CS.

35 Managerial Econonrics
Unit-1.
Demand and Supply

 Concept of Demand
Demand refers to the quantity of a commodity or a service that people are willing to buy at a
certain price during a certain time interval. It can be termed as a desire with the ‘willingness’
and ‘ability’ to pay for a commodity.

An increase in the price of the commodity decrease the demand for that commodity, while
the decrease in price increases its demand. The phenomena is termed as law of demand.

 Concept of Demand Function

Demand function is an algebraic expression that shows the functional relationship between
the demand for a commodity and its various determinants affecting it. This includes income
and price along with other determining factors.

Here, the demand for the commodity is the dependent variable, while its determinants are
the independent variables.

Some of the management experts have defined demand in the

following ways:

According to Prof. Benham, “The demand for anything, at a given price is the amount of it
which will be bought per unit of time at the price.”

In the words of Prof Hanson, “By demand is meant, demand at a price, for it is impossible to
conceive of demand not related to price.”

As per Prof Hibdon, “Demand means the various quantities of goods that would be
purchased per time period at different prices in a given market.”

According to Prof Mayers, “The demand for goods is schedule of the amounts that buyers
would be willing to purchase at all possible prices at any one instant of time.”

From the aforementioned definitions, it can be concluded that demand implies a desire
supported by an ability and willingness of an individual to pay for a particular product. If an
individual does not have sufficient resources or purchasing power to buy a particular
product, then his/her desire alone would not be regarded as demand.

For instance, if an individual desires to purchase a resort and does not have adequate
amount of money to purchase the resort, his/her desire is not considered as demand for the
resort Apart from It, if an affluent individual desires to purchase a resort, but does not have
willingness to spend money for purchasing the resort then his/her desire is also not
considered as demand.

Therefore, we can say that effective demand is the desire backed by the purchasing power
and willingness of an individual to pay for a particular product. An effective demand has
three characteristics namely, desire, willingness, and ability of an individual to pay for a
product.
  Individual and Market Demand Functions
Demand function shows the relationship between quantity demanded for a particular
commodity and the factors influencing it.

It can be either with respect to one consumer (individual demand function) or to all the consumers in
the market (market demand function).

 Individual Demand Function:

Individual demand function refers to the functional relationship between individual demand

and the factors affecting individual demand. It is expressed as: Dx = f (Px, Pr, Y, T, F) Where,

Dx = Demand for Commodity x; Px = Price of the given Commodity x;

Pr = Prices of Related Goods; Y = Income of the Consumer;

T = Tastes and Preferences; F = Expectation of Change in Price in future.

Demand function is just a short-hand way of saying that quantity demanded (Dx), which is on

the left-hand side, is assumed to depend on the variables that are listed on the right-hand

side.

 Market Demand Function:

Market demand function refers to the functional relationship between market demand and
the factors affecting market demand. As mentioned before, market demand is affected by all
factors affecting individual demand. In addition, it is also affected by size and composition of
population, season and weather and distribution of income.

So, market demand function can be expressed as:

Dx = f(Px, Pr, Y, T, F, PD, S, D) Where,
Dx = Market demand of commodity x; Px = Price of given commodity x; Pr = Prices of Related
Goods; Y = Income of the consumers;
T = Tastes and Preferences; F = Expectation of Change in Price in future;

P0 = Size and Composition of population; S = Season and Weather; D = Distribution of

Income.

 What Is Price Elasticity of Demand?

Price elasticity of demand is an economic measure of the change in the quantity demanded
or purchased of a product in relation to its price change. Expressed mathematically, it is:

Price Elasticity of Demand = % Change in Quantity Demanded / %

Change in Price

Price elasticity is used by economists to understand how supply or demand changes given
changes in price to understand the workings of the real economy. For instance, some goods
are very inelastic, that is, their prices do not change very much given changes in supply or
demand, for example people need to buy gasoline to get to work or travel around the world,
and so if oil prices rise, people will likely still buy just the same amount of gas. On the other
hand, certain goods are very elastic, their price moves cause substantial changes in its
demand or its supply. (Arc elasticity is the elasticity of one variable with respect to another
between two given points.) Here, we will look just at how the demand side of the equation is
impacted by fluctuations in price by considering the price elasticity of demand – which you
can contrast with price elasticity of supply.

The range of responses

The degree of response of quantity demanded to a change in price can vary considerably.
The key benchmark for measuring elasticity is whether the co-efficient is greater or less than
proportionate. If quantity demanded changes proportionately, then the value of PED is 1,
which is called ‘unit elasticity’.

PED can also be:

 Less than one, which means PED is inelastic.
 Greater than one, which is elastic.
 Zero (0), which is perfectly inelastic.
 Infinite (∞), which is perfectly elastic.

PED along a linear demand curve

PED on a linear demand curve will fall continuously as the curve slopes downwards, moving
from left to right. PED = 1 at the midpoint of a linear demand curve.
  The price elasticity of demand:
The price elasticity is a measure of the responsiveness of demand to changes in the
commodity’s own price. If the changes in price are very small we use as a measure of the
responsiveness of demand the point elasticity of demand. If the changes in price are not
small we use the arc elasticity of demand as the relevant measure. The point elasticity of
demand is defined as the proportionate change in the quantity demanded resulting from a
very small proportionate change in price. Symbolically we may write

which implies that the elasticity changes at the various points of the linear-demand curve.
Graphically the point elasticity of a linear-demand curve is shown by the ratio of the
segments of the line to the right and to the left of the particular point. In figure 2.33 the
elasticity of the linear-demand curve at point F is the ratio
Given this graphical measurement of point elasticity it is obvious that at the mid-point of a
linear-demand curve ep — 1 (point M in figure 2.34). At any point to the right of M

the point elasticity is less than unity (ep < 1); finally at any point to the left of M, ep > 1. At
point D the ep → ∞, while at point D’ the ep = 0. The price elasticity is always negative
because of the inverse relationship between Q and P implied by the ‘law of demand’.
However, traditionally the negative sign is omitted when writing the formula of the elasticity.
The range of values of the elasticity is

0 ≤ ep ≤ ∞
If ep = 0, the demand is perfectly inelastic (figure 2.35)
If ep = 1, the demand has unitary elasticity (figure 2.36)
If ep = ∞, the demand is perfectly elastic (figure 2.37)
If 0 < e < 1, we say that the demand is inelastic.

If 1 < e < ∞, we say that the demand is elastic.

 The income elasticity of demand:

The income elasticity is defined as the proportionate change in the quantity demanded
resulting from a proportionate change in income. Symbolically we may write

The income elasticity is positive for normal goods. Some writers have used income elasticity
in order to classify goods into ‘luxuries’ and ‘necessities’. A commodity is considered to be a
‘luxury’ if its income elasticity is greater than unity. A commodity is a ‘necessity’ if its income
elasticity is small (less than unity, usually).

The main determinants of income elasticity are:

1. The nature of the need that the commodity covers the percentage of income spent
on food declines as income increases (this is known as Engel’s Law and has some-
times been used as a measure of welfare and of the development stage of an
economy).

2. The initial level of income of a country. For example, a TV set is a luxury in an

underdeveloped, poor country while it is a ‘necessity’ in a country with high per
capita income.

3. The time period, because consumption patterns adjust with a time-lag to changes
in income.
  The cross-elasticity of demand:
We have already talked about the price cross-elasticity with connection to the classification
of commodities into substitutes and complements (see section I).

The cross-elasticity of demand is defined as the proportionate change in the quantity

demanded of x resulting from a proportionate change in the price of y. Symbolically we have

The sign of the cross-elasticity is negative if x and y are complementary goods, and positive
if x and y are substitutes. The higher the value of the cross-elasticity the stronger will be the
degree of substitutability or complementarity of x and y. The main determinant of the cross-
elasticity is the nature of the commodities relative to their uses. If two commodities can
satisfy equally well the same need, the cross- elasticity is high, and vice versa. The cross-
elasticity has been used for the definition of the firms which form an industry.

 Concept of Supply
Supply is as relevant to a business as gravitational force is to the Earth. A fundamental
economic theory, supply refers to the quantity of goods a producer is willing and able to
sell at a specific price. A firm's profitability depends upon its ability to price goods at the
market-clearing price--the price at which demand equals supply.

Factors that Determine Supply

The law of supply states that all other factors remaining constant, the higher the price of a
product, the larger the quantity supplied. Changes in price result in a shift along the
upward sloping supply curve. Several factors result in a shift in the supply curve itself.
These include changes in the price of substitute and complimentary goods, the size of the
supplier pool, input costs, future expectations about price levels and technology upgrades.
With better technology, your firm can supply more products at superior quality levels in a
shorter time frame.
  Determinants of supply
The factors on which the supply of a commodity depends are known as the determinants of
demand. These are:

 Price of the Commodity

 Firm Goals
 Price of Inputs or Factors
 Technology
 Government Policy
 Expectations
 Prices of other Commodities
 Number of Firms
 Natural Factors

1. Price of the Commodity

It is the main and the most important determinant of demand. When the price of the
commodity is high, the producers or suppliers are willing to sell more commodities.
Thus, the supply of the commodity increases. Similarly, when the price is low the
supply of the commodity decreases owing to the direct relationship between the price
of a commodity and its supply.

2. Firm Goals
The supply of goods also depends on the goals of an organization. An organization
may have various goals such as profit maximization, sales maximization, employment
maximization, etc.

3. Price of Inputs or Factors

The price of inputs or the factors of production such as land, labor, capital, and
entrepreneurship also determine the supply of the goods. When the price of inputs is
low the cost of production is also low.
Thus, at this point, the firms tend to supply more goods in the market and vice-versa.

4. Technology

When a firm uses new technology it saves the inputs and also reduces the cost of
production. Thus, firms produce more and supply more goods.

5. Government Policy

The taxation policies and the subsidies given by the government also impact the supply
of goods.
When the taxes are high the producers are unwilling to produce more goods and thus,
the supply will decrease.
On the other hand, when the government grants various subsidies and gives financial
aids to the producers, they increase the production of goods. Thus, the supply also
increases.

6. Expectations

When the producers or suppliers expect that the price shall increase in future they
hoard the goods so that they can sell them at higher prices later. This will result in a
decrease in the supply of goods.
Similarly, in case they expect a fall in price, they will increase the supply of goods.

7. Prices of other Commodities

When the price of complementary goods increases their supply also increases. Thus,
this results in the increase in the supply of commodity also and vice-versa.
Also, when the price of the substitutes increases their supply also increases. This
results in a decrease in the supply of goods.

8. Number of Firms
When the number of firms in the market increase the supply of goods also increases
and vice-versa.

9. Natural Factors
The factors like weather conditions, flood, drought, pests, etc. also affect the supply of
goods. When these factors are favorable the supply will increase.

 Elasticity of Supply
The elasticity of supply establishes a quantitative relationship between the supply of a
commodity and it’s price. Hence, we can express the numeral change in supply with
the change in the price of a commodity using the concept of elasticity. Note that
elasticity can also be calculated with respect to the other determinants of supply.

However, the major factor controlling the supply of a commodity is its price. Therefore,
we generally talk about the price elasticity of supply. The price elasticity of supply is the
ratio of the percentage change in the price to the percentage change in quantity
supplied of a commodity.

Es= [(Δq/q)×100] ÷ [(Δp/p)×100] = (Δq/q) ÷ (Δp/p)

Δq= The change in quantity supplied

 q= The quantity supplied

Δp= The change in price

p= The price

Elasticity from a Supply Curve

Along with the method mentioned above, there are two more ways to calculate the
price elasticity of supply, both of which make use of the supply curve. We can either
calculate the elasticity at a specific point on the supply curve, known as point elasticity
or between two prices, known as arc-elasticity.

The formula for calculating the point elasticity of supply is:

Es= (dq/dp)×(p/q)

Here dq/dp is the slope of the supply curve.

The formula for calculating the arc-elasticity of supply is:

Es= [(q1 – q2)/( q1 + q2)] × [( p1 + p2)/(p1 – p2)]

 Equilibrium Price

Equilibrium means a state of no change. Evidently, at the equilibrium price, both buyers
and sellers are in a state of no change. Technically, at this price, the quantity
demanded by the buyers is equal to the quantity supplied by the sellers. Both market
forces of demand and supply operate in harmony at the equilibrium price.
Graphically, this is represented by the intersection of the demand and supply curve.
Further, it is also known as the market clearing price. The determination of the
market price is the central theme of microeconomics. That is why the microeconomic
theory is also known as price theory.

Supply and Demand Schedule

Quantity Quantity
Price Impact on Price
Demanded Supplied

5 5 30 Downwards

4 12 25 Downwards

3 20 20 Equilibrium

2 25 15 Upwards

1 35 8 Upwards

A detailed look at the above supply and demand schedule reveals a bag full of
information about the market. Most importantly, we can observe that the demand and
supply become equal at a price of 3. Thus 3 is the equilibrium price.

Next, note how the impact on price is downwards when the price is too high for the
buyer’s taste. Lastly, again the impact on price is upwards when it is too low for the
supplier’s taste. To point out, the price tends to move towards the equilibrium mark.

Equilibrium Price Can Resist Change

As already mentioned, both consumers and sellers do not want to shift from the
equilibrium price. In that case, the equilibrium price can change only when there is a
change in both demand and supply. An increase in only demand or only supply is taken
by horns by a self-adjusting mechanism.
When the price of commodity increases, the sellers flock to the market with their
products for an opportunity to earn higher profits. This creates a condition of excess
supply, ultimately leading to a surplus of the particular product in its market.

In order to sell this surplus, the sellers have to reduce the price. Effectively, the price
continues to fall until it reaches the equilibrium level.

When the price of a commodity decreases, the consumers sense an opportunity to buy
the product at a lower price. This creates gives birth to excess demand in the product’s
market.

Consequentially, there starts brewing a situation of competition among the buyers

which eventually pushes up the price. Eventually, the price continues to rise until it
reaches the equilibrium level.

Note that the supply and demand schedule mentioned above is an indicator of all these
processes.
 Unit-2. Production:

 Production function in short run

The short run is a concept that states that, within a certain period in the future, at
least one input is fixed while others are variable. In economics, it expresses the idea
that an economy behaves differently depending on the length of time it has to react
to certain stimuli. The short run does not refer to a specific duration of time but
rather is unique to the firm, industry or economic variable being studied.

A key principle guiding the concept of the short run and the long run is that in the
short run, firms face both variable and fixed costs, which means that output, wages,
and prices do not have full freedom to reach a new equilibrium. Equilibrium refers to
a point in which opposing forces are balanced.

Examples of Short Run Costs

There are a number of ways to understand the challenges businesses and industries
face in the short run versus the long run. Here are a few examples.

Mining and energy giants were hit especially hard by the fall in iron ore, coal, copper,
and other commodity prices, underscoring their high fixed costs in the short run.
Glencore lost $5 billion in 2015, while Vale lost $12 billion, and Rio Tinto lost $866
million.

Despite lower prices, these firms continue to ramp up production due to new
investments, particularly in areas such as Brazil and Australia, made
when commodity prices were significantly higher around 2011. For instance,
Glencore purchased Xstrata in 2013 for $30 billion in a deal in which it acquired most
of its mining assets, which have significantly depreciated.

In the analysis of short-run versus long-run costs, it is important to understand the

behavior of the firms. In certain situations, it may be preferable to keep operating an
unprofitable firm over the short run if this helps to offset costs that are fixed partially.
In the long run, however, an expensive firm will be able to terminate its leases and
wage agreements and shut down operations.

 Law of Variable Proportions

Law of Variable Proportions occupies an important place in economic theory. This
law is also known as Law of Proportionality.

Keeping other factors fixed, the law explains the production function with one factor
variable. In the short run when output of a commodity is sought to be increased, the
law of variable proportions comes into operation.
Definitions:
“As the proportion of the factor in a combination of factors is increased after a point,
first the marginal and then the average product of that factor will diminish.” Benham

“An increase in some inputs relative to other fixed inputs will in a given state of
technology cause output to increase, but after a point the extra output resulting from
the same additions of extra inputs will become less and less.” Samuelson

“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.” Leftwitch

Assumptions:
Law of variable proportions is based on following assumptions:
(i) Constant Technology:
The state of technology is assumed to be given and constant. If there is an
improvement in technology the production function will move upward.

(ii) Factor Proportions are Variable:

The law assumes that factor proportions are variable. If factors of production are to
be combined in a fixed proportion, the law has no validity.

(iii) Homogeneous Factor Units:

The units of variable factor are homogeneous. Each unit is identical in quality and
amount with every other unit.

(iv) Short-Run:
The law operates in the short-run when it is not possible to vary all factor inputs.

Three Stages of the Law:

1. First Stage:
First stage starts from point ‘O’ and ends up to point F. At point F average product is
maximum and is equal to marginal product. In this stage, total product increases
initially at increasing rate up to point E. between ‘E’ and ‘F’ it increases at diminishing
rate. Similarly marginal product also increases initially and reaches its maximum at
point ‘H’. Later on, it begins to diminish and becomes equal to average product at
point T. In this stage, marginal product exceeds average product (MP > AP).
2. Second Stage:
It begins from the point F. In this stage, total product increases at diminishing rate
and is at its maximum at point ‘G’ correspondingly marginal product diminishes
rapidly and becomes ‘zero’ at point ‘C’. Average product is maximum at point ‘I’ and
thereafter it begins to decrease. In this stage, marginal product is less than average
product (MP < AP).

3. Third Stage:
This stage begins beyond point ‘G’. Here total product starts diminishing. Average
product also declines. Marginal product turns negative. Law of diminishing returns
firmly manifests itself. In this stage, no firm will produce anything. This happens
because marginal product of the labour becomes negative. The employer will suffer
losses by employing more units of labourers. However, of the three stages, a firm will
like to produce up to any given point in the second stage only.

 Long-Run Production Function

Production in the short run in which the functional relationship between input and
output is explained assuming labor to be the only variable input, keeping capital
constant.

In the long run production function, the relationship between input and output is
explained under the condition when both, labor and capital, are variable inputs.

In the long run, the supply of both the inputs, labor and capital, is assumed to be
elastic (changes frequently). Therefore, organizations can hire larger quantities of
both the inputs. If larger quantities of both the inputs are employed, the level of
production increases. In the long run, the functional relationship between changing
scale of inputs and output is explained under laws of returns to scale. The laws of
returns to scale can be explained with the help of isoquant technique.

 Isoquant Curve:
The relationships between changing input and output is studied in the laws of returns
to scale, which is based on production function and isoquant curve. The term
isoquant has been derived from a Greek work iso, which means equal. Isoquant
curve is the locus of points showing different combinations of capital and labor,
which can be employed to produce same output.

It is also known as equal product curve or production indifference curve. Isoquant

curve is almost similar to indifference curve. However, there are two dissimilarities
between isoquant curve and indifference curve. Firstly, in the graphical
representation, indifference curve takes into account two consumer goods, while
isoquant curve uses two producer goods. Secondly, indifference curve measures the
level of satisfaction, while isoquant curve measures output.

Following are the assumptions of isoquant curve:

i. Assumes that there are only two inputs, labor and capital, to produce a product
ii. Assumes that capital, labor, and good are divisible in nature
iii. Assumes that capital and labor are able to substitute each other at diminishing
rates because they are not perfect substitutes
iv. Assumes that technology of production is known
On the basis of these assumptions, isoquant curve can be drawn with the help of
different combinations of capital and labor. The combinations are made such that it
does not affect the output.

Figure-4 represents an isoquant curve for four combinations of

capital and labor:
In Figure-4, IQ1 is the output for four combinations of capital and labor. Figure-4
shows that all along the curve for IQ1 the quantity of output is same that is 200 with
the changing combinations of capital and labor. The four combinations on the IQ1
curve are represented by points A, B, C, and D.

Table-4 shows the relationship between input and output for

IQ1 curve:

Some of the properties of the isoquant curve are as follows:

i. Negative Slope:
Implies that the slope of isoquant curve is negative. This is because when capital (K)
is increased, the quantity of labor (L) is reduced or vice versa, to keep the same level
of output. As shown in Table-4, when the quantity of labor is increased from one unit
to two units, the quantity of capital is decreased from four to three, to keep the level
of output constant, which is 200.

ii. Convex to Origin:

Shows the substitution of inputs and diminishing marginal rate of technical
substitution (which is discussed later) in economic region. This implies that marginal
significance of one input (capital) in terms of another input (labor) diminishes along
with the isoquant curve. For example, in Table-4, it can be seen when more and
more units of capital are used to produce 200 units of output, less or less units of
labor are used.

iii. Non-intersecting and Non-tangential:

Implies that two isoquant curves (as shown in Figure-4) cannot cut each other.

Figure-5 shows the intersection of two isoquant curves:

In Figure-5, the two isoquant curves intersect at point A. The point B on isoquant
having Q2 = 300 and point C on isoquant curve having Q1 = 200 with the same
amount of labor that is OL2. However, the capital is different that is BL2 in case of
point B and CL2 in case of point C. A is the common point of isoquant for B and C
points.

iv. Upper isoquant have high output:

Implies that upper curve of the isoquant curve produces more output than the curve
beneath. This is because of the larger combination of input result in a larger output
as compared to the curve that s beneath it. For example, in Figure-5 the value of
capital at point B is greater than the capital at point C. Therefore, the output of curve
Q2 is greater than the output of Q1.

 Isocost
In economics an isocost line shows all combinations of inputs which cost the same
total amount. Although similar to the budget constraint in consumer theory, the use
of the isocost line pertains to cost-minimization in production, as opposed to utility-
maximization. For the two production inputs labour and capital, with fixed unit costs
of the inputs, the equation of the isocost line is where w represents the wage rate of
labour, r represents the rental rate of capital, K is the amount of capital used, L is the
amount of labour used, and C is the total cost of acquiring those quantities of the two
inputs. The absolute value of the slope of the isocost line, with capital plotted
vertically and labour plotted horizontally, equals the ratio of unit costs of labour and
capital. The slope is: The isocost line is combined with the isoquant map to
determine the optimal production point at any given level of output. Specifically, the
point of tangency between any isoquant and an isocost line gives the lowest-cost
combination of inputs that can produce the level of output associated with that
isoquant. Equivalently, it gives the maximum level of output that can be produced for
a given total cost of inputs. A line joining tangency points of isoquants and isocosts is
called the expansion path.

In this example, a unit of labour and capital cost £6,666 each.

 If we employ 30K and 30L, the total cost will be £200,000 + £200,000
 If we employ 10 K and 50L, the total cost will be £66,666 +£333,333 =
£400,000
Change in labour costs
  Ridge Lines
The marginal product of a particular factor may be negative if the quantity used is too
large. For example, if too much labour is used there may be congestion and the
efficiency of all the labourers may be affected. An isoquant will include points
denoting such factor quantities, because it includes all factor combinations producing
the same output.

But, a rational producer will not operate on this part of the isoquant. The area of
rational operation may be shown by drawing two lines from the origin enclosing only
those parts of the isoquants where each factor has a positive marginal product. Such
lines are called ridge lines. Negative marginal products appear in that part of the
isoquant which has a positive slope.

Ridge lines exclude these parts. This can be seen in Fig. 14. Let us focus our atten-
tion on isoquant Q1 over the interval from point A to point E. We now know that as
we substitute labour for capital and move from A toward E, the marginal productivity
of labour diminishes.

But, look what happens if we move beyond E, continuing to use more labour. The
isoquant Q1 turns upward, indicating that if we use more labour and still want
to produce Q1 units, we must now also use more capital. Why? Because beyond E,
the marginal product of labour has become negative, and so to compensate for using
more labour, we must add to the amount of capital used as well.
If we follow Q2, Q3 or Q4 from left to right, we see that a similar result occurs. Beyond
points F, G and H turn up. That is, the slopes of the isoquants become positive due
to the negative marginal productivity of labour.

The line (R’) connecting all points, such as £, F, G and H, is called a ridge line; it
marks off the boundary between stage II and stage III of production. No one would
want to produce in stage III, since the same level of production could be obtained
with fewer of both inputs by moving to the left along the appropriate isoquant until
stage II was reached.

We can now apply this same line of reasoning to rule out stage I. Again let us
concentrate attention on isoquant Q1. This time, suppose we move up and to the left
toward point A. As we do so, substituting capital for labour, the marginal productivity
of capital diminishes and becomes negative if we go beyond A. Thus, if we add more
capital above A while maintaining output at the Q1 level, we must use more labour.
This does not make much sense from a managerial perspective. Points B, C and D
are analogous to point A for their respective isoquants. Beyond these points, the
marginal productivity of capital is negative and so we would not wish to operate in
that region, which we refer to as stage I.

The ridge line R marks the boundary between stage I and stage II just as R’ marks
the boundary between stages II and III. We see that neither stage I nor stage III is
desirable for production, since the marginal productivity of at least one input is
negative in those stages. We can then conclude that the only relevant region for
production is stage II, which is bounded by the two ridge lines, R1 and R2. This region
is called the economic region of production.
  Returns to Scale :

An increasing returns to scale occurs when the output increases by a larger

proportion than the increase in inputs during the production process. For example, if
input is increased by 3 times, but output increases by 3.75 times, then the firm or
economy has experienced an increasing returns to scale.
A decreasing returns to scale occurs when the proportion of output is less than the
desired increased input during the production process. For example, if input is
increased by 3 times, but output is reduced 2 times, the firm or economy has
experienced decreasing returns to scale.
When increasing returns to scale occurs, it results in economies of scale. This is
owing to the fact that efficiency increases when organizations progress from small-
scale to large-scale production. A loss of efficiency in the production process, even
when the production has been expanded, results in decreasing returns to scale. This
may occur if the organization becomes too large to be operated as one single entity.
In this case, there is no economy of scale.

Returns to scale are of the following three types:

1. Increasing Returns to scale.
2. Constant Returns to Scale
3. Diminishing Returns to Scale
1. Increasing Returns to Scale:
Increasing returns to scale or diminishing cost refers to a situation when all factors of
production are increased, output increases at a higher rate. It means if all inputs are
doubled, output will also increase at the faster rate than double. Hence, it is said to
be increasing returns to scale. This increase is due to many reasons like division
external economies of scale. Increasing returns to scale can be illustrated with the
help of a diagram 8.

In figure 8, OX axis represents increase in labour and capital while OY axis shows
increase in output. When labour and capital increases from Q to Q1, output also
increases from P to P1 which is higher than the factors of production i.e. labour and
capital.

2. Diminishing Returns to Scale:

Diminishing returns or increasing costs refer to that production situation, where if all
the factors of production are increased in a given proportion, output increases in a
smaller proportion. It means, if inputs are doubled, output will be less than doubled. If
20 percent increase in labour and capital is followed by 10 percent increase in
output, then it is an instance of diminishing returns to scale.

The main cause of the operation of diminishing returns to scale is that internal and
external economies are less than internal and external diseconomies. It is clear from
diagram 9.

In this diagram 9, diminishing returns to scale has been shown. On OX axis, labour
and capital are given while on OY axis, output. When factors of production increase
from Q to Q1 (more quantity) but as a result increase in output, i.e. P to P1 is less.
We see that increase in factors of production is more and increase in production is
comparatively less, thus diminishing returns to scale apply.

3. Constant Returns to Scale:

Constant returns to scale or constant cost refers to the production situation in which
output increases exactly in the same proportion in which factors of production are
increased. In simple terms, if factors of production are doubled output will also be
doubled.

In this case internal and external economies are exactly equal to internal and
external diseconomies. This situation arises when after reaching a certain level of
production, economies of scale are balanced by diseconomies of scale. This is
known as homogeneous production function. Cobb-Douglas linear homogenous
production function is a good example of this kind. This is shown in diagram 10. In
figure 10, we see that increase in factors of production i.e. labour and capital are
equal to the proportion of output increase. Therefore, the result is constant returns to
scale.

 Producer’s Equilibrium
The value of all assets used for production is limited. Hence, the producer has to use
such a combination of inputs as would provide him with maximum output and profits.
This optimum level of production, also called producer’s equilibrium, is achieved when
maximum output is derived from minimum costs.

In order to achieve this, producers first have to classify their resources into different
combinations. Each combination would provide production in different quantities. The
combination that provides the highest amount of produce at the least amount of costs
is the optimum level of production.

In order to find out producer’s equilibrium, we first need to understand isoquant curves
and iso-cost lines. These two concepts help us calculate optimum production.

 optimum FactorCombination
Least-cost Combination. The producer will try to attain an equilibrium position by
hitting at the ‘most economical or the least cost combination of the factors of
production. Just as a consumer is faced wild the problem of making a choice
between different combinations of two or more goods, similarly a producer is
confronted with the problem of choosing between Where MPn is the marginal product
of factor A different combinations of two or more factors of production,
A rational entrepreneur would try to maximize his money profits from the production
and sale of commodities, just as a consumer tries to obtain maximum satisfaction
from the consumption of commodities. 1′(1 produce a given output various
combinations of factors of production are possible. But a rational producer or a linen
would seek to produce that output with the ‘optimum’ or ‘least-cost’ combination of.
factors of production. (In Economics factors of production arc also called ‘inputs.)
The producing line will use its productive resources in such proportions or such
ratios that whatever the output produced, the cost outlay should be as small as
possible for that output. Or, we can say that the linn should use that combination of
resources which produces the maximum output for given cost outlay. In arriving at an
optimum or least- cost combination. the producer is guided by the principle of
substitution or that of equal marginal returns. If a rupee spent of factor A result in a
greater output than a rupee spent on factor O. it would pay the producer to divert exit
CH1 therefrom fa tor 13 to factor A; that is. he will substitute factor A for factor 13.
He will be in equilibrium when the additional output resulting from the marginal rupee
spent on factor /I. equals the additional output resulting from the marginal
rupee spent on factor B. So long as the additional output due to the marginal rupee
spent on factor A is not equal to the additional output resulting from the marginal
rupee spent on factor B. it will he advantageous for the producer to go on
substituting one factor for the other. In this way the output will he Maximilian,
Out most often, guru of factors cost much more than one rupee each. In such cases.
the additional output due to the marginal rupee spent in factor A would he equal to
the marginal product of factor A divided by its price. As has been explained earlier,
the marginal product of a factor is the additional product resulting from the
employment of an additional uni: of the factor. It, therefore, follows that the
marginal product of a factor divided by the price of the factor is the additional product
resulting from a rupee spent on the factor. Suppose the marginal product of a factor
is 120 suitors or output and the price or the factor is Rs. 10. Then. 120 + 10, i.e., 12
is the additional output resulting from the marginal rupee spent on that factor. The
condition for the least-cost combination may, neur to employ more of factor A and
less of factor B. He will employ more of one factor and less of the other till the above
‘”rul’orticmalit~ rule’ is satisfied, It is in this manner. that the firm is able to
discover the least-cost combination which means producing the maximum output
with a given cot.
It will have been dearly understood that it is not the marginal products of the various
factors ihat are sought to be cqualiscd by the producer for garnishing output. What
he seeks to cqualise are the marginal products of the various factors divided by their
respective prices. or course. when the prices of all factors are equal. in that case
alone will he sed. to equalisc the marginal products of the various factors, In that
case, the denominators “.will all he equal to each other, so that all that the producer
is to attempt is to cqualisc the numerators, i.c.. the marginal products of the v.u ious
factors (Ml’.” MI'” ….. MP”,). But seldom are the pI ices of the various factors equal
to each other.
  Cost Function: Concept and
Importance
Concept of Cost Function:
The relationship between output and costs is expressed in terms of cost function. By
incorporating prices of inputs into the production function, one obtains the cost
function since cost function is derived from production function. However, the nature
of cost function depends on the time horizon. In microeconomic theory, we deal with
short run and long run time.

A cost function may be written as:

Cq = f(Qf Pf)
Where Cq is the total production cost, Qf is the quantities of inputs employed by the
firm, and Pf is the prices of relevant inputs. This cost equation says that cost of
production depends on prices of inputs and quantities of inputs used by the firm.
Importance of Cost Function:
The study of business behaviour concentrates on the production process—the
conversion of inputs into outputs—and the relationship between output and costs of
production.

We have already studied a firm’s production technology and how inputs are
combined to produce output. The production function is just a starting point for the
supply decisions of a firm. For any business decision, cost considerations play a
great role.

Cost function is a derived function. It is derived from the production function which
captures the technology of a firm. The theory of cost is a concern of managerial
economics. Cost analysis helps allocation of resources among various alternatives.
In fact, knowledge of cost theory is essential for making decisions relating to price
and output.

Whether production of a new product is a wiser one on the part of a firm greatly
depends on the evaluation of costs associated with it and the possibility of earning
revenue from it. Decisions on capital investment (e.g., new machines) are made by
comparing the rate of return from such investment with the opportunity cost of the
funds used.
  Cost in Short Run:
It may be noted at the outset that, in cost accounting, we adopt functional
classification of cost. But in economics we adopt a different type of classification,
viz., behavioural classification-cost behaviour is related to output changes.

In the short run the levels of usage of some input are fixed and costs associated with
these fixed inputs must be incurred regardless of the level of output produced. Other
costs do vary with the level of output produced by the firm during that time period.

The sum-total of all such costs-fixed and variable, explicit and implicit- is short-run
total cost. It is also possible to speak of semi-fixed or semi-variable cost such as
wages and compensation of foremen and electricity bill. For the sake of simplicity we
assume that all short run costs to fall into one of two categories, fixed or variable.

Short-Run Total Cost:

A typical short-run total cost curve (STC) is shown in Fig. 14.3. This curve indicates
the firm’s total cost of production for each level of output when the usage of one or
more of the firm’s resources remains fixed.

When output is zero, cost is positive because fixed cost has to be incurred
regardless of output. Examples of such costs are rent of land, depreciation charges,
license fee, interest on loan, etc. They are called unavoidable contractual costs.
Such costs remain contractually fixed and so cannot be avoided in the short run.

The only way to avoid such costs is

a. Short-run Cost Functions:

Summary of the Main Points All the important short-run cost relations may now be
summed up:

The total cost function may be expressed as:

TC = k + ƒ(Q) where k is total fixed cost which is a constant, and ƒ(Q) is total
variable cost which is a function of output.

ATC = k/Q + ƒ(Q)/ Q = AFC + AVC. Since k is a constant and Q gradually increases,
the ratio k/Q falls. Hence the AFC curve is a rectangular hyperbola.

Here
where ƒ'(Q) is the change in TVC and may be called marginal variable cost (MVC).
Thus, it is clear that MC refers to MVC and has no relation to fixed cost. Since
business decisions are largely governed by marginal cost, and marginal costs have
no relation to fixed cost, it logically follows costs do not affect business decisions.

b. Relation between MC and AC:

There is a close relation between MC and AC. When AC is falling, MC is less than AC. This
can be proved as follows:

When AC is falling,

c. Cost Elasticity:
On the basis of the relation between MC and AC we can develop a new concept,
viz., the concept of cost elasticity. It measures the responsiveness of total cost to a
small change in the level of output.

It can be expressed as:

So it is the ratio of MC to AC.

 Long Run Costs

Long run costs are accumulated when firms change production levels over time in
response to expected economic profits or losses. In the long run there are no
fixed factors of production. The land, labor, capital goods, and entrepreneurship all
vary to reach the the long run cost of producing a good or service. The long run is a
planning and implementation stage for producers. They analyze the current and
projected state of the market in order to make production decisions. Efficient long run
costs are sustained when the combination of outputs that a firm produces results in
the desired quantity of the goods at the lowest possible cost. Examples of long run
decisions that impact a firm's costs include changing the quantity of production,
decreasing or expanding a company, and entering or leaving a market.

 LONG-RUN MARGINAL COST:

The change in the long-run total cost of producing a good or service resulting from a
change in the quantity of output produced. Like all marginals, long-run marginal cost
is an increment of the corresponding total. It is the change in long-run total cost
divided by, or resulting from, a change in quantity. Long-run marginal cost is guided
by returns to scale rather than marginal returns.
Long-run marginal cost is the incremental cost incurred by a firm in production when
all inputs are variable. In particular, it is the extra cost that results as a firm increases
in the scale of operations by not only adding more workers to a given factory but also
by building a larger factory.
 Not the Short Run
In the long run, when all inputs under the control of the firm are variable, there are
no fixed inputs. With no fixed inputs, increasing and decreasing marginal returns,
and especially the law of diminishing marginal returns, are not relevant to long-run
marginal cost. There are, however, two similar influences, economies of
scale (or increasing returns to scale) and diseconomies of scale (or decreasing
returns to scale).

 The Short Run: In the short run, marginal cost decreases due to increasing
marginal returns and increases due to decreasing marginal returns and the
law of diminishing marginal returns. This also triggers changes in average
cost (variable and total).
 The Long Run: In the long run, there are no fixed inputs. As such, marginal
returns and especially the law of diminishing marginal returns do not operate
and thus do not guide production and cost. Instead long-run marginal cost is
affected by increasing and decreasing returns to scale, which translates into
economies of scale and diseconomies of scale.

 Economies and diseconomies of scale

Economies of scale are when the cost per unit of production (Average
cost) decreases because the output (sales) increases.

Diseconomies of scale are when the cost per unit of production (Average
cost) increases because the output (sales) increases.

Growth brings both advantages and disadvantages to a business. These interact,

and depending on the nature of the business and the way it is managed, decide the
optimum or most efficient size for the business.
This is the area of economies and diseconomies of scale.

The economies of scale are divided in to internal economies and

external economies discussed as follows:

i. Internal Economies:
Refer to real economies which arise from the expansion of the plant size of the
organization. These economies arise from the growth of the organization itself.

ii. External economies:

Occur outside the organization. These economies occur within the industries which
benefit organizations. When an industry expands, organizations may benefit from
better transportation network, infrastructure, and other facilities. This helps in
decreasing the cost of an organization.

Some of the examples of external economies of scale are

discussed as follows:
a. Economies of Concentration:
Refer to economies that arise from the availability of skilled labor, better credit, and
transportation facilities.

b. Economies of Information:
Imply advantages that are derived from publication related to trade and business.
The central research institutions are the source of information for organizations.

c. Economies of Disintegration:
Refer to the economies that arise when organizations split their processes into
different processes.

Diseconomies of scale occur when the long run average costs of the organization
increases. It may happen when an organization grows excessively large. In other
words, the diseconomies of scale cause larger organizations to produce goods and
services at increased costs
 Unit-3.Market structure:

 Price and Output Determination under

Perfect Competition
Perfect competition refers to a market situation where there are a large number of
buyers and sellers dealing in homogenous products.

Moreover, under perfect competition, there are no legal, social, or technological

barriers on the entry or exit of organizations.

In perfect competition, sellers and buyers are fully aware about the current market
price of a product. Therefore, none of them sell or buy at a higher rate. As a result,
the same price prevails in the market under perfect competition.

Under perfect competition, the buyers and sellers cannot influence the market price
by increasing or decreasing their purchases or output, respectively. The market price
of products in perfect competition is determined by the industry. This implies that in
perfect competition, the market price of products is determined by taking into
account two market forces, namely market demand and market supply.

In the words of Marshall, “Both the elements of demand and supply are required for
the determination of price of a commodity in the same manner as both the blades of
scissors are required to cut a cloth.” As discussed in the previous chapters, market
demand is defined as a sum of the quantity demanded by each individual
organizations in the industry.

On the other hand, market supply refers to the sum of the quantity supplied by
individual organizations in the industry. In perfect competition, the price of a product
is determined at a point at which the demand and supply curve intersect each other.
This point is known as equilibrium point as well as the price is known as equilibrium
price. In addition, at this point, the quantity demanded and supplied is called
equilibrium quantity. Let us discuss price determination under perfect competition in
the next sections.

 Demand under Perfect Competition:

Demand refers to the quantity of a product that consumers are willing to purchase at
a particular price, while other factors remain constant. A consumer demands more
quantity at lower price and less quantity at higher price. Therefore, the demand
varies at different prices.

Figure-1 represents the demand curve under perfect competition:

As shown in Figure-1, when price is OP, the quantity demanded is OQ. On the other
hand, when price increases to OP1, the quantity demanded reduces to OQ1.
Therefore, under perfect competition, the demand curve (DD’) slopes downward.

 Supply under Perfect Competition:

Supply refers to quantity of a product that producers are willing to supply at a
particular price. Generally, the supply of a product increases at high price and
decreases at low price.

Figure-2 shows the supply curve under perfect competition:

In Figure-2, the quantity supplied is OQ at price OP. When price increases to OP1,
the quantity supplied increases to OQ1. This is because the producers are able to
earn large profits by supplying products at higher price. Therefore, under perfect
competition, the supply curves (SS’) slopes upward.

 Equilibrium under Perfect Competition:

As discussed earlier, in perfect competition, the price of a product is determined at a
point at which the demand and supply curve intersect each other. This point is
known as equilibrium point. At this point, the quantity demanded and supplied is
called equilibrium quantity.

Figure-3 shows the equilibrium under perfect competition:

In Figure-3, it can be seen that at price OP1, supply is more than the demand.
Therefore, prices will fall down to OP. Similarly, at price OP2, demand is more than
the supply. Similarly, in such a case, the prices will rise to OP. Thus, E is the
equilibrium at which equilibrium price is OP and equilibrium quantity is OQ.

 Comparison Of Perfect Competition And

Monopoly Economics
Perfect Competition
Perfect competitive markets are those where there are large number of small buyers
and sellers dealing with a homogeneous product and a single small firm do not have
influence on the price allocation and acts as a price taker (Mankiw & Taylor, 2006).
In addition to this, in a perfectly competitive market the mobility of the factors of
production is perfect in the long run and both the producers and the consumers have
perfect information regarding the product (Frank, 2003). A competitive firm being the
price taker, to achieve the goal of profit maximisation, it produces a certain level of
output where the price is equal to the marginal cost of producing an extra unit of
product, a ‘Pareto efficient’ output level (Varian, 2006). As the price is also the
marginal revenue for a competitive firm, so the profit is maximised at the condition
where marginal revenue is equal to the marginal cost (Frank, 2003). This means that
for a company to remain in business, it has to cover its cost, which is to say the price
must be at least greater than the ‘minimum value of the average variable cost’ (ibid.)

Monopoly
At the extreme opposite end of the market organisation is monopoly. Monopoly is a
market structure, where a single firm serves the entire market and is the only seller
of a particular product with no close substitutes (Frank, 2003). Moreover, being the
only firm in the market, it does not take any price but instead it has influence over the
market price and produces a level of output at a particular price where the firms’
profits are the highest (Varian, 2006). Monopoly is created when a firm either takes
control of key resources or the government issues a license and give them exclusive
right for the production of goods and services. An economy of scale is another
source of monopoly for a firm, where a single firm has more efficient cost of
production as compared to a large number of firms and creates a natural monopoly
that arises with public utilities like gas, electricity etc (ibid.). Furthermore, a
monopolist will set his price higher than his marginal cost at a point where his
marginal revenue is equal to marginal cost, in order to make positive economic profit
(Frank, 2003). However the demand curve is negative for a monopolist and being a
‘price setter’, it cannot just randomly set a high price. It would rather set a price that
the market could bear and maximises its profit (Mankiw & Taylor, 2006).

Comparing Perfect Competition and Monopoly

A common appealing characteristic of the competitive market is that ‘Allocative
efficiency’ is achieved in this market when price is equal to marginal cost in both the
short and long run of market equilibrium (Frank, 2003). As mentioned earlier, in
competitive markets ‘Pareto Efficient’ output level is achieved where the consumer’s
willingness to pay for an additional unit of the good is equal to the producers
willingness to get paid for an additional unit of the good (Varian, 2006). Hence, the
total economics surplus is achieved, which is equal to the total consumer surplus
and total producer surplus (Frank, 2003), as shown in Figure1 below. Moreover in
perfective competition, ‘Productive efficiency’ is achieved where the product is
produced at the minimum average cost, and the firm charging price equal to
marginal cost enables the consumers to enjoy the lower prices in the competitive
firms (Riley, Perfect Competitiom, 2006). So, the firms earning normal profit in the
competitive firms means lower price for the consumers and leads to more equality in
society. According to Riley (2006), in perfect competition the resources of the
economy are used in a more efficient way, and hence enhance the performance of
the firms’ productivity rewarding consumers with low prices, better quality and wider
choice. Baily (1993) illustrate the benefits of competition in his paper by comparing
the banking in Germany and United Kingdom. He implies that EC commission
argued in 1988 that the higher prices of the banking services to the customers in the
EC countries were result of restrictions on competitions and these prices could have
dropped by 33 percent in Germany and 18 percent in UK within a single European
competitive market. In his paper he contrasts the airline industry in U.S and Europe,
and argues that network externalities were developed by deregulated U.S airlines,
whereas the European Airlines ability to make best use of route networks was
strongly limited by bilateral agreements (Baily, 1993).
 unit-4. Pricing

 Factor of Production: Demand and

Supply
Modern economists rejected the marginal productivity theory mainly because of two
reasons.

Firstly, according to modern economists, the marginal productivity theory does not
take into account the supply side of a factor of production.

Secondly, the marginal productivity theory is concerned only with the units of factors
of production, not with the determination of prices of factors. According to modern
economists, as the prices of products are determined by the interaction of two
forces, demand and supply in the market.

Similarly, in perfect competition, the prices of factors of production are also

determined by matching the demand and supply in the factor market. Therefore, we
will discuss the two aspects of a factor of production, namely demand and supply, in
the factor market.

 Demand for a Factor of Production:

The demand for factors is a derived demand. This is because the demand for a
factor of production (input) is derived from the demand of output. If the demand of
output is high, then the demand for input or factor of production would also be high
and vice versa.

According to the modern theory, the demand for a factor of production

depends on two parameters, which are explained as follows:
i. Magnitude of demand for a factor:
Involves three conditions, which are as follows:
a. Condition 1:
Implies that there would be high demand for a factor of production if it is highly
important in the production process.

b. Condition 2:
Implies that there would be high demand for a factor of production if the demand for
output or final product is high.

c. Condition 3:
Implies that there would be low demand for a factor of production if it has close
substitutes.

ii. Elasticity of demand for a factor:

Refers to the responsiveness of demand for a factor with change in its price.

The elasticity of demand for a factor also depends on three

conditions, which are as follows:
a. Condition 1:
Implies that if the price of a factor is very low with respect to the total cost, then the
demand for that factor will be inelastic and vice versa.

b. Condition 2:
Implies that if the demand for the product for which the factor of production is used is
elastic, then the demand for the factor used would also be elastic.

c. Condition 3:
Implies that if the factor of production has easy availability of substitutes in the
market, then its demand would be highly elastic. Now let us discuss the individual
demand curve of a factor of production.The demand curve of a factor of production is
determined with the help of MRP. Here, we take the example of labor and wages to
draw the individual demand curve. The demand for labor is determined by an
employer with the help of MRP and prevailing wage rates. In case, the wage rate is
low, then the labor employed would be higher and vice versa.

Figure-1 shows the demand curve of labor:

In Figure-1, when the wage rate is OW and the demand for labor is ON, then the
equilibrium is attained at point E. Similarly, at point E’, the wage rate is OW and
demand for labor is ON’ and at E” the wage rate is OW” with demand for labor ON”.
MRP represents the demand curve for an individual organization. However, it is
required to determine the market demand for labor.

 Supply of a Factor of Production:

After discussing the demand for a factor of production, it is important to understand
its supply, so that the price of the factor can be determined. Determining the supply
of factors of production is a complex task as each type of factor creates a problem.
For example the quantity of land is fixed, thus its supply cannot be increased or
decreased with change in its prices.

Similarly, if we analyze the total supply of labor in a country, it depends on a number

of factors, such as size and composition of population, efficiency of labor,
geographical distribution, expected wages, and educational qualifications.

In such a case, the total supply of labor is fixed; however, it can be increased by
increasing the working hours of labor employed. Moreover, the supply of capital also
depends on factors, such as rate of interest, saving capacity of individuals, and their
willingness to save. Therefore, in short, it can be said that the supply of a factor is
also a function of price.

If the price of a factor of production is higher, then its supply would also be higher
while others factors are constant and vice versa. Therefore, the slope of the supply
curve of a factor of production is upward to right. Here, again we take the example of
labor and wages to draw the supply curve.

Figure-3 shows the supply curve of labor:

  Interaction of Demand and Supply:
According to the modem theory, the price of a factor of production is determined at a
point where the demand and supply curves of the factor intersect each other. This
point is known as equilibrium point, where the demand of a factor is equal to its
supply.

Figure- 4 shows the equilibrium point where the price of a

factor of production is determined:

In Figure-4, demand and supply curves of labor intersect each other at point R,
which is the equilibrium point. At point R, the wage rate is OW (=MR) and demand
for labor is OM. At wage rate of OW, the demand for labor is W’M’, which is less than
its supply. This implies that there is surplus of labor in the market.

For overcoming the situation, the wage rate falls down to OW (where the equilibrium
is attained). Similarly, if the wage rate is OW”, then the demand for labor is W”L”,
which is more than its supply. This implies that there is a shortage of labor in the
market. In such a case, the wage rate increases to OW. Finally, we reach the
equilibrium point at which the demand and supply of labor is equal. At this point, the
wage rate for labor is determined.

The modern theory of factor pricing was an attempt to make improvement in

marginal productivity theory.

However, the modern theory is criticized due to its weak assumptions, which
are as follows:
i. Assumes only perfect competition in both the product market as well as the factor
market. However, in real situations, both of these markets face imperfect
competition.
ii. Assumes that there is homogeneity in all the factors of production, which is not
true in real market scenario.
iii. Assumes that all factors of production have close substitutes, which is not always
possible.

 Factors of Pricing in Perfectly

Competitive Markets
The mechanism of determination of factor prices does not differ fundamentally from
that of prices of commodities.

Factor prices are determined in markets under the forces of demand and supply. The
difference lies in the determinants of the demand and supply of productive
resources.

In the nineteenth century economists classified factor inputs into four groups land,
labour, capital and entrepreneurship.

The prices of these factors were called rent, wage, interest and profit respectively,
and each one was examined by a separate body of theory. Since, however, there
are many common factors underlying the determination of the price of inputs, a
general framework can be developed for analyzing the price mechanism of any
productive resource.

Thus, the theory to bedeveloped in will be presented in general terms, so that it is

applicable to all factors of production. Given that labour is the most important input,
we will usually speak of ‘the demand for labour’ or, ‘the supply of labour’. But the
reader should interpret such expressions as implying ‘the demand for a productive
factor’ and ‘the supply of a productive factor’.

We will first examine the determination of factor prices in perfectly competitive

product and input markets. Subsequently we will relax the assumption of perfectly
competitive market and we will discuss factor pricing in markets with various degrees
of imperfection.
A. Factor pricing in perfectly competitive markets:
In this part we will develop the so-called marginal productivity theory of distribution. It
takes its name from the fact that, in perfectly competitive product and input markets,
factors are paid the value of their marginal physical product. The price of a factor, w,
is determined by its total demand and supply schedules. The total demand is the
sum (aggregate) of the demands of individual firms for the productive factor.
Similarly, the total supply of a factor is the sum of the supplies by the individual
owners of the factor.

We will develop the demand for labour by a single firm. The aggregate demand will
then be derived from the summation of the individual demands. The same approach
will be adopted for the market supply. We will first derive the supply of labour by an
individual consumer. The aggregate supply of labour will then be derived from the
summation of the individual supply curves.

1. The Demand for Labour in Perfectly Competitive Markets:

We will examine the demand for labour in two cases:
(i) When labour is the only variable factor of production.

(ii) When there are several variable factors.

(i) Demand of a firm for a single variable factor

The following assumptions underlie our analysis:

(a) A single commodity X is produced in a perfectly competitive market. Hence Px is
given for all firms in the market.
(b) The goal of the firm is profit maximisation.

(c) There is a single variable factor, labour, whose market is perfectly competitive.
Hence the price of labour services, is given for all firms. This implies that the supply
of labour to the individual firm is perfectly elastic. It can be denoted by a straight line
through w parallel to the horizontal axis (figure 21.1). At the going market wage rate
the firm can employ (hire) any amount of labour it wants.

(d) Technology is given. The relevant production function is shown in figure 21.2.
The slope of the production function is the marginal physical product of labour
(ii) Remand, of a Firm for Several Variable Factors:
When there are more than one variable factors of production the VMP curve of an
input is not its demand curve. This is so because the various resources are used
simultaneously in the production of goods so that a change in the price of one factor
leads to changes in the employment (use) of the others. The latter, in turn, shifts the
MPP curve of the input whose price initially changed.

Assume that the wage rate falls. We will derive the new demand for labour, using
isoquant analysis. The change in the wage rate has in general three effects: a
substitution effect, an output effect, and a profit-maximising effect. Let us examine
these effects,

The demand for a variable factor depends on:

1. The price of the input. The higher the price of a factor, the smaller the demand for
its services.

2. The marginal physical product of the factor, which is derived by the production
function.

3. The price of the commodity produced by the factor. Recall that the VMPL is the
product of the MPPL times the price of the commodity, Px.
4. The amount of the other factors which are combined with labour. An increase in
the collaborating factors will shift the MPPL outwards to the right and hence will raise
its VMPL curve (and vice versa).
5. The prices of other factors, since these prices will determine their demand (and
hence the demand for labour).

6. The technological progress. Technological progress changes the marginal phy-

sical product of all inputs, and hence their demand.

(iii) The Market Demand for a Factor:

The demand curve of an individual firm for an ‘input. The next step is to use the
demand curves of the individual firms in order to derive the market demand curve for
the input. The market demand for an input is not the simple horizontal summation of
the demand curves of individual firms. This is due to the fact that as the price of the
input falls all firms will seek to employ more of this factor and expand their output.
Thus the supply of the commodity shifts downwards to the right, leading to a fall in
the price of the commodity, Px.
Since this price is one of the components of the demand curves of the individual
firms for the factor, these curves shift downward to the left. Figure 21.12 shows the
demand curve d1 of an individual firm for labour. Initially, suppose the wage rate is
w1. The firm is at point a on its demand curve and employs l 1 units of labour.
Summing over all employing firms, we obtain the total demand for the input at the
wage rate w1. Point A in figure 21.13 is one point on the market demand curve for
labour.

Assume next that the wage rate declines to w2. Other things being equal, the firm
would move along its demand curve d1, to point b’, increasing the employed labour to
l’2. However, other things do not remain equal. When the wage rate falls, all firms
tend to demand more labour, and the increased employment leads to an increase in
total output. The market supply curve for the commodity produced shifts downward
to the right, and the price of the commodity (given its demand) falls.

 Price Determination under Monopoly

Monopoly is that market form in which a single producer controls the whole supply of
a single commodity which has no close substitute.

From this definition there are two points that must be noted:

(i) Single Producer: There must be only one producer who may
be an individual, a partnership firm or a joint stock company. Thus single
firm constitutes the industry. The distinction between firm and industry
disappears under conditions of monopoly.
(ii) No Close Substitute: The commodity produced by the
producer must have no closely competing substitutes, if he is to be called
a monopolist. This ensures that there is no rival of the
monopolist. Therefore, the cross elasticity of demand between the product
of the monopolist and the product of any other producer must be very low.

PRICE-OUTPUT DETERMINATION UNDER MONOPOLY:

A firm under monopoly faces a downward sloping demand curve or average revenue
curve. Further, in monopoly, since average revenue falls as more units of output are
sold, the marginal revenue is less than the average revenue. In other words, under
monopoly the MR curve lies below the AR curve.

The Equilibrium level in monopoly is that level of output in which marginal revenue
equals marginal cost. The producer will continue producer as long as marginal
revenue exceeds the marginal cost. At the point where MR is equal to MC the profit
will be maximum and beyond this point the producer will stop producing.
COMPARISON OF PRICE DETERMINATION UNDER PERFECT
COMPETITION AND MONOPOLY:
The key points of comparison of price determination under Perfect Competition and
Monopoly is as below:

Perfect Competition Monopoly

(i) The demand curve or average revenue (i) The demand curve or average revenue
curve is perfectly elastic and is a horizontal curve is relatively elastic and a downward
straight line. sloping from left to right.
(ii) The firm is in equilibrium at the level of (ii) The firm is in equilibrium at the level of
output where MC is equal to MR. Since in output where MC is equal to MR.
perfect competition MR is equal to AR or
price, therefore, when MC is equal to MR, it
is also equal to AR or price at the
equlibrium position, i.e., MC=MR=AR
(Price)
(iii) In equilibrium position, the price (iii) In equilibrium position, the price
charged by the firm equals to MC. charged by the firm is above MC.
(iv) The firm is in long-run equilibrium at the (iv) The firm is in long-run equilibrium at the
minimum point of the long-run AC curve. point where AC curve is still declining and
has not reached the minimum point.
(v) The firm is in equilibrium at the level of (v) The firm is in equilibrium at the level of
output at which MC curve is rising, and is output at which MR curve is sloping
cutting MR curve from below. downwards, and MC curve is cutting it from
below or above. (See figure 1)
(vi) In the long run, the firm is earning (vi) The firm can earn abnormal or
normal profit. There may be super normal supernormal profit even in the long run, as
profit in the short run but they will be swept there is no competitor in the industry.
away in the long run, as new firms entered
into the industry.
(vii) Price can be set lower at greater (vii) Price is set higher and output smaller
output in case of constant-cost and by the monopolist.
decreasing-cost industries.

 Modern Theory of Rent

Modern theory of rent is an amplified and modified version of Ricardian theory of
Rent. It was first of all discussed by J.S. Mill and after that developed by economists
like Jevons, Pareto, Marshall, Joan Robinson etc.

According to modern theory, economic rent is a surplus which is not peculiar to land
alone. It can be a part of income of labour, capital, entrepreneur.

According to modern version rent is a surplus which arises due to difference

between actual earning and transfer earning.

That is:
Rent = Actual Earning-Transfer Earning.

What is Transfer Earning?

In this universe, each factor of production has varied uses. When we transfer one
factor from one use to another, we have to sacrifice the income earned by it from its
earlier use. Sacrifice of earning is called transfer earning.

Basically, the concept of transfer earning in economics is introduced by Prof.

Benham. According to him, “The amount of money which any particular unit could
earn in its best paid alternative use is sometimes called its transfer earnings.” A
similar idea was developed by Pigou. Different economists consider transfer
earnings as that amount of money which any particular unit could cam in its best
paid alternative use.

Modern Definitions of Rent:

“Rent is a payment in excess of transfer earning.” Stonier and Hague

“The essence of the conception of rent is the conception of a surplus earned by a

particular part of a factor of production over and above the minimum sum necessary
to induce it to do its work”. Mrs. Joan Robinson

Features of Modern Theory of Rent:

The major features of the modern theory of rent are as under:
1. Rent can be a part of the income of all factors of production.
2. Amount of rent depends upon the difference between actual earning and transfer
earning.
3. Rent arises when supply of the factor is either perfectly inelastic or less elastic.
Why Rent Arises:
According to modern theory, rent arises due to scarcity of land. Supply of other
factors like labour, capital etc. can also be scare in relation to demand. Therefore,
income earned by these factors in excess of their minimum income is called
economic rent.

Prof. Wieser divided factors of production into two parts viz.; specific factors and
nonspecific factors.

Specific Factors:
These factors refer to those factors which have only one use. For example, a farm
used for growing wheat alone. Such factors have no mobility.

Non-Specific Factors:
These factors are those which have mobility and can be put to different uses. It is
only due to the reason that specific factors cannot be put to another use. Specificity
of factors is the main cause of the emergence of rent. It is so because specific
factors cannot be put to any other use. So, its opportunity cost is zero. In other
words, its transfer earning is zero. So its entire actual earning in the existing use is
rent.

Determination of Rent:
Modern economists studied the determination of rent in two forms
as:
1.Rent of Land

2. General concept of Rent.

Determination of Rent of Land or Scarcity Theory of Rent:

Modern economists opined that rent arises due to scarcity of land.
Scarcity of land means that demand for land exceeds its supply.
Rent will be determined at a point where demand for land is equal
to its supply.

 Quasi-Rent
Quasi literally means ‘almost’. Quasi- rent is, therefore, a payment which is almost rent but is
not exactly economic rent.

Similar abnormal earnings or surplus may also arise in the case of other durable goods like
houses and machines.

Similarly, quasi-rent may also arise due to a temporary scarcity of a particular kind of skill
which can be increased only if enough time is given.

From the Ricardian theory of rent, a person might conclude that rent is a kind by itself and
does not resemble any other payment. But this is not so. The peculiarity of land after all is
that all its stock is fixed for ever. Rent arises from this peculiarity. That is why Benham
defines rent as “a surplus accruing to a specific factor, the supply of which is fixed.”

Now no other factor is permanently fixed like land. But whenever the supply of any other
factor is fixed even temporarily, its return resembles rent and is called quasi-rent. Thus, an
element of rent is present in interest, wages and profits, and is called quasi-rent. It lasts only
for a short period of time and disappears when conditions become normal.

This concept of quasi-rent was introduced in economic theory by Marshall. It is an extension

of the Ricardian concept of rent to the short-run earnings of capital equipment (such as
machinery, buildings), which is in inelastic supply in the short-run, that is, whose supply
cannot be increased in the short period. For example, during the last war merchant shipping
became scarce. New ships could not replace the lost ones quickly as ships take long to
build. As a result, the existing vessels began to charge high freights and earned exceptional
profits.
These profits were temporary, because had the need lasted long enough, new- ships would
have been constructed and profits reduced to normal. Such abnormal earnings, during the
period the supply of machines or ships is fixed, are termed by Marshall as ‘quasi-
rent’.

It is the whole income and not extra income:

It may clearly be understood that quasi-rent stands for the whole of the earnings or
income rather than the additional income. This income some agents of production
yield when demand for them has suddenly increased, while their supply cannot be
increased readily in response to that increase in demand.

Hence, quasi-rent is a short period concept. The adjoining diagram (Fig. 33.7) shows
quasi-rent. Here SS, a vertical straight line, is the absolutely inelastic supply curve
for machines. It cuts the demand curve DD at E. At the price OP (=SE), OS
machines are supplied. If, in the short run, demand increases to D’D’, the price will
go up to OP’ =SE’), but the supply of machines remains OS.

Since the number of machines is fixed in the short-run, the transfer earnings are
zero, the whole earnings OSE’P’ are quasi-rent. But in the long run, the supply of
machines will increase to OM, because the supply is inelastic only in the short-run; it
is perfectly elastic in the long run, which is represented by PL so that any number of
machines can be supplied at OP. The price now comes down to E”M (= OP). The
quasi-rent has vanished, because the price E” M just covers the supply price OP.

 Rent, Quasi-rent and Interest:

Rent, we know, is a payment for the use of land. Quasi-rent is yielded by machinery
and capital equipment i.e. old invested capital or ‘sunk’ capital, and interest is the
return on new investments of capital. They are all fundamentally similar in that they
are all scarce in- relation to demand for them. They all yield a differential surplus
arising from limitation of their supply only the duration of the limitation of supply
varies.

For instance, land is permanently limited and its supply is absolutely inelastic. That is
why; it is put in a separate category. Since its supply is limited permanently, it is a
perennial source of surplus income called rent. The supply of machinery, etc., is,
however, limited for a short period because it takes some time to produce it. Its
supply is, therefore, elastic but not so elastic i.e., it is less than perfectly elastic.
 Unit-5. Macroeconomics

 Macroeconomics'
It is that part of economic theory which studies the economy in its totality or as a
whole.

It studies not individual economic units like a household, a firm or an industry but the
whole economic system. Macroeconomics is the study of aggregates and averages
of the entire economy.

Such aggregates are national income, total employment, aggregate savings and
investment, aggregate demand, aggregate supply general price level, etc.

Here, we study how these aggregates and averages of the economy as a whole are
determined and what causes fluctuations in them. Having understood the
determinants, the aim is how to ensure the maximum level of income and
employment in a country.

In short, macroeconomics is the study of national aggregates or economy-wide

aggregates. In a way it is like study of economic forest as distinguished from trees
that comprise the forest. Main tools of its analysis are aggregate demand and
aggregate supply.

The scope of macroeconomics includes the following parts:

 Keynesian Theory of Income and
Employment
Total Spending and Economic Activity:
Basically, expansions and contractions in economic activity, or changes in real
output, are caused by changes in total, or aggregate, spending.

Total, or aggregate, spending refers to the total spending for all new goods and
services by households, businesses, government units, and foreign buyers
combined

Why do changes in spending cause the level of economic activity to change? In a

market economy, buyers, through their spending decisions, choose goods and
services that are produced by sellers. If buyers do not spend their money on
products, sellers will not produce those products for the market. Thus, if total
spending were to decrease, output would decrease; if total spending were to
increase, output would increase; and if total spending remained unchanged, output
would not change.

When the level of spending goes up and sellers increase production, more land,
labour, capital, and entrepreneurship are required. This means that there will be an
increase in the employment of resources, which will, in turn, enlarge incomes. Thus,
increased spending leads to economic expansion, or recovery, because it stimulates
a growth in output, employment, and income.

When spending falls and sellers reduce their outputs, a cutback occurs in the
employment of resources. This cutback in turn leads to a decrease in resource
owners’ incomes. Thus, a reduction in spending leads to a recession, or contraction
in economic activity, because of its dampening effect on output, employment, and
income. The relationship between spending and output, employment, and income is
summarised in Table 18.1.

Because aggregate spending is composed of expenditures by households,

businesses, the government, and foreign buyers, it is necessary examine the
spending behaviour of each of these sectors, along with how that behaviour affects
the level of economic activity.

 Aggregate Effective Demand:

Keynes’ analysis of general unemployment is based on the concept of aggregate (or
total) demand in the economy. To simplify his analysis, Keynes initially left aside the
government sector (and, therefore, the element of government expenditure in
aggregate demand). He also ignored foreign trade (or exports). (However, for the
sake of completeness, we shall incorporate these elements in our analysis at the
later stage.)

In a closed economy (i.e., one having no trading relation with the rest of the world)
with no government sector.

The two components of aggregate demand are:

(1) private consumption expenditure and
(2) private investment expenditure.
Table 18.1: Total Spending and the Level of Economic Activity

 The Household Sector:

In the aggregate, the largest spending group in the economy is households.
Households buy far more goods and services than do businesses, government units,
and foreign purchasers combined. Also, over time, household spending increases at
a relatively stable pace. Because individuals do not usually alter their expenditure
patterns from year to year, aggregate household spending on new goods and
services, which is technically termed personal consumption expenditures, tends to
fluctuate very little as it grows over time.

 The Consumption Function:

To construct Keynesian macroeconomic models, it is necessary to have a clear
understanding of the consumption function. The concept of propensity to consume or
the so- called consumption function is based on the— “fundamental psychological
law” which states that — “as a rule and on the average” — as income increases,
consumption increases but the rate of the increase in consumption is less than the
rate of increase in income.
Thus, in Keynes’ consumption function, a relationship between functions has
the following characteristics:
(i) Consumption is a function of (disposable) income, i.e., C = f (Y).
(ii) The relationship between consumption and income is a direct one.
(iii) The rate of increase in consumption is less than the rate of increase in income. In
Keynes’ terminology, the value of the marginal propensity to consume (MPC) is less
than one.

 The Saving Function:

The portion of income which is not consumed is automatically saved. Thus, saving is
the difference between income and consumption. That is,

S = Y- C

Like consumption function, saving also directly depends or income. To have a clear
understanding of the saving function, we must define Keynes’ concepts like average
and marginal propensities to save.

Four Definitions:
Before we proceed further we have to note four important definitions. These will
come up again and again in our discussion of macroeconomics.

1. The average propensity to consume (APC):

It is the proportion of income which is spent on consumption. It is worked out by
dividing total consumption expenditure (C) by total income (Y) – APC = C/Y. Thus, if
India’s national income is Rs. 10,000 crore and consumption expenditure is Rs.
7,000 crore, APC = 7/10 or 0.7.

2. The marginal propensity to consume (MPC):

It is the proportion of an addition to income that is spent on consumption. It is worked
out by dividing the (absolute) change in consumption by the (absolute) change in
income that brings it about.

 What Is a Multiplier?
In economics, a multiplier broadly refers to an economic factor that, when increased
or changed, causes increases or changes in many other related economic variables.
In terms of gross domestic product, the multiplier effect causes gains in total output
to be greater than the change in spending that caused it.

The term multiplier is usually used in reference to the relationship between

government spending and total national income. Multipliers are also used in
explaining fractional reserve banking, known as the deposit multiplier.

Many different multipliers exist in finance and economics.

 The Fiscal Multiplier
The fiscal multiplier is the ratio of a country's additional national income to the initial
boost in spending or reduction in taxes that led to that extra income. For example,
say that a national government enacts a $1 billion fiscal stimulus and that its
consumers' marginal propensity to consume (MPC) is 0.75. Consumers who receive
the initial $1 billion will save $250 million and spend $750 million, effectively initiating
another, smaller round of stimulus. The recipients of that $750 million will spend
$562.5 million, and so on.

 The Investment Multiplier

An investment multiplier similarly refers to the concept that any increase in public or
private investment has a more than proportionate positive impact on aggregate
income and the general economy. The multiplier attempts to quantify the additional
effects of a policy beyond those immediately measurable. The larger an investment's
multiplier, the more efficient it is at creating and distributing wealth throughout an
economy.

 The Earnings Multiplier

The earnings multiplier frames a company's current stock price in terms of the
company's earnings per share (EPS) of stock. It presents the stock's market value as
a function of the company's earnings and is computed as (price per share/earnings
per share).

This is also known as the price-to-earnings (P/E) ratio. It can be used as a simplified
valuation tool for comparing relative costliness of the stocks of similar companies,
and for judging current stock prices against their historical prices on an earnings
relative basis.

 The Equity Multiplier

The equity multiplier is a commonly used financial ratio calculated by dividing a
company's total asset value by total net equity. It is a measure of financial leverage.
Companies finance their operations with equity or debt, so a higher equity multiplier
indicates that a larger portion of asset financing is attributed to debt. The equity
multiplier is thus a variation of the debt ratio, in which the definition of debt financing
includes all liabilities.

Multiplying Money
One popular multiplier theory and its equations were created by British
economist John Maynard Keynes. Keynes believed that any injection of government
spending created a proportional increase in overall income for the population, since
the extra spending would carry through the economy. In his 1936 book, "The
General Theory of Employment, Interest, and Money," Keynes wrote the following
equation to describe the relationship between income (Y), consumption (C) and
investment (I):

Y=C+Iwhere:Y=incomeC=consumptionI=investment
 What Is the IS-LM Model?
The IS-LM model appears as a graph that shows the intersection of goods and the
money market. The IS stands for Investment and Savings. The LM stands for
Liquidity and Money. On the vertical axis of the graph, ‘r’ represents the interest
rate on government bonds. The IS-LM model attempts to explain a way to keep
the economy in balance through an equilibrium of money supply versus interest
rates.

The IS-LM is also sometimes called the Hicks-Hansen model.

Breaking Down IS-LM

In order to gain a full understanding of how the four components work together, it
is important to first understand what each component means on its own.

 Investment
In macroeconomics, an investment is defined as a quantity of goods purchased in
a period of time that are not consumed or used in that time. Investment increases
as interest rates decrease.

 Savings
Savings, sometimes known as deferred consumption, is income that is not spent.
As interest rates fall, savings also fall, as most households take advantage of
lower interest rates to make purchases.

 Liquidity
Liquidity refers to the demand for and amount of real money, in all of its forms, in
an economy. Those who part with liquidity, in the form of saving or investing, are
rewarded through interest payments or dividends.

 Money
Money is a any verifiable record or item that can be used as a means of paying for
goods and services.

 Monetary Policy
Monetary policy is a central bank's actions and communications that manage the
money supply. The money supply includes forms of credit, cash, checks, and money
market mutual funds. The most important of these forms of money is credit. Credit
includes loans, bonds, and mortgages.
Monetary policy increases liquidity to create economic growth. It reduces liquidity to
prevent inflation. Central banks use interest rates, bank reserve requirements, and
the number of government bonds that banks must hold. All these tools affect how
much banks can lend. The volume of loans affects the money supply.

Three Objectives of Monetary Policy

Central banks have three monetary policy objectives.1 The most important is to
manage inflation. The secondary objective is to reduce unemployment, but only after
controlling inflation. The third objective is to promote moderate long-term interest
rates.

The U.S. Federal Reserve, like many other central banks, has specific targets

for these objectives. It wants the core inflation rate to be around 2%. 2 Beyond that, it
prefers a natural rate of unemployment of between 3.5% and 4.5%.3

Types of Monetary Policy

Central banks use contractionary monetary policy to reduce inflation. They reduce
the money supply by restricting the volume of money banks can lend. The banks
charge a higher interest rate, making loans more expensive. Fewer businesses and
individuals borrow, slowing growth.

Central banks use expansionary monetary policy to lower unemployment and avoid
recession. They increase liquidity by giving banks more money to lend. Banks lower
interest rates, making loans cheaper. Businesses borrow more to buy equipment,
hire employees, and expand their operations. Individuals borrow more to buy more
homes, cars, and appliances. That increases demand and spurs economic growth.5

Monetary Policy vs. Fiscal Policy

Ideally, monetary policy should work hand-in-glove with the national government's
fiscal policy. It rarely works this way. Government leaders get re-elected for reducing
taxes or increasing spending. As a result, they adopt an expansionary fiscal policy.
To avoid inflation in this situation, the Fed is forced to use a restrictive monetary
policy.6
For example, after the Great Recession, Republicans in Congress became
concerned about the U.S. debt. It exceeded the debt-to-GDP ratio of 100%. 7 As a
result, fiscal policy became contractionary just when it needed to be expansionary.
To compensate, the Fed injected massive amounts of money into the economy with
quantitative easing.

Monetary Policy Tools

All central banks have three tools of monetary policy in common. First, they all use
open market operations. They buy and sell government bonds and other securities
from member banks. This action changes the reserve amount the banks have on
hand. A higher reserve means banks can lend less. That's a contractionary policy. In
the United States, the Fed sells Treasurys to member banks.
The second tool is the reserve requirement, in which the central banks tell their
members how much money they must keep on reserve each night. Not everyone
needs all their money each day, so it is safe for the banks to lend most of it out. That
way, they have enough cash on hand to meet most demands for redemption.
Previously, this reserve requirement has been 10%. However, effective March 26,
2020, the Fed has reduced the reserve requirement to zero.8
When a central bank wants to restrict liquidity, it raises the reserve requirement. That
gives banks less money to lend. When it wants to expand liquidity, it lowers the
requirement. That gives members banks more money to lend. Central banks rarely
change the reserve requirement because it requires a lot of paperwork for the
members.

 Fiscal Policy Types, Objectives, and Tools

Fiscal policy is how Congress and other elected officials influence the economy
using spending and taxation. It is used in conjunction with the monetary
policy implemented by central banks, and it influences the economy using the money
supply and interest rates.1

The objective of fiscal policy is to create healthy economic growth. Ideally, the
economy should grow between 2%–3% a year, unemployment will be at its natural
rate of 3.5%–4.5%, and inflation will be at its target rate of 2%.2 The business
cycle will be in the expansion phase.

Expansionary Fiscal Policy

There are two types of fiscal policy. The most widely-used is expansionary, which
stimulates economic growth. Congress uses it to end the contraction phase of the
business cycle when voters are clamoring for relief from a recession. The
government either spends more, cuts taxes, or both. The idea is to put more money
into consumers' hands, so they spend more. The increased demand forces
businesses to add jobs to increase supply.1
Politicians debate about which works better. Advocates of supply-side
economics prefer tax cuts because they say it frees up businesses to hire more
workers to pursue business ventures. Advocates of demand-side economics say
additional spending is more effective than tax cuts.4 Examples include public works
projects, unemployment benefits, and food stamps. The money goes into the
pockets of consumers, who go right out and buy the things businesses produce.
An expansionary fiscal policy is impossible for state and local governments because
they are mandated to keep a balanced budget. If they haven't created a surplus
during the boom times, they must cut spending to match lower tax revenue during a
recession.5 That makes the contraction worse. Fortunately, the federal government
has no such constraints; it's free to use expansionary policy whenever it's needed.
Unfortunately, it also means Congress created budget deficits even during economic
booms—despite a national debt ceiling.6 7 As a result, the critical debt-to-gross
domestic product ratio has exceeded 100%.8

Contractionary Fiscal Policy

The second type of fiscal policy is contractionary fiscal policy, which is rarely
used. Its goal is to slow economic growth and stamp out inflation. The long-term
impact of inflation can damage the standard of living as much as a recession. The
tools of contractionary fiscal policy are used in reverse. Taxes are increased, and
spending is cut. You can imagine how wildly unpopular this is among voters.1
Only lame duck politicians could afford to implement contractionary policy.

Tools
The first tool is taxation. That includes income, capital gains from investments,
property, and sales. Taxes provide the income that funds the government. The
downside of taxes is that whatever or whoever is taxed has less income to spend on
themselves, which is why taxes are unpopular.

The second tool is government spending—which includes subsidies, welfare

programs, public works projects, and government salaries. Whoever receives the
funds has more money to spend, which increases demand and economic growth.9

The federal government is losing its ability to use discretionary fiscal policy because
each year more of the budget must go to mandated programs. As the population
ages, the costs of Medicare, Medicaid, and Social Security are rising. Changing
the mandatory budget requires an Act of Congress, and that takes a long time.1 0 1 1
One exception was the American Recovery and Reinvestment Act. Congress passed
it quickly to stop the Great Recession.