Module No 2:

Role of
Government and
RBI
• Role of Government and RBI in Money, Banking, Households, Firms
• Economies and diseconomies of scale
• Market Structure
• Fiscal Policy
• Monetary Policy
• Economic Growth
• Causes and consequences of recession
• Causes of economic growth
• Measurement of economic growth inflation and deflation
• Living standards, indicators of living standards
Role of Government and RBI in
Money, Banking, Households, Firms
• The role of the Government and the Reserve Bank of India (RBI) in the economy,
particularly in money, banking, households, and firms, is crucial for maintaining
financial stability, promoting growth, and ensuring efficient functioning of the
economy.
• 1. Role of the Government
• The government plays a key role in regulating and overseeing the overall
economy, creating policies, and ensuring the welfare of households and firms. Its
role in money, banking, households, and firms can be understood as follows:
• In Money
• Monetary Policy and Regulation: The government, in collaboration with the RBI,
sets the framework for monetary policy, which influences the supply of money in
the economy, interest rates, and inflation control. It decides the fiscal policies
which impact taxation, spending, and government borrowing, indirectly affecting
the money supply.
• Currency Issuance: The government, through the RBI, is responsible for issuing
and controlling the country’s currency, ensuring that the economy has an
adequate supply of money.
• In Banking
• Regulation and Supervision: The government establishes the legal and regulatory
framework within which banks operate. For example, it sets rules for the
licensing, capital adequacy, and operations of banks, which the RBI enforces. This
ensures stability and transparency in the banking system.
• Public Sector Banks: The government owns and controls a large number of public
sector banks, which play a major role in financial inclusion by providing services
to underserved regions and sectors of society.
• In Households
• Welfare Policies: The government implements welfare policies such as subsidies,
income support programs, and pension schemes. These policies aim to improve
the financial well-being of households, especially vulnerable groups.
• Income and Wealth Redistribution: Through taxation and welfare schemes (like
the direct benefit transfer system), the government redistributes income, helping
lower-income households.
• In Firms
• Economic Stimulus and Support: The government provides incentives, subsidies,
and stimulus packages to businesses, especially in key sectors like agriculture,
manufacturing, and technology. It can also ease regulations to foster business
growth.
• Taxation and Regulation: The government sets corporate tax rates, compliance
standards, and regulations on business operations, impacting how firms function
and invest.
• 2. Role of the Reserve Bank of India (RBI)
• The RBI plays a central role in the financial system, acting as the primary
monetary authority and ensuring the stability and efficiency of banking systems.
The RBI’s role in money, banking, households, and firms includes the following:
• In Money
• Monetary Policy: The RBI controls money supply through the formulation and
implementation of monetary policies, primarily through instruments like the repo
rate, reverse repo rate, and open market operations. These policies help control
inflation, stabilize currency, and ensure adequate liquidity in the economy.
• Currency Management: The RBI is responsible for the design, production, and
management of India’s currency, ensuring there is an appropriate supply of
money in circulation for economic activity.
• In Banking
• Bank Regulation and Supervision: The RBI supervises commercial and
cooperative banks to ensure they follow sound banking practices. This includes
setting guidelines on capital adequacy, liquidity requirements, and maintaining
the stability of the financial system.
• Lender of Last Resort: In times of financial crises, the RBI acts as a lender of last
resort to banks facing liquidity shortages, providing them with funds to maintain
stability.
• In Households
• Financial Inclusion: The RBI promotes financial inclusion by encouraging banks to
extend services to the underserved and rural areas. It has introduced initiatives
like the Pradhan Mantri Jan Dhan Yojana, which aims to provide households with
access to banking services.
• Interest Rates and Inflation Control: The RBI’s monetary policy impacts interest
rates, which influence household borrowing and saving decisions. By managing
inflation, the RBI also helps preserve the purchasing power of households.
• In Firms
• Credit Availability: The RBI influences the availability and cost of credit for firms
through its monetary policy actions. By adjusting key rates, it can make credit
cheaper or more expensive, directly impacting firms' investment decisions.
• Bank Lending Norms: The RBI sets guidelines for banks on how to assess
creditworthiness, which affects the lending process to firms. It also ensures that
banks are not overly exposed to risky sectors.
Decision making units and the
circular flow model
• There are three decision making units in a closed economy. These are
households, firms and the government.
• i) Household: A household can be one person or more who live under one roof
and make joint financial decisions. Households make two decisions.
• Selling of their resources, and
• Buying of goods and services.
• ii) Firm: A firm is a production unit that uses economic resources to produce
goods and services. Firms also make two decisions:
• Buying of economic resources
• Selling of their products.
• iii) Government: A government is an organization that has legal and political
power to control or influence households, firms and markets. Government also
provides some types of goods and services known as public goods and services
for the society.
• The three economic agents interact in two markets:
• Product market: it is a market where goods and services are transacted/
exchanged. That is, a market where households and governments buy goods and
services from business firms.
• Factor market (input market): it is a market where economic units
transact/exchange factors of production (inputs). In this market, owners of
resources (households) sell their resources to business firms and governments.
• The circular-flow diagram is a visual model of the economy that shows how
money (Birr), economic resources and goods and services flows through markets
among the decision making units.
• For simplicity, let‘s first see a two sector model where we have only households
and business firms. In this case, therefore, we see the flow of goods and services
from producers to households and a flow of resources from households to
business firms.
• In the following diagram, the clock – wise direction shows the flow of economic
resources and final goods and services. Business firms sell goods and services to
households in product markets (upper part of the diagram).
• On the other hand, the lower part shows, where households sell factors of
production to business firms through factor market. The anti – clock wise
direction indicates the flow of birr (in the form of revenue, income and spending
on consumption).
• Firms, by selling goods and services to households, receive money in the form of
revenue which is consumption expenditure for households in the product market.
• On the other hand, households by supplying their resources to firms receive
income.
• This represents expenditure by firms to purchase factors of production which is
used as an input to produce goods and services.
• We have also a three sector model in which the government is involved in the
economic activities.
• As shown in figure 1.5 below, the only difference of the three sector model from
the two sector model is that it involves government participation in the market.
• The government to provide public services purchase goods and services from
business firms through the product market with a given amount of expenditure.
• On the other hand, the government also needs resources required for the
provision of the services.
• This resource is purchased from the factor market by making payments to the
resource owners (households).
• The service provided by the government goes to the households and business
firms.
• The government might also support the economy by providing income support to
the households and subsidies to the business firms.
• At this point you might ask the source of government finance to make the
expenditures, payments and additional supports to the firms and households.
• The main source of revenue to the government is the tax collected from
households and firms.
Economies and diseconomies of
scale
• Economies of Scale and Diseconomies of Scale are concepts in economics that
describe the relationship between the size of a company and its cost structure as
it grows.
• They play a significant role in understanding how firms achieve cost advantages
or face inefficiencies as they expand their operations.
• 1. Economies of Scale
• Economies of scale refer to the cost advantages that a firm can achieve as it
increases its production level. As output rises, the average cost of production per
unit generally falls. This occurs because the firm can spread its fixed costs over
more units of output and often benefits from more efficient production
techniques or bulk purchasing.
• There are several types of economies of scale:
• Technical Economies: Larger firms can invest in more advanced machinery and
production techniques, leading to increased efficiency. For instance, a factory
that produces a high volume of goods may use automated machines that are not
cost-effective for smaller firms.
• Managerial Economies: As firms grow, they can hire specialists in various areas
(e.g., finance, marketing, human resources) rather than having one generalist
handle all tasks. This specialization improves productivity and efficiency.
• Purchasing Economies: Large firms can buy raw materials in bulk, which often
results in discounts from suppliers due to the large volume of orders.
• Financial Economies: Bigger companies often have better access to credit and
can secure loans at lower interest rates than smaller firms, reducing their cost of
capital.
• Marketing Economies: Larger firms can spread the costs of advertising and
marketing campaigns over a larger volume of sales, reducing the cost per unit.
• Network Economies: In some industries, the more users or participants in a
network (such as telecommunications or software platforms), the more valuable
it becomes to each user, and this can reduce costs for the firm per customer.
• 2. Diseconomies of Scale
• Diseconomies of scale refer to the point at which a firm becomes too large and its
average costs start to rise instead of fall. This happens when the company faces
inefficiencies due to its size and complexity, resulting in increased costs per unit
of output.
• Several factors contribute to diseconomies of scale:
• Management Complexity: As a firm grows, it becomes harder to coordinate and
manage operations efficiently. The management structure may become overly
bureaucratic, leading to slower decision-making and increased administrative
costs.
• Communication Problems: In larger organizations, communication between
departments or employees can become slower and less effective, leading to
inefficiencies, delays, and misunderstandings.
• Employee Morale: Larger firms may struggle to maintain a cohesive company
culture. Employees might feel less motivated or less connected to the company’s
goals, which can lead to decreased productivity.
• Overhead Costs: As firms expand, they often need more layers of management,
support staff, and complex infrastructure, all of which add to fixed costs.
• Decreased Flexibility: Larger firms may be less able to adapt quickly to changes in
the market or new opportunities. Their size and structure may make them less
nimble than smaller competitors, which can hurt their ability to respond to shifts
in demand.
• Operational Inefficiency: As a firm grows, it may face diminishing returns on
certain factors of production. For example, increasing the scale of a factory
beyond a certain point may lead to bottlenecks, production slowdowns, or
logistical challenges.
Market Structure
• A particular firm makes a decision to achieve its profit maximization objective.
• A firm‘s decision to achieve this goal is dependent on the type of market in which
it operates.
• To this effect we distinguish between four major types of markets: perfectly
competitive market, monopolistically competitive market, oligopolistic market,
and pure monopoly market.
The concept of market in
physical and digital space
• Comprehensive definition of market according to American Marketing
Association (1985) is the process of planning and executing the conception,
pricing, promotion, and distribution of goods, services and ideas to create
exchanges that satisfy individual and organizational objectives.
• So market describes place or digital space by which goods, services and ideas are
exchanged to satisfy consumer need.
• Digital marketing is the marketing of products or services using digital
technologies, mainly on the internet but also including mobile phones, display
advertising, and any other digital media.
• Digital marketing channels are systems on the internet that can create, accelerate
and transmit product value from producer to the terminal consumer by digital
networks.
• Physical market is a set up where buyers can physically meet their sellers and
purchase the desired merchandise from them in exchange of money.
• In physical marketing, marketers will effortlessly reach their target local
customers and thus they have more personal approach to show about their
brands.
• The choice of the marketing mainly depends on the nature of the products and
services.
Perfectly competitive market
• Perfect competition is a market structure characterized by a complete absence of
rivalry among the individual firms.
• A market is said to be pure competition (perfectly competitive market) if the
following assumptions are satisfied.
• 1. Large number of sellers and buyers: Under perfect competition the number of
sellers is assumed to be too large that the share of each seller in the total supply
of a product is very small. Therefore, no single seller can influence the market
price by changing the quantity supply.
• Similarly, the number of buyers is so large that the share of each buyer in the
total demand is very small and that no single buyer or a group of buyers can
influence the market price by changing their individual or group demand for a
product.
• Therefore, in such a market structure, sellers and buyers are not price makers
rather they are price takers, i.e., the price is determined by the interaction of the
market supply and demand forces.
• 2. Homogeneous product: Homogeneity of the product implies that buyers do
not distinguish between products supplied by the various firms of an industry.
Product of each firm is regarded as a perfect substitute for the products of other
firms. Therefore, no firm can gain any competitive advantage over the other firm.
• 3. Perfect mobility of factors of production: Factors of production are free to
move from one firm to another throughout the economy. This means that labour
can move from one job to another and from one region to another. Capital, raw
materials, and other factors are not monopolized.
• 4. Free entry and exit: there is no restriction or market barrier on entry of new
firms to the industry, and no restriction on exit of firms from the industry. A firm
may enter the industry or quit it on its accord.
• 5. Perfect knowledge about market conditions: all the buyers and sellers have
full information regarding the prevailing and future prices and availability of the
commodity.
• 6. No government interference:- government does not interfere in any way with
the functioning of the market. There are no discriminator taxes or subsidies, no
allocation of inputs by the procurement, or any kind of direct or indirect control.
That is, the government follows the free enterprise policy. Where there is
intervention by the government, it is intended to correct the market
imperfection.
• From these assumptions, a single producer under perfectly competitive market is
a price-taker.
• That is, at the market price, the firm can supply whatever quantity it would like to
sell. Once the price of the product is determined in the market, the producer
takes the price (Pm in the figure below) as given. Hence, the demand curve (Df)
that the firm faces in this market situation is a horizontal line drawn at the
equilibrium price, Pm.
Short run equilibrium of the firm
• The main objective of a firm is profit maximization. If the firm has to incur a loss,
it aims to minimize the loss. Profit is the difference between total revenue and
total cost.
• Total Revenue (TR): it is the total amount of money a firm receives from a given
quantity of its product sold. It is obtained by multiplying the unit price of the
commodity and the quantity
• of that product sold.
• TR = P X Q, where P = price of the product
• Q = quantity of the product sold.
• Average revenue (AR):- It is the revenue per unit of item sold. It is calculated by
dividing the total revenue by the amount of the product sold.
• AR = P
• Therefore, the firm‘s demand curve is also the average revenue curve.
• Marginal Revenue: it is the additional amount of money/ revenue the firm
receives by selling one more unit of the product.
• In other words, it is the change in total revenue resulting from the sale of an extra
unit of the product.
• It is calculated as the ratio of the change in total revenue to the change in the
sale of the product.
• Thus, in a perfectly competitive market, a firm‘s average revenue, marginal
revenue and price of the product are equal, i.e. AR = MR = P =Df
• Since the purely competitive firm is a price taker, it will maximize its economic
profit only by adjusting its output.
• In the short run, the firm has a fixed plant.
• Thus, it can adjust its output only through changes in the amount of variable
resources.
• It adjusts its variable resources to achieve the output level that maximizes its
profit.
• There are two ways to determine the level of output at which a competitive firm
will realize maximum profit or minimum loss.
• One method is to compare total revenue and total cost; the other is to compare
marginal revenue and marginal cost.
• Total Approach (TR-TC approach)
• In this approach, a firm maximizes total profits in the short run when the
(positive) difference between total revenue (TR) and total costs (TC) is greatest.

• Note: The profit maximizing output level is Qe because it is at this output level
that the vertical distance between the TR and TC curves (or profit) is maximized.
Monopoly market
• This is at the opposite end of the spectrum of market structures.
• Pure monopoly exists when a single firm is the only producer of a product for
which there are no close substitutes.
• The main characteristics of this market structure include:
• Single seller: A pure or absolute monopoly is a one firm industry. A single firm is
the only producer of a specific product or the sole supplier of the product; the
firm and the industry are synonymous.
• No close substitutes: the monopolist‘s product is unique in that there are no
good or close substitutes. From the buyer‘s view point, there are no reasonable
alternatives.
• Price maker: the individual firm exercises a considerable control over price
because it is responsible for, and therefore controls, the total quantity supplied.
Confronted with the usual down ward sloping demand curve for its product, the
monopolist can change product price by changing the quantity of the product
supplied.
• Blocked entry: A pure monopolist has no immediate competitors because there
are barriers, which keep potential competitors from entering in to the industry.
These barriers may be economic, legal, technological etc. Under conditions of
pure monopoly, entry is totally blocked.
• Sources of monopoly
• The emergence and survival of monopoly is attributed to the factors which
prevent the entry of other firms in to the industry. The barriers to entry are
therefore the sources of monopoly power. The major sources of barriers to entry
are:
• Legal restriction: Some monopolies are created by law in public interest. Such
monopoly may be created in both public and private sectors. Most of the state
monopolies in the public utility sector, including postal service, telegraph,
telephone services, radio and TV services, generation and distribution of
electricity, rail ways, airlines etc… are public monopolies.
• Control over key raw materials: Some firms acquire monopoly power from their
traditional control over certain scarce and key raw materials that are essential for
the production of certain other goods. e.g., Aluminum Company of America had
monopolized the aluminum industry because it had acquired control over almost
all sources of bauxite supply; such monopolies are often called raw material
monopolies.
• Efficiency: a primary and technical reason for growth of monopolies is economies
of scale. The most efficient plant (probably large size firm,) which produces at
minimum cost, can eliminate the competitors by curbing down its price for a
short period and can acquire monopoly power. Monopolies created through
efficiency are known as natural monopolies.
• Patent rights: Patent rights are granted by the government to a firm to produce
commodity of specified quality and character or to use specified rights to
produce the specified commodity or to use the specified technique of
production. Such monopolies are called to patent monopolies.
Monopolistically competitive
market
• This market model can be defined as the market organization in which there are
relatively many firms selling differentiated products. It is the blend of competition
and monopoly. The competitive element arises from the existence of large
number of firms and no barrier to entry or exit. The monopoly element results
from differentiated products, i.e. similar but not identical products.
• A seller of a differentiated product has limited monopoly power over customers
who prefer his product to others. His monopoly is limited because the difference
between his product and others are small enough that they are close substitutes
for one another.
• This market is characterized by:
• Differentiated product: the product produced and supplied by many sellers in the
market is similar but not identical in the eyes of the buyers. There is a variety of
the same product.
• The difference could be in style, brand name, in quality, or others. Hence, the
differentiation of the product could be real (eg. quality) or fancied (e.g. difference
in packing).
• Many sellers and buyers: there are many sellers and buyers of the product, but
their number is not as large as that of the perfectly competitive market.
• Easy entry and exit: like the PCM, there is no barrier on new firms that are willing
and able to produce and supply the product in the market.
• On the other hand, if any firm believes that it is not worth to stay in the business,
it may exit.
• Existence of non-price competition: Economic rivals take the form of non-price
competition in terms of product quality, advertisement, brand name, service to
customers, etc.
• A firm spends money in advertisement to reach the consumers about the
relatively unique character of its product and thereby get new buyers and
develop brand loyalty.
• Many retail trade activities such as clothing, shoes, soap, etc are in this type of
market structure.
• Oligopoly market
• This is a market structure characterized by:
• Few dominant firms: there are few firms although the exact number of firms is
undefined. Each firm produces a significant portion of the total output.
• Interdependence: since few firms hold a significant share in the total output of
the industry, each firm is affected by the price and output decisions of rival firms.
• Therefore, the distinguishing characteristic of oligopoly is the interdependence
among firms in the industry.
• Entry barrier: there are considerable obstacles that hinder a new firm from
producing and supplying the product.
• The barriers may include economies of scale, legal, controlof strategic inputs, etc.
• Products may be homogenous or differentiated. If the product is homogeneous,
we have a pure oligopoly.
• If the product is differentiated, it will be a differentiated oligopoly.
• Lack of uniformity in the size of firms: Firms differ considerably in size.
• Some may be small, others very large. Such a situation is asymmetrical.
• Non-price competition: firms try to avoid price competition due to the fear of
price wars and hence depend on non-price methods like advertising, after sales
services, warranties, etc.
• This ensures that firms can influence demand and build brand recognition.