As per the Fifth Dean Committee Recommendations

for the B. Sc. (Hons.) Agri. Course Curriculum

Fundamentals of Agricultural Economics

Ag. Econ 2.1 (2+0)

Department of Agricultural Economics

College of Agriculture,
Navsari Agricultural University,Bharuch
 INDEX
Sr. NO Chapter Page No.
1 Economics 3-9
2 Nature of Economic Theory 10-11
3 Basic Concept 12-21
4 Agricultural Economics 22-24
5 Demand 25-32
6 Utility Theory 33-38
7 Consumer’s Surplus 39-40
8 Elasticity of Demand 41-45
9 Production 46-47
10 Laws of Returns 48-50
11 Cost 51-58
12 Supply 59-66
13 Distribution 67-71
14 National Income 72-77
15 Population 78-83
16 Money 84-90
17 Economic System 91-98
18 GST 99-102

2
 Chapter – 1
ECONOMICS

What is Economics?
If we see our day-to-day activities, most of which are related to earning one’s own
living and to the manner of satisfying one’s own wants. These human activities, which are
generally called economic, are mainly related to production, distribution, consumption and
exchange of goods and services. The scientific study of various problems arising out of
these economic activities is called economics.

Basic Economic Problem

The basic economic problem is Human wants are many; but means to satisfy these
wants are limited. These limited means are capable of alternative uses and hence there is a
need of satisfying maximum wants with limited resources. In reality most resources are
scarce. Similarly individuals and nations have unlimited wants. There are only a limited
number of resources such as workers, machines, factories, raw materials etc. Yet there are a
number of different ways in which they could be used. Similarly people only have a limited
amount of money. Yet they have lots of wants to satisfy.

The Basic Economic Problem

3
 CIRCLE OF ECONOMICS

The existence of human wants is the starting point of all economic activity in the
world. Unless we make efforts, we cannot satisfy wants. Hence, wants, efforts and
satisfaction form the circle of economics.

EFFORTS
(creation of
wealth)

WANTS SATISFACTION
(use of wealth)

NATURE OF ECONOMICS

1. Economics is a social science

Economics deals with human wants and human behavior and human welfare.
Therefore it is considered as a social science.

2. Economics is the science of scarcity

In the real world, the means which satisfy our wants are limited, that is, there is
scarcity of the means which satisfy our wants. Time and money are limited. And land, labour
and capital which are used in production are limited. We study economics because there is
scarcity of many goods we want. That is why we say Economics is the science of scarcity.
And scarcity is the basic fact of life.

3. Economics is the science of choice

Our wants are unlimited but means are limited. This leads to choice making. It is true
that we have many wants. But all wants are not of equal importance. So we choose the more
important and the more urgent wants. So choice is the essence of economic activity. We may
also say that Economics is the science of choice.

4. Economics studies about the role of money in the affairs of mankind.

Modern economy is a monetary economy. Prices are paid in money. Money is used
for buying and selling of goods, for payment of rent, wages, interest and so on. In economics,
we study about the role of money in the affairs of mankind.

5. Economics as a study of the relationship between wealth and welfare.

All the scarce goods which satisfy our wants are known as wealth. So, in economics,
we study about the production of wealth, exchange of wealth, distribution of wealth and
consumption of wealth. As wealth is produced to promote human welfare, we study the
relationship between wealth and welfare.

4
 DEFINITIONS OF ECONOMICS

The word economics has been derived from the Greek word “OIKONOMICAS” with
“OIKOS” meaning a household and “NOMOS” meaning management. It is understood that
the beginning was made by the Greek Philosopher, Aristotle who in his book “Economica”
focused that the field of economics deals with household management.

The economists in defining the term, economics, followed several approaches and
concepts. The concepts on which various definitions of economics given are:
1. Wealth, 2. Welfare, 3. Scarcity, and 4. Growth.

“Wealth” Definition by Adam Smith

Adam Smith (1723-90) in his book entitled “Wealth of

Nations”(1776) defined economics as “An enquiry into the nature
and causes of the of wealth of nations”. He is known as the
“Father of Economics” because he was the first person who put all
the economic ideas in a systematic way. It is only after Adam Smith,
we study economics as a systematic science.
The term “wealth” has a special meaning in Economics. In the
ordinary language, by “wealth”, we mean money, but in economics,
wealth refers to those goods which satisfy human wants. We consider
only those goods which are relatively scarce and have money value
as wealth. We study about consumption, production, exchange and
distribution of wealth.

But the definition of economics as a science of wealth cannot be regarded as being a

correct one. In this definition, attention was exclusively paid to wealth as if wealth was
everything. Little attention was paid to man for whom wealth is really meant. Writers like
Carlyle and Ruskin condemned this worship of Mamon (The god of wealth). They accused
economics of selfishness and, therefore, called it a dismal science. This definition was,
therefore, rejected.

A great demerit of Adam Smith’s definition is that there is overemphasis on wealth.

There is no doubt that we have to study about wealth in economics. But it can be only a part
of the study. There is the other side. In fact, it is a more important side and that is the study of
man. Economics is a social science. Hence the proper study of mankind should be man and
not wealth alone. Man is primary and wealth occupies only a secondary place. Emphasis was,
therefore, shifted from the study of wealth to that of human welfare.

Welfare Definition by Alfred Marshall

Alfred Marshall (1842-1924) wrote a book Principles of

Economics in 1890. According to him “Economics is a study of
man’s actions in the ordinary business of life; it inquires how he
gets his income and how he uses it”.
Marshall agrees that economics studies about wealth. But he
does not accept the view that economics studies about wealth
alone. In the words of Marshall, “Economics is on the one side a
study of wealth, and on the other and more important side, a part
of the study of man. Man is the centre of his study. According to
him, the study of man is more important than the study of wealth.
Wealth is sought only for promoting human welfare.. Hence wealth
is given a secondary position.
5
 Marshall’s definition is known as material welfare definition of economics because of
its emphasis on welfare. Welfare is the well being of individual or community. This
definition by Marshal remained current for a long time, but early in the 1930’s, a
distinguished economist Lionel Robbins challenged the definition as under.
- Economics was treated as a social science rather than a human science; and the term
“human science” is more apt on the ground that any individual either as a member of
society or in isolation does have economic problems.
- It classifies economic phenomena into material and non-material; and it ignores the
non-material services like those of teachers, doctors etc. which also make an important
contribution to economic welfare.

Scarcity Definition by Lionel Robbins

Lionel Robbins (1898-1984) has defined economics as follows:

“Economics is the science which studies human behaviour as a
relationship between ends and scarce means which have alternative
uses”. Robbins has given the above definition in his book “An Essay
on the Nature and significance of Economic Science”. The definition
of Robbins is based on the following basic assumptions.
- Ends are various. The term “ends” mean wants. Human wants are unlimited.
- Means are limited. Means like time, money and resources are limited.
- We can put means to alternative uses. For example, though time is limited, we can use it
for different purposes. We can use time for earning money or we may enjoy it as
leisure, and
- All wants are not of equal importance.

We know time is limited. There are only 24 hours in a day. If a worker wants only
money he has to work for long hours and forgo leisure. If he wants leisure, he has to forgo his
income. He cannot have both at the same time. We may, however, note that all means which
satisfy human wants are not limited. For example, air and sunshine are available in
abundance. They are free goods. But many things we want are scarce in relation to our wants.
So, economics studies human behaviour as a relationship between unlimited
wants and scarce means. As means are limited, we have to pay a price for them. We study
in economics how the prices of scarce goods are determined. We have to choose among
different wants. That is why we say that scarcity and choice are central problems in
economics

Robbins’s definition is superior to “wealth” and “welfare” definitions because

‘welfare’ aspect is embodied in the definition and ‘wealth’ is represented as means which is
always scare.

Growth Definition by Lord Keynes

During the last 40 years or so, economic thinking has moved

further from Robbins’s view. The credit for bringing about a
revolution in economic thinking goes to Lord Keynes (1883-1946).
He defined economics as “the study of the administration of scare
resources and of the determinants of employment and income”. Thus,
besides studying the resource allocation, Economics studies how the
levels of income and employment in an economy are determined. In
other words, it also studies the causes of economic fluctuations to see
how economic stability could be promoted.
6
 SUBJECT-MATTER / DIVISIONS OF ECONOMICS
Traditional View
Traditionally, the subject matter of economics can be studied under four divisions.
These are Consumption, Production, Exchange and Distribution.
Consumption: It means the use of wealth to satisfy innumerable wants. It also means the
destruction of utility. All the goods that are produced are consumed immediately or some
time in future. Consumption represents using up of utility.
Production: It is an activity that helps to create utility. It simply means the addition of
utilities. Hence, production is defined as the creation of utility. Through the process of
production one set of goods is transformed into the other. In the production process, inputs
are transformed into products.
Exchange: In a primitive society, the connection between wants, efforts and satisfaction is
close and direct. A primitive man feels hungry; he picks up some fruit, eats it, and is satisfied.
But in a modern society things are not so simple and straight. Here a man produces what he
does not consume and consumes what he dose not produce. For example, a farmer produces
wheat, but he cannot use them all by himself. He sells them for money with which he buys
the things he needs. This work of selling and buying is called exchange.
Distribution: Nowadays most of the things we need are produced in a field or factory. To
make them workers gives his labour, the landlord his land, the capitalist his capital, while the
businessmen organizes the work of all these. They all get a reward in money. The labour
earns wages, the landlord gets rent, and the capitalist gets interest, while the entrepreneur’s
reward is profit. Economics studies how these incomes-wages, rent, interest and profit are
determined. The process is called distribution.
Thus, Consumption, Production, Exchange and Distribution is the subject-matter of
economics. This traditional view is now regarded as constituting only one part of Economics,
viz., Price Theory or also called Micro-Economics.

Modern View
According to modern approach, the scope or the subject-matter of Economics is not
only the price theory but also the study of the economy as a whole. We study, for instance ,
how the income of an economy is generated and how the level of country’s income and
employment is determined. In other words, we also study the factors that determine a
country’s national income, savings, investment, output, employment, general price level, etc.
Such a study of the economy as a whole is called Macro-Economics.
Recently, economists have begun to pay special attention to how an economy grows.
i.e. how the under-developed countries grow into developed economy and the developed
countries grow still further. Economics thus also includes study of economic growth.

Micro Economics Macro Economics

It studies economy at unit or individual It studies economy as a whole. i.e. at
level. national level.
It includes Consumption, Production, It includes national income, employment,
Exchange and Distribution as its subject- welfare economics, interest, tax, growth etc.
matter. as its subject matter.
It is also known as price theory. It is also known as growth theory.
It is a traditional view of Economics. It is a modern view of Economics.

7
 ECONOMICS AS A SCIENCE

1. Is Economics a Science or an Art?

By definition science is a systematized body of knowledge. Analogous to science, an

art is also systematized body of knowledge. It directs through a system of procedures to attain
a given objective or goal. It tells us how to do a thing.

Treating economics as a science, a given theory is formed through conducts of

experiments, recording observations, analysis of data recorded, drawing the conclusions and
finally testing them. In economics also the same procedure is followed to present any
principle or theory. Hence, economics is as good as any science. Only the question is
regarding precision.

The scientific experiments are conducted under laboratory or controlled conditions,

while economic theories are subjected to several casual factors that influence human
behaviour. The situation of controlled experiments in economics is not possible, since it deals
with human behaviour, which is unpredictable. This indicates the fact that the degree of
precision of economics as a science is less, when compared with the pure science.

As an art, economics shows solutions to the problems. It helps us how to do a thing.

The role of economics as an art can be found in any sphere of economic activity. For
example, it advocates how to maximize the profits of a firm given the resource constraints
(e.g., producing more wheat from an acre of land).

Thus, the field of economics has the attributes of science and art. Economics,
therefore, is a science and art.

2. Economics as Social Science

Economics studies human beings as a member of the society participating in the

economic activities. It does not study humans as isolated individuals. He is interdependent.
Thus economics is a social science.

3. Is Economics a Positive Science or Normative Science?

A positive science explains the why and wherefore of things. i.e., their causes and
effects (why things are as they are). A normative science, on the other hand discusses the
rightness and wrongness of things (the things ought to be). e.g. atom bomb.

Economists differentiate positive economics and normative economics. Positive

economics is completely objective and is limited to the causes and effect relationship of
economic activity. It tells us why certain things happen. Normative Economics studies the
way that economic relations ought to be. It evaluates policy making, a conscious intervention
in the economy for the welfare of the people.

Thus, economics is both a positive and normative science. It not only tells us why
certain things happen, it also says whether it is the right thing to happen. For example, we
know that a few people in the world are very rich while the masses are very poor. Economics
should explain not only the causes of this unequal distribution of wealth, but it should also
say whether this is good or bad. It might well say that wealth ought to be fairly distributed.
Further, it should suggest the methods of doing it.

8
 IMPORTANCE OF ECONOMICS

Economics has become one of the important branches of social sciences. It is of great
practical value in our daily life. Economics is considered these days as one of the most
important branches of knowledge. Study of Economics is useful in several ways. Economics
has got theoretical as well as practical importance.

1. Theoretical Importance
Informative: Economics teaches us many interesting facts about man’s behaviour when he is
engaged in economic activity. We come understand the various motives which guide men in
economic affairs.
Mental training: Economic reasoning trains our mind. It enables us to think clearly and
judge correctly.
Understanding functioning of economic system: The study of economics helps us to
understand how the complicated economic system of today functions almost automatically
without any central control. Every economic disturbance somehow tends to smoothen itself
out. For example, if there is shortage of a commodity, its price will rise. This will cut down
unnecessary demand so that the demand will be brought down to the level of supply. If there
is bumper production of a commodity, then its price will go down which will create new
demand and thus the stock will be cleared. This is how economic system adjusts itself in all
spheres.
Teaches mutual dependence: Economic teaches us the important lesion of the mutual
dependence of man on man. We come to realize how we depend on others for the satisfaction
of our wants, and how others depend on us. This knowledge adds to our sense of
responsibility and understanding and thus leads to better work and a happier society.
Useful citizenship: Most of the problems of today are economic in nature. The study of
economics makes us useful and intelligent citizens. The knowledge of economics enables
everyone to perform one’s duties more intelligently and, therefore, more efficiently.

2. Practical Importance
Professional value: The study of economics is very useful in several professions. It is useful
to the bankers, to the businessmen, to the agriculturist, to the serviceman, to the workers, etc.
As a matter of fact, it is useful to all.
Useful for householders: A householder will arrange his expenditure much better if he has
studied economics. He can prepare a family budget and put his household expenditure on
rational basis.
Useful for political leaders: A political leader who knows economics is able to fight for the
rights of people more effectively. The knowledge of economics will help them in policy
planning in several problems of the country such as poverty, unemployment, etc.

9
 Chapter – 2

Nature of Economic Theory

Methodology of Economics
Economics as a science adopts two methods for the discovery of its laws and principles
(a) Deductive method:
Here, we proceed from the general to particular, i.e., we start from certain principles
that are self-evident or based on strict observations. Then, we carry them down as a process
of pure reasoning to the consequences that they implicitly contain. For instance, traders earn
profit in their businesses is a general statement which is accepted even without verifying it. It
is useful in analyzing complex economic phenomenon where cause and effect are
inextricably mixed up. However, the deductive method is useful only if certain assumptions
are valid. (Traders earn profit, if the demand for the commodity is more).
(b) Inductive method:
This method mounts up from particular to general, i.e., we begin with the observation
of particular facts and then proceed with the help of reasoning founded on experience so as to
formulate laws and theorems on the basis of observed facts. e.g. Data on consumption of
poor, middle and rich income groups of people are collected, classified, analyzed and
important conclusions are drawn out from the results.
In deductive method, we start from certain principles that are either indisputable or
based on strict observations and draw inferences about individual cases. In inductive method,
a particular case is examined to establish a general or universal fact. Both deductive and
inductive methods are useful in economic analysis.
Approaches to economic analysis
Static and Dynamic
The word 'statics' is derived from the Greek word statike which means bringing to a
standstill. It implies a state characterized by movement at a particular level without any
change. It is a state where five kinds of changes are absence. The size of population, the
supply of capital, methods of production, forms of business organization and wants of the
people remain constant but the economy continues to work at steady pace. Statics analysis
explains the static equilibrium position of the economy.

Economic dynamics, on the other hand, is the study of change. An economy may
change through time in two ways: (a) without changing its pattern, and (b) by changing its
pattern. Economic dynamics relates to the latter type of change. If there is a change in
10
population, capital, techniques of production, forms of business organization and tastes of
the people, in anyone or all of them, the economy will assume a different pattern, and the
economic system will change its direction.
Economic laws
Economic laws are the principles that govern the actions of individuals in their economic
activities. Just like any other law of science, economic laws too are conditional i.e. applicable
when certain conditions are fulfilled. Economists consider basic factors into account while
developing a theory, keeping other factors influencing theory as constant.
According to Robbins, economic laws are statements of uniformities, which govern
human behaviour concerning the utilization of limited resources for the achievement of
unlimited ends.
Characteristics of economic laws
1. Economic laws are not the Government laws: The Govt. laws are very stringent and
violation of these laws amounts to punishment. Economic laws on the other are
applicable, only if certain conditions are satisfied.
2. Economic laws are merely statement of tendencies: These are based on human
tendencies to a given phenomenon. This is the expected behaviour which is not
certain.
3. Economic laws are hypothetical: These laws hold good under the assumption of
number of things. These laws are characterised by the phrase ceteris paribus ( other
things are held constant).
4. Economic laws are positive but not normative: They only describe economic
phenomenon but do not describe how it should be.
5. Some economic laws are axiomatic in character: It means that they are self-evident
and universally valid. e.g. LDMU.
6. Economic laws lack exactness of the laws of science. Marshall said that these are the
laws of tide rather than the laws of gravitation.
Equilibrium:
It indicates ideal condition or when complete adjustment has been made to changes in an
economic conditions.

Types of equilibrium
• Stable: It tends to resume its original position.
• Unstable: Original position is never restored.
• Neutral: Disturbing forces neither bring it to the original position nor do they drive it
further away.
• Short term: Economic forces do not get sufficient time to bring complete adjustment.
E.g. supply is adjusted to change in demand.
• Long term: There is ample time to change even the means of production or resources
available. e. g. If demand increased supply is also increased.
• Partial: It relates to single individual, consumer, producer or a firm.
• General: It relates with multiplicity of variable. It covers all the organizations
functioning in the economy.

*****

11
 Chapter – 3

BASIC CONCEPT
Every science has its own language. Economics has its own language. There are
certain terms which are used in a special sense in economics. So we must understand the
meaning of some basic concepts like goods, wealth, income, value, price and market. If we
do not understand their meaning properly, it may result in a lot of confusion.

GOODS AND SERVICES

Anything that can satisfies a human want is called a good in economics. There are two
things with which he can satisfy these wants – goods and services.

Goods Services
It means the commodities that we It is any act or performance that one
use. party can offer to another.
It is almost always material. It is essentially non-material.
It is tangible. It is intangible.
It results in ownership. It dose not result in the ownership.
E.g.: land, house, foods, books, E.g.: the services rendered by doctor,
cloths, mobile, seeds, fertilizers, etc. teacher, lawyer, labourers, etc.

Classification of Goods

Free Goods Economic Goods

They are the free gifts of nature. They are produced through human
efforts.
No efforts are needed to get it. Efforts are required to get it.
No price needs to be paid. They are to be purchased at a given
price.
They are not scarce. They are scare.
Its supply is more than demand and Their supply is less than demand.
one can get to the extent they need.
They have value-in-use but no They have value in use and value-in-
value-in-exchange. exchange.
E.g.: air, sunlight, rainfall, etc. E.g.: food, cloth, car, books, etc.

Distinction between economic goods and free goods is not permanent

It is true that what is a free good in one place can become an economic good in
another place. It all depends on the supply of a good and the demand for it. For example,
sand which is a free good in riverbeds becomes an economic good in the places of house
construction activities. Similarly, water which is a free good near river or canal becomes an
economic good when there is scarcity of water and one has to pay price for that i.e., water in
a city. Thus, this distinction between economic goods and free goods is not permanent.
12
 Consumption Goods, Capital Goods and Intermediate Goods

Consumption Goods Capital Goods

They satisfy our wants directly. They are those goods that help to
produce other goods. So, they satisfy
our wants indirectly.
They are also called goods of the They are goods of second order in
first order in view of their ability to view of their ability to give indirect
give direct satisfaction. satisfaction.
They are called consumer goods. They are called producers’ good.

E.g.: food, car, cloths, books, etc. E.g.: machinery which are used to
produce a car, cloth, fertilizers, etc.

Distinction between consumption goods and capital goods is not permanent

It is true that what is a consumption good in one place can become a capital good in
another place. For example, when electricity is used for lighting purposes at home, it is a
consumption good. But the same electricity when used in factories for industrial purposes, it
becomes a capital good.

Intermediate Goods
In between the consumption goods and capital goods are the intermediate goods.
They are the raw materials used in the production of the final or consumption goods. For
example, the cloths that we wear are consumption goods; the textile machinery which is used
to make cloths is capital goods; and the cotton or silk or some synthetic fibers which are
used to make cloths are intermediate goods.

Material goods and non-material goods

Material goods Non-material goods

The goods which are tangible and They are various kinds of services. They
concrete are called material goods. are intangible, non-material and variable.
e.g.: land, house, foods, books, seeds, e.g.: the services rendered by doctor,
cloths, machinery, fertilizers etc. lawyer, labourer etc.

Transferable Goods and Non-transferable Goods

Transferable Goods Non-transferable Goods

They are goods which can change They are personal qualities which
their ownership. They can be cannot be transferred; only their
physically transferred from one place service can be used by others.
to other place; however in case of
land, physical transfer is not possible,
only ownership can be changed.
E.g.: car, book, cloths, land, patents, E.g.: skill, intelligence, degree
copyright, goodwill of a business, etc. certificate, driving license, etc.

13
 Impersonal Goods and Personal Goods

Impersonal Goods Personal Goods

The goods which are not personal, They refer to the personal qualities of
are impersonal goods. They are a person. They are what he is.
what he has.
They are also material and exist They are non-material and exist inside
outside him, therefore, they are also him, therefore, they are also called
called External Goods. Internal Goods.
E.g.: land, buildings, cloths, etc. E.g.: ability, skill, knowledge, etc.

Private Goods and Public Goods

Private Goods Public Goods

They are the property of private The goods which are common to all
individuals owned by them and are owned by society collectively.
exclusively.
They are not shared with others. Every one can use it.
E.g.: land, house, etc. E.g.: town hall, public garden, civil
hospital, railway, etc.

Mono-period Goods and Durable Goods

Mono-period Goods Durable (poly period) Goods

They are used only once to satisfy a The goods which are used once and
need. They cease to exist once their the same can be used again in future
use was over. for several times.
E.g.: foods, productive resources E.g.: land, machinery, implements, tv,
like seeds, fertilizers, etc. mobile, books, etc.

UTILITY
What is Utility?

We have seen that goods satisfy human wants. This want-satisfying quality in a
good is called Utility. Hence, utility means the power to satisfy a human want. In other
words, utility is the want satisfying power of a good.

In order to find out whether a good possess utility or not, ask a simple question:
“Does it satisfy a human want? If so, it has utility, otherwise not. Air, water, etc. (free goods)
and food, cloths, etc.(economic goods) satisfy human wants, and as such they possess utility.

Utility and Usefulness

A commodity may satisfy a human want, but may not be useful. On contrary, it may
actually be injurious e.g., opium, tobacco, poison, etc. But, because they satisfy a human
want, we say in Economics that they possess utility, even though their consumption is
injurious. The term utility as used in Economics has no ethical or moral significance. Thus, a
thing may be good or it may bad, but if it satisfies a human want, we shall say it possesses
utility.

14
 Characteristics of Utility
1. Utility is subjective
Utility is subjective to the interest of an individual. It depends on individual’s frame
of mind. Hence, a given commodity need not bring the same utility to all the consumers.
Utility varies from person to person. Example: Utility of bidi for a regular smoker is greater
than that of non-smoker.
2. Utility varies with purpose
Depending upon the purpose for which a commodity is used, utility of the same
varies. Example: Utility derived from water as drinking purpose and irrigation purpose are
different.

3. Utility varies with time

A particular commodity gives different utilities for the same person in different time
period. Cold drinks and ice-cream provide greater utility to the same person in summer than
in winter.

4. Utility varies with ownership

Ownership of good creates far greater utility from a good than that when it is hired.

5. Utility need not be synonymous with pleasure

Utility derived from a commodity need not be associated always with pleasure.
Consuming apples gives the pleasure to the consumer, while consuming medicine may not
give pleasure though it possesses utility. For example, quinine. In spite of its bitter taste,
quinine is purchased and consumed, for it does fulfill a need. Hence, utility is not the same
thing as pleasure. A thing which possesses utility may be pleasurable or it may not give
any pleasure.

6. Utility does not mean satisfaction

Utility is not satisfaction by itself. Utility is quality of a good by virtue of which it

gives satisfaction to an individual. To say that a mango gives utility is incorrect. We should
say, it possesses utility or it gives satisfaction. A thing possesses utility but it gives
satisfaction.

Kinds / types / Forms of utility

Form Utility
By changing the form of a good, great utility can be created. Examples: processing of
paddy into rice, cotton into cloths, groundnut into oils, etc.

Place Utility
By virtue of its position in area, the commodity will have different utilities. Such
utility is called place utility. Moving a good from one place or market to another place or
market increases its utility. Example: Apples from Himachal Pradesh, the area of abundant
production are transported to western and southern parts of the country (non-producing area),
hereby increasing the utility of apples.

Time Utility
Any time lag between production and consumption of commodities creates time
utility. Through storage over time, greater utility is created for the products. Storage helps to
15
create time utility. Example: Agricultural commodities like paddy, wheat, etc, are stored to
make them available for the regular use of consumers throughout the year. In doing so, higher
utility for commodity is imparted which we call time utility. Similarly, Utility of umbrella in
rainy season is higher than that is in winter season.

Possession Utility
Commodities in the transaction process change the hands from one person to another
person. Commodities in the hands of producers have some utility and by the time they reach
consumers their utility in increased. Such utility due to possession or transfer of ownership of
commodity is called possession utility. Example: Utility of Medicines for a patient is much
higher than that of its producer. Similarly, Utility of milk for a child is higher than that of its
producer (milkman).
VALUE

Meaning of Value
Value is of two kinds (1) value–in–use and (2) value–in– exchange.
Value-in-use
We often say education has great value or that fresh air, sunshine, rain are very
valuable. Here the term ‘value’ is used in the sense of usefulness. This is value-in-use for
which economists use the term ‘utility’.

Value-in-exchange
In Economics, the term ‘value’ is used in the sense of value-in-exchange’. Thus, in
Economics, the term ‘value’ refers to the exchange qualities of a good. Value of a commodity
refers to the goods that can be obtained in exchange for it. We cannot exchange fresh air for
anything; its value in economic sense is, therefore, zero even though it is otherwise so
valuable.
The value of a commodity, thus, means the commodities or services that we can get in
return for it; it is, in short, its purchasing power in terms of other commodities or services; it
is its power of commanding other things in exchange for itself.

Attributes of Value
It is clear, then, that in order to have value in the market; a commodity must not be a
free good. Only economic goods can have value in the economic sense. Three qualifications
are thus essential for a good before it can have value:
1. It must possess utility;
2. It must be scare in relation to demand; and
3. It must be transferable or marketable.
All these three qualities are required together. In absence of any one of these
qualities, a good will have no value at all. For example, air possesses utility, but it is not
scare. Rotten eggs may be scare; but since they possess no utility. A book has utility; it is also
scare and it is transferable. Hence, in economics, air and rotten eggs have no value; while
book has value.

Value is relative term

Since ‘value’ in Economics means value-in-exchange, it must be relative. It cannot be
absolute. It is impossible to speak of the value of a commodity in an absolute manner
independently of anything else.

16
 For example, to say that the value of a book is great, gives an idea of its utility only.
To talk of the value of a book, in economic sense, we must relate it to something else which
we can get in exchange for it. Say, value of a book is Rs. 100 or say value of a book is equal
to value of 5 kg rice.

Value equates certain commodities, i.e., a book may fetch 5 kg of rice. It expresses
relationship between two commodities, it relates one to other. That is why value is said to be
relative. If value of a book increase, it may fetch >5 kg of rice; while if value of rice
increases, a book may fetch <5 kg of rice.

PRICE
What is Price?
Value is not the same thing as price. When value is expressed in terms of money, it
is called price.
In pre-historic times, people did not know the use of money. They exchanged goods
for other goods. This system is called barter. In modern times, however, goods are ordinarily
exchanged for money. Therefore, the price of a commodity today means its money-value.
Price expresses value of a commodity in terms of money.
Generally, economists make no distinction between value and price. All prices are
related to one another. They form the price system. It plays a very important role in a
capitalistic economy. Buyers express their desire for goods only through prices. Every price
we pay for a good is a vote in favour of it. It is the price system that regulates the economic
activity of a society.

MONEY
What is money?

It refers to anything which is generally accepted as a medium of exchange.

WEALTH and WELFARE

What is wealth?
In ordinary speech, when we refer to wealth, we mean money or riches. But in
economics, it has a special meaning. It refers to those scarce goods which satisfy our wants
and which have money value. Anything which has money value is wealth. All economic
goods have value–in–exchange. So wealth includes all economic goods. In Economics the
term ‘wealth’ is synonymous with economic goods. Wealth has been defined as “stock of
goods existing at a given time that have money value”. Thus, in economics, every man,
even the poorest of the poor, possesses some wealth.

Attributes of Wealth or Characteristics of Wealth

There are three attributes of wealth as in the case of value; Utility, Scarcity and
Transferability or Marketability. Three qualifications are thus essential for a good before it
can be considered as wealth:

1. It must possess utility.

It must have the power to satisfy a want.
2. It must be scare.
For example, air and sunshine are essential for life. We cannot live without them.
But we do not consider them as wealth because they are available in large quantities. Such
goods are known as free goods. The goods which are scare are wealth.

17
3. It must be transferable.
That is, it should be possible for us to transfer the ownership from one person to
another. Land, buildings, machinery, etc. are examples of wealth. Degree certificate, skill of
doctor, artists, cricket, etc. is non-transferable; hence they are not considered as wealth
though they are source of wealth. But the good will of a company is transferable; hence, it is
a wealth.
What is welfare?
Welfare is the well being of individual or community. It refers to the condition of
mind. Hence, any good whether it is free or economic, is counted as long as it leads to
welfare. Hence, Welfare = Wealth (all economic goods) + All Free goods.

Wealth and Welfare are two different aspects having relationship. All economics
goods are wealth. Free goods have no place while representing wealth. Wealth is a path for
welfare, as all our desires are satisfied by means of wealth.

Money and wealth

All money is wealth but all wealth is not money. As wealth consists of all kinds of
property, some of them is not acceptable as medium of exchange or not transferable in
money.

Wealth and Income:

The amount of money which wealth yield is called income. Wealth is a fund and income is a
flow e.g. A person is having Rs. 2 lakhs i.e. wealth. By investing this amount, he earns Rs.
10,000 as interest. This is his income.

Distinction may also be made between money income and real income. Income of a person
expressed in terms of money per month or year is his money income while the amount of
goods and services he purchases with his money income is known as real income.A part of
current income is consumed and a part is saved or invested.

The excess of income over consumption is the saving. Investment means an addition
made to nation’s physical stock of capital like building, new machines, finished and semi
finished goods.

Y = C + S and Y = C + I where S = I

Classification of wealth
Wealth can be classified as follows:

(1) Individual wealth: The wealth of an individual consists of his property like cash, land,
buildings, livestock and goodwill of business which commands a price in the market.
(2) Personal wealth: Personal qualities like skill, ability and intelligence.
(3) Social or communal wealth: It consists of state, municipal or social properties like dams,
canals, state and museums.

(4) National wealth: Narrowly speaking it consists of the aggregate wealth of all citizens,
excluding the debts. In the wider sense, it includes rivers, mountains, high character of people
etc.
(5) Cosmopolitan wealth: It is the wealth of the whole world.

18
(6) Negative wealth: This refers to debts owned by individuals or state. If something is a
nuisance like wild pigs, or stray cattles damaging the crops, it may be regarded as negative
wealth.
(7) Representative wealth : Documents of title, documents of property, insurance policy etc
are representative wealth.

HUMAN WANTS
What is Human Wants?
Want means desire. Human wants mean human desire. “Man is a bundle of desire”.
His wants are infinite in variety and number. Wants vary from person to person. Food, shelter
and cloths are the basic wants. These are the bare necessaries of life. The struggle now is for
comforts and joy. As man becomes more civilized, his wants multiply. He wants better food,
fashionable clothing, comfortable housings, higher education, entertainments, etc.
Characteristics of Human wants
1. Human wants are unlimited
There is no end to human wants. When one want is satisfied, another crops up. The
never-ending cycle of wants goes on and on. Human wants keep on multiplying.
2. Any particular want is satiable
Although wants in aggregate are unlimited, yet it is possible to satisfy a particular
want, provided one has the means.
3. Wants are Complementary
It is common experience that we want things in groups. For, example, if we want to
write a letter, we want paper and pen. Paper alone is not enough. Thus, a car needs petrol,
oil, etc. before it starts working. Thus, wants are complementary.
4. Wants are competitive
We all have a limited amount of money at our disposal, whereas we want so many
things at the same time. We cannot buy them all. We must, therefore, choose between
them by accepting some and rejecting others. Thus, there is competition between the
various wants that we want to satisfy.
5. Some wants are both complimentary and competitive
For example, Factory manager wants machinery and labour. Machinery competes
with labour; and up to some extent they also complement each other.
6. Wants are alternative
There are several ways of satisfying a particular want. If we feel thirsty, we can
have water, soda, sarbat, lassi, thumps-up, pepsi, etc.
7. Wants vary with time, place and person
Different people want different things and the same person wants different things at
different time and in different places.
8. Wants vary in urgency and intensity
Some wants are more urgent and intense than others. These are generally satisfied
first, while others are given next priority / postponed.
9. Wants multiply with civilization
As civilization spreads among peoples, their wants also go on increasing.
10. Wants recur

19
 Most of the human wants are of recurring nature. For example, food, drink,
entertainment, etc. We eat something when we feel hungry. It will not last for ever. After
some hours, we again feel hungry and want some food again and again.
11. Wants change into habits
If a particular want is regularly satisfied, a person becomes used to it and it grows
into habit. For example, smoking, drug addiction, etc.
12. Wants are influenced by income, salesmanship and advertisement
It is obvious that if income is higher, more wants can be satisfied, and a poor man
cannot simply afford to have many wants. Besides, we do not always buy the things we
need. We often induced to buy particular brands or products by persuasive salesmen or
clever advertisement even though better alternatives may be available.
13. Wants may be the result of custom or convention
More or less, we all are slaves of custom. Many of our wants are conventional.
Whether, we like it or not, we have to spend a lot of money on social ceremonies.

Classification of Wants
WANTS

Necessaries Comforts Luxuries

Necessaries of Existence
Necessaries of Efficiency
Conventional Necessary

1. Necessaries
They may be sub-divided as:
1. Necessaries of Existence: These are the things without which we cannot exist, e.g.,
food, cloths, shelter, etc.
2. Necessaries of Efficiency: Some goods may not be necessary to enable us to live, but
necessary to make us efficient workers. A pen is necessary for student.
3. Conventional Necessary: These are the things which are forced to use either by
social custom or because of the people around us expect us to do so. Example: need of
black coat for lawyer.
2. Comforts
Having satisfied our wants for the necessaries of life, we desire to have some
comforts too. For a student, a book is a necessity, table and a chair are necessaries of
efficiency; but cushioned chair is a comfort.
3. Luxuries
Man does not stop even at comforts. After comforts have been provided he wants
luxuries too. ‘Luxury’ has been defined as a superfluous consumption, something we could
easily do without. Example: costly furniture, luxurious car, etc. For a college student, a fen in
summer is a comfort; but air-conditioner is a luxury.

20
Necessaries, Comforts and Luxuries are relative term

We cannot attach permanent and fixed labels of necessaries, comforts or luxuries to

commodities. We cannot say that car is always a luxury. The same thing may be a necessary
under one set of conditions and a luxury under others. For example, a car for a doctor is
necessary, but for a teacher it is comfort; while for a labour it is luxury. Today what may be a
luxury can become a necessary in future. In same manner, what may be regarded as a luxury
in India may be a necessary in England. Thus, necessaries, comforts and luxuries are relative
to person, time and place.

Comparison / difference

Necessaries of Efficiency Comforts

(1) Necessary to make us efficient workers (1) Make for fuller life, enjoyments etc.

(2) Benefit from money spent is more (2) Benefit from money spent is less

Comforts Luxuries
(1) Comforts make for a fuller life, (1) It is a superfluous consumption, something
enjoyment we could easily do without it.

(2) Money spent on comforts brings (2) Expenditure on luxuries brings negligible
some compensation return. There may be a loss or harm.

21
 Chapter – 4

AGRICULTURAL ECONOMICS

What is Agricultural Economics?

Agriculture
• The word agriculture comes from the Latin words ager, referring to the soil and
cultura, to its cultivation.
• Agriculture in its widest sense can be defined as the cultivation and/or production of
crop plants or livestock products.
• It is synonymous with farming: the production of field dependent production of food,
fodder and industrial organic material.
Economics
• Economics is the science that studies as how people choose to use scare productive
resources (like land, labour, capital and organiser) to produce various goods and to
distribute these goods to various members of the society for their consumption.

Agricultural Economics
• Agricultural economics is an applied field of economics in which the principles of
choice are applied in the use of scare resource such as land, labour, water, seeds,
fertilizers, etc. in farming and allied activities.
• It deals with the principles that help the farmer in efficient use of land, labour and
capital.
• Its role is evident in offering practicable solutions in using scare resource of the
farmers for maximization of income.
Definitions
1. Prof. Gray has defined agricultural economics as “The science in which the
principles and methods of economics are applied to the special conditions of
agricultural industry”.
2. According to Prof. Hibbard “Agricultural economics is the study of relationships
arising from the wealth-getting and wealth-using activity of man in agriculture”.
Thus, agricultural economics deals with the problems of the farms as the units of
industry, the income earning and spending activities of the farmers and also the management
of farm business and bringing necessary changes according to the situation so as to bring
stability to farm income.
Importance
• Agricultural Economics uses theoretical concepts of economics to provide answers to
the problems of agriculture and agri-business. Initially earnest efforts were made by
the economists to use the economic theory to agricultural problems. Now the subject
of agricultural economics is enriched in many directions and fields taking the relevant
tools of science particularly mathematics and statistics.
• Agriculture is the integral part of world food system having the foundation link
between crops and animal production system. Agricultural economists here have to
play a major role in understanding the foundation systems.
• The student of agricultural economics should have a clear insight and understanding
of the influences of climatic conditions in determining as to how the commodities are
produced and marketed in line with the consumption needs. Knowledge regarding
problems in production, finance, marketing and Government policies and their impact
on production and distribution is very essential to find out suitable solutions.

22
Major Fields of Agricultural Economics

1. Microeconomics
• Basic Concepts
• Consumer Behaviour
o Theory of Demand
o Theory of Supply
• Theory of Production
• Theory of Cost
• Market Structure
• Theory of Distribution
2. Macroeconomics
• National Income
• Money
• Public Expenditure
• Public Revenue
• Unemployment
• Trade Cycle
• Inflation
• Poverty
3. Agricultural Production Economics
• Laws of Returns
• Returns to Scale
• Factor-Product Relationship
• Factor-Factor Relationship
• Product-Product Relationship
4. Farm Management
• Types of Farming
• Types of Farm Business Organization
• Farm Planning
• Farm Budgeting
• Farm Records, Accountancy and Inventory
• Farm Efficiency Measures
• Risk and Uncertainty
5. Agricultural Finance
• Problems of Agricultural Finance
• Institutional Agencies in Farm Credit
• Tests of Farm Credit Proposals
• Tools of Farm Financial Analysis
• Agricultural Projects
6. Agricultural Marketing
• Marketing Functions
• Marketing Efficiency
• Marketing Channels
• Agricultural Prices
• Problems of Agricultural Marketing
• Role of Government in Agricultural Marketing

23
Characteristics of Agriculture
1. Perishability of the product
2. Seasonality of production
3. Bulkiness of products
4. Variation in quality of products
5. Irregular supply of agricultural products
6. Small size of holdings and scattered production
7. Processing

The contribution of agriculture to economic development is as follows

1. It provides food to the rapidly expanding population.
2. It increases the demand for industrial products and thus helps in the expansion of other
sectors.
3. It provides additional foreign exchange earnings for the import of capital goods for
development through increased agricultural exports.
4. It increases the rural income.
5. It increases the employment opportunities.
6. It improves the welfare of the rural people.

*****

24
 Chapter – 5

DEMAND
What is Demand?

Demand is defined as the quantity of a good or service that consumers are willing and
able to buy at a given price in a given time period.

It is necessary to distinguish between demand and desire or need. Demand in

economics must be effective. It means that when a consumers' desire to buy a product is
backed up by an ability and willingness to pay for it, then only it actually effect the market.
If a person below poverty line wants to buy a car, it is only a desire but not a demand as he
cannot pay for the car. If a rich man wants to buy a car, it is demand as he will be able to pay
for the car. Thus, desire backed by willingness and ability to pay is called demand.

Demand Function

The demand for any commodity mainly depends on the price of that commodity. The
other determinants include price of related commodities, the income of consumers, tastes and
preferences of consumers, and the wealth of consumers. Hence the demand function can be
written as under:

Dx = f (Px, Ps, Y, T, W)

Where,
Dx represents demand for good x
Px is price of good X
Ps is price of related goods
Y is income
T refers to tastes and preferences of the consumers
W refers to wealth of the consumer.

Types of Demand

There are three kinds of demands: Price Demand, Income Demand and Cross Demand.

1. Price Demand

Price demand refers to the various quantities of a commodity or service that a

consumer would purchase at a given time in a market at various hypothetical prices. It is
assumed that other things, such as consumer’s income, his taste and price of inter related
goods remain unchanged.

The demand of the individual consumer for a particular good or service at different
prices is called Individual Demand. The sum of the individual demand for a product in the
market is called Market Demand.

2. Income Demand
It refers to the various quantities of a good or service which would be purchased by
the consumers at various levels of income here we assume that the price of the commodity or
service as well as the prices of inter related goods and the taste and desires of consumers do
not changed. The Income Demand shows the relation between income and the quantities
demanded.

25
3. Cross Demand

It means the quantity of good or service which will be demanded with reference to
change in price not of this good but of other inter-related goods. These goods are either
substitutes (e.g., tea and coffee) or complementary (e.g. tractor and trailer) goods. A change
in price of tea, for instance, will affect the demand of coffee. A change in price of tractor will
affect the demand of trailer.

The Law of Demand

Other factors remaining constant (ceteris paribus) there is an inverse relationship

between the price of a good and its demand. Demand varies inversely with price, not
necessarily proportionately. If the price falls, demand will extend and vice-versa. Demand
thus is a function of price. i.e. it varies with price. It can be expressed as:
D = F (P)
Where,
D = Demand
P = Price

The ceteris paribus assumption

Understanding ceteris paribus is the key to understanding much of microeconomics.
Many factors can be said to affect demand. Economists assume all factors are held constant
except one–the price of the product itself. Thus, the assumptions of the law are:
1. No change in the consumer’s income
2. No change in consumer’s tastes and preferences
3. No changes in the prices of inter-related goods
4. No new substitutes for the goods have been discovered
5. Change in the price should not be anticipatory due to the fact that either on account of
the danger of war or widespread failure of rains.
6. The use of a commodity does not confers distinctions.
Demand Schedule
Demand schedule is a tabular statement showing how much of a commodity is
demanded at different prices. Table 2.1 is a hypothetical demand schedule of an individual
consumer. It shows a list of prices and corresponding quantities demanded by an individual
consumer. This is an individual demand schedule.

Individual Demand Schedule

Price (Rs./unit) Quantity Demanded (units)
5 10
4 20
3 30
2 40
1 50

26
 Market Demand Schedule
Price of Qty Qty Qty Total Qty.
(Rs./unit) Demanded Demanded Demanded Demanded
by “A” by “B” by “C”
5 10 15 0 25
4 20 25 5 50
3 30 35 10 75
2 40 45 15 100
1 50 55 20 125

Practical utility of a demand schedule

It is not possible to construct the demand schedule accurately even though it is useful
in the following ways.

1) All the businessmen make their forecast of quantity they could dispose of at different
prices and accordingly they forecast profit and also it helps in arranging production
level.

2) In order to find out the effect of different rates of taxes on the sale of commodity, a
finance minister takes the help of demand schedule. Imposition of tax is bound to
raise price, which would reduce demand while the government revenue depends on
how much actually sold.

Demand Curve
The demand schedule can be converted into a demand curve by measuring price on
vertical axis and quantity on horizontal axis as shown in the figure below.
6

5
Price (Rs./unit)

Demand Curve
4

0
0 10 20 30 40 50 60
Qty Demanded (units)

Fig. 1: Demand Curve

A demand curve shows the relationship between the price of an item and the quantity
demanded over a period of time. The curve slopes downwards from left to right showing that,
when price rises, less is demanded and vice versa. Thus the demand curve represents the
inverse relationship between the price and quantity demanded, other things remaining
constant.

27
 The demand curve is normally drawn in textbooks as a straight line suggesting a
linear relationship between price and demand but in reality, the demand curve will be non-
linear! No business has a perfect idea of what the demand curve for a particular product looks
like, they use real-time evidence from markets to estimate the demand conditions and this
accumulated experience of market conditions gives them an advantage in constructing
demand-price relationships.

Individual Demand Schedule

Price (Rs./unit) Qty Demanded (units)
1 100
2 80
3 65
4 55
5 47
6 40
7 34
8 29
9 25
10 22
11 20

12

10 Demand Curve

8
Price (Rs./unit)

0
0 20 40 60 80 100 120
Qty. Demanded (units)

Fig. 2: Normal Demand Curve

Why demand curve slopes downward?

Generally, the demand curve slops downwards. This is in accordance with the law of
diminishing marginal utility. The purchases of most of us are governed by this law. When the
price falls, new purchasers enter the market and old purchasers will probably purchase more.
Since, this particular commodity has become cheaper, it will be purchased by some people in
preference to other commodities.

Why people buy more when the price falls?

28
 1. A unit of money goes farther and one can afford to buy more. He is willing and able
to buy more because the thing being cheaper, his real income (i.e. income in terms of
goods) increases. It is called Income Effect

2. When the commodity becomes cheaper, it tends to be substituted wholly or partly for
other commodities. This is called Substitution Effect.

3. A commodity tends to be put to more uses or less urgent uses when it becomes
cheaper. For example, if water is dear, we shall use it for drinking only; but when it
becomes cheaper, we shall use it for washing and other less urgent uses.

Exceptions to the Law of Demand

As we have said above, generally the demand curve slops downwards to the left. But
sometimes the demand curve, instead of sloping downward, will rise upwards. In other
words, sometimes people will buy more when the price rises. This can be represented by a
rising demand curve. Such cases are very rare, but we can imagine some. The following is the
list of few exceptions to the law of demand.

Price

P’

O Q’ Q Quantity Demanded

Fig. 3: Exceptions to the Law of Demand

(1) Veblen Effect

Veblen has pointed out that there are some goods demanded by very rich people for
their social prestige. When price of such goods rise, their use becomes more attractive and
they are purchased in larger quantities. Demand for diamonds from the richer class will go up
if there is increase in price. If such goods were cheaper, the rich would not even purchase.

(2) Giffen Paradox

Sir Robert Giffen discovered that the poor people will demand more of inferior goods
if their prices rise and demand less if their prices fall. Inferior goods are those goods which
people buy in large quantities when they are poor and in small quantities when they become
rich. For example, poor people spend the major part of their income on coarse grains (e.g.
ragi, kodra, bavta) and only a small part on rice. When the price of coarse grains rises, they
will buy less rice. To fill up the resulting gap, more of coarse grains have to be purchased.
Thus, rise in the price of coarse grains results in the increase in quantity of coarse grains
purchased. This is called ‘Giffen Paradox’. In these cases, the law of demand has an
exception.

29
(3) When a serious shortage is feared, people may be in get panic and buy more even though
the price is rising. They are anxious to avoid the necessity of having to pay a still higher price
in future.

(4) Sometimes, people buy at a higher price in sheer ignorance.

Change in Demand (Extension / Contraction of Demand)

The demand curve does not change its position here. When change in demand for a
commodity is entirely due to a change in its price, it is called extension or contraction of
demand. The extension or contraction in demand are movements on or along the given
demand curve. It is shown in Fig. 4.

Price D

P’
P

P”
QQ” is Extension of Demand
QQ’ is Contraction of Demand

O Q’ Q Q” Quantity Demanded

Fig. 4: Changes in Demand

When the price of a good is OP, demand is OQ. If the price of good falls to OP”,
demand expands to OQ”. Thus extension in demand is QQ”. On the other hand, when the
price of good rises to OP’ demand contracts to OQ’. Thus contraction in demand is QQ’.

Shift in Demand (Increase / Decrease in Demand)

One of the basic assumptions of economic theory is ‘other things being equal’. Other
things are income, tastes, population, government policy, technology, price of related goods
etc. Change in such factors will bring about increase or decrease in demand. In Fig.5, the
increase in demand is shown by the shifts of the demand curve to the right from D to D’ and
D”. The increase in demand is shown by the shift to the right from D to D’ and QQ’
indicates increase in demand. The decrease in demand is shown by the shift to the left from D
to D” and QQ” indicates decrease in demand.
D’
Price D
D”

QQ’ is Increase in Demand

QQ” is Decrease in Demand

O Q” Q Q’ Quantity Demanded

Fig. 5: Shifts in Demand

30
Factors determining demand

The following are the factors that bring change in demand either increase or decrease.

1) Change in fashion: When some goods go out of fashion, they will be less in demand
even though they may become cheap

2) Change in weather: Demand change when the weather changes. A fall in the price of
woolen clothes does not increase their demand in summer.

3) Change in the quantity of money in circulation: If the quantity of money in circulation

increases, the people will have more purchasing power and consequently demand will
increase and vice versa.

4) Change in population: A change in size or composition of population will bring about a

change in demand. If birth rate increase, more toys and perambulators will be demanded,
country with old men will demand more walking sticks, false teeth and medicines.

5) Change in wealth distribution: Suppose wealth is distributed more evenly then the
demand for necessaries and comfort commonly used by poor people will increase, while
demand for luxuries will fall.

6) Change in real income: Increase in real income means things is cheap and with the same
money/income people are able to buy more goods.

7) Change in habit, test and customs: Demand also depends on the tastes, habits and
custom of a commodity. For example, if people develop tastes for tea in place of lassi, the
demand for tea will increase.

8) Technical progress: Inventions and discoveries bring new things in the market and
therefore demand for old things decline. For example, radio sets replaced gramophones
and TV sets are replacing radio sets.

9) Discovery of cheap substitutes: Manufacture of vegetable ghee has made available a

cheap substitute for ghee and therefore demand for pure ghee has decreased

10) Advertisement: A clear and persistent advertisement may create a new type of demand.

Inter-related Demand

Direct demand
The demand for the ultimate object e.g. demand for house, a cup of tea, ice cream is
called direct demand

Derived demand
The demand for various kinds of labour and materials which go to make the final
product is called derived demand e.g. the demand for new bricks, iron, cement is strongly
linked to demand of new buildings.

31
 The demand for new bricks is derived from the demand for the new
housings. When there is a boom in the construction industry, the
market demand for bricks will increase.

Joint demand
When several things are demanded for a joint purpose, it is a case of joint demand.
Milk, sugar and tea leaves are wanted for making a tea.

Composite demand
The demand for a commodity that can be put to several uses is a composite demand.
Coal can be used for heating, cooking and for a running steam engine etc. Similarly milk can
be used for making different dairy products like penda, cheese, curd, ice-cream etc.
Latent Demand
It is probably best described as the potential demand for a product. It exists when
there is willingness to buy among people for a good or service, but where consumers lack the
purchasing power to be able to afford the product. Latent demand is affected by advertising–
where the producer is seeking to influence consumer tastes and preferences.

Speculative Demand
The demand for a product can also be affected by speculative demand. Here,
potential buyers are interested not just in the satisfaction they may get from consuming the
product, but also the potential rise in market price leading to a capital gain or profit.
When prices are rising, speculative demand may grow, adding to the upward pressure on
prices. The speculative demand for housing and for shares might come into this category.

*****

32
 Chapter – 6

UTILITY THEORY

Concept of Utility
In the ordinary language, ‘utility’ means ‘usefulness’. In Economics, utility is defined
as the power of a commodity or a service to satisfy a human want. Utility is a subjective or
psychological concept. The same commodity or service gives different utilities to different
people. For a vegetarian, mutton has no utility. Warm clothes have little utility for the people
in hot countries. So utility depends on the consumer and his need for the commodity.

Total Utility
Total Utility refers to the sum of utilities of all units of a commodity consumed. For
example, if a consumer consumes ten biscuits, then the total utility is the sum of satisfaction
of consuming all the ten biscuits.

Marginal Utility

Marginal Utility is the addition made to the total utility by consuming one more unit
of a commodity. For example, if a consumer consumes 10 biscuits, the marginal utility of
10th unit is nothing but the total utility of 10 biscuits minus the total utility of 9 biscuits.
Law of Diminishing Marginal Utility
The law of diminishing marginal utility explains an ordinary experience of a
consumer. If a consumer takes more and more units of a commodity, the additional utility he
derives from an extra unit of the commodity goes on falling. Thus, according to this law, the
marginal utility decreases with the increase in the consumption of a commodity. When
marginal utility decreases, the total utility increases at a diminishing rate.

Definition According to Marshall, “The additional benefit which a person derives

from a given increase of his stock of a thing diminishes with every increase in the stock that
he already has”.

Explanation
Suppose Mr. X is hungry and eats apple one by one. The first apple gives him great
pleasure (higher utility) as he is hungry; when he takes the second apple, the extent of his
hunger will reduce. Therefore he will derive less utility from the second apple. If he
continues to take additional apples, the utility derived from the third apple will be less than
that of the second one. In this way, the additional utility (marginal utility) from the extra units
will go on decreasing. If the consumer continues to take more apples, marginal utility falls to
zero and then becomes negative.
For example, the utility derived by a person from successive units of consumption of
apples is as under.

Units of apple Total Utility Marginal utility

1 20 20
2 35 15
3 45 10
4 50 5
5 50 0
6 45 -5
7 35 -10
33
 Law of Dimishing Marginal Utility

60
50
40
30

Utility
Total Utility
20
Marginal Utility
10
0
-10 1 2 3 4 5 6 7

-20
Units of Commodity

From the above table and figure, it is very clear that the marginal utility (addition
made to the total utility) goes on declining. The consumer derives 20 units of utility from the
first apple he consumes. When he consumes the apples continuously, the marginal utility falls
to 5 units for the fourth apple and becomes zero for the fifth apple. The marginal utilities are
negative for the 6th and 7th apples. Thus when the consumer consumes a commodity
continuously, the marginal utility declines, reaches zero and then becomes negative.

The total utility (sum of utilities of all the units consumed) goes on increasing and
after a certain stage begins to decline. When the marginal utility declines and it is greater than
zero, the total utility increases. For the first four units of apple, the total utility increases from
20 units to 50 units. When the marginal utility is zero (5th apple), the total utility is constant
(50 units) and reaches the maximum. When the marginal utility becomes negative (6th and
7th units), the total utility declines from 50 units to 45 and then to 35 units.

Relationship between Total Utility and Marginal Utility

S.No. Total Utility Marginal Utility

1 Increases Declines
2 Reaches maximum Reaches zero
3 Declines Becomes negative

Importance

1. The Law of Diminishing Marginal Utility (DMU) is the foundation for various other
economic laws. For example, the Law of Demand is the result of the operation of the
Law of Diminishing Marginal Utility. In other words, as more and more units of a
commodity are consumed, each of them gives less and less marginal utility. This is

34
 due to the operation of the Law of DMU. As utility falls, consumer is therefore
willing to pay a lower price only.
2. The Law of DMU operates in the case of money also. A rich man already possesses a
lot of money. If more and more money is newly added to his income, marginal utility
of money begins to fall. Alfred Marshall assumed that the marginal utility of money
remains Constant
3. This law is a handy tool for the Finance Minister for increasing tax rate on the rich.
4. Producers are guided by the operation the Law of DMU, unconsciously. They
constantly change the design, the package of their goods so that the goods become
more attractive to the consumers and they appear as ‘new goods’. Or else, the
consumers would think that they are using the same commodity, over and over. In
such a situation, the Law of DMU operates in the minds of the consumers. Demand
for such commodities may fall.

Assumptions

1. The units of consumption must be in standard units e.g., a cup of tea, a bottle of cool
drink etc.
2. All the units of the commodity must be identical in all aspects like taste, quality,
colour and size.
3. The law holds good only when the process of consumption continues without any
time gap.
4. The consumer’s taste, habit or preference must remain the same during the process of
consumption.
5. The income of the consumer remains constant.
6. The prices of the commodity consumed and its substitutes are constant.
7. The consumer is assumed to be a rational economic man. As a rational consumer, he
wants to maximize the total utility
8. Utility is measurable.

Criticism / Limitations
1. Deriving utility is a psychological experience, when we say a unit of X gives ten units
of utility, this means that utility can be measured precisely. In reality, utility cannot be
measured. For example, when a person sees a film and says it is very good, we cannot
measure the utility he has derived from it. However, we can measure utility indirectly
by the cinema fare he is willing to pay.
2. The Law is based on a single commodity consumption mode. That is, a consumer
consumes only one good at a time. This is an unrealistic assumption. In real life, a
consumer consumes more than one good at a time.
3. According to the Law, a consumer should consume successive units of the same good
continuously. In real life it is not so.
4. The Law assumes constancy of the marginal utility of money. This means the
marginal utility of money remains constant, even when money stock changes. In real
life, the marginal utility derived from the consumption of a good cannot be measured
precisely in monetary terms.
5. As utility itself is capable of varying from person to person, marginal utility derived
from the consumption of a good cannot be measured precisely.

35
Law of Equi – marginal Utility
This law is also known as the law of substitution. “The law implies that if a person
has a thing which he can put to several uses, he will distribute it between those uses in such a
way that it has the same marginal utility in all” (Marshall). A consumer generally is
confronted with the problem of buying from among several goods and services, given his
limited income. He is left with the choice making, regarding purchase of commodities and
their quantities so that the purchases that are decided upon ensure him maximum satisfaction.
Here, the consumer aims at maximizing total utility by consuming possible goods and
services given the income constraint. In this process the consumer substitutes the goods
having greater utility for those which have lesser utility. This process is continued till the
marginal utilities of the commodities purchased are equalized. Hence the name, the law of
equimarginal utility.
Assumptions
Before explaining the law, the following assumptions are made.
1. The consumer behaves rationally.
2. He has full knowledge about the commodities, their attributes, prices, etc., in the
market.
3. Utility is measurable cardinally in terms of utils.
4. Commodities that are choosen are divisible and substitutable.
Explanation of the Law
Given the income constraint, the consumer makes prudent decisions in his purchases
such that the allocation so made ensures him maximum satisfaction. Let us assume that the
consumer has got Rs. 25 to spend. He has the options of spending this amount on three
vegetables viz., potato, tomato and ridge gourd. The marginal utilities that are derived from
the consumption of these vegetables and the amounts of money spent are presented in table.
The marginal utilities are derived from the consumption of three vegetables by spending a
unit of money (each unit of money is equal to Rs. 5). First unit of Rs. 5 on potato gives a
marginal utility of 19 utils, second unit 16 utils, third 14 utils and so on. Now to maximize
the satisfaction from the three vegetables the consumer has to spend Rs. 25 in such a way that
the marginal utility of the last unit of money is equal in all uses. Given the marginal utilities
derived from the three vegetables, the consumer has to spend first three units on tomato, one
unit each on potato and ridge gourd respectively. The total utility through this combination
would be 100 (22 + 21 + 20 + 19 + 18). No other combination of vegetables gives as high as
100 utils.
Equi – marginal Utility

No. of units Marginal utilities per unit of Rs. 5

(Rs. 5 per Potato Tomato Ridge gourd
unit)
1 19* 22* 18*
2 16 21* 17
3 14 20* 15
4 10 16 12
5 5 14 11
* Indicates units of money spent on vegetables

36
This combination is going to hold good till some changes occur either in the price or his
income or his tastes. This law is also called as the principle of proportionality, as the
consumer allocates his expenditure in such a way that the marginal utilities of the goods
purchased would be in proportion to their prices. Consumer attaining equilibrium by
spending his limited money is shown below:

MU of X MU of Y MU of Z
= = =K
Price of X Price of Y Price of Z

Practical Importance of Law of Equi – marginal Utility

1. Consumption: A rational consumer follows this law, while planning his expenditure. He
spends in such a way that marginal utility derived from each unit of money gives nearly
equal utility in the various goods he purchases.
2. Production: A rational producer allocates his limited resources among various possible
enterprises in such a way that the marginal value product derived from each unit of
resource on various enterprises are the same.
3. Marketing: The consumer should keep in mind that marginal utility of the commodity and
price of the commodities should be equal in purchasing the commodities from the
markets. Thus this law guides the consumers to spend the given amount efficiently on
different goods which provide utilities.
4. Distribution: The share of each factor of production is determined on the basis of marginal
value productivity.
5. Prices: When the price of a commodity goes up in view of shortfall in supply, consumer
prefers that commodity which is relatively less scarce. This preference of consumer brings
down the price of the commodity.

Limitations of the Law

It needs a very careful scrutiny by the consumer regarding prices of various commodities
and their substitutes. More often, the expenditure pattern is influenced by the habits, except in
the case of very high priced goods for which certain amount of thinking goes before taking
buying decisions. Another limitation for the operation of the law is indivisibility of certain
goods which would not permit the equalization of marginal utilities. Further, it is possible
that buying decisions are influenced by advertisement in which case rationality criterion may
not be followed.

Consumer Equilibrium

The term consumer’s equilibrium refers to the amount of goods and services which the
consumer may buy in the market given his income and given prices of goods in the market.
The aim of the consumer is to get maximum satisfaction from his money income. In simpler
words, consumer equilibrium is the point at which a consumer reaches optimum utility, or
satisfaction, from the goods and services purchased given the constraints of income and
prices. Consumer is in equilibrium position when marginal utility of money
expenditure on each good is the same.

37
Derivation of Demand Curve

The law of demand or the demand curve can be derived wit h the aid
of law of diminishing marginal utility. The law of diminishing marginal
utility states that as the quantity of a good with a consumer increases,
marginal utility of the good to him expressed in terms of money falls. In
other words, the marginal u tility curve of a good is downward sloping.
Now, a consumer will go on purchasing a good until the marginal utility of
the good equals the market price. His satisfaction will be maximum only
when marginal utility equals price. It, therefore, follows that t he
diminishing marginal utility curve implies the downward sloping demand
curve, that is, as the price of the good falls, more of it will be purchased.
In the figure, the diminishing marginal utility of the good is measured in
terms of money.

P0

P1

0 Q0 Q1
Quantity Consumed
Fig.3.2 Derivation of Law of
Demand from Law of
Diminishing Marginal Utility

Suppose, the price of the good is OP 0 and a consumer will be in

equilibrium if he purchased OQo, then the marginal utility is equal to the
given price OP 0. Now, if the price falls to OP 1 , the consumer would buy OQ 1
quantity of good and the equilibrium would be shifted from E 0 to E 1 . In order
to equate the marginal utility with the lower price OP 1, the consumer must
buy more of the good. Thus, there is an inverse relationship b etween quantity
demanded and price of the good.

*****

38
 Chapter – 7

CONSUMER’S SURPLUS

The concept of consumer’s surplus was first introduced by Alfred Marshall. When a
consumer is prepared to buy a commodity, he always calculates the utility he is going to
derive from its consumption. Every rational consumer compares the utility he derives from
the consumption of a commodity, against the price he has to pay. If the utility is more than
the price paid, he prefers it and if it is vice-versa, he does not buy the same good. The surplus
of utility he derives is consumer’s surplus.

In nutshell, consumer’s surplus is the difference between what the consumer is willing
to pay and what he actual pays.

Consumer’s surplus = Price that a consumer is willing to pay - Price he actual pays.

Suppose, a consumer wants to buys a shirt. He is willing to pay Rs 250 for it. But the
actual price is only Rs 200. Thus he enjoys a surplus of Rs 50. This is called consumer’s
surplus.
Consumer’s surplus is experienced in commodities which are highly useful but
relatively cheap. For example, newspaper, salt, match box, postage stamp etc. For these
commodities, we are ready to pay more than what we actually pay.
Estimation of Consumer’s surplus

Units of apple Marginal utility Actual Price of Consumer’s

Apple surplus
1 20 5 15
2 15 5 10
3 10 5 5
4 5 5 0
Total Units Total Utility Total Money Consumer’s
Purchased = 4 = 50 Spent = Rs. 20 Surplus = Rs.30

Marginal utility explains the price which a consumer is willing to pay for the unit of
the commodity. As more and more units of a commodity is purchased, the marginal utility
declines. Therefore the price, which the consumer is willing to pay, also decreases. The
difference between marginal utility and the market price (actual price) gives the consumer’s
surplus. Thus from the table consumer’s surplus for each unit is the difference between
Marginal Utility (column 2) minus market price (column 3). The consumer’s surplus for all
the units can be calculated as total utility minus the total amount spent on the commodity i.e.
consumer’s surplus = Rs 50 – 20 = Rs 30.

A rise in the market price reduces the consumer’s surplus and vice-versa. If price of
apple increases to Rs. 10, consumer will buy only 3 units and in such case consumer’s surplus
will be decreased to Rs. 15 only.

39
 25

20

Marginal Utility / Price (Rs./unit)

15

10 Consumer’s
Surplus

0
1 2 3 4
Units of Apple

In the above figure, MU is the marginal utility curve. OP is the price and OM is the
quantity purchased. For OM units, the consumer is willing to pay OAEM. The actual amount
he pays is OPEM. Thus consumer’s surplus is OAEM – OPEM = PAE (the shaded area). A
rise in the market price reduces consumer’s surplus.

Assumptions
1. Cardinal utility, that is, utility of a commodity is measured in money terms.
2. Marshall assumes that there is definite relationship between expected satisfaction
(utility) and realized satisfaction (actual).
3. Marginal utility of money is constant
4. Absence of differences in income, tastes, fashion etc.
5. Independent goods and independent utilities.
6. Demand for a commodity depends on its price alone; it excludes other determinants of
demand.
Criticism / Limitations
Two major criticisms against the Marshallian concept of Consumer’s Surplus are:
1. Marshall assumed that utility is measurable, but J.R.Hicks says that is immeasurable,
because it is psychological in nature
2. The Marshallian assumption of marginal utility of money remaining constant. But it
is unrealistic. Marginal utility of money increases with the fall in the stock of money.
Importance of Consumer’s Surplus
1. It is useful to the Finance Minister in formulating taxation policies.
2. It is helpful in fixing a higher price by a monopolist in the market, based on the extent
of consumer’s surplus enjoyed by consumers.
3. It enables comparison of the standard of living of people of different regions or
countries. This comparison helps to distinguish consumption levels between the
people, who are living in rich countries and poor countries. For example, a
middleclass person in New York enjoys more consumers’ surplus than a similar
person in Anand.

*****
40
 Chapter – 8

ELASTICITY OF DEMAND
The law of demand explains that demand will change due to a change in the price of
the commodity. But it does not explain the rate at which demand changes to a change in
price. The concept of elasticity of demand measures the rate of change in demand.

Demand extends or contracts with change in price. This quality of demand by virtue
of which it changes called elasticity of demand. Elasticity means sensitiveness or
responsiveness. Elasticity of demand expresses the degree of correlation between demand and
price. It is the measure of the responsiveness of demand to changing price.

Elastic and Inelastic Demand

A change in demand is not always proportionate to the change in price. A small

change in price may lead to a great change in demand. In that case, we shall say that the
demand is elastic. If, on other hand, even a big change in price there is followed only by a
small change in demand, it is said to be a case of inelastic demand. For example, demand of
mobile is elastic, while demand of salt is inelastic.

Types of Elasticity

1. Price elasticity

The degree of responsiveness of quantity demanded to a change in price is called

price elasticity of demand. It is the ratio of proportionate change in the amount demanded to a
proportionate change in price.

% change in Demand
Price Elasticity (Ep) = -------------------------
% change in Price
2. Income Elasticity

Income elasticity is a measure of responsiveness of demand to change in income,

when price remains the same. It is the ratio of proportionate change in the amount spent on
commodity to a proportionate change in income.

% change in Demand
Income Elasticity (Ei) = ----------------------------
% change in Income
3. Cross Elasticity

Here, a change in price of one good causes a change in the demand for other goods.
This type of elasticity arises in the case of inter-related goods such as substitutes and
complementary goods.
% change in Demand for commodity X
Cross Elasticity (Ec) = ------------------------------------------------
% change in Price of commodity Y
Degree of Price Elasticity

There are five types of elasticity of demand.

41
1. Infinite or Perfectly elastic demand (Ep=α)
P D
Elasticity of demand is infinity when even
a negligible fall in price of the commodity leads to
an infinite extension in the demand for it.
.

O Q Q’

2. Perfectly inelastic demand (Ep=0) D

P
Perfectly inelastic demand means a great rise
or fall in the price of the commodity, its demand P’
remains absolutely unchanged.

O Q

3. Relatively (very) elastic demand (Ep>1)

When even a small change in the price of a P D

commodity leads to a considerable extension/contraction P’
of demand, demand is said to be very elastic.
( PP’ < QQ’ )
O Q Q’

4. Unitary (unit) elastic demand (Ep=1)

When a change in price brings equal (but P

negative) change in demand is refered as unit elasticity. P’
For example, 10% increase in price results into 10%
contraction in demand. D
( PP’ = QQ’ ) O Q Q’

5. Relatively inelastic (or less elastic) demand (Ep<1)

When even a substantial change in price brings P

only a small extension/contraction in demand, it is said P’
to be a less elastic or relatively inelastic demand. D
( PP’ > QQ’ )
O Q Q’

Methods for Measurement of Price Elasticity

1. Total expenditure method / Total outlay method

Under this method we measure elasticity of demand by examine the change in the
total expenditure due to a change in price. Calculate Ep for following demand schedule.

42
 Price of Milk Quantity Total Amount Remarks
Rs./ lit. Demanded Spent
(lit.) (Rs.)
24 3 72 (1)
21 4 84 (2)
18 5 90 (3)
15 6 90 (4)
12 7 84 (5)
9 8 72 (6)

Rule to decide Ep Observations

found in example
Situation Conclusion
When the total amount of money The elasticity is said to Between no.1 & 2
spent increase with a fall in price be greater than unity. (84>72) and
or decreases with a rise in price. (Ep>1) 2 & 3 (90>84)
When the total amount of money The elasticity is said Between no.3 & 4
spent remains the same. The rise in to be a unity. (90=90)
price is exactly balanced by (Ep=1)
reduction in purchases and vice
versa.
When the total amount of money The elasticity is said Between no.4 & 5
spent decrease with a fall in price to be less than unity. (84<90) and
or increases with a rise in price. (Ep<1) 5 & 6 (72<84)

2. Proportional method

Under this method, we measure elasticity by comparing the percentage change in

price with percentage change in demand. The elasticity is the ratio of the percentage change
in the quantity demanded to the percentage change in the price.

% change in Demand
Elasticity (Ep) = ---------------------------
% change in Price

Change in Demand Change in Price

= -------------------------- ÷ ----------------------
Initial Demand Initial Price

Example : Find out Ep for following demand schedule.

Price of “X” Quantity of “X”

(Rs./kg) Demanded (kg)

250 10
200 15

Change in Demand Change in Price

Ep = -------------------------- ÷ ----------------------
Initial Demand Initial Price

43
 = 15-10 200 – 250
--------- ÷ -------------
10 250

= 5/10 ÷ 50/250

= 1/2 ÷ 1/5

= 5/2

= 2.5

Conclusion: Ep>1, Thus, the demand is very elastic.

3. Geometrical method /point elasticity

We can calculate the price elasticity of demand at a point on the linear demand curve
as under.

Formula to find out Ep through point method is,

Lower segment of the demand curve

Ep = -------------------------------------------
Upper segment of the demand curve

For example, in above figure, the length of the demand curve AB is 4 cm.

At point E, Ep = EB/EA = 2/2 = 1 (Ep=1, i.e., Unitary elastic demand)

At point C, Ep = CB/CA = 3/1 = 3 (Ep>1, i.e., Elastic demand)
At point D, Ep = DB/DA = 1/3 = 0.33 (Ep<1, i.e., Inelastic demand)
At point A, Ep = AB/0 = 4/0 = Infinite (Ep=α, i.e. Perfectly elastic demand)
At point B, Ep = 0/BA = 0/4 = 0 (Ep=0, i.e. Perfectly inelastic demand)

Factors determining elasticity of demand:

1. Nature of the commodity

2. Uses of commodity
3. Existence of substitutes
4. Postponement of demand
5. Amount of money spent

44
 6. Habits
7. Range of prices of commodity
Importance of Elasticity of demand
1. Price discrimination
If the demand for a product has different elasticities in different markets, then the
monopolist can fix different prices in different markets. This price discrimination is possible
due to different price elasticities.
2. Levy of taxes
The government will get higher revenue if tax is increased on goods having inelastic
demand. Conversely, the government will get lower revenue if tax is increased on goods
having elastic demand.
3. International Trade
Terms of trade refer to the rate at which domestic commodities are exchanged for
foreign commodities. The terms of trade will be favourable to a country if its exports enjoy
inelastic demand in the world market.
4. Determination of volume of output
Volume of goods and services must be produced in accordance with the demand for
the commodity. When the demand is inelastic, the producer will produce more goods to take
the advantage of higher prices. Hence the nature of elastic and inelastic demand helps in the
determination of the volume of output.
5. Fixation of wages for labourers
If the demand for workers is inelastic, efforts of trade unions to raise wages of the
workers will be successful. On the other hand, if the demand for labour is elastic, they may
not succeed in increasing the wage rate by trade union activity.
6. Poverty in the midst of plenty
The concept of elasticity of demand explains the paradox of poverty i.e. poverty in the
midst of plenty. For example, bumper crop of food grains should bring agricultural prosperity
but if the demand for food grains is inelastic, the agriculturist will be the loser if low price is
paid.
*****

45
 Chapter – 9

PRODUCTION
Production
Production means creation of value in the goods, i. e. creation of utility. Production
activity helps in transforming a set of inputs into goods and services. It essentially means
transforming of one set of goods into another. The output which comes out of production has
greater utility over the inputs combined in the production process. The inputs that are used in
production of goods may be provided by the nature and/ or by other industries.

Factors of Production
These mean the production resources required to produce a given product. Fraser
defined factor of production as “a group or class of original productive resources”. The
factors of production have been traditionally classified as land, labour, capital and
organization.

Land
According to Marshall, land means “the materials and forces which nature gives
freely for man’s aid, in land and water, in air and light and heat.” In Economics the term land
has a very broad meaning. It includes all free gifts of nature available to mankind viz., air,
water and land. It includes all types of land surfaces such as mountains, valley, plains, forests
etc. It includes all types of water resources such as rivers, oceans, etc. Thus the term land
includes all natural resources on, above and below the earth's surface.

Labour
The term, labour has wide and diversified meaning in economics. It can be physical
work or mental work that is done by a person with an aim of earning money. It includes the
work done by farmers, workers, the service of teachers, doctors, actors, etc. In the words of
Marshall, labour is defined as “any exertion of mind or body undergone partly or wholly with
a view to earn some good other than the pleasure derived directly from the work”. Any work
that is done for pleasure does not come under labour.

Characteristics of Labour
1. Labour is inseparable from labourer.
2. Labour is perishable.
3. Labour has very weak bargaining power.
4. Lack of free mobility.
5. Supply of labour is independent of demand.
6. Supply of labour peculiarly changes with the wages.

Capital
Capital is not an original factor like land, but it is the result of man – made efforts. Man
makes the capital goods to produce other goods and services. For example, machinery, raw
material, transport equipment, dams, etc., are considered as capital goods. Capital is produced
means of production. According to Karl Max, capital is ‘crystallized labour’. All capital is
necessarily wealth but all wealth is not necessarily capital. Money when used for the
purchase of capital goods, then only it beomes capital. For instance, residential buildings are
the wealth of the individuals, but these are not considered as capital.

Characteristics of Capital
1. Capital is not a free gift of nature. It is the result of man – made efforts. Machinery,
implements,
etc., are considered as capital goods.

46
2. Capital is productive, as it helps in enhancing the overall productivity of all the resources
employed
in the production process.
3. It is also prospective as its accumulation rewards income in future.
4. Capital is highly mobile as it possesses the characteristic of territorial mobility.
5. Capital is supply elastic as its supply can be altered according to the need.

Organization
In any business activity, there is always a person who guides and controls its function. He
also coordinates and regulates all the factors which are employed in the business activity.
Apart from monitoring it, he takes the responsibility of the outcome. We call such a person,
an entrepreneur (organizer) and the business activity which he is doing is called an enterprise
or organization. The performance of an organization depends upon the capabilities of the
organizer or entrepreneur. Through proper allocation of resources, the entrepreneur would be
in a position to maximize productivity of the resources that are used. Hence, the success or
failure of enterprise depends on the role of the entrepreneur in any business activity.
Following are the prime functions of an entrepreneur.

Functions of Entrepreneur
1. Identification and initiation: Entrepreneur is the person who identifies a particular business
activity and initiates the idea of commencing the business.
2. Location of the enterprise: The place where the business unit is proposed to be set up is
finalized by the entrepreneur.
3. Organizing
4. Supervision
5. Introduction of innovation
6. Risk taking
Production Function
Production function is a technical and mathematical relationship describing the
manner and the extent to which a particular product depends upon the quantities of inputs or
services of inputs, used at a given level of technology and in a given period of time. It shows
the quantity of output that can be produced using different levels of inputs. I. e.,
Y= f (X1 | X2, X3, …………..Xn)
Where,
Y = Output from a particular enterprise
X1 = Variable resource
X2 ……..Xn = Fixed resources
| (Vertical bar) = It separates variable resource from fixed resources

*****

47
 Chapter – 10

LAWS OF RETURNS

Law of Variable Proportions

This is the modern view point of traditional law of diminishing marginal returns.
According to the law, “As additional input of one factor in equal installment is carried out
while keeping all other factor input constant, after a certain point, the output of the product
also decreases i.e. the marginal product will decrease.” According to Leftwitch “the law of
variable proportion states that if the inputs of one resource is increased by equal increment
per unit of time while the inputs of other resources are held constant, total output will
increase, but beyond some point the resulting output increases will become smaller and
smaller.”

Explanation of the Law of Variable Proportion

(a) Total product: Total number of units of output obtained in a unit time by using all input
factors.
(b) Average Product: Total product per unit of a given variable factor.
(c) Marginal Product: The new additional total product obtained on addition of a unit of
variable factor to the production process, keeping all other factors constant.

Production with one variable input

Unit of Capital Unit of Total Product Average Product Marginal Product
(K) Labour (L) (Tp) (Tp/L) (Tp/L)
10 0 0 - -
10 1 40 40 40
10 2 120 60 80
10 3 240 80 120
10 4 320 80 80
10 5 380 76 60
10 6 432 72 52
10 7 448 64 16
10 8 448 56 0
10 9 432 48 -16
10 10 400 40 -32

The above table indicates phenomena of law of variable proportion. The capital is
fixed at 10 units and shown in first column. The labour units increase from zero to 10 units,
shown in second column. The third column show the total output. The data of the table
indicates that there is no production when labour unit is zero. Then as labour input increases,
keeping the capital fixed, output increases first at an increasing rate and then at a decreasing
rate, up to seventh unit of labour. At eighth unit, there is no increase in output. At seventh and
eighth labour unit the output remains same as 448 units. Beyond eighth unit more units of
labour is Counter Productive because output decrease as labour is increased. The average
product shown in fourth column also increases initially then falls after fourth unit. The
marginal product shown in fifth column also increases initially, then decreases and ultimately
becomes negative, reason being use of variable input too intensively with the fixed input
Returns to scale
It refers to the change in output as a result of a given proportionate change in all the
factors of production simultaneously. When all the factors or inputs involved in a production

48
process are increased or decreased simultaneously, in a certain fixed proportion, the response
of output to such an increase or decrease in the input levels, is explained through the concept
of returns to scale. Returns to scale is a long run concept as all the variables are varied in
quantity. Returns to scale are increasing or constant or decreasing depending on whether
proportionate simultaneous increase of input factors results in an increase in output by a
greater or same or small proportion. Returns to scale is illustrated with the help of
hypothetical data in the following table.

Returns to Scale

Labour Capital Total Output Increment in Nature of returns to scale

(L) (K) (Q) output
0 0 0 -
1 1 8 8
2 2 17 9 Increasing
3 3 28 11
4 4 38 10
5 5 48 10 Constant
6 6 58 10
7 7 68 10
8 8 76 8
9 9 82 6 Decreasing
10 10 86 4

From the table it can be seen the variation in total output for changing proportion of L and K.
Initially, when the input proportion is changing, output is changing by an increasing
proportion. This is increasing returns to scale. This trend is seen in the use of Land K up to
the ration of 3: 3. Constant increase in output is found till the proportion of L and K is
extended up to the ratio of 7: 7. This is constant returns to scale. The use of L and K in the
proportion of 8: 8 onwards reveals the decreasing returns to scale.

Let the estimated Cobb – Douglas production function be represented as

^
Y = 0.32 X1-0.0681 X20.6669X30.1202X40.1050

Y = Crop output in quintals

X1 = Human labour in man days
X2 = Fertilizers in kg
X3 = Manures in tonnes
49
X4 = Pesticides in litres

In Cobb – Douglas production function the returns to scale is obtained by the summation
of elasticity coefficients of the independent variables i. e.,
n
Σbi
i=1

If Σbi > 1 it is increasing returns to scale

If Σbi = 1 it is constant returns to scale and
If Σbi < 1 it is decreasing returns to scale

The value of Σbi from the estimated equation is 0.824, which indicates the prevalence of
decreasing returns to scale.

Differences between the Law of Variable Proportions and Returns to Scale

S.No. Law of variable proportions Returns to scale

1. Describes the behaviour of output Examines the behaviour of output, when all
when one input is varied the inputs are varied at the same time
2. Some factors of production are All factors are varied
constant
3. The proportion among factors varies The proportion among the factors remains
the same
4. It is a short run production function It is a long run production function
5. Here increasing, constant and Here increasing, constant and decreasing
decreasing returns to a factor are returns to scale are observed
observed
6. Increasing returns are due to the Increasing returns to scale are due to scale
efficient utilization of fixed resources economies of production
as a result of application of sufficient
quantity of variable resource
7. Optimum output is the result of best The optimum output is the result of
proportion among fixed and variable optimum size of the plant
resources
8. The diminishing returns are due to over Diminishing returns to scale are due to the
exploitation of fixed factor operation of diseconomies of scale
9. Y = f (X1| X2, X3……..Xn) Y = f (X1, X2, X3…….Xn)
10. It is a reality It is a myth

*******

50
 Chapter – 11
COST
Knowledge regarding various relationships existing between costs and output is
necessary to comprehend the concepts of equilibrium conditions of different firms under
different market conditions. Basically we require data on output, fixed costs, variable costs
and the prices of inputs and outputs. From this data we finally derive all the seven cost
concepts, viz.,TFC, TVC, TC, AFC, AVC, AC and MC. These cost concepts would have
implications for output expansion of the firms and equilibrium position of the firms in
different time periods. In the cost theory, economists use different names for cost concepts
under different context. They are money costs or nominal costs, real costs, opportunity costs,
economic costs, implicit costs, explicit costs, deflated costs, social costs, short run costs, long
run costs, separable costs, etc.

Nominal Costs or Money Costs

These are usually expressed in money terms at current prices. Nominal costs of
production refer to per unit cost of production of output at current market prices.

Real Costs
When the costs of inputs and input services are expressed at constant prices they become
real costs.

Opportunity Cost
Opportunity cost is the value of return sacrificed or foregone from the next best
alternative activity. In farming farmers don’t have to pay for their owned resources,
viz.,family labour, owned bullock labour, owned machinery, owned seed, etc. But still in the
cost analysis the value of these owned resources are considered on the basis of opportunity
cost.

Economic Costs
These are divided into explicit cost and implicit costs. Explicit costs include payments
made by the entrepreneurs for purchasing and hiring of inputs and input services. They are
also called paid out costs or cash costs. Entrepreneurs do not pay for the use of owned
resources. The value of such resources is called as implicit costs. Costs of self – owned and
self – employed resources are known as implicit costs.

Deflated Costs
Costs if deflated by general price index are called deflated costs. By doing so the effect
of inflation in an economy is taken out. Example: Real cost of commodities.

Social Costs
These are also called as externalities. Firms incur both implicit and explicit costs in the
production of goods and services. Their sum constitutes total cost of production. These costs
we name as private costs, but from the point of view of society, these firms will give rise to
some additional costs to the society in the form of environmental degradation, water, air or
noise pollution etc., in the areas where goods are produced by the private firms. In the
absence of well – drained system, irrigation projects bring problems to the command area of
the project in the form of new diseases. Such costs are called social costs.

Separable Costs
Separable costs are the costs which can exclusively be attributed to production of output
separately. Common costs are those which cannot be separated to the production of the

51
output. So they are called joint costs. The costs are involved in the production of several
products. For example, electricity generation, ground water use, etc.

Historical Costs and Replacement Costs

Historical costs are the costs involved in the purchase of durable goods like land,
buildings, machinery, equipment, etc. Purchase price of the asset should be considered as
price of the asset and hence it is considered as historical cost in analysis. Since the costs of
the assets are apportioned in computation, they are called as historical costs. Replacement
costs refer to the difference between the purchase price of the asset and the current price of
the same asset. Suppose a tractor is purchased 10 years ago at a price of Rs. 1,50,000 but its
present price is say, Rs. 2,50,000, the difference of Rs. 1,00,000 is the replacement cost.

Establishment Costs
Construction of plant in any business activity entails some costs. Such construction costs
are called establishment costs in the business analysis. They are also called first phase costs.
The other costs viz., licenses, site development expenditure for construction of factory,
purchase of equipment, furniture, expenditure on personnel, royalties for seeking product
rights, cost of raising finance, costs of maintaining raw materials etc., are also included in the
establishment costs.

Cost Concepts
Knowledge regarding the cost functions is very much essential for optimal managerial
decisions to be taken by the firm as well as the Government. In the short run, pricing and
output decisions are based on short run cost curves, while in the long run, long run cost
curves have crucial implications for development and growth of the firm and investment
policies of the firm. Consideration of cost curves is essential and forms the basis for entry and
exit of the firms in the industry. Profit maximizing rule is determined with the help of cost
curves, cost functions and production functions. This rule is popularly known as marginal
analysis at which MC = MR. The costs are also one of the major price determinants in all the
market situations of the economy and in all the economic models which would explain the
behavior of the firms.

There are seven costs, which explain the behavior of the firms in the production of requisite
products.

Fixed Costs
Fixed costs remain the same irrespective of level of production. These costs remain
invariant in the short run but in the long run there are no fixed costs as all the inputs can be
varied. Fixed costs include cost items like taxes, insurance, cess, depreciation on machinery,
implements, tools, buildings, salaries of personnel working in the firm, etc. These are also
known as indirect costs, sunk costs and overhead costs. The summation of all these costs is
called total fixed costs (TFC). TFC is a horizontal straight line parallel to X – axis.

52
Variable Costs
Variable costs as per definition vary with the level of output. These include costs of raw
materials, labour, power, repairs, maintenance charges of machinery, etc. These are also
known as working costs, operating costs, direct costs, prime costs, circulating costs and
running costs. These are second phase costs. The summation of these costs refer to total
variable costs (TVC). Graphically TVC as inverse ‘S’ shape.

Total Costs
These include total fixed costs as well as total variable costs. Its shape is similar to that of
TVC. Total cost

5000

4000
Cost (Rs)

3000

2000 Variable cost

1000 Fixed cost

Fixed cost

1 2 3 4 5 6 7 8 9 10

Average Variable Cost (AVC) Quantity (pieces)

It is the amount spent on the variable inputs to produce an unit of output. Algebraically it
is expressed as

AVC = Total variable costs = TVC

Output Q

When a small amount of output is produced, cost of variable input per unit of output
becomes very high. This is to say in other words, that productivity of variable input increases
when greater amounts are used in the production of the commodities due to economies of
scale. This causes AVC to have ‘U’ shape when it is graphed. When it is ‘U’ shaped it

53
becomes reciprocal of average physical product curve. AVC falls to minimum level at the
output level where APP is maximum. Thereafter due to production of greater amount of
output, AVC rises again and becomes vertical at certain level of maximum output.

Average Fixed Cost (AFC)

It is the cost of fixed resources or inputs required for producing one unit of output and it
is given by the formula as

AFC = Total fixed costs = TFC

Output Q

AFC curve is declining with the increased output because TFC is constant. Due to this it is
continuously falling up to its maximum output. It is having the shape of hyperbola.

Average Total Cost or Average Cost (ATC or AC)

When the total costs are divided by output, we get ATC.

AFC = Total costs = TC = TFC + TVC

Output Q Q

54
Marginal Cost (MC)
As per the definition, it is the change in the total cost due to the change in output.
Algebraically it is expressed as

Change in total costs = Δ TC or Δ TVC

Change in output ΔQ ΔQ

To compute MC, we can use TC or TVC because fixed costs cannot be changed. The
only component of change in TC is TVC. The specific shape of MC curve is due to marginal
product of the variable inputs. When MPP is maximum, MC is minimum. MC curve is
declining when MPP curve is increasing; hence there is an inverse relationship between MPP
and MC. When MPP is zero, MC becomes vertical. MC curve intersects AVC and ATC at
their minimum points.

Short run and Long run Costs

In the short run it is possible to vary the output by varying only the amount of variable
factors such as labour and raw materials. In the short run, the fixed factors such as capital
equipment, managerial persons, factory building etc cannot be changed. Thus in the short run
if an organization intends to increase production, then it can be done by hiring more workers
or buying and using more raw materials. In the short run it is not possible to enlarge the size
of the plant. Thus in the short run only variable factors can be varied and the fixed factors
remain the same.

55
 In long run time period it is possible to vary all factors of production. Thus it is
possible to increase output in long run either by increasing capital equipment or by adding
capacity to existing plant or installing an altogether new plant of bigger size.
Short run Cost Behaviour
The short run cost behaviour is explained by following hypothetical example.
Table-17.1: The short run total cost schedule
Capital Units Labour Units Total Total fixed Total Variable Total Cost
(Fixed (Variable product (TP) cost (TFC) cost (TC)
Factor) factor) (Rs.) (TVC)(Rs.) (TFC + TVC)
5 0 0 150 - 150
5 1 4 150 12 162
5 2 7 150 24 174
5 3 12 150 36 186
5 4 17 150 48 198
5 5 20 150 60 210
5 6 22 150 72 222
5 7 23 150 84 234
The data in the above table shows the behaviour of total fixed cost, total variable cost,
total cost in the short run. Following assumptions are made about the data: price of labour is
Rs. 12 per Unit and Price of capital is Rs 30 per Unit.
Behaviour of Total Cost
1. Total fixed cost remains same at Rs. 150 at all levels of output. Even when production is
not done (TP = 0), total fixed cost is Rs. 150.
2. Total variable costs varies with the output. When production is not done, total variable
cost is zero.
3. Total cost varies directly as total variable cost. In the short run fixed cost remains same
and change in total cost are affected due to change in variable costs.

Y
TC
350
CC
300 CC
TVC
250

200
Cost

150 TFC
100

50
X
10 20 30 40 50 60 70 80 90 100

Output
Behaviour of total cost, total variable cost and fixed cost
Short Run Average Cost Curves
For a hypothetical example, average cost curves are shown in the following table.

56
 Average cost
Output Total Total Total Average Average Average Marginal
(Units) Fixed cost Variable Cost Fixed cost Variable Total Cost Cost
(TFC) (TVC) (Rs.) AFC = Cost ATC =
(Rs.) (Rs.) AVC =

0 220 0 220 - - - -
1 220 100 320 220 100 320 100
2 220 140 360 110 70 180 40
3 220 160 380 73.33 53.33 126.66 20
4 220 192 412 55 48 103 32
5 220 260 480 44 52 96 68
6 220 400 620 36.66 66.66 103.33 140

MC AC
CC
CC AVC
CC CC
CC cC
CC
(Rs.)
Cost

AFC

Behaviour of average cost

Output
(No. of units)

From the above figure, following conclusions can be drawn about short run cost curve:
1. As output increases, average fixed cost decreases. The total fixed cost remains same for
all level of output, but average fixed cost decreases continuously because of spreading it
over more number of units as output increases.
2. Average variable cost first decreases and then increase as output increases.
3. Average total cost decreases initially. It remains same at a point for a while and then go
on increasing as output increases.
4. Marginal cost decreases initially but then increases as the output is increased.
5. When the average cost is minimum, marginal cost is equal to average cost.
LONG RUN COST CURVES
In the long run, all the factor inputs are variable. In the long run it is possible for the
organization to change the overall plant capacity as per demand. In the long run there is no
distinction of fixed and variable costs. There is only variable or direct cost as total cost.
Long run is a vision of future. It is a planning horizon. In the long run also, all
economic activities actually operate in the short run. Thus a long run consists of many
possible short run situations and a choice is made for actual courses of operation from them.
Thus long run average cost curve is the envelope of the number of short run cost curves. It is
drawn as tangent to the short run average cost curves. Long run cost curve is shown in
following figure in which long run cost curve is drawn on the basis of 3 possible plant sizes.
57
 SAC1 SAC2 SAC3
Long run cost
(Rs.)
Cost

Output

Behaviour of long run cost

58
 Chapter – 12
SUPPLY
Supply means the quantity of a good or service offered by a producer for sale at
different unit prices in a given market at a point of time. It is the willingness of the supplier to
offer the goods for sale at different unit prices. More specifically, supply is defined as a
schedule that shows the amounts of a product or service, sellers are willing to sell at each unit
price in a set of possible prices during some specified period of time in a specified market.
Meyers defined supply as “a schedule of the amount of good that would be offered for sale at
all possible prices at any one instance of time in which the condition of supply remains the
same”. Prof. Mc. Connel defined supply as “a schedule which shows the various amounts of
a product which a producer is willing to and able to produce and make available for sale in
the market at each specific price in a set of possible prices during some given period”.

Stock
Along with the concept of supply, another concept called stock needs to be explained.
Supply is drawn from the stock of the commodity. Supply is the actual quantity that a seller is
willing to sell at a particular price, while stock is the amount of output that exists in a market.
Depending on the demand for a commodity stock is converted into supply. For perishable
commodities stock and supply are the same. For durable commodities stock and supply are
different.

Individual Supply Schedule

Supply schedule depicts the list of quantities – price relationships of a commodity in a
market at a specific point of time by an individual seller. In other words, it reveals the mind
of sellers in offering various quantities of a given commodity against corresponding prices.
An example of supply schedule is presented in table.

Hypothetical Supply Schedule of a Commodity in a Market

Price (Rs./Q) Quantity supplied (Q)

300 30
325 40
350 50
375 60
400 70
425 80

It reveals that at price of Rs. 300 the quantity supplied by a seller is 30 Q at Rs. 325, 40 Q
and so on. As the price per unit of the commodity rises, the quantity supplied is also
increasing. As price increases, sellers are committed to increase their sales. When a supply
schedule is plotted on a graph it becomes a supply curve. The supply curve will have a
positive slope i.e., it slopes upwards from left to right.

59
Market Supply
It is the sum of the quantity of commodity that is brought into a market for sale by the
sellers in a given market at a specific point of time. Assume that there are three sellers in a
market viz., A, B and C with individual supply schedules as shown in table.
Market Supply Schedule
Price (in Rs./Q) Individual seller’s supply/week (Q) Market supply
A B C (Q) = (A + B
+C)
300 30 35 0 65
325 40 50 0 90
350 50 65 50 165
375 60 80 70 210
400 70 95 90 255
425 80 110 110 300

The price quantity relationship of the three sellers reveals that at Rs. 300 per quintal,
seller ‘A’ is prepared to sell 30 Q, while seller ‘B’ 35 Q and seller ‘C’ is not prepared to sell
at all at this particular price. The seller ‘C’ is not prepared to sell the commodity at any price
less than Rs. 350/Q. Market supply is the sum total of output that is sold by the three sellers
as presented in the last column of the table. Thus the market supply is 65, 90, 165 Q and so
on. It is the lateral or horizontal summation of the supply of individual sellers at each unit
price. The market supply curve is drawn based on the first and last columns of the table.

60
Law of Supply
The law of supply indicates the functional relationship between the quantity supplied of
a commodity and its unit price. The law signifies the positive relationship i.e., as the price of
a commodity rises its supply extends and as the price falls its supply contracts, with other
things remaining the same. Producers normally tend to increase the supplies in the wake of
rising prices and reduce the same when the prices are on the lower side. Supply varies
directly with the price, ceteris paribus.

Extension and Contraction of Supply (Change in Quantity Supplied)

Extension and contraction of supply refer to the movement of product supply on the
same supply curve. Extension of supply means offering more quantity for sale at a higher
price, while contraction means offering less quantity at a lower price. As seen from table that
the quantity of commodity supplied by ‘A’ at Rs. 300 is 30 Q and it is 40 Q when the price
rose to Rs. 325. Here the quantity supplied has increased from 30 to 40 Q. It is the case of
extension of supply, conversely if the price falls from Rs. 325 to Rs. 300, the quantity
supplied too falls from 40 to 30 Q. It is the contraction of supply.
Graphically, when it is depicted, it shows that the upward movement from A to B is
extension of supply and downward movement from B to A is contraction of supply.

Increase and Decrease in Supply (Shift in Supply)

Increase in supply implies more supply at the same price and decrease in supply means
less supply at the same price. The change in supply (increase and decrease in supply) results
in a shift of the supply curve. An increase in supply results in the shift of the supply curve
towards right side of the initial supply curve SS as shown in figure. The new supply curve is
S1S1. On the other hand, a decrease in supply causes a shift of the supply curve towards the
left side of the initial supply curve. The new supply curve thus formed is S2S2. Originally, OQ
quantity is supplied at OP price. But due to changes in supply conditions at the same price
OP, OQ1 quantity of commodity is supplied indicating increase in supply. On the other hand,
again influenced by changing supply conditions at the same price, OQ2 is supplied. This is
decrease in supply.

61
Factors Causing Changes in Supply (Shift Factors)
The factors that are responsible for changes in supply are discussed below:
1. Changes in Technology: Technological innovations viz., new varieties of crops and their
consequent increased yields per unit area, help to increase the supply of the commodity
2. Reduction in Resource Prices: When the price of input factors become cheaper than before,
it encourages producers to use more of them in producing more output. Supply curve shifts
towards the right side.
3. Reduction in the Relative Prices of Other Products: A reduction in relative prices of other
related products compel the producers to increase the production of that particular commodity
whose prices are relatively higher.
4. Market Infrastructure: When good communication and transport network increase, the
supply of the commodity also increases.
5. Number of Producers: Changes that are found regarding number of producers producing a
given commodity influence the supplies. More the number of producers, greater the supply
and vice versa.
6. Producers’ Expectations about Future Prices: Price expectations influence the sales
strategies of the producers positively.

Elasticity of Supply
Elasticity of supply of a commodity is the responsiveness, or sensitiveness of supply to
the changes in price. Supply is said to be elastic, if a small change in price causes
considerable change in the quantity supplied. The supply is inelastic when a given change in
price leads to little or less change or no change in the quantity supplied. In short, elasticity
measures the adjustability of supply of a commodity to price.
Elasticity of supply (price elasticity of supply) is expressed as the ratio of percentage
change in the quantity of good supplied and percentage change in price of the good ceteris
paribus.

Elasticity of supply (ES) = Percentage change in quantity of good supplied

Percentage change in price of good supplied

Algebraically elasticity of supply is expressed as

62
 ∆Q
× 100
Q

∆ P × 100

∆Q * P
=
∆P Q

Degrees of Elasticity of Supply

There are five degrees of elasticity of supply. They are as follows:

Perfectly Elastic Supply

When the supply of commodity increases to infinite quantity or unlimited quantity,
even though there is invisible rise or minute rise in the price, the elasticity of supply is said to
be infinity (ES = α).

Perfectly Inelastic Supply

It means that the quantity supplied is not responsive to change in prices. Elasticity of
supply in this case is zero (Es = 0).

63
Relatively Elastic Supply
Supply is referred as relatively elastic, when the percentage change in quantity
supplied is more than the corresponding percentage change in price. It is also called elastic
supply. Elasticity of supply is more than one (Es > 1).

Relatively Inelastic Supply

Supply is said to be relatively inelastic, when the percentage change in quantity
supplied is less than the corresponding percentage change in price. In this case the elasticity
of supply is less than one (Es < 1).

Unitary Elastic Supply

When percentage change in quantity supplied equals the percentage change in price,
it is called unitary elastic supply. Here the elasticity of supply is equal to one (Es = 1).

64
Factors Influencing Elasticity of Supply
1. Availability of Inputs of Production: If the needed inputs are available as per the
requirement, the supply is elastic. If any one of the factors is not available which is absolutely
necessary, supply would be inelastic.
2. Length of Time Period: It is the period of time required to adjust the supplies to the
changes in price. The biological characteristics of the product dictate the changes of
responsiveness.
3. Diversification of Production Activity: When the producer is engaged in production of a
number of products and facilities exist for shifting of production from one product to the
other, in such a case for each product the supply is elastic.
4. Availability of Alternative Markets: Suppose there exists several markets for the producer
to sell the goods, a fall in price in one market would prompt him to shift his goods to other
markets and a rise in price in one market induces him to shift his goods to that market. In
such a case the supply is elastic.
5. Flexibility in Starting and Winding up the Business: If a particular production activity is
quickly taken up and quickly wound up, the supply of the goods is elastic.

Price Determination
We know that market demand curve is a horizontal summation of individual demand
curves, and similarly horizontal summation of individual supply curves become market
supply curve.
Price determination can be examined by the following ways:
Arithmetic Approach
The information in table reveals that at Rs. 12, the quantities demanded and supplied
are both equal i.e.,80 Q. At this price, what the buyers are willing to purchase and what the
sellers are willing to offer are the same. Therefore, Rs. 12 per unit is the equilibrium price
and quantity amounting to 80 Q is the equilibrium output.

Demand, Supply and the Equilibrium Price and Output

Price/ unit (Rs.) Quantity demanded Quantity supplied (Q)
(Q)
14 60 120
13 70 100
12 80 80
11 90 60
10 100 40

Graphic Approach
The intersection of market demand curve (DD) and the market supply curve (SS)
indicates the equality of quantity demanded by the consumers and that supplied by the
producers. This equality of quantity demanded and quantity supplied is called equilibrium
quantity (OQ) and the price that occurs at this balancing point is called equilibrium price
(OP). When such a condition prevails in a market, the market is said to be in equilibrium,
because there are neither shortages nor surpluses of commodities.

65
*******

66
 Chapter – 13

Distribution
In the process of production, the producer coordinates different factors of production
i.e., land, labour, capital and management. In the process of distribution the returns obtained
through the production activity are apportioned to these factors that are employed in the
production process. Consequently land gets rent, labour gets wages and interest is paid to
capital and finally organization is rewarded with profit. Such an apportionment of returns
among different factors of production is called distribution. It is also called factor pricing.

Rent
Rent is the return for the fertility status of the land. In fact the land is defined in a
broad sense. All the natural resources existing on the surface and beneath the surface of land
like mines, rivers, etc., are also treated as land, from which rent is received. Some resources
are publicly owned, while others are privately owned. Rent is almost zero for publicly owned
resource because one cannot use it for one’s own purpose. These are meant for public
welfare. Rent is expressed in two forms i.e., one is economic rent and the other is contract
rent.

Economic Rent
Economic rent is the rent received exclusively from the use of land only. We use the
term, exclusively because the rent of a building refers to the return obtained by the owner on
the capital invested in the construction of building as well as the land. It is the return obtained
from the combined values of both. Then it does not become rent. In farming the rent paid by a
tenant to the landlord is not economic rent.

Contract Rent
This implies the money paid by the tenant to the land lord for cultivating the land in a
given year. Normally a certain rent is charged by a farmer not only for land but also for
making availability of certain infrastructure on land like buildings, machinery, wells, fencing,
etc. This means that he would like to realize some return on the investment made on the farm.
Then it is not exclusively rent for land only. Thus economic rent is a part of contract rent.

Quasi Rent
The basis for evolving this rent is the short run fixity of man made assets of production
like machines, buildings, etc. When in the short run, the demand for these assets increases,
consequently their income also increases. This results in a surplus income due to increased
demand. This surplus income of assets is called quasi rent This rise in quasi rent is a
temporary phenomenon. In fact, the supply of these assets being elastic it is increased in the
long run to match with the demand causing the surplus earnings to disappear. The concept of
quasi rent does not apply to land because supply of land is inelastic.

Scarcity Rent
This is the rent which arises due to scarcity of land in relation to demand. Scarcity rent
is due to inelastic supply of land. This is surplus rent over the market rent for land due to
increased demand for land.
Modern Theory of Rent
Modern economists assert that rent arises for any factor of production. It is the
surplus payment in excess of transfer earnings of a factor. Transfer earnings imply the
amount of money which any particular unit of factor could earn in its next best alternative
use.

67
 The rent of the land is determined by the two market forces viz., demand for and
supply of land. Demand curve for land slopes downwards because the rent of land is
influenced by the marginal productivity. On the other hand supply of land is fixed i.e., supply
is inelastic. Supply curve is vertical to X – axis. Equilibrium between demand and supply
determines the rent of land.
As seen from figure, D2 is the demand curve for land and S is the supply curve of
land. The two curves intersect at ‘E2’ and hence the rent is OR2. Changes in population and
consequent additional pressure on land increase the demand for land. Therefore the new
demand curve is D3 and the rent is OR3. Contrary to this when demand for land falls the new
demand curve D1 is formed and its corresponding rent is OR1.

Wages
Wages are the rewards paid for the labourers for sparing their productive services. It may
be paid either in cash or kind or both. A wage may be defined as a sum of money paid under
contract by an employer to a worker for services rendered (Benham). Wages are paid for
casual labourers, while salaries are paid for permanent staff and consultation fee for doctors,
lawyers, etc.

Methods of Wage Payment

Based on the payment, wages are classified as (1) Cash wages and kind wages (2) Time
wages (3) Piece wages; and (4) Task wages.

1. Cash Wages and Kind Wages: Wages for the workers are paid in cash or kind or both.
With the advent of currency, wages are paid in cash. However, kind payment is also in vogue
along with the cash payment.
2. Time Wages: It is the wage per unit of time. It is the payment of wages on hourly, daily,
weekly, fortnightly and monthly basis. In farming, casual labourers are paid on daily basis,
workers for domestic services are paid on monthly basis and attached servants in farming are
paid on half – yearly or yearly basis.
3. Piece Wages: It is based on the work performed by an individual in the production of
goods and services. In the manufacturing process of a good, the entire production activity is
divided into various sub – processes. An individual attending to a sub – process is paid
according to the work he completes on a particular day.
4. Task Wages: Wages are paid for a given work after its completion, say in farming, paddy
transplanting, weeding, harvesting, etc., are completed by a group of labourers. Wages are
decided based on the work assigned to the group and it has nothing to do with the number of
labourers in that group. The task is given to the group for completion of work in time
according to agreed wages. They are also called as contract wages.

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Types of Wages
1. Nominal Wage or Money Wage: It is the wage paid in terms of money at current market
prices.
2. Real Wage: It indicates the purchasing power of money wage. Real wage of the worker is
obtained by dividing nominal wage of the workers at different time periods by general price
index. Real wage is measured by
R = W/P
Where,
R = Real wage
W = Money wage
P = General price index

Modern Theory
Modern theory is based on demand for and supply of labour. Demand for labour is a
derived demand. If there is a higher demand for products from consumers, there would be
more demand from producers for labour for helping to bring the expected level of output.
A rise in demand for a commodity pushes up the demand for the labour involved in the
production of that commodity.
The supply of labour is represented by the number of workers willing to work in a
production activity at various wage rates taking into consideration the number of hours,
number of days in a week, etc. These two forces i.e., demand and supply determine the
wages.
DD is the demand for labour and SS is the supply of labour. The wage rate is OW.

Interest
Interest is the amount paid by the borrower to the lender for the use of capital.
According to Marshall “the payment made by a borrower for the use of loan for, say a year,
is expressed as the ratio which that payment bears to the loan” is called interest.
Interest is the price paid for the use of loanable funds (Meyers).
The interest charged by a lender from the borrower is termed as gross interest. It is
because lending activity is fraught with risk as well as inconvenience which are also
considered. Taking these items into account the gross interest is considered under the
following terms.
1. Net or Pure Interest: This interest is the payment exclusively made for the loan amount.
2. Insurance Against Risk: In the lending activity there is always the risk of not getting back
the funds lent by the lender. The loan may turn out into a bad debt. This risk needs to be
insured. For this purpose, some more interest is added to the net interest.
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3. Payment for Inconvenience: Through the lending activity the lender gets interest but in the
same process he is placed in inconvenience to get back his funds at the time he wants,
because the funds are locked up for a certain period of time. Unless the loan period was over
he cannot get back his funds. For this inconvenience, he charges some additional interest to
the net interest.
4. Reward for Management: The business of lending requires perfect maintenance of the
records to keep a close watch on the business performance. Apart from this, the borrowers are
to be pursued for prompt repayment. This calls for efficient management of the business.
Hence reward for management is included in gross interest.

Determination of Interest Rate

Liquidity preference and supply of money determine the rate of interest. Liquidity
preference here means the liquidity preference for speculative purpose according to Keynes.
Therefore, the equilibrium between liquidity preference for speculative purpose and supply of
money determine the rate of interest.
In figure, LP indicates liquidity preference for speculative purpose. It is the demand for
money. OQ represents the fixed amount of money available to meet the requirements of
liquidity preference for speculative purpose. Rate of interest is determined by the equality of
demand of money for speculative purpose and supply of money. The interest rate that
prevails is OR, which is the equilibrium interest.

Profit
Profit is the reward for entrepreneurial function of decision – making and uncertainty
bearing. Profit can be either positive or negative, since it is a residual income. Profit differs
from rewards of other factors of production like rent, wages and interest on the point that
these are all certain, while profit is tentative. These rewards are paid even before the ultimate
product is obtained, while profit happens to be the surplus of returns over total costs, and it is
obtained at the end of production activity.

Various Concepts of Profit

Gross Profit: It is the surplus of gross revenue over paid out costs (explicit costs)
obtained in a production activity. Gross profit cannot be treated as ultimate profit, for it
includes several items which are not actually profits as presented below:
Remuneration for Entrepreneur Himself: It is a practice for the entrepreneur to
contribute his own capital in the business besides offering his services as a manager. In such
a situation the opportunity cost of owned capital and the services rendered in his own
business are also included in the gross profit. These imputed costs are to be deducted from
the gross profit to arrive at the net profit.
Depreciation and Maintenance Charges: When the plant is in operation there will be
wear and tear (depreciation) on equipment and machinery which needs to be duly accounted
for. In addition to this, interest on fixed capital and insurance premium are other fixed cost
items that are incurred in a production activity. These cost items need to be deducted from the
gross profit to arrive at net profit.
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 Extra Personal Profits: These are the profits which accrue to a business unit not due to
the managerial ability of the entrepreneur, but due to other factor, say the profits of
monopoly. These are not due to the businessman’s managerial abilities but for his position as
a monopolist. The monopoly profit needs to be deducted from gross profit to arrive at net
profit. Another source of getting unexpected high profit is from windfall gains or chance
profits. Any sudden happening, say outbreak of war, natural calamities in certain pockets of
the country etc., lead to a rise in the product prices, resulting in abnormal profits for the
entrepreneur. Such unexpected profits should be deducted from gross profit to find out the net
profit.
Net Profit: The aforesaid three items viz., remuneration for entrepreneur himself,
depreciation and maintenance charges and extra personal profits are to be deducted from
gross profit to work out the net profit. It is the reward of the entrepreneur for coordination
and risk – taking.
Net profit = Gross income – Total cost

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 Chapter – 14
National Income
Concepts

In an economy goods and services keep on being produced, which need to be valued.

National Income is nothing but the aggregate money value of all goods and services
produced in a country in a year. It can also be viewed as income distributed among the
factors of production in the form of rent (to land), wages (to labour) interest (to capital) and
profits (to entrepreneurs).

According to Alfred Marshal National Income is defined as the labour and capital of a
country acting on its natural resources produce annually a certain net aggregate of goods and
services.

Limitations

• In an economy in which numerous goods and services are produced, it is really a

difficult proposition to estimate them correctly to arrive at the national income.
Coming to the farming, farmers do retain some part of production for personal
consumption and the rest is only marketed. In such a case, the methodology to
evaluate the amount of produce not reached the market has not been given.

• Double counting: It implies the same good being counted twice: say, cotton may be
counted in agricultural production and the cotton cloth in industrial production.

Marshall approached national income from production end. On the other hand, some other
economist approached from consumption end. At the same time this approach in reality
poses problems. Consumers who number in millions, consumes the same good at different
places, and the estimation of their total consumption is a difficult proposition. Hence, there
are problems in measurement of national income.

Modern View

Simon Kuznets defined national income as “the net output of goods and services flowing
during the year from the production to the hands of ultimate consumers”. Here the
income side as well as expenditure side is included to present the concept of national income.

Gross National Product (GNP)

GNP is the basic social accounting measure of the total production of goods and services in
an economy. GNP is defined as the total market value of all final goods and services
produced in a year. It includes the market value of such products as are produced in
agriculture, mines, forests, industries etc. and of services like transport, communication,
banks, lawyers, doctors, teachers, etc. and these are added together during one year.

GNP is a measure of current output of economic activity in a country. Goods and

services produced in an economy are subjected to purchase and sale several times. Therefore,
72
to avoid the possibilities of double counting, GNP includes the market value of final goods
only ignoring the transactions involving intermediate goods.

Those which are not included in GNP are as follows:

1. Services which are rendered freely e.g. free services offered by family members to others in
the family.
2. The sale and purchase of old goods (resale of used items).
3. The sale and purchase of shares, bonds, etc… because they do not add anything to the
national produce as they are simply transformed from one to other.
4. Old age pensions, unemployment allowances etc. as they do not provide any services.
5. The change in value of the capital assets as a result of changes in the market prices as they
have nothing to do with the current production.

Measures of GNP
Three methods to measure GNP are as under:

1. Income Method
According to this method GNP is the sum total of the following items:

a. Wages and salaries

b. Rents
c. Interest
d. Income of Non-company Business (individual proprietors/partners/self-employed person)
e. Corporate profits
f. Indirect taxes
g. Depreciation
h. Transfer payments (payments received by individuals as pension, unemployment allowance
are called transfer payments. These are received by the people for not doing any work, so
these should be deducted from GNP.

Thus, GNP = Wages and salaries + Rents + Interest + Incomes of Non-company

Business + Corporate profits + Indirect taxes + Depreciation - Transfer payments

2. Expenditure Method

Through this, GNP is the sum total of expenditure incurred on goods and services during a period
of one year. The expenditures included are as under:

a. Personal consumption expenditure (C): It includes all types of expenditure on personal

consumption by individuals of a country. It includes expenses on durable goods (car, bike, tv,
mobile, etc.) non-durable goods or consumable articles (food, cloth, soaps, etc.) and also the
expenditure incurred on services of all kind (doctor, transportation, etc.)

b. Gross domestic private investment (I): It includes private investment on capital and
producer goods like buildings, machinery, equipments, etc which are produced in the year
only. Purchase of used items and old buildings are not included here because they were
included earlier. Investment on purchase of share in stock exchange is also not included, since
it dose not help in new production.

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 c. Net foreign investment (X-M): In an economy, the entire production may not be consumed
within the country and part of it is exported to other countries. Similarly, the country imports
some products from other countries. The difference between the value of exports and of
imports should be worked out. If the difference is positive, it should be added to other items
of expenditure and it should be deducted from the other items of expenditure, if the
difference is negative.

d. Government expenditure on goods and services (G): The Central and State
Governments purchase consumer goods as well as investment goods for their own
enterprise. Apart from this, the Government spends on defense, police, education, etc.
These are included in GNP however, expenditure on transfer payments such as
pension, unemployment allowances, etc are not included in GNP.

In short, GNP = C + I + (X-M) + G

Value added Method

It is always difficult to distinguish between intermediate goods (raw materials, fuel, etc.)
and the final goods as it may be intermediate product for one industry and final product
for the other industry. For example, electricity is intermediate good when consumed by
industry and it is final good when consumed directly by consumers. So, to overcome this
problem the value of the intermediate goods used in a manufacturing industry should be
deducted from the value of the final goods. The difference that is arrives at is called value
addition. If the same procedure is adopted for all the industries in the economy, we can
find the GNP by value added method.

National Income at Market Price or Net National Product (NNP)

In the production process, the capital goods are worn-out. This amount of decline in the value
of capital goods due to wear and tear is called depreciation. To estimate NNP, depreciation is
deducted from GNP. NNP therefore is the market value of all final goods after duly
accounting for depreciation; hence, it is called National Income at Market Price. In other
words, NNP is the net money value of final goods and services produced at current prices in a
an year in a country.

Thus, NNP = GNP – Depreciation

National Income at Factor Cost : It implies the sum of all incomes earned by resource
suppliers for their contribution of land, labour, capital and entrepreneur which go into the net
production in a year. In fact national income depicts how much it costs the society in terms of
resources to produce net output. Hence, it is called national income at factor cost.

Thus, National Income at Factor Cost = NNP – indirect taxes + subsidies.

GDP vs GNP (or GNI)

Gross Domestic Product (GDP) can be contrasted with Gross National Product (GNP) or
Gross National Income (GNI). The difference is that GDP defines its scope according to
location, while GNP defines its scope according to ownership. GDP is product produced
within a country's borders; GNP is product produced by enterprises owned by a country's
citizens. The two would be the same if all of the productive enterprises in a country were
owned by its own citizens, but foreign ownership makes GDP and GNP non-identical.
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Production within a country's borders, but by an enterprise owned by somebody outside the
country, counts as part of its GDP but not its GNP; on the other hand, production by an
enterprise located outside the country, but owned by one of its citizens, counts as part of its
GNP but not its GDP.

To take the India as an example, the India's GNP is the value of output produced by Indian-
owned firms, regardless of where the firms are located.

Adjustments to GDP (the real, or constant, GDP)

When comparing GDP figures from one year to another, it is desirable to compensate for
changes in the value of money – inflation or deflation. The raw GDP figure as given by the
equations above is called the nominal, or historical, or current, GDP. To make it more
meaningful for year-to-year comparisons, it may be multiplied by the ratio between the value
of money in the year the GDP was measured and the value of money in some base year. For
example, suppose a country's GDP in 1990 was $100 million and its GDP in 2000 was $300
million; but suppose that inflation had halved the value of its currency over that period. To
meaningfully compare its 2000 GDP to its 1990 GDP we could multiply the 2000 GDP by
one-half, to make it relative to 1990 as a base year. The result would be that the 2000 GDP
equals $300 million x one-half = $150 million, in 1990 monetary terms. We would see that
the country's GDP had, realistically, increased by 1.5 times over that period, not 3 times, as it
might appear from the raw GDP data.

The GDP adjusted for changes in money-value in this way is called the real, or constant,
GDP. The factor used to convert GDP from current to constant values in this way is called the
GDP deflator. Constant-GDP figures allow us to calculate a GDP growth rate, which tells us
how much a country's production has increased (or decreased, if the growth rate is negative)
compared to the previous year.

Per Capita GDP

Another thing that it may be desirable to compensate for is population growth. If a country's
GDP doubled over some period but its population tripled, the increase in GDP may not be
deemed such a great accomplishment: the average person in the country is producing less
than they were before. Per-capita GDP is the measure compensated for population growth.

The Circular Flow in a Simple Economy

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The concept of circular flow is described in its simplest form, a simple economy is
considered in which there is no government, no financial markets, and no imports or exports.
As an illustration, imagine that the households in this economy live entirely from hand to
mouth, spending all their income on consumer goods as soon as they receive it, and that the
firms sell all their output directly to consumers as soon as they produce it.
Methods of Measuring National Income
There are four methods of measuring national income. Which method is to be employed
depends on the availability of data in a country and the purpose in hand.
(1) Product Method: According to this method, the total value of final goods and services
produced in a country during a year is calculated at market prices. To find out the GNP, the
data of all productive activities, such as agricultural products, wood received from forests,
minerals received from mines, commodities produced by industries, the contributions to
production made by transport, communications, insurance companies, lawyers, doctors,
teachers, etc. are collected and assessed at market prices. Only the final goods and services
are included and the intermediary goods and services are left out.
(2) Income Method: According to this method, the net income payments received by all
citizens of a country in a particular year are added up, i. e., net incomes that accrue to all
factors of production by way of net rents, net wages, net interest and net profits are all added
together but incomes received in the form of transfer payments are not included in it. The
data pertaining to income are obtained from different sources, for instance, from income tax
department in respect of high income groups and in case of workers from their wage bills.
(3) Expenditure Method: According to this method, the total expenditure incurred by the
society in a particular year is added together and includes personal consumption expenditure,
net domestic investment, government expenditure on goods and services and net foreign
investment. This concept is based on the assumption that national income equals national
expenditure.
(4) Value Added Method: Another method of measuring national income is the value added
by industries. The difference between the value of material outputs and inputs at each stage of
production is the value added. If all such differences are added up for all industries in the
economy, we arrive at the gross domestic product.
Problems of Measurement of National Income in a Developing Economy
In a developing economy, complete and reliable information relating to the various methods
of estimating national income are not available due to the following problems:
1. Non – monetized sector: There is a large non – monetized sector in a developing
economy. This is the subsistence sector in rural areas in which a large portion of production
is partly exchanged for the other goods and is partly kept for personal consumption. Such
production and consumption cannot be calculated in national income.
2. Lack of Occupational Specialisation: There is the lack of occupational specialization in
such a country which makes the calculation of national income by product method difficult.
Besides the crop, farmers in a developing country are engaged in supplementary occupations
like dairying, poultry, cloth making, etc. But income from such productive activities is not
included in the national income estimates.
3. Non – market Transactions: People living in rural areas in a developing country are able
to avoid expenses by building their own huts, tools, implements, garments and other essential
commodities. Similarly, people in urban areas having kitchen gardens produce vegetables
which they consume themselves. All such productive activities do not enter the market
transactions and hence are not included in the national income estimates.

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4. Illiteracy: The majority of people in developing countries are illiterate and they do not
keep any accounts about the production and sales of their products. Under the circumstances,
the estimates of production and earned incomes are simply guesses.
5. Non – availability of Data: Adequate and correct production and cost data are not
available in a developing country. Such data relate to crops, forestry, fisheries, animal
husbandry, and the activities of petty shopkeepers, small enterprises, construction workers,
etc. For estimating national income by the income method, data on unearned incomes and on
persons employed in the service sector are not available. Moreover, data on consumption and
investment expenditures of the rural and urban population are not available for the estimation
of national income by the expenditure method. Moreover, there is no machinery for the
collection of data in such countries.
Importance of National Income Analysis
The national income data have the following importance.
1. For the Economy: National income data are of great importance for the economy of a
country. These days the national income data are regarded as accounts of the economy, which
are known as social accounts. These refer to net national income and net national
expenditure, which ultimately equal each other. Social accounts tell us how the aggregates of
a nation’s income, output and product result from the income of different individuals,
products of industries and transactions of international trade. Their main constituents are inter
– related and each particular account can be used to verify the correctness of any other
account.
2. National policies: National income data form the basis of national policies such as
employment policy, because these figures enable us to know the direction in which the
industrial output, investment and savings, etc. change, and proper measures can be adopted to
bring the economy to the right path.
3. Economic Planning: In the present age of planning, the national data are of great
importance. For economic planning, it is essential that the data pertaining to a country’s gross
income, output, saving and consumption from different sources should be available. Without
these, planning is not possible. Similarly, the economists propound short – run as well as long
– run economic models or long – run investment models in which the national income data
are very widely used.
4. Economic Models: Economists build short – run and long – run economic models in
which the national income data are widely used.
5. For research: The national income data are also made use of by the research scholars of
economics. They make use of the various data of the country’s input, output, income, saving,
consumption, investment, employment, etc., which are obtained from social accounts.
6. Per Capita Income: National income data are significant for a country’s per capita income
which reflects the economic welfare of the country. The higher per capita income, the higher
the economic welfare and vice versa.
7. Distribution of Income: National income statistics enable us to know about the
distribution of income in the country. From the data pertaining to wages, rent, interest and
profits we learn of the disparities in the incomes of different sections of the society.
Similarly, the regional distribution of income is revealed. It is only on the basis of these that
the government can adopt measures to remove the inequalities in income distribution and to
restore regional equilibrium. With a view to removing these personal and regional
disequilibria, the decisions to levy more taxes and increase public expenditure also rest on
national income statistics.
*******

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 Chapter – 15
Population
Theories of Population
The theory of population is studied because the supply of labour depends upon
population and its growth. Observing the abnormal growth of population and consequent fall
in the standard of living, Thomas Malthus (1760 – 1834) an English Clergyman first studied
population growth in various countries of Europe. Later he wrote a book entitled “An Essay
on the Principles of Population” in 1798. His observations compelled him to foresee a
gloomy future for the human race and hence emphasized the immediate need to keep the
population growth under check. Now his theory is popularly known as Malthusian theory of
population. To quote the theory in his own words “By nature human food increases in a slow
arithmetic ratio, man himself increases in a quick geometric ratio unless want and vice stop
him.”

Propositions of Malthusian Theory

These are briefly presented below:
1. Population is necessarily limited by means of subsistence (food supply). According to
Malthus in a country the size of population depends on its food production. Greater the food
production, larger would be the size of population, which a country can support and smaller
the food production then the country would be in a position to support smaller population
only.
2. The power of population is infinitely greater than the power in the earth to produce
subsistence for men. He further adds that population growth always overtakes food
production, since agricultural production is constrained by the law of diminishing returns.
This prevents the food production to grow as faster as that of population. As such, there is no
limit to the growth of population.
3. Population increases in geometric progression, whereas food production increases in
arithmetic progression. This means that population tends to grow in quick geometric
progression i.e., 1, 2, 4, 8, 16,32, etc., while, food production tends to grow in arithmetic
progression i.e., 1, 2, 3, 4, 5, 6, etc. This implies that population doubles in every 25 years.
4. Population always increases, when the means of subsistence increase, unless it is prevented
by some powerful checks. When the food production of a nation increases, the tendency is
that it encourages people to have more children and consequently it leads to large families.
After certain time, the population would become excessive relative to the food production
and the per capita availability of food decreases.
5. There are two types of checks, which can keep population on a level with the means of
subsistence viz., preventive checks and positive checks.
a. Preventive checks: These are man – initiated checks to keep the population under control.
They aim at decreasing the birth rate. These checks are: 1. celibacy 2. late marriage 3. moral
restraints, etc.
b. Positive checks: These are the checks caused by the nature when man fails to take control
of the situation. These checks cause the reduction of excess population and thereby bring an
equilibrium between demand and supply. We have often the famines, epidemics, wars,
floods, earthquakes, etc. These positive checks are also called as natural checks, since they
are caused by nature.

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Criticism of Malthusian Theory of Population
This theory was criticized by many economists on several grounds. Some of the
important ones are presented below:
1. Presenting the mathematical precision for population growth and food production was
objected because as these ratios are found to be unrealistic. There were no instances in the
world, where this trend of population growth and food production recorded and the case of
doubling of population in every 25 years.
2. Malthus did not foresee the scientific advances that are bound to come in agricultural
production, even in the presence of operation of law of diminishing returns.
3. He did not consider total production of nation but confined to agricultural production alone
while presenting his theory. In fact it is total production of a country which gives the true
picture of its economic position. Consider the example of Great Britain. It was not self –
sufficient in agricultural production but it could make great progress through its industrial
production. Less agricultural production cannot make the country to be called over –
population.
4. It was viewed that increase in population would cause greater demand for foodgrains,
ignoring its contribution in the production of goods and services. Further it was criticized that
increase in population in an over – populated country is a matter of serious concern, as it
imposes heavy strain on the limited resources of the nation. In respect of an under populated
country, increase in population is a welcome sign and it helps to raise economic growth and
per capita income
5. Malthus also failed to view that the education and civilization would transform the people
to have smaller families. Hence, there would be no danger of over population.
6. Natural calamities which are infact the acts of nature are commonly found everywhere
regardless of whether a particular country is over populated or under – populated. So, the
statement that natural calamities would occur only in the over populated countries to reduce
population is not true.
Optimum Theory of Population
Prof. Sidgwick gave the foundation of the optimum theory in his principles of political
economy. It was later developed by Edwin Cannon. It is also called as the modern theory of
population.

Definitions of Optimum Population

1. It generally refers to that size of population which provides maximum income per head at a
given amount of resources and technology.
2. Optimum population is that population which produces maximum economic welfare (Carr
– Saunders).
3. Optimum population is that which gives the maximum income per head (Dalton).
4. Optimum population in a country ensures 1) best possible utilization of all resources; and
2) highest per capita income. More specifically, optimum population is the right size of
population that is most desirable in a country consistent with its supply of resources.

Under Population
If the population of a country is below optimum size i.e., below what it ought to be, the
country is said to be under – populated. In such a case the per capita income will not be the

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highest, as the population is insufficient to use the available resources (both natural and
capital) of the country efficiently. The resources are left unharnessed to their optimum level.

Over Population
If the population of a country is in excess of optimum level, the country is said to be
over populated. Since the resources are insufficient in relation to the population, the per
capita income will not be the highest. Gainful employment is not available to people in view
of the insufficiency of resources and requisite technology.
When we say optimum population, it is not fixed for all times. It keeps on changing with
the development of technology and growth of capital.
In figure, population is measured on X – axis and output per capita on Y – axis. It is
observed that output per capita increases with every increase in population till OQ is reached.
At this level of population (optimum population) the per capita output is the highest and is
equal to QP. Any further increase of population beyond OQ leads to reduction of output per
capita. If the actual population of a country is less than optimum population (OQ), it is under
populated and if it is more it is over populated.
Dalton’s Formula for Maladjustment
Dalton’s maladjustment means the extent of deviation of population from optimum size
of population. To measure maladjustment, Dalton gave the following formula.
M=A-O
O
Where,
M = Maladjustment
A = Actual population
O = Optimum population
A positive ‘M’ indicates that the country is over – populated.
A negative ‘M’ indicates that the country is under – populated.
A zero value of ‘M’ indicates that the actual population is equivalent to optimum population.

Malthusian Theory of Population Vs Optimum Theory of Population

1. Malthusian theory is based on the relationship between food production and the size of
population, while modern theory is based on the relationship between total production of a
country and the size of population.
2. Malthusian theory is more a pessimistic theory, while optimum theory is an optimistic one.
3. Malthusian theory has a limitation in its application as it is applicable to over populated
countries only, whereas the optimum theory is applicable universally.

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Natural and Socio – economic Determinants
Natural Factors
The abundance of resources influences the growth of population. In the presence of
abundant resources, populations can grow at geometric or exponential rates. If resources
become limited, population growth rate slows and eventually stops; this is known as logistic
population growth. Population growth stops when populations reach a maximum size called
the carrying capacity, the number of individuals of a particular population that the
environment can support. Population growth is a function both of per capita growth rates and
population size.
The environment limits population growth by changing birth and death rates. The factors
affecting population size and growth include biotic factors such as food, disease, competitors,
and predators and abiotic factors such as rainfall, floods, and temperature. Because the effects
of biotic factors, such as disease and predation, are often influenced by population density,
biotic factors are often referred to as density-dependent factors. Meanwhile, abiotic factors
such as floods and extreme temperature can exert their influences independently of
population density and so are often called density- independent factors.

Socio – economic Factors

The socio - economic factors play an important role in the growth of population. The
socioeconomic factors which affects the growth of population are industrialization, education,
religious beliefs, marriage, social status, family structure, health care, nutritional status etc.
There is an inverse relationship with the industrial growth and the rate of population
growth. The developed or industrialized countries have less growth of the population. They
are mostly stable. The zero growth occurs in Germany and around 1 percent growth occurs in
America and France. In Austria there is a negative growth. But in the developing countries
there has been an increase in the growth of population. They show a direct relationship.
The education shows an inverse relationship with the rate of population growth. The
developed or industrialized countries which have a high literacy rates show less growth of the
population. But it is not the only criteria which define the rate of growth of population. In
some states like Kerala the literacy rate is very high but they are thickly populated also. There
are few religious beliefs which prevent the people to undergo family planning. In such
religion dominated countries the population will continue to rise. This occurs despite the
higher literacy rates and economic growth. It occurs in the United Arab Emirates and Saudi
Arabia. They have a very high population growth rate.
The women can give rise to offspring mainly from the age 15 to 45. If she gets married
late naturally the chances of giving birth to more offspring will reduce. It is common in the
industrialized countries. The women marry late but in the developing countries the women
marry very early around 15 to 20 years of age.
The social status of women shows an inverse relationship with the rate of population
growth. The higher status women marry later in their age. The family structure also plays an
important role in the growth of population. The child labor plays a crucial role in the growth
of population. These families consider the children as their earning hands. So, more are the
children and more are their sources of income.
The health care shows a direct relationship with the rate of population growth. The better
is the health care system less is the mortality rate and higher is the natality rate. The families

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with the gainful employment show low mortality. It decreases the incidence with the large
number of children. A well maintained diet helps to reduce the mortality.
The sources of entertainment also play an important role in the growth of population.
They keep a routine check on the population. More are the sources of entertainment and
lesser are the chances of high natality. The population education shows an inverse
relationship with the rate of population growth. The better is the population education the
lesser is the growth of population.

National Population Policy (NPP) 2000

1. The Immediate Objective: The immediate objective is to address the unmet needs for
contraception, health care infrastructure and health personnel and to provide integrated
service delivery for basic reproductive and child health care.
2. The Medium Term Objective: The medium term objective is to bring the Total Fertility
Rate (TFR) to replacement level by 2010 through vigorous implementation in inter-sectorial
operational strategies.
3. The Long Term Objective: The long term objective is to achieve a stable population by
2045 at a level consistent with the requirements of sustainable economic growth, social
development, and environment protection.

Targets: The following are the targets of National Population Policy:

1. Achieve zero growth rate of population by 2045.
2. Reduce infant mortality rate of below 30 per thousand live births.
3. Reduce maternal mortality ratio of below 100 per 1, 00,000 live births.
4. Reduce birth rate to 21 per 1000 by 2010.
5. Reduce total fertility rate (TFR) to 2.1 by 2010
As a result of the initiatives of the Government, the country’s Total Fertility Rate (TFR)
has declined from 2.7 in 2006 to 2.2 in 2016. The Crude Birth Rate has declined from 23.8 in
2005 to 20.8 and 24 states/UTs have already achieved the replacement level TFR of 2.1 or
less out of 36 states/UTs.
National Socio-Demographic Goals for 2010:
To fulfill these objectives and targets, National Socio-Demographic goals have been
formulated which in each case are to be achieved by the year 2010.
They are as follows:
1. Make school education free and compulsory up to the age of 14 and reduce dropouts at
primary and secondary school levels to below 20 per cent for both boys and girls.
2. Address the unmet needs for basic reproductive and child health services, supplies and
infrastructure.
3. Achieve universal immunization of children against all vaccine preventable diseases.
4. Promote delayed marriage for girls, not before 18 and preferably after the age of 20 years.
5. Prevent and control communicable diseases.
6. Achieve universal access to information/counselling and services for fertility regulation
and contraception with a wide basket of choices.
7. Achieve 80 per cent institutional deliveries and 100 per cent deliveries by trained persons.
8. Achieve 100 per cent registration of births, marriage and pregnancy.
9. Integrate Indian Systems of Medicine (ISM) in the provision of reproductive and child
health services and in reaching out to households.

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10. Contain the spread of Acquired Immuno-Deficiency Syndrome (AIDS) and promote
greater integration between the management of Reproductive Tract Infections (RTI) and
Sexually Transmitted Infections (STI) and the National AIDS Control Organisation.
11. Bring about convergence in implementation of related social sector programmes so that
family welfare becomes a people centred programme.
12. Promote vigorously the small family norm to achieve replacement levels of TFR.
Implementation of NPP, 2000: National Commission on Population:
In pursuance of NPP, 2000, the Central Government has set up a National Commission
on Population (NCP) on 11 May, 2000. It is presided over by the Prime Minister, with the
Chief Ministers of all States and UTs and the Central Minister-in-charge of concerned
Central Ministries and Departments, reputed demographers, public health professionals and
non-government organisations as members. State Level Commissions on Population presided
over by the Chief Minister have been set up with the objective of ensuring implementation of
the NPP.

The functions of the Commission are:

(i) To review, monitor and give direction for the implementation of the NPP with a view to
achieve the goals set by it;
(ii) To promote synergy between health, educational, environmental and developmental
programmes so as to hasten population stabilization;
(iii) To promote inter-sectoral co-ordination in planning and implementation of the
programmes through different agencies at the Centre and in the States; and
(iv) To develop a vigorous people’s programme to support this national effort.

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 Chapter – 16
Money
When the human civilization was not developed, people used to exchange those goods which
they produced for those which others produced. Such an act of exchanging goods for goods is
called barter. But as the years rolled by and when the social organization became more
complex, barter system was found to be not practicable. The following are the main
difficulties which were found in the barter system.
1. Double coincidence of wants
2. Lack of a standard unit of account
3. Impossibility of subdivision of goods
4. Lack of information
5. Production of large and very costly goods not feasible
The difficulties in barter system were replaced with the introduction of money. Money
has been defined as the medium of exchange. According to Robertson money is defined as
“Anything which is widely acceptable in discharge of obligations”. The different stages in the
development of money are as follows.
1. Commodity Money: The earliest form of money consisted of goods like rice, wheat,
cattle, skins, elephant tusks etc. These were accepted as they were all desired by all the
people.
2. Metallic Money: As the civilization advanced, people found it difficult to carry on the
exchange transaction with commodities, as they were found to be very inconvenient.
Commodity money gave way for the metals to be used as money. These metals include gold,
silver, copper, bronze, etc. From the beginning of their introduction, Government kept the
right to issue coins and certify their weight and quality. Metals were converted into coins for
this purpose.
3. Paper Money: Paper money is introduced to supplement the metallic money. When paper
money was introduced, it was backed up by exactly equal amount of gold or silver kept in
reserve by the issuing authority. But now paper money is not backed up by metals like gold
and silver, but only proportional reserves are maintained. Their issue rests more on people’s
confidence on the issuing authority. Such a currency is called fiduciary issue and Indian
currency largely is of fiduciary issue.
4. Bank Money: Paper money has been supplemented or at times replaced by bank money. It
refers to the bank deposits. Deposits can be converted into money by the depositors through
cheques.

Kinds of Money
The main kinds of money are (1) Metallic money and (2) Paper money. These are
further divided into standard money and token money.
1. Standard Money: For such type of money, intrinsic value (real value) is equal to face value
(the value written on the coin). It is subjected to free coinage. The coins are made of gold
and/ or silver. As such, no country has such a money in circulation.
2. Token Money: This money is made up of cheaper metal. Its face value is greater than its
intrinsic value. The rupee is a standard unit of money in India, but its face value is greater
than its real value and also it is not subjected to free coinage. It is a mixture of standard and
token money.

Characteristics of Money: Following are the characteristics of money.

1. Cognisability: The medium used, as money should be easily recognized by one and all.
Keeping this in view, the citizens of a nation give value to their respective currencies, issued
by monetary authorities. In India the quantum of currency and its value are determined by
RBI and Ministry of Finance.
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2. Utility: When money is deposited by the public in different financing institutions, they will
get different interest rates. This is due to the fact that money receiving agency (borrowing
agency) will have different time utilities for money. In other words, they use the money for
the best alternative and accordingly pay the interest to the lenders, depending on the need.
Similarly money will have possession utilities and place utilities also.
3. Portability: It should facilitate easy carrying from one place to another without expense or
inconvenience to the individual user. In other words, the bulkiness, weight and other
inconveniences in the transactions are reduced with the help of currencies of different
denominations, such as Rs. 5, Rs. 10, Rs. 20, Rs. 50, Rs. 100, Rs. 500 and Rs. 1000 notes.
4. Durability: Coins are more durable than the paper currencies. Particularly, currencies of
lower denominations viz., 10 paise, 25 paise, 50 paise, one rupee and 5 rupees are being in
circulation in the form of coins in order to provide durability. Similarly keeping the same
purpose in view, the standard paper is used for printing currency notes.
5. Indestructibility: In the normal usage the coins should not get disfigured easily and the
paper currency should not get torn easily in the circulation.
6. Stability: The value of money should not be changing. It should be more stable. For this to
achieve there is need to eliminate inflation in the economy.
7. Homogeneity: All coins of the same metal should be as identified as possible with regard
to quality and weights. Similarly notes should be printed with the same quality paper with
utmost caution and use of sophisticated machinery, otherwise fake notes come into
circulation and cause inflation.
8. Universal Acceptability: The value of the currency issued by monetary authority in the
country should be recognized uniformly in all the states of the nation. Such currency of the
nation will be accepted internationally also, provided the currency follows the norms of
international monetary authority.

Functions of Money: Money performs five important functions.

1. Medium of Exchange: Money facilitates the buying and selling of goods and services as a
medium of exchange.
2. A unit of account: Money is used as the measure of value of all goods and services. Rupee
is the monetary unit in India. The value of all goods and services is expressed in rupees.
3. Standard of Deferred Payments: Money facilitates the settlement of debts and future
transactions without any risk.
4. Store of value: Money is a form of holding wealth. If one feels that the available money is
in excess of his requirements it is convenient to save and use it as and when the need arises.
5. Transferable: It facilitates the easy transfer of value. The disposal and purchase of assets
can be done very easily with money.

Money Supply
The supply of money conforms to the ‘stock’ concept and not the ‘flow’ concept. Just as
the demand for money is the demand for money to hold, similarly, the supply of money
means the supply of money to hold. Money must always be held by someone, otherwise it
cannot exist. Hence, the supply of money means the sum total of all the forms of money
which are held by a community at any given moment.
The stock of money, which constitutes the supply of it, constitutes of (a) metallic money
or coins (b) currency notes issued by the currency authority of the country whether the
Central bank or the government and (c) chequable bank deposits. In old times, the coins
formed the bulk of money supply of the country. Later, the currency notes eclipsed the
metallic currency and now the bank deposits in current account withdrawable by cheques
have overwhelmed all other forms of money. In modern times, the supply of money really
means the chequable bank deposits.
The modern economists include in money stock not only currency or cash balances and
demand deposits in banks together called M1. In addition to the items of M1, the concept of
money supply M2 includes savings deposits with the post office savings banks. M3 is a broad

85
concept of money supply. In addition to the items of money supply included in measure M 1,
in money supply M3 time deposits with the banks are also included. The measure M4 of
money supply includes not only all the items of M3 but also the total deposits with the post
office savings organisation.
The total supply of money in a country, by and large, depends on the credit control
policies pursued by the banking system of the country.

Inflation
In economics, inflation is a rise in the general price level of goods and services in an
economy over a period of time.
When the price level rises, each unit of currency buys fewer goods and services;
consequently, annual inflation is also an erosion in the purchasing power of money – a loss
of real value in the internal medium of exchange in the economy.

What is Inflation Rate?

Inflation rate is the rate at which prices of goods and services increase in its economy. It is an
indication of the rise in the general level of prices over time. Since it's practically impossible
to find out the average change in prices of all the goods and services traded in an economy
due to the sheer number of goods and services present, a sample set or a basket of goods and
services is used to get an indicative figure of the change in prices, which we call the inflation
rate.

Measuring inflation
Suppose the price of 1 kg of wheat changes from Rs. 20 to Rs. 25 over the course of a year,
with no change in quality, then this price difference represents inflation. This single price
change would not, however, represent general inflation in an overall economy. To measure
overall inflation, the price change of a large "basket" of representative goods and services is
measured. This is the purpose of a price index, which is the combined price of a "basket" of
many goods and services. The combined price is the sum of the weighted average prices
of items in the "basket". A weighted price is calculated by multiplying the unit price of an
item to the number of those items the average consumer purchases. Weighted pricing is a
necessary means to measuring the impact of individual unit price changes on the economy's
overall inflation. Those weighted average prices are combined to calculate the overall price.
To better relate price changes over time, indexes typically choose a base year price and
assign it a value of 100. Index prices in subsequent years are then expressed in relation to the
base year price.

Inflation measures are often modified over time. New products may be introduced, older
products disappear, the quality of existing products may change, and consumer preferences
can shift. Both the sorts of goods and services which are included in the "basket" and the
weighted price used in inflation measures will be changed over time in order to keep pace
with the changing marketplace.

Inflation numbers are often seasonally adjusted in order to differentiate expected cyclical cost
shifts. For example, price of air-conditioner is expected to rise in summer months. In such
cases, seasonal adjustments are used when measuring for inflation.

How does India calculate inflation?

In India, inflation is calculated on a weekly basis. India uses the Wholesale Price Index
(WPI) to calculate and then decide the inflation rate in the economy while most developed
countries use the Consumer Price Index (CPI) to calculate inflation.

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Wholesale Price Index (WPI)

WPI is the index that is used to measure the change in the average price level of goods traded
in wholesale market. It was first published in 1902, and was one of the more economic
indicators available to policy makers until it was replaced by most developed countries by the
Consumer Price Index in the 1970s.
In India, at present a total of 697 commodities are included in the commodity basket in
which Primary articles contribute 117 items, Fuel and Power contribute 16 items, and
Manufactured Products provide 564 items. The base year is 2011-12.

How is WPI (Wholesale Price Index) calculated in India?

For calculation, WPI for the base year is assumed to be 100. Assume that WPI for the year
1993-94 is considered as the base year. Let's calculate WPI for the year 2009-10 for a
particular commodity, say wheat. Assume that the price of a kilogram of wheat in 1993-94 =
Rs 7.00 and in 2009-10 = Rs 15.00
(Price of wheat in 2009-10 - Price of wheat in 1993-94)
WPI of wheat (2009-10) = -------------------------------------------------------------------- x 100
Price of wheat in 1993-94
= (15.00 – 7.00) / 7.00 x 100
= 114.28
Since WPI for base year is assumed as 100, WPI for 2009-10 will become 100+114.28 =
214.28.
In this way individual WPI values for all the commodities are calculated and then the
weighted average of individual WPI figures are found out to arrive at the overall Wholesale
Price Index. Commodities are given weight age depending upon its influence in the economy.

How is inflation rate calculated?

If we have the WPI values of two time zones, say, beginning and end of year, the inflation
rate for the year will be, (WPI of end of year – WPI of beginning of year) / WPI of beginning
of year x 100. For example, WPI for 1st Jan 2009 was 200 and WPI for 1st Jan 2010 was 210
then inflation rate for the year 2009 is (210-200)/200 x 100 = 5%.
Since WPI figures are available every week, inflation for a particular week (which usually
means inflation for a period of one year ended on the given week) is calculated based on
the above method using WPI of the given week and WPI of the week one year before.
Consumer Price Index (CPI)
CPI is a measure estimating the average price of consumer goods and services purchased by
households. A consumer price index measures a price change for a constant market basket of
goods and services from one period to the next within the same area (city, region, or nation).
It is a price index determined by measuring the price of a standard group of goods meant to
represent the typical market basket of a typical urban consumer.

Effects of Inflation
Inflation's effects on an economy are manifold and can be simultaneously positive and
negative.
Negative effects
1. Decrease in the real value of money and other monetary items over time
2. Uncertainty about future inflation may discourage investment and saving, or may lead
to reductions in investment of productive capital and increase savings in non-
producing assets. e.g. selling stocks and buying gold.
3. Reduce overall economic productivity rates, as the capital required to retool
companies becomes more elusive or expensive.
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 4. High inflation may lead to shortages of goods if consumers begin hoarding out of
concern that prices will increase in the future.
Positive effects
1. Mitigation of economic recessions
2. Debt relief by reducing the real level of debt.

Causes of Inflation

1. High rate of inflation is caused by an excessive growth of the money supply. A long
sustained period of inflation is caused by money supply growing faster than the rate of
economic growth.
2. Low or moderate inflation may be attributed to fluctuations in real demand for goods
and services, or changes in available supplies such as during scarcities, as well as to
growth in the money supply.
3. Generally during war and in the post-war period, there will be inflation. This is so
because during war, there will be shortage of goods and there may be rationing,
control and things like that. So during the post-war years, people who have been
forced to save money will spend. That is, demand for all sorts of goods will increase
during that period but supply will not increase so fast as that. This leads to inflation.
Inflation occurs during war because the one great aim at that time is that of winning
the war. Since modern wars are so expensive, the Government has to depend upon
created money to finance war. This leads to inflation.
4. And inflation breeds inflation. It means that inflation leads to inflation. During a
period of inflation, prices will be high. Since prices are high, workers will demand
high wages. High wages result in high costs. High costs in turn lead to high prices.
Thus it forms a vicious circle. Wages force up prices; prices force up wages. This is
the inflationary spiral.
5. Deficit financing is another cause of inflation. This applies particularly to
underdeveloped countries with planned economies.
Kinds of Inflation
There are three major types of inflation
1. Demand-pull inflation
It is caused by increases in aggregate demand due to increased private and government
spending, etc. Demand inflation is constructive to a faster rate of economic growth since the
excess demand and favourable market conditions will stimulate investment and expansion.
Demand-pull theory states that the rate of inflation accelerates whenever aggregate demand is
increased beyond the ability of the economy to produce (its potential output). Hence, any
factor that increases aggregate demand can cause inflation. However, in the long run,
aggregate demand can be held above productive capacity only by increasing the quantity of
money in circulation faster than the real growth rate of the economy.
2. Cost-push inflation
It is also called supply shock inflation. It is caused by a drop in aggregate supply (potential
output). This may be due to natural disasters, or increased prices of inputs. For example, a
sudden decrease in the supply of oil, leading to increased oil prices, can cause cost-push
inflation. Producers for whom oil is a part of their costs could then pass this on to consumers
in the form of increased prices.
3. Built-in inflation
It is induced by adaptive expectations, and is often linked to the "price/wage spiral". Rising
inflation can prompt employees to demand higher wages (above the rate of inflation), to keep
up with consumer prices and firms passing these higher labor costs on to their customers as

88
higher prices, leading to a vicious circle. Built-in inflation reflects events in the past, and so
might be seen as hangover inflation.
Other types of Inflation
Repressed Inflation : Generally price rise results in inflation. However, there can be
inflation even without a rise in the price level. This is known as Repressed Inflation. Usually
this happens during a war period. On account of many controls and rationing that exist during
wartime, prices will be kept under check. But the moment controls are withdrawn, prices will
go up. So the real test of inflation is neither an increase in the amount of money nor a rise in
prices, but the appearance of abnormal profits. Whenever businessmen and producers make
huge profits, it is a sign of inflation.
Runaway or Galloping or Hyper – Inflation : This is a serious type of inflation. For
example, it was experienced in Germany after World War I and in Hungary and China after
World War II. In this situation, prices rise to a very great extent at high speed and high prices
have to be paid even for cheap things. And money becomes quite worthless and new currency
has to be introduced. This situation is known as galloping inflation or hyper-inflation.
Profit – Push Inflation : Just as trade unions manage to push up wages, oligopolists and
monopolists will raise prices more than enough to cover increase in costs with the aim of
making monopoly profits.
Controlling inflation
Since inflation has many evils, every government tries to check it. A variety of methods have
been used in attempts to control inflation. Today, most mainstream economists favor a low
positive steady rate of inflation. Low inflation may reduce the severity of economic
recessions. The primary tool for controlling inflation is monetary policy. The task of keeping
the rate of inflation low and stable is usually given to monetary authorities. Generally, these
monetary authorities are the central banks that control the size of the money supply through
the setting of interest rates, through open market operations, and through the setting of
banking reserve requirements.
Some other measures
1. Increased taxation
2. By reducing government expenditure on capital projects. (In India, this measure has
been suggested to check inflation. Many capital projects proposed in our Third Five
Year Plan were either suspended or dropped completely.
3. Restrictions on imports.
4. Rationing and
5. Price controls.
Sometimes a “wage freeze’ is recommended to check inflation. That is, trade unions will be
requested not to ask for an increase in wages during a given period. The success of the above
measures in tackling inflation depends upon the efficiency of the government in
implementing the measures.

Related definitions
Deflation
Deflation is a state in which the value of money is rising, i.e., prices are falling. Deflation is
the opposite of inflation. Generally inflation is a period characterized by rising activity and
employment. But during deflation, there will be bad trade and unemployment. During
deflation, since prices fall faster than costs, there will be heavy losses for producers and
businessmen. There will not be profits in any branch of economic activity. So there will be a
fall in investment. This results in unemployment. Both inflation and deflation are evils.
There is nothing much to choose between them. While rising prices can be checked to some
extent by the monetary policy of the government, the latter is of little help in raising the price
89
level during deflation. It does not work. That is why during such periods, modern economists
suggest that the State must play an active role in the economic field and step up economic
activity by undertaking a series of public works programmes.
Disinflation – a decrease in the rate of inflation
Hyperinflation – an out-of-control inflationary spiral
Stagflation – a combination of inflation, slow economic growth and high unemployment
Reflation – an attempt to raise the general level of prices to counteract deflationary
pressures.

*****

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 Chapter – 17
Economic Systems
The term economic system refers to the mode of production and the distribution of goods and
services within which economic activity takes place. In a broader sense, it “refers to the way
different economic elements (individual workers and managers, productive organisations
such as factories or firms, and government agencies) are linked together to form an organic
whole.” The term also refers to how the different economic elements will solve the central
problems of an economy: What, how, and for whom to produce.

Capitalism or Free Enterprise Economy

Capitalism is an economic system in which each individual in his capacity as a
consumer, producer, and resource owner is engaged in economic activity with a large
measure of economic freedom. Individual economic actions conform to the existing legal and
institutional framework of the society which is governed by the institution of private
property, profit motive, freedom of enterprise, and consumers’ sovereignty. All factors of
production are privately owned and managed by individuals. The raw materials, the
machines, the firms, and the factories are owned and managed by individuals who are at
liberty to dispose of them within the prevalent laws of the country. Individuals have the
freedom to choose any occupation, and to buy and sell any number of goods and services.

Features of Capitalism
The principal features of capitalism are:
1. Private Property: It means that the owner of a firm or factory or mine may use it in any
manner he likes. He may hire it to anybody, sell it, or lease it at will in accordance with the
prevalent laws of the country.
2. Profit motive: The decisions of businessmen, farmers, producers, including that of wage –
earners are based on the profit motive.
3. Price Mechanism: Under capitalism, the price mechanism operates automatically without
any direction and control by the central authorities. It is the profit motive which determines
production. Capitalism is a system of mutual exchanges where the price – profit mechanism
plays a crucial role.
4. Role of the State: During the 19th century, the role of the state was confined to the
maintenance of law and order, protection from external aggression, and provision for
educational and public health facilities. This policy of laissez - faire – of non – intervention
in economic affairs by the state – has been abandoned in capitalist economies of the West
after the Second World War. Now the state has important tasks to fulfil. They are monetary
and fiscal measures to maintain aggregate demand; anti – monopoly measures and
nationalised monopoly corporations; and measures for the satisfaction of communal wants
such as public health, public parks, roads, bridges, museums, zoos, education, flood control,
etc.
5. Consumers’ Sovereignty: Under capitalism, ‘the consumer is the king.’ It means freedom
of choice by consumers. There is also freedom of production whereby producers are at liberty
to produce a vast variety of commodities in order to satisfy the consumer who acts like a
‘king’ in making a choice out of them with his given money income. These twin freedoms of
consumption and production are essential for the smooth functioning of the capitalist system.
6. Freedom of Enterprise: Freedom of enterprise means that there is free choice of occupation
for an entrepreneur, a capitalist, and a labourer. But this freedom is subject to their ability and
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training, legal restrictions, and existing market conditions. It is on account of the presence of
this important feature of freedom of enterprise that a capitalist economy is also called a free
enterprise economy.
7. Competition: Competition is one of the most important features of a capitalist economy. It
implies the existence of large number of buyers and sellers in the market who are motivated
by self – interest but cannot influence market decisions by their individual actions. It is
competition among buyers and sellers that determines the production, consumption and
distribution of goods and services.

Socialism
A socialist economy is an economic organization in which the means of production are
owned and regulated by the state. The production and distribution of goods and factors of
production are done by the state under the direction of the planning commission. The
decisions as to how much to produce, which methods of production to employ and for whom
to produce are taken by the planning authority. That is why, a socialist economy is also called
planned economy. Such economies are China, Cuba, Vietnam and North Korea. They possess
the following features.

Features of Socialism
1. Public Ownership: A socialist economy is characterised by public ownership of the means
of production and distribution. There is collective ownership whereby all mines, farms,
factories, financial institutions, distributing agencies (internal and external trade, shops,
stores, etc.), means of transport and communications, etc. are owned, controlled, and
regulated by government departments and state corporations.
2. Central Planning: A socialist economy is centrally planned which functions under the
direction of a central planning authority. It lays down the various objectives and targets to be
achieved during the plan period.
3. Definite Objectives: A socialist economy operate within definite socio – economic
objectives.
4. Freedom of Consumption: Under socialism, consumers’ sovereignty implies that
production in state – owned industries is generally governed by the preferences of consumers,
and the available commodities are distributed to the consumers at fixed prices through the
state – run department stores.
5. Equality of Income Distribution: In a socialist economy, there is great equality of income
distribution as compared with a free market economy. The elimination of private ownership
in the means of production, private capital accumulation, and profit motive under socialism
prevent the amassing of large wealth in the hands of a few rich persons.
6. Planning and the Pricing Process: The pricing process under socialism does not operate
freely but works under the control and regulation of the central planning authority. There are
administered prices which are fixed by the central planning authority. There are also the
market prices at which consumer goods are sold. There are also the accounting prices on the
basis of which the managers decide about the production of consumer goods and investment
goods, and also about the choice of production methods.

Mixed Economy
A mixed economy is a golden mean between a capitalist economy and a socialist economy. It
is an economic system where the price mechanism and economic planning are used side by

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side. There is mixture of private and public ownership of the means of production and
distribution. Some decisions are taken by households and firms and some by the planning
authority. All developing countries like India are mixed economies.

Features of Mixed Economy

A mixed economy possesses the following features:
1. Public Sector: The public sector is under the control and direction of the state. All
decisions regarding what, how and for whom to produce are taken by the state. Public
utilities, such as rail construction, road building, canals, power supply, means of
communication, etc, are included in the public sector. They are operated for public welfare
and not for profit motive. The public sector also operates basic, heavy, strategic and defence
production industries which require large investment and have long gestation period. But they
earn profits like private industries which are utilized for capital formation.
2. Private Sector: There is a private sector in which production and distribution of goods and
services are done by private enterprises. This sector operates in farming, plantations, mines,
internal and external trade, and in the manufacture of consumer goods and some capital
goods. This sector operates under state regulations in the interest of public welfare. In certain
fields of production, both public and private sectors operate in a competitive spirit. This is
again in the interest of the society.
3. Joint Sector: A mixed economy also has a joint sector which is run jointly by the state and
private enterprises. It is organised on the basis of a joint stock company where the majority
shares are held by the state.
4. Cooperative Sector: Under a mixed economy, a sector is formed on cooperative principles.
5. Freedom and Control: A mixed economy possesses the freedom to hold private property, to
earn profit, to consume, produce and distribute, and to have any occupation. But if these
freedoms adversely affect public welfare, they are regulated and controlled by the state.
6. Economic Planning: There is a central planning authority in a mixed economy. A mixed
economy operates on the basis of some economic plan.
7. Social Welfare: The principal aim of a mixed economy is to maximize social welfare. This
feature incorporates the merits of socialism and avoids the demerits of capitalism. To remove
inequalities of income and wealth, and unemployment and poverty, such socially useful
measures as social security, public works, etc. are adopted to help the poor. On the other
hand, restrictions are placed on the concentration of monopoly and economic power in the
hands of the rich through various fiscal and direct control measures.

Forms of Business Organization

A business activity can be organized in different ways. In practice we come across
business organization owned and run by a single person or group of persons. The ownership
patterns of business when looked into, reveal five distinct forms viz., 1) Individual
organization or single proprietorship or sole trader concern organization or the sole
proprietorship; 2) Partnership; 3) Joint stock company; 4) Co-operative – organization; and 5)
State enterprise.
The selection of each form of business organization by the entrepreneurs is influenced by
several factors viz., 1) type of business unit contemplated; 2) the care with which an
enterprise can be run; 3) owned funds available with the entrepreneur; 4) total capital

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requirements; 5) possibilities of securing borrowed capital; 6) the risk and liability aspects
which the entrepreneur has to assume; 7) tax aspects of different forms of business
organization; 8) Organizational, managerial and controlling aspects, etc.

Individual Enterprise or Single Proprietorship or Sole Trader or the Sole

Proprietorship
The individual enterprise is the most common form of business organization. Many small
business enterprises belong to this form. These enterprises are owned and operated by a
single person, who takes all the responsibilities of outcome of the business. These enterprises
are found to be small with a few exceptions here and there. This is more or less a family
proprietorship with all the family members participating in the business affairs. As far as the
size of the business is concerned, it is left to the desire of the entrepreneur keeping in view of
the resources at his disposal.

Partnership
It is an association of two or more individuals who join together as co – owners to share
profits or losses in agreed proportions. Partnership comes into existence based on the goals of
the co – owners. To safeguard the business interests of the partners, normally a written
partnership agreement is made covering various dimensions of business viz., capital
contribution, managerial responsibilities, sharing of profit and losses, withdrawal from the
business, termination of the business, etc.
There are two kinds of partnership, viz., general partnership and the limited partnership.
General partnership is the most common in partnership dealings. Every partner, irrespective
of the percentage of capital contributed to the business, has equal say in the management of
business. Each partner has equal rights and liabilities. In limited partnership, any number of
limited partners are allowed, but there should be atleast one general partner. Liability of each
member is limited to the extent of investment made only. Profits are also distributed among
the partners according to the contribution of capital in the business.
There are different kinds of partner, viz., active partner, sleeping partner, nominal
partner, secret partner, etc. Active partner is one who is actively involved in running the
business. He performs various roles like manager, organizer and adviser of business. A
sleeping partner is one who contributes capital, shares profits and takes the responsibilities of
losses of the business, but he does not participate in running the business. Normally persons
having capital but who do not find time in the business affairs, prefer to be sleeping partners.
Nominal partner is one who joins a business but does not contribute capital. He just lends his
name for the business and on his virtues the business prospers. But he is identified as a
partner by the third party. In the event of loss of a business, he is liable to the third party. This
is because third party thinks him as partner. Secret partner is one whose name is kept secret.
His name is not disclosed to outsiders. He is liable for the losses, if any. He differs from
sleeping partner in the matter that he takes part in running the business.

Joint Stock Private Limited Company

The minimum number of members is two but the number cannot exceed 50. There is no
need for the private limited company to call for a statutory meeting. Similarly, the company
need not submit its annual balance sheet to the registrar of joint stock companies. The transfer
of share is generally restricted by articles. It cannot issue prospectus inviting the public to

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subscribe to the share capital. The word ‘Pvt. Ltd’ must be used with the name of the
company.

Joint Stock Public Limited Company

The business can be started with seven persons and there is no maximum limit for
members. The business shall commence only after getting the certificate of incorporation
from the registrar of joint stock companies. The public limited company must issue a
prospectus inviting the public to contribute to the share capital. A statutory meeting must be
held within a prescribed period and its annual balance sheet must be submitted to the registrar
of joint stock companies. The main sources of finance for the company are through shares
and borrowings. The shares are freely transferable. A shareholder can sell his shares at any
time he prefers. The company will not return the shares to the shareholder till it winds up the
business, but shareholders can easily sell their shares through stock exchange. The common
types of shares are: 1) ordinary shares 2) preference shares; and 3) deferred shares. Ordinary
shares are those for which no special privilege is given. Ordinary shareholders get dividend
from the net profits of the company. Preference shares are those which carry a certain fixed
dividend from the net profits. This dividend is paid to the preference shareholders before
dividend is paid to other kind of shareholders. At the time of liquidation of the company after
paying outside creditors, preference share capital is returned. Ordinary shareholders will be
paid only when preference share capital is paid in full. Deferred shareholders receive
dividend, after payment of dividend to ordinary and preference shareholders.
Apart from selling shares the company raises required capital by floating debentures.
A debenture is a document under the company’s seal which provides for the payment of a
principal sum and interest there on at regular intervals, which is usually secured by a fixed or
floating charge on the company’s property or undertaking and which acknowledges a loan to
the company. Debentured are not shares but are just like promissory notes from which funds
are raised. It is a form of loan and debenture holders (creditors) are paid interest as promised
whether the company gets profits or not.

Co – operative Organization
The term, co – operation implies the self help made effective through mutual help.
The philosophy behind co – operative movement embodies in a slogan called “all for each
and each for all”. The basic objective of co – operation is protecting weaker sections of the
society so that they fulfill their needs. Various types of co – operative societies are: 1)
Consumers’ co – operatives 2) Producers’ co – operatives and 3) Credit co – operatives.

Consumers’ Co – operatives
These are present in rural and urban areas. Members in an area contribute capital to
form into a society. Any person, regardless of caste, creed or religion can become a member
of the society. The society is run by the elected executive members. The society undertakes
bulk purchases of consumer goods and sells to the members. In this process the middlemen
are eliminated. Non – members are also allowed to buy the goods but they are charged extra
price. The society makes small profits to cover the administrative costs. The surplus of profits
are distributed among the members as dividends. A certain percentage of profits is kept aside
as reserve fund for contingencies and growth of the co – operatives.

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Producers’ Co – operatives
These are the associations of producers which help them in procuring inputs and in
marketing their produce. These societies are formed with a sole aim of improving the
economic conditions of producers. The society supplies the raw materials to these members
who produce the goods. The society takes the responsibility of selling the goods. The
members as workers are paid wages for their services. Part of the profits is retained as reserve
fund and the balance is distributed among members. Examples: Weavers’ societies, co –
operative farming societies, etc.

Credit Co – operatives
Credit co – operatives are established to protect the small farmers and other weaker
sections. Here, through thee co – operatives, weaker sections of the society are protected
from the clutches of moneylenders, who charge exorbitant rates of interest. Credit co –
operatives are categorized into two. 1) Rural Credit Co – operative Societies and 2) Urban
Credit Co – operative Societies
1. Rural credit co – operatives can be formed with atleast 10 members. Individuals join as
members by contributing to the share capital in the form of shares. The societies receive loans
from State Co – operative Bank, and these are advanced to the members as short term loans.
These societies keep up a margin while advancing loan to meet the administrative costs. The
area of coverage of these societies is confined to one or two villages.
2. Urban co – operative credit societies are meant to advance loans to small traders, artisans
and employees receiving small incomes. The members are provided short term loans.
Liability is limited. Urban co – operatives raise their capital from Governmental agencies and
members.

State or Public Enterprise

State enterprise is an undertaking, owned and controlled by the local or State or
Central Government. Entire investment or major part of the investment is done by the
Government. The major considerations for the States to undertake the business are heavy
investment requirements, need to protect weaker sections against economically strong, and
when private traders are hesitant to venture into the enterprise. State enterprises are found in
manufacturing, trading and service activities. These enterprises are managed by the
Government. The Government programmes are implemented through State enterprises.

International/ Foreign Trade:-

With the introduction of the process of globalization of the economy and the
advantage of WTO, the degree of inter-dependence among the countries of the world has
increased. Many factors have favored international specialization and international trade in
tangible goods & in intangible goods and services.

Definition: Foreign trade/ international trade mean “Trade done outside the boundaries of
country and with other countries, e.g. Tea is exported from India to England.
a. Import Trade: It means purchase goods or services from other countries. E.g. Machineries
Purchased from USA and brought to India.

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b. Export Trade: It means to sell the goods, services or technology produced in our country
to other countries. e.g. Mango Juice sale in Australia
c. Re-export Trade: It means to purchase goods from other country and to sell the same
directly to other country. e.g. Machinery purchase from Russia and unloaded at Bombay port
and from Bombay, sent to Sri Lanka.

Differences between Inter Regional Trade (Domestic Trade) and International Trade
The classical economists proposed a specific theory of international trade which is
popularly known as the Theory of “Comparative Costs” or the theory of “Comparative
advantage”
While modern economists views against that of classical economist and states that the
difference between inter Regional trade and international trade are of only in degree rather
than in the kinds of trade.
1. Factor Immobility: The factors of production are perfectly mobile between the regions of
a country while they are perfectly immobile between the countries entering into international
trade. Labour and capital are regarded as immobile between countries while they are perfectly
mobile within a country. The factor prices are almost equal in a country but differ widely
between countries. It was due to the differences in languages, customs, tastes and
preferences, operational skills, economic, social, political and legal restrictions etc. But above
problems do not arise in the case of inter regional trade.
2. Differences in Natural Resources Endowments: The production of those commodities in
which they are richly endowed and trade them with other countries where such resources are
scarce. In Australia land is in abundance while labour and capital are relatively scarce,
whereas in England the capital is abundant and cheap, while land is scarce and dear.
Countries trade with each other on the basis of comparative cost differences in the
production of different commodities.
3. Geographical, Ecological and Climatic Differences:- Every country cannot produce all
commodities due to geographical, ecological and climatic conditions except at prohibitive
cost.
4. Different Markets: International markets are separated by differences in language, usage,
customs, habits, styles etc. e.g. the car models in France and the USA are quite different and
they are trade better within the country rather than across the country. Thus the goods differ
for sale in the inter-regional markets and international markets.
5. Different Currencies: The principal difference between inter-regional markets and
international markets lies in the use of different currencies in the international markets but the
same currencies in the inter-regional markets. To overcome this problem a common currency
has been introduced in the European countries (Euro-dollars).
6. Problems of Balance of payment: The problems of BOP are perpetual in the international
trade, but there is no such problem in inter-regional trade because of greater mobility of
capital within different regions of country. The problem of BOP is due to the problems of
deflection, devaluations, import restrictions, restrictions on the movement of currency etc.
7. Transport Costs: International trade involves huge transport costs while it was less in
inter-regional trade.
8. Different Economic Policies: Different countries follow different economic policies with
regards of taxation, tariff, commerce and trade considering a policy of free trade.
Advantages of International Trade:

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 The advantages of international trade rests on international division of labour. There
is world wide specialization in industries which results in increased total production and
other advantages which are as follows.
1. The productive resources of the world are utilized to the best advantage.
2. A country is able to consume goods which it cannot produce at all or only at an
impossible high cost.
3. Violent price fluctuations are turned down.
4. Shortage in time of famine and scarcity can be met from the imports.
5. Countries economically backward but rich in unused resources are able to develop
their industries.
6. Trade develops racial sympathies and creates common interests.
7. The existence of international trade promotes peace.

Disadvantages:
1. The worst effect of foreign trade on backward countries is the destruction of their
handicrafts and cottage industries.
2. The empire builder follows the trader e.g. a powerful country can easily find some
excuse for attacking a weak country.
3. Dependence on foreign goods creates difficulties in time of war when the country is
cut off by enemy action.
4. Countries which sell primary commodities and by manufactured goods in return are
losers.
5. Foreign trade may completely exhaust a country’s natural resources.
6. Imports of harmful drugs and luxuries, as opium in china, ruin the health of the
nation, negative and vulgar movie etc. affects the cultural value of the country.
7. Through foreign trade, the economic troubles of one country are transmitted to other.
For example, the collapse of American market in 1929 resulted in a world wide
depression.

Balance of payment:
The balance of payments is a comprehensive record of economic transactions of the
residents of a country with the rest of the world during a given period of time. It includes all
‘visible’ and ‘invisible’ items. The main purpose of keeping these accounts is to inform the
government of a country of the international economic position of the country and to help it
in making decisions on monetary and fiscal policies to be pursued as well as on the trade and
payment issues.

Importance of Balance of Payments

A study of BOP is important because –
1. It serves as an indicator of the changing international economic or financial position of a
country.
2. It helps in formulation of a country’s monetary, fiscal and trade policies.
3. It helps in determining the influence of foreign trade & transactions on the level of national
income of a country.
4. It is useful to banks, firms, financial institutions and individuals which are directly or
indirectly involved in international trade and finance.
5. It is an economic barometer of nation’s progress vis-à-vis rest of the world.

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 Chapter – 18
GST

 GST is one indirect tax for the whole nation, which will make India one unified
common market. GST is a single tax on the supply of goods and services.
 GST is a destination-based tax, which is levied only on value addition at each stage
because credits of input taxes paid at procurement of inputs will be available. Thus,
the final consumer will bear only the GST charged by the last dealer in the supply
chain.

Source: http://www.krestonsgco.com/wp-content/uploads/SGCO_GST_PPT_2017.pdf

Overview of GST

Proposed broader structure under GST

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Source: http://www.krestonsgco.com/wp-content/uploads/SGCO_GST_PPT_2017.pdf

The Journey of GST

Sourcehttp://www.cbec.gov.in/resources//htdocs-cbec/gst/ppt-on-gst-ason-0112017.PDF

What taxes will be levied under GST?

Answer: Since India is federal country, Centre Government and State Government both have
powers to levy taxes. Under GST regime, Centre and State both have power to levy GST.
Therefore, GST in India is divided into two parts:
1. Central GST (CGST)
2. State GST (SGST)
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 GST will be divided into two components, one is CGST, which is levied by Central
Government, and other is SGST, which is levied by State Government.
However, there will be one more type of GST is Integrated GST (IGST). IGST will be levied
on inter-state transactions. Since, there are chances that people will get confused in case of
transactions between two persons of two different States and there will be difficulty setting
off dues of taxes between two States, thus IGST will be levied by Centre. Now, Centre will
apportion the State’s portion of GST from IGST to relevant State.

Basic Rates on Agricultural Sector

Source: http://www.alankitgst.com

Benefits of GST
• Reduction in Cascading of Taxes
• Overall Reduction in Prices
• Common National Market
• Benefits to Small Taxpayers
• Self-Regulating Tax System
• Non-Intrusive Electronic Tax System
• Simplified Tax Regime
• Reduction in Multiplicity of Taxes
• Consumption Based Tax
• Abolition of CST
• Exports to be Zero Rated

Impact of GST on Agriculture

Impact on input-side
 Fertilisers that were subjected to a 0% to 8% VAT will henceforth attract 12% tax
under GST. This will increase the prices of fertilisers by 5% to 7% unless the
government offers to increase subsidy.
 Pesticides have been placed in 18% slab. This is an increase from the pre-GST 12%
excise and VAT of 4-5% in some states.
 While tractors are placed in 12% slab, several components and accessories of tractors
are placed in the 28% slab. It is not clear what impact GST will have on the prices of
tractor. However, it is expected that there is a scope for reduction in tractor prices.
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 Overall, from the input side, the cost of cultivation is expected to increase marginally.
Impact on Output side
 Highly used agri-commodities such as rice, wheat, milk, fresh fruits and vegetables
are placed in the zero tax slab. This will help in avoiding tax, cess and arhatiya
commission levied by some States.
 The taxation structure for processed food is not very encouraging. The processed
foods like fruit and vegetables juices under GST will be taxed at 12% up from 5%.
Some items like fruit jams, jellies, marmalades etc will be taxed at even higher 18%.
The higher tax rates are expected to discourage the development of food processing
industry, especially for perishable fruits and vegetables. This may also affect the
employment in food processing industry
GST will help to do away with mandi taxes and associated cess and levies, which
were distorting agricultural markets. It is one of the biggest gains for agriculture.
Introduction of GST could also help in reinvigorating the interest of private sector in
agriculture.
Source: www.gktoday.in

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