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Index
I. Content....................................................................... II
IV. Abbreviations..........................................................IX
Book at a Glance
I
Contents
Chapter I........................................................................................................................................................ 1
Basics of Economics...................................................................................................................................... 1
Aim................................................................................................................................................................. 1
Objectives....................................................................................................................................................... 1
Learning outcome........................................................................................................................................... 1
1.1 Introduction............................................................................................................................................... 2
1.2 Meaning and Definition of Economics..................................................................................................... 2
1.3 Economics Basics..................................................................................................................................... 2
1.4 Macroeconomics and Microeconomics.................................................................................................... 2
1.5 The Two Basic Concepts of Economics................................................................................................... 2
1.5.1 Production Possibility Frontier (PPF)....................................................................................... 2
1.5.2 Opportunity Cost....................................................................................................................... 4
1.6 Market Economy....................................................................................................................................... 4
1.7 Command Economy.................................................................................................................................. 4
1.8 Choice as an Economic Problem.............................................................................................................. 5
1.9 Central Problems of an Economy............................................................................................................. 5
1.10 Market Mechanism................................................................................................................................. 5
1.11 Positive Economics and Normative Economics..................................................................................... 5
1.12 Inductive Method and Deductive Method of Economic Analysis.......................................................... 6
Summary........................................................................................................................................................ 8
References...................................................................................................................................................... 8
Recommended Reading................................................................................................................................ 8
Self Assessment.............................................................................................................................................. 9
Chapter II.....................................................................................................................................................11
Business Economics- Meaning, Nature, Scope and Significance.............................................................11
Aim................................................................................................................................................................11
Objectives......................................................................................................................................................11
Learning outcome..........................................................................................................................................11
2.1 Introduction............................................................................................................................................. 12
2.2 Nature of Business Economics............................................................................................................... 12
2.3 Scope of Business Economics................................................................................................................ 12
2.3.1 Demand Analysis and Forecasting.......................................................................................... 12
2.3.2 Cost and Production Analysis................................................................................................. 13
2.3.3 Pricing Decisions, Policies and Practices............................................................................... 13
2.3.4 Profit Management................................................................................................................. 13
2.3.5 Capital Management............................................................................................................... 13
2.4 Significance of Business Economics...................................................................................................... 13
2.5 Theory of Consumer’s Behaviour........................................................................................................... 14
2.5.1 Utility Analysis or Cardinal Approach.................................................................................... 14
2.5.2 Meaning of Utility.................................................................................................................. 14
2.5.3 Concepts of Utility.................................................................................................................. 15
2.5.4 Relationship between total utility and Marginal Utility......................................................... 16
2.6 Laws of Utility Analysis......................................................................................................................... 16
2.6.1 Law of Diminishing Marginal Utility..................................................................................... 16
2.6.2 Law of Equi-Marginal Utility................................................................................................. 19
Summary...................................................................................................................................................... 21
References.................................................................................................................................................... 21
Recommended Reading.............................................................................................................................. 22
Self Assessment............................................................................................................................................ 23
II
Chapter III................................................................................................................................................... 25
Demand, Supply and Product Management............................................................................................ 25
Aim............................................................................................................................................................... 25
Objectives..................................................................................................................................................... 25
Learning outcome......................................................................................................................................... 25
3.1 Introduction............................................................................................................................................. 26
3.2 Concept of Demand................................................................................................................................ 26
3.3 Demand Schedule and Concept.............................................................................................................. 26
3.3.1 Market Demand Curve............................................................................................................ 26
3.3.2 Law of Demand...................................................................................................................... 27
3.4 Price Elasticity of Demand..................................................................................................................... 27
3.4.1 Types of Demand.................................................................................................................... 27
3.5 Factors Affecting Demand...................................................................................................................... 28
3.6 Concept of Supply................................................................................................................................... 28
3.6.1 Supply Schedule and Concept................................................................................................ 28
3.6.2 Market Supply Curve.............................................................................................................. 29
3.6.3 Law of Supply......................................................................................................................... 30
3.6.4 Price Elasticity of Supply....................................................................................................... 30
3.6.5 Types of Supply...................................................................................................................... 30
3.6.6 Factors Affecting Supply........................................................................................................ 30
3.7 Equilibrium in Demand and Supply....................................................................................................... 31
3.8 Equilibrium as per the Change in Demand and Supply.......................................................................... 32
3.9 Tax Impact on Price or Quantity of Goods............................................................................................. 35
3.10 Perfect Competition.............................................................................................................................. 35
3.11 Economic Factors Related to Industry with Perfect Competition......................................................... 36
3.11.1 Marginal Revenue................................................................................................................. 36
3.12 Perfect Competition in Short Run......................................................................................................... 37
3.13 Perfect Competition in Long Run......................................................................................................... 38
3.13.1 Economic Profit and Losses................................................................................................. 38
3.13.2 Zero Economic Profit in Long Run...................................................................................... 38
3.14 Monopoly Market................................................................................................................................. 38
3.15 Characteristics of Monopoly Firm........................................................................................................ 38
3.16 Factors of Monopoly Power.................................................................................................................. 38
3.17 Monopoly and Market Demand............................................................................................................ 39
3.18 Marginal Decision Rule in Monopoly Market...................................................................................... 39
3.19 Oligopoly Market.................................................................................................................................. 40
3.20 Concentration in Oligopoly................................................................................................................... 40
3.21 Game Theory and Oligopoly Behaviour............................................................................................... 41
Summary...................................................................................................................................................... 43
References.................................................................................................................................................... 43
Recommended Reading.............................................................................................................................. 43
Self Assessment............................................................................................................................................ 44
Chapter IV................................................................................................................................................... 46
Analysis of Consumer Choice, Production Analysis and Cost Concept................................................. 46
Aim............................................................................................................................................................... 46
Objectives..................................................................................................................................................... 46
Learning outcome......................................................................................................................................... 46
4.1 Introduction............................................................................................................................................. 47
4.2 Utility Theory.......................................................................................................................................... 47
4.2.1 Total Utility (TU).................................................................................................................... 47
4.2.2 Marginal Utility (MU)............................................................................................................ 47
4.2.3 Budget Constrain.................................................................................................................... 49
4.3 Production Analysis................................................................................................................................ 50
4.4 Short Run Production Function.............................................................................................................. 50
III
4.4.1 Total, Marginal and Average Product..................................................................................... 50
4.5 Cost Concept........................................................................................................................................... 52
4.5.1 Total Cost and Marginal Cost................................................................................................. 52
4.5.2 Average Total Cost.................................................................................................................. 53
4.6 Relationship between Marginal Cost, Average Fixed Cost, Average Variable Cost and Average
Total Cost in Short Run........................................................................................................................... 53
4.7 Cost Concept in Long Run...................................................................................................................... 54
4.8 Economy of Scale, Diseconomy of Scale and Constant Return to Scale............................................... 54
Summary...................................................................................................................................................... 56
References.................................................................................................................................................... 56
Recommended Reading.............................................................................................................................. 56
Self Assessment............................................................................................................................................ 57
Chapter V..................................................................................................................................................... 59
The Nature of Factor Demands................................................................................................................. 59
Aim............................................................................................................................................................... 59
Objectives..................................................................................................................................................... 59
Learning outcome......................................................................................................................................... 59
5.1 Introduction............................................................................................................................................. 60
5.2 Income and Wealth.................................................................................................................................. 60
5.2.1 Income.................................................................................................................................... 60
5.2.2 Wealth..................................................................................................................................... 61
5.3 Input Pricing by Marginal Productivity.................................................................................................. 61
5.4 The Nature of Factor Demands............................................................................................................... 61
5.4.1 Factors Demands and Derivation............................................................................................ 61
5.4.2 Factors Demands are Interdependent...................................................................................... 62
5.5 Distribution Theory and Marginal Revenue Product.............................................................................. 62
5.6 The Demand for Factors of Production.................................................................................................. 63
5.6.1 Rule for Choosing the Optimal Combination of Inputs.......................................................... 63
5.6.2 Least-Cost Rule....................................................................................................................... 63
5.6.3 Marginal Revenue Product and the Demand for Factors........................................................ 63
5.6.4 Substitution Rule..................................................................................................................... 64
5.7 Supply of Factors of Production............................................................................................................. 64
5.8 Determination of Factor Prices by Supply and Demand........................................................................ 65
5.9 The Distribution of National Income...................................................................................................... 67
5.10 Marginal-Productivity Theory with Many Inputs................................................................................. 68
Summary...................................................................................................................................................... 69
References.................................................................................................................................................... 69
Recommended Reading.............................................................................................................................. 69
Self Assessment............................................................................................................................................ 70
Chapter VI................................................................................................................................................... 72
The Markets for Labor, Capital and Land............................................................................................... 72
Aim............................................................................................................................................................... 72
Objectives..................................................................................................................................................... 72
Learning outcome......................................................................................................................................... 72
6.1 The Labor Market.................................................................................................................................... 73
6.2 Fundamentals of Wage Determination.................................................................................................... 73
6.2.1 The General Wage Level......................................................................................................... 73
6.2.2 Demand for Labor................................................................................................................... 73
6.2.3 International Comparisons...................................................................................................... 74
6.3 The Supply of Labor............................................................................................................................... 74
6.3.1 Hours Worked.......................................................................................................................... 74
6.3.2 Labor-force Participation........................................................................................................ 74
6.3.3 Immigration............................................................................................................................ 74
IV
6.4 Wage Differentials.................................................................................................................................... 75
6.4.1 Differences in Jobs: Compensating Wage Differentials.......................................................... 75
6.4.2 Differences in People: Labor Quality...................................................................................... 75
6.4.3 Differences in People: The “Rents” of Unique Individuals................................................... 75
6.4.4 Segmented Market and Noncompeting Groups...................................................................... 75
6.5 Economics of Labor Union..................................................................................................................... 76
6.5.1 Effect of Unions on Wages and Employment......................................................................... 76
6.6 Discrimination by Race and Gender....................................................................................................... 76
6.7 Techniques to Determine Extent of Discrimination................................................................................ 77
6.8 Reducing Labor Market Discrimination................................................................................................. 77
6.9 Land and Rent......................................................................................................................................... 77
6.10 Capital and Interest................................................................................................................................ 77
6.11 Rate of Return on Capital Goods.......................................................................................................... 78
6.12 Financial Assets and Tangible Assets..................................................................................................... 78
6.12.1 Financial Assets and Interest Rates....................................................................................... 78
6.12.2 Real and Nominal Interest Rates........................................................................................... 78
6.13 Present Values of Asset.......................................................................................................................... 79
6.13.1 Present Value for Perpetuities................................................................................................ 79
6.13.2 General Formula for Present Value....................................................................................... 79
6.14 Profits.................................................................................................................................................... 80
6.14.1 Profits as Rewards for Innovation......................................................................................... 80
6.14.2 Uncertainty and Profit........................................................................................................... 80
6.14.3 Profits and Market Structure................................................................................................. 80
6.15 The Theory of Capital and Interest....................................................................................................... 80
6.15.1 Applications of Classical Capital Theory.............................................................................. 81
Summary...................................................................................................................................................... 82
References.................................................................................................................................................... 82
Recommended Reading.............................................................................................................................. 82
Self Assessment............................................................................................................................................ 83
Chapter VII................................................................................................................................................. 85
International Trade . .................................................................................................................................. 85
Aim............................................................................................................................................................... 85
Objectives..................................................................................................................................................... 85
Learning outcome......................................................................................................................................... 85
7.1 Introduction............................................................................................................................................. 86
7.2 Factors Determining Gains from Trade.................................................................................................. 87
7.2.1 Relative Differences in Cost Ratio......................................................................................... 87
7.2.2 Reciprocal Demand................................................................................................................. 87
7.3 The Sources of International Trade in Goods and Services.................................................................... 87
7.4 Comparative Advantage among Nations................................................................................................ 87
7.4.1 Ricardo’s Analysis of Comparative Advantage...................................................................... 88
7.4.2 Autarky Equilibrium............................................................................................................... 88
7.5 Economic Gains from Trade .................................................................................................................. 89
7.6 Extensions to Many Commodities and Countries................................................................................... 90
7.6.1 Triangular and Multilateral Trade........................................................................................... 90
7.7 Protectionism.......................................................................................................................................... 91
7.7.1 Trade Barriers......................................................................................................................... 91
7.7.2 Tariffs...................................................................................................................................... 91
7.7.3 Quotas..................................................................................................................................... 92
7.8 Difference between Tariffs and Quotas................................................................................................... 92
7.9 Unsound Grounds of Tariff..................................................................................................................... 93
7.10 Potentially Valid Arguments for Protection.......................................................................................... 93
7.10.1 The Terms of Trade or Optimal Tariff Argument.................................................................. 94
7.10.2 Infant Industries.................................................................................................................... 94
V
7.10.3 Tariffs and Unemployment................................................................................................... 94
7.10.4 Protection against Dumping.................................................................................................. 94
7.11 Negotiating Free Trade.......................................................................................................................... 94
7.11.1 Multilateral Agreements........................................................................................................ 94
7.11.2 World Trade Organisation (WTO)........................................................................................ 95
Summary...................................................................................................................................................... 96
References.................................................................................................................................................... 96
Recommended Reading.............................................................................................................................. 96
Self Assessment............................................................................................................................................ 97
Chapter VIII................................................................................................................................................ 99
Government, Taxation and Expenditure.................................................................................................. 99
Aim............................................................................................................................................................... 99
Objectives..................................................................................................................................................... 99
Learning outcome......................................................................................................................................... 99
8.1 Types of Economy................................................................................................................................ 100
8.2 The Role of Government in the Economy............................................................................................. 100
8.3 Tools of Government Policy.................................................................................................................. 101
8.4 Importance of Size of Government....................................................................................................... 101
8.5 The Functions of Government.............................................................................................................. 102
8.6 Public Choice Theory............................................................................................................................ 102
8.7 Government Expenditure...................................................................................................................... 103
8.7.1 Nature of Government Expenditure...................................................................................... 103
8.7.2 Objectives of Government Expenditure Classification........................................................ 103
8.8 Economic Aspects of Taxation.............................................................................................................. 104
8.9 Taxes Levied by Central Government................................................................................................... 105
8.9.1 Direct Taxes........................................................................................................................... 105
8.9.2 Indirect Taxes........................................................................................................................ 106
8.10 Taxes Levied by State Governments and Local Bodies...................................................................... 107
8.11 Tax Incidence....................................................................................................................................... 108
8.12 Nature and Relevance of Regulation................................................................................................... 108
8.13 Government Intervention on Public Interest....................................................................................... 109
8.14 Instruments for Regulation...................................................................................................................110
8.14.1 Price Cap Regulation...........................................................................................................110
8.14.2 Revenue Cap Regulation.....................................................................................................110
8.14.3 Rate of Return Regulation...................................................................................................110
8.14.4 Benchmarking......................................................................................................................111
8.15 Effects of Regulation...........................................................................................................................111
8.16 Decline of Economic Regulation.........................................................................................................111
8.17 Deregulation.........................................................................................................................................112
8.18 Antitrust Policies..................................................................................................................................112
8.18.1 Antitrust Policy in US..........................................................................................................112
8.18.2 Indian Scenario....................................................................................................................113
8.19 Mergers: Law and Practice...................................................................................................................113
8.19.1 Merger or Amalgamation.....................................................................................................113
8.19.2 Acquisitions and Takeovers.................................................................................................114
8.19.3 Advantages of Mergers & Acquisitions...............................................................................114
8.20 Efficiency of Competition Laws..........................................................................................................115
Summary.....................................................................................................................................................116
References...................................................................................................................................................116
Recommended Reading.............................................................................................................................116
Self Assessment..........................................................................................................................................117
VI
List of Figures
Fig. 1.1 Production possibility frontier........................................................................................................... 3
Fig. 1.2 Production possibility frontier shifts outward................................................................................... 4
Fig. 1.3 Derivation of Eagle curve for a normal good.................................................................................... 7
Fig. 3.1 Market demand curve...................................................................................................................... 27
Fig. 3.2 Supply curve.................................................................................................................................... 29
Fig. 3.3 Market supply curve........................................................................................................................ 30
Fig. 3.4 Equilibrium in demand and supply.................................................................................................. 31
Fig. 3.5 Decrease in demand curve............................................................................................................... 32
Fig. 3.6 Increase in supply curve.................................................................................................................. 32
Fig. 3.7 Decrease in supply........................................................................................................................... 33
Fig. 3.8 Price ceiling..................................................................................................................................... 34
Fig. 3.9 Price floor........................................................................................................................................ 34
Fig. 3.10 Firm’s demand and industry equilibrium curve............................................................................. 36
Fig. 3.11 Marginal revenue and demand curve............................................................................................. 37
Fig. 3.12 Profit maximisation....................................................................................................................... 37
Fig. 3.13 Perfect competition vs. monopoly................................................................................................. 39
Fig. 3.14 Marginal decision rule in monopoly market.................................................................................. 40
Fig. 3.15 Prisnor’s dilemma rule in organisation.......................................................................................... 42
Fig. 4.1 Total utility....................................................................................................................................... 49
Fig. 4.2 Relation between marginal utility and demand curve..................................................................... 49
Fig. 4.3 Total production curve..................................................................................................................... 51
Fig. 4.4 Relationship between TP, MP and AP............................................................................................. 52
Fig. 4.5 Relationship between MC, AFC, AVC and ATC ............................................................................ 53
Fig. 4.6 Short run and long run average total curve...................................................................................... 54
Fig. 5.1 Factors demands are derived........................................................................................................... 62
Fig. 5.2 Demand for inputs derived through marginal revenue products..................................................... 64
Fig. 5.3 Supply curve for factors of production............................................................................................ 65
Fig. 5.4 Factor supply and derived demand interact to determine factor prices and income distribution.... 66
Fig. 5.5 The markets for surgeons and fast food workers............................................................................. 66
Fig. 5.6 Marginal product principles determine factor distribution of income............................................. 67
Fig. 6.1 Demand for labor reflects marginal productivity............................................................................ 73
Fig. 6.2 As wages rise, workers may work fewer hours................................................................................ 74
Fig. 7.1 Production possibilities of wheat and cloth..................................................................................... 89
Fig. 7.2 With many commodities, there is a spectrum of advantages........................................................... 90
Fig. 7.3 Triangular trades.............................................................................................................................. 90
Fig. 7.4 The impact of protectionist policies................................................................................................ 92
Fig. 7.5 U.S. tariff rates, 1820–2005............................................................................................................. 95
Fig. 8.1 The size of government-growth curve........................................................................................... 101
Fig. 8.2 Classification of Government Expenditure.................................................................................... 103
VII
List of Tables
Table 3.1 Demand schedule and concept...................................................................................................... 26
Table 3.2 Market demand curve.................................................................................................................... 26
Table 3.3 Types of demand........................................................................................................................... 27
Table 3.4 Factors affecting demand.............................................................................................................. 28
Table 3.5 Supply schedule............................................................................................................................ 28
Table 3.6 Market supply curve...................................................................................................................... 29
Table 3.7 Types of supply............................................................................................................................. 30
Table 3.8 Factors affecting supply................................................................................................................ 31
Table 3.9 Equilibrium in demand and supply............................................................................................... 31
Table 3.10 Demand and supply..................................................................................................................... 33
Table 3.11 Tax impact on price or quantity of goods.................................................................................... 35
Table 4.1 Utility of goods............................................................................................................................. 47
Table 4.2 Marginal utility.............................................................................................................................. 48
Table 7.1 Differences between domestic trade and international trade........................................................ 86
VIII
Abbreviations
IX
Chapter I
Basics of Economics
Aim
The aim of this chapter is to:
Objectives
The objectives of the chapter are to:
Learning outcome
At the end of this chapter, you will be able to:
1
Business Economics
1.1 Introduction
The motive behind studying economics could be anything like, to make money, understand and be adept at the
concepts of economics for in-general usage, or may be due to curiosity to know how technological revolutions and
economic reforms give a new direction to our society.
With limited resources at hand, a common man, on a daily basis, has to make certain choices in tune with his budget
to fulfil wants and needs. Economists are interested in the ‘choices’ that person makes, and inquire into why, for
instance, one might choose to spend one’s money on a new DVD player instead of replacing the old TV. Economics,
also called ‘Dismal Science’, is an in-depth study of certain aspects of society.
Each individual and nation will have different set of values and due to different level of scarce resources; their
decision on utilisation of those resources is also different. Furthermore, because of scarcity, people and an economy
must decide on how to allocate resources. In other words, we can say that Economics is a study that deals with the
decision and allocation of the resources.
Microeconomics
It is more specific in its approach and is concerned with individuals and firms within the economy. By analysing
human tendency and behavior, microeconomics shows how individuals respond to changes in price when there is
change in demand and supply.
2
Production Possibility
Frontier PPF
A Y
Product A: Wine
X C
Product B: Cotton
• Imagine one economy that produces only wine and cotton. According to PPF, points A, B and C all appearing
on the curve, represents most efficient use of resources by the economy.
• Point X represents the most inefficient use of resources, while point Y represents the goal that an economy
cannot attain with the present levels of resources.
• From the chart, we can see that if an economy produces more wine, it must give up some resources used for
cotton production. If the economy starts producing more cotton (represented by points B and C), it would have
to divert from wine production.
• If the economy moves from point B to C, wine output significantly reduces with small increase in cotton
production.
• Every nation must find out the ways for optimum allocation of resources so that they can achieve the PPF.
• If the demand for wine is more than the cost of increasing its output is proportional to the cost of decreasing
cotton production.
In another scenario
• If there is change in technology, while the level of land, labour and capital remains same then the time required
in production of cotton and wine will decrease.
• Point X shows the most inefficient way of utilisation of resources.
• When PPF shifts outward, as shown in the figure below, then we know that there is a growth in economy.
When it shifts inwards, it indicates that the economy is shrinking as a result of decline in efficient allocation of
resources.
3
Business Economics
Production Possibility
Frontier PPF
Shifts Outward
A
Y
B
Product A: Wine
X C
Product B: Cotton
An economy producing on the PPF curve is more theoretical than practical. In reality, an economy constantly
struggles to reach an optimal production capacity. As scarcity compels an economy to give up one choice for another,
the slope of the PPF will always be negative. Hence, if the production of A increases then for B it will decrease or
vice versa.
For example, assume that an individual has a choice between two telephone services. If he or she were to buy the
most expensive service, that individual may have to reduce the number of times he or she goes to the movies each
month. Giving up these opportunities to go to the movies may be a cost that is too high for this person, leading him
or her to choose the less expensive service.
Opportunity cost is different for each individual and nation. Thus, what is valued more than something else will
vary among people and countries when decisions are made about how to allocate resources.
For example, for years 2004-07, there was a huge rush in IT sector because of demand for IT professionals. There
was phenomenal growth in various IT sector with many IT education firms flourishing to cater the needs. This shows
how the demand factor influenced the economy. In the year 2009, there was a sharp decline in growth of various
industries, which resulted in recession in all sectors. Eventually, the demand for IT professional also declined. For
this reason, market economy is also called as Demand Driven Economy.
4
Some of the advantages of command economy are:
• In a command economy, government can utilise land, labour and capital to fulfil its economic and political
agendas. So the private players are reluctant to invest in command economy.
• For example, cholera is a widespread common disease in continents like Africa and Asia. Some of the world’s
major pharmaceutical industries like Pfizer and Novartis are not ready to invest in research of Cholera, because
people of Africa and Asia are not in a position to pay full price of drugs. In a command economy, the state can
take the initiative for R&D for the treatment.
5
Business Economics
Inductive method involves reasoning from particulars to the general or from the individual to the universal. This
method derives economic generalisations on the basis of experiments and observations. In this method detailed data
are collected on certain economic phenomenon and effort is then made to arrive at certain generalisations which
follow from the observations collected. (The Engel’s Law and the Malthusian Theory of Population have been
derived from inductive reasoning).
Giffen goods: Giffen goods may be any inferior commodity much cheaper than its superior substitutes, consumed
mostly by the poor households as an essential consumer good. If price of such goods increases, its demand increases
instead of decreasing because in case of a Giffen good the income effect of a price rise is greater than its substitution
effect. Thus, the law of demand does not apply in case of Giffen goods. This phenomenon is known as Giffen
paradox.
Consumer Surplus: The difference between the price a consumer is willing to pay and the price which he actually
pays is consumer’s gain which is referred to as consumer’s surplus. The concept of consumer’s surplus may also
be explained in terms of utility. Since, Marshall assumes constant MU of money, what a consumer is willing to pay
for a commodity indicates his expected utility and what he actually pays measures the actual cost in terms of utility
of money. The difference between the utility gained and the utility lost in acquiring the commodity is consumer’s
satisfaction which Marshall calls the ‘consumer’s surplus’.
Income-Consumption Curve (ICC): The income-consumption curve may be defined as the locus of points representing
various equilibrium quantities of two commodities consumed by a consumer at different levels of income, all other
things remaining the same.
Price-Effect: The price-effect may be defined as the total change in the quantity consumed of a commodity due to
a change in its price. Price effect is composed of two effects:
• Income-Effect: The income-effect arises due to change in real income caused by the change in price of the
goods consumed by the consumer.
• Substitution-Effect: The substitution effect arises due to the consumer’s inherent tendency to substitute cheaper
goods for the relatively expensive ones.
Inferior goods: Inferior goods are those goods whose demand decrease as the income of the consumer increases.
That is, the income-effect on inferior goods is negative.
The Engel Curve: The Engel curve shows the relationship between consumer’s income and his money expenditure
on a particular good. The shape of the Engel curve depends on the shape of the income-consumption curve (ICC).
6
As shown in the following figure we can derive the Engel curve from the ICC.
Quantity of Y
M4 ICC
M3 E4
M2 E3
M1 E2
E1
Quantity of X
X1 X2 X3 X4
Total Income
Engle curve
M4
M3
M2
M1
X1 X2 X3 X4 Quantity of X
7
Business Economics
Summary
• Economics, also called ‘Dismal Science’, is an in-depth study of certain aspects of society.
• Macroeconomics is concerned with total output of a nation and the way that nation allocates its limited resources
of land, labour and capital in an efficient way.
• Microeconomics is more specific in its approach and is concerned with individuals and firms within the
economy.
• Two basic concepts of economics are Production Possibility Frontier and Opportunity Cost.
• Opportunity cost is the value of what is given up in order to have something else. It is unique for each individual
and determined by his or her needs, wants, time and resources (income).
• Market Economy is a type of economic system in which the trading and exchange of goods and services and
information takes place in a free market, and hence it is also called as free market economy.
• An economy which is controlled by the government is called Command Economy.
• Human wants are unlimited but the means or resources to satisfy these wants are limited or scarce. Resources
are not only scarce but they have alternative uses.
• The market mechanism, works through supply and demand in a free market economy. It acts as the principal
organising force for economic efficiency.
• Positive economics is concerned with ‘what is’ whereas Normative economics is concerned with ‘what ought
to be’.
• Deductive method involves reasoning or inference from the general to the particular or from the universal to
the individual.
References
• Rittenberg, L. and Tregarthen, T., 2008. Principles of Microeconomics.
• Samuelson, P. A., 2002. Economics, Massachusetts Institute of Technology. Tata McGraw-Hill Publishing
Co.Ltd.
• David, A. D.,2004. Introduction to Microeconomics E201, [Pdf] Available at: <http://new.ipfw.edu/
dotAsset/142427.pdf>[Accessed 14 August 2012].
• Frank, A. C., 2004. Microeconomics Principles and Analysis, [Pdf] Available at: <http://www.railassociation.
ir/Download/Article/Books/MicroEconomics-%20Principles%20and%20Analysis.pdf> [Accessed 14 August
2012].
• 2010. Introduction to Microeconomics 101 [Video online] Available at: <http://www.youtube.com/
watch?v=gfiQ1xZfqV4> [Accessed 14 August 2012].
• About.com., 2011. What is Microeconomics? [Video online] Available at:<http://www.youtube.com/
watch?v=I2GH1MESQ5w>[Accessed 14 August 2012].
Recommended Reading
• Bernanke, B., 2009. Principles of Microeconomics, Marginal Decision Rule, Tata McGraw Hill Publication.
• Dr. Mithani, D. M., 2008. International Economics, Institute of Business Study and Research, Himalaya
Publishing House Pvt. Ltd.
• Mankiv, N. G., Economic: Principles and Applications, Cengage Learning Products, Canada, Nelson Education
Pvt. Ltd.
8
Self Assessment
1. Economics, also called ________ , is an in-depth study of certain aspects of society.
a. dismal science
b. dismal economics
c. economy
d. physiological study
2. ___________ is concerned with total output of a nation and the way that nation allocates its limited resources
of land, labour and capital in an efficient way stock of resources for future course action.
a. Microeconomics
b. Macroeconomics
c. Market economy
d. Opportunity cost
4. __________is a type of economic system in which the trading and exchange of goods and services and information
takes place in a free market.
a. Command economy
b. Product economy
c. Demand economy
d. Market economy.
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Business Economics
10. ________ are those goods whose demand decrease as the income of the consumer increases.
a. The Angel Curve
b. Price Effect
c. Inferior goods
d. Income Consumption Curve
10
Chapter II
Business Economics- Meaning, Nature, Scope and Significance
Aim
The aim of this chapter is to:
Objectives
The objectives of this chapter are to:
• define wholesaling
Learning outcome
At the end of this chapter, you will be able to:
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Business Economics
2.1 Introduction
Business Economics, also called Managerial Economics, is the application of economic theory and methodology
to business. Business involves decision-making. Decision making means the process of selecting one out of two or
more alternative courses of action. The question of choice arises because the basic resources such as capital, land,
labour and management are limited and can be employed in alternative uses. The decision-making function thus
becomes one of making choice and taking decisions that will provide the most efficient means of attaining a desired
end, say, profit maximisation.
Different aspects of business need attention of the chief executive. He may be called upon to choose a single option
among the many that may be available to him. It would be in the interest of the business to reach an optimal decision,
the one that promotes the goal of the business firm. A scientific formulation of the business problem and finding its
optimal solution requires that the business firm is he equipped with a rational methodology and appropriate tools.
Business economic meets these needs of the business firm.
It may be that business economics serves as a bridge between economic theory and decision-making in the context
of business. According to Mc Nair and Meriam, “Business economic consists of the use of economic modes of
thought to analyse business situations.” Siegel man has defined managerial economic (or business economic) as “the
integration of economic theory with business practice for the purpose of facilitating decision-making and forward
planning by management.” We may, therefore, define business economic as that discipline which deals with the
application of economic theory to business management. Business economic thus lies on the borderline between
economic and business management and serves as a bridge between the two disciplines.
The emphasis in business economics is on normative theory. Business economic seeks to establish rules which
help business firms attain their goals, which indeed is also the essence of the word normative. However, if the firms
are to establish valid decision rules, they must thoroughly understand their environment. This requires the study
of positive or descriptive theory. Thus, Business economics combines the essentials of the normative and positive
economic theory, the emphasis being more on the former than the latter.
These various aspects are also considered to comprise the subject matter of business economic.
12
It includes:
• Demand Determinants
• Demand Distinctions
• Demand Forecasting
The various aspects outlined above represent major uncertainties which a business firm has to reckon with viz.,
demand uncertainty, cost uncertainty, price uncertainty, profit uncertainty and capital uncertainty. We can therefore,
conclude that the subject matter of business economic consists of applying economic principles and concepts to
deal with various uncertainties faced by a business firm.
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Business Economics
• Business economics helps in reaching a variety of business decisions in a complicated environment. Certain
examples are:
What products and services should be produced?
What input and production technique should be used?
How much output should be produced and at what prices it should be sold?
What are the best sizes and locations of new plants?
When should equipment be replaced?
How should the available capital be allocated?
• Business economics makes a manager a more competent model builder. It helps him appreciate the essential
relationship characterising a given situation.
• At the level of the firm. Where its operations are conducted though known focus functional areas, such as finance,
marketing, personnel and production, business economics serves as an integrating agent by coordinating the
activities in these different areas.
• Business economics takes cognizance of the interaction between the firm and society, and accomplishes the key
role of an agent in achieving its social and economic welfare goals. It has come to be realised that a business,
apart from its obligations to shareholders, has certain social obligations. Business economics focuses attention
on these social obligations as constraints subject to which business decisions are taken. It serves as an instrument
in furthering the economic welfare of the society through socially oriented business decisions.
14
2.5.3 Concepts of Utility
There are three concepts of utility:
• Initial Utility: The utility derived from the first unit of a commodity is called initial utility. Utility derived from
the first piece of bread is called initial utility. Thus, initial utility, is the utility obtained from the consumption
of the first unit of a commodity. It is always positive.
• Total Utility: Total utility is the sum of utility derived from different units of a commodity consumed by a
household.
According to Left witch, “Total utility refers to the entire amount of satisfaction obtained from consuming various
quantities of a commodity.” Consider an example, a consumer has four units of apples. If the consumer gets 10 units
from the consumption of first apple, 8 units from second, 6 units from third, and 4 units from fourth apple, then the
total utility will be 10+8+6+4 = 28
or
TU = EMU
Here TU = Total utility and MU1, MU2, MU3, + __________ MUn = Marginal Utility derived from first, second,
third __________ and nth unit.
• Marginal Utility: Marginal Utility is the utility derived from the additional unit of a commodity consumed. The
change that takes place in the total utility by the consumption of an additional unit of a commodity is called
marginal utility.
According to Chapman, “Marginal utility is the addition made to total utility by consuming one more unit of
commodity. Supposing a consumer gets 10 units from the consumption of one mango and 18 units from two mangoes,
and then the marginal utility of second mango will be 18-10=8 units. Marignal utility can be measured with the help
of the following formula MUnth = TUn – TUn-1.
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Business Economics
The relationship between total utility and marginal utility can be explained with the help of the above table and
diagram based thereon.
• Total utility, initially, increases with the consumption of successive units of a commodity. Ultimately, it begins
to fall.
• Marginal Utility continuously diminishes.
• As long as marginal utility is more than zero or positive, total utility increases, total utility is maximum when
marginal utility is zero. It falls when marginal utility is negative.
• When marginal utility is zero or total utility is maximum, a point of saturation is obtained.
According to Chapman, “The more we have of a thing, the less we want additional increments of it or the more
we want not to have additional increments of it.” According to Marshall, “The additional benefit which a person
derives from a given stock of a thing diminishes with every increase in the stock that he already has.” According to
Samuelson, “As the amount consumed of goods increase the marginal utility of the goods tends to decrease.” In short,
the law of Diminishing Marginal Utility states that, other things being equal, when we go on consuming additional
units of a commodity, the marginal utility from each successive unit of that commodity goes on diminishing.
Assumptions
Every law in subject to clause “other things being equal” This refers to the assumption on which a law is based. It
applies in this case as well. Main assumptions of this law are as follows:
• Utility can be measured in cardinal number system such as 1, 2, 3 _______ etc.
• There is no change in income of the consumer.
• Marginal utility of money remains constant.
• Suitable quantity of the commodity is consumed.
• There is continuous consumption of the commodity.
• Marginal Utility of every commodity is independent.
16
• Every unit of the commodity being used is of same quality and size.
• There is no change in the tastes, character, fashion, and habits of the consumer.
• There is no change in the price of the commodity and its substitutes.
It is clear from the above Table that when the consumer consumes first unit of bread, he get marginal utility equal
to 8. Marginal utility from the consumption of second, third and fourth bread is 6, 4 and 2 respectively. He gets zero
marginal utility from the consumption of fifth bread. This is known as point of satiety for the consumer. After that he
gets negative utility i.e. -2 from the consumption of sixth unit of bread. Thus, the table shows that as the consumer
goes on consuming more and more units of bread, marginal utility goes on diminishing.
Pricing Decision
A retailer’s price policy is a crucial positioning factor and must be decided in relation to its target market, its product
and service assortments and its competition. This involved the decisions regarding the price lilies to be earned and
overall markdown or sale policies:
Promotion Decision
Retailers use the promotional tools - advertising, personal selling, sales promotion and public relations to reach.
Customers Personal selling requires careful training of sales people in how to greet customers, meet their needs
and handle their complaints.
Wholesaling
Wholesaling is the sale, and all activities directly related to the sale, of goods and services, to business and other
organisations for:
• Resale
• Use in producing other goods and services
• Operating an organisation
Wholesalers buy mostly from producers and sell mostly to retailers, industrial consumers and other wholesalers.
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Business Economics
quantities and have only a limited knowledge of the market and source of supply. Thus there is gap; a wholesaling
middleman can fill this gap by providing services of value to manufacturers and or to the retailers. Wholesaling
brings to the total distribution system the economies of skill, scale and transactions.
Wholesaling skills are efficiently concentrated in a relatively few hands. This saves the duplication of effort that would
occur if many producers had to perform wholesaling function themselves. Economics of Scale are there because of
the specialisation of who leasing function that might otherwise require several small departments run by producing
firms. Wholesalers typical can perform wholesaling functions more efficiently than most manufacturers can.
Function of Wholesalers
Wholesalers perform number of functions. They facilitate the task of producer and retailer by performing one or
more of the following channel functions.
• Selling and promoting: Wholesalers’ sales force help manufacturers reach many small customers at low cost.
The wholesalers have more contacts and are often more trusted by the buyer than the distant manufacturer.
• Buying and assorting: Wholesalers can select items and build assortments needed by their customers, thereby
saving the consumers much work.
• Warehousing: Wholesalers hold inventories, thereby reducing the inventory costs and risks of suppliers and
customers.
• Transportation: Wholesalers can provide quicker delivery to buyers because they are closer than the
producers.
• Financing: Wholesalers finance their customers by giving credit and they finance their suppliers by ordering
early and paying bills in time.
• Risk bearing: Wholesalers absorb risk of the manufacturers by taking title and bearing the cost of theft damage,
spoilage and obsolescence.
• Market information: Wholesalers give information to suppliers and customers about competitors’ new product
and price developments.
• Management services and advice: Wholesalers often help retailers train their sale clerks, improve store layouts
and displays and setup accounting and inventory control systems.
Types of Wholesalers
Wholesalers can be broadly divided into three broad categories Merchant wholesaler, Agent wholesaling middleman
and Manufacturers’ Sales facility.
Merchant Wholesalers
A merchant wholesaler is independently owned business that takes title to the merchandise it handles. Merchant
wholesalers include Full service, Truck jobbers, Drop Shippers.
• Full service wholesalers: Full service wholesalers provide a full set of services, such as carrying stock, using a
sales force, offering credit, making deliveries and providing management assistance. They are either wholesale
merchants or industrial distributors. Wholesale merchants sell mostly to retailers and provide a full range of
services. Industrial distributors are merchant wholesalers that sell to producers rather than to retailers.
• Truck Jobbers: They perform a selling and delivery function. They carry a limited line of goods (such as milk,
bread or snack food) that they sell for cash as they make their rounds of supermarkets, small groceries, hospitals
etc.
• Drop Shippers: They operate in bulk industries such as coal and heavy equipment. They do not carry inventory
or handle the product. Once an order is received, they find a producer who ships the goods directly to the
customer.
18
• Manufacturers Agents: Agents represent buyers a seller on a more permanent basis. Manufacturers’ agents
represent two or more manufacturers of related lilies. They have a formal agreement with each manufacturer
covering prices, territories, order handling procedures, delivery and warranties and commission rates. They
know each manufacturer’s product line and use their wide contact to sell the products.
• Brokers: A broker brings buyer and sellers together and assists in negotiations. The parties hiring them pay
brokerage. They do not carry inventory, get involved in financing or assume risk. Examples are: Food brokers,
real estate brokers, insurance brokers and security brokers.
It is clear from the Table that if the consumer, spends Rs.3 on apples and Rs.2 on bananas, the marginal utility lie
gets from the last rupee on both becomes equal i.e. 6. In this way he gets maximum satisfaction. The total utility
from both the commodities will be 10+8+6+8+6 = 38, which is maximum. In case the consumer spends his income
in any other manner, he will act lesser total utility.
In this diagram units of money are shown on ox-axics and marginal utility on oy-axics. It indicates that if the income
of the consumer is Rs. 5.00, he will spend Rs. 3.00 on apples and Rs. 2.00 on bananas, because third rupee spent on
apples and second rupee spent on banana yield him equal marginal utility, i.e., 8 units. By distributing his income
on apples and bananas in this manner, the consumer gets total utility of 38 units. It will be the maximum total utility
derived by the consumer out of his expenditure of Rs. 5.00. So by spending his income in this manner the consumer
will get maximum satisfaction.
If the, consumer spends his income on apples and bananas in any other manner, his total utility will be less than the
maximum as shown in diagram. It is evident from the above figure that by spending one rupee less on apples the
loss will be equal to ABCD and by spending one rupee more on bananas the gain win be equal to EFGH. It is clear
that (ABCD) < (EFGH), hence loss is more than gain.
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Business Economics
20
Summary
• Business Economics, also called Managerial Economics, is the application of economic theory and methodology
to business.
• Different aspects of business need attention of the chief executive. He may be called upon to choose a single
option among the many that may be available to him.
• Business economic consists of the use of economic modes of thought to analyse business situations.
• Business economic seeks to establish rules which help business firms attain their goals, which indeed is also
the essence of the word normative.
• A business firm is an economic organisation which transforms productive resources into goods to be sold in
the market.
• Demands analysis helps identify the various factors influencing the product demand and thus provides guidelines
for manipulating demand.
• An element of cost uncertainty exists because all the factors determining costs are not known and
controllable.
• Pricing is an important area of business economic.
• Business firms are generally organised for purpose of making profits and in the long run profits earned are taken
as an important measure of the firm’s success.
• Relatively large sums are involved and the problems are so complex that their solution requires considerable
time and labour.
• Business economics makes a manager a more competent model builder.
• Business economics takes cognizance of the interaction between the firm and society, and accomplishes the key
role of an agent in achieving its social and economic welfare goals.
• The theory of consumer’s behaviour seeks to explain the determination of consumer’s equilibrium.
• The Cardinal Approach to the theory of consumer behaviour is based upon the concept of utility.
• The term utility in Economics is used to denote that quality in a good or service by virtue of which our wants
are satisfied.
• The utility derived from the first unit of a commodity is called initial utility.
• According to Chapman, “Marginal utility is the addition made to total utility by consuming one more unit of
commodity.
• Law of Diminishing Marginal Utility is an important law of utility analysis.
• A retailer’s price policy is a crucial positioning factor and must be decided in relation to its target market, its
product and service assortments and its competition.
References
• Sivagnanam, 2010. BUSINESS ECONOMICS, Tata McGraw-Hill Education.
• Reddy, J. R., Advanced Business Economics, APH Publishing.
• Dr. Khanchi, M.S., Business Economics- Meaning, Nature, Scope and significance [Pdf] Available at: <http://
www.ddegjust.ac.in/studymaterial/bba/bba-103.pdf> [Accessed 18 June 2013].
• UNIT –I: BUSINESS ECONOMICS AN INTRODUCTION [Pdf] Available at: <http://www.b-u.ac.in/sde_book/
bcom_be.pdf> [Accessed 18 June 2013].
• Economics for Business Lecture 1 [Video online] Available at: <http://www.youtube.com/watch?v=f6bSmaMUkIc>
[Accessed 18 June 2013].
• Econ110 Instruction: #6 Equimarginal Rule – Procedural [Video online] Available at: <http://www.youtube.
com/watch?v=xf4GTVqMjp0> [Accessed 18 June 2013].
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Business Economics
Recommended Reading
• Venugopal, K., 2006. Business Economics Volume - I, Volume 1, New Age International.
• Kumar, A. & Sharma, R., 1998. Managerial Economics, Atlantic Publishers & Dist.
• Basu, 1998. Business Organisation And Management, Tata McGraw-Hill Education.
22
Self Assessment
1. Match the following
1. Business Economics A. Demand Distinctions
2. Emphasis in business economics B. Serves as a guide to management
3. Demand forecast C. Normative theory
4. Demand analysis and forecasting D. Managerial Economics
a. 1-D, 2-C, 3-B, 4-A
b. 1-A, 2-C, 3-D, 4-B
c. 1-C, 2-B, 3-A, 4-D
d. 1-B, 2-A, 3-C, 4-D
2. ____________ means the process of selecting one out of two or more alternative courses of action.
a. Normative theory
b. Demand Analysis
c. Decision making
d. Traditional economics
3. A ___________ is an economic organisation which transforms productive resources into goods to be sold in
the market.
a. market
b. resource
c. company
d. business firm
5. The Cardinal Approach to the theory of consumer behaviour is based upon the concept of ___________.
a. utility
b. profit
c. approach
d. cost
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Business Economics
7. The utility derived from the first unit of a commodity is called __________.
a. total utility
b. marginal utility
c. initial utility
d. positive marginal utility
24
Chapter III
Demand, Supply and Product Management
Aim
The aim of this chapter is to:
Objectives
The objectives of this chapter are to:
• explain the concept and change in demand and supply on equilibrium price and quantity
Learning outcome
At the end of this chapter, you will be able to:
• compare the concepts of price elasticity demand and price elasticity supply
25
Business Economics
3.1 Introduction
In a market economy, individual consumers make plans of consumption and individual firms make plans of production,
based on changes in market prices. Economists use the term ‘invisible hand’ to describe the frequent exchanges
in the market because everyone (no matter consumer or producer) takes the market price as a signal on trade and
makes exchanges with private property rights.
The price system works in market economy only if there is a free choice within the market. The following explains
how the market price is determined by the interaction of producer (supply) and consumer (demand).
26
Demand Curve for Tom Demand Curve for Mary Market Demand Curve
30 30 30
20 20 20
10 10 10
0 0 0
2 4 6 8 10 1 3 5 7 9 5 10 15 20
The slope implies that price and quantity are inversely related.
Some types of premium goods, for example. Expensive French wines, BMW cars are sometimes claimed to be
Giffen goods. It is said that, decrease in the price of such high status goods can reduce its demand, as they are no
longer perceived to be exclusive or of high status.
Perfectly Elastic Demand Here the value for price elasticity of demand is infinity
Perfectly Inelastic Demand Here demand doesn’t change with change in time
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Business Economics
For example, previously there was a difference in price and usage of mobile phone
and land line. The main objective behind phone is communication but mobile
phone is also useful for other multipurpose activities. So, the demand for land line
phone came down in comparison to mobile phone.
Income of consumer This is one of the most important aspects which affect the demand for goods in
market. Increase in income of a consumer lead to increase in demand for normal
goods.
Preference of consumer It refers to the subjective choice of a consumer. The demand of a product may be
affected by knowledge, friends, education and culture.
Weather fluctuation The demand for different product varies as per the seasons. For example demand
of AC is more during the time of summer but in off seasons the price is less as
compared to summer.
28
Supply curve shows the relationship of above mentioned data.
220
210
200
0 X
50 60 70 80 90 100
Quantity Supplied (Units)
Quantity Supplied
Price
(per unit) Market
B N
(i.e. B + N)
10 2 3 5
18 4 5 9
28 6 8 14
40 8 10 18
50 10 11 21
Like the market demand curve, the market supply curve is obtained by summing up the individual supply curves in
the market. The technique is also known as Horizontal Summation.
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Business Economics
50 50 50
30 30 30
10 10 10
0 0 0 5 10 15 20
2 4 6 8 10 3 5 7 9 11
a
Here the Price Elasticity of Supply is more than 1 but less than infinity. Change in
Elastic Supply
supply is more than proportionate to change in the price of goods.
Unit Elastic Supply When the coefficient is equal to one, supply is called unit elastic.
Perfectly Elastic When Price Elasticity of Supply is equal to infinity, it is called as perfectly Elastic
Supply Supply.
Perfectly Inelastic When Price Elasticity of Supply is equal to zero, it is called as perfectly Inelastic
Supply Supply.
30
Factors which affect supply of goods are mentioned in the following table.
From the above table we can see that, there is only one point i.e., 3.5 where both demand and supply is equal. As
per the table 3.9 the graph is mentioned below.
Y
Demand Curve
Supply curve
E
Price
X
8000
Quantity
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Business Economics
The demand curve move towards right due to increase in demand. It will have an impact on current equilibrium.
New equilibrium for increased demand will have the higher price.
For example, there is a demand for 200 motor bikes, each costing Rs.30,000. Due to increase in population, the
demand for motorbikes increases from 200 to 500. This increased demand changed equilibrium price level from
Rs. 30,000 to Rs. 50,000.
Increased Demand
Y
S
50,000 E1
Price
30a,000 E0 D2
D1
0 X
200 500
Quantity
Increase in supply
• The supply curve will shift rightward with increase in supply.
• This will lead to increase in quantity demand and increase in price, as shown
Increase in Supply
Y S1
S2
Price
D
0 X
Quantity
32
Decrease in supply
• The supply curve will shift leftward with decrease in supply.
• This will lead to decrease in quantity demand and increase in price, as shown.
Decrease in Supply
S2
Y S1
Price
D
0 X
Quantity
Table 3.10 shows the changes in price and quantity when there is a change in demand and supply.
• In most of the markets, prices are free to rise or fall as per the demand from consumers. Sometimes it happens
that the price in market is either “too high” or “too low”.
• At this point, the Government plays a crucial and applies some legal limits on how high or how low may price
go, as high price may be unfair to the buyer and low price may be unfair to the seller.
• Two basic concepts, called Price Ceiling and Price Floor are used for high and low price, respectively.
• If the price of a product is unfairly high, the government can set a price ceiling, or legal maximum price a seller
may charge for a product. Similarly, if the price of a product is unfairly low, the government can set a price floor
or minimum fixed price that sellers can charge.
• In price ceiling, the consumers can afford some essential goods or services that they could not afford at the
equilibrium price as it was too high before, which can create shortage of goods.
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Business Economics
Price Ceiling
S
Y
2.50
Price
2
D
Shortage
0 QS QO Qd X
Quantity
The main goal of price floor is to provide a sufficient income to a certain group of resource suppliers or producers,
so that people from all classes and group can afford the goods or services which will create surplus of goods.
Price Floor
S
Y
Surplus
3
2.50
0 X
Qd QO QS
34
3.9 Tax Impact on Price or Quantity of Goods
Table shows the tax impact on goods in various situations.
Various Demand
Tax paid by Description Graph
and Supply
Perfectly Elastic Supplier The entire tax is S1
0
Q
0 Q
0 Q
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Business Economics
The main behavior of a perfectly competitive market is based on the following two factors;
• Quantity of good to be produced by a firm
• Price to be charged for the goods
One of the new concepts called “Price Takers” is very commonly used in perfect competition market. In other words,
we can say that perfect competition is the world of price takers. Individual or firms who must take the market price
as given are called as Price Takers. In a perfectly competitive environment, the seller is so small in caparison to
market that it cannot affect the market price; hence it simply takes the price as given. The price of any commodity
depends entirely upon the supply and demand, and each firm and consumer is a price taker.
Price-taking consumer assumes that he or she can purchase any quantity at the market price, without affecting the
price. Price-taking firm assumes that it can sell whatever quantity it wishes at the market price, without affecting
the price.
All above requirements are rarely found in any one industry. As a result, perfect competition is difficult to find in
reality. Most products have some degree of differentiation, like in case of mineral water; the difference can vary
in methodology of purification. That’s why the price of Himalaya Mineral Water is twice than any other mineral
water like Aquafina. In the figure, we can see that in equilibrium, the price remains unaffected with variation in
output that the firm find feasible to produce. If the perfectly competitive firm tries to change the price that is higher
than the equilibrium price, then the consumer will move to the near substitute product and the firm would lose its
existing customer.
Market
Supply
S
Price (Rs.)
Price (Rs.)
Market
10 Demand 10 d
D
0 2,000 Quantity
100 Quantity
Industries
Single firm
36
Marginal Revenue = Change in Total Revenue / Change in Quantity
Or
MR = ∆TR / ∆Q
Total Revenue = Price X Quantity
Where,
MR - Marginal Revenue
∆TR - Change in Total Revenue
∆Q - Change in Quantity
By the above equation, the Marginal Revenue of the product is, MR = [(1, 1010 – 1,000) / (101 - 100)] = 10, i.e.
Rs 10.
Thus, we can say that price equals to the marginal revenue (P = MR). So the marginal revenue curve is same as the
demand curve because price is equal to marginal revenue.
Price (Rs.) d1 MR
1 2 3 4
Quantity
As per the Fig. 3.12, the firm is in equilibrium at E, but at F there is a possibility for the firm to earn profit equivalent
to the shaded half, i.e. PQ amount.
MC
F E
Profit & Cost
MR
0
P Q
Quantity
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Business Economics
Given easy entry and exit, some firms in Industry B will leave it and enter Industry A to earn the greater profits
available there. As they do so, the supply curve in Industry B will shift to the left, increasing prices and profits there.
As former Industry B firms enter Industry A, the supply curve in Industry A will shift to the right, lowering profits
in A. The process of firms leaving Industry B and entering A will continue until firms in both industries are earning
zero economic profit. Thus, we can say that, “Economic profits in a system of perfectly competitive markets will,
in the long run, be driven to zero in all industries.”
38
• Sometimes monopoly power is the result of location. Sellers in markets isolated by distance from their nearest
rivals have a degree of monopoly power, for example, doctors, first run movies, etc. in a small town.
Sunk Cost
An expenditure that has already been made and cannot be recovered is called a sunk cost. For example, an entry into
a particular industry requires extensive advertising to make consumers aware of the new brand. Should the effort
fail, there is no way to recover the expenditures for such advertising.
MC
P d P1
Demand
Price
P2
P3
Q Q 1 Q2 Q3
Quantity per period
Quantity per period
From Panel (b) we can find out that, for a perfectly competitive firm all the commodities and services are sold at the
going market price, where as in monopolistic market a greater quantity can be sold only by cutting its price.
MR > MC
To determine the profit maximisation output, we can see that the point where firm’s marginal revenue intersects
firm’s marginal cost, as shown in point Qm in Fig. 3.14.
We read up from Qm to the demand curve to find the price Pm at which the firm can sell Qm units per period. The
profit maximising price and output are given by point E on the demand curve.
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Business Economics
Thus, we can determine a monopoly firm’s profit maximising price and output by following three steps:
• Determine the demand, marginal revenue, and marginal cost curves
• Select the output level at which the marginal revenue and marginal cost curves intersect
• Determine from the demand curve the price at which that output can be sold
F
ATCm
Monopoly
profit
G
Marginal Demand
revenue
Qm
Quantity per period
In an Oligopoly, the market is dominated by a few firms, and each of these firms is recognised by their own action,
which produce a response from its rivals and that response has its own effects.
The concentration ratio is the percentage of market share owned by the largest firms in an industry.
m = specified number of firms, say its value is 4
The concentration ratio often is expressed as CRm, i.e., CR4.
Then, the concentration ratio can be expressed as:
CRm = s1 + s2 + s3 + ... ... + sm
Where s = Market share of firm
40
If the concentration ratio is high then the few firms make out the entire industry, and if it is low then more than a
few sellers actually make up the industry.
Suppose two men, named X and Y, have been arrested and charged for committing a crime jointly. Both are kept in
separate cells and each is offered the following deal:
• If you confess the crime, whereas the other does not, you will get minimum sentence of six months.
• If other confess, where as you do not confess, you will get sentence of 2 years.
• If both parties refuse to confess, then each of them will get the sentence of one and half year.
• If both confess, then each will get the sentence of 1 year.
X choice
Y Choice Refuse to confess If confesses
X will get 1 and half year jail X will get six months jail
Y will get 1 and half year jail Y will get 2 years jail
X will get 2 years jail X will get 1 year jail
Y will get six months jail Y will get 1 year jail
From the above matrix structure it is easily understood that, if both confess, each of them will get 1 year jail. This is
the outcome of game theory. Similarly, from the industry perspective, if two firms have been given choices to remain
in partnership or to break the partnership, then the following matrix structure for this situation is shown below.
41
Business Economics
Firm A
Partnership
Refuses
Refuses Partnership Accept Partnership
A wil get the profit of Rs. 10,000 A will get the profit of Rs 20,000
B will get the profit of Rs. 10,000 B will get the profit of Rs 5,000
A will get the profit of Rs 5,000 A will get the profit of Rs. 20,000
Partnership
B will get the profit of Rs 20000a B will get the profit of Rs 20,000
Accept
Firm B
From the above structure, we can find that both the firms A and B want more profit, so both will accept the
partnership.
42
Summary
• The entire demand concept is based on price, if the price of a commodity increases, then the demand will
decrease and vice versa.
• The Market Demand Curve is obtained by plotting the graph of sum of the individual demand curve of a particular
goods in the market, at the same price, within a time period.
• The direct relationship between price and quantity supplied is called Law of Supply. In other words, if the price
is high then supply is also high or vice versa.
• It elaborated the main concept of equilibrium as per change in demand and supply and also the role of the
government in setting prices.
• Two basic concepts, called Price Ceiling and Price Floor are used for high and low price, respectively. If the
price of a product is unfairly high, the government can set a price ceiling, or legal maximum price a seller may
charge for a product.
• If the price of a product is unfairly low, the government can set a price floor or minimum fixed price that sellers
can charge.
• A choice based on the recognition that the actions of others will affect the outcome of the choice and that takes
these possible actions into account is called a Strategic Choice.
• Game theory is an analytical approach through which strategic choices can be assessed.
References
• Walter, N., Microeconomic Theory: Basic Principles and Extensions. 9th ed.
• Robert, S. P. and Daniel, L.R., Microeconomics. 3rd ed, Prentice Hall.
• Rittenberg, L. and Tregarthen, T., 2010. Principles of Microeconomics, [Online] Available at: <http://www.
web- books.com/eLibrary/NC/B0/B63/018MB63.html> [Accessed 25 October 2010].
• Swanson, M. 2010. Diminishing Marginal Utility, [Online] Available at: <www.ehow.com/how_5993061_
calculate-diminishing-marginal-utility.html> [Accessed 25 October 2010].
• MIT, Lecture 9., 2012. Principles of Microeconomics [Video online] Available at: <http://www.youtube.com/
watch?v=Q4iKuKAjzK0>[Accessed 25 October 2010].
• RegisUniversity., 2010. .Aggregate Demand/Aggregate Supply Macro Model.[Video online] Available at: <http://
www.youtube.com/watch?v=5D06HqwsVtM> >[Accessed 25 October 2010].
Recommended Reading
• Bernanke, B., 2009. Principles of Microeconomics, Marginal Decision Rule, Tata McGraw Hill Publication.
• Mithani, D., 2008. International Economics. Institute of Business Study and Research, Himalaya Publishing
House Pvt. Ltd.
• Dr. Mithani, D. M., 2008. International Economics, Institute of Business Study and Research, Himalaya
Publishing House Pvt. Ltd.
43
Business Economics
Self Assessment
1. Which of the following will lead to decrease in quantity demand and increase in price?
a. Decrease in supply
b. Increase in demand
c. Demand remain same
d. Decrease in demand
4. In which of the following demand does not change with change in time?
a. Perfectly Inelastic Demand
b. Perfectly Elastic Demand
c. Inelastic Demand
d. Elastic Demand
44
8. In Perfectly Elastic Demand who will take the full burden of tax?
a. Buyer
b. Supplier
c. Government
d. Public
9. __________ is a model of market based on the assumption that a large number of firms are producing the
identical goods and services, which is consumed by large number of buyers.
a. Perfect competition
b. Marginal revenue
c. Market Demand curve
d. Price ceiling
10. The rate of quantity demanded due to price change is called _____________.
a. Price Elasticity of Demand
b. Price Elasticity
c. Price Elasticity of Supply
d. Price Inelasticity
45
Business Economics
Chapter IV
Analysis of Consumer Choice, Production Analysis and Cost Concept
Aim
The aim of this chapter is to:
Objectives
The objectives of this chapter are to:
• enlist the approaches of utility theory called cardinal approach and ordinal approach
Learning outcome
At the end of this chapter, you will be able to:
• identify the concepts of marginal utility and law of diminishing marginal utility
46
4.1 Introduction
Why do people buy goods and services? The answer could be, all the goods and services provide satisfaction to
people, and economists call this satisfaction as utility. People have unlimited demands but limited resources and
the consumption patterns differ as per the individual income level. The buying patterns maximise the satisfaction
level and people will prefer one good over the other.
TU = U1 + U2 + U3 + U4 + U5
47
Business Economics
From the above table, one can figure out that, marginal utility comes down with an additional consumption while
total utility goes up. The Law of Diminishing Marginal Utility helps an economist to understand the law of demand
and the negative slope of the demand curve. The less something is had, the more satisfaction is gained from each
additional unit consumed and the marginal utility gained from that product is high because of higher willingness
to pay for it.
The marginal utility comes to zero when the total utility is maximum. The relationship between marginal utility and
total utility is explained with the help of following (Table 4.3 and Fig. 4.1) graph and schedule.
• From the above table (Table-4.3), when a person does not consume any apple, he gets no satisfaction. Total
utility becomes zero.
• When he consumes one apple per day, total utility become seven.
• In case he consumes second apple then the marginal utility will increase to four. Thus, giving him total utility of 11.
• The marginal utility will fall to two when the total utility is 13 that is (7 + 4 + 2).
• If consumer takes fifth apple, then his marginal utility will fall to zero and the total utility is maximum that is
14.If sixth apple is consumed, the marginal utility is reduced to negative (13 – 14 = -1).
48
The curve showing total utility and marginal utility is plotted in the figure below.
TU
12 a
8
d
0
1 2 3 4 5 6 MU
-2 Apples consumed (per day)
Fig. 4.1 Total utility
(Source: http://ecoarun.blogspot.in/2010/07/6-diffrent-total-curves-total.html)
Y
Y MUx / Px
MU
MU1 P1
Marginal Utility
De
De
m
m
an
an
P2
Price
MU2
d
d
Cu
Cu
rv
rv
e
MU3 P3
0 Q1 Q2 Q3 X 0 Q1 Q2 Q3 X
Quantity Quantity
(a) (b)
49
Business Economics
As per the Law of Diminishing Marginal Utility, an increase in quantity consumed results in a decreasing marginal
utility. Thus, the consumer needs to increase the consumption of goods. The left hand side of Fig. 4.2 shows the
Diminishing Marginal Utility of goods. The next diagram shows the demand curve in terms of price and quantity.
The price of goods OP1 equilibrium is possible at quantity OQ1 where MU1 = OP1. Now suppose price comes
down to OP2, then the equilibrium will definitely change.
Marginal utility will be definitely less than the MU1. So we can state this as,
Wages in China are relatively low for both skilled and unskilled labour to produce any goods. Where as, in United
States the labour cost is very high so they use more machinery and less labour. All types of production require
the choices in the use of uFactors of Production. This chapter gives the analysis of such choices. The analysis of
production and cost begins with a period called Short Run. The Short Run is defined in economics as, a period of
time where at least one factor of production or variable is fixed, i.e., it cannot be changed. For example, the various
capital inputs like plant and machinery is fixed and that can be changed by supplier by altering the variable inputs
such as labour, components, raw materials and energy inputs.
50
12 H
G I
F
10
E
8
D
Production
6
per day
Total
product
4
C
2
B
A
0 1 2 3 4 5 6 7 8
Units of labor per
day
Factors of Production: In economics Factor of Productions are any commodity or services used to produce goods
and services:
• The slope of Total Product curve for any variable factor is a measure of change in output associated with change
in amount of variable factor, with all other factors held constant.
• The amount by which output rises with addition of one extra unit of a variable factor is the Marginal Product
of the variable factor like labour. We can also derive Marginal Product of Labour (MPL), from mentioned
formula below;
MPL = ∆Q /∆L
Where, ∆Q = Change in Output
∆L = Change in units of Labour
• We can also define Average Product of variable factor, which is the output per unit of variable factor. The Average
Product of Labour (APL) is the ratio of output to the number of units of labour.
APL = Q / L
Where, Q = Number of output
L = Number of units of Labour
• In Fig. 4.2, the Marginal Product rises as the slope of the total curve increases, falls as the slope of the Marginal
Product curve declines and reaches Zero when the Total Product curve achieve the maximum value. When the
Total Product curve moves downward it becomes negative.
• Also, one can notice that the Marginal Product curve intersects the Average Product curve at maximum point
on Average Product curve. When marginal product is above average product, then average product is rising and
when marginal product is below average product, the average product is falling.
• For example, as a student you can use your own experience to understand the relationship between marginal and
average values. Your Grade Point Average (GPA) represents the average grade you have earned in all your course
work so far. When you take an additional course, your grade in that course represents the marginal grade.
• What happens to your GPA when you get a grade that is higher than your previous average? It rises.
• What happens to your GPA when you get a grade that is lower than your previous average? It falls.
• If your GPA is a 3.0 and you earn one more B, your marginal grade equals your GPA and your GPA remains
unchanged.
51
Business Economics
Panel (a)
12 G H I
F
10 E
slope = 0.3
slope = 0.5
slope = 0.7
8 D
slope = 10
Production
per day
6 Total
slope = 2.0
product
4
C
slope = 4.0
2 B
slope = 2.0
A
slope = 1.0
4
Marginal product
avarage product
Panel (b)
3
Avrage
2 product
1
Marginal
0 product
-0.5
1 2 3 4 5 6 7 8
Units of labor per day
While, the cost related with the use of fixed factors like plant, buildings is called as Fixed Cost. The fixed costs
are incurred by company irrespective of the level of production, as it is fixed in nature. For example, the rent of
the factory premises or machinery or insurance premium all falls under fixed cost. Sometimes, the salary of top
management may also be counted as fixed cost.
We have already discussed the concept of total product and marginal product. Similar to it, Marginal Cost is the
change in Total Cost that arises when the quantity produced changes by one unit. The marginal cost plays an important
role for evaluation of occurrence of cost in the firm. Marginal cost shows the additional cost of each addition unit
of output a firm produces. The formula to determine marginal cost is:
MC = ∆T / ∆Q
Where,
MC = Marginal Cost
∆T = Change in Total Cost
∆Q = Change in output
52
4.5.2 Average Total Cost
The second important concept of cost is Average Total Cost (ATC). It is a firms total cost divided by quantity that
is firm’s total cost per unit of output.
ATC = TC / Q
Where,
ATC = Average Total Cost
TC = Total Cost
Q = Output produced
The Average Total Cost is the summation of Average Variable Cost (AVC) and Average Fixed Cost (AFC)
Average Variable Cost is Total Variable Cost (TVC) per unit of output.
AVC = TVC / Q
Where,
AVC = Average Variable Cost
TVC = Total Variable Cost
Q = Output produced
Similarly, in case of Short Run, where at least one production factor is fixed, the Average Fixed Cost (AFC) becomes
the Total Fixed Cost (TFC) divided by quantity.
AFC = TFC / Q
Where,
AFC = Average Fixed Cost
TFC = Total Fixed Cost
Q = Output Produced
4.6 Relationship between Marginal Cost, Average Fixed Cost, Average Variable Cost and
Average Total Cost in Short Run
$200
AFC, AVC, ATC, and MC
MC
AFC
150
ATC
100
AVC
50
0 1 2 3 4 5 6 7 8 9 10 11
Quantity Produced
53
Business Economics
In the above figure, the marginal cost curve intersects the average total cost and average variable cost curves at
their lowest points. When marginal cost is below average total cost or average variable cost the average total and
average variable cost curve slopes downward. When marginal cost is greater than short-run average total cost or
average variable cost; then the average cost curve slopes towards upward. The logic behind the relationship between
marginal cost and average total cost and variable cost is the same as it is for the relationship between marginal
product and average product.
Fig. 4.6 below shows the relationship between the short run and long run average total curve.
$9
8 ATC20 ATC50
7 ATC30
Cost per unit
ATC40
6
B D
5
C
0 5 10 15 20 25 30 35 40 45 50
Fig. 4.6 Short run and long run average total curve
(Source: http://ecoarun.blogspot.in/2010/07/6-diffrent-total-curves-total.html)
The LRAC curve assumes that the firm has chosen the uoptimal factor combination for producing any level of output.
Therefore, the cost it shows is the lowest cost possible for each level of output. In the figure above, the Platinum
Disc Corporation manufactures CDs by using capital and labour.
If it has 30 units of capital, then the average total cost associated with the curve is ATC30. In long run, the firm can
examine the ATC with varying level of capitals. The relevant curves are labelled as ATC20, ATC30, ATC40, ATC50
etc., as per capital invested. The LRAC curve is derived from the set of short-run curves by finding the lowest ATC
associated with each level of output. Here, we can notice that LRAC curve is U Shaped and it is surrounded by
various shot run curves.
54
A firm is said to experience diseconomies of scale when long-run average cost increases with expansion of output.
Constant returns to scale occur when long-run average cost stays the same over an output range.
Optimal factor combination: Where the factors of production cost as little as possible and produce as more as
possible. In other words it has to minimise costs while maximising output.
55
Business Economics
Summary
• Utility is an abstract concept rather than a concrete, observable quantity.
• Total utility is the aggregate of some of the satisfaction or benefits that the individual gains by consuming a
given amount of goods and services in an economy.
• Marginal utility is the additional satisfaction or amount of utility gained from each extra unit of consumption.
• The marginal utility comes to zero when the total utility is maximum.
• The processes and methods which convert tangible inputs (manpower, raw materials, and semi finished goods)
and intangible inputs (ideas, information) into goods and services is called as production.
• Firms use production factor to produce products. The relationship between production factor and output is
called as Production Function.
• A total product curve shows the quantity of outputs that can be obtained from different amount of variable factor
of Production, assuming that the Factors of Production are fixed.
• The cost associated with the use of variable factors such as materials, manpower, semi-finished goods, etc. is
called as Variable Cost.
• The Total Cost (TC) of any firm is the summation of Total Variable Cost (TVC) and Total Fixed Cost (TFC).
• The second important concept of cost is Average Total Cost (ATC). It is a firms total cost divided by quantity
that is firm’s total cost per unit of output.
• In Long Run, there are no fixed inputs and as a result there is no fixed cost too. So, in long run a firm has a
greater level of flexibility than in short run.
• A firm experiences economies of scale when long-run average cost declines as the firm expands its output.
References
• Samuelson, P. A., 2002. Economics, Tata McGraw-Hill Publishing Co.Ltd.
• Robert, S. P. and Daniel, L. R., Microeconomics. 3rd ed, Prentice Hall.
• Rittenberg, L. and Tregarthen, T., 2010. Principles of Microeconomics. [Online] Available at: <http:// www.
web-books.com/eLibrary/NC/B0/B63/018MB63.html> [Accessed 25 October 2010].
• Swanson, M., 2010. Diminishing Marginal Utility, [Online] Available at: <www.ehow.com/how_5993061_
calculate-diminishing-marginal-utility.html> [Accessed 25 October 2010].
• 2010. Introduction to Microeconomics 101 [Video online] Available at: <http://www.youtube.com/
watch?v=gfiQ1xZfqV4> [Accessed 14 August 2012].
• About.com., 2011. What is Microeconomics? [Video online] Available at: <http://www.youtube.com/
watch?v=I2GH1MESQ5w>[Accessed 14 August 2012].
Recommended Reading
• Mankiw, N. G., 2008. Economics: Principles and Applications, Cengage Learning Products, Canada, Nelson
Education Pvt. Ltd.
• Samuelson, P. A., 2002. Economics, Massachusetts Institute of Technology, Tata McGraw-Hill Publishing
Company.
• Bernanke, B., 2009. Principles of Microeconomics, Marginal Decision Rule, Tata McGraw Hill Publication.
56
Self Assessment
1. Which of the following approaches to utility theory?
a. Cardinal and ordinal approach
b. Systematic and unsystematic approach
c. Fundamental and sequential approach
d. Constant and variable approach
2. Total utility increases as more goods are consumed, marginal utility usually decreases with each additional
increase in the consumption of goods, this decreasing part is called ______________.
a. Law of Diminishing Return
b. Law of utility
c. Law of Total utility
d. Law of Diminishing Marginal Utility
3. A person consumes five units of commodity and derives U1, U2, U3, U4 and U5 utility from the successiveunits
of goods, the total utility will be __________.
a. U1 + U2 – U3 + U4 + U5
b. U1 + U2 + U3 + U4 + U5
c. U1- U3 + U2 – U4 + U5
d. U1 – U4 + U2 + U3 + U5
4. The additional satisfaction or amount of utility gained from each extra unit of consumption, is called
_________.
a. Total Utility
b. Average Utility
c. Marginal Utility
d. Utility Theory
6. _________ is the aggregate of some of the satisfaction or benefits that the individual gains by consuming given
amount of goods and services in an economy.
a. Marginal utility
b. Budget constrain
c. Total utility
d. Average production
57
Business Economics
9. Which of the following is an abstract concept rather than a concrete, observable quantity?
a. Law of Diminishing Marginal Utility
b. Utility
c. Law of Diminishing Marginal Return
d. Marginal Utility
10. Consumption of more amounts of goods and services up to certain extent is acceptable beyond that saturation
point will come which causes the reduction of _______.
a. Marginal Utility
b. Total Utility
c. Average Utility
d. Mixed Utility
58
Chapter V
The Nature of Factor Demands
Aim
The aim of this chapter is to:
Objectives
The objectives of the chapter are to:
• elucidate the application of marginal revenue product and the demand for factors
Learning outcome
At the end of this chapter, you will be able to:
59
Business Economics
5.1 Introduction
Demand for a commodity refers to the quantity of the commodity that people are willing to purchase at a specific
price per unit of time, other factors (such as price of related goods, income, tastes and preferences, advertising,
etc) being constant. Demand includes the desire to buy the commodity accompanied by the willingness to buy it
and sufficient purchasing power to purchase it. For instance-Everyone might have willingness to buy “Mercedes-S
class” but only a few have the ability to pay for it. Thus, everyone cannot be said to have a demand for the car
“Mercedes-s Class”.
Demand may arise from individuals, household and market. When goods are demanded by individuals (for instance-
clothes, shoes), it is called as individual demand. Goods demanded by household constitute household demand
(for instance-demand for house, washing machine). Demand for a commodity by all individuals/households in the
market in total constitutes market demand.
5.2.1 Income
Income is the consumption and savings opportunity gained by an entity within a specified time frame, which is
generally expressed in monetary terms. There are two main approaches to examine the income distribution:
Personal distribution
Personal distribution of income means the distribution of national income among the various members of the society.
These persons perform various kinds of activities and are paid according to their services. For example, workers,
teachers, clerks and other officers get salaries, and professionals like advocates, chartered accountants and physicians
doing private practice charge fees for their services. Since these services do not require the same skill and are not
uniformly productive, earnings of different persons engaged in these activities differ. Incomes of a large number
of people are not from one source only. Some people get salary for the work which they do in offices and also earn
interest on their bank deposits and dividend on their investments in shares.
Functional distribution
In functional distribution, an attempt is made to examine how wages, rent, interest and profit are determined. It refers
to the mechanism whereby different factors are rewarded for the services they render to the productive process.
According to modem economists, rent, wages, interest and profit are the prices for the services rendered by land,
labour, capital and enterprises respectively in the production process. The principles which determine commodity
prices are used to determine prices of various factors of production. As a result, the factors of production are
considered as part of the price theory.
60
5.2.2 Wealth
Wealth is the net worth of a person, household, or nation, that is, the value of all assets owned net of all liabilities
owed at a point in time. Wealth is a stock, while income is a flow per unit of time. A household’s wealth includes
its tangible items (house, car and other consumer durable goods and land) and its financial holdings (such as cash,
savings accounts, bonds, and stocks). All items that are of value are called assets, while those that are owed are
called liabilities. The differences between total assets and total liabilities are called wealth and net worth.
61
Business Economics
D D
Rent of Cornland
Price of Corn
P P
D D
O O
Cornland
Corn
62
5.6 The Demand for Factors of Production
To determine the demand of production factor we need to analyse how a profit-oriented firm chooses its optimal
combination of inputs.
Under perfect competition the marginal revenue product equals price times marginal product, i.e., MRP = P * MP
The profit maximising combination of inputs for a perfectly competitive firm comes when the marginal product
times the output price equals the price of the input:
For instance, suppose you own a cable television monopoly for a particular area. If you want to maximise profits, you
will want to choose the best combination of workers, land easements for your cables, trucks, and testing equipment
to minimise costs. If a month’s truck rental costs Rs. 10,000 while monthly labour costs are minimised to Rs.2000,
costs are minimised when the marginal products per rupee of input are the same. Since trucks cost 5 times as much
as labour, trucks MP must be 5 times the labour MP.
63
Business Economics
d
60
30
20
10
d L
0 1 2 3 4 5
Labor inputs (workers)
Fig. 5.2 Demand for inputs derived through marginal revenue products
(Source: http://www.managementstudyguide.com/consumer-demand.htm)
With the MRP schedule for an input, we can determine the relationship between the price of the input and the
quantity demanded of that input. This relationship is called demand curve. The MRP schedule for each input gives
the demand schedule of the firm for that input.
Labour supply is determined by many economic and noneconomic factors. The important determinants of labour
supply are:
• Price of labour (wage rate)
• Demographic factors like age, gender, education and family structure
64
Determinants of capital depend upon:
• Past investments made by businesses, households and governments.
The different possible elasticity’s for the supply of factors are illustrated by the supply curve below:
PF S
Factor price B
S
QF
Factor quantity
Supplies of factors of production depend upon characteristics of the factors and the preferences of their owners.
Generally, supply will respond positively to price, as in the region below A. For factors that are fixed in supply,
like land, the supply curve will be perfectly inelastic, as from A to B. In special cases, where a higher price of the
factor increases the income of its owner greatly, as with labour or oil, the supply curve may bend backward, as in
the region above A.
Thus, at a given price of land, we add together all the demands for land of all the firms at that price, and we do the
same at every price of land. We add horizontally the demand curves for land of all the individuals firms to obtain
the market demand curve for land. This procedure is followed to get the market demand for each input. Here the
derived demand for the input is based on the marginal revenue product of the input under consideration. Fig. 5.4
shows a general demand curve for a factor of production as the DD curve.
65
Business Economics
PF
D S
Factor price
E
S
QF
Factor quantity
Fig. 5.4 Factor supply and derived demand interact to determine factor prices and income distribution
(Source: http://www.managementstudyguide.com/consumer-demand.htm)
Factor prices and quantities are determined by the interaction of factor supply and demand. The equilibrium price
of the input in a competitive market comes at that level where the quantities supplied and demanded are equal. This
is illustrated in figure above, where the derived demand curve for a curve for a factor intersects its supply curve at
point E. Only at this price will the amount that owners of the factor willingly supply just balances the amount that
the buyers willingly purchase.
The figure below shows the markets for two kinds of labour – surgeons and fast-food workers
Ws Es
Hourly earnings
DF
Hourly earnings
Ds
EF
WF SF
DF
L L
Ls Labor supply LF
Labor supply
Fig. 5.5 The markets for surgeons and fast food workers
(Source: http://www.managementstudyguide.com/consumer-demand.htm)
For (a), we see the impact of a limited supply of surgeons: small amount and high earnings per surgeon.
For (b), open entry and low skill requirements imply a highly elastic supply of fast-food workers. Wages are beaten
down and employment is high.
The supply of surgeons is severely limited by the need for medical licensing and the length and cost of education
and training. Demand for surgery is growing rapidly along with other health-care services. Moreover, an increase
in demand will result in a sharp increase in earnings with little increase in output.
At the other end of the earnings scale are fast-food workers. These jobs have no skill or educational requirements
and are open to virtually everyone. The supply is highly elastic. Wages are close to minimum, because of the ease
of entry into this market. The major difference between the earning powers is because of the quality of labor and
not the quantity of hours.
66
5.9 The Distribution of National Income
How market allocates national income among the many factors of production can be well understood by Factor-
Income Distribution Theory* by John Bated Clark. It can be applied to competitive markets for any number of final
products and factor inputs. This can be understood through “real” units in terms of goods. The goods can be corn
or a basket of different goods and services; we will term it as Q and price it equal to 1.The value of output being Q
and with the wage rate being the real wage in terms of goods or Q. In this situation, a production function tells how
much Q is produced for each quantity of labour-hours, L, and for each quantity of acres of homogeneous land, A.
Note: P=1, under perfect competition MRP=MPXP= MPX1=MP, the wage is therefore equal to MPL
The following marginal product curve of labour gives the demand curve of all employers in terms of real wages.
W
S
D
Marginal
product of
Marginal product, wage rate
labor
E
N
D
S
L
0
Quantity of labor
• Factor-income distribution theory refers to the way total input or income is distributed among individuals or
among factor of production (land, labour and capital).
• Each vertical slice represents the marginal product of that unit of labour. Total national output ODES is found by
adding all the vertical slices of MP up to the total supply of labour at S. The distribution of output is determined
by marginal product principles. Total wages are the lower rectangle (equal to the wages are ON times the quantity
of labour OS). Land rents get the residual upper triangle NDE.
• Labour-supply factors determine the supply of labour (shown as SS). The equilibrium wage comes at E. The
total wages paid to labour are given by W X L; this is shown by the dark area of the rectangle, OSEN.
• NDE in figure measures all the surplus output which was produced but was not paid out in wages. The size of
the rent triangle is determined by how much the MP labor declines as additional labour is added.
67
Business Economics
This distributes 100 % of output among all the factors of production. The aggregate theory of the distribution of
income is compatible with the competitive pricing of any number of goods produced by any number of factors.
While the market can work wonders in producing a growing array of goods and services in the most efficient manner,
there is no visible hand which ensures that a Laissez-faire* economy will produce a fair and equitable distribution
of income and property.
* Laissez-faire is an economy that relies chiefly on market forces to allocate goods and resources and to determine
prices.
68
Summary
• Income is the consumption and savings opportunity gained by an entity within a specified time frame, which is
generally expressed in monetary terms.
• Wealth is the net worth of a person, household, or nation, that is, the value of all assets owned net of all liabilities
owed at a point in time.
• The Theory of Income Distribution or Distribution Theory studies how incomes are determined in an
economy.
• The Marginal Productivity Theory of income states that, “the marginal revenue productivity of a factor reveals
the demand for that factor”.
• The demand for factors differs from that for consumption goods in two important respects: Factor demands are
derived demands and Factor demands are interdependent demands.
• The fundamental point about distribution theory is that the “demands for the various factors of production are
derived from the revenues that each factor yields on its marginal product”.
• To determine the demand of production factor we need to analyse how a profit-oriented firm chooses its optimal
combination of inputs.
• An outcome of the least-cost rule is the substitution rule. It states that, “If the price of one factor rises while
other factor prices remain fixed, the firm will profit from substituting more of the other inputs for the more
expensive factor”.
• The distribution of income combines the supply and demand for factors of production.
• The marginal-productivity theory is a great step forward in understanding the pricing of different inputs. In
competitive markets, the demand for inputs is determined by the marginal products of factors.
References
• Samuelson, P., 2002. Economics: Massachusetts Institute of Technology, Tata McGraw-Hill Publishing
Co.Ltd.
• Pindyck, R. and Rubinfeld, D., 2008. Microeconomics, Prentice Hall, 7th ed., Pages 768.
• Ana, B.A., 2012.Advanced Microeconomics Production, [Pdf] Available at: <http://homepage.univie.ac.at/ana-
begona.ania-martinez/vorlagen/Microeconomics_B_WS11_04_Production.pdf > [Accessed 21 August 2011].
• Kenneth, J. M., 2006. Principles of Microeconomics, [Pdf] Available at: <http://econ.hunter.cuny.edu/microprin/
Handouts/21Marginal%20Productivity%20Theory%20of%20Distribution.pdf> [Accessed 21 August 2011].
• Lec 8, Introduction to Producer Theory, MIT. 2012. Principles of Microeconomics [Video online] Available at:
<http://www.youtube.com/watch?v=A6FOBdtbcz4> [Accessed 21 August 2011].
• Lec 18, Factor Market,MIT. 2012. Principles of Microeconomics [Video online] Available at: <http://www.
youtube.com/watch?v=IuQjBqzmUKA>[Accessed 21 August 2011].
Recommended Reading
• Colander, D., 2009. Microeconomics, 8th ed., McGraw-Hill/Irwin.
• Besanko, D. and Braeutigam, R., 2007. Microeconomics, 3rd ed.,Wiley.
• Krugman, P. and Wells, R., 2010. Microeconomics, Worth Publishers.
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Self Assessment
1. _________states that, “if the price of one factor rises while other factor prices remain fixed, the firm will profit
from substituting more of the other inputs for the more expensive factor.”
a. Substitution Rule
b. Least-Cost Rule
c. Marginal revenue product
d. Income distribution theory
4. MRP schedule for an input, we can determine the relationship between the __________ of the input and the
quantity demanded of that input.
a. supply
b. price
c. quality
d. demand
5. Marginal revenue product represents the additional ______ that a firm earns from using an additional unit of
an input, with other inputs held constant.
a. revenue
b. demand
c. resource
d. output
6. The money collected through tax is spent or given away by the government through ______ that are not made
in return for current goods or services.
a. transfer payments
b. social service
c. insurance
d. subsidies
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7. Wealth is a stock while income is a flow per unit of _________.
a. rupee
b. dollar
c. time
d. capital
9. Which of the following is the money value of the additional output generated by an extra unit of input?
a. Marginal Cost Product
b. Marginal Revenue Product
c. Marginal Demand Product
d. Marginal Supply Product
10. The equilibrium price of the input in a competitive market comes at that level where the quantities supplied
and demanded are ______.
a. unrelated
b. different
c. equal
d. varying
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Chapter VI
The Markets for Labor, Capital and Land
Aim
The aim of this chapter is to:
Objectives
The objectives of the chapter are to:
• elucidate the application of marginal revenue product and the demand for factors
Learning outcome
At the end of this chapter, you will be able to:
72
6.1 The Labor Market
Our economy is primarily designed to provide people with good jobs with high wages so that they can sustain
themselves. The distribution of income between labor and property, and within different labor groups, has been a
continual source of social strife and political uproar. With the flow of the chapter, we will discuss how wages are
set in a market economy.
20
L
0
10
Labor inputs
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w
s
c
Wage rate
s
0 L
6.3.3 Immigration
Immigration has always played an important role in labor-force supply. The flow of legal immigrants is controlled by
an intricate quota system which favors skilled workers and their families, as well the close relatives of the country
citizens and permanent residents.
74
6.4 Wage Differentials
Wage differentials play an important role in the analysis of the general wage level for different countries and times. In
practice, wage rates differ enormously therefore it is hard to define average wage for an average person. In addition,
there is a wide range of wage rates among broad industry groups. But within major sectors there are large variations
that depend on worker skills and market conditions- for instance, fast-food workers make much less than doctors
though they all provide services.
To understand wage differentials, let’s consider first a perfectly competitive labor market, one in which there are
large numbers of workers and employers, none of which has the power to affect wage rates appreciably. If all jobs
and all people are identical in a perfectly competitive labor market, competition will cause the hourly wage rates
to be exactly equal.
The differences in wages across industries and the individuals also have other reasons to it, as listed below:
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Employment
Economists suggest that when an economy gets locked in to real wages that are too high, high levels of unemployment
may result. The unemployment will not respond to the traditional macroeconomic policy of increasing aggregate
spending, but will require remedies that lower real wages.
Discrimination by Exclusion
• The most pervasive form of discrimination is to exclude certain groups from employment or housing. Exclusion
lowers the incomes of the groups that are targets of discrimination.
Statistical Discrimination
• One of the most interesting variants of discrimination occurs because of the interplay between incomplete
information and perverse incentives. This is known as statistical discrimination, in which individuals are treated
on the basis of the average behavior of members of the group to which they belong rather than on their personal
characteristics.
• Statistical discrimination leads to economic inefficiencies because it reinforces stereotypes and reduces the
incentives of individual members of a group to develop skills and experience.
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Economic Discrimination against Women
• In countries around the world, women have a documented disadvantage in earned income relative to men. The ILO
reports that women earn 20-30% less than men worldwide. The causes for this difference are varied, but they
are linked to labor market segregation, in which women and men tend to predominate in distinct fields, and the
phenomenon of the glass ceiling, in which women are clustered in the lower rungs of the employment ladder.
• Wage based discrimination is a major factor as well. Wage based discrimination occurs when work of equal
and. comparable value is treated differently in terms of remuneration.
In capitalist economy like US, the capital, land and assets are largely privately owned. By contrast, in socialist
countries like China most of the land and capital is owned by government, and there are no superrich individuals
as such. Under capitalism, individuals and private firms do most of the saving, own most of the wealth, and get
most of the profits on these investments. The study of factor markets for land and capital, market for land, supply
and demand for capital is necessary.
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Business Economics
For example, a person buys grape juice for $10 and sells it a year later as wine for $11. If there is no other expense,
the rate of return on this investment is $1/$10, i.e., 10 percent per year.
Tangible Assets
• Tangible assets include equipment, machinery, plant, property anything that has long-term physical existence
or is acquired for use in the operations of the business and not for sale to customers.
• In the balance sheet of the business, such assets are listed under the heading ‘Plant and Equipment’ or ‘Plant,
Property and Equipment.’
• Tangible assets, unlike intangible assets, can be destroyed by fire, hurricane, or other disasters or accidents.
• However, they can be used as collateral to raise loans, and can be more readily sold to raise cash in
emergencies.
• Tangible assets are essential parts of an economy because they increase the productivity of other factors, whereas
financial assets are crucial because of a mismatch between savers and investors. A vast financial system of
banks, insurance companies etc serve to the channel the funds from those who are saving to those who are
investing.
78
• Now suppose the inflation rate is 3% for that year. We can buy a basket of goods today and it will cost $100,
or we can buy that basket next year and it will cost $103. If we buy the bond with a 6% nominal interest rate
for $100, sell it after a year and get $106, buy a basket of goods for $103, we will have $3 left over. So after
factoring in inflation, our $100 bond will earn us $3 in income; a real interest rate of 3%.
• The relationship between the nominal interest rate, inflation, and the real interest rate is described by the Fisher
Equation:
Real Interest Rate = Nominal Interest Rate - Inflation
If inflation is positive, which generally is, the real interest rate is lower than the nominal interest rate. If we have
deflation and the inflation rate is negative, then the real interest rate will be larger.
Calculating Perpetuity
The present value (V), at the interest rate I % per year, where the present value is the amount of money invested today
that would yield exactly $N each year, can be calculated as, V=$N/i
Where, V= present value of the land ($)
$N= perpetual annual receipts ($ per year)
I= interest rate in decimal terms (e.g. 0.005 or 5/100 per year)
• This says that if the interest rate is always 5% per year, an asset yielding a constant stream of income will sell
for exactly 20 (= 1÷ 5/100) times its annual income. Which means, at a 5% interest rate, its present value would
be $2000 (=$100÷0.005)
Acting to maximise present value: present value must be calculated from each possible decision and action must be
taken to maximise the present value
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Business Economics
6.14 Profits
Accountants define profits as, the difference between total revenues and total costs. Economists have, over the
years, developed several theories regarding profits. For example, Joseph Schumpeter attributed profits to innovation.
But Frank Knight associated them with uncertainty.
Schumpeter is of the opinion that one who innovates is able to earn more profits, and thus gets more incentive to innovate
further. He/She will soon attract followers or imitators. These people very soon catch up with original innovator. As
a consequence, he/she makes more efforts to stay ahead. Thus, innovation leads to profits; and profits make it
possible to innovate (acting as incentive).
Whereas wage, rent interests are all payments, which have been agreed to and settled in advance, profits cannot be
put on a similar footing. Uncertainty leads to fluctuation in both costs and revenue. They may not balance. Thus,
ultimately profits are the ‘surplus’ that remains after meeting the entire contractual payment obligation.
80
Diminishing returns and the demand for capital
More generally, as capital accumulates, diminishing returns set in and the rate of return on the investments tends
to fall. The rate of return on capital has not fallen markedly over the course of the last two centuries, even though the
capital stocks have grown many folds.
Rates of return have remained high because innovation and technological change have created profitable new
opportunities as rapidly as past investment has annihilated them.
To understand interest rates and the return on capital, consider an idealised case of a closed economy with perfect
competition and without risk or inflation. In deciding whether to invest, a profit maximising firm will always compare
its cost of borrowing funds with the rate of return on capital. If the rate of return is higher than the market interest
rate at which the firm can borrow funds, it will undertake the investment. If the interest rate is higher than the rate
of return on investment, the firm will not invest. In a competitive economy without risk or inflation, the competitive
rate of return on capital would be equal to the market interest rate.
Technological disturbances
• Historical studies show that inventions and discoveries raise the return on capital and there by affect equilibrium
interest rates. Indeed, the tendency toward falling interest rates via diminishing returns has been just about
canceled out by inventions and technological progress.
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Business Economics
Summary
• The distribution of income between labor and property, and within different labor groups, has been a continual
source of social strife and political uproar.
• Labor supply refers to the number of hours that the population desires to work in gainful activities. The three
key elements for labor supply are: hours worked, labor-force participation and immigration.
• Regression Analysis is the traditional approach and uses statistical procedures to separate wage differences in to
differences in human capital.
• In audits, people are actually observed in the act of discrimination.
• Discrimination is a complex social and economic process. It is rooted in social customs and even after equality
under law was established, social and economic stratification prevails.
• The price of using a piece of land for a period of time is called as its Rent.
• In capitalist economy, the supply curve for land is completely inelastic that is vertical, because the supply of land
is fixed.
• Capital (or capital goods) consists of those durable, produced goods that are in turn used as productive inputs
for further production.
• Financial assets include cash and bank accounts plus securities and investment accounts that can be readily
converted into cash.
• Tangible assets include equipment, machinery, plant, property anything that has long-term physical existence
or is acquired for use in the operations of the business and not for sale to customers.
• Investment in capital goods involves indirect or roundabout production. That investment in capital goods
involves forgoing present consumption to increase future consumption. Capital is productive because by forgoing
consumption today, there is more consumption for future.
References
• Samuelson, P. and Nordhaus, W., 2001. Economics, New Delhi: Tata McGraw-Hill Publishing Co. Ltd.
• Tewari, D. D. and Katar, S., 2003.Principles of Microeconomics.New Age International Publishers.
• Labor Market Discrimination against Women – at Home and Abroad. A UNIFEM Briefing Paper. [Pdf] Available
at: <http://www.unifemeseasia.org/projects/migrant/HR%20Protections%20Applicable%20to%20WMW/Part%20
3%20Labour%20market%20discrimination.pdf> [Accessed 30 October 2010].
• Lectures in Labour Market Policy Studies: Labour Economics, [Pdf] Available at :<http://www.lmps.gofor.de/
Labour%20economics.pdf> [Accessed 30 October 2010].
• Mindbitesdotcom., 2011. Economics:The Labor Market. [Video online] Available at:<http://www.youtube.com/
watch?v=ZXt99pqTNZ0> [Accessed 30 October 2010].
• Mindbitesdotcom., 2011. Economics:Minimum Wages in Labor Markets. [Video online ] Available at:<http://
www.youtube.com/watch?v=nnq6mXYm_LQ>[Accessed 30 October 2010].
Recommended Reading
• Becker, G., 1971. The Economics of Discrimination (Economic Research Studies), 2 n d e d . , University
Of Chicago Press.
• Boeri, T., and Ours, J., 2008. The Economics of Imperfect Labor Markets [Paperback], Publisher: Princeton
University Press.
• Kaufman, B. and Hotchkiss J., 2005. The Economics of Labor Markets (with Economic Applications and InfoTrac
Printed Access Card) , 7th ed., South-Western College Pub.
82
Self Assessment
1. By the law of diminishing returns, each additional unit of labor input will add a .
a. smaller slab of output
b. smaller slab of returns
c. larger slab of output
d. larger slab of returns
3. ________________ refers to the number of hours that the population desires to work in gainful activities.
a. Demand supply
b. Labor supply
c. Demand activities
d. Labor activities
5. Which of the following is not the reason for differences in wages across industries and the individuals?
a. Differences in work place- work environment
b. Differences in jobs-Compensating wage differentials
c. Differences in people-Labor quality
d. Differences in People-The “Rents” of Unique Individuals
7. The theory of non competing groups helps to understand labor market and_________.
a. wages
b. skills
c. competition
d. discrimination
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Business Economics
84
Chapter VII
International Trade
Aim
The aim of this chapter is to:
Objectives
The objectives of the chapter are to:
Learning outcome
At the end of this chapter, you will be able to:
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Business Economics
7.1 Introduction
Increased trade has meant greater choice of what to buy and often at lower prices. The relatively free trade that
exists today provides us with expanded choices. Our gains are being experienced worldwide because the winds
of international trade have blown generally freer in the past decades. Nations all over the world have dramatically
lowered the barriers they impose on the products of other countries.
Trade
Trade, also called commerce or transaction, is the voluntary, often asymmetric, exchange of goods, services, or
money. A mechanism that allows trade is called a market. The original form of trade was barter, the direct exchange
of goods and services.
Domestic trading
Trading that is aimed at a single market, the firm’s domestic trade, is referred to as domestic trading. In domestic
trading, the firm faces only one set of competitive, economic, and market issue, and essentially must deal with only
one set of customers, although the company may have several segments in one market.
International trade
International trade is the exchange of goods and services between countries. This type of trade gives rise to a world
economy, in which, prices, supply and demand affect and are affected by global events.
Trade facilitates the flow of capital and speed up the acquisition of new technology. Exports not only contribute
directly to economic growth but also permit more imports, and a rapid modernisation of production.
Following are the major differences between domestic and international trade:
Movement of goods Easier to move goods without much Restricted due to complicated custom
restriction. May need to pay sales tax procedures and trade barriers like
and so on tariff, quotas or embargo
Usage of different currencies Same type of currency used Different currencies for different
countries
Broader markets Limited market due to limits in
population, and so on Broader markets
Language and cultural barriers Speak same language and practice Communication challenges due to
same culture language and cultural barriers
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7.2 Factors Determining Gains from Trade
The extent of gain from trade is determined by many factors, as discussed under the following heads
Thus, gains are directly related to productivity and efficiency conditions prevailing in a country. Higher the
productivity and efficiency greater will be the gains from trade.
The relative strength and elasticity of demand of both the countries will determine the gains from trade. High efficiency
in production will result in greater gains. Further, income and nature of the commodity, which will influence the
demand, will also influence the gain.
As more than one country is involved in trade, we have to consider the relative capability and demand of both the
countries. It can be said that the gains to a small country will be relatively larger, because, a small country faces
many obstacles and limitations in large scale production.
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Business Economics
• The principle of comparative advantage holds that each country will benefit if it specialises in the production
and export of those goods that it can produce at relatively lower cost. Conversely, each country will benefit if
it imports those goods, which it produces at relatively high cost.
Consider the following example: Assume that it takes 3 hours of labor to make one yard of cloth and 5 hours of
labor to 10 kilogram of wheat. The wheat and cloth markets are perfectly competitive and labor is free to move
from wheat production to cloth production and vice versa. This implies that the wage rate (W) will be same in the
cloth and wheat industries. Then the average costs (cost per unit, one unit of cloth is one yard and one unit of wheat
is 10 Kg) in cloth and wheat production will be respectively 3W and 5W. These will also be the prices of cloth and
wheat respectively, because under perfect competition price is equal to average cost. Thus the relative price of cloth
in term of wheat is 3W/5W or 3/5 which simply means that 3/5th of a unit of wheat will buy one unit of cloth, or 6
kg wheat will be exchanged for one yard of cloth. In the terminology of classical economics, this exchange ratio is
known as the value which is determined only by labor and nothing else.
In the above example, we would, of course, assume that the labor requirements per unit of wheat or cloth (5, 3)
remain the same, no matter how many units of both goods the economy produces. This assumption is known as the
Constant Returns to Scale (CRS). CRS means that the labor productivities are independent of the scale of output.
What are the labor productivities in cloth and wheat production?
These are 1/3 and 1/5 respectively, one hour of labor will produce 1/3 yard of cloth and 1/5 x 10 = 2 Kg of wheat.
Labor productivity is just the reciprocal of the unit labor requirement. With 300 hours of labor available and fully
employed at one time in an economy, the production possibility frontier is shown as AB.
Note that if all labor is devoted to the production to cloth, then 100 units of cloth will be produced and that if all
labor go into wheat production, then 60 units of wheat will be produced. Thus the slope of the production possibility
frontier is 60/1 00 = 3/5, which is the exchange ratio.
In Autarky Equilibrium, the economy’s consumers will choose a point like P on the production frontier in such a way
that their welfare is maximised. Thus in equilibrium, OW and OC are the quantities of wheat and cloth respectively,
both demanded and supplied. The point P, in other words, represents a general equilibrium in the economy where
demand and supply in each of the two markets are equal.
88
Wheat
A
60
P
W
B
0 C 100 Cloth
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Business Economics
America’s CA Europe’s’
Comparative
Advantage (CA)
The above Fig. 7.2 shows that America’s CA is to produce and export aircrafts, while Europe’s advantage is in
production and export of apparel. But the dividing line depends on the demand and supplies of different goods.
Many Countries
Introducing many countries does not change the above analysis. As far as a single country is concerned, all the other
nations can be lumped together as one group as “the rest of the world.” The advantages of trade have no special
relationship to national boundaries. The principles developed apply between groups of countries and also to regions
within a country.
Oil
Developing Japan
Countries
Computers Consumer
Electronics
America
Multilateral trading system is one in which a large number of nations interact with each other. By and large, a
multilateral trading system is like a large free market with physical boundaries removed as far as the transactions
and movement of goods are concerned.
Goods flow freely between nations. Goods produced in a country compete freely for the consumer’s dollars with
the goods produced in any other country.
90
7.7 Protectionism
In spite of the strong theoretical case that can be made for free international trade; every country has established
some barriers to trade. A protectionist policy is one in which a country restricts the import of some goods and
services produced in foreign countries. Trade restrictions are typically undertaken in an effort to protect companies
and workers in the home economy from competition by foreign firms.
No trade equilibrium
• An equilibrium position with domestic demand equal to domestic supply for an autarkic state. For example,
consider the clothing market in America. To easily analyse supply and demand, assume that America is a small
part of the market and therefore cannot affect the world price of clothing. The supposed price of clothing is
determined in the world market and is equal to $4 per unit. Although transactions in international trade are
carried out in different currencies, for now we can simplify by converting the foreign supply schedule into a
dollar supply curve by using the current exchange rate.
• Presume that transportation costs or tariffs for clothing were prohibitive.
Free trade
Free trade among nations assures that the resources available are put to their best possible use.The model of free
trade is based on the assumption that all the nations have a global view of the use of resources.
Most trade barriers work on the same principle; the imposition of some sort of cost on trade that raises the price of
those products.
7.7.2 Tariffs
Tariffs are usually associated with protectionism, the economic policy of restraining trade between nations. For
political reasons; tariffs are usually imposed on imported goods, although they may also be imposed on exported
goods. A Prohibitive tariff is so high that nearly no one imports any of those items. A Non- prohibitive tariff is a
lower tariff that would injure but not kill off trade. It tends to raise price, lower the amounts consumed and imported,
and raise domestic production.
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Business Economics
7.7.3 Quotas
A quota is a direct restriction on the total quantity of a good or service that may be imported during a specified
period.
Quotas restrict total supply, and therefore increase the domestic price of the good or service on which they are imposed.
Quotas generally specify that an exporting country’s share of a domestic market may not exceed a certain limit.
Transportation Costs
The cost of moving bulky and perishable goods has the same effect as tariffs, reducing the extent of beneficial
regional specialisation.
As shown here, the supply curve shifts to S2, the equilibrium price rises to P2, and the equilibrium quantity falls
to Q2
S2 S1
Price of good or service
P2
P1
D1
Q2 Q1
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Economic Costs of Tariff
There are three effects:
• The domestic producers can expand production
• Consumers are faced with higher prices and therefore reduce consumption
• Government gains tariff revenue
Non-economic Goals
National security is one of the major non-economic goals in trade policy. A nation should not sacrifice its liberty,
culture, and human rights for some extra income.
Retaliatory tariffs
It usually leads other nation to raise their tariffs higher and is rarely an efficient bargaining chip for multi lateral
tariff reduction.
Import relief
It is any of several measures, imposed by a government, to temporally restrict imports of a product or commodity
to protect domestic producers from competition. Or, any of several measures such as subsidies, educational and
training assistance to workers, low interest loans, tax relief and so on to strengthen domestic producers.
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Business Economics
Consider a situation in which firms in a country are attempting to enter a new industry in which many large firms
already exist in the international arena. The foreign firms have taken advantage of economies of scale and have,
therefore, achieved relatively low levels of production costs. New firms, facing low levels of output and higher
average costs, may find difficult to compete. The infant industry argument suggests that by offering protection during
an industry’s formative years, a tariff or quota may allow the new industry to develop and prosper.
Economic theory provides an insight into why dumping occurs in the first place. It can be shown that when markets
are imperfectly competitive, firms have an incentive to carry out price discrimination whenever they face segmented
markets for their products.
94
7.11.2 World Trade Organisation (WTO)
WTO started functioning from January 1, 1995 and has substantially increased powers to enforce International Trade
Agreements. The WTO is different from and an improvement over the GATT in the following respects:
• The WTO is more global in its membership.
• The WTO has introduced commercial activities into the multilateral trading system.
• GATT provisions in case of disputes were time-consuming; GATT could levy penalties only through
unanimous decision, which were virtually impossible.
Under WTO, unanimous decisions are no longer desired; all disputes are to be settled within 18 months.
WTO has one-country one-vote principle, unlike in the World Bank and IMF where the economic strength
of rich countries translates into a voting majority. 60
Tariff of
Abominations Morrill and Civil Smooath-Hawley
Ratio of duties collected to dutiable imports %
1820 1840 1860 1880 1900 1920 1940 1960 1980 2000
Year
As shown in Fig. 7.5, tariff rates on “dutiable imports” have fallen dramatically over the course of U.S. history.
• The World Trade Organisation (WTO) was established to “help trade flow smoothly, freely, fairly and predictably”
among member nations.
• In 2008, it had 153 member countries. Since World War II, the General Agreement on Tariffs and Trade
(GATT)- WTO’s predecessor - and WTO have generated a series of agreements that slashed trade restraints
among members.
• These agreements have helped propel international trade, which in 2006 was more than 35 times its level in
1950, but the negotiations leading to these agreements have always been protracted and tumultuous and issues
of nationalism and patriotism are often not far from the surface.
• The imposition of trade barriers such as tariffs, antidumping proceedings, quotas, or voluntary export restrictions
raises the equilibrium price and reduces the equilibrium quantity of the restricted good. Although there are many
arguments in favor of such restrictions on free trade, economists generally are against protectionist measures
and support free trade.
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Business Economics
Summary
• Trade, also called commerce or transaction, is the voluntary, often asymmetric, exchange of goods, services,
or money.
• Trading that is aimed at a single market, the firm’s domestic trade, is referred to as domestic trading.
• International trade is the exchange of goods and services between countries. This type of trade gives rise to a
world economy, in which, prices, supply and demand affect and are affected by global events.
• The extent of gain from trade is determined by the relative differences in cost ratios.
• Trade, whether within a country or between countries, is an act of exchange. Countries normally do not produce
each and everything and thus exchange one thing for another.
• Triangular trade usually evolves when a region has export commodities that are not required in the region from
which its major imports come.
• A protectionist policy is one in which a country restricts the import of some goods and services produced in
foreign countries.
• Trade barriers are a general term that describes any government policy or regulation that restricts international
trade.
• Tariffs are usually associated with protectionism, the economic policy of restraining trade between nations.
For political reasons; tariffs are usually imposed on imported goods, although they may also be imposed on
exported goods.
• An important distinction between quotas and tariffs is that quotas do not increase costs to foreign producers;
tariffs do.
• The General Agreement on Trade and Tariffs (GATT) was concluded in Havana in 1947, after a series of
negotiations between the participating countries.
References
• Samuelson, P. and Nordhaus, W., 2001. Economics, New Delhi, Tata McGraw-Hill Publishing Co. Ltd.
• Atkinson, A. B., 1996.Economics in a Changing World:Microeconomics Vol 2 (International Economic
association).
• John, P., 2002. Microeconomics [Online] Available at :<http://www.peoi.org/Courses/Coursesen/mic/fram15.
html> [Accessed 20 October 2010].
• Heakal, Reema, What is International Trade? [Online] Available at: <http://www.investopedia.com/
articles/03/112503. asp> [Accessed 20 October 2010].
• Mindbitesdotcom., 2011. Economics:Analysing the Labor Market.[Video online] Available at: <http://www.
youtube.com/watch?v=5ReW_bzaqHk>[Accessed 20 October 2010].
• KnowledgeOneInc., 2011. Introduction to Microeconomics. [Video online] Available at: <http://www.youtube.
com/watch?v=2Jou2u3CVDU>>[Accessed 20 October 2010].
Recommended Reading
• Ralph, H. F. and lvlichael, W. and John, A. S., 2008. lnternaiional Trade and Economic Relations in a Nutshell,
4th ed.
• Jagdish, B., Arvind, P. and Srinivasan, T. N., 1998. Lectures on International Trade, 2nd ed., The lV ITPress.
• Robert, C. F., 2003. Advanced International Trade. Theory and Evidence. Princeton University Press.
96
Self Assessment
1. Which of the trade is the exchange of goods and services between countries?
a. Barrier trade
b. No-trade
c. International trade
d. Multilateral trade
2. The relative ______________________ of demand of both countries will determine gains from trade.
a. strength and elasticity
b. production and efficiency
c. strength and efficiency
d. production and elasticity
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7. A quota is a direct restriction on the total quantity of a good or service that may be _______ during a specified
period.
a. imported
b. exported
c. restricted
d. traded
9. The imposition of trade barriers such as tariffs the equilibrium price and reduces the equilibrium quantity
of the restricted good.
a. maintains
b. restricts
c. raise
d. reduces
10. _______ are usually associated with protectionism, the economic policy of restraining trade between nations.
a. Tarrifs
b. Quotas
c. Goods
d. Trade
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Chapter VIII
Government, Taxation and Expenditure
Aim
The aim of this chapter is to:
Objectives
The objectives of the chapter are to:
Learning outcome
At the end of this chapter, you will be able to:
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When both, private individuals and government, hold significant proportion of production units, the economy is
termed as a mixed economy. In reality, the major proportion of production activity in a mixed economy is carried out
by the private sector and a smaller but significant proportion by the government. As such, it is sometimes referred
to as a mixed capitalist economy. Most of the developing countries of Asia, including India, and other regions of
the world are a mixed economy.
Regulatory role
The basic objective of regulating business is to:
• Prevent the market structure from becoming monopolistic
• Flourish small and new entrepreneurs,
• Promote welfare of weaker sections of the society.
Regulatory role involves regulating the business and economic activities of the country by the government. It
includes controls through which general norms and standards are laid down by the government. This could be
done by putting limitations on public utility profits, ceiling on dividends and imposition of excess profit tax.
Through regulation, undue concentration of economic power in fewer hands and concentration of business in
fewer regions is also controlled. It also aims at settling the conflicts between management and the labor.
Entrepreneurial role
Entrepreneurial role means that the government itself becomes entrepreneur by taking the ownership in its hand. This
is called as the emergence of public sector.
Heavy and basic industries involve high risk and since they do not yield attractive return, they are ignored by the
private enterprises. Then there are certain industries where considerable time duration is involved between their
establishment and beginning of production and sales. Therefore, in the beginning, there might be chances of losses. But
from the national point of view, at the macro level, they are of vital importance. The government comes forward
and takes entrepreneurial lead in this direction. Steel, minerals, chemicals, engineering, irrigation, power and heavy
electrical plants are the examples of industries where public sector is assigned the entrepreneurial role.
Promotional role
Following are the various functions of the government in promoting the business operations:
• To maintain public utilities
• To encourage the developmental attitude among various sectors
• To make economic resources productive and progressive
• To ensure the effective utilisation of various resources
• To equally distribute wealth and income
• To bring about equitable balance between various regions
• To control the quantity of money available in terms of developmental needs
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• To push up investment climate in the country
• To provide incentives for the promotion of foreign trade
• The promotional role of the government thus encompasses fiscal, monetary and budgetary incentives for the
fast expansion and development of priority sectors of the economy.
Planning role
Planning role implies that the government has to plan in a way that limited resources are directed to right objects, with
a view to achieve the defined objectives in the interest of all concerned.
Fig. 8.1 illustrates the relationship between size of government and economic growth, assuming that governments
undertake activities based on their rate of return. As the size of government, measured on the horizontal axis, expands
from zero (complete anarchy), initially the growth rate of the economy—measured on the vertical axis—increases.
The A to B range of the curve illustrates this situation. As government continues to grow as a share of the economy,
expenditures are channeled into less productive (and later counterproductive) activities, causing the rate of economic
growth to diminish and eventually decline. The range of the curve beyond B illustrates this point.
9
Growth Rate
6
B
3 A
0
Size of Government (percent of GDP)
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If government undertakes activities in the order of their productivity, at first government expenditures would promote
economic growth (moves from A to B above), but additional expenditures would eventually retard growth (moves
along the curve to the right of B).
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8.7 Government Expenditure
The economy of a country is greatly influenced by the level of government or public expenditure. It helps in
overcoming the inefficiencies of the market system in the allocation of economic resources. It also helps in
smoothing out cyclical fluctuations in the economy and ensures a high level of employment and price stability. Thus,
government expenditure plays a crucial role in the economic growth of a country.
Government
expenditure
(GE)
Functional/Budget GE
Functional classification establishes adequate links between budget and account heads and the plan heads of
development. It facilitates obtaining information of progressive expenditure on plans, programs and projects. The
principle adopted in the new accounting classification is that, all expenditures on a function, program or activity
should be recorded under the appropriate major, minor or subhead. Functional classification has facilitated the
monitoring and analysis of expenditure on functions, programs and activities to aid the management function.
Economic GE
Economic classification refers to the resources allocated by government to various economic activities. It involves
arranging the public expenditures and receipts by significant economic categories, distinguishing current expenditure
from capital outlays, spending for goods and services from transfers to individuals and institutions, tax receipts by
kind from other receipts and from borrowing and inter-governmental loans, grants, etc. This classification brings out
such important aggregates as public expenditure of the consumption kind, public investment and the draft of public
authorities on public savings for financing the development outlays in the public sector.
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Business Economics
Cross or economic-cum-functional GE
Under a scheme of cross classification, functional classification of expenditure can be analysed according to its
economic character and economic classification of expenditure can be analysed according to the functions performed
by it.
The two types of classification therefore supplement each other and give a clear picture of the total transactions of
government.
Accounting GE
Accounting classification of government expenditure can be analysed under:
• Revenue and capital: Revenue expenditure is for the normal running of government departments and various
services, interest charges etc. On the other hand, capital expenditure or at least some portion of it, results in
creation of assets in the economy.
• Developmental and non- developmental: Developmental expenditure leads to economic growth, whereas Non-
Developmental expenditure does not. Developmental expenditure comprises the expenditure incurred on social
and community services and economic services. Non-developmental expenditure comprises the expenditure
incurred on general services.
• Plan and non-plan: The classification of government expenditure into “Plan” and “Non-Plan” is purely an
administrative classification and is not related to economic or national accounting principles. Plan expenditure
refers to the expenditure incurred by the Central Government on programs/projects, which are recommended by
the Planning Commission. Non-Plan expenditure, on the contrary, is a generic term used to cover all expenditure
of government not included in the plan. This classification is found useful by the Planning Commission and
Finance Commission for determining the central assistance to states for planning schemes from time to time.
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8.9 Taxes Levied by Central Government
Following are the taxes levied by central government:
• Direct Taxes
Tax on Corporate Income
Capital Gains Tax
Personal Income Tax
Tax Incentives
Double Taxation Avoidance Treaty
• Indirect Taxes
Excise Duty
Customs Duty
Service Tax
Securities Transaction Tax
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Tax Incentives
• Government of India provides tax incentives for:
Corporate profit
Accelerated depreciation allowance
Deductibility of certain expenses subject to certain conditions
• These tax incentives are subject to specified conditions and available for new investment in:
Infrastructure
Power distribution
Certain telecom services
Developing or operating industrial parks or special economic zones (SEZs)
Production or refining of mineral oil
Companies carrying on R&D
Developing housing projects
Undertakings in certain hill states
Handling of food grains
Food processing
Rural hospitals etc.
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Customs Duty
The levy and the rate of customs duty in India are governed by the Customs Act, 1962 and the Customs Tariff Act,
1975. Imported goods in India attract basic customs duty, additional customs duty and education. The rates of basic
customs duty are specified under the Tariff Act. The peak rate of basic customs duty has been reduced to 15% for
industrial goods. Additional customs duty is equivalent to the excise duty payable on similar goods manufactured
in India.
Education cess at 2% is leviable on the aggregate of customs duty on imported goods. Customs duty is calculated
on the transaction value of the goods. Rates of customs duty for goods imported from countries with whom India
has entered into free trade agreements such as Thailand, Sri Lanka, South Asian countries, etc. are provided on the
website of CBEC. Customs duties in India are administrated by Central Board of Excise and Customs under the
Ministry of Finance.
Service Tax
Service tax is levied at the rate of 10% (plus 2% education cess) on certain identified taxable services provided in
India by specified service providers. Service tax on taxable services rendered in India are exempt, if payment for
such services is received in convertible foreign exchange in India and the same is not repatriated outside India.
The CENVAT (the Central value added tax) Credit Rules allow a service provider to avail and utilise the credit of
additional duty of customs/excise duty for payment of service tax. Credit is also provided on payment of service
tax on input services for the discharge of output service tax liability.
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Let’s imagine, the government decided to impose an increased tax on cigarettes. In this case, the producers may increase
the sale price by the full amount of the tax. If consumers still purchased cigarettes at the increased in price, then it
would be said that the tax incidence fell entirely on the buyers.Thus, people demand government participation in
three areas of economic activity:
• First, people may want correction of market failure involving public goods, external costs and benefits, and
inefficient allocation created by imperfect competition. In each case of market failure, the shift from an
inefficient allocation to an efficient one has the potential to eliminate or reduce deadweight losses.
• Second, people may seek government intervention to expand consumption of merit goods and to reduce
consumption of demerit goods.
• Third, people often want government to participate in the transfer of income. Therefore, people and
government move ahead and progress with each others cooperation.
Regulation can be seen as a process, which continues over time and changes according to need of the hour and
perception of the policy makers. Secondly, regulation is often seen as a red tape as it may lead to poor governance
and corruption. Thus, in recent years there is a process of de-regulation operating world over. Both developed and
developing countries have modified their policy towards economic liberalisation, emphasising on free trade of goods
and services.
In Western Europe, particularly the European Union (EU) geographical boundary of a country has become
insignificant as there is a common currency and free movement of not only goods and services but also of labor across
member countries of EU. The process, popularly known as globalisation, has minimised the role of the government.
Market mechanism has come to the forefront over government regulation.
Relevance
The market mechanism has brought in competitiveness to the industry. Firms equipped with better technology and
better quality products come up everyday. Economic growth has accelerated and there is a general atmosphere
of optimism around. However, market mechanism and the process of change have not been able to take care of
problems such as poverty and inequality.
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8.13 Government Intervention on Public Interest
Following are the situations under which government intervention is necessary:
Imperfect Competition
• It is a market structure that does not meet the conditions of a perfect competition. Under perfect competition,
price is equal to marginal cost (P = MC) while in the presence of monopoly power, price is higher than marginal
cost (P > MC).
• Thus, perfect competition is considered as an ideal condition and any deviation from it is seen as a loss of social
welfare.
Externalities
• Externalities imply inadequate expression of costs or benefits in prices and economic decision-making. In all
the cases of externalities, both positive and negative, there is no incentive on the part of the economic agent to
restrict his/her equilibrium production/consumption to socially optimum level.
• In the presence of externalities, the economy produces less of what is desired and more of undesired.
• For goods with positive externalities social benefit is higher than private benefit. Thus, social optimum is at a
higher level than the equilibrium achieved on the basis of private benefit. On the other hand, for goods involving
negative externalities, private cost is lower than social cost. Thus equilibrium realised on the basis of private
cost is higher than social optimum.
Transaction Costs
• One of the basic assumptions, under perfect competition, is the availability of complete information on the part
of both the parties entering into a contract or transaction. Procurement of information, however, involves cost,
which is ignored in traditional economic theory.
• Transaction costs such as search, measurement, inventory, and decision-making costs are considered important.
However, traditional economic theory assumes away these costs in the garb of perfect information.
• Secondly, once a contract is undertaken, its enforcement and litigation (in the event of breach of contract) should
also be considered while deciding on costs of production. If these costs are not taken into account, socially
optimum output and consumption levels cannot be achieved.
Asymmetric Information
In certain cases, there is asymmetric information available to the contracting parties. For example, purchase of
life insurance policies. While purchasing life insurance policy the insured knows better about his/her health than the
insurance company.
Adverse Selection
• Asymmetric information may give rise to ‘adverse selection’.
• It refers to a market process in which bad results occur due to information asymmetries between buyers and
sellers.
Organisational Failures
• In economics, the problem of motivating one party to act on behalf of another is known as ‘the principal-agent
problem’.
• The principal-agent problem arises when a principal compensates an agency for performing certain acts that
are useful to the principal and costly to the agent, and where there are elements of the performance that are
costly to observe.
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Business Economics
Some examples of regulatory bodies for fixing prices of products, particularly of services in India are Telecom
Regulatory Authority of India, Central Electricity Regulatory Commission, etc.
The regulator usually fixes the price of the goods or services by constructing an index (I-X). The price index (I) could
be the average increase in prices of a comparable basket of goods and services. The X-efficiency could measure
productivity increase in the firms.
Advantages
• It protects the consumer from excessive price increase by producers
• It provides an incentive for firms to reduce costs of production
Revenue cap regulation is more appropriate than price cap regulation in situations where costs do not vary
appreciably with unit of sales. For example, for electricity supply the major cost is distribution lines. Increase in
supply of electricity to one more household in the colony does not increase cost remarkably.
Advantages
• Revenue cap regulation does not require monitoring of prices; to see whether the service provider is over-
charging or not.
• It is beneficial in cases where cost variation is low with unit of sales.
110
Disadvantages
The rate of return regulation is criticised on the ground that it encourages cost-padding and if the allowed rate of
return is too high it encourages adoption of an inefficiently high capital-labor ratio. This is called Averch- Johnson
effect.
8.14.4 Benchmarking
In benchmarking, a firm is compared to similar firms in other markets while fixing prices. On the basis of relative
cost efficiency, rewards or penalties are given to the firm. The firm is expected to perform at par with other firms in
similar conditions.
Here, the difficult task is identification of similar firms as the markets are different. Statistical techniques are used
while comparing the performance of firms so that the control for dissimilar variables can be taken into account.
The liberalisation measures in China appear to have yielded results and the Chinese economy is showing high growth
rate for several years now. The disintegration erstwhile USSR also points to the deficiencies in controlled economies.
The rationale behind traditional theory of regulation is that it serves public interest by correcting some form of market
failure, typically natural monopoly. The public interest theory, however, is based on the assumption that perfectly
informed decision makers are either managing the regulation or running the regulated firms. Such an assumption
may not be true in many cases.
Costs of Regulation
Economists have studied the impact of regulation to weigh its costs and benefits. The effects of regulation include
both, efficiency gains or losses and income redistribution.
Most studies suggest that the main effects of economic regulation are losses in efficiency and large amounts of income
redistribution. However, it is likely that the overall burden of regulation today is lower with the declining barriers to
trade, deregulation of industries, etc.
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8.17 Deregulation
The trend towards deregulation is spreading throughout the world after it has become quite apparent that
the economic conditions in market economies are generally better than economies heavily regulated by the
government.
India is one of the growing countries that have followed the lead of the U.S. in freeing industries and allowing them
to compete in domestic as well as in global markets. Since 1991, the Indian government has been pursuing economic
liberalisation, focusing particularly on short term problems such as low foreign exchange reserves, implementing
structural reforms to bolster competitiveness and rein in inflation, and aligning India with the global economy.
Success in a deregulated marketplace is likely to be achieved by Indian companies that can spot the signs of
deregulation early and are prepared to maximise this advantage. However, as deregulation sweeps through the
economy, it is wise to recall that the government still has an important role to play in monitoring the economy and
setting the rules of the road.
Substance and practice of competition law varies as per the jurisdiction. Protecting the interests of consumers
(consumer welfare) and ensuring that entrepreneurs have an opportunity to compete in the market economy are often
treated as important objectives. Competition law is closely connected with law on deregulation of access to markets,
state aids and subsidies, the privatisation of state owned assets and the establishment of independent sector regulators.
In recent decades, competition law has been viewed as a way to provide better public services.
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Clayton Antitrust Act
• The Clayton Antitrust Act of 1914 was enacted in United States to add further substance to the U.S. antitrust
law regime by seeking to prevent anti competitive practices in their incipiency. That regime started with the
Sherman Antitrust Act of 1890, the first Federal law outlawing practices considered harmful to consumers
(monopolies and cartels).
• The Clayton act specified particular prohibited conduct, the three-level enforcement scheme, the exemptions,
and the remedial measures. The act is still active today in a growing interconnected market and merging of the
industries.
The Monopolies and Restrictive Trade Practices Act 1969 (MRTP Act) has now been repealed and the MRTP
Commission has been dissolved. The central government also established the Competition Appellate Tribunal
(Appellate Tribunal) to hear appeals against orders passed by the CCI.
In order to create awareness and to educate stakeholders, the CCI has put in the public domain a series of advocacy
booklets and the findings of several market studies, which were undertaken to gain better understanding of the
market structures and anti-competitive practices prevailing therein.
TCL, an acquiring company (a buyer), survived after merger while TFL, an acquired company (a seller), ceased to
exist. TFL transferred its assets, liabilities and shares to TCL.
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A fundamental characteristic of merger (either through absorption or consolidation) is that the acquiring company
(existing or new) takes over the ownership of other and combines their operations with its own.
Vertical Merger
It is a combination of two or more firms involved in different stages of production or distribution of the same product.
For example, joining of a TV manufacturing (assembling) company and a TV marketing company. Vertical merger
may take the form of forward or backward merger. When a company combines with the supplier of material, it is
called backward merger and when it combines with the customer, it is known as forward merger.
Conglomerate Merger
It is a combination of firms engaged in unrelated lines of business activity. For example, the merging of differen
businesses, like manufacturing of cement products, fertilizer products, etc.
Under the Monopolies and Restrictive Practices Act, takeover meant acquisition of not less than 25 percent of the
voting power in a company. While in the Companies Act (Section 372), a company’s investment in the shares of
another company in excess of 10 percent of the subscribed capital can result in takeovers. An acquisition or takeover
does not necessarily entail full legal control. A company can also have effective control over another company by
holding a minority ownership.
114
• Synergy implies a situation where the combined firm is more valuable than the individual firms. It refers to
benefits other than those related to economies of scale. Operating economies are one form of synergy benefits,
but apart from it, synergy may also arise from enhanced managerial capabilities, creativity, innovativeness,
R&D and market coverage capacity due to the complementarities of resources and skills and a widened horizon
of opportunities.
• Diversifying the risks of the company, particularly when it acquires those businesses whose income streams
are not correlated. It results in reduction of total risks through substantial reduction of cyclicality of operations.
The combination of management and other systems strengthen the capacity of the combined firm to withstand
the severity of the unforeseen economic factors which could otherwise endanger the survival of the individual
company.
• A merger may result in financial synergy and benefits for the firm in many ways like:
By eliminating financial constraints
By enhancing debt capacity. This is because a merger of two companies can bring stability of cash flows
which in turn reduces the risk of insolvency and enhances the capacity of the new entity to service a larger
amount of debt
By lowering the financial costs. Due to financial stability, the merged firm is able to borrow at a lower rate
of interest.
• Limiting the severity of competition by increasing the company’s market power. A merger can increase the
market share of the merged firm. This improves the profitability of the firm due to economies of scale. The
bargaining power of the firm vis-à-vis labor, suppliers and buyers is also enhanced. The merged firm can exploit
technological breakthroughs against obsolescence and price wars.
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Summary
• To understand the role of government, it will be useful to distinguish four broad types of government involvement
in the economy.
• Regulatory role involves regulating the business and economic activities of the country by the government. It
includes controls through which general norms and standards are laid down by the government.
• Entrepreneurial role means that the government itself becomes entrepreneur by taking the ownership in its hand.
This is called as the emergence of public sector.
• The promotional role of the government thus encompasses fiscal, monetary and budgetary incentives for the
fast expansion and development of priority sectors of the economy.
• Planning role implies that the government has to plan in a way that limited resources are directed to right objects,
with a view to achieve the defined objectives in the interest of all concerned.
• Tax incidence reveals which group, the consumers or producers, will pay the price of a new tax.
• Regulation has both positive and negative effects. The studies on the effect of regulation have mostly been on
a case-to-case basis.
• There are three major types of mergers such as vertical, horizontal and conglomerate.
• An acquisition may be defined as, ‘an act of acquiring effective control by one company over assets or management
of another company without any combination of companies’.
References
• Hugh, S. E.and Gravelle, R. R., 2004. Microeconomics. Publisher, Pearson Education.
• David, M. K., 1990. A Course in microeconomic Theory. Financial Times/Prentice Hall.
• Role of Government in Business, IGNOU, [Pdf] Available at: <http://egyankosh.ac.in/bitstream/123456789/8955/1/
Unit-5 (complete).pdf> [Accessed on 23 October 2010].
• Nicholas, E., 2011. Notes for Microeconomics, [Pdf] Available at: <http://www.stern.nyu.edu/networks/micnotes/
micnotes.pdf>[Accessed on 23 October 2010].
• MIT, Lecture 9, 2012. Principles of Microeconomics [Video online] Available at: <http://www.youtube.com/
watch?v=Q4iKuKAjzK0> [Accessed 25 October 2010].
• MIT, Lecture 24. Priciples of Microeconomics, [Video online] Available at: <http://www.youtube.com/
watch?v=ni0aX0tUAd0> [Accessed 25 October 2010].
Recommended Reading
• Steiner, J. and Steiner, G. Business, Government and Society: A Managerial Perspective, 12th ed., McGraw-
Hill.
• Irwin, N. and Mankiw, G., 2008, Essentials of Economics, 5th ed., South-Western College.
• Salanie, B., 2003, The Economics of Taxation, The MIT Press.
116
Self Assessment
1. What are the tools of government policy?
a. Taxes, income, progress
b. Taxes, expenditure, progress
c. Taxes, expenditure, regulation
d. Expenditure, taxes, entrepreneurship
3. Entrepreneurial role means that the government itself becomes entrepreneur by taking the ownership in its hand,
which is also called as .
a. emergence of public sector
b. emergence of private sector
c. emergence of joint sector
d. emergence of co-operative sector
4. Which among the following is not amongst the functions of government to regulate the economy?
a. Reducing economic inequality
b. Stabilising the economy through microeconomic policies
c. Conducting international economic policy
d. Improving economic efficiency
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Business Economics
8. The decision whether the consumer or producer will pay the price of new tax is stated by .
a. tax benefit
b. tax evasion
c. tax incidence
d. pubic choice theory
10. involves regulating the business and economic activities of the country by the
government.
a. Entrepreneurial role
b. Promotional role
c. Planning role
d. Regulatory role
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Case Study I
Coke and Pepsi both are trying to gain market share in the beverage market, which is valued at over $30 billion a
year. The facts are that, each company is coming up with new products and ideas in order to increase their market
share. The creativity and effectiveness of each company’s marketing strategy will ultimately determine the winner
with respect to sales, profits, and customer loyalty. Not only these two companies are constructing new ways to sell
Coke and Pepsi, but they are also thinking of ways to increase market share in other beverage categories. Although
the goals of both companies are same, the two companies form different marketing strategies. Pepsi has always
taken the lead in developing new products, but Coke also learned their lesson and started to do the same. Coke
hired marketing executives with good track records. Coke also implemented cross training of managers so it would
be more difficult to form groupism. On the other hand, Pepsi has always taken risks, acted rapidly and developed
new marketing ideas.
Both the companies tried to capture the foreign markets. Coke had carried out market research in different regions,
and got to know that the customer requirements differ according to their regions. So, Coke has been more successful
in foreign markets than Pepsi.
However, after 2-3 years, many changes were made by both the companies; some of the development techniques
failed, while some gained profit. For instance, the transformation of Coke into New Coke was a major failure. Pepsi’s
failure included Pepsi Light, Pepsi Free, Pepsi AM, and Crystal Pepsi.
To overcome failures, the company has to take next step to develop new products to meet customer requirements.
If both companies sell the same product, they will never succeed. Gaining market share is possible if the company
knows what the customer wants, and takes one step ahead than the competitor to achieve customer satisfaction. To
understand the customer requirement, market research is necessary. The companies should collect feedback from
customers, next analyse this data, and then develop the new product based on the data. Thus, once the product is
developed it should be in the marketplace at the right time. Therefore, if any company follows these factors, it can
achieve the market share.
(Source: Coke Vs. Pepsi Case Study, [Online] Available at: <www.exampleessays.com/viewpaper/84955.html>
[Accessed 4 June 2013]).
Questions
1. Which type of competition is seen in this case study? Give reasons.
Answer
In this case study, Perfect Competition is seen. The factors that are present in the perfect competition are as
follows:
• Coke and Pepsi are the two competitors which sell an identical product
• The industries are characterised by freedom of entry and exit
• The firms have relatively small market share
2. What are the different marketing strategies adopted by both the companies?
Answer
Coke hired marketing executives with good track records. Coke also implemented cross training of managers
so it would be more difficult to form groupism.
On the other hand, Pepsi has always taken risks, acted rapidly and developed new marketing ideas.
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120
Case Study II
Three Aspects of Organisational Architecture
First, assignment of decision rights involves giving the responsibility of decision-making to top-level executives.
It is imperative that an organisation is able to delegate the duty of making a decision to a manager who has
relevant information and knowledge on the internal and external factors that affects the operations and goals of the
organisation. The architecture of an organisation and its environment will determine who will be the decision-maker
for the company. In some organisations, the top-level executive may have them most relevant information and thus,
a centralised decision-making process can be adopted. There are instances when the lower-level employees may
have the most relevant information, thus, decision-making rights become decentralised.
Second, methods of rewarding individuals determine how the organisation will provide incentives to its employees.
Organisational goals and employee’s productivity play great roles in determining a scheme of remuneration. Some
organisations repay their employees through financial rewards such as the monthly wage, and cost of living allowance,
and other benefits. Also, some firms offer nonfinancial rewards such as improving the workplace and enhancing the
employees’ skills and knowledge through trainings and seminars.
Third, structure of systems to evaluate the performance of both individuals and business units. Every company has
its own way of evaluating the performance of each department and employees. Such evaluation system is dependent
on how an employee’s productivity contributed to the achievement of organisational goals.
Questions
1. What are the three vital components of organisational architecture?
2. What does assignment of decision rights involves?
3. What does methods
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Business Economics
Established in 1964, Nike is one of the world’s leading designer, marketer, and distributor of athletic footwear,
apparel, equipment, and accessories of sports and other fitness activities. Nike was formed by Philip H. Knight. In
January 2006, Fortune magazine listed Nike in the 100 best companies, and in 2005, it had achieved remarkable
sales and profitability in the US.
With the increase in athletics, the demand for Nike shoes was increasing, but Nike was not able to supply that much
quantity of products as it had never forecasted this massive demand. At the same time, Reebok entered the market
with similar range of products. Thus, the demand for Nike came to a standstill when Reebok entered the market.
Reebok introduced athletic shoes for women with surplus quantity and captured the market share. They launched
new styles and the looks of shoes attracted most of the customers. Thus, the demand for Nike decreased.
Nike had not forecasted demand, and had never analysed any competitor to enter the market with the same products.
Thus, Nike started market research and realised that Reebok only had style and appearance of shoes, but was lacking
in promotions. Thus, Nike started promoting its products and carried out different marketing strategies like, having
slogans Nike’s “Just Do It” Now, Nike had analysed demand and supply and entered the market with surplus quantity
and different marketing strategies. Thus, again Nike captured the market share and is still leading it.
Questions
1. What were the likely reasons that resulted in such a huge gap between demand and supply at Nike? What, in
your opinion, could have been done to avoid this situation?
2. What strategies were followed by Nike to capture the market share again?
3. What is the relationship between demand and supply?
4. Why was Reebok not able to sustain in the competition?
122
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• Bernanke, B., 2009. Principles of Microeconomics, Marginal Decision Rule, Tata McGraw Hill Publication.
124
• Bernanke, B., 2009. Principles of Microeconomics, Marginal Decision Rule, Tata McGraw Hill Publication.
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• Besanko, D. & Braeutigam, R., 2007. Microeconomics, 3rd ed. Wiley.
• Boeri, T. & Ours, J., 2008. The Economics of Imperfect Labor Markets [Paperback], Publisher: Princeton
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• Colander, D., 2009. Microeconomics, 8th ed., McGraw-Hill/Irwin.
• Dr. Mithani, D. M., 2008. International Economics, Institute of Business Study and Research, Himalaya
Publishing House Pvt. Ltd.
• Dr. Mithani, D. M., 2008. International Economics, Institute of Business Study and Research, Himalaya
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• Irwin, N. & Mankiw, G., 2008, Essentials of Economics, 5th ed., South-Western College.
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• Robert, C. F., 2003. Advanced International Trade. Theory and Evidence, Princeton University Press.
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125
Business Economics
Chapter II
1. a
2. c
3. d
4. c
5. a
6. b
7. c
8. a
9. d
10. b
Chapter III
1. a
2. c
3. b
4. a
5. a
6. a
7. a
8. b
9. b
10. a
Chapter IV
1. a
2. d
3. b
4. c
5. a
6. c
7. a
8. c
9. d
10. b
126
Chapter V
1. a
2. a
3. a
4. b
5. a
6. a
7. c
8. a
9. b
10. c
Chapter VI
1. a
2. c
3. b
4. d
5. a
6. b
7. d
8. c
9. b
10. a
Chapter VII
1. c
2. a
3. d
4. a
5. b
6. d
7. a
8. b
9. c
10. a
Chapter VIII
1. c
2. d
3. a
4. c
5. d
6. a
7. b
8. c
9. c
10. d
127