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Module 1
Unit -1
TEN PRINCIPLES OF ECONOMICS -I
Unit Structure:
1.0 Objectives
1.1 Introduction
1.2 Principles of Individual Decision Making
1.3 Individual face trade off
1.4 Significance of opportunity cost in decision making
1.5 Rational people thin ko nt h em a r g i n
1.6 People respond to incentives
1.7 Questions
1.0OBJECTIVES
1.To stud y basic principles of economics
2.Tostudy marginal profit principle
3.To study h ow people respond to incentives
.
1.1INTRODUCTION
The word ‘Economics’ is originated from the Greek Work
‘Oikonomikos’ which can be divided into two parts.
a)‘Oikos’ which means ‘Home’ or ‘House’ and
b)Nomos means ‘Management’.
Thus in simple terms ,economics means ‘Home
Management’ or ‘Management’ of a Household.
This management becomes essentia l because our wants
are unlimited and the resources at our disposal are limited. Thus
scarcity of resources is the root cause of eco nomic problem.
Thus economics ex plains the optimum allocation of scarce
resources to satisfy as many wants as possible.
Economics deals with people and is a reflection of how
they interact with each other when they go about making
decisions regarding their lives. It explains how people make
decisions say how, when, where, what, whom ,how much to sell ,
what to buy, where to wo rk, whom to sell etc.
Basically the 10 principles are divided into there broad
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(I) (II) (III)
Principles of How How the
Decision people Economy as
Making Interact a whole works.
1.2PRINCIPLES OF DECISION MAKING
Out o f 10 principles the first four economic principles are
in principles of Individual Decision Making.
1.3PRINCIPLE 1 : INDIVIDUAL FACE TRADE OFF
(PEOPLE FACE TRADE OFF)
Trade off means a situation where we have to give up
onething in order to h ave another. Thus it is said that ‘There is
no such thing as free lunch’. Thus to ge tsomething we like we
usually have to give up something we don’t like. Thus in simple
terms to get one thing we have to sacrifice or give up another
thing.
This situatio n arises because our wants are unlimited and
the resources which are used to satisfy these wants are limited.
Now in this case we have only one plot of land. If we use
it for the school building then we have to give up or sacrifice
other alternatives i e industry agriculture, playground etc.
Society comes across several tradeoffs like toh a v eg u n s
(military goods) or Butter (civilian goods). If we spend more on
national defence to protect the country from external aggression
then we will have to spend l ess on personal goods which will
increase the std .of living of people.
Similarly for a student, if he decides to go out to watch a
film with friend then he is losing out the time for studies
In this case though you with to have both (shirt and
shoes ), you cannot have it due to limited income. Thus if you
decide to buy a shirt then you will lose shoes and vice versa.munotes.in
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Another trade -off faced by the society is between
efficiency and equality .
Efficiency means that society is getting the maximum
benefi ts from its scarce resources. Equality means that those
benefits are distributed uniformly among society’s members.
Thus efficiency refers to the size of economic pie and equality
refers to how the pie is distributed into individual slices.
When the g overnment tries to cut the economic pie into
more equal slices, the pie gets smaller. Government policies get
this conflict between efficiency and equality. For eg. Govt.
policies of unemployment insurance or welfare system will help
the mostneedy people i n the society. This will bring equality .B u t
other policies say like personal income tax, then only those who
earn more will pay more tax. More on rich, no or less on poor.
This will bring equality. But it might reduce efficiency. It is so
because when wea lth gets distributed from rich to poor then
people will feel that why to work hard and earn more. They will
work less and produce less goods and services.
Of course it does not mean what decisions they will or
should make. Society should not stop protecti ng the
environment just because environmental regulations reduce our
material std. of living or the poor should not be ignored just
because helping them disturbs the work incentives.
Nonetheless, people are likely to make good decisions
only if they under stand the options which are available to them.
Thus study of economics starts by acknowledging life’s trade -
offs.
1.4PRINCIPLE 2 : SIGNIFICANCE OF
OPPORTUNITY COST IN DECISION MAKING
Scarcity of resources forces the people to make tradeoffs.
This peopl e must always consider how to spend their limited
income or time to satisfy their unlimited wants or needs. This
decision making requires comparing the costs and benefits of
alternative uses or course of action.
Here we use the term ‘ opportunity cost ’. It means the next
best alternative given up by the factor. For e .g. The opportunity
cost of playing football today evening is perhaps the foregoing ormunotes.in
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giving up the chance to play cricket. When we eat ice -cream
then we forego or sacrifice or give up the cha nce of using that
money for some other purpose.
Let us take another example let us assume that a person
say Mr. A is having Rs. 1000/ -with him. Now he has two
options. One option is that he can keep this money in the banks
fixed deposit and earn 5% rat e of interest per annum (year). It
means he will get interest of Rs.50/-.T h eo t h e roption is that Mr
A can invest this money in some business activities which gives
him 10/ -returns (income) per year. i. e.Mr. A will earn Rs.100/-
Now Mr. A will cho ose the best. ie he will use that money
in business activity. It gives him Rs.100/-onRs.1000/ -.B u t to
remain in business activity, Mr. A has to sacrifice or forego or
give up the option of keeping in fixed deposit and earn Rs.50/-.
Thus the opportun ity cost of remaining in business is to give up
Rs.50/-.
Another example is that a person has Rs.50/-with him.
He is going to spend the income on samosa and Idli whose price
isRs.10/-per unit.
Samosa Idli
A5 0
4 1
3 2
2 3
1 4
0 5
Figure 1.1
First take point D. It shows that he will have 2 idli s(Rs.
20) + 3 samosa ( Rs.30) = Rs.50. Now if the consumer wishes
to have 4 idlis (4 x Rs.10 = 40/ -)t h e nh ew i l lh a ve to give up or
sacrifice the samosas. Now at point F, the consumer will have 4
idlis ( Rs.40/-) and only one samosa ( Rs.10) = Rs.50/-.T h u smunotes.in
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the opportunity cost of getting more idli is to sacrifice few
samosas.
Economics normally assumes that people a re rational.
Rational people systematically and purposefully do the best to
achieve their objectives. For e .g. A rational consumer tries t o
maximise his satisfaction (TU i.e. Total Utility) and the producer
tries to maximize profit rational people make the best use of
available opportunities.
1.5PRINCIPLE 3 : RATIONAL PEOPLE THINK ON
THE MARGIN
Marginal changes are small, incremental changes to an
existing plan of action.
For e .g.a student who is pondering whether she should
add one more study cours e next semester. As a rational
decision maker, she will add the extra course as long as her
marginal benefits of carrying extra course is greater than the
marginal cost of doing that course.
Let us take another example. We know that marginal
means additi onal or extra or one more or incremental etc. let us
assume that a person is producing cricket ball. Now after
producing one more c ricket ball there is some additional cost
and benefit. L et us say that the additional c ricket bats is sold at r
50/-and I’ts cost is only Rs. 20/ -Now here the person will
produce the additional cricket ball because the profit is of Rs.
30/-. But on the other hand, if the price of cr icket batfalls to Rs.
15, but the cost remain Rs.20/-only. Now it is not correct to
produce a dditional c ricket ball because the cost of making
additional ball ( Rs.20/-) is greater than the revenue which can
be earned from it ( Rs.15/-).
The cost of additional ball is called as marginal cost (MC)
and revenue obtained by selling extra ball is call ed marginal
Revenue (MR) Now if MR > MC then there is a sense in
producing additional ball.
Let us take an example of airline Company. It is about
how much the airline should charge the passengers who fly
standby, for e .g. Let us assume that the airline is flying a plane
with 100 seats. It costs Rs. 50,000/ -to the airline. Now the
average cost of each seat is Rs. 500/ -(Rs. 50,000/ -100/-). Now
we might conclude that the airline should never sell a ticket for
less than Rs. 500/ -.
But a rational firm wi ll always try to find out different ways
to increase its profit. For that it will have to think at margin.
Suppose, if the plane is about to take off with 10 empty seats
and if the standby passenger will pay less for a seat. Here themunotes.in
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airline shoul ds e l lt h e ticket at little low price. If the plane has
empty seats then the cost of adding one more passenger is very
less. Although the Ac is r 500/ -. Yet the MC is very less. Here
selling the ticket is profitable as long as the standby passenger
pays more than M C.
1.6PRINCIPLE 4 : PEOPLE RESPOND TO
INCENTIVES
Incentive is something that induces a person to act.
Incentives are the motivating forces. Incentives may be positive
or negative.
Prices act QS incentives and signals changes in price act
as ince ntives. For e .g.,if price rises t hen it acts as an incentive
to the seller to sell more. The firm may now divert the resources
from the production of low price product to the production of high
price product. It is done to get more profit. It is done to g et more
profit.
Another e .g.is of public policy towards seat belts and
auto safety. In 1960s, P alph Nader’s book. ‘Unsafe at Any
speed’ influenced the congress to pass a law which required
that the car makers must make the seat belts as standard
equipmen t on all cars. The direct effect of this law is to save
lives.
Wages also act as incentives. Increment in wage may
improve the efficiency of the labourer.
Societies where the disincentives to tax evasion are very
high will produce honest tax payers. But if the incentives to tax
evasion (i .e.n o n -payment of tax) were outweigh the incentives
to being honest, then the same tax payer will become dishonest.
If the returns on coming to the meeting on time are high then the
people will be more punctual. But if p eople get high returns on
coming late then those who come on time than the rational
individual will decide not to be punctua (will come late).
Incentives to keep small size of family wil llower birth
1.7 QUESTIONS
1.What is opportunity cost? Expla in the significance of
opportunity cost in decision making.
2.Explain ‘People respond to incentives’ .
3.Explain four principles of e conomics in individual decision
making.
4.Explain how individuals face trade off in decision making.
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Unit -2
TEN PRINCIPLE S OF ECONOMICS -II
Unit Structure: -
2.0 Objectives
2.1 How people interact
2.2 Organisation of eco nomic activities through market
2.3 Role of government in improving market outcomes
2.4 Macroeconomic instability
2.5 Growth in the quantity of money a nd inflation
2.6 Inflation and unemployment trade off
2.7 Questions
2.0 OBJECTIVES
1)To study how do people communicate with each other
2)To underst and how does whole economy work
3)To study the relationship between increase in quantity of
money and inflation
4)To study the relationship between inflation and
unemployment
2.1 HOW PEOPLE INTERACT
It includes following principles.
PRINCIPLE 5 : -INDIVIDUALS AN DN A T I O N SB E N E F I T
FROM EXCHANGE
This principl e states that trade can make ev ery one better
off. As an individual consumer we consume a variety or
products. But as a individual producer we cannot produce all the
things which we consume. So we concentrate on the production
of few and for remaining products we depend on others. Then
we fulfi ll all our wants by entering into exchange.
Adam Smith’s pointed out the basic propensity to truck,
barter and exchange. Exchange gives you benefit let us take a 2
x2x1m o d e li .e.2 countries, 2 Commodities and 1 labour
model.
Commodity x Commodity y
Country A 10 25
Country B 25 10munotes.in
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Suppose in country ‘A’ a laboures produces 10 units of
com. x and 25 units of com. y and in country B, the labourer
produces 25 units of com. x and 10 units of com y. Now instead
of producing both the goods, country A sho uld specialize in the
production of commodity y and country B must specialse in the
production of com. x and then they should exchange. In that
case both the countries will get more of x and y.
Division of labour also results in specialization and
increa ses the efficiency of labour. This will result in more
production. This higher output will be exchanged to get some
other thing which is less in supply.
2.2 PRINCIPLE 6 : -ORGANISATION OF ECONO MIC
ACTIVITIES THROUGH MARKET
Most of the time it is more e fficient to organize economic
activity through market. Market provides exchange. A variety of
goods and service are exchanged in the market. We come
across different types of markets. For e .g.
Markets can be local orglobal :-Market for groceries, market
for Marathi films in Maharashtra etc is local. Whereas market for
crude oil is international.
Market can be Physical orVirtual :Physical market is where
actual sell and purchase takes place for e .g. vegetable or fish
market in a your local area. Simila rly we get virtual market
where buyers and sellers don’t know each other directly (one to
one) for e .g. selling on internet, teleshopping etc.
The organisation of economic activities depend on the
economic system which prevails in a economy. An economic
system is composed of people, institutions and their relationship
to resources. It deals with the problem of scarcity and allocation
of resources. We come across 3 economic systems.
a) Command Economy : Here the economy is controlled by the
government or b ureaucracy. The government, through the
central planning makes all decisions about how, when, where,
what, how much etc. to produce.
b) Market economy : Here the decision making activity is done
by firm and individuals. The forms decide on how, when, whe re,
what etc to produce and individuals decide on how, when,
where, at what price to buy. The demand and supply decisions
of individuals and firms are transmitted through the price
system. in this system, self interest is the main motive.
c) Mixed Economy :It is a mixture of command and market
economy.munotes.in
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Now In a market economy price mechanism plays an
important role. Equilibrium is attained through price mechanism.
Allocative Function is the most important role of the market. It
brings efficient allocatio n of scare resources by the firm and the
household. It is done through invisible hand and market forces.
Market price acts as a signal to producers, whether to produce
more or less.
Market also performs the creative function . It provides an
environment fo r change that helps the expansion of production
and consumption.
Thus, following are the important functions of market.
a)Market economy functions automatically
b)It is highly competitive
c)It gives incentives to producers to produce goods needed by
consumers.
d)It provides an incentive to acquire useful skill.
e)It encourages o conserve resources.
f)There is a high degree of economic freedom. ie freedom to
take economic decisions.
2.3 ROLE OF GOVERNMEN TI NI M P R O V I N G
MARKET OUTCOMES
Prob lems of Market Economy: The markets do not
achieve maximum efficiency in the allocation of scarce
resources and governments feel it necessary to intervene to
rectify this and other problems of the market. The conditions
required for markets to perform their allocative and creative
functions in an optimal manner are not likely to be satisfied in
any economy. The important problems of a market economy
are:
1)Domination by few : Competition between firms is often
limited. A few large firms may dominate the industry. In these
cases they may charge high prices and make large profits.
Rather than responding to consumer wishes, they may
attempt to persuade consumers by advertising. Consumers
are susceptible to advertisements for products that are
unfamiliar to them.
2)Removes incentive to be efficient : Lack of competition
and high profits may remove the incentive for firms to be
efficient.
3)Unequal distribution : There is nothing in the market that
guarantees an equitable distribution of income in the
society. Power and property may be unequally distributed.
Those who have power and property will gain at the expense
of those without power and property.munotes.in
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4)Externality : Presence of externality leads to market failure.
Externalities arise whenever an individual or firm can take an
action tha t directly affects others without paying for a harmful
one. When externalities are present, firms and individuals do
not bear all the consequences of their action. A very good
example of an externality is the pollution emitted by a firm.
When the firm do n ot pay for the pollution their cost would be
low and hey would prod uce more. Presence of externaliti es
leads to inefficient allocation of resources.
5)Imperfect information : The role of invisible hand in a
market is based on the assumption that the market
participants such as consumers, firms, government,
workers, etc. have perfect information. They have full
information about their opportunities, availability of goods,
characteristics of goods and so on.
In reality the market participants are not perfectly
informed. Imperfect information inhibits the ability of markets to
perform the tasks that they carry out well when the information is
complete.
The imperfect information posses the problem of
asymmetric information Asymmetric information is am a r k e t
situation in which one party in a transaction has more
information than the other party. This can affect the firm’s
strategy. It can lead to market failures. For instance, asymmetric
information can lead to poorly -functioning markets, that is, to o
much or too little of a good may be produced. Contracting can
be difficult. Fraud is possible. Consumers may fear purchasing
goods when they know that the seller knows more about the
quality of a good than they do. The problem of buyer ignorance
allows rogue traders to operate. The greater the information
asymmetry between sellers and consumers, the greater the
scope for deception and fraud. Under these circumstances
rogue traders are more likely to thrive. For instance, take the
case of builders; by cu tting corners and using inferior materials
lower quality builders can undercut higher quality builders.
However, consumers, due to information asymmetry, may
simply believe ‘hat all builders are much the same and may go
with the cheapest cost. As a result, reputed builders may be
forced to cut their costs, by reducing the quality of their work,
simply to stay in business. Thus, imperfect information leads to
the market inefficiencies and market failures. Thus,
governments have to make measures to help impro ve the
information for consumers, investors and other market
participants.
6)Fail to provide public goods : The public goods are those
goods that the marginal cost of providing a pure public good to
an additional person is zero and it is impossible to ex clude
people from receiving the good. In other words, public goods are
characterized by two important features, that is, non-rival inmunotes.in
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consumption and non -excludability .N o n -rival in consumption
means that the consumption of one individual does not reduce
the benefits derived by other individuals. Thus, it would not be
appropriate to exclude others from enjoying such benefits. The
provision of such goods cannot be undertaken through market
forces because market failure occurs.
Since the benefits of such go ods are available to all,
consumers will not voluntarily pay for those goods. This is the
free-rider problem that accompanies public goods. Since it is
difficult to exclude anyone from using them, those who benefit
from the public goods have an incentive t oa v o i dp a y i n gf o r
them. Hence, the market failure occurs in the provision of public
goods.
The examples of public goods are defence, law and order
and so on.
2.4PRINCIPLE 8 :-MACROECONOMIC
INSTABILITY
A market economy may lead to macroeconomic
instability. There may be periods of recession with high
unemployment and falling output, and other periods of rising
prices.
Role of Government: -
Since there are many problems and failures of market
economy we need government to correct market failures or at
least to lessen them. The government has an important role to
play in the economic development of a country, but not so much
as a direct provider of goods and services, rather as an agency
to correct market failures.
The government can play an important role to correct
market failures and improve economic efficiency. The
government intervention is needed in the economy.
i)To improve economic efficiency by correcting market
failures.
ii)To pursue social values of equity by altering market
outcomes.
iii)To pursue other social objectives by the provision of public
and merit goods and at the same time prohibit ing the
consumption of merit goo ds.
According to R. A. Musgrave and P. B. Musgrave,
government policy is needed to guide, correct, and su pplement
the market mechanism in certain respects. The operation of
government includes not only financing but has broad bearing
on the level and allocation of resource use, the distribution ofmunotes.in
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income, and the level of economic activity. These functio ns are
carried out through government budget.
1)The government has an important role to play in
development process. It is essential to correct market
imperfections : Government regulation and measures will be
needed to secure the conditions necessary for t he functioning of
market mechanism. Government has an important role at
correcting market failures arising from imperfect information,
imperfect competition, externalities and public goods. In the
case of imperfect competitions, firms use their market pow er to
raise prices and reduce output. The MRTP Act or Competition
Policy Act of the government can help to maintain competitive
force and restrain firms from abusing their monopoly power.
Similarly, imperfect information can lead to inefficient functioning
of product and labour markets. Government can set up
regulatory authorities such as SEBI (Securities Exchange Board
of India) to compel the firms to provide information about their
financial conditions.
2)To correct problems of imperfect information :
Asymmetric information refers to the imbalance of knowledge in
a market between buyers and sellers. For example, in the
market for bank loans the borrowers know more about their own
circumstances than the lenders. As consequences, banks could
make bad loans. (i.e. adverse selection) which makes them
cautious and leads to credit rationing. It would be very costly for
banks of obtain all the information about high -risk customers. In
this case the government has to make provisions to make the
banks o lend to hig h risk customers at concessional rates.
Similarly, in the insurance market, the individuals know more
about their health than the suppliers of insurance. Those who
know they are prone to illness are more likely to take out
insurance, and also more likely t ob et u r n e dd o w n . Moral
hazard is present when the possession of insurance
encourages the activity that is insured leading to resource waste
and higher insurance premium to all. In this case where prob.
and the government may have to regulate private insu rance
companies or to provide the service itself at a lower cost.
3)To provide legal structure : The contractual arrangements
and exchanges needed for market operation cannot exist
without the protection and enforcement of a governmentally
provided legal s tructure. In this respect, government can provide
necessary legal structure and ensure their implementation by
the firms and other parties in the market.
4)To provide public goods and merit goods : Even if the
legal structure is provided and barriers to com petition are
removed, the production or consumption characteristics of
certain goods like public goods and merit goods are such that
they cannot be provided through the market. In the case of
public goods there is the free -rider problem due to itsmunotes.in
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charac teristics. The important characteristics of a public good
are : i) It is non-rival in consumption , that is, the consumption
by one user does not reduce the supply available to others, ii)
It is non-excludable i.e. users cannot be prevented from
consumin g the public good. As a consequence the market fails
in the provision of public goods. Thus, government has to
ensure their provision. The important public goods that are very
important for economic development are defence, law and
order, and the provision of basic infrastructure such as roads,
sewers, clean water and so on.
On the other hand merit goods are the goods that the
government consider to be good for the people, for example
education, health, etc. if they are provided by the market people
may under consume such good. Thus they having to be
subsidised or provided free by the government. Merit goods
have to be provided by the private sector as well as by the state.
5)To correct the problems arising from externalities :T h e r e
will arise problems o f “externalities” which lead to “market
failure”. This requires correction by the government either by
way of budgetary provisio ns, subsidy or taxation. In the case of
goods with positive externalities (like research) the firms
produce too little of goods and in the case of goods with
negative externalities (such as that generate pollution) the firms
production of goods with positive externalities. Most
infrastructure projects, such as transport facilities, power
generation, irrigation schemes and so on, a nd social ,capital,
such as e ducation and health facilities come under this
category. They have greater social returns than the private
returns and therefore they will be underprovided from a social
point of view unless the private providers in the market are
compensated or subsidised.
The activities with negative externalities (those that
pollute the environment) impose costs on the society that are
not paid for by the provider and hence the market oversupplies
those goods from a social point of view. G overnment can curb
negative externalities through regulation or taxation.
6)To correct unequal distribution of income and wealth : The
distribution of income and wealth which result from the market
system and form the transfer of property rights through
inheritance is likely to be unequal. In the market system,
individual’s incomes are related to their ownership of assets and
their productivity. In most of the countries, wealth is
concentrated in the hands of the few. In many countries
inequalities are lin ked to inheritance. The government has to
take variety of programs aimed at the poor. These programs
aimed at redistribution of income from the rich to the poor
through welfare programs and taxation policies.munotes.in
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7)To provide an institutional environment :T h e state has to
provide the appropriate institutional environment for markets to
flourish and operate efficiently including the maintenance of
macroeconomic stability. In this sense the markets and
governmental intervention are complementary. Economic, soci al
and sustainable development is not possible without an effective
state. State should act as partner and facilitator than director.
State should work to complement markets, not replace them.
Good economic policies including the promotion of
macroeconomic stability is needed for sustainable growth and
the reduction of poverty.
8)To secure important social objectives :T h em a r k e t
system does not necessarily bring high employment, price level
stability, socially desired rate of growth, poverty eradication a nd
economic development. Measures should be taken to improve
health and nutrition in developing countries. The living standards
of the poor has to be improved by providing clean water,
adequate sanitation and ensuring basic amount of food to the
poor. Gove rnment policies are needed to secure these
objectives.
9)To provide social security : The market system cannot
provide the social security to its citizens, suffering from
unemployment, sickness, old age disability and so on. The
government has to step in to provide social security to the
citizens.
10)To guide the use of natural resources : The market
mechanism cannot bring about appropriate allocation of natural
resources for the present and future generations similarly, the
market mechanism may not be a ble to control the pollution of
environment. Therefore, consumption of natural resources,
pollution control, etc. should be guided by government policies.
It should be noted, while the government policies can
improve on market outcomes, government measu res always
may not succeed. This is because government policy is not
made by angels but by a political process that is far from perfect.
2.5PRINCIPLE 9 : -GROWTH IN THE QUANTITY OF
MONEY AND INFLATION
Inflation is a situation of a continuous, uninterru pted, long
term increase in price level.
It is a situation of too much of money supply chasing too
few goods . This can be explained with an example we wish to
overcome the problem of poverty. We think that the people are
poor because they do not have eno ugh money. Then people
might think that let’s ask the central bank (RBI in India) of the
country to print new notes and distribute them amount people.
But the problem is that when they have enough money to buymunotes.in
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goods, and if the Quantity of goods remains co nstant then the
prices will start rising. It shows that people have enough money
to buy goods but goods are not available. This is a case of too
much money, chasing too few goods. This leads to inflation i.e.
price rise.
But of course if this higher mo ney supply is used to bring
full utilisation of unused resources then the production will
increase.
But generally mere increase in money supply leads to
price rise.
Figure 2.1
2.6PRINCIPLE 10 : -INFLATION AND
UNEMPLOYMENT TRADE OFF
Inflation –Unemployment Tradeoff is a situation where
increased employment is accompanied by increased inflation
and lower inflation is accompanied by lower growth.
People wish to have less inflationand less unemployment
is less then inflation is high and when un employment is high,
inflation is less. This is explained in the Phillips curve.
Figure 2.2munotes.in
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At point ‘A’ unemployment is less. It is only OU1. It
means more people are employed. They get income. They get
income. Their purchasing power and so demand for g oods
increases. As this is not matched by the supply of goods, we get
high price situation (OP1) i .e.inflation.
If unemployment is high i .e.OU2 then a large number of
people do not have sufficient income –thus they have less
purchasing power –so dema nd for goods is less –prices fall
(OP2) –so less inflation.
Similarly if prices are high (P1) i .e.if there is inflation then
the profit of producer is high –so high investment –so more
employment and less unemployment (OU1).
But if prices are low (OP2) i .e.if inflation is low –low
profit –low investment –less demand for labour and other
resources –so low employment –i.e.high unemployment.
2.7 QUESTIONS
1)Explain ‘trade is good for all’ by giving example.
2)Explain the r ole of g overnment in improving market
structure.
3)Write notes on
a)Private market and role of government
b)Inflation and unemployment
c)Market failure
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Module 2
Unit -3
ECONOMICS AND ITS METHODS
Unit Structure:
3.0 Objectives
3.1 Scientific method
3.2 Role of assumptions
3.3 Economic models
3.3.1 Circular flow of income
3.3.2 Production possibility curve (PPC)
3.4 Micro economics an d macro economics
3.4.1 Micro economics
3.4.2 Macro economics
3.5 What do Economists do?
3.6 Positive economics and normative economics
3.6.1 Positive economics
3.6.2 Normative economics
3.7 Questions
3.0 OBJECTIVES
To stud y the methods of economics
To understand the importance of assumptions
To study the circular flow of income and production possibility
curve.
To study the difference between micro and macro economics
To study difference between positive economics and norma tive
economics.
3.1 SCIENTIFIC METHOD
The economy is generally a very complex organisation.
Systematic thinking about the economy requires a great deal of
mental discipline. Economists use a set of specialised tools and
techniques to analyse the economy.
Economics is a science. The essence of science is to use
scientific method. The process of the scientific method involves
making hypothesis, deriving predictions from them as logical
consequences, and then carrying out experiments or empiricalmunotes.in
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observati ons based on those predictions. A hypothesis is a
conjecture, based on knowledge obtained while seeking answers to
the questions.
The scientific method involves identifying a problem,
gathering data, forming a hypothesis, testing the hypothesis and
analy sing the results. In economics, extensive testing and
observations is required because the outcome must be obtained
more than once in order to be valid.
Following are the important steps in scientific method.
1)Identify the problem : This is the first step in economics. We
have to identify the problem first. It focuses on the area of work. It
tries to identify what the economist is studying. For eg. An
economist may find that his country is experiencing rapid rise in
prices. Then from this he can develop a t heory of inflation. The
theory may assert that the inflation arises due to rapid increase in
money supply .
2)Collecting or Gathering Data : Scientific method needs o
collect data to get the solution for the problem collected data will
be used in the stu dy. For e .g. The economist can collect data on
prices and money supply in that country.
3)Framing the Hypothesis : Hypothesis is simply a prediction i .e.
what the economis tthink about the outcome of his study. As per
our example the hypothesis can be that increase in the quantity of
money supply leads to rise in prices.
4)Test the Hypothesis (Conducting Experiments) :It is not
easy to undertake experiments in economics. It is difficult to carry
out experiments in economics. Here economist can make use of
data. He can also take note of historical data from different
countries in the world. Later on it can be analysed statistically.
5)Analyse the result : By analysing the results of the statistical
study the economists can come to the conclusion whether his
hypothesis is right or wrong. A negative result does not mean the
study is over. It just states that more work is required.
3.2 ROLE OF ASSUMPTIONS
Assumptions play an important role in economic models.
Assumptions are important to economic analysis. So me
assumptions are used to simplify a complex analysis into more
easily manageable parts. Other assumptions are used as control
conditions that are subsequently changed to evaluate the
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Assumptions from the foundation upon which the theories,
models and analysis are constructed. They simplify and highlight
the problem or topic under study. They make it possible to analyse
the complex set of events. The art of good economic modelling
requires the economist to have the skills to choose he correct set of
assumptions. While assumptions are not required to be realistic,
they definitely need to be carefully chosen.
Every economic theory is based on a set of assumptions.
Assumptions are necessary for constructing economic laws or
principles because th ey help to reduce the complexities of real
world and give simplified models to explain economic laws.
Therefore, economic laws are statement of certain human
tendencies which mean that human tendencies which mean that
human beings tend to act in a certain way under certain
circumstances or assumptions. In the absence of assumptions,
formulation of reliable economic laws would be difficult.
Assumptions are initial conditions made before a micro or macro
economic analysis is built.
Sometimes assumptions are used for simplification.
Assumptions can be used to isolate the effects of a change in
one variable on another.
Many assumptions are criticised for being unrealistic.
Economic assumptions are based on certain assumptions.
These assumptions are classified into following four categories.
1)Psychological or Behavioural Assumptions : -These
assumptions are about the individual human behaviour. They refer
to the rational behaviour of individuals like consumers and
producers for e.g. Rational consumer tries to m aximise his level of
satisfaction and a rational producer tries to maximise his level of
profit.
2)Institutional Assumptions : -These assumptions in economic
theory relate to social, political and economic institutions. All
economic theories have been devel oped on the assumption of a
capitalist economy in which the means of production and
distribution are privately owned and used for per sonal gain. It
assumes stable government and certain socio -economic institutions
which include pr ivate property, economic l iberalisation, competition
and the price theory. The government’s role is to enforce the “rule
of the game” in the market. These assumptions are the basis of
microeconomic theories.
3)Structural Assumptions : -These assumptions relate to the
nature, Physica l structure or topography of the state of. In the short
run, economic theories are based on the assumption of given
resources and technology.munotes.in
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These assumptions relate to a static economy where there is
movement but no change. But in the long run, labour, capital and
other resources and technology are assumed to change in certain
theories. They relate to a dynamic theory. The structural
assumptions are used in production functions of various types and
in growth theories. Most economic theories are based on the
assumption of static economy.
4)Ceteris paribus Assumption : -This is another important
assumption in economics. Ceteris Paribus means other things
being equal. This is used to simplify reality. In order to consider the
impact of one factor at a time, th e other factors are held constant.
Inreality or real world, there may be a number of factors operating
simultaneously. If all of them are included in the analysis, then it
would become complex. Thus we assume certain things to remain
constant. for e.g. In low of Demand we state that. When price
rises, demand falls and when price falls, demand rises. But we
assume that the income, taste, preference, habit etc. remains
constant. Ifwe allow these factors to change then the analysis will
become complicated., , , , . ,....xx s u b
xxDf P P Y T P H
Df P
xx xxPDPD3.3 ECONOMIC MODELS
An economic model is a simplified version of reality that
allows us to observe, understand, and make predictions about
economic behaviour. The purpose of a model is to take a co mplex,
real-world situation and pare it down to the essentials. If designed
well, a model can give the analyst a better understanding of the
situation and any related problems.
Economists use models as the primary tool for explaining or
making predictions about economic issues and problems.
Economic models can be represented using words, mathematics,
graphs, flowcharts, diagrams etc.
Let us study two basic models.
1)Circular Flow of Income.
2)Production Possibilities Curve.
3.3.1 Circular flow of income: -
The circular flow of Income economy consists of two groups Vi z
Household and Firm,munotes.in
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Figure 3.1
To begin with let us assume that the household sector gives
services to the firm sector (factor services). These are the services
given by land, labour etc. n ow, firm makes use of these services
and products (goods) are produced. These products are given to
the household sector. This is a real flow where services are
exchanged for goods and goods for services.
Now when the factor services are given by the hous ehold
sector to the firm sector then the firm sector gives them their
rewards. For e.g. land gets rent ,labour gets wages and so on
(Factor pricing) .Similarly when the firm sector then the household
sectors pays the prices of products (product pricing). T his is called
as Money flow. In this was expenditure of household is income to
the firm and expenditure of household is income to the firm (one
man’s expenditure is another man’s income).
Figure 3.2
Circular flow with sa ving, Investment and Governmentmunotes.in
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We come across say three types of leakage sviz.saving, tax
and imports (Payment). But these leakages can be corrected in the
economic system itself such as the saving leakage can be
corrected as investmen tthrough financial sector and rate of
interest. Whe nsavings take place, the money goes out of
circulation. We can inject it back in the form of investmen t.
Tax leakage is corrected in the form of public expenditure
through Budget (government) when we pay the tax, once again the
money goes out of circulat ion. Money leaves individuals pockets
and goes to the government (tax revenue). Later, the government
spends that money on society itself in the form of public
expenditure.
Similarly when we import goods from abroad, the money
goes out of the country ( outflow ). But we can bring it back through
export earnings (inflow). It is done through foreign sector.
3.3.2 Production possibilities curve (PPC)
PPC is a curve which shows various combinations of the
amounts off two goods which can be produced with the g iven
resources and technology. A PPC illustrates several economic
concepts such as alloca tive efficiency, economies of s cale,
opportunity cost, productive efficiency and scarcity of resources.
Scarcity of resources is the fundamental economic problem faced
by all societies . The economic problem arises because our wants
are unlimited and the resources at our disposal to sati sfy these
wants are limited.
Every economy faces trade -offs. If resources or factors of
production are used to pro duce a particular com modity then fewer
resources are available for producing other commodity. For e.g. if
we spend more money on education then less amount will be
available for public health services (If we wish to achieve both).
Let us assume that the given resources, man p ower,
technology, organisational skills are used to produce say the
consumer goods and defence goods. It is explained in the following
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Table 3.1: Production Possibility Schedule
Production Possibility
CombinationsConsumer Goods
(in thou sand units)Defence Goods
(in thousand units)
P 300 0
Q 250 1
R 200 2
S 150 3
T 100 4
U 50 5
F 0 6
Figure 3.3
In the above diagram we see that if all the productive
resources are used to produce the defence goods then we can
produce 6 uni ts of defence goods (F) and none of consumer goods.
This is one extreme. Similarly, if all the productive resources are
used to produce consumer goods then we can produce 300 units of
it but zero of defence goods (P). This is another extreme. If we jo in
these two points then we get a curve PF known as PPC. All the
points on this curve are within our given resource.
Let us take p point below the PPS such as w. at this point
the economy will have 2 units of defence and 100 units of
consumer goods. It shows u nderutilisation of resources. Now if we
use the resources optimally then we can produce either more of
defence goods (T) or more of consumer goods (R) or few more of
defence and consumer goods (S). This is possible by shifting on
the PPC. Any point above t he PPC, like M, is beyond the capacitymunotes.in
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of the country as it requires more productive resources than
available.
PPC has 3 important aspects of production.
a)It explains scarcity of resources. It is shown with the point
outside PPC ( Point in ).
b)It explains the concept of choice to choose among the different
attainable combinations of R and T.
c)It explains opportunity cost i.e. the cost of acquiring more of one
good by sacrificing the other good.
Shift in PPC
Figure 3.4
PF is the original production Possibili ty Curve, with given
resources. It is achieved with a given technology and skill. But if we
bring a change in technology and skill then with given resources we
get a shift in PPC from PF to PF1. It is also possible due to
innovation. The PPC shifts outward . It shows a larger combination
of the two goods (defence and consumer goods).
3.4 MICRO ECONOMICS AND MACRO ECONOMICS
Economics is a science which deals with the problem of
efficient allocation of scarce resources among alternative uses. The
subject ma tter of economics is divided into two parts namely
Microeconomics and Macroeconomics. Terms coined by French
economist Ragner Frisch.
3.4.1 Micro Economics : -The term Mi cro economics is derived
from G reek work ‘micros’ meaning small. Thus micro econom ics
deals with the behaviour of individual economic units such as
individual consumer or an individual producer. Micro meansmunotes.in
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millionth part. It deals with a small part of national economy. M icro
economics gives a microscopic picture of the economy. It is a study
of particular firm, particular households, individual prices, wages,
income . Thus micro economics is a part of a system and not the
whole.
Basic Assumptions of Micro -Economics
1)Economic Man ner :-Micro economic assumes that the
individual behave s in an economically rational manner. A rational
consumer tries to maximise his level of satisfaction (within certain
constraints like income and prices) and a rational producer tries to
maximise his profits (with given investment outlay and factor
prices. )
2)Mobile Resources : -Economic units or say factors of
production are free to move. There are no restrictions on the
mobility of the economic units for e.g. labourer is free to move from
one occupation to another or owners of capital are free to invest
their funds in different production activities, which are profitable.
3)Free flow of Information : -Micro economics assumes free flow
of complete and reliable information about market conditions and
varied opportunities. This helps people to make rational d ecisions.
4)Diminishing Returns : -Micro economics takes note of
diminishing returns –say diminishing marginal product in
production or diminishing marginal utility in consumption. It shows
that additional benefit from additional homogenous commodity
goes on diminishing (Law of Diminishing Marginal Utility)
5)Divisibility : -Micro economics assumes that goods and labour
forces are divisible.
Uses of Micro Economics
1)Micro Economics provides some very important tools for
formulating several economic poli cies and understanding some
major economic issues. For e.g. the price theory helps us to
understand that how the tax burden of an indirect tax is shared
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2)Micro economics is useful in the formulation of economic
policies which ar e essential for the promotion of economic
welfare. For e.g. price policy, tax policy, exchange rate policy
etc.
3)Micro economic theory explains the composition or allocation of
total production. For e.g. why more units of some commodities
are produced than others.
4)Micro economic theory helps us to understand the working of
free private enterprise economy.
5)It explains the working of price or market mechanism. It tells us
that how goods and services produced are distributed amoung
various people.
6)It helps us i n finding out the relative prices of various factors and
products.
7)Micro economics is useful in constructing behavioural models
which are useful in understanding complicated and confusing
phenomena.
8)Micro economics is applied to the various branches of
economics such as public finance, international economics etc.
Limitations
1)It is based on unrealistic assumption of full employment.
2)It does not focus on the economy as a whole. It takes care of
individual units only.
3)Description of a large and complex univ erse of facts like the
economic system is impossible in terms of individual items.
3.4.2 Macro Economics : -
The world Macro Economics is derived from G reek word
‘Makros’ meaning large or aggregate (Ragner Frisch) .
Macroeconomics analyses the behaviour of the economy as a
whole, for e.g. study ofNational Income, General Price Level,
National output, Business cycle etc. The credit for the development
of Macroeconomic approach goes to J. M. Keynes.
Macroeconomics deals with economic affairs ‘in the large’; it
concerns the overall dimensions of economic life. It studies the
character of the forest and not only a tree like Micro economics.
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Uses of Macro Economics
1)Macro economic analysis helps us to get an idea of how a
complex economic system functions
2)It is of great significance in formulating suitable economic
policies for eg. Controlof inflation, promotion of economic growth
etc.
3)It helps us in understanding the functioning of an economy as a
whole.
4)It helps us in studying phenomenon of trade cycle or busin ess
cycle.
5)It helps us to evaluate the resources and capabilities of an
economy. It will help us to increase NI, output etc.
6)Macro economics helps us to study the problems related to the
measurement of NI and related concepts
7)It helps us to analyse the pro blems arising from frequent
changes in the value of money. It helps us to understand the
effects of inflation and deflation.
8)It helps us to use monetary, fiscal policies for the economy as a
whole
3.5 WHAT DO ECONOMISTS DO?
Models used by economists can be broadly classified into
two groups : a) Microeconomic models, which studies, how
households and firms make decisions and the way interact or b)
Macroeconomic models, which look at the economy as a whole.
Microeconomic models study decision making at th e level of the
individual or the firm, while macroeconomic models study economic
aggregates like national income, investment etc. economists can
play two distinct but often related roles. One role is of an analyst.
For example, an economist may use an mode l to analyse a
situation. An economist may use his model to analyse how a
change in the interest rate charged by the American Federal
Reserve will impact the investment level in India. As another
example, an economist might use his model to analyse how the
introduction of UBER taxis in Mumbai will affect the wages of
drivers employed on private cars. When economists use their
models to explain the world in this fashion, they are in the role of
scientists. On the other hand, they might want to use their mode ls
for making specific recommendations. For example, should there
be a subsidy on kerosene in order to reduce the incidence of
poverty is a policy question. When economists are addressing
policy issues of this kind, they are being policy advisors. When
economists analyse a situation as scientists, they are describing
the world “as it is”. Statements that describe the world as it is, are
called “positive statements”, while statements that describe how
things should be, are called “normative statements”. When
economists are describing the world as it is, they are doing positivemunotes.in
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analysis while when they are prescribing policy measures, they are
engaging in normative discussion. A lot of times, economists do not
always agree with one another. One of the reasons that they may
disagree a great deal is that they may be using models that are
widely different. A model is an abstract representation of reality.
When one is abstracting from reality, one is given particular
importance to some factors while relegating othe r factors into the
background. The features of the real world that different economists
chooses to ignore (or give importance to) may be different, resulting
in different models. For example, suppose two economists are
studying the determinants of hours wo rked by a landless
agricultural worker in rural India. One of the economists might
decide to focus on the wage rate obtained by the worker while
another may focus on the fact that because the worker belongs to a
backward caste, he or she is required to wor k rather hard. The first
model gives particular importance to the wage rate while the
second model gives particular importance to the social status of the
worker. Because the two models are so widely different, the two
economists are bound to disagree. Som etimes, economists
disagree because they have different normative positions. For
example, some economists might argue that taking money away
from the rich by taxing them and redistributing it among the poor is
valid because the income losses of the rich ar e less hurtful than the
benefits of the income gains of the poor. This is a specif ic
normative position, because we are making an explicit normative
value judgement here. The value judgment is that it is OK to hurt
the rich in order to benefit the poor. An other economist may
disagree with this value judgment. Such differences in value
judgements are also another reason why economists disagree
among each other.
3.6 POSITIVE ECONOMICS AND NORMATIVE
ECONOMICS
Economics deals with the economic problems. Econ omic
problem arises due to u nlimited wants and scarce resources. The
study of economics leads to deriving economic laws and their
application to solve economic problems. It helps the government to
devise economic policy. In order to understand this role, i ti s
necessary to study positive and normative economics.
3.6.1 Positive Economics :
Positive economics deals with the objective or scientific
explanations of the working of an economy. It is concerned with
explain what it is. Positive economics is define da sab o d yo f
systematized knowledge relating to or concerning what is. It is
concerned with how the economic problems facing the society are
actually solved.munotes.in
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In positive economics we derive generalization, theories and
laws following certain rules of lo gic. These theories, laws and
propositions explain the cause and effect relationship between
economic variables. Positive economics deals with statements that
can be shown to be wrong or correct by appeal of facts. It attempts
to describe and analyse the e xisting situation, rather than
suggesting how to change it.
Classical and neo -classical economists, considered
Economics as a positive science To Lionel Robbins, economics is a
positive a pure science. It is purely analytical. Its purpose is to
describe and not be prescribe d.I ti sal i g h t -bearing science and not
a fruit bearing one. To Robbins, economics is neutral between
ends. The economist is not concerned with ends as such. He is
concerned with the way in which the attainment of ends is limited.
The ends may be noble or ignoble, good or bad, but if the
attainment of one set of ends involves the sacrifice of others than it
is an economic problem. Economics is morally colorless concept.
Economics is morally colorless concept. Economics studies facts
asthey are and does not pass any value judgements.
The aim of positive economics is to explain how society
makes decisions about consumption, production and exchange of
goods.
3.6.2 Normative Economics :-Normative economics offers
prescription or recomme ndations based on personal value
judgements. It is concerned with what should be or what o ught to
be or how the economic problems facing the society should be
solved Normative economics explains us what it ought to be. It has
value judgements and tells us what ought to be.
Normative economics is a regulating science is a body of
systematized knowledge relating to criteria of ‘what ought to be’.
The objective of normative economics is the determination of
ideals. It is also called as prescriptive economics as it explains what
should be the things.
Questions like whether the government should give money
to the poor, whether the budget deficit should be reduced by higher
taxes or lower spending, etc can be solved by value judgements
rather than facts. Econom ists being a social scientist cannot
overlook the social aspects of the problem. Problems like inequality
of income, poverty, unemployment are to be dealt with normative
approach. Determination of wage rate cannot be entirely left to the
market forces (Dem and and supply) as desired by the positive
approach. To avoid exploitation of labourers the normative
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Economists not only explain how economy actually operates
but they also suggest how it shoul d operate. It is essential for the
problems of national economy.
It is said that no two economists ever agree. They may
agree on a positive economic analysis of how the economy / world /
system work . But there is lot of scope for disagreements on
normati ve recommendations based on differing value judgements.
Thus, there is a great deal of disagreement between economists in
normative economics.
Positive Economics Normative Economics
1)Concerned with ‘What is’ or
What it isConcerned with ‘What ought
tobe’
2)It describes the Fact It deals with the desirability of
the facts
3)It is not concerned with
value JudgementsIt is based on value
judgements
4)It is purely objective in
ApproachIt is subjective in
consideration
3.7 QUESTIONS
1)What is scien tific method?
2)Explain the difference between positive economics and
normative economics.
3)Discuss the circular flow income.
4)Explain the difference between micro and macro economics.
5)Explain production possibility curve.
6)What are economic models?
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Unit -4
TOOLS OF ECONOMIC ANALYSIS
Unit Structure :
4.0 Objectives
4.1 Introduction
4.2 Graphs
4.3 Slope
4.3.1 Positive slope
4.3.2 Negative slope
4.4 Straight lines and curves
4.4.1 Straight Line
4.4.2 Curves
4.5 Direct function
4.6 Questions
4.0 OBJECTIVES
To understand how to derive the graph
To study the concepts of slope and curve
To study the functional relationship
4.1 INT RODUCTION
The tools of economic analysis are found in the realm of
mathematics. Math ematics is being profusely used in modern
economic analysis. Diagrams, graphs provide us with visual impact
and help to understand and learn economics.
4.2 GRAPHS
Graph is the most commonly used tool to present the
functional relationship between two va riables. The use of graph
offers a better understanding of the economic generalizations. This
is because it presents a visual picture of an abstract idea. Graphs
can be drawn on a plain paper. But for greater accuracy and
precision a graph paper is used.munotes.in
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X is a horizontal axis and y is the vertical axis. Th e space is
divided into for Qua drants
I.Shows both x and y are positive
II.Shows x negative, y positive
III.Shows x negative, y negative (both are negative)
IV.Show x positive, y negative e
4.3SLOPE
4.3.1 Positive slope : -It gives us the direct relation ship between
two economic variables. For e .g.the graphical presentation of a
supply curve which gives us a direc tr e l a t i o n s h i pb e t w e e np r i c ea n d
supply. (Change in price is cause and change in supply is effed).
Price is shown on the y -axis and supply on the x -axisChange in value of vertical axisChange in value of horizontal axisySlopex
Figure 4.1munotes.in
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Since both BD and CD are positive there is a positive slope.
It is s linear equation y = a + bx
4.3.2 Negative slop e–It gives us indirect or inverse relationship
between two economic variables. For e .g.graphical presentation of
a demand curve which gives us inverse / indirect relationship
between price and demand. Price rises, demand falls and price
falls, demand rises.11CD
DBPPySlope orxM M
Figure 4.2
Slope of a straight Line : (Rise over Run)
A slope can also be defined as the rise over run. The rise is
the vertical distance whereas the run is the horizontal distance
between two variables.
Figure 4.3munotes.in
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Rise is the vertical distance between A and C
Run is the horizontal distance between C and B
AB is measured asAB RiseCB Run
4.4 STRAIGHT LINES AND CURVE
The lines can be divided as linear (Straight line) and non -
linear (curve)
Lines are simple and express a proportionate change or
relationship between two variables. Where as curves are complex
in nature and they explain disproportionate relationship between
two variables.
4.4.1 Straight Line : If the expression of a function is linear using
first degree of variables we ge t a straight line. The function for
straight line is expressed as follows.
Y=x
Y=3 x
Y = 0.25 x and soon.
Now if we plot the points and a graph of theseequation we
will get three straight lines passing through the origin.
Figure 4.4
If we get the equation y = x and y = a + b x the we get two
straight lines parallel to each other but with different intercept. For
e.g.munotes.in
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Figure 4.5
4.4.2 Curves : -When the expression of a function is non -linear
then we get a curve. a curve is used to show a comple xr e l a t i o n s h i p
between the variables represented by several points on a g raph.
The slop goes on changing from point to point. Thus it represents
different marginal value.
Let us take an example of an indifference curve which
slopes downwards from left to right.
Figure 4.6
Points P and Q show different combinations of commodity x
and y. To get more units of one commodity we have to give up /
part with some units of other commodity.munotes.in
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Figure 4.7
Let us now take a case of direct function.
Function is a numerical relationship between the variables.
Out of the two variables, one variable is a dependent variable and
other is independent variable for e.g. = y = f (x) i.e. y is dependent
variable and x is independent D = f (p) or s = f (p)
4.5 DIRECT FUN CTION
Suppose xa n dya r eb o t hs e t st h a tc o n t a i nn u m b e r .L e txb e
the domain of the functio n and y be the range of the function. Let us
assume that y = 2 + 3 x X. now assume that x contains elements of
1,2,3,4,5,6.
X y Increase / Decrease
1 2+3x 1=2+ 3 =5
2 2+3x 2=2+ 6=8 3
3 2+3x 3=2+ 9=11 3
4 2+3x 4=2+ 12=14 3
5 2+3x 5=2+ 15=17 3
6 2+3x 6=2+ 18=20 3munotes.in
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The graphical presentation is as follows.
Figure 4.8
Let us take another example.
Let y = 6–2xX .V a l u eo fX is 0,1,2,3,4,5,6,7,8,9,10
X Y Increase / Decrease
0 6–2xX=6 –2x0=6 –0=6
1 6–2xX=6 –2x1=6 –2=4 2
2 6–2xX=6 –2x2=6 –4=2 2
3 6–2xX=6 –2x3=6 –6=0 2
4 6–2xX=6 –2x4=6 –8=–2 2
5 6–2xX=6 –2x5=6 –10 = –4 2
6 6–2xX=6 –2x6=6 –12 = –6 2
7 6–2xX=6 –2x7=6 –14 = –8 2
8 6–2xX=6 –2x8=6 –16 = –10 2
9 6–2xX=6 –2x9=6 –18 = –12 2
10 6–2xX=6 –2x1 0=6 –20 = –14 2munotes.in
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Figure 4.9
Now let us take a case of function which is not constant
Y = 2 + 3 xX 2, Let X = 0, 1, 2, 3, 4, 5
x y
0 2 + 3 xX 2 =2+3x( 0 ) 2 =2+3x0 =2+0 =2
1 2 + 3 xX 2 =2+3x( 1 ) 2 =2+3x 1=2+3 =5
2 2 + 3 xX 2 =2+3x( 2 ) 2 =2+3x4 =2+1 2= 14
3 2 + 3 xX 2 =2+3x( 3 ) 2 =2+3x9 =2+2 7= 29
4 2 + 3 xX 2 =2+3x( 4 ) 2 =2+3x6 =2+4 8= 50
5 2 + 3 xX 2 =2+3x( 5 ) 2 =2+3x2 5= 2+7 5= 77
Figure 4.10
4.6 QUESTIONS
1)Explain the concept of slope .
2)Write anote on curve s.
3)Explain the importance of graph in economics .
munotes.in
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Module 3
Unit -5
THE MARKET FORCES OF DEMAND (D)
AND SUPPLY (S)
Unit Structure:
5.0 Objectives
5.1 Market: (Market and Competition)
5.2 Meaning of tem demand
5.3 Determinants of demand
5.4 Law of demand
5.5 Individual demand and market demand
5.6 Changes in demand (Increase and decrease in Demand
5.7 Supply
5.8 Law of supply
5.9 Individual supply and market supply
5.10 Change in supply
5.11 Market equilibrium
5.12 Questions
5.0 OBJECTIVES
1.To study the concept of market
2.To understand law of demand and demand curve
3.To study the concepts of individual demand and market
demand
4.To study the concept of market equilibrium
5.To study the difference between individual supply and
market supply
5.1 MARKET: -(MARKET AND COMPETITION)
Market, in econ omics, means, a network of deali ngs
between buyers and sellers irrespective of any geographical
specification. Thus, market brings together the buyers and
sellers of a particular goods or services. Demand and supply
explain the behaviour of people and thei r interactions with one
another in a competitive market economy. Demand and supply
are the two basic tools which
a)are at the core (cent re) of exchange economy
b)make the economies work
c)affect the events and policies in an economy
Depending on the number o f buyers and sellers, nature of
the commodity, concept of entry and exit etc. w e come acrossmunotes.in
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different types of markets such as perfect competition,
monopoly, monopolistic competition, Oligopoly, duopoly etc .for
e.g.
Perfect Competition is a market of la rge number of buyers
and large number of sellers ,selling homogeneous product.
(Seller as Price taker)
Monopoly is a market of large number of buyers and single
seller ,selling homogeneous product (Seller / monopolist as
Price maker)
Monopolistic competit ion is a market of large number of
buyers and sufficiently large number of sellers selling
heterogeneous or differentiated product.
Oligopoly is a market of large number of buyers and few
sellers selling differentiated products (Kinked Demand curve)
Duopo ly is a market of large number ofbuyers and two
sellers selling differentiated products (Special case of
oligopoly.)
Similarly we also have
Local Market mainly for perishable goods and services.
State or National market for durable items. Other case is
Marathi films have bigger market in Maharashtra state. But
Hindi films have national market.
International Market is for different goods and services like
financial services.
We also come across share (Stock Market) bullion Market
(for precious metals lik e gold / silver etc.), Real Estate
market.
We come across competition in the market. Competition
is the effort of two or more parties to ensure their position and
efficiency. Competition brings out the best of quantity and
quality. It ensures the most eff icient or optimum allocation of
productive resources.
5.2 MEANING OF TERM DEMAND
In an ordinary language, demand means a desire or a
want for som ething. But a mere desire or willingness is not a
demand in economics. In economics demand means any desire
or willingness backed by purchasing power. Thus demand =
willingness to Buy + Ability to pay.
E.g. IfMr. X wan tst ob u yB MW carbut does not have the ability
then want will not be converted into demand. Similarly Mr. Y
may have the ability to buy chicke n but has no desire or
willingness to buy it as he is vegetarian.munotes.in
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In both the cases there is no demand because
willingness and ability both do not go together.
5.3 DETERMINANTS OF DEMAND
(Factors influencing Demand for a product.)
Demand for a particula r commodity or a product depends
on the following factors: -
1) Price of the product (P)
Price is the basic determinant of demand. Demand for
any product depends on the price of that product. Usually, there
is an inverse relationship between the two i .e.higher the price,
lower is the demand and lower the price, higher is the demand.
2) Prices of substitutes (Psub) :
Demand for a particular product depends not only on the
price of that product but also on the prices of other substitutes
availabl ei nt h em a rket. If ‘X’ and ‘Y’ are two substitutes (Pepsi /
coke), then demand for x depends not only on the price of x but
also on the price of Y.
3) Income (Y):
Demand for a product depends on the disposable income
of the individual usually; income and demand are directly
related. Income reveals the purchasing power. Thus higher the
income, greater is the demand and lower the income, lower is
the demand.
4) Taste and Preference (T/P) :
Dem oand for several products like ice creams, cakes
etc. depends on the taste of a person. At the same time,
different people have different preferences for different products.
For eg. Non -vegetarian person will give higher preference to
non-veg food than veg. food.
5)Habit (H) :
Demand for a product also depends on the ha bit.When
the person is habituated to the consumption of a particular
commodity then he creates demand for it. For e .g. Demand for
cigar, tobacco, liquor, pan masala etc.
6) Fashion (F) :
When the consumption or use of a particular product is in
fashion trend , then demand for that product rises. Once the
consumption goes out of fashion the demand decreases.
(7) Expectations about future price change : -(Fp)
If the consumer expects some change in future price then
his present demand for the product gets affec ted. For e .g. If the
consumer expects that the price is going to rise in future, then
his present demand for the product increases.munotes.in
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8) Advertising (A) :
In the competitive market, the demand for many products
depends on advertisements and sales propaganda .D e m a n df o r
many products such as soaps, toothpastes etc. is determined by
the advertisement
9) Government Policy (GP) :
If a govt. imposes a tax on the commodity then its
demand falls due to increase in price. If the govt. offers the
subsidy on the pro duct then its demand rises.
10) Climate / Season : -(CI)
Demand for certain products depends on the climatic
conditions and seasonal changes. For e .g. Demand for umbrella
in rainy season.
11) Social Factor (S) :
Demand for a commodity is also a ffected by social factors
like customs, traditions, value system, culture etc. For e.g.
Demand for traditional sweets.
5.4 LAW OF DEMAND
The law of demand establishes a functional relationship
between the price and demand for a commodity.
Demand for any produc t depends on several factors like
Price of the product, income, taste, habit, fashion etc. But, if we
allow all of them to change then the analysis becomes
complicated. To avoid this we make use of the assumption
‘Ceteris Paribus’ i .e.‘other things being equal’ or ‘other things
remaining same or constant and take relation between P and D .’
This gives us the law of demand.
The law of demand states that other things being equal,
Quantity demanded of any commodity (say X) varies inversely
with the Price of that commodity (i .e.X).Thus when Price rises,
the demand falls and when price falls, the demand rises.,,,, ,, , . . . . .xx
xxDf P Y Y P H A F
Df P
xxPDandxxPDDemand Schedule : -
Demand schedule is a tabular presentation of a relation
between Price and Quantity demanded. It snows the quantities
of the goods that people plan to buy at various prices.munotes.in
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Price per Unit (com. x)
(Rs.)Quantity Demanded (com. x)
(units)
50 8 Q
40 12 R
30 20 S
20 30 T
10 50 U
5 65 V
Table 5.1
The above schedule or table shows an inverse
relationship between price and demand. It shows that when
price falls from Rs. 50 to Rs. 5 per unit, the quantity demanded
rises from 8 units to 65 units. Similarly when price rises from Rs.
5 to Rs. 50 per unit, the quantity demanded falls from 65 units to
8 units. Thus, higher the price (Rs. 50), lower is the demand (8
units) and lower the price (Rs. 5), higher is the quantity
demanded (65 units).
Demand Curve :-Demand curve is a graphical presenta tion of
ar e l a t i o nb e t w e e np r i c ea n dq u a n t i t yd e m a n d e d .
Figure 5.1
The demand (dependent variable) is shown on the X -axis
and price Independent variable is shown on the Y -axis. DD is a
demand curve which slopes downwards from left to right. It
shows an inverse relationship between price and quantity
demanded. Each and every point on the demand curve gives amunotes.in
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specific relationship between price and quantity demanded. For
e.g. At some point ‘T’, the price is Rs. 20 and Quantity
demanded is 30 units. The inverse relationship between price
and demand is true for almost all goods in the economy.
Assumptions of the law of Demand
Law of demand is based on following assumption
1.Income remains constant : -There is no change in income –
i.e.neither increas e nor decrease.
2.There is no change in the prices of substitutes.
3.There is no change in the taste and preference of the
consumer.
4.There is no change in fashion and advertisement.
5.No change in govt. Policy. There is neither increase nor
decrease in taxes or subsidies.
6.Consumer does not expect any change in the future price.
7.The quantity of money in circulation remains constant.
Demand function for price
Law of demand explains the functional relationship
between price and quantity demanded.xxQf P
xQQuantity Demanded of commodity XfFunctional relationshipxPPrice of commodity X100 5xxxxQ a bPQPrice Per Unit
`Quantity Demanded in Unit100 5xxQ0 100
1 95
2 90
3 85
4 80
5 75
Table 5.2
It shows an inverse relationship between price and
quantity demanded.munotes.in
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Demand
Figure 5.2
Individual Demand Vs Market Demand is a desire backed by
purcha sing power.
5.5 INDI VIDUAL DEMAND AND MARKET DEMAND
Individual Demand :
Individual demand is the demand for a commodity by an
individual buyer, at a particular price and at a particular point of
time in the market. It is a part of market demand.
Individu al Demand schedule gives us the tabular presentation
of a relation between price and Quantity demanded by an
individual.
Letus take the price of some commodity Xand the
Quantity demanded of commodity Xby two individuals, say
individual A and individua l‘ B ’s e p a r a t e l y .
Price of
Com. XDemand
Individual APrice of
Com xDemand
Individual A
50 1 50 2
40 2 40 4
30 3 30 6
20 4 20 8
10 5 10 10
Table 5.3
The above tables show that as the price of commodity x
falls, the demand for commodity x ,rises fo r both the individuals .
From these two schedules we can draw two demand curves for
individual A and B respectively.munotes.in
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Figure 5.3
In both cases the demand curve slopes downwards from
left to right, indicating inverse relationship between price and
quanti ty demanded.
Market De mand :
If refers to the sum of (aggregate or total) all the
individuals demand in the market for a particular commodity, at
a particular price and time in the market. Market demand is a
summation of individual demands.
Market Deman d scheduler is a tabular presentation of the
relation between quantity demanded and different prices of com.
X by all consumers in the market. It is calculated at a point of
time.
Quantity Demanded Price of Com. X
Individual A Individual BMarket Demand
50 1 2 03
40 2 4 06
30 3 6 09
20 4 8 12
10 5 10 15
Table 5.4munotes.in
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Market Demand curve
Figure 5.4
Demand on x axis and price on y -axis
The above diagram shows that the demand curves of
individual A, B and the market demand curve (D x A+B ) slope
downwards from left to right. This indicates an inverse
relationship between price and demand. Market demand curve
(D x A + B) being the summation of D x A and D x Bis bit flatter.
Variation in Demand and changes in Demand. ( Movement
Vs shi ft in Demand curve )
Variation in demand :-There are many factors that determine
demand .One of the important factors is price. When he demand
changes only due to changes in price then we get variation in
demand. It is explained in two ways namely Extensi on
(Expansion) andContraction ofdemand .
In this we keep all other variables constant and bring
change in price of the product alone.,, , , , , , , . . . . .xx s u b
xxDf P P Y T P H A F
Df P
Figure 5.5(com -x)munotes.in
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Demand is shown on the x -axis and price on the y -axis.
DDx is a demand curv e which slopes downwards from left to
right. Let us take two points viz .Aa n dBo nt h i sd e m a n dc u r v e .
At point ‘A’ the price is1OPand the demand is1OM.A t
point ‘B’ the price is2OPand the demand is2OM.
Now when Price falls from1OPto2OPthen the demand
expands from1OMto2OM.The consumer moves from point A
to point B, but remains on the same demand curve DD. This is
called as the Extension or expansion of demand. Similarly when
price rises from2OPto1OP, then demand contracts from2OMto1OM. The consumer moves from point B to A, but remains on
the same demand curve DD. This is called as contraction of
Demand.
Thus in expansion (extension) and contraction of demand
we get two important things :
1.Change in p rice of commodity alone. (Keeping other
variables constant.)
2.Movement along a given demand curve
For e .g. If government increases the tax on a soft drink
say ‘Goldy’ to discourage the consumption. Now due to the
imposition of tax the price of ‘Go ldy’ drin k rises and thus the
demand contracts. But if the tax is removed then the price of
‘Goldy’ falls and the demand expands.
5.6 CHANGES IN DEMAND (INCREASE AND
DECREASE IN DEMAND) (SHIFT IN D
CURVE)
Demand for any product depends on the price of that produ ct
and also on several factors like prices of substitutes, income,
taste, preference etc. In changes in demand we remove the
assumption other things remaining the same and bring a change
in all demand determinants .
Thus the price may or may not change bu t the change in
factors other than price gives us either increase or decrease in
demand.munotes.in
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Increase in Demand :
Figure 5.6
In this diagram, the demand is shown on the x -axis and
the price on the y -axis. DD is the original demand curve and op
is the original price.
Now increase in demand is shown in two ways
1.At a higher price (OP 1),same quantity is demanded i .e.OM
and
2.At a same price (OP) more quantity is demanded i .e.OM 1.
We ge ta shift in the demand curve from DD to D 1D1.T h e
demand cu rve shifts to the right of the original demand cure
This happens due to
i) Increase in income ii) change in taste and preference in favour
of that commodity iii) Rise in prices of substitutes iv) Change in
fashion v) Rise in population etc.
Decrease in Demand: -
Figure 5.7
Demand on the x -axis and price on the y axis. DD is the
original demand curve. OP is the original price and OM is the
original quantity demanded. Now the decrease in demand is
shown in two ways.munotes.in
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3) At same price (OP 1) less quanti ty is demanded i .e.OM2 and.
4) At a lower price (OP2), same quantity demanded i .e.OM 1.
In this case ,the demand curve shifts from DD to D 2D2.
The demand curve shifts to the left of the original demand curve.
This happens due to
i)Fall in income
ii)Change in taste and preference against the commodity
iii)Consumption goes out of fashion.
iv)Fall in prices of substitutes
v)Fall in population etc.
Thus in increase and decrease in demand weget 2
things
I)Change in factors other than price (price may or may not
change)
II)A shift in the demand curve. To the right increase and to the
left decrease.
A combined case (you can draw a linear
ornon-linear
demand. )
Figure 5.8
Variation in Demand Change in Demand
1) It occurs due to ch ange
in price alone1) It occurs due change in
factors other than price
2) It gives us movement
along a given demand
curve2) It gives us a shift in
demand curves
3) It is explained with
Expansion (Extension)
and Contraction of
Demand.3) It is explaine dw i t h
increase and decrease
in Demand.munotes.in
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Figure 5.9
5.7 SUPPLY (S)
The supply side of the market explains the behaviour of
the seller. In economics supply means, the amount of the
commodity which the seller is able and willing to offer for sale at
ap articular price, during a particular period of time. Supply is a
relative term. It is always referred in relation to price and time.
Supply & price are directly related.
In economics, supply means. “the amount of the
commodity which the seller (producer) i sa b l e&w i l l i n gt oo f f e r
for sale at a particular price, during certain period of time.
Determinants of supply :-(factors influencing supply) Factors
affecting supply of a commodity are –
1)Price of the commodity :-Price is the single largest factor
influencing the supply of a commodity. More is supplied at a
lower price & less at a higher price.
2)Seller’s expectations :-sellers expectations about the
future price affects the supply. If a seller expects the price to
rise in the future, he will with -hold his stock at present and
there will be less supply now.
3)Natural Conditions :-Supply of some commodities such as
agricultural products, depends on the natural environment or
climatic conditions like rain fall, temperature etc. eg. A good
monsoon will produ ce a good harvest ,so the supply of the
agricultural products will increase.
4)Transport Conditions : -There should be well connected
proper approach routes, quick & cheap modes of
transportation & effective and quick communication systems.
This will increa se supply.
5)Price of Related products :-Prices of substitutes or related
products also influence the supply of a commodity. If the
price of wheat rises, farmers may grow more of wheat &
wheat & less of rice so supply of wheat will rise .
6)Cost of Production :-When the cost of production rises the
supply decreases. E .g. When factor payments (rent, wages
etc.) increases ,the cost of production rises & supply falls.munotes.in
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7)The state of Technology :-The supply of the commodity
depends upon the methods of production. An improvement in
technique of production reduces cost & so supply increases.
8)Factor soutside the Economic sphere :-Fire, wars ,
earthquakes etc. may destroy productive assets of the
commodity and restrict future supplies.
9)Govt. policies (Taxes & subsidies) :-With an increase in
the rate of a tax on a commodity, the supply of that
commodity would decrease & vice versa .Ont h eo t h e rh a n d ,
with an increase in the amount of a subsidy on a commodity,
its supply would increase and vice versa.
10)Nature of Market :-Supply of a commodity would be higher
when there is a competitive market. But in monopoly, the
supply may be low. This is so because a monopolist may
create artificial scarcity to raise the price.
11)Period of time :-In a very short period, the supply of a
commodity may be fixed, whatever may be the price. But
over a period of time, the supply is adjusted with demand.
12)Self –Consumption :-If a farmer keeps a large stock for
self–consumption then the supply is less.
Sx = f (Px, Psub, Sex p, Mat, Cond, …)
5.8 LAW OF SUPPLY
The law of supply explains the relationship between price
and quantity supplied. The law of supply states that ‘other things
remaining the same, quantity supplied of any Commodity (say x)
varies directly with the price of that commo dity (ie x). Thus when
price rises, the supply rises and when the price falls, the supply
also falls.,, , , , , . . . . .,xx s u b p
xx
xxxxSf P P I G T G
Sf P
PS PS
(I = Investment, G = Goal, T = Technology etc.)
Supply Schedule :-Supply schedule is a tabular presentation
of a relation b etween price and quantity supplied of a particular
commodity. It shows the quantities of the good that the seller
plans to sell at various prices.
Table 5.5
Price () (Com. X) Supply (Com. X)
50 500 T
40 400 U
30 300 V
20 200 W
10 100 Xmunotes.in
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The above table (schedule) shows the direct relationship
between the price and Quantity supplied. It shows that when
price falls from Rs.50/-toRs.10/-then the supply also falls
from 500 units to 100 units. Similarly, when the Price rises fro m
Rs.10/-toRs.50/-then the supply prises from 100 units to 500
units. Thus, higher the price ( Rs.50/-), higher is the supply (500
units) and lower the price ( Rs. 10/-), lower is the Quantity
supplied (100 units).
Supply Curve :It is a graphical (diagrammatic )p r e s e n t a t i o no fa
relation between price and quantity supplied.
Figure 5.10
Supply on x –axis and price on the y -axis. SS is the
supply curve which slopes upwards from left to right. It shows a
direct relationship between price and quantit ys u pplied .Each
and every point, onthe supply curve gives us a specific
relationship between price and supply at that point. For e.g.
Point ‘V’ shows that the price is Rs.30/-and the supply is 300
units. This direct relationship between price and supply is true
for almost all goods in the economy.
Assumptions of Law of supply
Assumptions : -The law of supply is based on following
assumptions.
1)Self-consumption :-The law assumes that the producer of
a commodity dose not increase his own consumption of a
commodity.
2)Technology :-The law assumes that there is no change in
the technique of production. The technology or the method of
production remains constant. i.e. absence of technological
change.
3)Cost of Production :-The law of supply assumes t hat the
cost of production remains constant. There is no change in
the cost of production. E .g. Wages, Interest etc. are
unchanged.munotes.in
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4)Fixed Scale of Production :-During a given period of time it
is assumed that the scale of production remains constant. If
the scale of production changes, then the level of supply will
also change irrespective of change in the price of the
product.
5)Govt. Policies :-Govt. Policies liketaxation policy, trade
policy etc. are assumed to be constant. There is no change
insubsidies also.
6)No change in Transport Cost :-The law assumes that
transport facilities & transport costs are unchanged .There
are given means of transport.
7)No speculation :-The law assumes that the sellers don’t
speculate about the future chang es in the price of the
product.
8)Prices of Competitive Goods :-It is assumed that the
prices of all competitive goods which are substitute to a
product remain constant.
9)Weather Conditions :-The law assumes that the weather
conditions are normal e .g. Normal rain fall, absence of
natural calamities etc.
5.9 INDIV IDUAL SUPPLY AND MARKET SUPPLY
Supply is the quantity (amount) of a commodity which the
seller is able and willing to sell a ta particular price and at a
particular time in the market.
Individual supply :It is the supply of a commodity by an
individual seller at a particular price and at a particular point of
time in the market.
Individual supply schedule :It gives us the price and quantity
supplied of a commodity by an individual seller .
Let us take the price of some commodity X and the
quantity supplied of commodity X by say two sellers A and B.
Table 5.6
Price of
Com. XSupply of X
by Seller APrice of
Com xSupply of X
by Seller B
50 5 50 10
40 4 40 8
30 3 30 6
20 2 20 4
10 1 10 2munotes.in
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The above tables show that for both the sellers (A and B),
sell less of X when price falls andsupply more of commodity x
when price of commodity x rises.
Individual supply curve :-It is a graphical presentation of a
relation between price and suppl y.
Supply curve Supply curve
(Seller -A) (Seller -B)
Figure 5.11
Upward sloping supply curve (SxA and S x B )give direct
relationship between price and supply.
Market supply :-It refers to a sum of (aggregate / total) all th e
sellers supply in the market of a particular commodity, at a
particular price and time in the market. Market supply is the
summation of all individual supply.
Market supply schedule :-It is a tabular presentation of a
relation between quantity su pplied at different prices of com. x
by all the sellers in the market. It is calculated at a point of time.
Quantity Supplied Price of Com. X
Seller A Seller BMarket Supply
50 5 10 15
40 4 8 12
30 3 6 9
20 2 4 6
10 1 2 5
Table 5.7munotes.in
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Total Market supply curve :-
Supply
Figure 5.12
Supply on the x -axis and price on the y -axis. The above
diagram shows that the supply curves of sellers Aa n dBa n dt h e
market supply curve (Sx A+B) ,slope supwards from left to right.
This shows a direct relationship between price and supply. The
market supply curve (S x A + B) being the summas sion of s x A
and S x B is flatter.
Variation in supply and changes in supply (Movement
V/S shift in supply curve)
Variation in Supply : Supply of any commodity d epends on
several factors such as price of that product, prices of
substitutes, investment outlay, goal, technology etc. But in
variation in supply we assume that all other variables remain
constant and we take note of change in price alon ethat affects
the supply. It is explained in two ways viz .extension
(Expansion) and contraction of supply.
In this case we keep all other variables constant and
bring change in price of the product alone, which affects supply .,, , , , . . . . .xx s u b p
xxSf P P I T G
Sf P
Figure 5.13munotes.in
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Supply is shown on the x axis and price on the y -axis.
SSx is he supply curve which slopes upwards from left to right.
Weselect two points on supply curve as A and B.
At point ‘A’ the price is OP 1and supply is OM 1.Atpoint
‘B’, the price is OP2 and the supply is OM2.
Now, when price rises from OP1 to OP2 then the supply
expands from OM1 to M2. The seller moves from point A to B
but remains on the same supply curve i .e.SS. This is called as
Expansion (Extension) of supply .
Similarly ,when price f alls from OP2 to OP1, the supply
contracts from OM2 to OM1. Now the selle r moves from point B
to point A but remains on the same supply curve i .e.SS.This is
called as contraction of supply .
Thus in extension and contraction of supply, w e get i) change i n
price alone ii) movement along a given a supply.
5.10 CHANGES IN SUPPLY –SHIFT IN SUPPLY
CURVE (INCREASE AND DECREASE IN
SUPPLY)
Supply of any product or commodity depends on the price of
that product and also on the technology, govt. policy, goal o r
objective etc. In, changes in supply we remove the assumption
‘other things remaining constant ’and bring a change in all
variables.
Thus the price may or may not change but change in
factors other than price gives us either increase or decrease in
supp ly. We get a shift in supply curve .
Increase in Supply :
Figure 5.14
Supply on the x-axis and y-axis. SS is the upward sloping
supply Curve (original) .The original Prince is OP and Original
Quantity supplied is OM. Now, increase in supply is shown i n
two ways .munotes.in
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1.At same price (OP), more quantity is supplied i .e.OM1 and
2.At a lower price (OP1), same quantity is supplied i .e.OM.
We get a shift in the supply curve from SS to S1S1. The
supply curve shifts to the right of the original supply curve.
This happens due to
i)Fall in cost of production,
ii)Improvement in technology
iii)Favourable change in govt. Policy
iv)Increase in investment etc.
Decrease in supply :
Figure 5.15
SS is the Original supply curve. OP is the origina l price
and OM is the original quantity supplied. Now increase in supply
isshown in two ways : -
3)At same price (OP), less quantity is supplied i .e.OM2 and
4)At a higher price (OP2), same quantity is supplied, OM.
In this case the supply curve shifts to the left of the
original s upply curve (SS to S 2S2)
This happens due to
i)Rise in cost
ii)govt. policy becomes unfavourable
iii)fall in investment outlay
iv)Transport bottleneck etc.
Thus in increase and decrease in supply we get
I)Change in factors other than price
II)Shift in the supply curve –to the right then increase and to
the left then decrease in supply.munotes.in
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Figure 5.16
Variation in Supply Change in Supply
1)It occurs due to change in
price alone1) It occurs due change in
factors other than price
2)It gives us movement
along a given supply curve2) It gives us a shift in
supply curves
3)It is explained with
Extension and Contraction
of supply.3) It is explained with an
increase and decrease
in supply. If the curve
shifts to the right then
increase and if to the left
then decrease
Figure 5.17
5.11 MARKET EQUILIBRIUM
Market is a network of dealings between buyers and
sellers irrespective of any geographical specification.
Equilibrium is a state of rest or balance where two
opposite forces are balanced with each other in such a way that
any further movement away from that position is not possible as
well as profitable.
As to cut a piece of cloth we need two blades of scissors,
similarly to determine the market price of a commodity we need
two economic variables viz .demand and supply. Demand and
supply together give us the market equilibrium.munotes.in
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The demand and price are inversely related and the
demand schedule and curve explains the quantities that
individual plan to demand at various prices.
Similarly the supply and Pr ice are directly related and the
supply schedule and supply curve explains the quantities that a
seller plans to sell at various prices.
Price ( `) Demand Supply Pressure on Price
50 100 500 Downward
40 200 400 Downward
30 300 300 Neutral
20 400 200 Upward
10 500 100 Upward
Table 5.8
To begin with, let us assume that the price is Rs. 50/ -At
this price the supply (500 units) is greater than the demand (100
units). Due to the excess supply we get a downward pressure
on the price (t oom u c ho fa nything reduces its value). Now the
price falls to Rs. 40/ -Now there is some increase in demand
and fall in supply, yet the supply is greater than the demand.
Thus we ge ta further downward pressure on price. The process
continues till we reach equilibriu mp o i n ti .e.price (Rs. 30/ -)
wher eD=S( 3 0 0u n i t s ) .
Similarly at the price Rs. 10/ -, we find that the supply (100
units) is less than the demand (500 units). It shows scarcity
(Sis an upwar d pressure on price. It rises till i t reaches the
equilibrium point, i.e. E.
Thus Rs. 30/ -is the equilibrium price where D = S. No
further movement is possible as well as profitable. 300 units is
the equilibrium quantity. This e quilibrium price is also c alled a
‘market clearing price’ because at this price everyone in the
market is satisfied.munotes.in
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It is explained in the following diagram
Figure 5.18
Units of commodity (D and S) are shown on the x -axis
and price on the y -axis. The downward slop ing demand curve
DD xcuts the u pward sloping supply curve SS xat equilibrium
point ‘E’. At this point the equilibrium price is ‘OP’ (Rs. 30/ -)a n d
equilibrium quantity is OM. (300 units).
Now, let us assume that the price rises from OP to OP1.
Now we find that the supply P b is greater than the demand P1a.
Due to surplus, there is a downward pressure on the price and it
falls back to OP.
Similarly at OP2 price, the supply P 2dis less than the
demand P2C. Now, due to scarcity the price rises till it comes
back to the original price OP.
In this way, with the necessary changes in demand and
supply, the system comes back to the original point of
equilibrium (e .g. A ball kept at the bottom of the bowl.)
Example
Equilibrium Price
Demand Equation: -xxD a bPWherexD=Demand for commodity x
a= constant parameter giving Quantity demanded
irrespective of price.
b= Constant parameter giving relation between P x
andxDxP= Price of Commodity X.
As ‘b’ has negative sign the relationship is inverse.munotes.in
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Supply Equation: -xxS c dPxSSupply of commodity xcConstant parameter giving quan tity supplied
irrespective of price
d= Constant Parameter giving relationship between P x
and S x
Px= Price of commodity X
Here ‘d ’ has a positive sign. Thus the relationship is
direct.
Let us assume that34 3xxDPand64xxSPNow at equilibrium :xxDS34 3 6 434 6 4 328 7
28
7
4xxxxx
x
xPPPPP
P
P
Now let us insert price ‘4’ in the equations of demand and
supply.
34 334 3 434 1222xxx
x
xDPD
D
D
6464 46 1622xxx
x
xSPS
S
S
4xPis the equilibrium price where Quantity demanded
equals quantity supplied. (i.e. 22 units)
Market Not in Equilibrium :
Market not in equilibrium explains a situation of
disequilibrium in the market. It is a situation where D >So rS <
D. Thus there is either shortage or surplus.
At equilibrium S = D but ifSDt hen
(I) (II)
S>D S(surplus) (scarcity)munotes.in
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Figure 5.19
I)In diagram I, we find that at OP1 price the supply P1 b (OM2)
is greater than the demand P1 a (OM1). It shows that there
is surplus in the market. The seller wishes to sell more bu t
demand is less. Thus to attract the buyers, the seller will
lower the price. The process continues till we reach the
equilibrium point (E), price (OP) and quantity (OM).
II)In diagram II, we find that at OP2 Price, the supply P2d
(OM,) is less than the dem and P2C (OM2). It shows that
there is a scarcity or shortage of goods. The buyers are
willing to buy more but the supply is less. Now the seller will
take advantage of this situation and will raise the price. The
process continues till the system reaches t he equilibrium
point (E), Price (OP) and quantity ( OM).
Thus the activities of buyers and sellers always push the
market price towards the equilibrium price. The shortages and
surpluses are temporary. Reaching equilibrium point (fast or
slow) differs from market to market .
Three steps toanalyse changes in Equilibrium :
The position of the demand and supply determines
equilibrium price and quantity. Due to the changes in factors
other than price we get a shift in the demand and supply curves.
These factor s are changes in prices of substitutes, income,
investment outlay, govt. policy etc. it gives us either increase or
decrease in demand and supply.
The effects of shift in demand and supply on market
equilibrium are studied in three steps.
a)A change due to shift in demand curve.
b)A change due to a shift in supply curve
c)A change due to shift in both i .e.the demand and supply.munotes.in
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A)Change in Market equilibrium due to a shift in demand curve.
Figure 5.20
Let us explain the situation with an example of Air-
conditioners (A Cs). In the above diagram ‘E’ is the original point
of equilibrium, OP is original equilibrium price and OM is original
equilibrium quantity (D=S) .
a)Case of increase in demand :
Let us assume that it is a summer. Due to the rise in heat
we g et an increase in demand of ACs in spite of no change in
price. When the demand for ACs increases we get a shift in the
demand curve (to the right) from DD to D1D1. It cuts the supply
curve (SS) at a new equilibrium point E1. Now the price rises
from OP to OP 1.This rise in price brings higher supply and at
new equilibrium point ,the demand equals supply at OM 1.
In this case we get two important things. One is we get a
shift in demand curve from DD to D1D1.i.e.increase in demand .
Another is that at new equilibrium point E1 there is an expansion
of supply as we remain on the same supply curve.
b)Case of Decrease inDemand : -
During winter the demand for ACs falls due to cold. Thus
the demand curve shifts to D 2D2i.e.decrease in demand. It cuts
the sup ply curve (SS) at new equilibrium point E 2.T h ep r i c ef a l l s
to OP 2. Now due to fall in price, the seller will contract the
supply. Now the new quantity will be OM 2.I nt h i sw eg e t
decrease in demand where we shift over to a new demand
curve D 2D2. We also g eta contraction ofsupply (movement on
the same supply curve SS).munotes.in
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B)Change in market equilibrium due to a shift in supply
curve.
Figure 5.21
In both the diagrams D Di st h eo r i g inal demand curve
cutting S S which is original supply curve .Original equilibrium
point is E, equilibrium price is OP and equilibrium quantity is
OM.
Letus take e .g. Of production of sugarcane and sugar,
affecting its supply.
a)Increase in supply : -
Let us assume that due to sufficient rainfall, the
production of sugarcane increases. Thus the supply of sugar
increases which results in the fall in price of sugar. Thus the
supp ly curve shifts to the right S1 S1 and cuts the demand curve
at new equilibrium point E1. The price falls from OP to OP and
supply increases to OM1.
Now due to the fall in price of sugar, the demand for
sugar will rise. More sweets will be created due to fall in cost of
input i .e.sugar. Thus higher supply will be matched by higher
demand (OM 1)a tn e w equilibrium price OP 1.H e r e( a tE 1 )w e
get an increase in supply where supply curve shifts to the right
(S1S1) and expansion of demand i .e.movement along a given
demand curve DD.
b)Decrease in supply : -
Let us assume that due to a bad monsoon, the production
of sugarcane falls. Thus the supply of sugar decreases. The
curve shifts to the left (S2 S2) and we get a new equilibrium
point E2. Now the price rises to OP2. Now new quantity supplied
(OM2 )will be matched by contraction of demand to OM2. (fall in
supply of sugarcane reduces the supply of sugar OM2).T h u s
price of sugar rises to OP2.munotes.in
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In this case we get decrease in supply i .e. shift in supply
curve SS to S2 S2 and contraction of demand i .e.movement
from E to E2 along a given demand curve DD.
c)Change in market Equilibrium due to a shift in both i .e.
Demand and supply.
In this case we observe and study a simultaneous
increase or decrease in demand and supply. We can explain
this with the help of several situations like increase in s upply ,
decrease in demand and vice versa and even the change in
extent (more or less).
In this case let us observe two situations with increase in
demand and decrease in supply.
Figure 5.22
In both the cases the original point of equilibrium is E(D =
S), OM is original quantity and OP is original equilibrium price.
a)In this we find that demand increases more than
proportionately. We get a large increase in demand. Thus
demand curve shifts from DD to D1D1 (greater distance). Say
due to festival demand for sugar increases very fast.
But we get a decrease in supply may be due to bad
season. But here supply decreases slightly from SS to S1S1.
Now the new equilibrium point is E1 and price rises
sharply from OP to OP1 due to very high increase in demand.
b)In his case we get a moderate increase in demand from DD
toD2D2 . But due to a very bad season the supply of sugarcan e
and so sugar decreases sharply from SS to S2S2. Now the price
again rises sharply from OP to OP2 and Quantity falls from OM
to OM2.munotes.in
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Thus in both the cases, the price rises sharply from OP to
OP1. In one case (a) the quantity rises and in other it falls (b).
5.12QUESTIONS
1)What is market?
2)What is competition?
3)Write a note on Demand Curve .
4)Explain the difference between Individual demand and
market demand.
5)Explain the difference between individual supp ly and
market supply.
6)Explain the concept of market equilibrium.
7)Write notes on
Law of demand
Law of supply
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Unit -6
ELASTICITY OF DEMAND
Unit Structure:
6.0 Objectives
6.1 Elasticity of Demand
6.2 Price elasticity of demand
6.3 Types of price elasticity of demand
6.4 Concept of Revenue
6.5 Tax and its impact
6.6 Uses of the concept of elasticity of demand
6.7 Questions
6.0 OBJECTIVES
To study the price elasticity of demand
To understand the relationship between revenue and
elasticity
To study the impact on price elasticity of demand
To study tax and its impact
6.1 ELASTICISES OF DEMAND (ED)
The law of demand explains an inverse relationship
between price and quantity demanded i .e.when pr ice rises
(falls), the demand falls (rises). But here we do no tmeasure the
change i .e.how much is the change in price and how much is
the change (response) in dema nd.
Thus in elasticity of demand we try to measure the
change.
6.2 PR ICE ELASTICITY OF D EMAND (PED)
PEd is the degree of responsiveness of quantity
demanded of any commodity (Say x) to change in the price of
that commodity (say x).
It is measured as
Percentage change in Quantity demanded of com xPercentage change in price of com.xPEd munotes.in
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New D D100D
New P P100P
D
D
P
P
D P
DP
PD
DPxx
x
xx
x
x
x
X
X
x X
xX
xx
xxOriginal
OriginalPEdOriginal
Original
PEd
PEd
PEd
Px= original price of corn .x
Dx= original Demand for corn .x
Dx= change in demand (New -original)
Px= change in Price (New -original)
Original New
Price Rs. 50 Rs. 48
Demand 100 units 110 units
Pr
50 110 100
100 48 50
50 10100 2PDPEdDPP NewD OriginalDemandPEdD NewP Original icePEd
PEd
550 10100 252PEd
PEd
PED = -2.5 ( -ve sign sho ws the inverse relation between P and
D).
6.3 TYPES OF PRICE ELASTICITY OF DEMAND
(PED)
1)Unit Elastic Demand : When change in price brings about
exactly proportionate change in quantity demanded then
demand is said to be Unit elastic. The Ed = 1. For e .g.If price
falls by 10%, then the demand rises by 10% and when price
rises by 10%, the demand falls by 10% .munotes.in
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10110PEd
Figure 6.1
When price falls from OP to OP1 then demand rises from
OM to OM 1.HereMM1 (rise in D) = PP1 fall i n price. Similarly
when price rises from OP 1to OP, then demand falls from OM 1to
OM. Once again M 1M=P 1P.
2)Relatively Inelastic Demand :-when change in price brings
about a less than proportionate change in quantity demanded
then demand is said to be r elatively inelastic. If price falls by
10%, then the demand rises say by 5% and if price rises by 10%
then demand falls by 5% .
51110 2PEDPEdis less than one (Ed < 1)
Figure 6.2munotes.in
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When price falls from OP to OP1 then demand rises from OM to
OM1. Here rise in demand MM1 < fall in price PP1 .
We get a steeper demand curve10% 5%PDand5% 10% 5%P
This h appens in case of necessary goods.
3)Relatively Elastic Demand :-
When change in price brings about a more than
proportionate change in quantity demanded then demand is said
to be relatively elastic. For eg. If price falls by 10% then demand
rise by say 20% or when price rises by 10%, demand falls by
20%1Ed10%P20%D
202110Ed
Figure 6.3
When the price falls from OP to OP1 then demand rises
from OM to OM1 Here MM1 i .e.rise in demand is greater than
fall in price PP1 (MM1 > PP1).
The dema nd curve is flatter. This happens in case of
luxury goods.
4)Perfectly Inelastic Demand :-When change in price brings
outno change in quantity demanded then demand is said to be
perfectly inelastic. He reEd = 0.H e r ep r i c e may fall or rise by
10% but deman d remains constant. It does not change.10%. .010%. .00010PDPDEd
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Figure 6.4
Though price falls from OP to OP1, yet demand remains
constant i .e.OM. We get a vertical straight line demand curve.
This happens in case of neural goods, for e .g. Salt
5)Perfectly Elastic Demand :-When a slight change in price
brings out infinite (immeasurable) change to quantity demanded
then demand is said to be perfectly elastic demand.Ed
Figure 6.5
When price falls from PP1, We get i nfinite change (rise) in
demand.munotes.in
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We get a horizontal demand curve.
P D Ed
Unit Elastic10%10%=1
Relatively Inelastic10%5%<1
Relatively Elastic10%20%>1
Perfectly Inelastic10%D.0 =0
Perfectly Elastic
6.4 CONCEPT OF REVENUE
Let us now study the concept of revenue say the Total
Revenue (TR). Purchase of goods by the consumer involves
payment i .e.Total Expenditure or sell of goods by the seller
involves receipts i .e.Total Revenue.
When the consumer spends (Total Expenditure) then the
selle rr e c e i v e si n c o m ei .e.Total Revenue. Thus expenditure of
the consumer is income or revenue to the seller.
Thus we get the concept as Total Revenue or Total
Expenditure or Total Outlay.
Now let us find out how change in price brings out
change in demand to measure the change in (TR or TO or TE)
elasticity of demand.
Total Revenue or Total outlay or Total expenditure is
measured as PX Q Dd (i.e. Price multiplied by quantity demand)
1)Unit Elastic Demand :-when change in price brings about
change in deman d in such a way that the total outlay remains
constant then demand is said to be unit elastic
Price x Q Dd. = TO / TR / TE
60 100 6000
50 120 6000 Ed < 1
40 150 6000
2)Relatively Inelastic Demand :When change in price brings
about change in demand in such a way that total outlay goes on
decreasing then demand is said to be relatively inelastic or Ed<1
PxQDd =TO or TR or TE
60 x1 0 0 =6000
50 x1 1 0 =5500 Ed < 1
40 x1 2 0 =4800munotes.in
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3)Relatively Elastic Demand :-when change in pric eb r i n g s
out charge in demand in such a way that the total outlay goes on
increasing then demand is said to be relatively elastic or Ed > 1
Price xQDd =TO or TE or TR
60 x100 =6000 Ed > 1
50 x150 =7500
40 x200 =8000
Eg 1
Change in price Chan ge in Total Expenditure PEd
Fall Constautor No change Ed = 1
Rises constant or No change Ed =1
Falls Rises Ed =1
Rises Falls Ed =1
Falls Falls Ed =1
Rises Rises Ed =1
Eg.2
Price QDol To ed
50 8 400 Relative elastic Ed > 1
40 12 480
30 20 600 unit Elastic Ed =1
20 30 600
10 50 500 Relatively Inelastic Ed =1
5 65 325
E.g.
SR. No. Price P Quantity Demanded TR / TO Price Ed
(P x Q)
1 5 8 40 Unit elastic
8 5 40 Ed =1
2 5 8 40 Relatively
elastic
7 6 42 Ed >1
3 5 8 40 Relatively
Inelastic
4 9 36 Ed <1
*Price ceilings and Floor Taxes and their impact .
*Price ceiling :-Price ceiling is a situation when the price is no
allowed to rise above a certain level. Price ceiling has been
found to be of gre at imp ortance in many cases e.g.house rent
market.munotes.in
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Figure 6.6
Government imposes a price ceiling to control the
maximum prices that can be charged by suppliers for the
commodity. This is done to make commodities affordable to the
general public. However, pr olonged application of a price -ceiling
can lead to black marketing and unrest in the supply side.
For e .g., : Let’s consider the house -rent market. In the
above graph, a price of Rs. 3/ -has been determined as the
equilibrium price with the quantity at 30 homes. Now, the
government determines a price ceiling of Rs. 2/ -.A tt h i sr a t e
there is a shortage (demand for 40 houses, but supply is only 20
houses). In the long run, the extra 20 people will try to get a
house on rent, which will eventually give rise to black market
and higher rents.
Price Floor : Price floor refers to a situation in which the price is
not allow ed to decrease below a certain level. For e .g.
Government of India announces procurement price for minimum
prices at which the government purc hases commodities like
wheat, rice and other agricultural commodities.
Floor price is higher than the market equilibrium prise.
Figure 6.7munotes.in
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The government in order to increase the supply of rice
declares a floor or minimum price of Rs. OP1 per kg. The
market demand and supply settles on the equilibrium price OP.
Since floor price is higher than market equilibrium price, supply
becomes more than demand resulting in surplus of rice o the
extent of OM2.
6.5 TAX AND ITS IMPACT
Factors Influencing Elasti city of Demand :
The demand for a commodity may be elastic or inelastic
depending upon the following factors.
1)Urgency of wants : One of the most obvious factor
influencing the elasticity of demand is the urgency of wants.
When the desire for a commodit y is as strong as a
necessity then the demand for it will tend to be inelastic.
Less strongly felt wants are likely to have an elastic demand
2)Nature of commodity : Goods and services which are
regarded as necessaries of life have generally inelastic
deman d. E.g.:-food grains, clothes, salt etc.
Where as, the demand for luxury goods is generally
elastic. E .g.:-Demand for diamonds, jewellery etc.
3)Availability of substitutes : Ag o o dw h i c hh a sn o
substitutes will have inelastic demand e .g.:-Demand f or
salt, onions, chalks etc.
Where as, goods which have a wide range of substitutes
will have more elastic demand e .g.:-demand for pepsi, case.
Etc.
4)Number of uses of commodity : If a commodity can be put
to several uses then demand for it is reactiv ely elastic. E .g.:-
Multipurpose goods like coal, electricity etc. will have elastic
demand.
5)Income : A consumer having high income displays relatively
inelastic demand for many goods where as a poor consumer
has more elastic demand for the goods in gene ral.
6)Proportion of Income : The proportion of income which is
spent on commodities also influences elasticity of demand. If
this proportion is very small then demand tends to be
inelastic.
7)Influence of Habit : When a person is habituated to the
consumpti on of certain commodities then his demand for that
commodity will be inelastic. E .g.:-Demand for cigarettes to a
chain smoker is relatively inelastic.munotes.in
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8)Element of Time : Market demand for any commodity in
general will be less elastic in the short period b ut it becomes
more elastic in the long period. It is so because.
It requires time in spreading the news of a given change
to all the buyers in the market.
Consumer may expect a further change. This he may not
ract immediately to a given change.
People may not change their habits and preferences
instantaneously.
6.6 USES OF THE C ONCEPT OF ELASTICITY OF
DEMAND
1)Fixation of price (product pricing) : The concept of
elasticity of demand is useful to the monopolist in formulating
a suitable price policy. H e can charge a higher price if the
demand for his product is relatively inelastic.
2)Formulation of Tax policy : The concept of elasticity of
Demand is useful to the Govt. in formulating an appropriate
policy. Tax can not be levied heavily on a commodity the
demand for which is elastic. When the seller tries to shift the
burden of tax over to the buyers by charging higher prices
these buyers may immediately reduc et h ed e m a n df o rt h e
product it self. Hence the govt. may not be able to raise
adequate revenue fro m taxes on such commodities.
3)Price Discrimination : Price discrimination implies the seller
charges different prices to different buyers for the same
product one of the factors underline price discrimination is
differences in elasticity of demand. The sel ler charger a
higher price to the buyer or in the market where demand for
his product is relatively inelastic & at a lower price to the
buyer oriented market where the demand is relatively elastic.
Thus differences in elasticity of demand for the product
makes price discrimination possible.
4)Factor Pricing : The concept of elasticity of demand is also
useful in determining factor prices. Those factor prices, the
demand for whose services is inelastic command higher
rewards in the factor market. E .g. :-We c an well observe that
the demand for highly skilled and specialised labour say air
pilots is relatively inelastic and hence they command higher
wages .
5)Process of Devaluation : The concept of elasticity of
demand is to be carefully applied when the Govt. is planning
to undertake the measure of devaluation of currency.
Devaluation measures reducing the value of a currency in
terms of other currency. This measure is undertaken to
overcome disequilibrium in the counties balance ofmunotes.in
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payments. Through devaluation it is expected that the
country’s exports will rise & its imports will decline. But if our
demand for foreign good is inelastic, we will co ntinue to
import goods from abroa d&t h u so u rb a l a n c eo fp a y m e n tw i l l
become more unfavourable.
6)Policy of Nationalis ation : The concept of elasticity of
demand is also useful in formulating the policy of
nationalisation. The Govt. tries to take over or nationalisation
the utility whose demand is inelastic. If such concerns are left
in the hands of private sector t hen th e producers would fix
exorbitant prices & thereby exploit the consumers. Thus to
safeguard the interested the consumers, the Govt.
nationalises such industries.
Thus concept of elasticity of demand is useful in policy
formation and has considerable prac tical utility.
6.7 QUESTIONS
1)What is the price elasticity of demand?
2)Explain the types of price elasticity of demand.
3)Explain the relationship between price elasticity of demand
and total revenue.
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79Module 4
Unit -7
INTERDEPENDENCE AND TRADE
Unit Structure :
7.0 Objectives
7.1 Specialization and trade
7.2 Meaning of absolute cost advantage
7.3 Meaning of Opportunity cost and comparative cost
advantage
7.4 Comparative advantage and tra de
7.5 Application of comparative cost a dvantage to international
trade
7.6 Gains from trade
7.7 Questions
7.0 OBJECTIVES
To understand the concept of international trade and
specialization
To study the concept of absolute cost advantage
To study the diff erence between opportunity cost and
comparative cost advantage
To study the relevance of Comparative advantage and trade
To understand the applications of comparative cost advantage
to international trade
To understand the gains from trade
7.1 SPECIALIZAT ION AND TRADE
International trade refers to trade in goods and services
between the countries of the world. When producers and traders
from one country sell goods and services to other countries, they
are said to be exporting. Similarly, when producers and sellers
from one country buy goods and services from other countries, they
are said to be importing. International trade thus constitutes
exporting and importing of goods and services by countries of the
world. An economy that involves in internationa l trade is called an
open economy and one that does not involve in international trademunotes.in
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80is called a closed economy. The advantages from international
trade are known as gains from trade.
Trade within the country is called domestic trade. Without
domestic trade, each region within the country will have to be self -
sufficient and the country as a whole will have to sacrifice the
benefits of regional specialization. With domestic trade, each
region can specialize in producing those goods and services in
which it has either a natural or an acquired advantage. Nations can
also gain from specialization. Every country produces more of
some goods than their residents wish to consume i.e. they create
anexportable surplus . Every country also consumes more than
what it can produce and hence create an importable deficit.
Surpluses and deficits in consumption give rise to international
trade. International trade is required to enjoy the gains of
specialization. International trade allows each nation to specialize
in producing those goods and services that it produces relatively
efficiently while trading to buy those goods and services that it
would produce relatively less efficiently. There are three main
sources of gains from trade. The first is those difference sb e t w e e n
countries of the world in climate and factor endowment that lead to
advantages in producing certain goods and disadvantages in
producing others. The second source is the reduction in the cost of
production of each country as a result of speciali zation and large
scale production. The third source is international competition
which promotes rapid technological change and economic growth
than what is possible without international competition.
7.2 MEANING OF ABSOLUTE COST ADVANTAGE
The absolute cost advantage theory of international trade
was put forward by Adam Smith in his work “ The Wealth of
Nations ”. Smith believed that every country has an absolute
advantage in producing some commodity over the others. Thus a
country must import those good sw h i c ha r er e l a t i v e l yc h e a pi no t h e r
countries and export those goods which are cheaply produced
inside the country. Smith advocated a laissez faire economy and
believed in free trade between the countries. Free trade will lead to
specialization, improv ed productive efficiency and greater economic
welfare of the people in the world. Specialization or international
division of labor would lead to a more efficient labor force and the
excess output produced domestically can be traded internationally
for th ose goods which the home country is not efficient in producing
it.
According to Smith, a country should specialize in those
products in which it either has a natural or an acquired advantage.
Natural advantage may be available to a country on account o fmunotes.in
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81climatic conditions, availability of natural resources, abundant
supply of labor etc. However, natural advantage can be exploited
to one’s own advantage only in producing and exporting primary
goods. In value terms, primary goods constitute an insignif icant
percentage of world trade the bulk of international trade is carried
out in manufactured goods and services. The competitive
advantage of nations in the export of manufactured goods and
services depends upon acquired advantage. For example, Japan
has an acquired advantage in the production of high quality steel
although she has a natural disadvantage in not having iron and coal
mines. While India has abundant supply of natural resources in
terms of minerals and mines, it can exploit its natural adv antage
only exporting iron ore and import value added steel from Japan for
want of an acquired advantage. Rapid technological advances
have replaced old products by new ones and have altered the
competitive advantage of nations in world trade. For instan ce,
natural yarn such as cotton, silk and wool have been replaced by
synthetic yarn and synthetic rubber have displaced natural rubber.
APPLICATION OF ABSOLUTE COST A DVANTAGE IN
INTERNATIONAL TRADE
The theory of absolute cost advantage can be illustrated with
the example of a two country two commodity model. Let us
assume that the two countries are India and the United States and
the commodities are tea and wheat. Let us also assume that both
the countries have the same quantum of productive resources
available to them to produce the two goods. Both the countries
have 200 units of resources. In the absence of international trade,
both India and the United States decide to allocate her resources
equally between tea and wheat. Accordingly, India would be
producing 12.5 quintals of tea and 5 quintals of wheat, whereas,
United States would be producing 2.5 quintals of tea and 10
quintals of wheat. The total production of tea and wheat will be 15
+ 15 = 30 quintals. The production possibilities of tea and wheat
are given in Table 7.1 below. It is clear from these figures that
India has absolute advantage in the production of tea over the
United States and the United States has absolute advantage in the
production of wheat over India. In India, eight units of resources
are required to produce one quintal of tea as against 20 units to
produce one quintal of wheat. In the United States, 20 units of
resources are required to produce one quintal of tea as against 10
units to produce one quintal of wheat. Indi a can produce one
quintal of tea with only 40% of resources required to produce in the
United States and the United States can produce one quintal of
wheat with only 50 % of the resources required to produce in India.
When both countries decides to specia lize as per the principle of
absolute cost advantage and agree to trade in the ratio 1 : 1, India
will produce 25 quintals of tea and the United States will produce
20 quintals of wheat. The total output will now be 45 quintals. Themunotes.in
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82world as a whole wil l be better off because specialization has led to
an increase in output by 50 per cent. Further trading in the ratio
1:1, India will receive 0.6 more wheat for every unit of tea exported
and the United States will receive 0.75 more tea for every unit of
wheat exported.
If the princip le of absolute cost advantage is applied to the
countries of the world, it will lead to international division of labor
and specialization. Greater efficiency will improve world output and
the economic welfare of the world as a whole will improve.
7.3 ME ANING OF OPPORTUNITY COST AND
COMPARATIVE COST ADVANTAGE
The comparative cost advantage theory of international trade
was put forward by David Ricardo (1772 -1823) in his well known
work ‘Principles of Political Economy’, 1817. David Ricardo based
his th eory of comparative cost advantage on his labor theory of
value. According to the labor theory of value, the value of any
product can be determined by the labor content or the labor cost
and the exchange of goods take place on the basis of the relative
content of labor in the products. If the prices of products in a given
industry are higher than the labor cost, it will attract labor from other
industries and the supply of products will increase until the prices
become equal to labor cost. The principle of labor cost is based onTable 7.1 –Absolute Cost Advantage (200 Units of Resources)
India United
StatesAbsolute cost
ratio
Tea (Quintals) 25 (8
Units)5( 4 0
Units)8/40 = 0.2
Wheat (Quintals) 10 (20
Units)20 (10
Units)20/10 = 2.0
Domestic
Exchange Ratio1T=0 . 4 W 1W=0 . 2 5 T
If the terms of trade are set in the ratio 1:1, then India will receive
0.6 more wheat for every unit of tea exported and the United States
will receive 0.75 more tea for every unit of wheat exported. Before
trade, given equal distribution of resources between tea and wheat,
India will produce 12.5 quintals of tea and 5 quintals of wheat
whereas the US will produce 2.5 quintals of tea and 10 quintals of
wheat. Total output of tea and wheat would be 15 quintals each i.e.
30 quintals. Post specialization, India will produce 25 quintals of
tea and the US will produce 20 quintals of wheat. World output will
be 45 quintals. Specialization will therefore lead to improved
economic welfare of the people.
munotes.in
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83the assumption that labor is the only productive factor, that it is
homogeneous, perfectly mobile between occupations and regions
within a country and that there is perfect competition in the labor
market. Since the factors of pr oduction are immobile between
countries, the labor theory of value was found to be inadequate to
explain international trade. In order to explain the basis of
international trade, David Ricardo put forward the theory of
comparative cost advantage.
Accord ing to the doctrine of Comparative Cost Advantage,
international trade takes place because every country has different
advantages in the production of different products. A country will
specialize in the production of that product in which it has a greate r
comparative advantage or her comparative disadvantage is the
least. A country will therefore export the product in which it has
comparative advantage and import the products in which it has less
comparative advantage or has a comparative disadvantage.
Opportunity cost is the cost of opportunity lost. Given the
resources and the production possibility frontier, any country can
produce only a given combination of two goods. In order to
produce more of one good, the country will have to sacrifice more
ofanother good i.e. produce less of another good. If India wants to
produce more wheat, it will have to sacrifice more cloth and vice
versa. The opportunity cost of producing more wheat will be the
additional units of cloth that India will have to sacrifi ce. The
opportunity cost of production is given by the slope of the PPF. A
straight line PPF indicates constant opportunity cost whereas a
concave PPF indicates increasing opportunity cost.
The principle of ‘comparative cost advantage’ explains
interdep endence both within and without the countries of the world
and the gains arising out of specialization. We live in an inter -
dependent world not only in the economic sphere but also every
other sphere of human endeavor. Amongst all the spheres, the
econom ic sphere of inter -dependence is measurable, factual and
verifiable. Comparative advantage has many practical applications
due to interdependence.
Should Sachin Tendulkar cook his own Food?
Sachin is known to be the greatest batsman in the world
today. He has an incredible record in international cricket. With
more than 100 first class centuries and 15000 plus runs in his
cricketing kitty, his record shall remain unrivalled for many more
years to come. Sachin may be multi -talented and possibly he may
be a good cook. But does it mean that he should spare his time
and energy in cooking food for himself and his family. In order to
answer this question, we take recourse to the concepts of
opportunity cost and comparative advantage. Let us assume thatmunotes.in
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84Sachin can cook food for himself and his family in three hours. But
in the same three hours, he could film a commercial for any multi -
national product and earn Rs.10 million. In contrast, Sanjay a
professional chef can work in Sachin’s kitchen and earn Rs.2 500/-
for four hours of cooking. In the same four hours, Sanjay can work
in Copper & Silver, a Grade -A restaurant and earn Rs.2500.
The opportunity cost of Sachin for cooking is Rs.10 million
and that of Sanjay is Rs.2500. Sachin has an absolute advan tage
in cooking because he can do it in three hours i.e. a lesser input of
time. However, Sanjay has a comparative advantage in cooking for
Sachin because he has a lower opportunity cost.
7.4 COMPARATIVE ADVANTAGE AND TRADE
The gains from specialization and international trade depend
upon the comparative cost ratios i.e. trade is possible even when
one country has an absolute advantage in producing both the
commodities. David Ricardo (1772 -1823), the English economist
put forward the comparative cost ad vantage theory of international
trade. In order to understand his theory, let us assume that there
are two countries, the United States and India. Both produce the
same two goods, wheat and cloth. However, the opportunity cost
of producing these two goo ds is different in these two countries.
Assuming a linear PPF i.e. the opportunity cost is assumed
to be constant, let us assume that the opportunity cost of producing
one kilogram of wheat is 0.60 meter of cloth in USA and two meters
of cloth in the UK. The opportunity cost of cloth and wheat in
respect of the t wo countries is given in Table 7 .2.
Table 7 .2–Opportunity cost of wheat and cloth in India and
the USA
Wheat (Kg) Cloth (Meters)
USA 0.60 m cloth 1.67 kg wheat
UK 2.00 m cloth 0.50 kg w heat
Column one reveals opportunity cost per kilogram of wheat and
column two shows the opportunity cost per meter of cloth. The
USA has comparative advantage in wheat whereas the UK has in
cloth.
Column two shows the opportunity cost of producing clo th in
both the countries. The numbers in column two are the reciprocals
of the numbers in column one (1/0.60 = 1.67 and ½ = 0.5). The
opportunity cost of producing wheat is lower in the USA than the
UK. The world output of wheat will be higher if the US A specialized
in the production of wheat. However, the opportunity cost of
producing one unit of cloth in the UK is lower than USA. Worldmunotes.in
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85cloth output would be higher if the UK produces cloth. The
opportunity cost of producing one unit of cloth is only 0.50
kilograms of wheat in the UK whereas it is 1.67 kilograms of wheat
in the USA. The gains from USA specializing in wheat and the UK
in cloth are shown in Table 7 .3.
The advantages of international trade flow from the differing
opportunity costs in the two countries. The following conclusions
are made:
1.Country A has a comparative advantage over coun try B in
producing a product when the opportunity cost of production in
country A is lower. It means, country A has comparative
disadvantage in the other product.
2.Opportunity costs depend on the relative costs of producing two
products and not on absolut e costs.
3.When opportunity costs are the same in both countries, there is
no comparative advantage and there is no gain from
specialization or international trade.
4.When opportunity costs differ in any two countries and both
countries are producing both pr oducts, it is always possible to
increase production of both products by reallocating resources
within each country.
7.6 GAINS FROM TRADE
The classical theory of international trade is based on free
trade between countries of the world and that trade ben efits all
participants due to comparative cost differences. The main benefits
or gains of international trade are as follows:
1.Maximum Output. Free trade maximizes world output. Trade
enables the developing countries to benefit from technological
develo pment taking place in the advanced countries.Table 7.3 –Gains from Specialization with different
opportunity costs.
Wheat ( Kg) Cloth (Meters)
USA +1 . 0 -0.6
UK -0.5 +1 . 0
Total +0 . 5 +0 . 4
To produce one more kg of wheat, the USA must sacrifice 0.6 m of
cloth and to produce one more meter of cloth, the UK must sacrifice
0.5 kg of wheat. If USA specializes in wheat a nd the UK in cloth,
world output of wheat and cloth will increase.
munotes.in
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86Developing countries can import the most modern means of
production and maximize their output. Economists G Haberler
and AK Cairncross observes that developing countries need
foreign capital and technological know how for their
development and without earning foreign exchange through
exports, they will not be able to import foreign capital.
2.Enlarged Consumption Basket. International trade helps
countries to import those goods and services which are either
not produced at home because of the higher costs or the factor
endowments of the country are not suitable for the production of
such goods. Countries of the world can therefore enjoy a larger
consumption basket with trade than without trade.
3.Greater Compet ition and check on Domestic Monopolies.
International trade increases the scope of competition thereby
increasing the efficiency of domestic producers. Further, due to
greater competition, the emergence of monopolies can be
prevented. Greater competitio n can increase the economic
welfare of the people.
4.Mobility of Goods. International trade in goods and services is
a proxy for factor mobility. The disadvantages of factor
endowments are greatly neutralized and the trading countries
are benefited from i nternational division of labor.
5.Increase in the Size of the Markets and Rise in Real
Incomes. According to Professor Myint, due to specialization,
international trade expands the size of markets and hence
goods and services are produced on a larger scale ,t h e r e b y
reducing the cost of production. Greater demand for goods and
services not only increases factor prices but also lead to
innovation and reduced cost of production. Thus higher
demand and lower cost would increase the real income of factor
owner s.
7.7 QUESTIONS
1.What is specialization and how specialization leads to
international trade?
2.What is absolute cost advantage? Explain the application of the
principle of absolute cost advantage to international trade.
3.What is opportunity cost? Explain the application of the
principle of opportunity cost in every -day life.
4.Explain the applications of the principles of opportunity cost and
comparative cost advantage in international trade.
5.Explain the gains from international trade.
munotes.in
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87Unit -8
TRADE POLICY PREVIEW
Unit Structure :
8.0 Objectives
8.1 Trade policy
8.2 Free Trade and Protectionism
8.3 Instruments of Trade Policy
8.4 The Policy of Free Trade
8.5 Advantage s&D i s a d v a n t a g e so fF r e eT r a d e
8.6 Protectionist Policy
8.7 Arguments in favor of the Policy of Protectionism
8.8 Questions
8.0 OBJECTIVES
To understand the meaning of trade policy
To study the difference between Free Trade and Protection
To study various instruments of Trade Policy
To understand the Poli cy of Free Trade
To study the advantages and disadvantages of Free Trade
To understand the meaning of Protectionist policy
To study the arguments in favor of Protectionist Policy
8.1 TRADE POLICY -INTRODUCTION
Trade policy is also known as commercial po licy which is
concerned with international trade between countries of the world.
Exports and imports are the two components of international trade.
Hence, trade policy can be classified into two main policies i.e.
import policy and export policy. Trade policy aims at influencing the
volume; composition and direction of international trade i.e. trade
between one’s own country and the rest of the world. The volume
of trade pertains to the size of imports and exports. The
composition of trade refers to th e goods and services imported and
exported and the direction of trade refers to the countries from
which goods and services are imported and the countries to which
goods and services are exported. If a country has balance of trade
problem i.e. when a coun try has a negative trade balance, its
import policy will be geared to reduce the quantity of imports and itsmunotes.in
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88export policy will be aiming to increasing exports so that there is
equilibrium on the trade account. Thus countries having a problem
of trade def icit follow a policy of import restriction -cum-import
substitution and export promotion to achieve trade balance.
8.2 FREE TRADE AND PROTECTIONISM
Ideologically speaking, there are two policy options available
to a country in the context of international trade. One is the free
trade policy and the other is the protective trade policy. The policy
of free trade was propagated by classical economists like Adam
Smith and David Ricardo by emphasizing on the allocative
efficiency of free trade. The free trad em o v e m e n tb e g a ni nt h e1 9th
Century Great Britain with a heavy emphasis on the distributive
efficiency of free trade. David Ricardo had argued that removal of
tariffs on corn would increase the real wages of workers in Great
Britain on account of reduced prices of corn and also increase the
demand for labor on account of higher profits and more
investments made by the capitalist class.
The policy of protection or protective trade policy was
pursued by the United States in the 19thcentury. Trade polic yi n
the US was dominated by the ‘Infant Industry Argument’ during the
first half of the 19thcentury. Alexander Hamilton put forward two
arguments in favor of protection in his ‘Report on Manufactures’.
He argued that infant industries will achieve econ omies of scale on
account of protection and consequent preferential access to the
domestic market. Further, infant industries will also achieve
economies of experience due to protection which gives them time
to learn by doing.
Towards the end of the 19thcentury when Europe faced
competition from the United States, Argentina and Russia, the
policy of free trade was gradually replaced by the policy of
protection. Germany was the first European nation to invoke the
policy of protection in 1879. Bismarck, the German Chancellor
introduced tariff law in 1879 by giving more protection to industry
and agriculture. In Germany, Friedrich List was the chief advocate
of the ‘ infant industry’ argument. Based on his experience in the
United States and the success o f US protectionist trade policies,
Friedrich List passionately argued in favor of protection in
Germany. His main argument against free trade and for protection
was that that free trade is advantageous between equal countries
and that nations should not b e influenced by allocative arguments
alone. Nations can prosper by the international division of labor or
free trade only if their domestic industries are developed and are
capable of exporting manufactured goods and not raw materials.
Germany was followe db yF r a n c ew i t ht h eM e l i n eT a r i f fL a wo fmunotes.in
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891892 enacted to promote industrial development in France. By the
middle of the 20thcentury, free trade policy was completely
replaced by the policy of protection.
However, after the Second World War, the count ries
following protectionist trade policy began to realize their mistakes
and started making plans for liberalizing international trade and
payments. The International Monetary Fund (IMF) and the
International Bank for Reconstruction and Development were set
up to manage the international monetary system and encourage
international lending. The movement of free trade was reborn after
the Second Great War and the constitution of GATT in the year
1947. With the formation of GATT, a new era of trade liberal ization
began in the world. The GATT (General Agreement for Trade and
Tariffs) was reconstituted into World Trade Organization (WTO) in
the year 1995.
8.3 INSTRUMENTS OF TRADE POLICY
Tariffs, quotas and non -tariff barriers to trade are the
three instrum ents of trade policy. Tariffs and quotas are imposed
by governments to raise customs revenue, improve terms of trade,
restrict imports and expand exports. When government imposes
tariffs on imported goods which are not domestically produced, it is
aimed at raising revenue from imports. Similarly, tariffs are also
imposed on exports in the form of export duties.
In India, tariffs are imposed on imports whereas exports do
not carry any tariffs because India has been consistently
experiencing a negative tr ade balance. In India, export promotion
measures are therefore implemented to encourage exports. For
instance, Export Oriented Units, Export Processing Zones,
Electronic Hardware Technology Park and Software Technology
Parks are set up in India amongst o ther measures to boost exports.
Tariffs on imports and import quotas known as Quantitative
Restrictions are devices used to protect import competing
domestic industries and to accelerate domestic production. Import
duties in particular affect the quant ity and direction of international
trade through prices. Subsidies on export are offered to
encourage exports. Although the WTO prohibits the use of
subsidies to encourage exports, many countries subsidized their
exports in more discreet manner by way of charging low interest
rates on export credit, tax concessions, subsiding production of
export industries and by giving various other facilities thereby
imparting a competitive edge. Import quotas or QRs are direct in
their effect in terms of restricting imports. Aq u o t ai sa na b s o l u t emunotes.in
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90limit fixed by the government on the quantity of import of a
given commodity.
In India, QRs or import quotas were imposed on a large
number of items. It was only on 01stApril 2001 that the QRs were
removed on more than 7 00 items of imports in pursuant to WTO
agreement. All quantitative restrictions constituting quotas,
licenses and canalization were to be phased out by 2003 as per the
commitment made by India to WTO. India lost the case on QRs
against USA and accordingl yo n0 1A p r i l2 0 0 1 ,q u a n t i t a t i v e
restrictions on 715 items were removed.
Quotas as an instrument of trade policy have drawbacks
such as allocative inefficiency and corruption. The WTO prohibits
imposition of quotas, save exceptions. However, tariffs, subsidies
and quotas are easily identifiable instruments of trade policy as
against restrictive trade instruments such as environmental
consideration, child labor content, phy7to -sanitary conditions etc.
Other more discreet forms of trade barriers can be explained in
terms of preferential buying of goods and services by the
government agencies from the domestic producer without any
regard to competitive prices. Such practice can be rampant in fairly
mixed economies and not so rampant in capitalist free ec onomies
like the USA.
8.4 THE POLICY OF FREE TRADE
Laissez faire or free trade refers to the free play of market
forces of demand for imports and supply of exports. A free trade
regime is however not free from customs duties. Both imports and
exports d o attract custom duties to the extent they do not affect the
competitive advantage of trading nations and that sovereign nations
are enable to earn tax revenue in the same manner as they would
be earning from domestic trade. It only means absence of
restrictive government intervention in the sphere of international
trade. Prohibitive duties and quantitative restrictions are the two
instruments used by governments to restrict international trade.
For Adam Smith, free trade is “that system of commercial po licy
which draws no distinction between domestic and foreign
commodities and therefore neither imposes additional burden on
the latter nor grants any special favor to the former”. Under free
trade, there are no trade barriers and there is free movement of
goods and series across the borders. The classical economists
like Adam Smith and David Ricardo propagated globalization in the
form of free trade in the 18thand 19thcenturies.munotes.in
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918.5ADVANTAGES & DISADVANTAGES OF FREE
TRADE
The arguments made by the classical economists in favor of
free trade are as follows:
Advantages of Free Trade :
1.Greater Gains from Trade :Free trade maximizes allocation
efficiency of scarce resources i.e. resources will be allocated to
their most profitable use. Amongst other factors, trade emerges
between countries on account of comparative cost advantage.
According to David Ricardo, a country should specialize in the
production of those goods and services in which it either enjoys
a comparative cost advantage or has the leas t comparative cost
disadvantage. Following the dictum of comparative cost
advantage, international division of labor or specialization will
take place and maximum world output can be produced leading
to maximum economic welfare of participating nations.
2.Greater Employment, Greater Income and Greater
Consumption. Due to international division of labor and
specialization, economies of scale will emerge and the cost of
production will be minimized. Markets will be more perfect both
nationally and internati onally, each firm will be maximizing
output and minimizing cost resulting in optimum firms with
optimum employment. With maximization of profits, there will
be greater investment, employment, output, income and
consumption.
3.Cheaper and Variegated Imports .Under free trade, every
country would be specializing in those lines of production in
which it has either a comparative cost advantage or a
comparative least cost disadvantage. Every country would
therefore be producing goods and services at relatively least
cost. For instance, let us assume that India emerges a software
giant in the international market, the rest of the world will be in a
position to buy the cheapest software from India and India will
have the access to the world market for its softwar e exports.
Increased income thus generated can be used to make cheap
imports of a variety of consumer goods produced elsewhere in
the world. For instance, a wide variety of consumer durables
could be imported at the cheapest rates, an area in which India
has a comparative cost disadvantage. Thus free trade not only
makes your exports cheaper to the rest of the world but also
makes imports cheaper for you.
4.Greater Competition and Anti -Monopolistic Business
Environment. Free trade contributes to an unfett eredmunotes.in
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92international market wherein factors of production are freely
mobile between countries and uses. Free trade can thus obtain
maximum allocation and distributive efficiency. Both monopoly
and monopolistic markets fair poorly in terms of allocation and
distribution efficiencies. Mal -allocation of resources and mal -
distribution of income are some of the serious weaknesses of
imperfect markets like monopoly and monopolistic competition
or even oligopoly. Under -utilization of production capacity, want
ofspecialization and less than optimum employment are other
weaknesses. Since there is unrestricted entry in the markets
and inefficient firms are free to exit, only efficiency is rewarded
under free trade and free markets. Free markets produce the
spirit of innovation and invention and to maintain one’s
competitive edge in the international market there is no
alternative to innovation and invention which are the driving
forces of a market economy.
5.Greater Economic Equality both within and between the
Nations. Free trade promotes and rewards economic
efficiencies leading to every expanding world GDP through
expanding employment, output, income and demand. Since
economic activities will be optimized, there will be little or no
scope for inflation. Both i mperfect markets and inflation are
welfare reducing aspects of modern monetary economies.
Sustained economic growth with creeping inflation or constant
price levels will bring about rapid growth in economic welfare of
the people. Further on account of fr ee factor mobility, surplus
labor will be able to move into areas of deficit and similarly
surplus capital will also be able to move into capital deficit
countries. Thus ever expanding economic opportunities and
equal factor rewards promote economic equal ity both within and
between the nations.
6.Economic Integration and Globalization. Free movement of
factors of production and free movement of goods and services
will bring about rapid economic integration of the world
economy. Free movement of labor, cap ital and entrepreneurs
will bring about both economic and social integration of the
world economy and the world society. On account of
optimization of economic activities there may be stability in the
price level in the international and national markets. Since
prices will be same both in the national and international
markets, various currencies will have the same purchasing
power which may lead to a single world currency. Thus there
will be not only economic and social integration of the world
economy but also a political integration. The logical conclusion
of economic globalization must necessarily and essentially be
political globalization or the world State.munotes.in
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93Disadvantages of free trade :
The following arguments are made against free trade:
1.Anti-competitive Practices amongst the Trading Countries.
Unilateral protectionist measures adopted by trading countries
would invite counter -imposition of trade barriers. Trade barriers
can be either tariff based or non -tariff based. As a result, there
will b em o v e sa n dc o u n t e rm o v e sl e a d i n gt oa ne n v i r o n m e n to f
uncertainty and discordance. However, the element of
uncertainty and discordance is due to the absence of a
regulating mechanism or the lack of effectiveness of the existing
trading mechanism.
2.Unfavo rable Terms of Trade. Terms of trade refers to the
relationship between the export price and import price of a
country. Terms of Trade are said to be favorable if the export
price of a country is greater than the import price. However,
underdeveloped co untries mainly exports primary commodities
and hence have unfavorable terms of trade. Unfavorable terms
of trade occur on account of inefficiencies in production and
other areas of business activities. These inefficiencies can be
corrected by pursuing ri ght agricultural policies and equilibrium
terms of trade can be established.
3.Unfair Competition, Unequal Gains and the Argument of
Dependence. International trade left free to the trading
countries and their exporting firms may give rise to unfair trade
practices. Creation of artificial scarcity, dumping, misuse of
trade -marks and brands, competitive advertising and mal -
information campaigns are all some of the unfair trade practices.
However, unfair trade practices can be regulated and effectively
controlled provided effective supervisory and regulative
mechanism is put in place. Gains of trade are based on
efficiencies in production and marketing. The argument that
under -developed countries are at a competitive disadvantage is
not strong enough becau se underdevelopment of countries is
on account of lack of or absence of factor mobility. One cannot
unshackle trade in goods and services without unshackling
factor movement. The argument of dependence is not a rational
economic argument. It is more bas ed on emotion and
thoughtless nationalism. Competitive advantage and inter -
dependence are the guiding principles of free trade and they
need to be protected and upheld by all trading countries.
8.6 PROTECTIONIST POLICY
A protectionist policy is adopted by a country to give
protection to domestic or national industries against competitionmunotes.in
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94from imports. The most common instruments of protection are
import tariffs and import quotas. Other instruments of protection
include exchange control, state trading, subsidies and international
cartels. It was Alexander Hamilton who put forward the argument
for a protectionist trade policy in the 19thCentury in the USA. The
famous ‘infant industry argument’ put forward by Alexander
Hamilton dominated trade policy in the United States in the first half
of the 19thcentury. Germany and France followed protectionist
policy in the last quarter of the 19thcentury. Although the world as
aw h o l eu n d e rt h ea e g i so ft h eW o r l dT r a d eO r g a n i z a t i o na p p e a r s
to be moving towards a policy of free trade, almost all the countries
are found to be practicing one or other form of protection.
Arguments put forward in favor of protection can be divided
into economic and non -economic arguments. The economic
arguments are: infant industr y argument, diversification of industry
argument, employment promotion argument, balance of payment
and terms of trade arguments, the pauper -labor argument and the
anti-dumping argument. The non -economic arguments constitute
the defense issue, the issue o f patriotism and the protection to
categories of people and occupation.
8.7 ECONOMIC ARGUMENTS IN FAVOR OF
PROTECTION
1.The Infant Industry Argument.
A child needs to be nursed and cared to adulthood.
Similarly, a country or a nation needs to be nursed a nd cared to
independence in the realm of the economy. Industries which are
newly established in a country needs to be protected from
competition from abroad. Alexander Hamilton argued that
protection to the manufacturing industries in the United States wi ll
offer them the benefits flowing from economies of scale and
economies of experience. In Germany, Friedrich List argued that
free trade was advantageous only between equal countries and
hence less developed countries must follow a protectionist policy
until they become equally developed. However, it is obvious from
the arguments made by Hamilton and List that the protectionist
policy must be temporary and therefore transitory. Once the infant
industries become adults, protection must be withdrawn and fr ee
trade should be allowed.
2.The Diversification of Industry Argument.
The Diversification of Industry argument is in fact an
argument in favor of self -sufficiency and independence. The
proponents of this argument believes that international trade based
on international division of labor leads to specialization and
specialization in turn leads to unbalanced growth of nationalmunotes.in
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95economies. Further, there are no safeguards against risks arising
out of specialization and the only safeguard against specializati on
IS DIVERSIFICATION OF THE INDUSTRY. Accordingly, a country
should not only develop its industry according to her factor
endowments and competitive advantage but also set up industries
tin which it is a at a competitive disadvantage. However, the
advan tage of free trade is in the balanced growth of the world
economy and not national economies. Once the world understands
the importance of maximizing wealth generation, it also learn to
enjoy the fruits of prosperity, I am sure they will not foolishly ind ulge
in war and destroy wealth.
3.The Employment Promotion Argument.
Countries facing a deficit on the balance of payment account
due to net negative exports along with the problem of
unemployment can promote employment generation by imposing
restrictions o n imports and promoting domestic demand. Increase
in domestic demand in a recessionary phase of the trade cycle
would uplift the level of private investment, generate employment,
output, income and demand via the investment multiplier. The
growth in dome stic demand by import restriction will however be
offset by a fall in exports due to retaliation by the trading partners,
thereby nullifying the gains of import restriction. Further, imposition
of such tariffs can also open up un -official trade channels i nt h e
form of smuggling activities. Finally, trade policy is not the only
policy option available for employment generation. Both monetary
and fiscal policies are must more efficient and less disruptive in
promoting employment generation in a recessionar yp e r i o d .
4.The Balance of Payments and Terms of Trade Argument.
Countries having a trade deficit can use tariff as a corrective
instrument. Imposition of tariffs on imports will increase the price of
imports and therefore reduce demand. However, the impo rts on
which tariff is imposed must have elastic demand so that the
expenditure on imports falls down and helps in reducing the trade
deficit. Further, the exporting country may have to share the
burden of tariff wholly or partly depending upon the price elasticity
of demand for imports. If the demand for imports is highly elastic,
the exporting country will have to reduce prices of exports due to
imposition of tariff by the importing country in order to offset the
contraction in demand. How the exporting country responds to a
tariff imposition does not matter to the importing country as long as
increase in tariffs helps the importing country to reduce its trade
deficit.
Tariff as an instrument of correction of trade deficit is only a
short term measure. In the long run, a country will have to improve
its export competitiveness and correct the negative trade balance.munotes.in
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96Sooner or later a country must learn the adult play and cannot
afford to be a child in an indefinite manner.
5.The Cheap Labor Argument.
Labor is believed to be cheap in labor abundant countries
and hence it is assumed that they can produce labor intensive
goods at much cheaper rates. However, labor productivity is also
very low in labor surplus countries. Hence the argument made by
rich cou ntrie3s that cheap labor intensive commodities will flood the
markets of rich countries and will pull down the wage rates or
create unemployment is not economically sound. Cost of
production is not determined by wage rates alone. Amongst other
factors, l abor productivity is an important factor determining the
cost of production and if the labor productivity in high wage
countries is sufficiently high enough to off -set the wage differential
between high wage and low wage countries, there is no rationale to
make the cheap labor argument and impose tariffs to protect
domestic industry. And if the labor productivity in hi8gh wage
countries is not high enough to off -set the wage differential, there,
they do not deserve high wages. There is every reason for th eir
wages to go down and establish the competitive parity.
6.The Anti -dumping Argument.
A firm which has a monopoly in the domestic market may
resort to dumping in the foreign markets with a view to capture the
foreign markets. A monopoly firm or a monopol istic firm or even an
oligopoly firm may resort to dumping provided domestic demand is
sufficiently high enough to off -set any losses that may arise due to
dumping. A firm is believed to be dumping when it sells the
products at a higher price in the domes tic market and at a lower
price in the international market. There is no doubt that dumping is
an unfair trade practice and it must be stopped by a countervailing
duty so that the motives of dumping are not realized. However, if
the exporting firm, thoug hs e l l i n ga tal o w e rp r i c ei nt h ef o r e i g n
market, is not selling at less than cost price, its action cannot be
considered as one of dumping.
Non-economic Arguments in favor of Protection.
Free trade is only a precursor or a beginning of the historical
process of dismantling national borders and transforms the world
into a borderless globe. Free trade is pregnant with globalization
and globalization cannot be limited to trade in goods and services.
It has to logically extend to land, labor, capital and en terprise.
Given the historical destination of free trade, the arguments both
economic and non -economic logically appear to be stupid except
under exceptional circumstances. Nonetheless, let us have a look
at the non -economic arguments made against free t rade.munotes.in
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97The Defense, Patriotism and Culture Argument.
As long as the world is divided into nation states and each
nation state is a closed society, the defense argument is perfectly
correct in pursuing independence in the production of defense
requirements and assigning the necessary protection to defense
industries. However, one must note that cutting -edge technology is
not available in the international market even if you have the foreign
exchange to pay for it. Further, the risk arising out of dependen ce
on other countries for the supply of essential articles or defense
goods can be easily minimized by diversifying the sources of
supply. Today, no country is militarily independent. If countries
were militarily independent or economically independent, there
would not have been grand military alliances like the NATO or
grand economic alliance like the European Union and other lesser
grand military and economic alliances. It has been more than fifty
years since the colonial countries of Asia and Africa g ained
independence and their entire history of military and economic
independence has been one of fighting with each other and
resulting in their common impoverishment. Today, none of these
countries are either militarily independent or economically self -
sufficient. While the rich countries of Europe, America and Asia are
intelligent enough to form grand economic and military alliances,
the poor countries of Asia and Africa seems to be stuck in the muck
of time and space. They are yet to come to terms wi th nationalism
and fail to understand that nationalism is not the end of evolution of
human societies and that is only an intervening stage continuing its
evolutionary process. Countries and people cannot be evil. It is
individuals at helm of affairs who can be evil and potentially
capable of destroying collectivities of people and wealth. Well
meaning people, institutions and nation states should marshal their
resources to create a defense against evil individuals and save
planet earth and its inhabitan ts from collective annihilation. The
countries of Asia and particularly the countries of south Asia have
the worst record of human rights violations and particularly
women’s right violations. This has been definitely on account of the
fact that winds of individual freedoms which the west steadfastly
upholds are yet to completely blow over the dark regions of Asia
and Africa. Civil liberties, economic freedoms, individual freedoms
and planet earth as a common abode will become a reality only
though free m obility of products and factors across a borderless
world.
CONCLUSION :
International trade is only half complete without free
international movement of factors of production. Many of the
arguments made against free trade are on account of lack of or the
absence of factor mobility between nation states. Free factor
mobility will help in equalizing product prices and convert
international trade into simply trade. Adequate and effectivemunotes.in
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98supervisory and regulatory bodies at the international level will
eliminate or control the element of unfair trade practices and ensure
that gains from trade are obtained through real efficiencies.
8.8 QUESTIONS
1.What is trade policy? Explain the arguments made in favor of
free trade policy.
2.Explain the disadvantages of f ree trade.
3.Explain the instruments of trade policy.
4.Explain the superiority of free trade over protectionist trade.
5.Explain the arguments made in favor of protectionist trade
policy.
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Modified Pattern of Question Paper for Semester End
Assessment implemented from 2020 -2021 For
Economics courses at F.Y.B.A.
Duration 3 hours Total Marks = 100 (per semester)
All 5 questions carry 20 marks and are compulsory.
There will be internal choice in each Question.
Q1.Attempt any two questions (Module 1) 20marks
A.
B.
C.
Q2.Attempt any two questions (Module 2) 20marks
A.
B.
C.
Q3.Attempt any two questions (Module 3) 20marks
A.
B.
C.
Q4.Attempt any two questions (Module 4) 20marks
A.
B.
C.
Q5.Attempt any two questions (Module 1,2,3,4. One question from
each module) 20 marks
A.
B.
C.
D.
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