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3rd Semester ECONOMICS I Notes

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ECONOMICS I
Introduction
Q. State and explain critically different definitions of Economics.

1. General Definition of Economics:

The English word economics is derived from the ancient Greek word oikonomia—meaning the
management of a family or a household.

It is thus clear that the subject economics was first studied in ancient Greece.

What was the study of household management to Greek philosophers like Aristotle (384-322 BC) was
the “study of wealth” to the mercantilists in Europe between the sixteenth and eighteenth centuries.

Economics, as a study of wealth, received great support from the Father of economics, Adam Smith, in
the late eighteenth century.

Since then, the subject has travelled a long and this Greek or Smithian definition serves our purpose no
longer. Over the passage of time, the focus of attention has been changed. As a result, different
definitions have evolved.

These definitions can conveniently be grouped into three:

(i) Smith’s Wealth definition;

(ii) Marshall’s Welfare definition; and

(iii) Robbins’ Scarcity definition.

2. Adam Smith’s Wealth Definition:

The formal definition of economics can be traced back to the days of Adam Smith (1723-90) — the great
Scottish economist. Following the mercantilist tradition, Adam Smith and his followers regarded
economics as a science of wealth which studies the process of production, consumption and
accumulation of wealth.

His emphasis on wealth as a subject-matter of economics is implicit in his great book— ‘An Inquiry into
the Nature and Causes of the Wealth of Nations or, more popularly known as ‘Wealth of Nations’—
published in 1776.

According to Smith: “The great object of the Political Economy of every country is to increase the riches
and power of that country.” Like the mercantilists, he did not believe that the wealth of a nation lies in
the accumulation of precious metals like gold and silver.

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To him, wealth may be defined as those goods and services which command value-in- exchange.
Economics is concerned with the generation of the wealth of nations. Economics is not to be concerned
only with the production of wealth but also the distribution of wealth. The manner in which production
and distribution of wealth will take place in a market economy is the Smithian ‘invisible hand’
mechanism or the ‘price system’. Anyway, economics is regarded by Smith as the ‘science of wealth.’

Other contemporary writers also define economics as that part of knowledge which relates to wealth.
John Stuart Mill (1806-73) argued that economics is a science of production and distribution of wealth.
Another classical economist Nassau William Senior (1790-1864) argued “The subject-matter of the
Political Economics is not Happiness but Wealth.” Thus, economics is the science of wealth. However,
the last decade of the nineteenth century saw a scathing attack on the Smithian definition and in its
place another school of thought emerged under the leadership of an English economist, Alfred Marshall
(1842-1924).

Criticisms:

i. This definition is too narrow as it does not consider the major problems faced by a society or an
individual. Smith’s definition is based primarily on the assumption of an ‘economic man’ who is
concerned with wealth-hunting. That is why critics condemned economics as ‘the bread-and-butter
science’.

ii. Literary figures and social reformers branded economics as a ‘dismal science’, ‘the Gospel of
Mammon’ since Smithian definition led us to emphasise on the material aspect of human life, i.e.,
generation of wealth. On the other hand, it ignored the non-material aspect of human life. Above all, as
a science of wealth, it taught selfishness and love for money. John Ruskin (1819-1900) called economics
a ‘bastard science.’ Smithian definition is bereft of changing reality.

iii. The central focus of economics should be on scarcity and choice. Since scarcity is the fundamental
economic problem of any society, choice is unavoidable. Adam Smith ignored this simple but essential
aspect of any economic system.

3. Marshall’s Welfare Definition:

Alfred Marshall in his book ‘Principles of Economics published in 1890 placed emphasis on human
activities or human welfare rather than on wealth. Marshall defines economics as “a study of men as
they live and move and think in the ordinary business of life.” He argued that economics, on one side, is
a study of wealth and, on the other, is a study of man.

Emphasis on human welfare is evident in Marshall’s own words: “Political Economy or Economics is a
study of mankind in the ordinary business of life; it examines that part of individual and social action
which is most closely connected with the attainment and with the use of the material requisites of well-
being.”

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Thus, “Economics is on the one side a study of wealth; and on the other and more important side, a part
of the study of man.” According to Marshall, wealth is not an end in itself as was thought by classical
authors; it is a means to an end—the end of human welfare.

This Marshallian definition has the following important features:

i. Economics is a social science since it studies the actions of human beings.

ii. Economics studies the ‘ordinary business of life’ since it takes into account the money-earning and
money-spending activities of man.

iii. Economics studies only the ‘material’ part of human welfare which is measurable in terms of the
measuring rod of money. It neglects other activities of human welfare not quantifiable in terms of
money. In this connection A. C. Pigou’s (1877- 1959)—another great neo-classical economist—definition
is worth remembering. Economics is “that part of social welfare that can be brought directly or indirectly
into relation with the measuring rod of money.”

iv. Economics is not concerned with “the nature and causes of the Wealth of Nations.” Welfare of
mankind, rather than the acquisition of wealth, is the object of primary importance.

Criticisms:

i. Marshall’s notion of ‘material welfare’ came in for sharp criticism at the hands of Lionel Robbins (later
Lord) (1898- 1984) in 1932. Robbins argued that economics should encompass ‘non- material welfare’
also. In Teal life, it is difficult to segregate material welfare from non-material welfare. If only the
‘materialist’ definition is accepted, the scope and subject-matter of economics would be narrower, or a
great part of economic life of man would remain outside the domain of economics.

ii. Robbins argued that Marshall could not establish a link between economic activities of human beings
and human welfare. There are various economic activities that are detrimental to human welfare. The
production of war materials, wine, etc., are economic activities but do not promote welfare of any
society. These economic activities are included in the subject-matter of economics.

iii. Marshall’s definition aimed at measuring human welfare in terms of money. But ‘welfare’ is not
amenable to measurement, since ‘welfare’ is an abstract, subjective concept. Truly speaking, money can
never be a measure of welfare.

iv. Marshall’s ‘welfare definition’ gives economics a normative character. A normative science must pass
on value judgments. It must pronounce whether a particular economic activity is good or bad. But
economics, according to Robbins, must be free from making value judgment. Ethics should make value
judgments. Economics is a positive science and not a normative science.

v. Finally, Marshall’s definition ignores the fundamental problem of scarcity of any economy. It was
Robbins who gave a scarcity definition of economics. Robbins defined economics in terms of allocation
of scarce resources to satisfy unlimited human wants.

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4. Robbins’ Scarcity Definition:

The most accepted definition of economics was given by Lord Robbins in 1932 in his book ‘An Essay on
the Nature and Significance of Economic Science. According to Robbins, neither wealth nor human
welfare should be considered as the subject-matter of economics. His definition runs in terms of
scarcity: “Economics is the science which studies human behaviour as a relationship between ends and
scarce means which have alternative uses.”

From this definition, one can build up the following propositions:

(i) Human wants are unlimited; wants multiply—luxuries become necessities. There is no end of wants.
If food were plentiful, if there were enough capital in business, if there were abundant money and
time—there would not have been any scope for studying economics. Had there been no wants there
would not have been any human activity. Prehistoric people had wants. Modern people also have
wants. Only wants change—and they are limitless.

(ii) The means or the resources to satisfy wants are scarce in relation to their demands. Had resources
been plentiful, there would not have been any economic problems. Thus, scarcity of resources is the
fundamental economic problem to any society. Even an affluent society experiences resource scarcity.
Scarcity of resources gives rise to many ‘choice’ problems.

(iii) Since the prehistoric days one notices constant effort of satisfying human wants through the
scarcest resources which have alternative uses. Land is scarce in relation to demand. However, this land
may be put to different alternative uses.

A particular plot of land can be either used for jute cultivation or steel production. If it is used for steel
production, the country will have to sacrifice the production of jute. So, resources are to be allocated in
such a manner that the immediate wants are fulfilled. Thus, the problem of scarcity of resources gives
rise to the problem of choice.

Society will have to decide which wants are to be satisfied immediately and which wants are to be
postponed for the time being. This is the choice problem of an economy. Scarcity and choice go hand in
hand in each and every economy: “It exists in one-man community of Robinson Crusoe, in the
patriarchal tribe of Central Africa, in medieval and feudalist Europe, in modern capitalist America and in
Communist Russia.”

In view of this, it is said that economics is fundamentally a study of scarcity and of the problems to
which scarcity gives rise. Thus, the central focus of economics is on opportunity cost and optimisation.
This scarcity definition of economics has widened the scope of the subject. Putting aside the question of
value judgment, Robbins made economics a positive science. By locating the basic problems of
economics — the problems of scarcity and choice — Robbins brought economics nearer to science. No
wonder, this definition has attracted a large number of people into Robbins’ camp.

The American Nobel Prize winner in Economics in 1970, Paul Samuelson, observes: “Economics is the
study of how men and society choose, with or without the use of money, to employ scarce productive

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resources which could have alternative uses, to produce various commodities over time, and distribute
them for consumption, now and in the near future, among various people and groups in society.”

Criticisms:

i. In his bid to raise economics to the status of a positive science, Robbins deliberately downplayed the
importance of economics as a social science. Being a social science, economics must study social
relations. His definition places too much emphasis on ‘individual’ choice. Scarcity problem, in the
ultimate analysis, is the social problem—rather an individual problem. Social problems give rise to social
choice. Robbins could not explain social problems as well as social choice.

ii. According to Robbins, the root of all economic problems is the scarcity of resources, without having
any human touch. Setting aside the question of human welfare, Robbins committed a grave error.

iii. Robbins made economics neutral between ends. But economists cannot remain neutral between
ends. They must prescribe policies and make value judgments as to what is good for the society and
what is bad. So, economics should pronounce both positive and normative statements.

iv. Economics, at the hands of Robbins, turned to be a mere price theory or microeconomic theory. But
other important aspects of economics like national income and employment, banking system, taxation
system, etc., had been ignored by Robbins.

Conclusion: The science of political economy is growing and its area can never be rigid. In other words,
the definition must not be inflexible. Because of modern research, many new areas of economics are
being explored.

That is why the controversy relating to the definition of economics remains and will remain so in the
future. It is very difficult to spell out a logically concise definition. In this connection, Mrs. Barbara
Wotton’s remarks may be noted – ‘Whenever there are six economists, there are seven opinions!’

Despite these, Cairncross’ definition of economics may serve our purpose:

“Economics is a social science studying how people attempt to accommodate scarcity to their wants and
how these attempts interact through exchange.” By linking ‘exchange’ with ‘scarcity’, Prof. A. C.
Cairncross has added another cap to economics.

However, this definition does not claim any originality since scarcity—the root of all economic
problems—had been dealt with elegantly by Robbins.

That is why, Robbinsian definition is more popular: Economics is the science of making choices.
Modern economics is a science of rational choice or decision-making under conditions of scarcity.

Q. Distinguish between (i) Welfare and Scarcity Definition of Economics. (ii) Micro and Macro
Economics. (iii) Production and Consumption.

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(i) Welfare and Scarcity definition of economics OR MARSHALL'S DEFINITION VS ROBBIN'S DEFINITION

1. Economic activity – material / immaterial:

Marshall believes in only material activities which promote material welfare.

Robbins believes in both material and immaterial activities to tackle the problem of choice.

2. Social science / natural science:

For Marshall, Economics is a social science.

On the other hands, Robbins is of the view that Economics is natural science like Physics, Chemistry etc.

3. Normative science / positive science:

Marshall is of the opinion that in Economics, we not only consider the problems as they are but we also
suggest that how the given problem should be tackled. It means according to Marshall, Economics is
basically a normative science.

Robbins thinks otherwise. He says that economists must be just neutral observers of economic events
around them, ignoring their personal likings. They can talk of facts only. Hence Robbins believes that
Economics is basically a positive science in which the economists describe the economics facts as they
are.

4. Classification / universality:

Marshall has classified the goods into material / non-material and Individuals into social / isolated.

Robbins does not believe in such artificial classification. He has analyzed economic problem which
appears due to multiple wants and scarce means. It is a universal phenomenon.

5. Practical / theoretical:

Marshall’s definition is practical in nature. This definition is useful for economic policies.

Robbins definition is theoretical in nature.

6. Social / isolated individual:

Marshall considers only the activities of a social person. It ignores the activities of an isolated person.

Robbins considers activities of both the persons, i.e. activities of a social person and activities of an
isolated person.

7. Appreciable / non-appreciable activities:

Marshall considers only appreciable activities of a social person.

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Robbins considers both appreciable and inappreciable activities of both the social person and isolated
person.

8. Human touch:

Marshall concentrates on human material welfare. He gives due importance to man.

Robbins focuses on scarcity of resources. He gives no importance of man.

9. Welfare / scarcity:

Marshall’s definition is based on the concept of human material welfare.

Robbin’s definition is based on the concept of scarcity of resources.

10. Scope of Economics:

Marshall considers only material aspects of human welfare. It reflects limited scope of Economics.

Robbins makes no difference between material and non-material aspects. It indicates wider scope of
Economics.

11. Moral values:

Marshall’s definition makes a direct link of economic activities with moral values.

Robbin’s definition has nothing to do with moral or ethical values. It is the problem of social reformers,
politicians etc.

12. Subjective / objective:

The concept of welfare in Marshall’s definition is subjective and it varies from person to person and
place to place.

The concept of scarcity in Robbins’ definition is objective and applicable equally to every person or to
every place.

13. Qualitative / quantitative:

The concept of welfare is a qualitative phenomenon in Marshall’s definition and we cannot measure it.

The concept of scarcity is a quantitative phenomenon in Robbin’s definition and we can measure it.

14. Cause / effect:

In Marshall’s definition, major concern is of material welfare which is the effect of economic
development.

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Robbin’s definition is primarily concerned with allocation of scarce resources which is the cause of
economic development.

15. Vague / clear:

The pivot of Marshall’s definition is welfare which is a vague concept and its indicators change with the
passage of time.

Robbin’s definitions is based on a clear concept of scarcity and its basic indicator, i.e. excess demand
sustains.

16. Macro / micro approach:

In Marshall’s definition, material welfare is a macro phenomenon.

In Robbin’s definition, major macro problems like unemployment, inflation etc. has not been
considered. It concentrates only on micro aspects of economic activities.

(ii) Micro and Macro Economics

Basis for
Microeconomics Macroeconomics
Comparison

The branch of economics that studies The branch of economics that studies the
the behavior of an individual behavior of the whole economy, (both
Meaning
consumer, firm, family is known as national and international) is known as
Microeconomics. Macroeconomics.

Deals with Individual economic variables Aggregate economic variables

Business Applied to operational or internal Environment and external issues

Application issues

Covers various issues like demand, Covers various issues like, national income,
supply, product pricing, factor pricing, general price level, distribution,
Scope
production, consumption, economic employment, money etc.
welfare, etc.

Helpful in determining the prices of a Maintains stability in the general price level
product along with the prices of factors and resolves the major problems of the
Importance of production (land, labor, capital, economy like inflation, deflation, reflation,
entrepreneur etc.) within the unemployment and poverty as a whole.
economy.

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It is based on unrealistic assumptions, It has been analyzed that 'Fallacy of

i.e. In microeconomics it is assumed Composition' involves, which sometimes
Limitations that there is a full employment in the doesn't proves true because it is possible
society which is not at all possible. that what is true for aggregate may not be
true for individuals too.

(iii) Production and consumption

Production

i. Primary production includes age-old activities of production which are directly and indirectly taken
from the earth such as hunting animals and gathering wild products; extracting minerals from the
earth’s crust; fishing from rivers, lakes and oceans; and growing trees. In general, five primary activities
recognised are: agriculture, cattle grazing, forest production, hunting and fishing, and mining and
quarrying.

ii. Secondary production increases the value or usefulness of a previously existing item by changing its
form. Such activities include manufacturing and commercial agriculture.

iii. Tertiary production involves the service sector rather than the tangible goods. In tertiary production
no particular article is directly related, various kinds of aids are rather used for transport, distribution
and primary and secondary production.

iv. these production services represent special type of services such as financial, health, education,
information, data processing, etc.

v. . these production activities include high -level managerial and executive administrative services both
public and private. Research scientists, legal authorities, financial advisers and professional consultants
are included in this category.

Consumption

A third aspect of all the economic activity involves the consumption of goods and services. The term
‘consumption’ refers to the final or direct use of goods and services to satisfy the wants and needs of
human beings. This aspect, i.e., geography of consumption has largely been ignored by geography. But
now, there is a growing interest among geographers to study spatial aspects of consumer behaviour.

The above mentioned activities are having functional interrelationship at various stages of economic
production. This functional interrelationship is related to secondary and tertiary production through
various services. The direct or indirect functional relation of all the resources of production depends
upon location, relief, climate, soil and technical know-how of those areas.

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Just as the various aspects of primary production have established functional interrelationship with one
another, in the same way, all the factors of secondary production have established functional relation
with the factors of primary production.

In the same way tertiary production has functional relation with the primary and secondary production.
This functional interrelationship of production not only changes the form and utility of material but also
effects a transformation in their ownership and value.

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Economic System
Q. Discuss the meaning, characteristic features, merits and demerits of Socialist Economy, Mixed
Economy and Capitalist Economy.

Socialist Economy

“Socialism refers to the government ownership of the means of production, planning by the
government and income distribution”-Samuelson.

Meaning: Socialist means the system under which economic system is controlled and regulated by the
government so as to ensure welfare and equal opportunity to the people in a society.

The idea of socialism is first introduced by Karl Marx and Fredric Engles in their book, ‘The Communist
Manifesto’.

The word socialism means ‘all things to all men’. According to Samuelson, “Socialism refers to the
government ownership of the means of production, planning by the government and income
distribution”.

Main Features of Socialist Economy:

(i) Collective Ownership: In socialism, all means of production are owned by the community, i.e.,
Government, and no individual can hold private property beyond certain limit. Therefore, it is
government who utilises these resources in the interest of social welfare.

(ii) Economic, Social and Political Equality: Under socialism, there is almost equality between rich and
poor. There is no problem of class struggle.

(iii) Economic Planning: Under socialism, government fixes certain objectives. In order to achieve these
objectives, government adopts economic planning. All types of decisions regarding the central problems
of an economy are taken in the economic plans. There is a Central Planning Authority, who plans for the
economy.

(iv) No Competition: Unlike capitalistic economy, there is no cut throat competition. It means lack of
competition as state is the sole entrepreneur.

(v) Positive Role of Government: In socialism, government plays significant role in decision making.
Thus, government has complete control over economic activities like distribution, exchange,
consumption, investment and foreign trade etc.

(vi) Work and Wages According to Ability and Needs: In socialistic economy, work is according to ability
and wage according to need. It is said that under socialism “from each according to his ability to each
according to his needs, is socialism.”

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(vi) Maximum Social Welfare: The sole objective of socialism is the maximum social welfare of the
society. It means that there is no scope of exploitation of labour class. Government keeps a close eye on
the needs of the poor masses while formulating plans.

Merits of Socialist Economy:

(i) No Labour Exploitation: There is only one class in a socialistic economy hence there is no question of
exploitation. There are no concept of strikes and lock-outs. Everybody works in a well-knit family way.

(ii) Proper Utilisation of Resources: Under this economy, all types of natural resources are utilized in a
most organized manner. Its main objective is to exploit these resources for the welfare of society.

(iii) No Wasteful Advertisement: The government is virtually the owner of almost every sector. Hence,
all the individual producers are also more according to the plan targets. Therefore, the competition
among the producers is almost nil. Hence, very less money is spent on wasteful advertisement.

(iv) Proper Planning: In order to solve various problems, which arise from time to time, there is proper
economic plan in this type of economy. Thus, with the help of economic plans socialist economy will
adopt the balanced development strategy.

(v) No Cyclical Fluctuations: Under socialist economy, no cyclical fluctuations are found. It means
economy faces no boom, depression, unemployment or over production etc. Economic stability is
maintained by the government on the basis of economic planning.

(vi) Social Welfare: The aim of socialist economy is to maximize social welfare of the society. It provides
equal opportunities of employment to all individual according to their abilities.

(vii) Rapid Economic Development: The Central Planning Authority is the main figure in a socialist
economy. It coordinate the natural, human and physical resources to attain economic progress of the
country. In turn it accelerates the path of tremendous progress and people enjoy higher standard of
living.

(viii) Most Suitable to Developing Countries: This type of economic system is most suitable to the needs
of developing countries as all means of production are controlled by the government.

Demerits of Socialist Economy: Economists like Robbins, Maurice Dobb, Georg Halm etc. have
criticised the socialist economy on the following grounds:

(i) Loss of Consumer Sovereignty: A consumer has no choice of his own, he acts as a mere slave under
this system. Government produces goods and services keeping in view the needs of the people.

(ii) Less Democratic: Socialist economy is always less democratic as it possesses no element of freedom.
It is also like government dictatorship.

(iii) No Automatic Functioning: Under this system, no automatic function in system exists at all. It is the
Central Authority, i.e., government, that governs the country according to its own interest.

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(iv) Evils of Bureaucracy: In socialist economy, all economic activities are controlled by the government.
Thus, they develop all evils of bureaucracy like favouritism, delay, corruption and other sue evils,

(v) Rigid Economy: Socialist economy is very rigid and not susceptible to change according to
requirements. Hence people work like a machine and never get any incentive to work.

(vi) Burden on Government: All the economic activities are performed by the Central Authority on
behalf of the government. Hence, it is overburdened with daily activities and, therefore, it gets very less
time to think and plan for the economic prosperity of the economy.

(vii) Expenditure on Planning: In fact, planning is a long process in a socialist economy. This expenditure
is unnecessarily wasteful and a burden on the national economy.

Mixed Economy

“Mixed economy is that economy in which both government and private individuals exercise economic
control.” –Murad.

Meaning: It is a golden mixture of capitalism and socialism. Under this system there is freedom of
economic activities and government interferences for the social welfare. Hence it is a blend of both the
economies. The concept of mixed economy is of recent origin.

The developing countries like India have adopted mixed economy to accelerate the pace of economic
development. Even the developed countries like UK, USA, etc. have also adopted ‘Mixed Capitalist
System’. According to Prof. Samuelson, “Mixed economy is that economy in which both public and
private sectors cooperate.” According to Murad, “Mixed economy is that economy in which both
government and private individuals exercise economic control.”

Main Features of Mixed Economy:

(i) Co-existence of Private and Public Sector: Under this system there is co-existence of public and
private sectors. In public sector, industries like defence, power, energy, basic industries etc., are set up.
On the other hand, in private sector all the consumer goods industries, agriculture, small-scale industries
are developed. The government encourages both the sectors to develop simultaneously.

(ii) Personal Freedom: Under mixed economy, there is full freedom of choice of occupation, although
consumer does not get complete liberty but at the same time government can regulate prices in public
interest through public distribution system.

(iii) Private Property is allowed: In mixed economy, private property is allowed. However, here it must
be remembered that there must be equal distribution of wealth and income. It must be ensured that the
profit and property may not concentrate in a few pockets.

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(iv) Economic Planning: In a mixed economy, government always tries to promote economic
development of the country. For this purpose, economic planning is adopted. Thus, economic planning
is very essential under this system.

(v) Price Mechanism and Controlled Price: Under this system, price mechanism and regulated price
operate simultaneously. In consumer goods industries price mechanism is generally followed. However,
at the time of big shortages or during national emergencies prices are controlled and public distribution
system has to be made effective.

(vi) Profit Motive and Social Welfare: In mixed economy system, there are both profit motive like
capitalism and social welfare as in socialist economy.

(vii) Check on Economic Inequalities: In this system, government takes several measures to reduce the
gap between rich and poor through progressive taxation on income and wealth. The subsidies are given
to the poor people and also job opportunities are provided to them. Other steps like concessions, old
age pension, free medical facilities and free education are also taken to improve the standard of poor
people. Hence, all these help to reduce economic inequalities.

(viii) Control of Monopoly Power: Under this system, government takes huge initiatives to control
monopoly practices among the private entrepreneurs through effective legislative measures. Besides,
government can also fake over these services in the public interest.

Types of Mixed Economy:

The mixed economy may be classified in two categories:

Capitalistic Mixed Economy: In this type of economy, ownership of various factors of production
remains under private control. Government does not interfere in any manner. The main responsibility of
the government in this system is to ensure rapid economic growth without allowing concentration of
economic power in the few hands.

Socialistic Mixed Economy: Under this system, means of production are in the hands of state. The
forces of demand and supply are used for basic economic decisions. However, whenever and wherever
demand is necessary, government takes actions so that basic idea of economic growth is not hampered.

However, this system is again sub-divided into two parts:

(i) Liberal Socialistic Mixed Economy: Under this system, the government interferes to bring about
timely changes in market forces so that the pace of rapid economic growth remains uninterrupted.

(ii) Centralised Socialistic Mixed Economy: In this economy, major decisions are taken by central agency
according to the needs of the economy.

Merits of Mixed Economy:

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(i) Encouragement to Private Sector: The most important advantage of mixed economy is that it
provides encouragement to private sector and it gets proper opportunity to grow. It leads to increase in
capital formation within the country.

(ii) Freedom: In a mixed economy, there is both economic and occupational freedom as found in
capitalist system. Every individual has a liberty to choose any occupation of his choice. Similarly, every
producer can take decisions regarding production and consumption.

(iii) Optimum Use of Resources: Under this system, both private and public sectors work for the
efficient use of resources. Public sector works for social benefit while private sector makes the optimum
use of these resources for maximisation of profit.

(iv) Advantages of Economic Planning:In the mixed economy, there are all advantages of economic
planning. Government takes measures to control economic fluctuations and to meet other economic
evils.

(v) Lesser Economic Inequalities: Capitalism enhances economic inequalities but under mixed economy,
inequalities can easily controlled by the efforts of government.

(vi) Competition and Efficient Production: Due to competition between both private and public sectors,
the level of efficiency remains, high. All factors of production work efficiently in the hope of profit.

(vii) Social Welfare: Under this system, the main priority is given to social welfare through effective
economic, planning. The private sector is controlled by the government. Production and price policies of
private sector are determined to achieve maximum social welfare.

(viii) Economic Development: Under this system, both government and private sector join their hands
for the development of socio-economic infrastructures, Moreover, government enacts many legislative
measures to safe guard the interests of the poor and weaker section of the society. Hence, for any
underdeveloped country, mixed economy is a right choice.

Demerits of Mixed Economy:

(i) Un-stability: Some economists claim that mixed economy is most unstable in nature. The public
sector gets maximum benefits whereas private sector remains controlled.

(ii) Ineffectiveness of Sectors: Under this system, both the sectors are ineffective in nature. The private
sector does not get full freedom, hence it becomes ineffective. This leads to ineffectiveness among the
public sector. In true sense, both sectors are not only competitive but also complementary in nature.

(iii) Inefficient Planning: There are no such comprehensive planning in mixed economy. As a result, a
large sector of the economy remains outside the control of the government.

(iv) Lack of Efficiency: In this system, both sectors suffer due to lack of efficiency. In public sector it is so
because government employees do not perform their duty with responsibility, while in private sector,

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efficiency goes down because government imposes too many restrictions in the form of control, permits
and licenses, etc.

(v) Delay in Economic Decisions: In a mixed economy, there is always delay in making certain decisions,
especially in case of public sector. This type of delay always leads to a great hindrance in the path of
smooth functioning of the economy.

(vi) More Wastages: Another problem of the mixed economic system is the wastages of resources. A
part of funds allocated to different projects in public sector goes into the pocket of intermediaries. Thus,
resources are misused.

(vii) Corruption and Black Marketing: There is always corruption and black marketing in this system.
Political parties and self- interested people take undue advantages from public sector. Hence, this leads
to emergence of several evils like black money, bribe, tax evasion and other illegal activities. All these
ultimately bring red-tapism within the system.

(viii) Threat of Nationalism: Under mixed economy, there is a constant fear of nationalism of private
sector. For this reason private sector does not put into use their resources for the common benefits.

Capitalist Economy

“Capitalism is a free-market form or capitalistic economy may be characterised as an automatic self-

regulating system motivated by self-interest of individuals and regulated by competitions.” –Ferguson.

Meaning: It is one of the oldest economic systems and its origin is at the time of mid-eighteenth century
in England in the wake of Industrial Revolution. It is that system, where means of production are owned
by private individuals, profit is the main motive and there is no interference by the government in the
economic activities of the economy. Hence, it is known as free market economy.

According to Karl Marx, in his ‘Das Kapital’, the capitalist on an average takes twelve hours work from
the worker and pays him wages equal to six hours work. According to Ferguson, “Capitalism is a free-
market form or capitalistic economy may be characterised as an automatic self-regulating system
motivated by self-interest of individuals and regulated by competitions.”

Main Features of Capitalist Economy:

(i) Private Property: In this economy private property is allowed. All means of production like machines,
implements, mines and factories etc. come under private property.

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(ii) Price Mechanism: Capitalist economy is gained by price mechanism. Here prices are determined by
the interaction of demand and supply without the interference of any kind by the government or any
other external forces.

(iii) Freedom of Enterprise: In this system every individual is independent to his means of production in
any occupation that one likes.

(iv) Sovereignty of that consumer: Under this system, consumer plays the most vital role. The entire
production pattern is based on the desires, wishes and the demand of the consumer.

(v) Profit Motive: The maximisation of profit is the main motive of the producer. Profit guides the
production in this type of economy.

(vi) No Government Interference: Under capitalistic system, government does not interfere in day-to-
day economic activities. This means producers and consumers are free to take decisions.

(vii) Democratic: The capitalistic system is more democratic in comparison to other economic systems
as there are more changes to chancel according to new environments of the economy.

(viii) Self-Interest: The inspiring force in this system is self-interest. It leads to hard work and to earn
maximum income by satisfying their consumers.

Merits of Capitalistic System

(i) Economic Freedom: The foremost advantage of this system is that everybody enjoys’ economic
freedom as one can spend one’s income according to one’s wishes. Producers have complete freedom
to invest in any business or trade.

(ii) Automatic Working: Another advantage according to classical economists is an automatic system.
Equilibrium point is automatically come with the forces of demand and supply.

(iii) Variety of Goods and Services: All the basic decisions of what to produce, how to produce and for
whom to produce are taken by producers. Every producer gives attention to consumers’ taste and
preferences. Hence, there are large variety of goods and services; produced in the economy.

(iv) Optimum Use of Resources: All natural resources are used to their optimum level as production is
undertaken with a sole purpose: of earning profit and no scope for wastages at all.

(v) Efficient Producer: There is very tough I competition among entrepreneurs. They always encouraged
to produce best quality of products. Thus, technical development will lead to increase in higher
productivity as well as efficiency.

(vi) Higher Standard of Living: Varieties of goods at cheap rates make it easy to be within the; reach of
poor and weaker sections of society. This results in rise in their standard of living.

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(vii) Incentive to efficient: In this system, incentives are given to the efficient workers in cash or kind.
This means every worker should get reward according to his ability. Hence, workers will try to work
more and more, therefore, total output will also increase.

(viii) New Inventions: In this type of economy, there is ample scope of new invention. To get more profit
every producer takes initiative to develop new techniques in production.

Demerits of Capitalistic System: According to Karl Marx, “Capitalism contains the seeds of its own
destruction.”

(i) Labour Exploitation: The main defect of capitalism is the exploitation of labour. Labourers get less
wages in comparison to their working hours. The wages less than their marginal productivity are not
sufficient for their livelihood.

(ii) Class Struggle: A lion’s share of income and resources is controlled by the upper sections of the
society, while others remain deprived of the basic amenities of life. Thus, the entire society is divided
between ‘haves and ‘have not’s. Hence, the continuous class struggle spoils the health environment of
the economy.

(iii) Wasteful Competition: Capitalism is a wasteful competition. A lot of money is spent on

advertisement and publicity for pushing the sale of the commodity. Its burden ultimately is borne by the
poor consumers in the form of increased price.

(iv) Threat of Over-Production: The production is made on a large scale which cannot be changed in a
short period. Therefore, under capitalism, fear of over-production always exists. The Great Depression
of 1930s in USA is an example of it.

(v) Economic Fluctuations: Being automatic in nature, capitalist economy always faces the problem of
economic fluctuations and unemployment. This means the state of instability and uncertainty,

(vi) Unbalanced Growth: All the resources are put only to those channels where there is maximum
profit. Other sectors of the economy are neglected. As there is no check on the economic system, the
growth is unbalanced in nature.

(vii) No Welfare Activities: In capitalism, the sole motive is maximum profit, but not the public welfare.
Variety of goods are produced according to market demand, not for any welfare activity.

(viii) Monopoly Practices: This economic system has been criticised on the fact that it develops
monopoly activities within the country.

Q. Distinguish between Socialist and capitalist economy

Basis for Capitalist Economy Socialist Economy

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Comparison

Capitalism refers to the economic The economic structure in which the

system prevalent in the country, where government has ownership and control
Meaning
there is private or corporate ownership over the economic activities of the
on the trade and industry. country is known as Socialism.

Basis Principal of Individual Rights Principal of Equality

Advocates Innovation and individual goals Equality and fairness in society

Means of Privately owned Socially owned

Production

Prices Determined by the market forces Determined by the Government

Competition Very High No competition exists between firms

Degree of High Low

distinction in the
class of people

Each individual works for the creation Equally shared by all the people of the
Wealth
of his own wealth country

Freedom to follow any religion Freedom to follow any religion but it

Religion
encourages secularism

Efficiency Much Less

Government No or marginal Government decides everything

Interference

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Demand
Q. Explain the Law of Demand with exceptions. Explain the reasons of downward slope of demand
curve.

This law of demand expresses the functional relationship between price and quantity demanded.

The law of demand or functional relationship between price and quantity demanded of a commodity is
one of the best known and most important laws of economic theory. According to the law of demand,
other things being equal, if the price of a commodity falls, the quantity demoded of it will rise, and if
the price of the commodity rises, its quantity demanded will decline.

Thus, according to the law of demand, there is inverse relationship between price and quantity
demanded, other things remaining the same. These other things which are assumed to be constant are
the tastes and preferences of the consumer, the income of the consumer, and the prices of related
goods. If these other factors which determine demand also undergo a change at the same time, then
the inverse price-demand relationship may not hold good. Thus, the constancy of these other things
which is generally stated as ceteris paribus is an important qualification of the law of demand.

Demand Curve and the Law of Demand:

The law of demand can be illustrated through a demand schedule and a demand curve. A demand
schedule of an individual consumer is presented in Table 6.1. It will be seen from this demand schedule
that when the price of a commodity is Rs. 12 per unit, the consumer purchases 10 units of the
commodity. When the price of the commodity falls to Rs. 10, he purchases 20 units of the commodity.

Similarly, when the price further falls, quantity demanded by him goes on rising until at price Rs.2, the
quantity demanded by him rises to 60 units. We can convert this demand schedule into a demand curve
by graphically plotting the various price-quantity combinations, and this has been done in Fig. 6.1 where
along the X-axis, quantity demanded is measured and along the Y-axis price of the commodity is
measured.

By plotting 10 units of the commodity against price 12, we get a point in Fig. 6. 1 Likewise, by plotting 20
units of the commodity demanded against price 10 we get another point in Fig. 6.1. Similarly, other
points are plotted representing other combinations of price and quantity demanded of the commodity
and are shown in Fig. 6.1. By joining these various points, we get a curve DD, which is known as the

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demand curve. Thus, this demand curve is a graphic representation of quantities of a good which are
demanded by the consumer at various possible prices in a given period of time.

It should be noted that a demand schedule or a demand curve does not tell us what the price is; it only
tells us how much quantity of the good would be purchased by the consumer at a various possible
prices. Further, it will be seen from both the demand schedule and the demand curve that as the price
of a commodity falls, more quantity of it is purchased or demanded.

Since more is demanded at a lower price and less is demanded at a higher price, the demand curve
slopes downward to the right. Thus, the downward-sloping demand curve is in accordance with the law
of demand which, as stated above, describes inverse price-demand relationship.

It is important to note here that behind this demand curve or price-demand relationship always lie the
tastes and preferences of the consumer, his income, the prices of substitutes and complementary
goods, all of which are assumed to be constant in drawing a demand curve.

If any change occurs in any of these other factors, the whole demand schedule or demand curve will
change and new demand schedule or a demand curve will have to be drawn. Further, in drawing a
demand curve, we assume that the buyer or consumer does not exercise any influence over the price of
a commodity, that is, he takes the price of the commodity as given and constant for him.

Why does Demand Curve Slope Downward?

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A demand curve is the graphical representation of the demand schedule for a commodity. It is the
graphic statement of an individual buyer's reaction on amount demanded at a given price in the given
point of time. A demand curve has got a negative slope. It slopes downwards from left to right. A
demand curve shows the maximum quantities per unit of time that consumers will buy at various prices.
In the words of Richard Lipsey "The curve which shows the relation between the price of a commodity
and the amount of that commodity the consumer wishes to purchase is called Demand Curve.

(1) Law of diminishing marginal utility: A consumer always equalises marginal utility with price. The law
states that a consumer derives less and less satisfaction (utility) from the every additional increase in the
stock of a commodity. When price of a commodity falls the consumer's price utility equilibrium is
disturbed i.e. price becomes smaller than utility.

The consumer in order to restore the new equilibrium between price and utility buys more of it so that
the marginal utility falls with the rise in the amount demanded. So long the price of a commodity falls,
the consumer will go on buying more amount of it so as to reduce the marginal utility and make it equal
with new price.

Thus the shape and slope of a demand curve is derived from the slope of marginal utility curve.

(2) Income effect: Another cause behind the operation of law of demand is income effect. As the price
of a commodity falls, the consumer has to buy the same amount of the commodity at less amount of
money. After buying his required quantity he is left with some amount of money.

This constitutes his rise in his real income. This rise in real income is known as income effect. This
increase in real income induces the consumer to buy more of that commodity. Thus income effect is one
of the reasons why a consumer buys more at falling prices.

(3) Substitution effect: When the price of a commodity falls, it becomes relatively cheaper than other
commodities. The consumer substitutes the commodity whose price has fallen for other commodities
which becomes relatively dearer.

For example with the fall in price of tea, coffees. Price being constant, tea will be substituted for coffee.
Therefore the demand for tea will go up.

(4) New consumers: When the price of a commodity falls many other consumers who were deprived of
that commodity at the previous price become able to buy it now as the price comes within their reach.
For example the units of colour TV. increases with a remarkable fall in price of it. The opposite will
happen with a rise in prices.

(5) Multiple use of commodity: There are some commodities which have multiple uses. Their uses
depend upon their respective, prices. When their prices rise they are used only for certain selected
purposes. That is why their demand goes down.

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For example electricity can be put to different uses like heating, lighting, cooling, cooking etc. If its price
falls people use it for other uses other than that. A rise in price of electricity will force the consumer to
minimise its use. Thus with a fall and rise in price of electricity its demand rises and falls accordingly.

7 essential exceptions to the Law of Demand

The law of demand does not apply in every case and situation. The circumstances when the law of
demand becomes ineffective are known as exceptions of the law. Some of these important exceptions
are as under.

1. Giffen goods: Some special varieties of inferior goods are termed as Giffen goods. Cheaper varieties
of this category like bajra, cheaper vegetable like potato come under this category. Sir Robert Giffen of
Ireland first observed that people used to spend more their income on inferior goods like potato and
less of their income on meat. But potatoes constitute their staple food. When the price of potato
increased, after purchasing potato they did not have so many surpluses to buy meat. So the rise in price
of potato compelled people to buy more potato and thus raised the demand for potato. This is against
the law of demand. This is also known as Giffen paradox.

2. Conspicuous Consumption: This exception to the law of demand is associated with the doctrine
propounded by Thorsten Veblen. A few goods like diamonds etc are purchased by the rich and wealthy
sections of the society. The prices of these goods are so high that they are beyond the reach of the
common man. The higher the price of the diamond the higher the prestige value of it. So when price of
these goods falls, the consumers think that the prestige value of these goods comes down. So quantity
demanded of these goods falls with fall in their price. So the law of demand does not hold good here.

3. Conspicuous necessities: Certain things become the necessities of modern life. So we have to
purchase them despite their high price. The demand for T.V. sets, automobiles and refrigerators etc. has
not gone down in spite of the increase in their price. These things have become the symbol of status. So
they are purchased despite their rising price. These can be termed as “U” sector goods.

4. Ignorance: A consumer’s ignorance is another factor that at times induces him to purchase more of
the commodity at a higher price. This is especially so when the consumer is haunted by the phobia that
a high-priced commodity is better in quality than a low-priced one.

5. Emergencies: Emergencies like war, famine etc. negate the operation of the law of demand. At such
times, households behave in an abnormal way. Households accentuate scarcities and induce further
price rises by making increased purchases even at higher prices during such periods. During depression,
on the other hand, no fall in price is a sufficient inducement for consumers to demand more.

6. Future changes in prices: Households also act speculators. When the prices are rising households
tend to purchase large quantities of the commodity out of the apprehension that prices may still go up.
When prices are expected to fall further, they wait to buy goods in future at still lower prices. So
quantity demanded falls when prices are falling.

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7. Change in fashion: A change in fashion and tastes affects the market for a commodity. When a broad
toe shoe replaces a narrow toe, no amount of reduction in the price of the latter is sufficient to clear the
stocks. Broad toe on the other hand, will have more customers even though its price may be going up.
The law of demand becomes ineffective.

Q. What do you mean by Price-Elasticity of Demand? Explain the factors which determine price-
elasticity of demand of a commodity. State different kinds of price of demand with figures.

Price elasticity of demand measures the responsiveness of demand after a change in a product's own
price.

This is perhaps the most important microeconomic concept that you will come across in your initial
studies of economics. The key is to understand the formula for calculating price elasticity, the factors
that affect elasticity and then why elasticity matters for businesses when setting their prices.

What is the formula for calculating the coefficient of price elasticity of demand?

The formula for calculating the co-efficient of elasticity of demand is:

Percentage change in quantity demanded divided / percentage change in price

Since changes in price and quantity usually move in opposite directions, usually we do not bother to put
in the minus sign. We are more concerned with the co-efficient of elasticity of demand rather than the
sign!

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Numerical examples of price elasticity of demand

How much does quantity demanded change when price changes? By a lot or by a little? Elasticity can
help us understand this important question.

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What are the important values for price elasticity of demand?

We use the word "coefficient" to describe the values for price elasticity of demand

1. If Ped = 0 demand is perfectly inelastic - demand does not change at all when the price changes
– the demand curve will be vertical.

2. If Ped is between 0 and 1 (i.e. the % change in demand from A to B is smaller than the
percentage change in price), then demand is inelastic.

3. If Ped = 1 (i.e. the % change in demand is exactly the same as the % change in price), then
demand is unit elastic. A 15% rise in price would lead to a 15% contraction in demand leaving
total spending the same at each price level.

4. If Ped > 1, then demand responds more than proportionately to a change in price i.e. demand is
elastic. For example if a 10% increase in the price of a good leads to a 30% drop in demand. The
price elasticity of demand for this price change is –3

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Q. Distinguish between change in quantity demanded and change in demand.

Change in quantity demanded refers to change in the quantity purchased due to increase or decrease in
the price of a product. In such a case, it is incorrect to say increase or decrease in demand rather it is
increase or decrease in the quantity demanded.

On the other hand, change in demand refers to increase or decrease in demand of a product due to
various determinants of demand, while keeping price at constant. Changes in quantity demanded can be
measured by the movement of demand curve, while changes in demand are measured by shifts in
demand curve. The terms, change in quantity demanded refers to expansion or contraction of demand,
while change in demand means increase or decrease in demand.

1. Expansion and Contraction of Demand: The variations in the quantities demanded of a product with
change in its price, while other factors are at constant, are termed as expansion or contraction of
demand. Expansion of demand refers to the period when quantity demanded is more because of the fall
in prices of a product. However, contraction of demand takes place when the quantity demanded is less
due to rise in the price o a product.

For example, consumers would reduce the consumption of milk in case the prices of milk increases and
vice versa. Expansion and contraction are represented by the movement along the same demand curve.
Movement from one point to another in a downward direction shows the expansion of demand, while
an upward movement demonstrates the contraction of demand.

When the price changes from OP to OP1 and demand moves from OQ to OQ1, it shows the expansion of
demand. However, the movement of price from OP to OP2 and movement of demand from OQ to OQ2
show the contraction of demand.

2. Increase and Decrease in Demand: Increase and decrease in demand are referred to change in
demand due to changes in various other factors such as change in income, distribution of income,
change in consumer’s tastes and preferences, change in the price of related goods, while Price factor is
kept constant Increase in demand refers to the rise in demand of a product at a given price.

On the other hand, decrease in demand refers to the fall in demand of a product at a given price. For
example, essential goods, such as salt would be consumed in equal quantity, irrespective of increase or
decrease in its price. Therefore, increase in demand implies that there is an increase in demand for a
product at any price. Similarly, decrease in demand can also be referred as same quantity demanded at
lower price, as the quantity demanded at higher price.

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Increase and decrease in demand is represented as the shift in demand curve. In the graphical
representation of demand curve, the shifting of demand is demonstrated as the movement from one
demand curve to another demand curve. In case of increase in demand, the demand curve shifts to
right, while in case of decrease in demand, it shifts to left of the original demand curve.

In Figure-12, the movement from DD to D1D1 shows the increase in demand with price at constant (OP).
However, the quantity has also increased from OQ to OQ1.

In Figure-13, the movement from DD to D2D2 shows the decrease in demand with price at constant
(OP). However, the quantity has also decreased from OQ to OQ2.

Basis for Demand Quantity Demanded

Comparison
Demand is defined as the willingness Quantity Demanded represents exact
of buyer and his affordability to pay quantity (how much) of a good or service
Meaning
the price for the economic good or is demanded by consumers at a
service. particular price.
It lists out quantities that would be It is the actual amount of goods desired
What is it?
purchased at various prices. at a certain price.
Change Increase or decrease in demand Expansion or contraction in demand.
Reasons Factors other than price Price
Measurement of
Shift in demand curve Movement along demand curve
change
Consequences of
change in actual No change in demand. Change in quantity demanded.
price

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Q. State and critically explain the law of Diminishing Marginal Utility. What are the assumptions of the
law? What are the exceptions of the law?

The law of diminishing marginal utility was first propounded by 19th century German economist H.H.
Gossen which explains the behavior of the consumers and the basic tendency of human nature. Hence,
this law is also known as Gossen’s First Law. This was further modified by Marshall.

According to Marshall,

The additional benefit a person derives from a given increase of his stock of anything diminishes with
the growth of the stock that he already has.

According to Paul A. Samuelson,

As the amount consumed of a good increases, the marginal utility of the good leads to decrease.

As per the definitions, we can conclude that, if the consumer consumes goods continuously, the utility
obtained from every successive unit goes on diminishing. If the consumer is consuming the goods
continuously, firstly he reaches the point of maximum satisfaction which is known as level of satiety. If
he continues to consume the goods again, the utility obtained from that particular goods goes in
negative aspect or he gets inutility.

Law Of Diminishing Marginal Utility Assumptions

1. The consumer who is consuming the goods should be logical and knowledgeable to consume
every unit of goods.

2. The goods which are to be consumed should be equal in size and shape.

3. Consumer should consume the goods without time gap.

4. The consumer’s income, preference, taste and fashion should not be changed while consuming
the goods.

5. To hold the law good, utility should be measured in countable units or cardinal numbers. The
utility obtained from those goods is measured in ‘utils’ unit.

6. As we know that money is the measuring rod of utility, being so, marginal utility of money
should remain constant during consumption of the goods.

Example to Demonstrate Law of Diminishing Marginal Utility

This law can be illustrated with the help of a table shown below:

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The table shows that when a consumer consumes 1st unit of orange he derives the marginal utility equal
to 6utils. As the consumer consumes 2nd and 3rd units of orange, the marginal utility is declined from
4utils to 2utils respectively. When he consumes 4th unit of orange the marginal utility becomes zero,
which is called the point of satiety. Similarly, from the consumption of 5th and 6th units of orange, the
marginal utility becomes negative, i.e., he gets disutility instead of utility from these units of
consumption. Thus, the table shows that a consumer consumes more and more units of a commodity at
a certain period of time, the marginal utility declines, becomes zero and even negative.

This law can be further explained with the help of a diagram:

In the figure, X-axis represents units of orange and Y-axis represents utility. MU is the marginal utility
curve which slopes downward from left to right. It means that as a consumer consumes more and more
units of a commodity, the marginal utility he derives from the additional unit of consumption goes on
declining, becomes zero(at point D) and even negative(at point E and F.)

Exceptions Where Law of Diminishing Marginal Utility Doesn't Apply

Dissimilar units: This law is applicable for homogenous unit only, i.e. only if all units of a commodity
consumed are similar in length, breadth, shape and size. If there is a change in such factors, the utility

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obtained from it can be increased. For example: If the 2nd orange is much larger than the 1st one, it will
yield more satisfaction than the 1st.

Unreasonable quantity: The quantity of the commodity a consumer consumes should be reasonable. If
the units of consumption are too small, then every successive unit of consumption may give higher
utility to the consumer. For example: If a person is given water by a spoon when he is very thirsty, each
additional spoonful will give him more satisfaction.

Not a suitable time period: There should not be very long gap between the consumption of different
units of the commodity. If there is time lag between the consumption of different units, then this law
may not hold good. For example: If a man has lunch at 10 a.m. and dinner at 8 p.m. and eats nothing in
between, the dinner will possibly yield even more satisfaction than the lunch, i.e. his marginal utility will
not diminish.

Rare collection: This law does not apply for rare collections such as old coins, stamps and so on because
the longer and larger the number he collects, the greater will be the utility.

Change in taste and fashion of the consumer: The law of diminishing marginal utility will be applicable
only if the consumer is not supposed to change taste and fashion of the commodity whatever he/she
was using previously.

Abnormal person: The law of diminishing marginal utility is applicable for normal person only. Abnormal
persons such as drunkards and druggist are not associated with the law.

Change in income of the consumer: To hold the law good, there should not be any change in the
income of the consumer. If the income of the consumer increases, he will consume more and more units
of a commodity which he prefers. As a result, utility can be increased rather than decreased.

Habitual goods; The law will not be applicable for habitual goods such as consumption of cigarettes,
consumption of drugs, alcohol, etc.

Durable and valuable goods: The law is not applicable in case of durable goods as well as valuable goods
such as buildings, vehicles, gems, gold, etc.

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Supply
Q. Define supply. Discuss the factors affecting supply. Explain different types of elasticities of supplies
with supply curves. Why does the supply curve slope upward from left to right?

In economics, supply refers to the quantity of a product available in the market for sale at a specified
price at a given point of time.

Unlike demand, supply refers to the willingness of a seller to sell the specified amount of a product
within a particular price and time.

Supply is always defined in relation to price and time. For example, if a seller agrees to sell 500 kgs of
wheat, it cannot be considered as supply of wheat as the price and time factors are missing.

Similarly, if a seller is ready to sell 500 kgs at a price of Rs. 30 per kg then again it would not be
considered as supply as the time element is missing. Therefore, the statement “a seller is willing to sell
500 kgs at the price of Rs. 30 per kg in a week” is ideal to understand the concept of supply as it relates
supply with price and time.

Apart from this, the supply also depends on the stock and market price of the product. Stock of a
product refers to quantity of a product available in the market for sale within a specified point of time.

Both stock and market price of a product affect its supply to a greater extent. If the market price is more
than the cost price, the seller would increase the supply of a product in the market. However, the
decrease in market price as compared to cost price would reduce the supply of product in the market.

For example Mr. X has 100 kgs. of a product. He expects the minimum price to be Rs. 90 per kg and the
market price is Rs. 95 per kg. Therefore he would release certain amount of the product, say around 50
kgs. in the market, but would not release the whole amount. The reason being he would wait for better
rates for his product. In such a case, the supply of his product would be 50kgs at Rs. 95 per kg.

Determinants of Supply:

Supply can be influenced by a number of factors that are termed as determinants of supply. Generally,
the supply of a product depends on its price and cost of production. In simple terms, supply is the
function of price and cost of production.

Some of the factors that influence the supply of a product are described as follows:

i. Price: Refers to the main factor that influences the supply of a product to a greater extent. Unlike
demand, there is a direct relationship between the price of a product and its supply. If the price of a
product increases, then the supply of the product also increases and vice versa. Change in supply with
respect to the change in price is termed as the variation in supply of a product.

Speculation about future price can also affect the supply of a product. If the price of a product is about
to rise in future, the supply of the product would decrease in the present market because of the profit

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expected by a seller in future. However, the fall in the price of a product in future would increase the
supply of product in the present market.

ii. Cost of Production: Implies that the supply of a product would decrease with increase in the cost of
production and vice versa. The supply of a product and cost of production are inversely related to each
other. For example, a seller would supply less quantity of a product in the market, when the cost of
production exceeds the market price of the product.

In such a case the seller would wait for the rise in price in future. The cost of production rises due to
several factors, such as loss of fertility of land, high wage rates of labor, and increase in the prices of raw
material, transport cost, and tax rate.

iii. Natural Conditions: Implies that climatic conditions directly affect the supply of certain products. For
example, the supply of agricultural products increases when monsoon comes on time. However, the
supply of these products decreases at the time of drought. Some of the crops are climate specific and
their growth purely depends on climatic conditions. For example Kharif crops are well grown at the time
of summer, while Rabi crops are produce well in winter season.

iv. Technology: Refers to one of the important determinant of supply. A better and advanced
technology increases the production of a product, which results in the increase in the supply of the
product. For example, the production of fertilizers and good quality seeds increases the production of
crops. This further increase the supply of food grains in the market.

v. Transport Conditions: Refer to the fact that better transport facilities increase the supply of products.
Transport is always a constraint to the supply of products, as the products are not available on time due
to poor transport facilities. Therefore even if the price of a product increases, the supply would not
increase.

In India sellers usually use road transport and the poorly maintained road makes it difficult to reach the
destination on time the products that are manufactured in one part of the city need to be spread in the
whole country through road transport This may result in the damage of most of the products during the
journey, which can cause heavy loss for a seller. In addition the seller can also lose his/her customers
because of the delay in. the delivery of products.

vi. Factor Prices and their Availability: Act as one of the major determinant of supply. The inputs, such
as raw material man, equipment, and machines, required at the time of production are termed as
factors. If the factors are available in sufficient quantity and at lower price, then there would be increase
in production.

This would increase the supply of a product in the market. For example, availability of cheap labor and
raw material nearby the manufacturing plant of an organization would help in reducing the labor and
transportation costs. Consequently, the production and supply of the product would increase.

vii. Government’s Policies: Implies that the different policies of government, such as fiscal policy and
industrial policy, has a greater impact on the supply of a product. For example, increase in tax on excise

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duties would decrease the supply of a product. On the other hand, if the tax rate is low, then the supply
of a product would increase.

viii. Prices of Related Goods: Refer to fact that the prices of substitutes and complementary goods also
affect the supply of a product. For example, if the price of wheat increases, then farmers would tend to
grow more wheat than nee. This would decrease the supply of rice in the market.

5 Most Important Kinds of Elasticity’s of Supply (With Observation)

Different commodities respond differently to a given change in price. Depending upon the degree of
responsiveness of the quantity supplied to the price change, there are five kinds of price elasticities of
supply.

1. Perfectly Elastic Supply: When there is an infinite supply at a particular price and the supply becomes
zero with a slight fall in price, then the supply of such a commodity is said to be perfectly elastic. In such
a case Es = ∞ and the supply curve is a c horizontal straight line parallel to the X-axis, as shown in Fig.
9.23:

Price (in Rs.) Supply (in units)

30 100

30 200

30 300

Table 9.8: Perfectly Elastic Supply:

Quantity supplied can be 100, 200 or 300 units at the same price of Rs. 30. As seen in the diagram,
quantity supplied can be OQ or OQ1 or OQ2 at the same price of OP. It must be noted that perfectly
elastic supply is an imaginary situation.

2. Perfectly Inelastic Supply: When the supply does not change with change in price, then supply for
such a commodity is said to be perfectly inelastic.

In such a case, Es = 0 and the supply curve (SS) is a vertical straight line parallel to the Y-axis as shown s
in Fig. 9.24.

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20 20

30 20

40 20

Table 9.9: Perfectly Inelastic Supply:

Quantity supplied remains same at 20 units, whether the price is Rs. 20, Rs. 30 or 140. As seen in the
diagram, quantity supplied remains the same at OQ, with change in price from OP to OP 1 or OP2. It must
be noted that perfectly inelastic supply is an imaginary situation.

3. Highly Elastic Supply: When percentage change in quantity supplied is more than the percentage
change in price, then supply for such a commodity is said to be highly elastic. In such a case, Es > 1 and
the supply curve has an intercept on the Y-axis as shown in Fig. 9.25.

Price (in Rs.) Supply (in units)

10 100

15 200

Table 9.10: Highly Elastic Supply:

As seen in the schedule, the quantity supplied rises by 100% due to a 50% rise in price. In Fig. 9.25, the
quantity supplied rises from OQ to OQ1 with rise in price from OP to OP1. As QQ1 is proportionately more
than PP1 elasticity of supply is more than 1.

4. Less Elastic Supply: When percentage change in quantity supplied is less than the percentage change
in price, then supply for such a commodity is said to be less elastic. In such a case, Es < 1 and the supply
curve has an intercept on the X-axis as shown in Fig. 9.26.

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Price (in Rs.) Supply (in units)

10 100

15 120

Table 9.11: Less Elastic Supply:

In Table 9.11, the quantity supplied rises by 20 % due to 50% rise in price. In Fig. 9.26, the quantity
supplied rises from OQ to OQ1 with rise in price from OP to OP1. As QQ1 is proportionately less than PP1,
elasticity of supply is less than 1.

5. Unitary Elastic Supply: When percentage change in quantity supplied is equal to percentage change
in price, then supply for such a commodity is said to the unitary elastic. In such a case, Es = 1 and supply
curve is a straight line passing through the origin as shown in Fig. 9.27.

Price (in Rs.) Supply (in units)

10 100

15 150

Table 9.12: Unitary Elastic Supply:

In Table 9.12, the quantity supplied also rises by 50% due to 50% rise in price. In Fig. 9.27, the quantity
supplied rises from OQ to OQ1 with rise in price from OP to OP1. As QQX is proportionately equal to PP1,
elasticity of supply is equal to 1.

SUPPLY CURVE SLOPED UPWARD

The basic reason why a supply curve slopes upward is because producers want to make as much profit
as they can. The fact that the supply curve slopes upward means that there is a direct relationship
between the price at which the producer can sell their product and the quantity of the product that they
can and will sell. This makes sense because a higher price will bring (all other things being equal) a

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higher profit. As the sale price of the good rises, the profit gained by selling it increases and the
producer has a greater incentive to produce and sell a higher quantity.

Another way to look at this is that firms have to keep their marginal revenues equal to their marginal
costs. This is an economic law because that is the way to maximize profit or minimize loss. Because of
the law of diminishing marginal returns, marginal costs tend to increase as a firm produces more of a
thing. When this happens, firms will need to charge higher prices so that their marginal revenue can
continue to equal their marginal costs.

Q. Explain Market Equilibrium.

Market equilibrium, also known as the market clearing price, refers to a perfect balance in the market
of supply and demand, i.e. when supply is equal to demand.

When the market is at equilibrium, the price of a product or service will remain the same, unless some
external factor changes the level of supply or demand.

According to economic theory, in a market economy there is a single price which brings demand and
supply into balance – the equilibrium price.

When the quantity of goods supplied is equal to the quantity of goods demanded, the equilibrium price is
reached.

Market equilibrium evolves over time

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Eventually, over time, the constant interaction of buyers and sellers brings about a stable price for a
product or service.

As consumers, we are often not aware of the power we have regarding the price of things. If the
majority of potential buyers refused to buy a product, the seller would rapidly reduce its price.

Collectively, as consumers, we have influence over the market price. Sellers experiment with price until
market equilibrium is reached – a price where good sales are achieved, supply matches demand, and the
seller can still make a profit.

Demand, supply & equilibrium

If a market is not at equilibrium, market forces – supply and demand – will eventually push towards an
ideal balance.

Excess supply: if the current market price is above the equilibrium value, supply is greater than demand.

Market equilibrium: a market state where supply is equal to demand.

When supply exceeds demand, sellers will typically lower the price of their good or service, and reduce
production or order less.

The reduction in price encourages people to buy, which further reduces supply. This convergence in
supply and demand will gradually bring the product to its equilibrium price.

Excess demand: this occurs when the market price is lower than the equilibrium value. There is a supply
shortage.

When supply is lower than demand, buyers are willing to pay more for a good or service. Sellers will
start raising their prices. They will also increase production.

Eventually, as more buyers stop purchasing the good or service, and more of it is made available, the
price will stabilize and market equilibrium is reached.

When market equilibrium is reached, there will be nothing ‘left over’. It is also called the market clearing
price because it is at this price that all the supply is bought by consumers – it is all cleared.

It is the ideal market situation, because there is neither wasted output due to excess supply, nor a
shortage.

Classical economics

Classical economists say that markets work best on their own, without any interference from
government. They belong to a school of thought that was exemplified by Adam Smith’s publications in
the 18th century that claimed that any changes in supply would eventually be matched by adjustments
in demand levels – so that the market, if left to find its own way, would naturally move towards
equilibrium.

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Most economists say the market tends towards equilibrium. George Soros, a Hungarian-born American
business magnate, investor, author, and philanthropist, disagrees. Mr. Soros said:

“The reality is that financial markets are self-destabilizing; occasionally they tend toward disequilibrium,
not equilibrium.” By financial markets, he meant banks and other financial institutions that bring
investors (lenders) and borrowers together.

According to Cambridge Dictionaries Online, market equilibrium is:

“A situation in which the amount of goods or services people want to buy is equal to the amount of
goods or services being supplied.”

Monopoly refers to a market situation where there is only single seller of a commodity and there are no
close substitutes of that commodity. In such a situation, monopolist or the single seller of the
commodity has some kind of power or control over the supply of a commodity and hence he is in a
position to influence the price.

Since under monopoly, there is only one firm selling a commodity, this firm exercises some control over
the supply and price of the commodity.

However, this can be possible only when there are no close substitutes of that commodity. Therefore,
the two distinct features of monopoly are – a single seller producing and selling the commodity and no
close substitutes of that commodity.

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Production Analysis
Q. Explain the 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.

Therefore, when the number of one factor is increased or decreased, while other factors are constant,
the proportion between the factors is altered. For instance, there are two factors of production viz., land
and labour.

Land is a fixed factor whereas labour is a variable factor. Now, suppose we have a land measuring 5
hectares. We grow wheat on it with the help of variable factor i.e., labour. Accordingly, the proportion
between land and labour will be 1: 5. If the number of laborers is increased to 2, the new proportion
between labour and land will be 2: 5. Due to change in the proportion of factors there will also emerge a
change in total output at different rates. This tendency in the theory of production called the Law of
Variable Proportion.

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.” Bentham

“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:

(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.

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

Explanation of the Law:

In order to understand the law of variable proportions we take the example of agriculture. Suppose land
and labour are the only two factors of production.

By keeping land as a fixed factor, the production of variable factor i.e., labour can be shown with the
help of the following table:

From the table 1 it is clear that there are three stages of the law of variable proportion. In the first stage
average production increases as there are more and more doses of labour and capital employed with
fixed factors (land). We see that total product, average product, and marginal product increases but
average product and marginal product increases up to 40 units. Later on, both start decreasing because
proportion of workers to land was sufficient and land is not properly used. This is the end of the first
stage.

The second stage starts from where the first stage ends or where AP=MP. In this stage, average product
and marginal product start falling. We should note that marginal product falls at a faster rate than the
average product. Here, total product increases at a diminishing rate. It is also maximum at 70 units of
labour where marginal product becomes zero while average product is never zero or negative.

The third stage begins where second stage ends. This starts from 8th unit. Here, marginal product is
negative and total product falls but average product is still positive. At this stage, any additional dose
leads to positive nuisance because additional dose leads to negative marginal product.

Graphic Presentation: In fig. 1, on OX axis, we have measured number of labourers while quantity of
product is shown on OY axis. TP is total product curve. Up to point ‘E’, total product is increasing at
increasing rate. Between points E and G it is increasing at the decreasing rate. Here marginal product
has started falling. At point ‘G’ i.e., when 7 units of labourers are employed, total product is maximum
while, marginal product is zero. Thereafter, it begins to diminish corresponding to negative marginal
product. In the lower part of the figure MP is marginal product curve.

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Up to point ‘H’ marginal product increases. At point ‘H’, i.e., when 3 units of labourers are employed, it
is maximum. After that, marginal product begins to decrease. Before point ‘I’ marginal product becomes
zero at point C and it turns negative. AP curve represents average product. Before point ‘I’, average
product is less than marginal product. At point ‘I’ average product is maximum. Up to point T, average
product increases but after that it starts to diminish.

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.

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In Which Stage Rational Decision is Possible: To make the things simple, let us suppose that, a is
variable factor and b is the fixed factor. And a1, a2 , a3….are units of a and b1 b2b3…… are unit of b.

Stage I is characterized by increasing AP, so that the total product must also be increasing. This means
that the efficiency of the variable factor of production is increasing i.e., output per unit of a is increasing.
The efficiency of b, the fixed factor, is also increasing, since the total product with b1 is increasing.

The stage II is characterized by decreasing AP and a decreasing MP, but with MP not negative. Thus, the
efficiency of the variable factor is falling, while the efficiency of b, the fixed factor, is increasing, since
the TP with b1 continues to increase.

Finally, stage III is characterized by falling AP and MP, and further by negative MP. Thus, the efficiency of
both the fixed and variable factor is decreasing.

Rational Decision: Stage II becomes the relevant and important stage of production. Production will not
take place in either of the other two stages. It means production will not take place in stage III and stage
I. Thus, a rational producer will operate in stage II.

Suppose b were a free resource; i.e., it commanded no price. An entrepreneur would want to achieve
the greatest efficiency possible from the factor for which he is paying, i.e., from factor a. Thus, he would
want to produce where AP is maximum or at the boundary between stage I and II.

If on the other hand, a were the free resource, then he would want to employ b to its most efficient
point; this is the boundary between stage II and III.

Obviously, if both resources commanded a price, he would produce somewhere in stage II. At what
place in this stage production takes place would depend upon the relative prices of a and b.

Condition or Causes of Applicability:

1. Under Utilization of Fixed Factor: In initial stage of production, fixed factors of production like land or
machine, is under-utilized. More units of variable factor, like labour, are needed for its proper

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utilization. As a result of employment of additional units of variable factors there is proper utilization of
fixed factor. In short, increasing returns to a factor begins to manifest itself in the first stage.

2. Fixed Factors of Production: The foremost cause of the operation of this law is that some of the
factors of production are fixed during the short period. When the fixed factor is used with variable
factor, then its ratio compared to variable factor falls. Production is the result of the co-operation of all
factors. When an additional unit of a variable factor has to produce with the help of relatively fixed
factor, then the marginal return of variable factor begins to decline.

3. Optimum Production: After making the optimum use of a fixed factor, then the marginal return of
such variable factor begins to diminish. The simple reason is that after the optimum use, the ratio of
fixed and variable factors become defective. Let us suppose a machine is a fixed factor of production. It
is put to optimum use when 4 labourers are employed on it. If 5 labourers are put on it, then total
production increases very little and the marginal product diminishes.

4. Imperfect Substitutes: Mrs. Joan Robinson has put the argument that imperfect substitution of
factors is mainly responsible for the operation of the law of diminishing returns. One factor cannot be
used in place of the other factor. After optimum use of fixed factors, variable factors are increased and
the amount of fixed factor could be increased by its substitutes.

Such a substitution would increase the production in the same proportion as earlier. But in real practice
factors are imperfect substitutes. However, after the optimum use of a fixed factor, it cannot be
substituted by another factor.

Applicability of the Law of Variable Proportions:

The law of variable proportions is universal as it applies to all fields of production. This law applies to any
field of production where some factors are fixed and others are variable. That is why it is called the law
of universal application.

The main cause of application of this law is the fixity of any one factor. Land, mines, fisheries, and house
building etc. are not the only examples of fixed factors. Machines, raw materials may also become fixed
in the short period. Therefore, this law holds good in all activities of production etc. agriculture, mining,
manufacturing industries.

1. Application to Agriculture: With a view of raising agricultural production, labour and capital can be
increased to any extent but not the land, being fixed factor. Thus when more and more units of variable
factors like labour and capital are applied to a fixed factor then their marginal product starts to diminish
and this law becomes operative.

2. Application to Industries: In order to increase production of manufactured goods, factors of

production has to be increased. It can be increased as desired for a long period, being variable factors.
Thus, law of increasing returns operates in industries for a long period. But, this situation arises when
additional units of labour, capital and enterprise are of inferior quality or are available at higher cost.

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As a result, after a point, marginal product increases less proportionately than increase in the units of
labour and capital. In this way, the law is equally valid in industries.

Postponement of the Law: The postponement of the law of variable proportions is possible under
following conditions:

(i) Improvement in Technique of Production: The operation of the law can be postponed in case
variable factors techniques of production are improved.

(ii) Perfect Substitute: The law of variable proportion can also be postponed in case factors of
production are made perfect substitutes i.e., when one factor can be substituted for the other.

Q. Distinguish between (i) law of Variable Proportions and the law of returns to scale (ii) Short run and
Long run production function.

(i) law of Variable Proportions and the law of returns to scale

Basis of Difference Law of variable proportions Law of returns to scale

Time period Applies in the short run Applies in the long run
All factors are increased
Variable and Fixed Only variable factors are changed and units
simultaneously. No distinction
factors of fixed factors remains the same.
between fixed and variable factors

There are 3 stages: There are 3 stages:

Stages (i) Increasing returns, (ii) Diminishing (i) Increasing returns, (ii) Constant
returns, (iii)Negative returns returns, (iii) Decreasing returns

Optimum Stage 2 is considered to be the optimum There is no stage which is the best in
stage stage of production the long run

(ii) Short-Run and Long-Run Production Functions

The firm may change only the quantities of the variable inputs in the short run when the quantities of
the fixed inputs remain unchanged.

That is, in the short run, the output quantity can be increased (or decreased) by increasing (or
decreasing) the quantities used of only the variable inputs. This functional relationship (of dependence)
between the variable input quantities and the output quantity is called the short run production
function.

We have to remember here, of course, that in the short-run, the firm uses a particular combination of
fixed inputs, and its short-run production function is obtained in respect of that combination.

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In the long run, however, all the inputs used by the firm, the variable inputs and the so called fixed
inputs, all are variable quantities and the firm’s production is a function of all these inputs. This
functional relation of dependence between all the inputs used by the firm and the quantity of its output
is called the long run production function of the firm.

We may illustrate the difference between the short-run and the long run production functions in the
following way. Let us suppose that the firm uses only two inputs X and Y to produce its output of one
commodity, Q, and of these two inputs X is a variable input and Y is a fixed input.

Therefore, in this case, the firm’s short-run production function may be written as:

q = f(x, y̅) (8.5)

where y̅ is the fixed quantity of the fixed input y. The firm’s long run production function in this
example would be:

q = f(x, y) (8.6)

where x and y are the variable quantities of the inputs X and Y.

We may write the firm’s short-run production function (8.5) in the following form also:

q = h(x) (8.7)

For, in our example, in the short-run, the change in the firm’s output depends on the change in the
quantity used of the input X only.

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Cost Analysis
Q. Explain the inter relationship between Marginal Cost and Average Cost. Why average cost curve is
U-shaped?

The Relation between the Average and Marginal Cost Curve!

The relationship between the marginal cost and average cost is the same as that between any other
marginal-average quantities. When marginal cost is less than average cost, average cost falls and when
marginal cost is greater than average cost, average cost rises.

This marginal-average relationship is a matter of mathematical truism and can be easily understood by a
simple example. Suppose that a cricket player’s batting average is 50. If in his next innings he scores less
than 50, say 45, then his average score will fall because his marginal (additional) score is less than his
average score.

If instead of 45, he scores more than 50, say 55, in his next innings, then his average score will increase
because now the marginal score is greater than his previous average score. Again, with his present
average runs of 50, if he scores 50 also in his next innings, then his average score will remain the same
because now the marginal score is just equal to the average score.

Likewise, suppose a producer is producing a certain number of units of a product and his average cost is
Rs. 20. Now, if he produces one unit more and his average cost falls, it means that the additional unit
must have cost him less than Rs. 20. On the other hand, if the production of the additional unit raises his
average cost, then the marginal unit must have cost him more than Rs. 20.

And finally, if as a result of production of an additional unit, the average cost remains the same, then
marginal unit must have cost him exactly Rs. 20, that is, marginal cost and average cost would be equal
in this case.

The relationship between average and marginal cost can be easily remembered with the help of Fig.
19.4. It is illustrated in this figure that when marginal cost (MC) is above average cost (AC), the average
cost rises, that is, the marginal cost (MC) pulls the average cost (AC) upwards.

On the other hand, if the marginal cost (MC) is below the average cost (AC); average cost falls, that is,
the marginal cost pulls the average cost downwards. When marginal cost (MC) stands equal to the
average cost (AC), the average cost remains the same, that is, the marginal cost pulls the average cost
horizontally.

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Now, take Fig. 19.5 where short-run average cost curve AC and marginal cost curve MC are drawn. As
long as short-run marginal cost curve MC lies below short-run average cost curve, the average cost curve
AC is falling. When marginal cost curve MC lies above the average cost curve AC, the latter is rising.

At the point of intersection L where MC is equal to AC, AC is neither falling nor rising, that is, at point L,
AC has just ceased to fall but has not yet begun to rise. It follows that point L, at which the MC curve
crosses the AC curve to lie above the AC curve is the minimum point of the AC curve. Thus, marginal cost
curve cuts the average cost curve at the latter’s minimum point.

It is important to note that we cannot generalise about the direction in which marginal cost is moving
from the way average cost is changing, that is, when average cost is falling we cannot say that marginal
cost will be falling too. When average cost is falling, what we can say definitely is only that the marginal
cost will be below it but the marginal cost itself may be either rising or falling.

Likewise, when average cost is rising, we cannot deduce that marginal cost will be rising too. When
average cost is rising, the marginal cost must be above it but the marginal cost itself may be either rising
or falling. Consider Fig. 19.5 where up to the point K, marginal cost is falling as well as below the average
cost.

As a result, the average cost is falling. But beyond point K and up to point L marginal cost curve lies
below the average cost curve with the result that the average cost curve is falling. But it will seen that
between K and L where the marginal cost is rising, the average cost is falling.

This is because though MC is rising between K and L, it is below AC. It is therefore clear that when the
average cost 4 is falling, marginal cost may be falling or rising. This can also be easily illustrated by the
example of batting average.

Suppose a cricket player’s present batting average is 50. If in his next innings he scores less than 50, say
45, his batting average will fall. But his marginal score of 45, though less than the average score may
itself have risen.

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For instance, he might have scored 40 in his previous innings so that his present marginal score of 45 is
greater than his previous marginal score. Thus one cannot deduce about marginal cost as to whether it
will be falling or rising when average cost is falling or rising.

why cost curve is “U” shaped.

The addition of fixed and Variable Cost gives us total costs, which when divided by the output give us
Average Costs in the short period.

The nature of short period Average Cost Curve is ‘U’ shaped. To begin with, the Average Costs are high
at low levels of output because both the Average Fixed Costs and Average Variable Costs are more.

But, as the level of output increases, the Average Costs fall more sharply due to the combined effect of
the declining average fixed and Average Variable Costs.

This results from the use of indivisible factors and the reaping of internal economies of labour, technical,
managerial, marketing etc. The Average Cost will continue to fall till they reach the minimum point
which is the optimum point level of output. Once the optimum level of output is reached, Average Costs
starts rising as more are produced beyond this level.

The rise in Average Variable Cost is more than offset by the small fall in Average Fixed Costs and hence
the Average Costs rises quickly. This is due to the change of economies into dis-economies. This gives
the short-run as well as long-run Average Cost Curve of the firm IP shaped.

The nature ‘U’ shaped short-run Average Cost curve

can be attributed to the law of variable proportions. This law tells that when the quantity of one variable
factor is changed while keeping the quantities of other factors fixed, the total output increases with an
increasing rate and then declines with more than proportionate.

Thus, the Average Costs of the firms continue to fall as output increases because it operates under the
increasing returns due to various internal economies. Due to the operation of the law of increasing
returns the firm is able to work with the machines to their optimum capacity and as a consequence the
Average Cost is minimum.

If the firm tries to raise output after that point by increasing the quantities of variable factors the fixed
factors like machines would be worked beyond their capacity. This would lead to diseconomies of

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production and diminishing returns. The Average Costs will start rising rapidly. Hence, due to the
operation of Law of Variable proportions the short-run as well as long-run Average Cost Curve is TJ
shaped’.

Q. Distinguish between (i) Fixed cost and Variable cost. (ii) Explicit and Implicit cost.

Basis for Fixed Cost Variable Cost

Comparison

Meaning The cost which remains same, regardless of the The cost which changes with the
volume produced, is known as fixed cost. change in output is considered as
a variable cost.

Nature Time Related Volume Related

Incurred when Fixed costs are definite, they are incurred whether Variable costs are incurred only
the units are produced or not. when the units are produced.

Unit Cost Fixed cost changes in unit, i.e. as the units Variable cost remains same, per
produced increases, fixed cost per unit decreases unit.
and vice versa, so the fixed cost per unit is
inversely proportional to the number of output
produced.

Behavior It remains constant for a given period of time. It changes with the change in the
output level.

Combination Fixed Production Overhead, Fixed Administration Direct Material, Direct Labor,
of Overhead and Fixed Selling and Distribution Direct Expenses, Variable
Overhead. Production Overhead, Variable
Selling and Distribution Overhead.

Examples Depreciation, Rent, Salary, Insurance, Tax etc. Material Consumed, Wages,
Commission on Sales, Packing
Expenses, etc.

Basis for Comparison Explicit Cost Implicit Cost

Meaning The costs which involve outflow of cash The costs in which there is no cash
due to the use of factors of production outlay, is known as Implicit Cost.

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is known as Explicit Cost.

Alternatively known as Out-of-pocket Costs Imputed Costs

Occurrence Actual Implied

Recording and Yes No

Reporting

Estimation of Cost Objective Subjective

Which profit can be Accounting Profit and Economic Profit Economic Profit
calculated with the
help of cost?

Example Salaries, rent, advertisement, wages, Interest on owner's capital, Salary

etc. to owner, rent of owner's building,
etc. which do not occur in reality.

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Market Structures and Revenue Concepts

Q. Discuss the essential features of perfect competition. Explain the price-output equilibrium of
perfectly competitive firm in the short run and also in the long run.

According to John. F. Dve "market as a group of buyers and sellers in sufficiently close contact with one
another, that exchange takes place among them". Market consists of different forms like perfect
competition, imperfect competitions, etc. Below are given some of the important characteristic features
of a perfectly competitive market.

Perfect competition, is said to prevail when the following conditions are found in the market.

(1) Large number of buyers and sellers: nder perfectly competitive market there is large number of
buyers and sellers. The position of a single seller in the market is just like a drop in the ocean. Each buyer
purchases only a small quantity of the total amount. Each buyer and seller has no ability to influence the
ruling price by their independent action.

The price under perfect competition is given and each seller adjusts its sale to earn maximum profits.
Under perfect competition the sellers of a commodity is the price taker and output adjuster and not
price makers. They take the market price as a given datum.

(2) Homogeneous Products: The second condition of perfect competition is that the products sold by
the suppliers are fully homogeneous. The commodities available everywhere are the same. The products
of various sellers are indistinguishable from each other. They are perfect substitutes for one another.

The cross elasticity between the products is infinite. The commodities are perfectly similar in quality,
quantity, size and shape. The buyers are indifferent to any commodity sold in the market. If the
commodities sold in the market were differentiated, each seller would influence over the price of his
own variety.

The control over price is removed only when all the sellers are producing homogenous products. Thus in
a perfectly competitive market, buyers have no other basis of attaching to one seller for purchasing a
product other than price.

(3) Uniform price: Under perfect competition the ruling market price is the same. Price is uniform as the
products in the market are identical. Price is fixed by all the buyers and sellers in the market. No
Individual effort of a buyer or seller goes to determine price.

If any miller sells at the price less than prevailing price, the demand for his commodity will be so high
that he will not be able to supply the commodities at low price to the increased demand. On the other
hand if a seller sells at a price higher than the ruling market mice, he will lose by doing so as most of his
customers will leave him for his higher price.

(4) Free entry and free exit: Under perfect competition buyers and sellers are absolutely free to enter
and leave the market. No restriction is imposed on their entry and exit. Under perfect competition firms

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get only normal profit. At this normal profit there is no tendency on the part of the existing firms to
leave the market or the new firms to leave market.

But at abnormal profit and abnormal loss, firms tend to enter and leave the market according" to their
will. Thus on the basis of profit and loss firms are at liberty to enter or quit the market.

(5) Perfect knowledge about the market: One of the most pre-requisite of perfect competition is that
both buyers’ and-sellers must have perfect knowledge about the conditions of the market. Sellers must
know the ruling market price charged by other sellers from the buyers. Similarly buyers It in know the
prices charged by different sellers.

This condition is highly essential for a competitive market. Single price and homogeneous commodity
cannot prevail if the buyers remain ignorant of the market. When all the buyers can know the price fend
the uniform quality of the commodity, nobody will offer more fend therefore single price prevails in the
"market,

(6) Perfect mobility: Under perfect competition it is understood that various factors of production are
perfectly mobile within the industry. Factors of production can freely move from one occupation to
another and from one place to another. There is no barrier on their movement. Factors move from place
to place in search of higher wage. There should not be any kind of imposition on the mobility of
resources.

(7) Absence of transport cost: In a perfectly competitive market there is single unit price. Price being
charged by the firms is free of transportation cost. Price is not affected by the cost of transportation of
goods. The market price charged by different sellers does not differ due to location of different sellers in
the market.

No seller is near or distant to any buyers. Thus there is no transportation cost from one part of the
market to the other. Perfectly competitive market is a myth. Such a market is never found in the real
world. It is an ideal. As an ideal market it compares the price and profit condition in imperfect market.

(8). Wide Extent: Sometimes wide market is regarded as the same thing as the perfect market. For wide
market, the commodity should have permanent and universal demand. The commodity should be
portable. Means of transport and communication should be quick. There should be peace and security
and extensive division of labour.

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Price and Output Determination under Imperfect Competition

Q. What are the characteristics features of Monopoly Market? Explain the short run equilibrium of a
monopoly firm.

Characteristics of Monopoly Market:

1. Single seller: The producer or seller of the commodity is a single person, firm or an individual and that
firm has complete control on the output of the commodity.

2. No Close Substitutes: All the units of a commodity are similar and there are no substitutes to that
commodity.

3. No Entry for New Firms: Monopoly situation in a market can continue only when other firms do not
enter the industry. If new firms enter the industry, there will not be complete control of a firm on the
supply. As such, whenever a firm enters the industry, monopoly situation comes to an end. There/art,
monopoly industry is essentially one-firm industry. This signifies that under monopoly there is no differ-
ence between a firm and an industry.

4. Profit in the Long Run: A monopolist can earn abnormal profit even in the long run because he has no
fear of a competitive seller. In other words, if a monopolist gets abnormal profits in the long run, he
cannot be dislodged from this position. However, this is not possible under perfect competition. If
abnormal profits are available to a competitive firm, other firms will enter the competition with the
result abnormal profits will be eliminated.

5. Losses in the Short Period: Generally, a common man thinks that a monopoly firm cannot incur loss
because it can fix any price it wants. However, this understanding is not correct. A monopoly firm can
sustain losses equal to fixed cost in the short period. A monopolist means that there is only a single
person or a firm to sell the commodity.

Therefore, anybody who would like to buy that commodity will buy it from the monopolist only.
However, if a firm has monopoly of such a commodity which people buy less or do not buy, it can incur
losses or it may have to stop production even. For example, if someone has the monopoly of yellow hair
dye, it is natural that the firm has the possibility of incurring losses because it is a product which people
generally don't buy.

6. Nature of Demand Curve: Under monopoly the demand for the commodity of the firm is less than
being perfectly elastic and, therefore, it slopes downwards to the right. The main reason of the demand
curve sloping downwards to the right is the complete control of the monopolist on the supply of the
commodity. Due to control on the supply a monopolist makes changes in the supply which brings about
changes in the price and because of this demand changes in the opposite direction. In other words, if a
monopolist increases the price of the commodity, the amount of quantity sold decreases. Therefore,
demand curve (AR) slopes downwards to the right. The nature of demand curve has been shown in the
diagram. DD is demand curve, which has a negative slope.

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7. Price-discrimination: From the point of view of profit a monopolist can change different prices from
different consumers of his commodity. This policy is known as price discrimination. He adopts the policy
of price discrimination on various bases such as charging different prices from different consumers or
fixing different prices at different places etc.

8. Firm is a Price-Maker: A competitive firm is a price-taker whereas a monopoly firm is a price-maker.

This is because a competitive firm is small compared to market and therefore, it does not have market
power. This is not true in the case of a monopoly firm because it has market power. Hence, it is a price
maker

9. Average and Marginal Revenue Curves: Under monopoly, average revenue is greater than marginal
revenue. Under monopoly, if the firm wants to increase the sale it can do so only when it reduces its
price. This means AR would decline when sale increases. In that case MR would be less than AR. (ii) AR
slopes downwards to the right and is greater than MR.

Short Run Equilibrium of the Monopoly Firm:

In the short period, the monopolist behaves like any other firm. A monopolist will maximize profit or
minimize losses by producing that output for which marginal cost (MC) equals marginal revenue (MR).
Whether a profit or loss is made or not depends upon the relation between price and average total cost
(ATC). It may be made clear here that a monopolist does not necessarily makes profit. He may earn super
profit or normal profit or even produce at a loss in the short ran.

Conditions for the Equilibrium of a Monopoly Firm:

First Order Condition: MC = MR.

Second Order Condition: MC curve cuts MR curve from below.

Explanation:

(a) Short Run Monopoly Equilibrium With Positive Profit: n the short period, if the demand for the
product is high, a monopolist increase the price and the quantity of output. He can increase the, output
by hiring more labor, using more raw material, increasing working hours etc. However, he cannot change
his fixed plant and equipment. In case, the demand for the product falls, he then decreases the use of
variable inputs, (like labor, material etc.).

As regards the price, the monopolist is a price maker. There is a greater tendency for the monopolist to
have a price which earns positive profits. This can only be possible if the price (AR) is higher than average
total cost (ATC). The short run profit earned by the monopolist is now explained with the help of the
diagram (16.3) below.

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In this diagram, the monopoly firm is in equilibrium at point K where SMC = MR. The short run marginal
cost (SMC) curve cuts MR from below. At point K both the equilibrium conditions are fulfilled. As a result,
therefore, OE is monopoly price and OB, the monopoly output. At the monopoly output OB, the average
total cost OF = BN. The profit per unit is FE. The short run monopoly profit is ETNF, It is represented by
the area of shaded rectangle in figure 16.3.

At the output smaller than OB (say at point P) MR > SMC. Therefore, increased output up to B adds more
to total receipts than to total costs. In case, the output is increased beyond OB, the MR < SMC. Hence,
the increased outputs beyond OB adds more to total cost than to total receipts. This causes profits to
decrease. So the best level of output for the monopolist firm is that where SMC curve cuts the MC curve
from below.

(b) Short Run Equilibrium With Normal Profit Under Monopoly: There is a false impression regarding
the powers of a monopolist. It is said that the monopolistic entrepreneur always earns profits. The fact,
however, is that there is no guarantee for the monopolist to earn profit in the short run. If a monopolist
firm produces a new commodity and attempts to change the taste pattern of the consumers through
advertising campaigns etc., then the firm may operate at normal profit or even produce at a loss
minimizing price in the short run (Covering variable cost only). The normal profit short run equilibrium of
the monopoly firm is explained, in brief, with the help of the diagrams.

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In figure (16.4), a firm is in the short run equilibrium at point K, where SMC = MR. The price line is
tangent to SAC at point C. The firm charges CB price per unit for units of output OB. The total revenue of
the firm is equal to the area OPCB. The total cost of the firm is also equal to the area OPCB. The firm
earns only normal profits and continues operating.

(c) Short Run Equilibrium With Losses Under Monopoly: A monopolist also accepts short run losses
provided the variable costs of the firm are fully covered. The loss minimizing short run equilibrium
analysis is presented graphically.

In this figure (16.5), the best short run level of output is OB units which is given by the point L where MC
= MR. A monopolist sells OB units of output at price CB. The total revenue of the firm is equal to OBCF.
The total cost of producing OB units is OBHE. The monopoly firm suffers a net loss equal to the area
FCHE. If the firm ceases production, it then has to bear to total fixed cost equal to GKHE. The firm in the
short run prefers to operate and reduces its losses to FCHE only. In the long, if the loss continues, the firm
shall have to close down.

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Equilibrium in Long Run: In the preceding sections, we have discussed that in the short run,
organizations can earn supernormal profits. However, in the long run, there is a gradual decrease in the
profits of organizations. This is because in the long run, several new organizations enter the market due
to freedom of entry and exit under monopolistic competition.

When these new organizations start production the supply would increase and the prices would fall. This
would automatically increase the level of competition in the market. Consequently, AR curve shifts from
right to left and supernormal profits are replaced with normal profits.

In the long run, the AR curve is more elastic than that of in the short run. This is because of an increase
in the number of substitute products in the long- run. The long-run equilibrium of monopolistically
competitive organizations is achieved when average revenue is equal to average cost. In such a case,
organizations receive normal profits.

Figure-4 shows the long-run equilibrium position under monopolistic competition:

In Figure-4, P is the point at which AR curve touches the average cost curve (LAC) as a tangent. P is
regarded as the equilibrium point at which the price level is MP (which is also equal to OF) and output is
OM.

In the present case average cost is equal to average revenue that is MP. Therefore, in long run, the profit
is normal. In the short run, equilibrium is attained when marginal revenue is equal to marginal cost.
However, in the long run, both the conditions (MR=MC and AR=AC) must hold to attain equilibrium.

Q. Distinguish between Perfect Competition Market and Monopoly Market. When price -
discrimination by a monopolist becomes possible and profitable?

The distinction between monopoly and perfect competition is only a difference of degree and not of
kind.

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1. Output and Price: Under perfect competition price is equal to marginal cost at the equilibrium
output. While under monopoly, the price is greater than average cost.

2. Equilibrium: Under perfect competition equilibrium is possible only when MR = MC and MC cuts the
MR curve from below. But under simple monopoly, equilibrium can be realized whether marginal cost is
rising, constant or falling.

3. Entry: Under perfect competition, there exist no restrictions on the entry or exit of firms into the
industry. Under simple monopoly, there are strong barriers on the entry and exit of firms.

4. Discrimination: Under simple monopoly, a monopolist can charge different prices from the different
groups of buyers. But, in the perfectly competitive market, it is absent by definition.

5. Profits: The difference between price and marginal cost under monopoly results in super-normal
profits to the monopolist. Under perfect competition, a firm in the long run enjoys only normal profits.

6. Supply Curve of Firm: Under perfect competition, supply curve can be known. It is so because all firms
can sell desired quantity at the prevailing price. Moreover, there is no price discrimination. Under
monopoly, supply curve cannot be known. MC curve is not the supply curve of the monopolist.

7. Slope of Demand Curve: Under perfect competition, demand curve is perfectly elastic. It is due to the
existence of large number of firms. Price of the product is determined by the industry and each firm has
to accept that price. On the other hand, under monopoly, average revenue curve slopes downward. AR
and MR curves are separate from each other. Price is determined by the monopolist. It has been shown
in Figure 10.

8. Goals of Firms: Under perfect competition and monopoly the firm aims at to maximize its profits. The
firm which aims at to maximize its profits is known as rational firm.

9. Comparison of Price: Monopoly price is higher than perfect competition price. In long period, under
perfect competition, price is equal to average cost. In monopoly, price is higher as is shown in Fig. 11.
The perfect competition price is OP1, whereas monopoly price is OP. In equilibrium, monopoly sells ON
output at OP price but a perfectly competitive firm sells higher output ON1 at lower price OP1.

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10. Comparison of Output: Perfect competition output is higher than monopoly price. Under perfect
competition the firm is in equilibrium at point M1 (As shown in Fig. 11 (a)), AR = MR = AC = MC are equal.
The equilibrium output is ON1. On the other hand monopoly firm is in equilibrium at point M where
MC=MR. The equilibrium output is ON. The monopoly output is lower than perfectly competitive firm
output.

Summary of Comparison:

A general comparison between monopoly and perfect competition for easy understanding has been
depicted as under:

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Conditions when Price Discrimination is Profitable

1. Larger Output: The term discrimination suggests that consumers are exploited in order to increase
the profits of the monopolists.

Since price discrimination enables the monopolist to obtain a higher total revenue (and thus higher
profits) than if he charges a single price for the whole of his output.

But, this also means that he produces a larger output than with a single price.

He is able to do this because, he is able to separate the markets and he does not charge higher price in
one market by selling extra goods in another market. Indeed, if there were different markets for all units
of his product (that is, perfect discrimination), the marginal revenue for each unit would have been
equal to the price at which it is sold. The monopolist output would then be identical with perfectly
competitive output. Hence, the society at large is benefitted, since output under discriminating
monopoly is larger than with a single price.

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2. Equity: Under price discrimination, higher prices are charged from the rich people and lower prices
are charged from the poor people. It has a redistributive effect. The poor are benefitted at the cost of
the rich people. Therefore, inequalities in income and wealth can be reduced through price
discrimination. It is because of this reason that the government sometimes permits or even encourage
price discrimination, especially when it controls prices in the private sector”.

3. Helpful to Weaker Section: As a result of price discrimination, the weaker section of the society may
be benefitted. For instance, the services of a doctor may be available at cheap rates to the poor when
the doctor practices price discrimination by charging higher fees from the rich patients and lower fees
from the poor. The railways charges lower rates from class II passengers and higher rates from class I
passengers.

Had there been no discrimination, these services would not have been available. This fact has also been
emphasized by Mrs. Joan Robinson in the following words, “It may happen for instance, that a railway
would not be built or a country doctor would not set up his practice, if discrimination were forbidden.

Q. Discuss with the help of a suitable diagram, the conditions of equilibrium of a monopolist
practicing third degree price.

Degrees of Price Discrimination:

Price discrimination has become widespread in almost every market. In economic jargon, price
discrimination is also called monopoly price discrimination or yield management. The degree of price
discrimination vanes in different markets.

i. First-degree Price Discrimination: Refers to a price discrimination in which a monopolist charges the
maximum price that each buyer is willing to pay. This is also known as perfect price discrimination as it
involves maximum exploitation of consumers. In this, consumers fail to enjoy any consumer surplus.
First degree is practiced by lawyers and doctors.

ii. Second-degree Price Discrimination: Refers to a price discrimination in which buyers are divided into
different groups and different prices are charged from these groups depending upon what they are
willing to pay. Railways and airlines practice this type of price discrimination.

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iii. Third-degree Price Discrimination: Refers to a price discrimination in which the monopolist divides
the entire market into submarkets and different prices are charged in each submarket. Therefore, third-
degree price discrimination is also termed as market segmentation.

In this type of price discrimination, the monopolist is required to segment market in a manner, so that
products sold in one market cannot be resold in another market. Moreover, he/she should identify the
price elasticity of demand of different submarkets. The groups are divided according to age, sex, and
location. For instance, railways charge lower fares from senior citizens. Students get discount in
cinemas, museums, and historical monuments.

Necessary Conditions for Price Discrimination:

Price discrimination implies charging different prices for identical goods.

i. Existence of Monopoly: Implies that a supplier can discriminate prices only when there is monopoly.
The degree of the price discrimination depends upon the degree of monopoly in the market.

ii. Separate Market: Implies that there must be two or more markets that can be easily separated for
discriminating prices. The buyer of one market cannot move to another market and goods sold in one
market cannot be resold in another market.

iii. No Contact between Buyers: Refers to one of the most important conditions for price discrimination.
A supplier can discriminate prices if there is no contact between buyers of different markets. If buyers in
one market come to know that prices charged in another market are lower, they will prefer to buy it in
other market and sell in own market. The monopolists should be able to separate markets and avoid
reselling in these markets.

iv. Different Elasticity of Demand: Implies that the elasticity of demand in the markets should differ
from each other. In markets with high elasticity of demand, low price will be charged, whereas in
markets with low elasticity of demand, high prices will be charged. Price discrimination fails in case of
markets having same elasticity- of demand.

Advantages and Disadvantages of Price Discrimination:

A monopolist practices price discrimination to gain profits. However, it acts as a loss for the consumers.

Following are some of the advantages of price discrimination:

i. Helps organizations to earn revenue and stabilize the business

ii. Facilitates the expansion plans of organizations as more revenue is generated

iii. Benefits customers, such as senior citizens and students, by providing them discounts

In spite of advantages, there are certain disadvantages of price discrimination.

Some of the disadvantages of price discrimination as follows:

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i. Leads to losses as some consumers end up paying higher prices

ii. Involves administration costs for separating markets.

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Theory of Distribution- Rent and Wages

Q. Define Rent and Quasi rent. Distinguish between Rent and Quasi Rent. State and discuss Ricardio's
theory of rent.

Rent: Definition and Types of Rents

In simple words, ‘ rent’ is used as a part of the produce which is paid to the owner of land for the use of
his goods and services.

But, in economics, rent has been differently defined from time to time.

Thus rent refers only to make payments for factors of production which are in imperfectly elastic supply.
For instance, it is the price paid for the use of land.

Definition of Rent:

The concept of rent has been defined as follows:

“Rent is that portion of the produce of earth which is paid to landlord for the use of original and
indestructible powers of the soil.” -Ricardo

“Rent is the income derived from the ownership of land and other free gifts of Nature.” He further called
it ‘Quasi Rent’ which arises on the manmade equipment’s and machines in the short period and tend to
disappear in the long run. – Marshall

“Rent is the price paid for the use of land.” –Prof. Carver

Economic rent is also termed as surplus as it is received by landlord without any effort. Prof. Bounding
termed it as “Economic Surplus.” Moreover, modern economists comprising of Mrs. Joan Robinson,
Boulding etc. opined that part of the income of each factor can be rent.

Income alone received by land cannot be rent. It is so because different factors have different uses. As
such, each factor will be used for that purpose in which its income is maximum. Opportunity cost of a
factor for its use in the work yielding maximum income is the price of output that the factor concerned
can earn by working in next alternative use.

Definition of Economic Rent:

Classical Definitions:

“Economic rent is the payment for the use of scarce natural resources”. – Jacob Oser

“Economic rent is that portion of a landlord’s income which is attributable to his ownership of land.” –
Anatol Murad

Modern Definitions:

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“Economic Rent may be defined as any payment to a factor of production which is in excess of the
minimum amount necessary to keep the factor in its present occupation.” – Boulding

“Rent is the difference between actual payment to a factor and its supply price or transfer earnings.” –
Hibdon

Types of Rent:

1. Economic Rent: Economic rent refers to the payment made for the use of land alone. But in
economics the term rent is used in the sense of economic rent. In the words of Ricardo and other
classical economists, economic rent refers to the payment for the use of land alone It is also called
Economic Surplus because it emerges without any effort on the part of landlord. Prof. Boulding termed
it “Economic Surplus”.

2. Gross Rent: Gross rent is the rent which is paid for the services of land and the capital invested on it.

Gross rent consists of:

(1) Economic rent. It refers to payment made for the use of land.

(2) Interest on capital invested for improvement of land.

(3) Reward for risk taken by landlord in investing his capital.

3. Scarcity Rent: Scarcity rent refers to the price paid for the use of the homogeneous land when its
supply is limited in relation to demand. If all land is homogeneous but demand for land exceeds its
supply, the entire land will earn economic rent by virtue of its scarcity. In this way, rent will arise when
supply of land is inelastic. Prof. Ricardo opined that land was beneficial but it was also scarce.
Productivity of land was indicative of the generosity of nature but its total supply remaining more or less
fixed symbolized niggardliness of nature.

4. Differential Rent: Differential rent refers to the rent which arises due to the differences in the fertility
of land. In every country, there exists a variety of land. Some lands are more fertile and some are less
fertile. When the farmer’s are compelled to cultivate less fertile land the owners of more fertile land get
relatively more production. This surplus which arises due to difference in fertility of land is called the
differential rent. This type of rent arises under extensive cultivation. According to Ricardo, “In order to
increase production on same type of land, more units of labour and capital are employed.”

5. Contract Rent: Contract rent refers to that rent which is agreed upon between the landowner and the
user of the land. On the basis of some contract, which may be verbal or written, contract rent may be
more or less than the economic rent.

The concept of quasi-rent was given by Alfred Marshall. He defined quasi rent as surplus earnings
generated by the factors of production, except land.

The earnings from machines and instruments are termed as quasi-rent.

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The quasi-rent refers to the income produced when the demand for products increases suddenly.

It is used for a short-period of time. In economic rent, the supply of factor is fixed, such as land.
However, in quasi-rent the supply of factor is temporary and can be increased or decreased after some
time, such as machine.

For example, there is a sudden increase in the demand of houses, but the supply of houses does not
increase with that speed because of the limited building material.

The sudden increase in the return from selling of houses is termed as quasi- rent. Quasi-rent is regarded
as the surplus that is temporary in nature. When the building material would be available, then the
surplus amount would automatically be eradicated. Similarly, same type of surplus arises in case of
other goods, such as ships, machines, and automobiles.

In long-run, the earnings from durable goods are equal to the current interest rate. However, they can
provide surplus earnings for temporary period, which are termed as quasi-rent. In short-run, equipment
is used for only one purpose and not for other purposes. This implies that the transfer earning for such
equipment is zero in the short run.

Therefore, the total earnings generated from the short run equipment are termed as quasi-rent. The
supply of equipment is fixed in the short-run and cannot be increased with the increase in demand.
However, in long-run, the supply of equipment can be increased that would result in the extinction of
surplus earnings.

Quasi rent can also be expressed in terms of revenue, which is as follows:

Quasi-rent = Total revenue – total variable cost

In the long run, all the costs are considered as variable cost. In long-run, the equilibrium can be attained
when total revenue is equal to total costs. In such a case, there is no quasi-rent.

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In Figure-16, SS represents the inelastic supply curve. The demand (DD) and supply (SS) curve intersects
at point E. At point E, the price is equal to OP and quantity of equipment is OS. In the short run, the
increased demand (D’D’) reaches to the price level of OP’ with the constant supply of OS.

As the number of equipment is constant in short-run, therefore, the transfer earnings are zero and
quasi-rent is equal to total earnings from the equipment. However, in long-run, the supply of equipment
(PL) is perfectly elastic. Therefore, any number of equipment can be supplied at OP. Now, the supply
reaches to OM and prices fall to E”M. The quasi- rent would disappear because the price gets equal to
the transfer earning (OP).

Distinction Between Rent and Quasi Rent

Similarities

1. Quasi rent arises when the demand for man made goods increases, while rent arises with the
rise in the demand for the products of land.

2. Just as the supply of manmade appliances is fixed in the short period, so is that of land.

3. Transfer earnings are as much important for determining quasi rent as they are for determining
rent.

4. Quasi rent like the rent of land is price determined and not price determining.

Differences

1. Rent is a payment for natural gifts of nature like land. Quasi rent is a payment for man made
appliances like machines.

2. As the supply of land cannot be changed, rent persists in both short run and long run. But quasi
rent is a short run phenomenon which disappears in the long run when the supply of man made
goods is increased.

3. Rent is permanent in nature while quasi rent is a temporary phenomenon.

4. Rent is the disparity amidst total revenue and total costs. Conversely, quasi rent is difference
between total revenue variable costs.

5. Some economists regarded rent as unearned income. But quasi rent is a necessary payment
which all factors of production receive due to their inelastic supply in the short run.

6. Ricardo’s rent arises due to differences in fertility of land. Marshall’s quasi rent arises due to the
scarcity of manmade appliances in the short run.

7. Rent cannot be zero but quasi rent can be zero when the short run price of the commodity
equals its average variable cost.

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Ricardian Theory of Rent

Meaning:

Just as the Malthusian Theory of population is the basis for all further studies in population, in the same
fashion Ricardian theory of rent has been considered the ground for all discussions on the problem of
rent.

Generally, this theory is named after David Ricardo, an eminent economist of the 19th century. Prior to
Ricardo, Physiocrates and Adam Smith regarded rent as the result of the bounty of nature. According to
them, the amount of labour employed for the cultivation of land is rewarded by nature by yielding
produce which is many times more than the labour involved.

This excess production is named as net production or rent. Moreover, classical economists like James
Anderson opined that rent arises due to difference in the fertility of land. According to them to increase
agriculture production when extensive cultivation is done then inferior land is also brought under
cultivation. Therefore, extra produce obtained from relatively superior land is called rent. But, to
Ricardo, “rent is that portion of the produce of earth which is paid to the landlord for the use of the
original and indestructible powers of the soil.”

Thus, rent according to Ricardian definition is a payment for the use of land only and it is different from
contractual rent which includes the returns on capital investment made by the landlord in the form of
hedges, drains, wells and the like. In simple words, if we deduct the return on the capital investment
made by the landowner from the contractual rent, we will be left only with the pure land rent which
according to Ricardian terminology is the price for the use of land only.

Assumptions: Ricardian Theory of rent is based on certain assumptions which are as follows:

1. No Alternative Use: It has been assumed that land has no alternative use as it is used only for
farming.

2. Difference in Fertility: The theory also assumes that fertility differs from land to land. It means some
pieces of land are more fertile as compared to other pieces of land.

3. Law of Diminishing Returns: The theory assumes that law of diminishing returns holds in agriculture.
It states that output will not be increasing at the same rate at which labour and capital increases.

4. Increase in Population: The population of the country increases continuously which results in an
increase in agricultural production to feed the larger population.

5. Long Run: The Ricardian theory of rent is based upon the assumption of long period. This assumption
is basic to the classical economics.

6. No-Rent Land: The Ricardian theory assumes the existence of no-rent land which does not enjoy any
rent.

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7. Scarcity of Land: The Ricardian theory assumes that the supply of superior grade of land is limited.

8. Original and Indestructible Powers of the Soil: The Ricardian theory rests upon the fundamental
assumption that land possesses some original and indestructible powers.

9. Perfect Competition: The theory assumes the existence of perfect competition in the market. Since
under perfect competition, the product price is given, economic rent is that surplus which accrues over
and above the cost of production.

10. Descending Order of Cultivation: Theory assumes that different tracts of land are brought under
cultivation in a descending order of fertility. In the words of Ricardo, “The most fertile and most
favourably situated land will be first cultivated”.

Statement of the Theory: According to Ricardo, in the beginning of the civilization, when population is
not much, the food requirements of the people may be met by the cultivation of only the best tracks of
land. But when population increases or new people come to the country, people will be forced to take
up the cultivation of second best or less fertile pieces of land. To the application of same amount of
labour and capital as was applied on the best grade land, the less fertile land will yield less produce. The
price of produce must be equal to the cost of cultivation on the less fertile land.

The cost of cultivation of the superior grade of land will be less than the cost of cultivation of the less
fertile grade of land. With the result, the owners of superior grade of land will come to enjoy a sort of
surplus which by definition constitutes rent. Thus, rent appears as a surplus on superior grade of land
because of the difference in the fertility of different pieces of land. If all pieces of land are
homogeneous, rent arises due to scarcity of land. The difference in fertility is the measure of the size of
the rent.

Features of Ricardian Theory:

1. Rent is the Factor Income of Land: It is payment made to the landlord on account of the original and
indestructible powers of the soil.

2. Rent Increases with the Increase in Population: As the population goes on increasing and the law of
diminishing returns becomes applicable to agriculture, due to the niggardliness of the nature, rent goes
on increasing. In other words, as the population increases, the demand for food also increases and
therefore, inferior quality of land is cultivated. Thus, the rent arises on the superior quality of land. Thus,
Ricardo, unwittingly though, proved that the unearned income of the capitalist goes on increasing with
the increase in population. This provided to socialists a very important point of criticism of the capitalist
system.

3. Rent Does not Enter into Price: The market price of an agricultural commodity is equal to the cost of
producing it on the marginal land. Rent in the Ricardian sense, is a surplus above cost. Therefore, rent
does not determine price. It is the price which determines the rent.

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4. Rent is Unearned Income: Rent is not due to any labour or effort on the part of the landowner.
Therefore, it is an unearned income’. The abolition of such income by taxation or otherwise will not
reduce the supply of land.

5. Rent Arises Both in Intensive and Extensive Form: It arises in the intensive form when more units of
labour and capital are put to work on the same plot of land or, in the extensive form, when more and
more plots are put to cultivation. In both the cases total output increases but at a diminishing rate.

6. Rent is a Differential Return: The rent of a plot of land tends to equal the difference between its yield
and the yield of marginal plots.

7. Rent is Due to the Original and Indestructible Power of the Soil: According to Ricardo, every plot of
land is endowed by nature with certain powers which are original and indestructible. The original
qualities of land can neither be created nor destroyed. The yield obtained from any plot is determined
by the extent of those powers.

8. Rent is Due to Niggardliness of Nature: The differential surplus, which is called rent, arises whenever
inferior lands have to be cultivated. If the supply of good quality land was adequate it would not have
been necessary to do so. Rent arises because good quality land is scare. Hence, according to Ricardo,
rent is not due to the bounty of nature but to her ‘niggardliness’.

Criticism on Ricardian Theory of Rent:

(i) No Original and Indestructible Power: Ricardo is of the opinion that rent is paid due to the original
and indestructible powers of the soil. It is pointed out that there are no powers of the soil which are
indestructible. As we go on cultivating a piece of land time and again, its fertility gradually diminishes. To
this criticism, it is replied that there are properties of the soil, such as climate situation, sunshine,
humidity, soil composition, etc., which are infect original and indestructible.

(ii) Wrong Assumption of 'No Rent Land': Ricardo assumes the existence of no-rent land. A land which
just meets the cost of cultivation. The modern economists are of the opinion that if a plot of land can be
put to several uses, then it does yield rent.

(iii) Rent Enters Into Price: According to Ricardo, rent does not enter into price. The modern economists
are of the opinion that it does eater into price.

(iv) Wrong Assumption of Perfect Competition: Ricardo is of the opinion that perfect competition
prevails between the landlord and the tenant, but in the actual world, it is imperfect competition which
is the order of the day.

(v) All Lands are Equally Fertile: Ricardo assumes that rent arises due to difference in the fertility of the
soil. But the modern economists assert that if all lands are equally fertile, even then the rent will arise.
The rent can arise: (a) if the produce is not sufficient to meet the requirements of the people, and (b)
due the operation of the law of diminishing returns.

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(vi) Historically Wrong: Carey and Roscher have criticized the orders of cultivation assumed by Ricardo.
They are of the opinion that it is not necessary that A grade land will be cultivated first, even if it lies far
away from the city. To this it is replied by Walker that when Ricardo uses the words 'best land' he means
by it the land which is superior both in fertility and in situation.

(vii) Neglect of Scarcity Principle: It is pointed out by the modem economists that the concept of rent
can be easily explained with the help of the scarcity principle and so there is no need to have a separate
theory of rent.

Q. Discuss the three theories of wages. Discuss the role of trade union in raising wages. Distinguish
between real wages and money wages.

The important theories of wages are as under:

A. Subsistence Theory of Wages.

B. Marginal Productivity Theory of Wages.

C. Modern Theory of Wages.

A. Subsistence Theory of Wages:

The subsistence theory of wages was first formulated by Physiocratic School of French economists of
18th century. Further, this theory was developed and improved upon by the German economists. Lasalle
styled it as the Iron Law of Wages or the Brazen Law of Wages. Ricardo and Malthus also contributed to
the theory of wages. Karl Marx made it the basis of his theory of exploitation.

Assumptions: According to Ricardo, this theory is based on the following two assumptions:

1. Population increases at a faster rate.

2. Food production is subject to the law of diminishing returns.

According to this theory, wages of a worker in the long run are determined at that level of wages which
is just sufficient to meet the necessaries of life. This level is called the subsistence level. The classical
economists called it the neutral level of wages. In this way, the pro-pounders of the theory believed in
the bargaining power of the workers. In such a situation, trade unions play an important role in
increasing wages.

Wages of labour are equal to subsistence level in the long ran. If wages fall below this level, workers
would starve. It will reduce their supply. Thus, the wage rate will rise to the subsistence level. On the
other hand, if wages tend to rise above the subsistence level, workers would be encouraged to bear
more children which will increase the supply of workers, which in turn will bring wages down to the
subsistence level. It can be shown with the help of the following figure:

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In Fig. 1 demand and supply of labour has been measured on OX-axis and wage rate on OY-axis. OW is
the subsistence level of wages. At OW wage rate supply of labour is perfectly elastic. Since, supply of
labour is perfectly elastic, wage rate neither can fall below OW nor can increase above the level of OW.
Although demand increases from DD to D1D1 yet the wage rate remains the same at OW.

Criticism:

1. One Sided Theory: This theory examines the wage determination from the side of supply and ignores
the demand side.

2. Pessimistic: Subsistence theory of wages is highly pessimistic for the working class. It presents a dark
picture of the future of the society.

3. Long Period: This theory is based on the assumption of long run. It does not explain the
determination of wages at a particular period of time.

4. No Historical Evidence: This theory has been criticized on the grounds that it has not been correct in
conclusions. The case of western countries is different from the conclusions of this theory.

5. No Difference in Wages: This theory explains that all the workers get equal wages. As we know, the
workers differ in their productivity, and hence, the difference in their wages is natural.

B. Marginal Productivity Theory of Wages:

Marginal productivity theory of wages is an important theory of wages. This theory was first of all
propounded by Thunnen. Later on, economists like Wicksteed, Walras, J.B Clark etc. modified the
theory. The marginal productivity theory states that labour is paid according to his contribution in
production. A producer hires the services of labour because he possesses the ability to contribute in
production. If worker contributes more to production he is paid more wages and if he contributes less,
w ages also will be low.

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“Marginal productivity of labour refers to change in total revenue by putting one more labourer,
keeping all the other factors constant.” Dooley

“As a result of competition between employees for labour and between workers for employment, a
wage-rate is determined that is equal to the marginal productivity of the labour-force, the employers as
a whole are willing to employ.” Prof. S.E. Thomas

“The marginal productivity theory contends that in equilibrium each labourer will be rewarded in
accordance with its marginal productivity”.

Assumptions: The marginal productivity theory of wages is based on certain assumptions as stated
below:

1. All labourers are equally efficient.

2. Constant technology

3. Perfect competition prevails both in factor and product markets.

4. There is full employment in the economy.

5. Law of diminishing marginal returns apply on the marginal productivity of labour.

6. Labour is perfectly mobile.

Explanation of the Theory:

Under the conditions of perfect competition, wages are determined by the value of marginal product of
labour. Marginal product of labour in any industry refers to the amount by which output increases when
one more labour is employed.

Value of marginal product of labour is the price which the marginal product can fetch in the market.
Under the conditions of perfect competition, an employer will go on employing more labourers but, due
to the operation of the law of diminishing returns, the marginal product of labour will diminish until a
point comes when the value of the increase in the product will be equal to the wages paid to that
labourer.

The marginal productivity theory can be explained with the help of the following figure:

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In Fig. 2 number of labourers is measured on OX-axis and wage rate on OY-axis. ARP and MRP are
average revenue productivity and marginal revenue productivity curves respectively. The equilibrium
wage rate will be determined at a point where both the ARP and MRP are equal to each other.

In the figure, the equilibrium wage rate (OW) is determined at point E because at this point both the
ARP and MRP are equal. The firm at OW wage rate will employ OX number of labourers. If the firm
employs more workers than OX, it will have to face more losses or fewer profits. Therefore, the ideal
situation for a firm is to employ workers up to the point where ARP and MRP are equal.

Why Marginal Productivity Theory is Most Satisfactory:

Here we may compare the Marginal Productivity Theory with the earlier classical theories.

The Marginal Productivity theory is an improvement over the earlier theories in the following ways:

(i) This theory is not as rigid as the subsistence level theory and other classical theories.

(ii) It takes into consideration the demand for labour by the employers and the supply of labour,
although in an indirect form.

(iii) It shows why there are differences in wage rate. Wages according to this theory vary because of
marginal productivity differences of different workers.

(iv) It gives importance to the productivity of labour.

Criticism:

The marginal productivity theory of wages also suffers from certain defects as:

1. Unrealistic Assumptions: The foremost defect of the theory is that it is based on unrealistic
assumptions like perfect competition, homogeneous character of labour etc. All these assumptions do
not prevail in the real world.

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2. Incomplete: Again, this theory fails to take into account that labour is also a function of wages. Less
productivity may be the effect of low wages which adversely affects the efficiency of labour and in turn
reduces the labour productivity. Thus, the theory is incomplete in all respects.

3. Static Theory: Lord J.M Keynes criticized the theory as it is based on static conditions. It is only true
when there occurs no changes in the economy. But in real practice it cannot be so. Change is the law of
nature, though it may come gradually.

4. One Sided: The marginal productivity theory is one sided. It takes into consideration only the demand
side and ignores the supply side.

5. Fails to determine Wages: This theory only guides the employer to employ workers up to the level
where their marginal productivity equals price. But, it does not tell how the wages are determined.

6. Long Period: The theory concerns itself with the long run. It explains that wages will be equal to MRP
and ARP in the long run but, the long run like tomorrow never comes. In other words, it does not deal
with the short-run.

C. Modern Theory of Wages: Modern theory of wages regards wages as a price of labour and all other
prices determined by the usual supply and demand analysis. According to this approach, wages are
determined by the interaction of market forces of demand and supply.

Demand for Labour: The demand for labour comes from the entrepreneurs as it is used for the
production of goods and services. Thus, the demand for labour depends upon the productivity of labour
i.e., the higher the productivity of labour, the greater will be the demand for it from employers. Thus,
demand for labour depends upon the marginal productivity of labour; since the marginal productivity of
labour will slope downwards after a stage, the demand curve of labour will also slope downward.

Factors Affecting the Demand for Labour:

1. Technological Changes: Technological changes influence the marginal productivity of labour.

Therefore, these changes also influence the demand for labour.

2. Derived Demand: Demand for labour is a derived demand. It means that demand for labour depends
upon the demand for goods and services which it produces. If at any given time the demand for a
particular commodity produced by the labour is high, it is natural that the demand for labour shall also
be high. Hence, the greater is the consumer demand for the product, the higher will be the demand for
the labour to produce that commodity.

3. Proportion of Labour: The demand for labour also depends upon the proportion in which labour is
mixed with other factors of production. When a small amount of labour is engaged in the production of
a product, the demand for that type of labour is inelastic. For instance, the demand for labour for
operating automatic machines or latest machines in large scale factories is inelastic.

4. Cost of other Factors: The demand for labour depends upon the cost of other factors of production
which can be used as substitute for labour. If substitute factors are costly, the entrepreneur will
naturally substitute labour in place of costly factor.

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In such a case the demand for labour will be high. If the prices of substitute factors which can be used in
place of labour have declined, the substitute factor will be used in place of labour. Hence, the demand
for labour will decline.

This can be shown with the help of Fig. 3:

In Fig. 3 number of labourers has been measured on OX-axis and the wage rate on Y-axis. DD is the
industry’s demand curve. It slopes downward from left to right indicating that when wages are low,
demand for labourers increases and when the wage rate tends to increase, demand for labour
decreases.

Supply of Labour: Supply of labour in an economy depends upon both economic as well as non-
economic factors. Economic factors influencing the supply of labour comprises of existing employment,
desire to increase monetary income, bargaining power of the labourers, size of population, income
distribution etc. while the non-economic factors consist of family affection, social conditions, domestic
environment etc.

Psychological factors also affect the supply of labour. It is only due to the psychological factors that a
worker decides how much time he should devote to work and how much to leisure. Moreover, the
supply of labour also depends on the elasticity.

The supply of labour for a firm is perfectly elastic, so, the firm at current wages can employ as many
workers as it wishes. On the contrary the nature of supply of labour for an industry is not infinitely
elastic. Thus, it cannot employ more and more labourers at the current wage rate. The industry can do
so by attracting labourers from other industries by offering them higher wages. Following diagram clears
this point more vividly.

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In Fig. 4 hours supplied has been taken on X-axis and wages on Y-axis. SS is the backward bending supply
curve. OW relates to the initial wage rate. When the wage rate is OW’, the hours supplied are OX1. The
maximum working hours are OX at wage rate OW. Now suppose the wage rate increases to OW”, in that
case hours supplied will decrease to OX1. Thus, we may conclude that like other factors of production,
supply curve of labour is also upward sloping from left to right.

Factors Affecting Supply:

1. Size of Population: The supply of labour depends upon several factors. In the first place, the supply at
any given time depends upon the number of labourers in the country. This, in itself is a result of the size
of population and that proportion of this population which is called working population.

The size of population is determined by the difference in birth rate and the death rate. The proportion
of total population which is called working population depends upon occupational distribution, level of
technical advancement, conservation and mobility of labour.

2. Efficiency of Labour: The supply of labour does not merely depend upon the size of population. It also
depends upon the efficiency of labour. Efficiency depends upon several factors like hours of working,
service and working conditions, wage rates, economic incentives and other conditions that have a
bearing upon the working ability of labour.

3. Mobility of Labour: The supply of labour also depends upon the mobility of labour. If the labour is less
mobile either because the means of transport are not developed or there is conservatism among the
labourers, or because there are climatic, language or traditional hindrances, then it follows that supply
of labour shall be highly limited.

Determination of Wage Rate by Collective Bargaining

Trade union gets existence under monopolistic competition. The trade union bargains with the
employer on the issue of wage rate.

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Generally, trade unions negotiate wages to be given to labor with employers.

This process of negotiating wages is called collective bargaining.

In Figure-13, ARP represents the average net revenue productivity curve and MRP represents marginal
net revenue productivity curve. IC1, IC2, IC3, IC4, and IC5 show indifference curves at different wage
rates with respect to the satisfaction of trade unions. It can be seen from Figure-13 that an increase in
the wage rate would result in the increase of satisfaction level of trade unions.

In this case, trade union would prefer the wage rate at point P where indifference curve is tangent to
ARP. At point P, the wage rate is OW4 and number of labor is OM. In case the wage rates goes up from
OW4, then the employer would suffer losses and he/she needs to close his/her unit.

Therefore, it is not beneficial for the employer as well as for the union. This makes OW4 an upper limit
for deciding on the wage rate. According to classical economists, the wage rate can be determined by
market forces only and there is no contribution of trade unions in the increase of wages. If the trade
unions try to increase the wage rate, the employers need to reduce the number of workers.

However, according to modem economists, trade unions contribute in raising wage rates by adopting
the following measures:

i. Helps in reducing labor exploitation by ensuring that the wage rates are equal to VMP. This can be
done by increasing the bargaining power of labor by trade unions.

ii. Helps in increasing the MRP of labor through different ways, such as convincing employers to provide
new and advanced machines to labor and inculcating the values of honesty and thrift among workers.
Another way to increase MRP is by restricting the supply of labor.

iii. Reduces the supply of labor by convincing the government to pass immigration laws, reduce working
hours, and limit the entry of labor in the trade union. This is done to increase wage rates.

iv. Helps in increasing the standard wage rates. If the standard wage rate increases, then it would
automatically increases the wage rates of labor. This is a modern method adopted by trade unions for
increasing the wage rate.

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Nominal wages vs. Real wages (Distinguish between nominal wages and real wages)

Nominal wages are paid or received in terms of money. But money wages alone do not give a correct
idea of the real earnings of a worker. In order to ascertain his real wages, we have to consider several
other factors. The term 'real wages' is applied to the total amount of necessaries, comforts, and other
facilities which a worker may enjoy by working at a job. The term 'nominal wage', however, simply refers
to the amount of money that a worker may be getting. In order to determine the "real wage" of a
worker, we must make an allowance for the following factors determining real wages:

(i) Purchasing Power of Money. When comparing wages from place to place and from time to time,
changes in the purchasing power of money must be taken into account. Three hundred rupees per
month in a village may give a much more comfortable life than a similar amount in a town, where
certain necessaries of life may be very dear. Three hundred rupees in 1970 had much greater purchasing
power than they have today. Therefore, even an increase of money wage may leave real wages behind if
the increase is not proportionate to a rise in the price level.

(ii) Subsidiary Earnings. In order to find the real earnings of a worker we should not only consider his
salary but we must also take into consideration any extra earning 'hat he may be able to make. For
example, a professor can make extra money from tuition work, from examinership, and from writing
books. A worker in a vegetable garden or in a dairy farm may be supplied free vegetables and free milk
respectively. We must add to his salary the money value of these facilities which he gets free. A
Government employee may be provided with free quarters. The rent of the quarter must be added to
his nominal salary to get an idea of his total earnings. Who does not know that a patwari or a sub-
inspector of police is able to make much more money over and above his salary? Thus, we are not
merely to be guided by the salary of a person. We must also consider possibilities of extra earnings or of
other advantages that a worker enjoys in that employment.

(iii) Extra Work Without Extra Payment. Just as a worker may be able to supplement his wage by
working in spare hours, which means an addition to his wage, similarly, there are some workers who are
expected to work for their employers in extra time without being paid anything. It is very common that
peons have to work at the homes of their officers without getting any payment.

Money value of this service must be calculated and deducted from their nominal salary in order to find
out what they really earn.

(iv) Regularity or Irregularity of Employment. Regular work, even if it is low paid, is preferred to
irregular work with high rates of wages. It is much better for a worker to earn Rs. 6 a day regularly
instead of getting Rs. 10 per day but working only half the month. Hence, the need to distinguish
between wage-rates and earnings.

(v) Conditions of Work. In order to estimate the real earnings of a worker, we must make an allowance
for the conditions under which he has to work. For if the work is agreeable, pleasant and respectable,
even a lower salary may be considered much better than when the work is disagreeable and it has to be
performed under irksome conditions.

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From this point of view, a professor's job is much better; there is a greater amount of leisure, the job is
quite respectable and the constant association with the youth is so pleasant. It is not surprising that
people with similar qualifications or even with less qualification is able to get nearly double their salary
in some other departments after putting in almost the same number of years of service.

(vi) Future Prospects. A low money wage would be considered a high real wage if there are good
prospects of a rise in the future. On the other hand, a high initial salary may not be considered as good
in the absence of prospects for a further rise,

Q. Why the labour - supply curve is backward bending?

In economics, a backward-bending supply curve of labour, or backward-bending labour supply curve, is a

graphical device showing a situation in which as real, or inflation-corrected, wages increase beyond a
certain level, people will substitute leisure (non-paid time) for paid work time and so higher wages lead
to a decrease in the labour supply and so less labour-time being offered for sale.

Diagram of Backward Bending Supply Curve

The reason is that there are two effects related to determining supply.

The Substitution effect states that a higher wage makes work more attractive than leisure. Therefore,
supply increases.

The income effect states that a higher wage means workers can achieve a target income by working less
hours. Therefore, because it is easier to get enough money they work less.

When your wage is low, the substitution effect dominates. As wages increase, the income effect starts
to dominate.

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Factor Pricing - Interest and Profit

Q. What is normal Profit? Discuss the arguments in favour of and in against the policy of profit
maximisation objective of a business firm. Distinguish between Accounting Profit and Economic Profit.

Normal profit

In markets which are perfectly competitive, the profit available to a single firm in the long run is called
normal profit. This exists when total revenue, TR, equals total cost, TC. Normal profit is defined as the
minimum reward that is just sufficient to keep the entrepreneur supplying their enterprise. In other
words, the reward is just covering opportunity cost - that is, just better than the next best alternative.

The accounting definition of profits is rather different because the calculation of profits is based on a
straightforward numerical calculation of past monetary costs and revenues, and makes no reference to
the concept of opportunity cost. Accounting profit occurs when revenues are greater than costs, and not
equal, as in the case of normal profit.

To the economist, normal profit is a cost and is included in total costs of production.

Arguments in Favor of Firms Profit Maximization Objective

Profit maximization is the most important assumption, which helps the economists to introduce the
price and production theories. The traditional economic theory assumes that the profit maximization is
the only objective of business firms. According to this theory, profits must be earned by business to
provide for its own survival, coverage of risks, growth and expansion. It is a necessary motivating force
and it is in terms of profits that the efficiency of a business is measured. It forms the basis of
conventional price theory. Profit maximization is regarded as the most reasonable and analytically the
most productive business objective.

The profit maximization assumption in this theory helps in predicting the behavior of business firms and
also the behavior of price and out pet under different market conditions. No alternative hypothesis or
assumption explains and predicts the behavior of firms better than the profit maximization assumption.

The traditional theory supports the profit maximization hypothesis also on the following grounds:

• Profit is essential for survival of a business: The survival of all the profit oriented firms in the
long run depends on their ability to make a reasonable profit depending on the business
conditions and the level of competitor. Profit is the biggest incentive for work. It is the driving
force behind the business enterprise. It encourages a man to work to do the best of his ability
and capacity. Making a profit is a necessary condition for the survival of the firm. Once the firms
are able to make profit, they try to maximize it.

• Achieving other objectives depends on the ability of a business to make profit: Many other
objectives of business are maximization of managerial utility function, maximization of long-run

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growth, maximization of sales revenue. The achievement of such alternative objectives depends
wholly or partly on the primary objective of making profit.

• Profit maximization objective has a greater predicting power: As compared to other business
objectives, profit maximization assumption has been found to be good in
predicting certain aspects related to a business. Milton Friedman supports this by saying that
the profit maximization is considered to be good only if it predicts the business behavior and the
business trends correctly.

• Profit is a more reliable measure of efficiency of a business: Thought not perfect, profit is the
most efficient and reliable measure of the efficiency of a firm. It is also the source of internal
finance. The recent trend shows a growing dependence on the internal finance in
the industrially advanced countries. In fact, in developed countries, internal sources of finance
contribute more than three-fourths of total finance. Keeping this in mind, it can be said that
profit maximization is a more valid business objective.

In practice, however, firms have been found to be pursuing objectives other than profit maximization.
For the large business firms, pursuing goals other than profit maximization is the distinction between
the ownership and management. The separation of management from the ownership gives managers an
opportunity to set goals for the firms other than profit maximization. Large firms pursue goals such as
sales revenue maximization, maximization of managerial utility function, maximization of firm’s growth
rate, making a target profit, retaining market share, building up the net worth of the firm, etc.
Secondly, traditional theory assumes perfect knowledge about current market conditions and the future
developments in the business environment of the firm. Thus a business firm is fully aware of its demand
and cost functions in both short and long runs. The market conditions are assumed to be certain. On the
contrary, it is also recognized that the firms do not possess the perfect knowledge of their costs,
revenue, and their environment. They operate in the world of uncertainty. Most of the price and output
decisions are based on probabilities.

Criticisms Or Drawbacks Of Profit Maximization Objectives

Although profit maximization objective is widely known objective of a firm, some theorists have raised
doubts on the validity of this objective. They have criticized the profit maximization objective on the
following grounds:

1. The profit maximization objective ignores the timing of returns. It equates a dollar received today
with a dollar received in the future. In fact, $ 100 today is valued more than $ 100 received after one
year. It is because the money received in earlier period may be reinvestable to earn more.

2. The critics of profit maximization objective argue that it ignores the risk associated with stream of
cash flow of the project. For example, the total profit from two projects may be same but the profit
from one project may be fluctuating widely than the profit from the other project. The firm with wider
fluctuation in profit is riskier. This fact is ignored by profit maximization objective.

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3. The profit maximization objective has greater relevance to a perfectly competitive firm than to a
monopoly firm. Critics argue that a monopoly firm would be earning super normal profit more or less
automatically.

4. Today large-scale corporate type of organizations exist. Different stakeholders such as owners,
managers, customers, creditors, and employees are directly connected with the organization. The
interest of each member in this organizational collusion cannot be achieved with the sole objective of
profit maximization.

5. The profit maximization objective of the firm has greater relevance to short-run. In long-run, a firm
cannot survive with this objective.

6. If all firms keep profit maximization as the primary objective, they may commit unfair practice to
maximize profit.

Accounting vs Economic Profit

Many people think that profit is the revenue one gets after the costs have been deducted, but many of
us are not aware that there are two kinds of profits ‘“ accounting profits and economic profits. Well, the
two profits ‘“ economic and accounting -have certain differences between them.

Accounting profit is the difference between the total revenue and the total cost, excluding the cost of
the opportunity. On the other hand, economic cost is the difference between the total revenue and the
total cost, including the cost of the opportunity.

Economic profit is obtained when the revenue exceeds the opportunity’s cost. On the contrary, a firm
can be said to have accounting profits if the revenue exceeds the accounting cost of the firm. In other
words, accounting profit can be referred to as the revenue obtained by a firm after all the economic
costs are met.

One of the differences that can be seen, is that the economic profit will always be lesser when
compared to accounting profits. When compared to economic profit, the accounting profits are only
given during leap years.

When considering accounting profits, it is defined as the revenue deducted from the explicit costs, and
economic profits, as the revenue deducted from explicit and implicit costs.

When calculating accounting profits, the things that are considered include leased assets, non-cash
adjustments/transactions for depreciation, provisions, allowances, and capitalising development costs.
When calculating economic profits, several things, like opportunity costs, residual value, inflation level
changes, tax rates, and interest rates on cash flow, are taken into account.

When compared to economic profits, accounting profit is calculated for a certain period of time.

Summary:

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1. Accounting profit is the difference between the total revenue and the total cost, excluding the cost of
the opportunity. On the contrary, economic cost is the difference between the total revenue and the
total cost, including the cost of the opportunity.

2. Accounting profit can be defined as the revenue deducted from the explicit costs, and economic
profits, as the revenue deducted from explicit and implicit costs.

3. When compared to economic profits, accounting profit is calculated for a certain period of time.

4. Economic profit will always be lesser when compared to accounting profits. In comparison with
economic profit, the accounting profit is only given during leap years.

5. Accounting profit can be called as the revenue obtained by a firm after all the economic costs are
met. A firm can be said to have accounting profits if the revenue exceeds the accounting cost of the
firm.

Q. Define interest. Briefly discuss the liquidity Preference Theory of interest rate determination.
Distinguish between Gross interest and Net interest.

Interest is payment from a borrower or deposit-taking financial institution to a lender or depositor of an

amount above repayment of the principal sum (i.e. the amount borrowed). It is distinct from a fee which
the borrower may pay the lender or some third party.

For example, a customer would usually pay interest to borrow from a bank, so they pay the bank an
amount which is more than the amount they borrowed; or a customer may earn interest on their
savings, and so they may withdraw more than they originally deposited. In the case of savings, the
customer is the lender, and the bank plays the role of the borrower.

Interest differs from profit, in that interest is received by a lender, whereas profit is received by the
owner of an asset, investment or enterprise. (Interest may be part or the whole of the profit on an
investment, but the two concepts are distinct from one another from an accounting perspective.)

In economics, the rate of interest is the price of credit, and it plays the role of the cost of capital. In a
free market economy, interest rates are subject to the law of supply and demand of the money supply,
and one explanation of the tendency of interest rates to be generally greater than zero is the scarcity of
loanable funds.

The Liquidity Preference Theory was propounded by the Late Lord J. M. Keynes.

According to this theory, the rate of interest is the payment for parting with liquidity.

Liquidity refers to the convenience of holding cash. Everyone in this world likes to have money with him
for a number of purposes. This constitutes his demand for money to hold.

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The sum-total of all individual demands forms the demand for money for the economy. On the other
hand, we have got a supply of money consisting of coins plus bank notes plus demand deposits with
banks. The demand and supply of money, between themselves, determine the rate of interest.

Motives for Liquidity: Money may be demanded to satisfy a number of motives.

These are:

(i) Transactions Motive: We get income only periodically. We must keep some money with us till we
receive income next, otherwise how can we carry on transactions? Transactions motive also includes
business motive. It takes some time before the businessman can sell his product in the market. But he
must pay wages to the workers, cost of raw material, etc., now. He must keep some cash for the
purpose.

(ii) Precautionary Motive: Everyone lays by something for a rainy day. Some money must be kept to
meet unforeseen situations and emergencies.

(iii) Speculative Motive: Future is uncertain. Rate of interest in the market continues changing. No one
can guess what turn the change will take. But everybody hopes, and with confidence, that his guess is
likely to be correct. It may or may not be so. Some money, therefore, is kept to speculate on these
probable changes to earn profit.

Interest-rate Determination: Money demanded for all these motives or purposes constitutes demand
for money, or liquidity preference. Liquidity preference means how much cash people like to keep with
them at a particular time. The higher the liquidity preference, given the supply of money, the higher will
be the rate of interest; and vice versa. Further, given the liquidity preference, the larger the supply of
money, the lower will be the rate of interest, and the smaller the supply of money, the higher the rate of
interest.

According to Keynes, the demand for money, i.e., the liquidity preference, and supply of money
determine the rate of interest. It is in fact the liquidity preference for speculative motive which along
with the quantity of money determines the rate of interest.We have explained above the speculative
demand for money. As for the supply of money, it is determined by the policies of the Government and
the Central Bank of the country. The total supply of money consists of coins plus notes plus demand
deposits with banks.

We see, thus, that according to liquidity preference theory, the rate of interest is purely a monetary
phenomenon. Productivity of capital has very little, though indirect, say in determining the rate of
interest. How the rate of interest is determined by the equilibrium between the liquidity preference for
speculative motive and the supply of money is shown in Fig. 34.4.

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In part (a) of the figure, LPS is the cur of liquidity preference for speculative motive. In other words, LPS
curve shows the demand for money for speculative motive. To begin with, OM2 is the quantity of money
available for satisfying liquidity preference for speculative motive. Rate of interest will be determined
where the speculative demand for money is in balance with, or equal to, the (fixed) supply of money
OM.2It is clear from the figure that speculative demand for money is equal to OM2quantity of money at
or rate of interest. Hence or is the equilibrium rate of interest.

Assuming no change in expectations, an increase in the quantity of money (via open-market operations)
for the speculative motive will lower the rate of interest. In part (a) of the figure, when the quantity of
money increases from OM1 to OM2, the rate of interest falls from Or to Or’, because the new quantity of
money OM’; is in balance with the speculative demand for money at Or’ rate of interest. In this case, we
move down the LPS curve. Thus, given the schedule or curve of liquidity preference for speculative
motive, an increase in the quantity of money brings down the rate of interest.

It is worth mentioning that shifts in liquidity preference schedule or curve can be caused by many other
factors which affect expectations and might take place independently of changes in the quantity of
money by the Central Bank. Shifts in the liquidity preference curve may be either downward or upward,
depending on the way in which the public interprets a change in events.

If some change in events leads the people on balance to expect a higher rate of interest in the future
than they had previously anticipated, the liquidity preference for speculative motive will increase, which
will bring about an upward shift in the curve of liquidity preference for speculative motive and will raise
the rate of interest.

In part (b) of Fig. 34.3, assuming that the quantity of money remains unchanged at OM 2, with the rise of
the liquidity preference curve from LPS to L’P’S’, the rate of interest rises from Or to Or”, because at Or”,
the new speculative demand for money is in equilibrium with the supply of money OM2. It is worth
noting that when the liquidity preference speculative motive rises from LPS to L’P’S’, the amount of
money hoarded does not rise; it remains as OM; as before. Only the rate of interest rises from Or to Or”

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to equilibrate the new liquidity preference for speculative motive with the available quantity of money
OM 2.

Thus, we see that Keynes explained interest in terms of purely monetary forces and not in terms of real
forces like productivity of capital and thrift, which formed the foundation-stones of both classical and
loanable fund theories. According to him, demand for money for speculative motive together with the
supply of money determines the rate of interest.

Moreover, according to Keynes, interest is not a reward for saving or thriftiness or waiting, but for
parting with liquidity. Keynes asserted that it is not the rate of interest which equalises saving and
investment, but this equality is brought about through changes in the level of incomes.

Criticism: Keynes’s theory, too, has come in for considerable criticism:

(i) Firstly, it has been pointed out that the rate of interest is not a purely monetary phenomenon. Real
forces like productivity of capital and thriftiness also play an imp i.ant role in the determination of the
rate of interest.

(ii) Keynes makes the rate of interest independent of the demand for investment funds. In fact, it is not
so independent. The cash-balances of the businessmen are largely influenced by their demand for
savings for capital investment. The demand for capital investment depends upon the marginal revenue
productivity of capital. Therefore, the rate of interest is not determined independently of the marginal
productivity of capital or marginal efficiency of capital, as Keynes calls it.

(iii) Liquidity preference is not the only factor governing the rate of interest. There are several other
factors which influence the rate of interest by affecting the demand for and supply of investable funds.

(iv) This theory does not explain the existence of different rate of interest prevailing in the market at the
same time.

(v) Keynes ignores saving or waiting as a source or means of investible funds. To part with liquidity
without there being any saving is meaningless.

(vi) The Keynesian theory explains interest in the short run only. It gives no clue to the rates of interest
in the long run.

(vii) Finally, exactly the same criticism applies to Keynesian theory itself on the basis of which Keynes
rejected the classical and loanable funds theories. Keynes’s theory of interest, like the classical and the
loanable funds theories, is indeterminate.

According to Keynes, the rate of interest is determined by the speculative demand for money and the
supply of money available for satisfying speculative demand. Given the total money supply, we cannot
know how much money will be available to satisfy the speculative demand for money unless we know
how much the transactions demand for money is; and we cannot know the transactions demand for

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money unless we first know the level of income. Thus, the Keynesian theory, like the classical, is
indeterminate.

“In the Keynesian case the supply and demand for money schedules cannot give the rate of interest
unless we already know the income level; in the classical case the demand and supply schedules for
savings offer no solution until the income is known. Precisely the same is true of loanable-funds theory.
Keynes’s criticism of the classical and loanable-funds theories applies equally to his own theory.”—
Hansen.

difference between Gross interest and net interest

In common language interest is a payment made by a borrower to the lender for the use of money
usually stated as per. cent per year. But economics interest is defined differently by different
economists. According to wick sell interests is "a payment made by the borrower of capital by virtue of
its productivity as a reward for his abstinence." According to Keynes interest is a monetary
phenomenon.

It is the reward for parting with liquidity. The whole amount paid by a borrower to the lender for the use
of borrowed fund is known as interest. A lender who receives interest not only receives rewards on
capitalize but also rewards for other factors. The payment which is paid exclusively for the use of capital
is known as net interest.

Net interest is otherwise known as pure interest. Thus Gross interest is a wider concept in which net
interest is a part. Besides net interest Gross interest includes many elements. There elements are
reward for risk taking wages of management and payment for inconveniences.Net interest is a payment
for the loan of capital, when no risk, no inconveniences and no work is entailed on the lender.

Net interest=Payment for the use of capital

Gross interest=Net interest + reward for risk + reward for inconvenience + reward for management.

Difference in interest rates:

The rate of interest at which supply of and demand for capital interest each other is known as
equilibrium rate of interest. This is single uniform rate of interest prevailing in the market. But what is
seen in the market that are various rates of interest prevailing in the market. Different borrowers pay
different interests on the loan. Some pay higher interests than others.

Thus in the market we find a number of interest rates centering round the equilibrium rate of interest.
The rates vary from person to person from place to place and from time to time. Interest rate may be
different for different borrowers. For example a big industrialist gets loan at a very nominal rate
whereas a farmer has to pay a very high rate of interest on the borrowed amount.

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It may be seen that rate of interest income part of country is higher than the other parts. It. also varies
with time a long term loan fetches a very nominal rate of interest where as short term loans or
borrowing claims a higher rate of interest. Below are discussed some of the important causes for the
differences in the rates of interest.

(i) Difference in risks: Interest rates differ due to the difference in risks involved in various investments.
Lending always involves risks. The degree of vary in different investments. When a loan is advanced the
lender can't be sure of a smooth and timely repayment of interest d principle. The risks may be personal
or trade. A man may become poor due to misconduct and prodigality. He wills not eligible repay the
borrowed amount on the other hand due to fall in and the trade may suffer losses. In such a case the
business n in spite of his honesty and worthiness may not able to repay, us the greater risk involved the
higher will be the rate of interest the less the risk the lower will be the rate of interest. Thus gross
interest is higher loss depends on the risks involved in the investment in which money is utilized.

(2) Differences in Distances:- Rate of interest may vary in two different places because of the distance.
Lenders may fear to lend in different distant places because of the psychological fear of non-repayment.
That is why mobility of capital is inhibited. This results in over supply, of loan able funds in some areas
and in some places there will be scarcity supply of capital. Thus the rate of interest will be naturally high
in the area where capital fund is short. Thus on the basis of supply and demand conditions rate of
interest varies.

(3) Duration of Maturity:- The length of period or duration of loan (term) also affects rate of interest.
The rate of interest charged on short term lending or long term loan. The Govt, of a country borrows
loans for a longer period with a view to boost up economic development. In such a loan the Govt, avails
of the loan with higher interest. But loans for duration of one year or some months carry a lower rate of
interest.

4. Liquidity of Security:- A Loan is advanced against some securities. These securities may be either
more liquid or less liquid. Liquidity means shift ability without loss. A financial asset that can be
converted into cash money quickly and without any penalty is called a liquid asset. This liquidity is also a
cause of the differenced in interest rate. The greater the liquidity of an asset, the lower the rate of
interest, and the lower the liquidity, the lower the rate of interest. Securities in the form of Govt bonds
and bills of exchange and Treasury bill are highly liquid. As against them, landed property, buildings are
less liquid as they can't be shifted eerily.

(5) Size of loan:- The rate of interest also varies with the size of the loans. A loan of a smaller amount
carries lower of interest than the loan of a higher amount given the duration and risks involved. For
example a vehicle loan up to 2lakhs carries 18% of rate of interest but up to 4 lakhs the rate of interest is
20%.

(6) Productivity of Capital Interest rate varies with the productive of capital. If the marginal productivity
of capital is high, the rate of interest will higher.

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(7) Tax treatment:- Rate of interest on different types of loan also depends on the exemption tax. For
example some bonds floated by gout and other put enterprise allow income tax exemption. In such a
case the rich people buy bonds (lends) even at a lower interest rates. Then a rich man having larger
income prefer 5% per cent interest rate on tax-exempt bond to 10% present interest rate on a bond of a
private company.

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