The expenditures of the government on both consumption and investments. A medium, a measure, a standard and a store. 1. Mobilization of people's savings: Commercial banks accept deposits from the
In a closed economy, there will be three sectors as household, business and Importance of money people in different accounts (fixed, current and saving) and give them interest. This
government sectors. Money is very important in our day- to-day activities. Life without money is almost money deposits are utilized by the banks in giving loans to businessmen and
impossible today. Money is important in all spheres and walks of human life and industrialists to invest in productive sectors of the economy.
activities as discussed below: 2. Monetization of the economy: Monetization of the economy is necessary for
In production: People save part of their earned money income. This saved money is trade and other economic activities. Banks are creators as well as the distributors of
Main features of closed economy invested by entrepreneurs and investors for the production of various goods to money. They spread in different parts of the economy through their branches.
-There is no trade relation with other countries of the world people's satisfy wants and necessities. People keep money in banks and withdraw in times of need. Thus, there is
-There are no exports and imports of the country In consumption: People earn money by doing different works and activities. They monetization of the economy through the banking system.
-There is no inflow and outflow of capital and investments spend this earned money in buying different goods and services and satisfy their 3. Capital formation: Capital formation is a pre-requisite to the economic
-The country does not receive any foreign aid and does not provide foreign aid wants. development of a country. It is the increase in physical and human capital. The
-The Gross Domestic Product and Gross National Product of the country will be banks collect the money from the people in the form of savings and channelize
equal as there is no any exports and imports
them for productive investments in all sectors. This helps in the capital formation 2. To reduce the disparity between the rich and the poor:In order to reduce the gap b. Taxes on the consumption of goods and services: It includes the income
and economic development. between the rich and the poor, the government charges progressive taxation and obtained from sales tax, VAT, entertainment tax, contract tax, road tax, etc.
4. Creation of employment opportunities: Establishment of many banks in all parts spends the same for the welfare of the poor through social welfare programmes c. Land revenue and registration tax: It includes the income obtained from land
of the country creates employment opportunities directly. When banks provide like education, health, drinking water, skills development, training, etc. registration tax, house registration tax, etc.
loans to businessmen and industrialist for investment, many industries, businesses 3. Development of infrastructures: Development of social and economic d. Taxes on property, income and profit: It includes the income obtained from the
and development projects will be set up which will create a lot of employment infrastructure like education, health, transport, communication, drinking water, imposition of property tax, income tax, house tax, vehicle tax, tax on profit, etc.
opportunities in the economy. electricity, etc. are the most important responsibility of the government and these 2. Non-Tax Revenue:
5. Promotion of foreign trade of a country: All the financial transactions involved in infrastructures cannot and will not be developed by the private sector. a. Fee, fines and penalties: Fee means the amount collected by the government for
export and import of goods and services between countries are done through 4. Maintain economic stability: Economic stability is very important for the smooth the services of education, health drinking water, registration fee. A fine is a
banks. Without banks, it is very difficult and almost impossible to conduct foreign development of the country. Pubic finance controls both inflation and deflation. monetary punishment imposed by the government for the violation of the law and
trade now. The transfer of money from one country to another is also done The increase in direct taxes reduces the purchasing power of the people and help order by the people. The additional amount charged on late payments of
through banks. to reduce inflation. The increase in public expenditures increases the demand of telephone, water, electricity, license renewal, etc.is also fine. The amount paid for
6. Reduce poverty: The banks give loans to the rural poor at lower rates of interest the people and control deflation the violation of any agreement or contract is the penalty.
under different targeted programs. The poor farmers are provided agricultural 5.Increase in employment opportunities: The government collects a lot of money b. License and Permit: The government collects revenue from the distribution of
credit programmes by Agricultural Development Banks and Commercial Banks. from various sources and spends it in different social and economic infrastructures license to guns, pistols and vehicles. The revenue collected from issuing license to
Classification of Banks and projects where a lot of employment opportunities are created. teachers, doctors, engineers, auditors, drivers, contractors, etc. It also collects
There are different types of banks established for different purposes. The main 6. Achieve a favorable balance of payments: The government can charge high taxes revenue by giving permissions to mountaineering and trekking expeditions, visitors
types of banks are: on imports and reduce taxes on exports of the country. It can also promote more of national parks, zoos, museums, issue of visa and passport, etc.
1. Central Bank: The Central bank is the apex bank of a country. It regulates controls export- oriented industries. This will reduce imports and increase exports, making c. Escheats: The claim of the government on the property death persons who don't
and acts like a guardian of all banking institutions of a country. It is established by the balance of payments favorable. have legal heir is called escheats. The bank deposits not claimed and other
the government. The central bank issue notes, works as a bank and an advisor to unclaimed property of people and private organizations also come under escheats.
the government, bankers bank controls credit, regulates the foreign exchanges, Public/ Government Expenditure d. Income from public properties and public enterprises: It includes the income
prepares monetary policies, and acts as a lender of last resort. The public expenditure means the expenditure made by the government. In the that the government collects from the sale of goods and services it produces and
2. Commercial Banks: Commercial banks dominate the banking system in a country. modern days, the function of the government is not only to protect the country and the income from the government enterprises and industries.
These banks are established primarily to earn profit mainly from the private maintain law and order but also to develop the social and economic infrastructure
sectors. They accept deposits, advance loans, facilitate domestic and foreign trade and to work for the welfare of its citizens. Taxes
and make other agency functions. Nepal Bank Limited established in 1994 B.S is the Tax is a compulsory monetary charge imposed by the government to its citizens.
first commercial bank of Nepal. Presently, there are about 28 commercial banks in The taxpayers do notget director immediate benefit from the tax paid but get the
Nepal with their numerous branches. Besides the Rastriya Banijya Bank, Nepal indirect benefit in the form of public services like transport, education, health,
Bank Limited and Agricultural Development Banks. All other commercial banks are drinking water, etc. In the words of Taylor, 'Taxes are compulsory payment to the
established by the private sector. Kumari Bank, Himalayan Bank, Bank of government without expectation of direct benefits in return to the tax payer.'
Kathmandu, Nabil Bank, Standard Chartered Bank Nepal, Everest Bank, Siddhartha Importance/Role of public expenditure The main features of tax are:
Bank, etc. are some of the commercial banks in Nepal. The government expenditure has a lot of roles especially in a developing country - Tax is a compulsory payment to the government by the citizens.
3. Development Banks: The development banks are established for the like Nepal. The following are the importance/roles of public expenditures: -Tax payers do not receive direct or immediate benefits in return.
development of any sector or area. They can be industrial development bank, 1. To maintain law and order and preserve the security of the country: The primary -Fund raised from taxes is spent for public welfare.
agricultural development bank or rural development bank. function of the government is to maintain law and order and to protect the country -Tax is imposed by the government on the basis of the law.
Those banks which are established for the development of the industrial sector from foreign aggression. For these, a country has to spend a huge amount of Types of Taxes
providing long term loans are the industrial development banks. money as public expenditure in police, army and weapons. Direct Tax: Direct taxes are those taxes of which the impact and the incidence fall
2. To provide administrative services: The government spends a lot of money as on the same person. In other words, direct taxes cannot be shifted. The same
Functions of Central Bank with special reference to Nepal Rastra Bank public expenditure through ministries, departments, provinces, urban or rural person bears the burden of the tax on whom it is imposed by the government.
Nepal Rastra Bank is the central bank of Nepal which was established on Baisakh municipalities, districts, wards and offices to provide administrative services to the Examples of direct taxes are: Income tax, property tax,etc.
14, 2013 B.S. Its functions are: people. Indirect tax: Indirect taxes are those taxes of which the impact and incidence falls
1. Issue of currency notes: Nepal Rastra Bank has the monopoly authority to issue 3. Provide Infrastructures in the country: The government spends a lot of money to on different persons. In other words, the burden of indirect taxes can be shifted.
currency notes in Nepal on the basis of the proportionate reserve system. The bank provide the basic infrastructures in the country like education, health, drinking The tax is imposed on one person by the government, but it is paid by another
has issued currency of paper and coins of different denominations like 1, 2, 5, 10, water, transport, communication, irrigation, electricity, etc. Since these person. Examples of indirect taxes are: sales tax, custom duties,VAT, etc.
20 25, 50, 100, 500 and 1000 since 2016 B.S. infrastructures need huge capital and are not profit-oriented, the private sector These types of taxes are imposed on the producers but are shifted to the
2. Bank's bank: Just like the commercial banks are the banks of the people, the does not invest there. consumers by adding them onto the prices of goods and services.
central bank is the bank of all the commercial and development banks in Nepal. All 4. To maintain equality in the country:
other banks of the country have their account deposits in the central banks and can The government expenditure is directed mainly for the upliftment and betterment Features of Direct Taxes/ Merits and Demerits of Direct Taxes
withdraw money when needed and can also take loans. of the poor through different socially benefitting programmes and help to reduce Merits
3. Government's bank and advisor: All ministries, departments and offices of the the inequality gap between the rich and the poor. 1. Equality: Direct taxes ensure equality in the society as it is imposed on the level
government have their account in a central bank. The central bank is the bank of 5. For Economic growth and development of the country: The task of the of income and ability to pay. The rich pay more taxes than the poor on the basis of
the government. It is the economic advisor and of the government and helps to government expenditure in the developing countries is to accelerate the pace of income earned.
formulate economic and fiscal policies that best suit the conditions of the country. economic development. The government launches economic plans for rapid 2. Certainty: It ensures certainty in the sense that the tax payer is certain of the
4. Clearing House function: All other banks should keep a cash reserve in the Rastra development and spends a large amount of money to fulfill the objectives ad amount of tax he/she has to pay, the place to pay, the time to pay. The government
Bank and the record of their transactions. Different banks have mutual claims and targets of the plans in agriculture, industry, trade and commerce through public is also certain of the tax it collects.
dues. Nepal Rastra Bank can adjust their debit and credit entries in their respective enterprises. 3. Elastic: The direct tax is elastic and increases with the rise in income and
entries on request by the concerned banks. For example: If Nabil Bank has to pay property and decreases with the decrease in income and property. The government
rupees 5 lakhs to Laxmi Bank, Nepal Rastra Bank can deduct rupees 5 lakhs from Classification of Public expenditure can also increase or decrease the rate of such taxes as desired.
the accounts of Nabil Bank and add the same amount to the account of Laxmi Bank. The public expenditure can be classified into different groups as discussed below: 4. Economical: The cost of collection of direct taxes is economical and does not
This is the clearing house function. 1. Regular/Maintenance/Administrative Expenditures: It is the expenditures involve a lot of cost as it is collected at the source.
5. Custodian of gold and foreign currency: Nepal Rastra Bank is the custodian of incurred by the government to run the day-to-day administrative function of the 5. Progressive: It is progressive in nature as more taxes are imposed on the rich and
gold, silver and foreign exchanges in the country. It protects the gold, silver and the country. It constitutes the expenditure on the following government organizations less on the poor. This will help toreduce inequality.
foreign currency reserves of the country. It also fixes the rates of foreign currency as: Demerits
with the home currency on the basis of their demand and supply. a. Constitutional Organs including the regular expenditure made by the 1. Inconvenient: It is inconvenient to the tax payer to keep accounts, visit the tax
government on constitutional organs like the Supreme Court, Auditor General's office and pay the taxes on lump sum amount.
Concept of Money Market and Capital Market Office, Election Commission, Public Service Commission ,Human Rights 2. Tax evasion: There are chances of tax evasion as the taxpayer may submit wrong
Money Market: In a money market, short-term credit instruments of less than a Commission, Office for the Investigation of the Abuse of Authority, etc. records of income and property. This results in corruption and black- marketing.
year like treasury bills, certificates of deposits, commercial bills etc. are transacted. b. General administration which includes the regular expenditure made in the The honest pay taxes whereas the dishonest are free.
According to World Bank, 'Money market is a market in which short-term securities Council of Ministers, various departments of the government, district 3. Discouraging: The direct tax kills the spirit of the people to work harder and earn
like treasury bills, certificates of deposits and commercial bills are traded'. Central administration, regional and local offices, jail, etc. more. This adversely affects the economic development of the country.
Bank, Commercial banks, Development banks, Finance companies, bill brokers, c. Revenue administration which includes the regular expenditures on collection of 4. Limited scope: The direct taxes have limited scope, especially in poorer countries
landlords, money lenders are the different constituents of the money market. The land revenue, custom offices, VAT and other revenue offices. like Nepal where most people are poor and have less income. So the government
main purpose of the money market is to make available working capital to the d. Economic administration which includes the regular expenditure made on cannot collect more revenue from direct taxes.
business sector and short term loan to the government. It is a ready source of National Planning Commission, Department of Statistics, Survey, Measurement, 5. Unscientific: The direct taxes are unscientific in the sense that the rates of such
liquidity and any individual or institution can use this source when needed. It is like etc.. taxes may increase as per the need of the government and not paying according to
a bank balance to the credit system. e. Judicial administration which includes the regular expenditure on courts and the capacity of the payers.
Capital Market: Capital market deals with the lending and borrowing of long term special courts, etc.
funds of more than a year. The main instruments of credit traded in the capital f. Defense including the regular expenditure on security organizations like army, Features/ Merits and Demerits of Indirect Taxes
market are shares, bonds and debentures. The institutions of capital market are police, arms and weapons, etc. Merits/role/importance/advantages of indirect taxes
banks, financial companies, stock exchanges. Nepal Stock Exchange is the g. Social and Economic services which includes the regular expenditure on 1. Convenient: The indirect taxes are convenient to pay as the tax is hidden in
responsible authority to deal with capital markets in Nepal. According to World education, health, drinking water, transport, communication, electricity, prices and the payers do not feel the burden of the tax. It is also convenient to the
Bank, 'The market in which long term financial instruments such as shares, agriculture, industries, etc. government as it collected from producers.
debentures and bonds are traded". h. Miscellaneous expenditure which includes other regular miscellaneous 2. Difficult to evade: As the tax is included in price, it is difficult to evade and the
expenditure like loan repayments of the government, expenses of travelling of payers pay it when they buy goods and services.
Differences between money market and capital market dignitaries, pensions, emergency relief, etc. 3. Broad-based: The indirect taxes are levied on all types of people, rich or poor,
whoever buy goods. So, it is broad based and a large amount of revenue is
Money Market Capital Market 2. Developmental/ Capital Expenditures collected.
1. The credit instruments on The credit instruments on The developmental or capital expenditures are the long term or new investments 4. Maintains social value: The government imposes high taxes on harmful
money market mature in less than capital market mature in more made in the economy in various sectors. It consists of the followings: commodities like tobacco, wine, beer and uses the same for public welfare
a year. than a year. a. Constitutional organs which include the capital expenditures made by the programmes.
2. The market provides short term The market provides long term government on the development of infrastructures of the constitutional organs like 5. Progressive: Government imposes higher rates on luxury and expensive goods
funds to the business sector. funds to the business sector. the Supreme Court, the Election Commission, Auditor General's Office, Public consumed by rich and less taxes on necessary and cheaper goods.
3. The funds are made available The funds are made available Service Commission, etc. Demerits
for expenses of working capital for investment in fixed assets b. General administration which includes the capital expenditures on the 1. Inequality: The indirect taxes are not based on equality as all people, rich or poor
investment and reforms of the ministries, departments, regional and local pay the same rate of tax when they buy goods and services.
4. The rate of interest is generally The rate of interest is
high generally low government, jail, etc. 2. Uneconomical: The cost of collect of tax may be even higher than the revenue as
c. Economic administration which includes the capital expenditures on the Planning many staff should be recruited to collect indirect taxes.
5. The main instruments of credit The main instruments of credit
Commission, statistics, survey, measurement, etc. 3. Uncertainty: Both the government as well as the tax payers are uncertain about
are treasury bills, commercial are shares, bonds, debentures,
d. Social and Economic Services which include the capital expenditures on health, the amount of tax to be collected or to be paid.
papers, draft, etc. etc.
education, drinking water, transport, communication, electricity, agriculture, 4. Unproductive: Due to indirect taxes, the saving of the people will be less. This
6. There is less risk of investment There is more risk of
industries, etc. reduces investment and capital formation in the country. So, it is unproductive.
in money market investment in capital market.
e. Judicial administration which includes the capital expenditure made in the 5. Harmful to industries: Indirect taxes are imposed on the producers and industries
various courts of the country. as sales tax, VAT, excise duties, taxes on raw materials, etc. When a lot of such
Unit 11: Public /Government Finance f. Defense which includes the capital expenditure made in the army, police, arms taxes are imposed, the cost of production becomes very high and the industries
and weapons, etc. find it difficult to pay them and might be closed altogether.
Concept of Public/ Government Finance g. Miscellaneous expenditure which includes all the capital expenditures made by Differences between direct tax and indirect tax
The government collects revenue as income from different sources and spends it the government on miscellaneous headings. Direct tax Indirect tax
on economic and social activities as expenditure for the welfare of the citizens and Government Revenue 1. Its burden cannot be shifted to 1. Its burden can be shifted to others
the development of the country. This income and expenditure of the government is Government revenue means the income of the government obtained from various others
known as public/ government finance. In the words of Bastable, "Public Finance sources. It is needed by the government to perform social and economic activities
deals with income and expenditure of public authorities of a state and their mutual 2.Its impact and incidence fall on 2. Its impact and incidence fall on
for the welfare of the people and the development of the country. same person different persons
relation with the financial administration and control".
3.It is progressive in nature 3. It is regressive in nature
Sources of Government Revenue 4.It has a narrow scope 4. It has a broader scope
Importance/Role of Public Finance There are various sources of government revenue. We can classify them into three
Public finance is very important especially in a developing country like Nepal as 5. It is inconvenient for tax payers 5. It is more convenient for taxpayers as
major sources as:
discussed below: they do not feel the burden
1. Tax revenue 2. Non-tax revenue and 3. Foreign assistance
1. Increase agricultural and industrial production: The production of agricultural 6. It ensures equality in the society 6. It widens the inequality gap in the
1. Tax Revenue:
and industrial goods depends upon the fiscal policy of the government. If the society
a. Custom duties: It includes the income obtained from taxes imposed by the
government reduces the taxes, protects the industries and creates a business- government on the export and import of goods and services. 7.It reduces the spirit of tax payers 7. It does not reduce the spirit of the tax
friendly environment in agriculture and industries, there will be large-scale to work hard and earn more payers to work harder and earn more
production of goods in these sectors. 8. Example: income tax, property 8. Example: sales tax, VAT, etc.
tax, etc. 7. Cannon of Elasticity: A good tax should be elastic and not rigid. As the available in the markets of the country. This will enable the people to make a choice
expenditure of the government increases every year, the tax rate should also from among the variety of goods.
Progressive Tax increase to collect more revenue for the government. 4. Availability of raw materials: The foreign trade makes it possible to import the
If the tax rate is imposed according to the level of income of the tax payer, it is 8. Canon of Popularity: The tax should be popular among the payers. The tax payers raw materials necessary for the industries from foreign countries. This enables
should feel proud to pay taxes.. production and hence economic development.
progressive tax. In other words, when the taxes are imposed more on rich and less
9. Cannon of Uniformity: The tax should be imposed on all citizens of the country 5. Widens the market: The international trade will help to widen the market as the
on the poor, it is a progressive tax. This type of taxes helps to reduce the unequal
according to their paying capacity. All people should pay taxes, high or low. goods can be sold even in the international markets, besides the home market.
distribution of income in the country. The developing countries of the world mostly
6. Creates more employment opportunities: Increase in international trade
implement this type of tax. The progressive tax can be explained in a table as: 10. Canon of Diversity: A good tax should be broad-based. It should find new areas
increases the development of more export-oriented industries. Similarly, more
Income in rupees Tax rate in % Tax amount in rupees of tax collections. The more number of taxes with minimum tax rates and minimum
people will be employed in export and import of goods. This creates more job
10,000 10 1000 burden is the diversity of tax. opportunities.
20,000 15 3000 7. Increase in government revenue: Due to increase in international trade, more
Government/ Public Borrowing goods will be exported and imported. This will help the country to earn more
30,000 20 6000
The expenditure of the government has been increasing every year but the revenue through export as well as import taxes, sales tax, etc.
40,000 25 10,000
revenue has not been able to increase in the same proportion. Hence, all the Differences between domestic and foreign trade
The table shows that with the increase in the level of income, the tax rate increases government expenditure cannot be met from the revenue and there arises budget Domestic trade Foreign trade
and the amount of tax also increases. The progressive tax can be shown in a curve deficit. The government takes loans from various sources, internal or external to 1. It is carried within the geographical 1. It is carried out across the boundary
as below: meet the budget deficit which is called government/ public borrowing. This is a boundary of a country. of a country
temporary source of government revenue and has to be repaid together with 2. The traders have to follow the trade 2. The traders have to follow the trade
In the diagram, tax rates in % is interest on their maturity. Borrowing is done by the government to meet budget policy of the country. policy of both the trading countries.
shown in the Y axis and the level deficit, to develop infrastructures and other development works, in times of war, in 3. The factors of production like land, 3. The factors of production are not
of income in rupees is shown in times of natural calamities, in times of inflation or deflation, etc. labour, capital and organization are perfectly mobile between countries.
the X axis. OP is the Progressive Internal Borrowing perfectly mobile within the country. There are certain barriers and
tax curve which is positively The revenue collected by the government from individuals, financial institutions restrictions.
sloping. It indicates that the tax and other enterprises within the country is known as internal borrowing. There are 4. Only one currency is used 4. More than one currency can be used.
rate increases with an increase in two types of internal borrowing: 5.The volume of trade can be small 5. The volume of trade can be large.
the level of income and vice- 1. Market borrowing: It is the type of borrowing in which the government collects
versa. loans by selling government securities likeTreasury bills,bills of exchange, currency,
Proportional Tax government bonds, etc.. The borrowing is voluntary in nature. The government
If the tax is imposed at the same rate to all classes of people, irrespective of their pays a good and a good rate interest which is more than the market rate of Differences between BOT (Balance of Trade) and BOP (Balance of Payments)
level of income, it is proportional tax. In other words, if the same tax rate is interest. Balance of Trade Balance of Payments
imposed on rich and poor alike, it is proportional tax. The amount of tax increases 2. Non-market borrowings: If the government collects loans without selling its 1. It is a narrower concept of It is a broader concept of international
with increase in income but the tax rate remains the same at all levels of income as securities, it is non-market borrowings. Under this, the government collects loans international trade trade.
shown in the table below: from public and private organizations like insurance companies, Provident Fund, 2. It is the volume of exports and It is the comprehensive record of all
Income in rupees Tax rate in % Tax amount in rupees Citizen Investment Trust, Agricultural Development Bank, other private and public imports of a country with the rest of the economic transactions of a country
10,000 10 1000 institutions of the country. world. with the rest of the world.
20,000 10 2000 External Borrowings 3. It includes only the visible and It includes both the visible as well as
30,000 10 3000 The loans taken from foreign/international individuals, governments, international tangible items of trade. non-visible items of trade.
40,000 10 4000 institutions are called external borrowings. The external borrowings can be: 4. It is only a part of the economic It is the total economic transaction. So,
1. Bilateral borrowing: If the government borrows loan from the friendly countries transaction. So, cannot show the real it shows the real economic
of the world, it is bilateral borrowing. For example: loan taken from the USA, Japan, economic performance of a country. performance of a country.
The table shows that the amount of tax increases directly with the income but the
tax rate is same at all levels of income. This can be shown in a curve form as: China, etc.
2. Multi lateral borrowing: If the government borrows loans from international Importance of balance of payment
-Balance of payment serves as an indicator of economic position of a country.
organizations, it is multilateral borrowing. For example the loan borrowed from the
-It provides vital information to understand a country's economic condition.
In the diagram, the tax rate in % is shown IMF, World Bank, UNICEF, ADB, etc.
-It shows the extent of dependence of a country in financial assistance especially of
in the Y axis and the levels of income in developing countries from developed countries.
rupees is shown in the X axis. PT is the Government Budget -It helps the government to take the appropriate monetary or fiscal policy to make
proportional tax curve which is a horizontal The term 'budget' has been derived from the French word 'bougette' which means the balance of payment favourable.
straight line and parallel to the X axis. It leather bag or purse. It shows the foreign exchange reserve of a country.
indicates that the tax rate remains Budget is a document or a statement that contains estimation of government A country's balance of payment situation cannot be taken as an indicator of
constant at all levels of income. income and expenditure for a year. It is the financial planning for any fiscal year economic prosperity and an unfavorable balance of payment cannot be taken as a
related to income and expenditure of the government. According to World Bank, reflection of economic failure. But it is a proof of the competitive weakness of a
'The annual budget is usually the legal authority for public spending'. country in the international trade. An unfavorable balance of payment of a country
Budget is regarded as a powerful means to achieve economic stability, growth and for a long time reflects the presence of some economic problems in the country.
equitable distribution of wealth in the country. A budget contains:
--Total amount of income and expenditure of the government in the previous fiscal
Regressive Tax year 12.3. Free trade and Protectionism
--An analysis of the income and expenditure of the current fiscal year The concept of free trade was first introduced by Adam Smith and David Ricardo.
If a high tax rate is imposed on poor and low tax rate on rich people, it is a
--The estimation of revenue including their sources Under free trade policy, the government does not impose any kinds of restrictions on
regressive tax. The tax rate falls with an increase in income and rises with a
exports and imports of legal goods
decrease in income of people. Such tax increases inequality and the social injustice. -- Estimate of expenditure of the government of the coming fiscal year
and services. The government may impose some taxes on exports and imports but
Regressive tax can be shown in a table as below: --The proposal of new taxes and tax rates in the coming fiscal year.
they are levied only with the objective of raising revenue and not for restricting
Income in rupees Tax rate in % Amount of tax in rupees exports and imports.
10,000 10 1000 Adam Smith defines, 'The term free trade is used to denote that commercial policy
20,000 9 1800 which draws no distinction between domestic and foreign commodities and
30,000 8 2000 therefore neither imposes additional burden on the later nor grants special favour
40,000 7 2800 to the former".
Protectionism
The protection policy encourages the domestic industries by providing them
The table shows that as the level of income increases, the tax rate decreases and protection or subsidies. The policy discourages the import of foreign goods by
vice-versa. The regressive tax can be shown in a curve form as: Steps/Process of Budget Formulation imposing high custom duties. The protectionism policy uses two types of
The process of budget formulation begins a few months before the instruments:
In the diagram, the tax rate in % is shown in the Y commencement of the new fiscal year. It is formulated by the Ministry of Finance.
axis and the levels of income in rupees is shown In Nepal, the new fiscal year begins from the first of Shrawan and ends in the last of i. Tariff barriers: The government imposes high custom duties on import of foreign
in the X axis. PT is the regressive tax curve which Ashad. The process of budget formulation may differ from country to country but goods. It will make the foreign goods relatively expensive than the domestic goods.
is negatively sloping. It indicates that there is an the most common one is as follows: So, the imports decline as the domestic consumers prefer and demand more home
inverse relation between tax rate and levels of products and reject the foreign products.
1. Estimate of overall expenditure: The primary step of budget formulation is to
income which means when income increases, II. Non-tariff barriers: The governments control the imports through quota system
collect the estimate of expenditure and the possible incomes from ministries,
the tax rate will decrease and vice-versa. or provides subsidy to domestic industries.
departments and local offices. It is carried out by the budget unit of Finance
Ministry every year. Advantages/merits/argument for/in favour of Free Trade
2. Determination of Priorities: The planning unit then fixes the priority on main
sectors of the government. It then sends directions to all ministries, departments The followings are the main advantages of free trade
and other offices to submit the projects to be included in the coming fiscal year but Benefits of specialization: Free trade encourages specialization in the production of
Digressive Tax within the budgetary limit. goods
This type of tax is a blending (mixture) of proportional and progressive tax. The tax 3. Discussion: After that a thorough discussion takes place among the and services which in turn develops production efficiency at lower cost. This enables
which is mildly progressive and then is proportional is the digressive. In other representatives of the budget unit, finance ministry, experts, economists, etc. The large scale production and thereby exports leading to increase in government
words, the tax is mildly progressive up to a certain limit of income and then conclusion of such a discussion will be most useful guideline in the preparation of revenue.
proportional is digressive tax. It can be shown in a table as below: the budget. 2. Benefit to consumers: Due to free trade consumers get a choice of various and
Income in rupees Tax rate in % Amount of tax 4. Selection of Projects: The budget unit of the finance ministry submits the list of better quality goods of the world at cheaper prices in the markets.
10,000 5 500 projects to be the Planning Commission for feasibility study. The planning 3. Expansion of markets: Free trade will increase the size of markets. The products
20,000 6 1200 commission makes the review, analysis of the proposed budget and gives positive of a country will find markets all over the world and goods from all over the world
30,000 7 2100 decision on economically feasible projects. will come to home markets.
5. Proposal of new taxes: If the revenue of the government estimation is less than 4. Gain in technology: Free trade helps the developing countries to import new and
40,000 7 2800
advanced technology from the advanced countries. It also helps the advanced
As shown in the table, the tax rate is mildly progressive in the beginning and then the expenditure, new taxes and tax rates, government borrowing will be proposed.
countries to make investments in the developing countries, benefitting both.
proportional afterwards. It can be shown in a curve form as: 6. Final Budget: After all these processes, the final budget is prepared and the 5. Maximum utilization of resources: Due to free trade, there will be free
In the diagram, the tax rate in % is shown in the Y Finance Minister makes it public through "Budget Speech". The necessary changes movement of resources, labour and capital without restrictions. The country will
axis and the levels of income is shown in the X axis. can be made in the budget after discussion with different parties in the parliament. specialize in the production of goods which it has advantages and increase
OT is the digressive tax curve which rises in the 7. Authorization: The final step is the authorization of the budget by the production. This will lead to maximum utilization of resources and economic
beginning and is positively sloping and then remains parliament. Both the houses of the parliament will pass the budget by a majority, development.
constant and is a horizontal straight line afterwards. after voting, if need be. It then goes to the President and when he endorses it, it is 6. Promotion of friendly relations: Due to free trade and fair competition, there
This indicates that the tax rate increases at the authorized budget of the country. develops goods trade relation among the countries of the world.
beginning and then remains constant.
Disadvantages/demerits/arguments against free trade
Unit 12: International trade There are a lot of disadvantages of free trade as discussed below:
Characteristics/ Qualities of a good tax system/ Cannons of taxation 1. Danger to the domestic industries: The domestic industries, especially of
A good tax system should have the following characteristics/features: .Concept and Importance of International Trade developing countries feel insecure due to free trade. Due to free trade,thereis an
Trade is the exchange of goods and services between people. Trade can be influx of better and cheaper foreign goods into the home markets and the home
1. Cannon of Equality/Ability: A good tax should have the quality of equality and
domestic/internal trade or foreign/external/ international trade. products cannotcompete with them. This might lead to the closure of home
according to the ability of the tax payers. Rich people should pay higher tax and
If the goods and services are bought and sold within the geographical boundary of a industries.
poor people should pay less.
country, it is domestic/ internal trade. But if the goods and services are bought and 2. Exploitation by developed countries: Under free trade, the developed countries
2. Cannon of Certainty: A good tax should be certain about the amount, time, place sold across the boundary of a country, it is external/ foreign or international trade. buy the raw materials and labor at low price from developing countries. They in turn
and the method of tax payment so that both the payers and the receivers of tax can According to Luckeet, "The purchase of goods and services by the citizens of one export the finished goods to the developing countries at high prices. So, free trade is
make the necessary arrangement. country from the citizens of another country is called international trade". more beneficial to developed countries at the cost of the developing countries.
3. Cannon of Convenience: A good tax should be convenient to the tax payers in 3. Dependency on other countries: Under free trade, a country will not produce
terms of time, place and method of tax payment. The tax payment should not be Importance of international trade those goods which have higher cost of production. This increases dependency on
troublesome to the payer. 1. Benefit of specialization: Due to international trade, a country engages in the foreign countries, economically and politically.
4. Cannon of Economy: A good tax system should be able to collect maximum production of those goods which it can produce efficiently and at lower cost. This is 4. Unhealthy Competition: The free trade may lead to rat-race, cut-throat and
revenue. The amount of tax collected should be far more than the cost of collection specialization and it will lead to the improvement in quality and enables large scale unhealthy competition among countries in international trade. The industries of the
of tax. production of goods and services. developing countries cannot compete with the developed countries in price, quality,
5. Cannon of Productivity: The tax imposed should not discourage the people to 2. Benefit of technological progress: Through international trade, countries get technology, resources. So, they will be closed down leading to increased
work harder and earn more and increase production in the country. The tax access to new and better technologies of the developed countries. Developing unemployment.
collected should be used in productive areas. countries like Nepal can import new and advanced technologies from advanced 5. Trade of harmful products: Free trade can increase the inflow of harmful
6. Cannon of Simplicity: A good tax system should be simple and be easily countries and accelerate their economic development. products like wines, cigarettes, drugs, guns, pistols, bombs, crime-based films and
understood by common people. They should know the reason of paying the tax. 3. Availability of varieties of goods: All goods needed cannot be produced in any magazines, etc. It can also bring in AIDS, flu, corona virus and other harmful
country. Through international trade, different varieties and quality of goods will be diseases. All these are harmful to public health and morality.
 The SAFTA, South Asian Free Trade Area is a trade agreement among the eight
Problems of forgian tread in nepal SAARC countries where there will be free flow of goods and services among the
The foreign trade of Nepal faces a lot of problems as discussed below: member countries without any trade barriers.
Land-lockedness:Nepal is not touched by any seas but surrounded by land on all
sides. To conduct trade with anyothercountries of the world, Nepal has to transit Objectives of SAFTA
route through India. India lays down many conditions in the trade route in order to 1. To reduce the trade barriers among member countries,
take the concessions from Nepal. This complete dependence on India for trade route 2. To promote healthy competition among member countries,
has created a lot of problems in the foreign trade of Nepal. 3. To prepare a mechanism to solve disputes among member countries,
Low quality of products:The products of Nepal are of poor quality due to the use of 4. To prepare an outline of mutual profit and extension of mutual cooperation,
primitive technology and unskilled child labour. As a result, Nepalese products 5. To provide special benefits to poorer and landlocked countries of SAARC.
cannot compete in the international markets with the better quality products of other
countries.
Slow industrialization:Due to poor and slow industrialization, the agricultural and
crude materials which are the major exports of Nepal. On the other hand, the imports
of the country are finished products, machineries and electronic goods which have
high price. So, the value of imports is higher than the value of exports leading to
increasing trade deficit.
Dependence on a few products and countries:The exports of Nepal are mainly
dependent on woollen carpets and ready-made garments. But due to the use of
unskilled and child labour and the poor quality of the products, questions are often
raised by foreign countries against our products. Nepal exports her products to only
a few countries like India,China. USA, Germany, Japan, France, Singapore,
Australia, etc. When these countries do not or cannot buy our products, it creates
huge trade deficit.
Ineffective government policy:The policy of the government regarding foreign
trade is not effective. It encourages imports which have led to the closure of many
home industries. Instead of protecting the export-oriented industries, the government
levies high taxes on the exported products making them expensive in the
international markets.
High cost of production: The Nepalese goods have high cost of production due to
use of primitive technology, high taxes, inefficient labour and imported raw-
materials. So, it is very difficult for Nepalese goods to get international markets
Ricardian Comparative Cost Theory of International Trade
This theory was developed by David Ricardo and later modified by J.S Mill and
Bastable. Since, the theory was developed by classical economists, it is also known
as the Classical Theory of International Trade.
Assumptions of the theory:
-The trade takes place between two countries and only two commodities are traded.
-The cost of production is only the labor cost as labor is the only factor of
production.
-The labourers are homogeneous and equal in efficiency.
-The laborers are perfectly mobile within the country, but immobile between
countries.
-There is an absence of transport cost in trade.
-The international trade is free trade without any trade barriers.
-The law of constant cost operates in production.
According to Ricardo, ''Each country will specialize in the production of those
commodities in which it has a greater comparative cost advantage and least
comparative cost disadvantage". A country will produce and export those goods in
which it has got greater comparative cost advantage and imports those goods in
which it has got least comparative cost disadvantage.
The Comparative Cost Theory can be explained with the help of a table as below:
Countries Total Wheat Rice Cost Exchange Rate
Cost ratio
Nepal 10 80 Kg 80 1:1 1Kg Wheat=1
labour Kg Kg Rice
India 10 20 Kg 10 1:2 2 Kg Wheat=1
labour Kg Kg rice
wheat.
According to the table Nepal can produce 80 Kg of wheat and 80 Kg of rice by using
10 labourers. The internal cost ratio in Nepal is 1:1 or 1 Kg of wheat = 1 Kg of rice.
On the other hand, India can produce 20 Kg of wheat and 10 Kg of rice using 10
labourers. The internal cost ratio in India is 1:2 or 2 Kg of Wheat = 1 Kg of rice.
This means that Nepal can produce both wheat and rice at a lower cost than India. In
other words, Nepal is 4 times more efficient in wheat production and 8 times more
efficient in rice production than India. Nepal has comparative cost advantage in rice
production and India has comparative less cost disadvantage in wheat production. In
this situation, Nepal should specialize in rice production and import wheat from
India and India should specialize in wheat production and import rice from Nepal.
Both countries will benefit from international trade. If Nepal produces 80 Kg of rice
and export to India, it will get 80×2= 160 Kg of wheat in exchange from India
because the internal exchange rate in India is 2 kgs. of wheat = 1 kg of rice..
Similarly if India produces and exports 20 Kg of wheat to Nepal, it will get 20×1=20
Kg of rice from Nepal because the internal exchange rate in Nepal is 1 kg of rice = 1
kg of. But, if Nepal itself produces wheat, it will get only 80 Kg and if India itself
produces rice, it gets only 10 Kg. Thus, both countries gain from international trade.
Criticisms of the theory
The Ricardian Theory of Comparative Cost of International trade has been criticized
mainly on its unrealistic assumptions as follows:
1. The theory has been restricted to only two countries and two commodities. But in
reality, international trade takes place among many countries and many commodities
are traded.
2. The theory takes into account only labourer's cost. But the cost of production
includes the cost of land, capital and management also.
3. The theory assumes homogeneity of labourers. But labourers are not
homogeneous and differ from one another in efficiency and capacity.
4. It is wrong to assume constant returns to scale in production. In reality production
is either by decreasing or increasing returns.
5. It is wrong to exclude transport costs as it is included in price itself.
6. There is no complete free trade between countries as assumed by the theory. In
reality, custom duties and custom quota act as barriers in trade between countries.

General Introduction to World Trade Organization (WTO)

The World Trade Organization was established on January 01, 1995with its
headquarters in Geneva in Switzerland. It is the modern form of the former
organization, GATT, (General Agreement on Trade and Tariff), established in 1947
immediately after the Second World War. Nepal became a member of WTO on
April 23, 2004 as its 147th member with its ministerial conference held in Cancun in
Mexico. The WTO functions on the principle of non-discrimination, fair-
competition, free trade and security guarantee between member countries.
Objectives of WTO
1. To solve trade conflicts that arises among the member countries on the basis of
mutual benefits.
2. To simplify and reduce the custom duties and other trade barriers among member
countries.
3. To attain sustainable economic development of each member nation through trade
diversification.
4. To preserve and promote the environmental resources in a scientific way.
5. To assist the developing countries in trade policy issues through technical
assistance and training programmes.
But there are often questions raised during the implementation of principles and the
protection of trade to small and backward economies. The provisions of the WTO
are more favorable to developed countries, but unfavourable to the under-developed
and the developing countries.
12.6. General Introduction to South Asian Free Trade Area (SAFTA)
The SAARC, with the objective to reduce poverty and achieve economic growth was
established on December 8, 1985. With the inclusion of Afghanistan in 2006, there
are eight countries in the SAARC. Before SAFTA, SAPTA (South Asian
Preferential Trading Arrangement) existed where each member country provided
reduced import taxes on the preferential items of other member countries. Every year
the preferential goods will be increased by the member countries and ultimately all
goods would be included and it would be converted into SAFTA.
The concept of SAFTA was introduced in the eleventh SAARC summit in
Kathmandu and SAFTA came into existence on January 01, 2006 with the twelfth
summit meeting held in Islamabad in Pakistan.