Expected Question SeriesBook – 1(Economics)

1. Explain the problem of What to Produce?What to Produce:

i) Due to scarcity of resources every society must decide on how much of each of the many possible goods and services it will produce.

ii) Whether to produce more of food, clothing, housing etc. or to have more of luxury goods. Whether to use mot resources in education and health or to use more resources in building military services.

iii) An economy has to decide what to produce on the basis of availability of technology, cost of production, demand and supply of the commodity.

iv) The guiding principle in solving this problem is to produce goods that would ensure maximum aggregative satisfaction.

v) In economics the problem of what to produce is studies under “PRICE THEORY”.

2. Explain the problem of How to Produce?How to Produce:

i) It is the question of choice of technique of production. A technique of production which would maximize output or minimize cost should be used.

ii) Generally 2 types of techniques of production are considered which are labor intensive and capital intensive. In labor intensive method more labor than capital is use whereas in capital intensive method more capital than labor is used.

iii) In India where labor is in abundance, labor intensive techniques should be used.iv) The guiding principle in solving this problem is to use that technique of production which

involves least lost of production.v) Every economy should choose the most efficient technique of producing an economy. In

economics the problem of choice of technique of production is studied under the theory of ‘Production’.

3. Explain the problem of For whom to Produce?For Whom to Produce:

i) It is the problem of distribution of goods and services in the economy i.e. to determine who is to get what share in the total output produced in the economy.

ii) In a socialist economy the distribution is done either equally or on the basis of needs whereas in a capitalist economy the distribution is done on the basis of income. A person who is getting a higher income gets a higher share because with his higher income he can buy more goods and services. A person getting a lower income gets a smaller share.

iii) E.g. a computer engineer gets a higher income as compared to an unskilled construction worker who gets a lower income and hence gets a smaller share.

iv) The guiding principle in solving this problem is to fulfill the urgent wants of each productive factor to maximum possible extent.

v) In economics the problem of distribution of income is studied under the theory of ‘Distribution’.

4. Reason for concave shape of PPC?PP curve is concave to the origin due to increase in Marginal Opportunity Cost, which means for producing an additional unit of a commodity more units of the other commodity needs to be sacrificed. It is based on the assumption that resources are not equally efficient in producing both the goods. As a result when the resources from the production of a more efficient product are withdrawn to produce an additional unit of less efficient production, marginal cost increases.

5. Consumer’s equilibrium in case of single good and two goodsConsumer’s Equilibrium: Single Commodity CaseA consumer consuming a single commodity achieves equilibrium when the MU in terms of money is equal to the price of the commodity.

Y

Tan

ks

X

3

6

9

12

15

1 2 3 4 5 6W heat

A BC

E

F

DG

0

H

P

P

1

1

P roduction P ossib ility C urve

G row th o f resources

Fu ll em ploym ento f resources

underutilisa tionof resources

MUxMUm

=Price

MU of a good is measures in utils but price is paid in rupees. Therefore they can’t be compared. MU of a good is therefore converted into rupees by dividing it with MU of a rupee (MUm)

MU of a rupee is defined as the extra utility when an additional rupee is spent on other available good in general.

MUM = 2 Units, Price = 1Units of Orange

Consumed

MU (utils) MU in terms of Money

Price of Orange

Gain Direction of Change

0 0 0 1 - Consumption1 10 10 / 2 = 5 1 4 Consumption2 8 8 / 2 = 4 1 3 Consumption3 5 5 / 2 = 2.5 1 1.5 Consumption4 2 2 / 2 = 1 1 0 Equilibrium5 1 1 / 2 = 0.5 1 -0.5 Consumption6 0 0 / 2 = 0 1 -1 Consumption

From the table, we find that when he buys 4th orange it gives him utility 2 / 2 = 1 which is equal to the price of the orange ( 1) paid by the consumer. He will not buy 5th or 3rd unit of orange because its MU of money is not equal to its price. Thus at the level of 4 th orange the consumer reaches the state of equilibrium.

If MUx(Money) > Px, Consumer keeps on consuming more units. When he consumes more units, the additional utility derived from consuming x keeps on falling. He keeps on consuming till MU x(Money) = Px.

If MUx(Money) < Px, Consumer will decrease the consumption of x. When he decreases the consumption of x, the additional utility derived from consuming x keeps on rising. He keeps on decreasing consumption till MUx(Money) = Px.

Consumer’s Equilibrium: Two Commodity Case

When a consumer wants to buy 2 commodities his equilibrium will be determined in accordance with the Law of Equi-Marginal utility. He will distribute his money income among these goods in such a way as he gets equal marginal utility in terms of money from all the goods. In case of 2 goods consumer equilibrium would be:

i) MUxPx

=MUyPy

ii) Expenditure on X + Expenditure on Y = Consumer’s Income

The 2 conditions can be explained with the help of an illustration. Suppose there are 2 commodities X and Y. Px = Rs 4 per unit and Py = Rs 2 per unit and consumer’s Income is Rs 30. MU x and MUy is given in the table

Units MUx MUy MUxPx

MUyPy

1 80 40 20 202 72 38 18 193 64 36 16 184 56 34 14 175 48 32 12 166 40 30 10 157 32 28 8 14

8 24 26 6 139 16 24 4 1210 8 22 2 11

i) If MUxPx

>MUyPy

, he will consume more of x. When he consumes more of x, MU derived from x will

fall. He will keep on consuming more if x, till MUxPx

=MUyPy

.

ii) If MUxPx

<MUyPy

, he will consume more of y. When he consumes more of y, MU derived from y will

fall. He will keep on consuming more if y, till MUxPx

=MUyPy

.

6. Consumer’s equilibrium in case of I.C. ApproachConditions of EquilibriumGiven income and prices, and given that consumer spends his entire income and consumes both the goods, and subject to the assumptions stated above, the consumer attains equilibrium when the two conditions are fulfilled:These are:(i) Marginal rate of substitution (MRS equals Market rate of exchange (MRE)(ii) MRS falls as more is consumed of one good in place of another.(iii) Budget Line should be tangent to Indifference CurveFirst condition

MRS = MRESince MRE equals ratio of prices of the two goods the condition can also be stated as:

MRS = Ratio of prices = PxPy

Thus the transactions can take place only when MRS is higher or at least equal to MRE. The consumer will continue to transact so long as MRS is higher than MRE. As he buys more of X, MRS goes on falling and at some stage becomes equal to MRE. When MRS becomes equal to MRE, he stops purchasing more. He has no incentive to buy more or less of X. The consumer comes at rest and is in equilibrium.This can be illustrated with the help of a diagram:The two slopes are equal where the budget line is tangent to the indifference curve, i.e. IC. The tangency condition is fulfilled at P. This is consumer’s equilibrium. The highest the consumer can reach is the utility level indicated by the indifference curve I2 The utility maximizing, i.e. optimum, combination of the two

goods i.e. Ox1 of X plus OY1 of Y.

Second condition: MRS continuously falls: This is according to the Law of Diminishing Marginal Utility. The condition ensures that if MRS is not equal to MRE, the falling MRS will lead to equality again, as explained in the first condition. Graphically, the condition means that the indifference curve is strictly convex, i.e. rounded throughout. There is no flat spot. This ensures a unique equilibrium.

7. Properties of I.C.(1) Indifference curves are negatively sloped: The indifference curves must slope down from left to right. This means that an indifference curve is negatively sloped. It slopes downward because as the consumer increases the consumption of X commodity, he has to give up certain units of Y commodity in order to maintain the same level of satisfaction.

 (2) Higher indifference curve represents higher level: A higher indifference curve that lies above and to the right of another indifference curve represents a higher level of satisfaction and combination on a lower indifference curve yields a lower satisfaction. In other words, we can say that the combination of goods

Good XO

E

A

B

Good Y

Y

F

I1

I2

I3y1

x1

G

X

which lies on a higher indifference curve will be preferred by a consumer to the combination which lies on a lower indifference curve.In this diagram there are three indifference curves, IC1, IC2 and IC3 which represents different levels of satisfaction. The Indifference curve IC3 shows greater amount of satisfaction and it contains more of both goods than IC2 and IC1 (IC3 > IC2 > IC1).

(3) Indifference curve are convex to the origin: This is an important property of indifference curves. They are convex to the origin (bowed inward). This is equivalent to saying that as the consumer substitute commodity X for commodity Y, the marginal rate of substitution diminishes of X for Y along an indifference curve.In this figure as the consumer moves from A to B to C to D, the willingness to substitute good X for good Y diminishes. This means that as the amount of good X is increased by equal amounts, that of good Y diminishes by smaller amounts. The marginal rate of substitution of X for Y is the quantity of Y good that the consumer is willing to gives up to gain a marginal unit of good X. The slope of IC is negative. It is convex to the origin.

8. Difference between Movement and Shift in DemandBasis Movement along Demand Curve /

Change in Qty. DemandedShift in Demand Curve / Change in

DemandMeaning Keeping non-price factor constant,

with the fall in price of the commodity, the demand of the commodity increases and with the rise in price of the commodity, the demand of the commodity decrease, it is known as Movement along DD curve.

Keeping price factor constant, with the rise in Income of the consumer the demand of the commodity increases and with fall in income of the consumer the demand of the commodity decreases, it is known as shift in DD curve.

Reason It is caused by fall & rise in price of the commodity.

It is caused by fall & rise in income of the consumer.

Movement / Shift in Demand

It results in downward & upward movement along the DD curve.

It results in rightward & leftward shift in the DD Curve.

Diagram

P

0

D

D

P1

P2

Price(R s.)

Q 1 Q 2Q X

Qty. Dem and (Units)

P

Y

O X

D em and (un its)

Price(R s)

Q 1Q 2 Q

D

D1

D1

D1

D1

D

D

Income

Rs. 600

Income

Rs. 400

Income

Rs. 200.

9. Reasons for Increase and Decrease in DemandReasons for rightward shift in DD curve:1. Increase in price of substitute goods.2. Fall in price of complementary goods.3. Increase in income of consumer goods (normal).4. Fall in income of the consumer goods (Inferior goods).5. Favorable change in taste & preference of the consumer.

Reasons for leftward shift in DD curve: 1. Decrease in price of substitute goods.2. Rise in price of complementary goods.3. Decrease in income of consumer goods (normal).4. Rise in income of consumer (inferior goods).5. Unfavorable change in taste & preference of the consumer.

10. Factors affecting elasticity of demandAvailability of Close Substitutes: Commodity having large no. of substitutes will have elastic demand as compare to the commodity having no close substitutes. For example: demand for soft drinks is elastic while that of salt is inelastic.2. Possibility of Postponement of Consumption: If the demand for the commodity can be postponed then it will have elastic demand. For e.g., TV, Fridge, etc. On the other hand, if the demand cannot be postponed. Then it will have inelastic demand.

3. Sharing Total Expenditure: If the past of the income spent on the consumption of the commodity. Then it will have inelastic demand. for e.g., Matchbox. On the other hand if the past of income spent on the commodity is more, then it will have elastic demand. e.g. T.V. etc.

4. Nature of the Commodity: Demand for the necessity products like food crops etc, will be inelastic as these have to be consumed at any cost. On the other hand demand for the luxury product like T.V. will be elastic.

5. Level of Prices: High priced commodity like diamond etc, have inelastic demand because change in their price levels will not affect their demand much. On the other hand medium price products like Radio will have elastic demand.

6. Various Uses of the Commodity: Commodities having various uses like milk have elastic demand because change in price affects their demand greatly whereas products having united uses like patrol will have inelastic demand.

11. Total expenditure method of measuring Ed.Total Expenditure/Outlay Method: According to this method, there can be following three broad possibilities: (i) If there is inverse relationship between price & total expenditure i.e., with the rise in price total expenditure falls & with the fall in price total expenditure rise, then eP > 1.(ii) If there is direct relationship between price & total expenditure i.e., with rise in price total expenditure rises and with the fall in prices total expenditure falls, then eP < 1.(iii) If with rise or fall price of the commodity, total expenditure remains same, then eP = 1

The above can be illustrated with the following schedule: Price Per Unit (Rs.)

Qty. Demanded (Units)

Total Expenditure (Rs.)

Comment

8 3 24ep > 17 4 28

6 5 30 ep = 15 6 304 7 28 ep < 13 8 24

12. Geometric method of Ed13. Geometric/Point Method: According to the point Method,

elasticity of demand at any point is measured by dividing the lower section of the demand curve with the upper section of demand curve at that point.

14. ep=Lower Segment of t h e demand curveUpper Segment of t h edemand curve

15. ep at Point D=DBDA

=1

16. (Since D is the mid Point of demand Curve AB)

17. ep at PointC=CBCA

>1

Pric

e (

Rs.

)

Tota l E xpenditure (R s.)

E p = 1

E p < 1 (D irect R ela tionsh ip)

E p > 1 (Inverse R e la tion)

P rice(R s.)

0 X

Q ty. Dem anded (un its )

Y

C D = A

C

D

E

B

C D = 0

C D = 1

C D < 1

C D > 1

P

Q

18. ep at Point E= EBEA

<1

19. ep at Point B=020. ep at Point A=∞

21. Difference between Substitute & Complementary GoodsBasis Substitute Goods Complementary Goods

Meaning Substitute goods are those goods which are used in place of one another to satisfy the given want. For e.g., Tea and Coffee.

These are those goods which are used together to satisfy the given wants For e.g., Car and petrol.

Type of Relationship

There is direct relation between price & demand of substitute good

There is an inverse relationship between price & demand of these goods.

Diagram

P

Y

O X

D em and (un its) coffee

P rice(R s)

C offee

Q 1Q 2 Q

D

D1

D1

D1

D1

D

D

Price of Tea = Rs. 60

Price of Tea = Rs . 40

Price of Tea = Rs. 20

22. Difference between Normal & Inferior GoodsBasis Normal Goods Inferior Goods

Meaning These are those goods which have a positive relationship i.e. with a rise in income of the consumer, demand for the goods also rises and vice versa.

These are those goods which have an inverse relationship i.e. with a rise in income of the consumer, demand for the goods falls and vice versa.

Type of Relationship

There is a direct relationship between income and demand of the good.

There is an inverse relationship between income and demand of the good.

Diagram

23. Relation between TU and MUMeaning of Total Utility: It refers to the sum of all the utilities derived from the consumption of a certain no. of units of the give commodity.

TUx=f (Qx) TU = ∑MU

Meaning of Marginal Utility: The addition made to the total utility when an additional unit of the commodity is consumed

MU=△ TU△Q

MUn = TUn – TUn–1

Pri

ce o

f Car

(R

s.)

P

O Q 2 Q Q 1X

Y

D em and of car (un its)

Pri

ce (

Rs.

)

P

O Q 2 Q Q 1X

Y

D em and (units)

Pri

ce (

Rs.

)

P

O Q 2 Q Q 1X

Y

D em and (units)

Relationship between TU and MU: Oranges TU (Utils)

MU=△ TU△Q

0 0 -1 16 162 28 123 36 84 40 45 40 06 36 -4

i) TU increases at a increasing rate, reaches a maximum point and then starts falling.

ii) As more and more units of a commodity are consumed, MU derived from each successive unit tends to diminish. It may become zero or negative.

iii) MU is the slope of TU Curve.iv) TU increases as long as MU is positive.v) TU is Maximum when MU is Zero. This point is known as

Saturation Point.vi) TU starts declining when MU becomes Negative.

24. Law of Variable Proportion with diagram and reasons

According to this law, if more & more units of a variable factor are employed with fixed units of fixed factors, total physical product (TPP) increases at an increasing rate in the beginning, then increases at a diminishing rate & finally starts falling.Hypothetical Schedule of TP, AP and MP

Land (acre)

No. of Laborers

TP(Quintal)

AP(Quintal)

MP(Quintal)

1 0 0 0 -1 1 2 2 21 2 6 3 41 3 12 4 61 4 16 4 41 5 18 3.6 21 6 18 3 01 7 14 2 -41 8 8 1 -6

25.PHASE I TPP increases at an increasing rate (Increasing returns) : TPP increases up to OQ, level of output at an increasing rate. TPP curve indicates the same trend from point O to M. MPP keeps rising between 0 to Q1, level of output and reaches its maximum point (where R), where this phase ends. This is reflected

by MPP curve from point O to R.

PHASE IITPP increases at diminishing rate till it reaches its maximum point (here N) (Diminishing Return): This is reflected by TPP curve from point M to point N which lies between Q1 and Q2 level of output.

MPP is falling but remains positive: This phase covers from point R where MPP is Maximum to point Q2 where MPP = 0.

PHASE IIITPP starts declining (Negative Returns): As a result, TPP curve starts shopping downward as depicted in figure. So, phase III is called the phase of Negative returns.

25

20

15

10

5

1 2 3 4 5 6 7- 3

0

Tu a

nd

Mu

Units of oranges

Mu curve

Tu curve

Mu is zero

Tu is m axim um

Stage I Stage II Stage III

1

1

2

2

3

3

4

4

5

5

6

6

8

7

9

8 9

7

Mar

gin

alP

rod

uct

Tota

l Pro

du

ct

(

un

its)

Y

Units of Labour MPP

R

M

0

0

Units of Labour

X

X

N

TPP

2

68

10121416182022

4

2

6

8

10

4

MPP becomes negative and its curve goes below x-axis as shown in the figure. This phase starts from Q2 (where MPP = O and TPP is maximum) & covers the whole range of Negative returns.

ASSUMPTIONS OF LAW OF VARIABLE PROPORTION 1. Technique of production does not change.2. Different quantities of one factor can be varied with fixed factors.3. All units of a variable factor are equally efficient.4. There is short period of operation.

REASONS FOR STATE 1 OF LAW / LAW OF INCREASING RETURNS TO FACTOR / LAW OF DIMINISHING COST:

1. Realization of Optimum combination of factor of production: The firm is moving towards the achievement of optimum combination of factors of production which gives maximum output with given resources.

2. Full utilization of fixed factors: When we go towards the optimum, we get increasing return because the underutilized fixed factors (like machinery, building) are better and more fully used.

3. Specialization: It resulting from division of labor helps in getting increasing returns i.e., MP goes on rising till it achieves maximum production with given inputs.

4. Volume Discounts: It is the discount on price when a large quantities of raw materials, etc, is purchased by a firm.

REASONS FOR STAGE 2 OF LAW/LAW OF DIMNISHING RETURNS OF FACTORS / LAW OF INCREASING COST:

.1. Use beyond optimum capacity: After achieving optimum combinations of variable & fixed factors, efficiency starts declining when more units of a variable factor are employed. As a result, marginal product starts falling.

2. Lack of perfect substitution between factors: Up to a certain limit, factors of production can be substituted for one another e.g., more labor can be employed instead of machinery but beyond a certain stage, this is not possible, the factors become imperfect substitutes leading to diminishing returns.

3. Fall in quantity of fixed inputs per unit of variable factor inputs adds decreasing returns to total product. In other words, fixed factor becomes too small.

4. Scarcity of resources: Beyond a certain level of output factors of production becomes scarce & hence increases the cost of production.

26. Producer’s equilibrium through MR-MC approach – P. competition and MonopolyProducer’s equilibrium refers to the level of output of a commodity that gives the maximum profit to the producer of that commodity.

Conditions for Producer’s Equilibrium:-a) MR = MCb) MC>MR from next unit onwards i.e. MC intersects MR from its below

Numerical Illustration:-Perfect Competition Imperfect Competition

27. Relation Between ATC,AVC and MCRELATIONSHIP BETWEEN ATC, AVC AND MC

1. ATC, AVC and MC curves are U-shaped because they are subject of Law of Variable Proportion.

2. AFC decreases with the increase in level of output because TFC which is a constant value gets divided with increased level of output. Moreover, AFC can never touch any axis because TFC can never be zero. Hence, it assumes the shape of rectangular hyperbola.

3. With the increased level of output the gap between ATC & AVC decreases because the difference between the two i.e., AFC goes on decreasing with the increase in level of output also AVC & ATC never intersects each other because AFC can never be zero.

4. MC curve goes intersects AC curve and the AVC curve at there respective minimum points. However the minimum point of AVC lies to the left of minimum point of AC.

Qty. of Output TFC (Rs.) TVC (Rs.) AVC AFC ATC / AC (Rs.) MC(Rs.) (Rs.) (Rs.)

0 10 0 - - - -

1 10 10 10.00 10.00 20.00 10.00

2 10 28 14.00 5.00 19.00 18.00

3 10 44 14.67 3.33 18.00 16.00

4 10 62 15.50 2.50 18.00 18.00

5 10 90 18.00 2.00 20.00 28.00

6 10 140 23.33 1.67 25.00 50.00

28. Relation Between ATC,AVC and AFCBoth AVC and ATC curves are U-Shaped because they are subject to Law of Variable Proportion i.e. initially both falls, reaches their minimum and then start rising.

AFC decreases with the increase in level of output because TFC which is a constant value gets divided with increased level of output. Moreover, AFC can never touch any axis because TFC can never be zero. Hence, it assumes the shape of rectangular hyperbola.

With the increased level of output the gap between ATC & AVC decreases because the difference between the two i.e., AFC goes on decreasing with the increase in level of output also AVC & ATC never intersects each other because AFC can never be zero.

Qty. of Output

TFC (Rs.) TVC (Rs.)

AVC AFC ATC / AC (Rs.)

(Rs.) (Rs.)

0 10 0 - - -

1 10 10 10.00 10.00 20.00

2 10 28 14.00 5.00 19.00

3 10 44 14.67 3.33 18.00

4 10 62 15.50 2.50 18.00

5 10 90 18.00 2.00 20.00

6 10 140 23.33 1.67 25.00

29. Relation Between AC and MCQty. of Output TFC

(Rs.)TVC (Rs.)

TC (Rs.)

ATC / AC (Rs.) MC Diagram(Rs.)

0 10 0 10 - -

O

Y

Output

Co

st (

Rs.

)

D

E

B

A

M CAC

Q1 Q

2

1 10 10 20 20.00 10.00

2 10 28 38 19.00 18.00

3 10 44 54 18.00 16.00

4 10 62 72 18.00 18.00

5 10 90 100 20.00 28.00

6 10 140 150 25.00 50.00

1. When MC is less than AC, AC falls because MC pulls AC down 2. When MC = AC, AC is constant & at its minimum 3. When MC is more than AC, AC rises because MC pulls up ACAC falls even when MC is rising. This happens between point E to B because MC intersects AC at its minimum point.

30. Relation between AR and MR under P. Competition and Imperfect CompetitionPerfect Competition Monopoly Monopolistic CompetitionIn this situation, firm has to accept the same price as determined by the industry. It means, any quantity of a commodity can be sold at that particular price.

In this situation, firm follows its own pricing policy. However, it can increase sales only by reducing the price.

In this situation, firm follows its own pricing policy. However, it can increase sales only by reducing the price.

O

Y

O utput

AV C

ATC

A FC

When price remains constant, firms can sell any quantity of output at the price fixed by the market. As a result, MR curve (and AR curve) is a horizontal straight line parallel to the X-axis. Since MR remains constant, TR also increases at a constant rate Due to this reason the TR curve is a 45° positively sloped straight line. As TR is zero at zero level of output, the TR curve starts from the origin. This can be illustrated with the help of a schedule and diagram:-

In the above diagram AR and MR are shown along y-axis and units sold are shown along x-axis. Both AR and MR curves are downward sloping depicting that a monopolist can sell more units only by lowering its prices. Also the fall in MR will be more than of AR i.e. with reduced prices, addition to the total revenue diminishes. Moreover both the curves are less elastic due to products having no close substitutes.

In the above diagram AR and MR are shown along y-axis and units sold are shown along x-axis. Both AR and MR curves are downward sloping depicting that a monopolist can sell more units only by lowering its prices. Also the fall in MR will be more than of AR i.e. with reduced prices, addition to the total revenue diminishes. Moreover both the curves are less elastic due to products having no close substitutes. However under Monopolistic Competition both the AR and MR curves are more elastic due to the availability of close substitutes of goods.

31. Features of Oligopoly Market1. Few firms: Under oligopoly, there are a few large firms. Each firm produces a significant

portion of the total output. There exists serve competition among different firms and each firm try to manipulate both prices and volume of production to outsmart each other. For example market for automobiles.The number of the firms is so small that an action by any one firm is likely to affect the rival firms. So, every firm keeps a close watch on the activities of rival firms.Implication of few firms: Action of each firm not only influences itself but also firms are affected by it.

2. Interdependence: Firms under oligopoly are interdependent. Interdependence means that actions of one firm affect the actions of other firms. A firm considers the action and reaction of the rival firms while determining its price and output levels. A change in output or price by one firm evokes reaction from other firms operating in the market.

A change by any one firm (say, Tata) in any of its vehicle (say, Indica) will induce other firms (say, Maruti, Hyundai, etc.) to make changes in their respective vehicles.Implication of Interdependence: this feature makes oligopoly different from other forms of market. Demand curve of a firm here s indeterminate.

3. Non-Price Competition: Under Oligopoly, firms are in a position to influence the prices. However, they try to avoid price composition for the fear of price war. They follow the policy of price rigidity. Price rigidity refers to a situation in which price tends to stay fixed irrespective of changes in demand and supply conditions. Firms use other methods like advertising, better services to customers, etc. to compete with each other.If a firm tries to reduce the price, the rivals will also react by reducing their prices. However, if it tries to raise the price, other firms might not do so. It will lead to loss of customers for the firm, which intended to raise the price. So, firms prefer non-price competition instead of price competition.Implication of Non-Price competition: Prices remain rigid in the market.

4. Barriers to Entry of firms: The main reason for few firms under oligopoly is the barriers, which prevent entry of new firms into the industry. Patents, requirement of large capital, control over crucial new materials, etc. are some of the reasons, which prevent new firms from entering into industry.Implication of Barriers to Entry of Firms: Due to entry barriers, the number of firms in the industry remains same or limited.

5. Group Behavior: Under oligopoly, there is complete interdependence among different firms. So, price and output decisions of a particular firm directly influence the competing firms. Instead of independent price and output strategy, oligopoly firms prefer group decisions that will protect the interest of all the firms.

32. First 3 features of Perfect Competition with implications(i) Very large number of buyers and sellers: The number of buyers and sellers is so large that none of them can influence the prevailing price in the market. Each buyer and seller buys or sells a very insignificant proportion of total supply of the commodity in the market.

Implication of "large number of sellers in the market" is that the share of each seller in total market supply is so small that no single seller can influence the price. Hence, it has no option but to sell the product at the price given (determined) by the industry. It is because of this position that each firm is said to be price taker in perfect competition.

(ii) Homogeneous product: Products sold in the perfect market are homogeneous, i.e., they are identical in all respects like quality, colour, size, weight, design, etc. They are perfect substitutes of one another. The products sold by different firms in the market are equal in the eyes of the buyers. The product being homogeneous, no seller can charge higher price; otherwise, he is liable to lose his customers.

Implication of product being homogeneous is that all firms have to charge the same price for the product; otherwise, no one will buy from the firm selling at a higher price.

(iii) Free entry and exit of firms: Buyers and sellers are free to enter or leave the market (industry) at any time they like. New firms induced by large profits can enter the industry whereas losses make the inefficient firms to leave the industry. Firms are free to enter the market if they earn profits and free to leave the market if they incur losses.

Implication of free entry and exit is that no firm can earn above normal profit in the long run i.e. firms earn zero abnormal profit. In other words, each firm earns just normal profit (i.e. minimum profit which is necessary to carry on business)

33. First 3 features of Monopoly with implications(i) Single seller of the commodity: There is only one seller or producer of a commodity in the market. As a result, the monopoly firm has full control over the supply of the commodity a monopoly firm can exploit the buyers by charging almost any price for its product.

Implication of single seller: Firm is a price maker. It usually exploits the buyers by charging a high price of its product.

(ii) Absence of close substitute of product: The product sold by the monopolist has no close substitute. As a result, the consumer will have to buy the commodity from the monopolist or go without it altogether. In other words, a monopolist does not face competition.

Implication of absence close substitute of product: Buyers have to purchase the commodity from the monopolist or go without it.

(iii) Difficult entry of a new firm: The monopolist controls the situation in such a way that it becomes very difficult for a new firm to enter the monopoly market and compete with the monopolist by producing a homogeneous or identical product. As a result, a monopoly firm earns abnormal profit in the long run due to blocked entry of new firms.

Implication of difficult entry of firms: Firm earns abnormal profits in the long run.

34. First 3 features of Monopolistic Competition with implications(i) Large number of firms: The number of firms selling similar product is fairly large but not very large as in perfect competition, each supplying a small percentage of total supply of the product. As a result, firms are in a position to influence marginally the price of their product due to their brand name etc.

Implication of Large number of firms: Firms can influence the market price of the commodity marginally.

(ii) Product Differentiation: Differentiated products are variants off a given commodity. Products are closely related but not identical (homogeneous). Each firm produces a unique brand of the same product which can be differentiated from brands of other firms. Products are not the same but are closely similar to each other.

Implication of product differentiation: Firms can influence the market price of the commodity marginally due to differences in their brands.

(iii) Free entry and exit of firms: New firms can enter the market if found profitable. Similarly, inefficient firms already operating in the market are free to quit the market if they incur losses. It is because of this feature that like perfect competition, monopolistic competition also gives rise to normal profit.

Implication of free entry and exit of firms: All the firms earn only normal profits in the long run.

35. Geometric method of ESGeometric/Point Method: According to this method is measured on a linear Supply Curve which is as

follows:

In the above diagram there are three straight line supply curve. In all diagrams P is the original price, OM is the quantity supplied and A is the point on the supply curve where elasticity of supply is to be measured. In order to measure elasticity of supply, we may extend supply curve (SS) to the x-axis in its negative range (i.e. left to the origin) at point T. In the diagram (III) SS Supply curve intersects the x-axis in its positive range (i.e. right to the origin) at point T and finally in the diagram(III) the SS curve passes through the origin.

Es = Horizontal segment on x−axis

Quantity Supplied

1. In the diagram (I) where supply curve intersects the x-axis in its negative range TQ>OQ. Hence Elasticity of supply is greater than one(Es>1).

2. In the diagram (II) where supply curve intersects the x-axis in its negative range TQ<OQ. Hence Elasticity of supply is less than One(Es<1).

3. In the diagram (III) where supply curve intersects the x-axis in its negative range TQ=OQ. Hence Elasticity of supply is equal to One(Es=1).

36. Movement and shift in supplyBASIS MOVEMENT ALONG SS CURVE SHIFT IN SUPPLY CRUVE

Meaning Keeping non-price factor constant, with the rise in price of commodity, the qty supplied increases & with the fall in price of the commodity, the Qty. supplied decreases, it known a Movement along supply curve.

Keeping price factor constant, with a rise in cost of input, the Qty. supplied of the commodity decreases and with a fall in cost of input, the qty, supplied increases. It is known as shift in supply curve.

Effect on Supply Curve

There is an upward and downward movement along the supply curve.

There is a rightward and leftward shift in the supply curve.

Other Name It is also known as Change in Qty. Supplied.

It is also known as Change in Supply.

Reason It occurs due to change in the price of the given commodity.

It occurs due to change in factors other than price say increase or decrease in the price of inputs.

Diagram

P1

P2

Q1 Q2

P

Q

Y

S

S

O X

Price(R s.)

Q ty. S upplied (un its)

Y

O X

Supply (units)

S1

S1 S2

S2

Q1 Q2

S

S

Price(Rs.) P

Cost of input Rs. 300

Cost of input Rs. 200

Cost of input Rs. 100

Q

37. Reason for increase and decrease in supply

REASON FOR RIGHTWARD SHIFT IN SUPPLY CURVE: 1. Fall in Cost of inputs. 2. Advancement in the technique of production.

QOT

S

S

Y

X

Price(R s.)

Q ty. Supplied (un its)QO T

S

Y

X

P rice(R s.)

Q ty. S upp lied (units )

QO T

S

Y

X

P rice(R s.)

Q ty. S upp lied (units )

3. Fall in the rate of excise tax. 4. Fall in price of related goods.

REASONS FOR LEFTWARD SHIFT IN SUPPLY CURVE: 1. Rise in Cost of inputs. 2. Unfavorable advancement in the technique of production.3. Rise in the rate of excise tax. 4. Rise in price of related goods.

38. Factors affecting supply – cost of inputs, technology and excise duty1. Change in Technology of Production: Technological changes influence the supply of a commodity. Advanced and improved technology not only reduces the cost of production, but also raises the profit of the firm. This naturally, provided incentives to the supplier to increase the supply of his product. However, technological degradation or complex and outdated technology will increase the cost of production and it will lead to decrease in supply. This can be illustrated with the help of diagram:

In the above diagram price is shown along y-axis and supply is shown along x-axis. Initially, OQ is the supply at OP price. With favorable change in the technology, cost of production reduces and as a result supply curve shifts towards right and vice versa.

2. Change in Price of Inputs: When the amount payable to factors of production (like rent, wages etc.) increase, the cost of production also increases. This decreases the profitability. So, the seller reduces the supply of the commodity. On the other, decrease in prices of factors of production increases the supply, due to fall in cost of production and rise in profit margin. This can be illustrated with the help of a diagram.

In the above diagram, price is shown along Y-axis & supply along X-axis. Initially, when Price of Input is Rs. 200, the supply is OQ units and with the rise in price of input from Rs. 200 to Rs. 300, the supply falls from OQ to OQ2 units. Similarly with the fall in price of inputs from Rs.

200 to Rs. 100, supply increases from OQ to OQ1 units.

3. Change in Excise Duty(Taxation Policy) : Increase in taxes raises the cost of production and thus, reduces the supply, due to lower profit margin. On the other hand, tax concessions and subsidies increase the supply as they make it more profitable for the firms to supply goods. This can be illustrated with the help of diagram:

In the above diagram price is shown along y-axis and supply is shown along x-axis. When Excise duty is Rs. 200, the supply is OQ units. With the increase in excise duty from Rs. 200 to Rs. 300, the supply falls from OQ to OQ, units. With the fall in excise duty, from Rs. 200 to Rs. 100, the supply rises from OQ to OQ, units.

39. Reasons for operation of Law of Demand1. Law of Diminishing Marginal Utility: According to this law, when more & more commodity is consumed then the utility derived from successive units goes on decreasing. A consumer will buy more units of a commodity at a lower price because he is getting lesser utility from it.

2. Income Effect: With the fall in price of a commodity, money income remains constant, the purchasing power or real income of the consumer increases. As a result, he is in a position to buy more units of a commodity. This effect of change in price on income of a consumer is known as income effect.

P

Y

O X

Supply (units )

Price(Rs)

Q 1Q 2 Q

S1

S2

S2

S1

Unf

avou

rab le

Cha

nge

Favo

urab

leC

hang

e

S

S

P

Y

O X

Su pply (units )

Price(Rs)

Q 1Q 2 Q

S1

S2

S2

S1

Price

of Input

=R

s.20

0

Price

of Input =

Rs.

300

Price

of Inpu t =

Rs.

100

S

S

P

Y

O X

Supply (units)

Price(Rs)

Q 1Q 2 Q

S1

S2

S2

S1

Excis

eD

uty

=R

s.20

0

Excis

eD

uty

=R

s.30

0

Excis

eD

uty

=R

s.10

0

S

S

3. Substitution Effect: With the rise in price of a commodity the demand for its substitute commodity rises therefore, the consumer will substitute the expensive with a cheaper one. This effect of change in price on the demand for the substitute commodity is known as substitution good.

Price Effect = Income Effect + Substitution Effect.4. Number of Consumers: When the price of a commodity falls, the demand rises because the consumers who were not able to purchase earlier can now purchase and the existing consumer will buy more units because of increased purchasing power.

5. Different uses of a commodity: When the price of a commodity rises, the consumption for the commodity gets restricted to its most important uses only & as a result lesser quantity of a commodity is demanded.

Book – 21. Circular Flow of Income in two Sectors

In a two sector economy there exists two sectors namely households and firms along with a financial intermediary called Capital Market. The household renders productive services to the firms and in return receives factor payments. Firm produce goods and services and provide them to the households and in return receives money in form of consumption expenditure. The capital sector channelizes the financial resources in form of savings and investments among the sectors of the economy.

Real Flows: These refer to the flows of goods & services. Thus are real because they consist of actual goods & services, when factor services (services of land, labour, capital, enterprise) flow from household to firms which require them for producing goods and services, these are called real flows.

Money Flows: These refer to the flows of money in the form of factor payments and consumption expenditure.

Leakage & Injections: A leakage is the amount of money which is withdrawn from the flow of income whereas injections are the amount of money that is added to the flow of income in the economy. Thus,

(i) Savings and (ii) Taxes by households and firms constitute a leakage from the circular flow and (iii) Export payments become injection into the circular flow of income (money).

2. Difference between Stock and FlowBasis FLOW STOCKMeaning It is a quantity which is measured

over a period of time.It is a quantity which is measured at a point of time.

Length of Time

Flows are defined with reference to a specific period (length of Time)

Flows are NOT defined with reference to a specific period (length of Time)

Time Dimensions

It has time dimensions. It has no Time Dimensions.

Examples Expenditure, savings, depreciation, Interest.

Wealth, foreign debts, loan, investors, opening stock, money supply, population, etc.

3. Difference between Factor Income and Transfer IncomeBasis Factor Payment / Income Transfer Payment / IncomeMeaning These refer to the payment

which received in return of rendering productive services.

These refer to the payment which received without rendering productive services.

Components It includes rent, wages, interest and profit.

It includes scholarship, gifts, donations, old age pension, unemployment allowance, subsidies etc.

Concept It is an earned income (earning concept)

It is an unearned income (receipt concept)

Type of Payment It is a bilateral payment. It is a unilateral payment.Treatment in National Income

It is included in National Income.

It is excluded in National Income.

4. Difference between Final and Intermediate GoodsBasis Final Goods Intermediate Goods

Meaning All goods which are meant either (a) All goods which are used as (a) raw

Factor Market

& E

F irm o rP ro d u c in g

S ec to r

H o u s e h o ld o rC o n s u m e r

S ec to r

Product Market

A

nte

for consumption by consumption or (b) for investment by firms are called final goods

materials for further production of other goods or (b) resale in same year are called Intermediate Goods.

Treatment while calculating National Income

It is included while calculating National Income.

It is excluded while calculating National Income.

Demand They have a direct demand as they satisfy the wants directly.

They have a derived demand as their demand depends on the demand for final goods.

Value Addition They are ready for use by their final users i.e. no value has to be added to the final goods.

They are not ready for use i.e. some value has to be added to the intermediate goods.

Production Boundary They have crossed the boundary line of production.

They are still within the production process.

Example Milk used by households for consumption.

Milk in diary shop for resale etc.

5. Steps in value added method with precautions (i) Identify all the producing units in the domestic economy and classify them into three industrial sectors such as primary, secondary & territory sectors on the basis of similarity of their activities.(ii) Estimates net value added at FC by each producing units. By deducting intermediate consumption, depreciation & net indirect taxes from value of output, we get net value added at FC.(iii) Estimates net value added of each industrial sector by summing up net value added at FC of all producing units falling in each industrial sector.(iv)Compute Domestic Income (NDP at FC) by adding up NVA at FC of all industrial sectors.(v) Estimate net factor income from abroad which is added to Domestic Income for deriving National Income.

PRECAUTIONSItems should be included while calculating National Income by Value Added method.(i) Imputed rent of owner occupied houses.(ii) Imputed value of goods and services produced for self-consumption of for free distribution.(iii) Value of own-account production of fixed assets of enterprises, Govt. & households.(iv) Only value added and not value of output by production units should be included.Items should be excluded(i) Sales & Purchase of Second hand Goods: They are not a part of production of the current year. Moreover, their value had already been included in the national income of the year in which they were produced.(ii) Sale of Brands of a Company: This is merely a financial transaction which does not contribute directly to the flow of goods & services.(iii) Income of a Smuggler: It is an illegal activity and all illegal activity (like smuggling, gambling, black marketing etc.) is excluded from the national income.

6. Steps in income method with precautions(i) Identify enterprises which employ factors of production (land, labour, etc).(ii) Classify factor payments into various categories like rent, wages, interest, profit and mixed income.(iii) Estimate amount of factor payments made by each enterprise.(iv) Sum up all factor payments made within domestic territory to get Domestic Income (NDP at FC).(v) Estimate net factor income from abroad which is added to Domestic Income to derive National Income.

PRECAUTIONS(i) Only factor incomes which are caused by rendering productive services are included as these results in the creation of goods and services.

(ii) All types of transfer income are excluded because these are received without rendering any productive activities.(iii) Sale & Purchase of second hand goods are excluded since they are not part of production of current year. Moreover they lead to the problem of double counting.(iv) Sale proceeds of shares & bonds are not included as these are mere financial transactions and do not contribute to the production directly.(v) Imputed rent of owner occupied dwellings and value of production for self-consumption is included but value of self-consumed services is not included.(vi) Income from illegal activities like smuggling, black-marketing etc, as well as windfall gains are excluded as these are capital gains and are received without contributing to the total product.(vii) Direct taxes such as income tax which are paid by the employees from their salaries are included.(viii)Indirect taxes like sales tax, excise duties, which tend to increase market prices, are not included.

7. Steps in expenditure method with precautions(i) Identification of economic units incurring final expenditure, e.g., household sector, firm sector & govt. sector(ii) Classification of final aggregate expenditure into following components

(a) Private final consumption expenditure(b) Govt. final consumption expenditure(c) Gross fixed capital formation(d) Change in stocks(e) Net exports

By summing up all the five components, we get GDPMP(iii) Measurement of final expenditure on the above components. Sum total of the above five items gives us the value of GDP at MP. By deducting depreciation and net indirect taxes from GDP at MP, we get NDPFC.(iv) Estimation of net factor income from abroad which is added to NDP at FC (Domestic Income) to obtain NNPFC (National Income).

Precautions: (i) To avoid double counting, expenditure, on all intermediate goods & services is excluded. Intermediate goods and services are those which are sold by one enterprise to another for resale or for further production.(ii) Govt, expenditure on all transfer payments such as scholarships, unemployment allowance, old age pension, etc, is excluded because no productive services is rendered by the recipients in exchange.(iii) Expenditure on purchase of second hand goods is excluded from national income because this type of expenditure is not on currently produced goods.(iv) Expenditure on purchase of old shares/bonds or new shares/bonds, etc. is excluded because it is not payment for goods or services currently produced. It shows mere transfer of property from one person to another.

8. Is GDP/GNP a Correct Index of Welfare? (i) Distribution of GDP: A mere rise in GDP (or GNP or National Income) may not lead to rise in economic welfare if its distribution results in concentration of income in the hands of very few individuals or firms.(ii) Non-Monetary exchanges or transactions: Many economic activities in the economy are not evaluated in monetary terms. Thus, non-market transactions like services of house wife, exchange or transactions through barter, enjoyment from hobbies like painting, etc, which increase economic welfare, are not included in measurement of GDP.(iii) Externalities: These refer to benefits or harms which a firm or an individual causes to another but for which they are not paid or penalized. For e.g., negative externalities occur such as smoke of a factory pollutes the air or its industrial waste causes pollution in the nearby river resulting in loss of social welfare.

(iv) Rate of Population Growth: If rate of population growth is higher than the rate of growth of real GDP, this will lead to fall in per capita availability of goods & services. As a result, overall welfare of the society tends to fall.

9. Difference between Nominal and Real GNPReal GNP (i.e. at Constant Prices) truly reflects performance and level of economic growth in an economy whereas Nominal GNP (i.e., at current prices) does not.(ii) Real GNP is a better tool to make a year to year comparison of changes in the physical output of goods & services.(iii) Real GNP eliminates the effect of change in prices whereas Nominal GNP does no. Therefore, Real GNP truly reflects growth of the country.(iv) It is Real GNP which is often used to making international comparisons of economic performance across the countries.

10. Functions of moneyA unit of value: The values of goods can be measured in terms of money. It is a common medium through which we can calculate the value of each and every good. The value of a good in terms of money is called the price. In barter system the lack of a common denominator for measuring values of goods was a major drawback.

Money is a medium of exchange: Money acts as a medium of exchange as it facilitates exchange through a common medium, i.e. currency. In other words, money helps in the buying and selling of goods. For example, a person can sell his goods to another for money and that person can use money to purchase goods of his choice. Money solves the problem of double coincidence of wants.

Money as a standard of deferred payments: Payments can easily be made through the medium of money. In other words, it is very difficult to pay back a loan in terms of goods and services. However, with the advent of money the payments of loans or interests can easily be made.

Money as a store of value: This function explains the importance of money as value storage. This implies that wealth in the form of money can be stored easily as a medium of exchange for future use. For example, money can be stored in banks for meeting emergency and future needs.

11. Money supply measuresSupply of money is a stock variable measured at a point of time. Stock of money means stock of money hold by public. Time series of total stock of money is prepared to see its effects on income, prices, employment etcIn India RBI has been publishing data on four alternative measures of money supply. Amongst these M1 is the most common used.

1. M1 : C + DD + OD (Currency held with public + Demand deposits of all commercial and co-operative banks + OD with RBI excluding inter-bank deposits)C is currency held by public. It consists of paper currency as well as coins.

DD is the demand deposits in Banks. Only the net demand deposits of banks are included in money supply because the part of demand deposits that represents inter-bank deposits held by one bank with another does not constitute demand deposits held by public.

OD is other deposits with the RBI. These are the deposits held by the RBI of all economic units except the Govt. and Banks. It includes demand deposits of IMF, World Bank, Foreign Banks etc.

12. Credit creation function of commercial banksCredit Creation:- Credit creation (or deposit creation or money creation) by the banks is determined by (i) the amount of the initial fresh deposits and (ii) the Legal Reserve Ratio (LRR), the minimum ratio of deposit legally required to be kept as cash or in liquid form by the banks. It is assumed that all the money that goes out of banks is re-deposited into the banks, and LRR consists of CRR and SLR decided by RBI.

Example:- Let the LRR be 20% and there is a fresh deposit of Rs.10,000. As required the banks keep 20% i.e. Rs.2,000 as cash. Suppose the banks lend the remaining Rs. 8,000. Those who borrow, use this money for making payments. As assumed those who receive payments put the money back into the banks. In this way bank receives fresh deposits of Rs. 8,000. The bank again keep 20% i.e. Rs.1,600 as cash and lend Rs.6,400, which is also 80% of the last deposits. The money again comes back to the banks leading to a fresh deposit of Rs.6,400. The money goes on multiplying in this way this process continues till new deposit become nil, and ultimately total money creation is Rs.50,000.Total money creation = initial deposit x 1/LRR =10000 x1/20% = 10000 x100/20Total money creation = 50000.

Table: The working of deposit creation by commercial banks:Deposits Loans Cash Reserves

Initial 10000 8000 2000First Round 8000 6400 1600Second Round 6400 5120 1280

_____ _____ _____50000 40000 10000

Money Multiplier - It explains the multiplying effect of initial deposits on the total deposits. It is determined by the LRR.

Money Multiplier = __1__ LRR

Money Multiplier = __1__ = 5 0.2

Total Money Creation = Initial deposits x __1__ LRR

= 10000 x __1__ = Rs. 50000 0.2

13. Functions of Central BankIssue of Currency: The central bank has the sole authority for the issue of currency in the country. All the currency issued by the central bank is its monetary liability and circulates as Legal Tender Money. The Central bank has to keep assets of equal value as reserves in the form of gold and foreign securities, government securities. This ensures uniformity in note issue, makes it easier to control credit supply and stabilizing internal and external value of the currency. (2) Banker to the government the central bank acts as a banker to the government both central as well as state governments as:- a) It acts as a Banker to Govt. as it receives deposits from Govt., provides cash to the Govt., makes payments, advances short-term loans to Govt. and buys and sells securities on behalf of the Govt. b) It acts as a Fiscal Agent to Govt. as it manages the public debt, collects taxes and other payments on behalf of Govt.c) It acts as an Advisor to Govt. as it gives advice to the Govt. on all financial and economic matters such as deficit financing, devaluation of currency, trade policy, foreign exchange policy etc.

(3) Banker's bank and supervisor: The central bank acts as a banker's bank and supervisor as:-

a) Commercial banks are required to keep a part of their net total deposits with the central bank in form of cash. This is known as CRR.

b) Central bank advances loans to commercial banks. These advances generally take the form of rediscounting of bills of exchange.

c) Central bank acts as the lender of last resort - if a commercial bank is faced with a financial crisis, then they can approach central bank and gets loans against the valid bills of exchange.

d) Clearing house function - Since all banks have their accounts with the central bank, the central bank can easily settle the claims of various banks against each other simply by book entries of transfers from and to their accounts.

e) Licensing of banks, Branch expansion, liquidity of assets, - Management, amalgamation and liquidation of banks.

f) RBI controls banks through periodic inspection of banks and returns filed by them. - When banks fail to meet obligations of their depositors and are facing bank failures

(4) Controller of Credit: Central bank through its monetary policy acts as a controller of credit. It uses following policy:- (I) Quantitative Instrument: (a) Bank Rate Policy (Discount Rate): The bank rate is the rate at which the central Bank lends to the commercial banks. By changing the bank rate, central bank controls the credit supply in the economy i.e. credit expansion takes place when bank rate is decreased where as credit restriction takes place when bank rate is increased.

(b) Open Market Operations: Open market operations is the buying and selling of government securities by the central banks from to the public and banks on its own account. By selling or buying, central bank controls the credit supply in the economy i.e. credit expansion takes place when securities are bought where as credit restriction takes place when securities are sold.

(c) Cash Reserve Ratio: Banks are required to keep a part of their cash in form of reserves with the central bank, this is known as CRR. By changing the CRR, central bank controls the credit supply in the economy i.e. credit expansion takes place when CRR is decreased where as credit restriction takes place when CRR is increased.

(II) Qualitative Credit Control: (a) Imposing margin requirement on secured loans: A margin is the difference between the amount of the loan and market value of the security offered by the borrower against the loan. By changing the Marginal requirements, central bank controls the credit supply in the economy i.e. credit expansion takes place when marginal requirement is decreased where as credit restriction takes place when marginal requirements increased.

(b) Moral suasion: This is a combination of persuasion and pressure that the Central Bank applies on the other banks in order to get them to fall in line with its policy.

(5) Lender of Last Resort: When commercial banks fail to meet obligations of their depositors and are facing bank failure due to Bank runs, Central bank supports them by acting as lender of Last resort. Here instead of Re-discounting RBI gives short term advances to commercial banks against the bills of exchange, promissory notes, treasury bills, government securities etc. But banks have to first approach all other sources to get credit like call money market, then only approach RBI. RBI stands by commercial banks as a guarantor and extends loans to ensure the solvency of the commercial bank.

(6) Clearing House Function: RBI settles mutual indebtedness between banks. It makes entire process of collecting bank to bank payments easy and much less time consuming. Central bank has a clearing house where mutual indebtedness between banks is settled. Representatives of different banks meet daily in the clearing house to settle interbank payments by debt and credit entries in the cash reserve account held by commercial bank with RBI. The difference between various banks at the end of the day of each daily clearing are settled by transfer between their respective account with RBI.

14. Difference between Commercial Bank and Central BankBasis Central Bank Commercial BankMeaning It is an apex institution of the monetary and

banking structure of the country. It regulates It is a bank which deals in money and credit for the purpose of earning profit. It operates

entire baking system of the country. under guidelines of the central bank.Objective It is a non profit making institution. It acts in

the public interest. It is a profit making institution.

Ownership It is generally a government owned institution.

It can be government or privately owned institution.

Number There can be only 1 Central bank in a country.

There can be many commercial banks in a country.

Note Issue It has sole monopoly over the issue of currency notes.

It does not enjoy privilege of issuing currency in the country.

Banker It is a banker to Govt. as well as commercial banks. It does deal directly with the public.

It directly deals with the public and engaged in providing services to the customers.

15. Components of Aggregate DemandHousehold (or private) Consumption Demand: It is defined as ‘Value of goods & service that households are able and willing to buy. Alternatively, it refers to total expenditure to be incurred by all households on purchase of goods and services. Household consumption demand depends mainly on household’s disposable Income i.e. higher the disposable income, higher will be the consumption expenditure and vice versa.

Private Investment Demand: This refers to planned expenditure on creature of new capital assets like machines, buildings & raw materials by private entrepreneurs. Investment demand by private enterprises depends mainly on two factors, namely, MEI (Marginal Efficiency of Investment) and Rate of Interests. There is an inverse relationship between Rate of Interest and Investment demand i.e. higher the interest rate, higher will be the investment demand. Also it is directly related to MEI i.e. higher the MEI, higher will be the investment and vice versa.

Govt. Demand for Goods & Services: It refers to govt. planned expenditure on purchase of consumer and capital goods to fulfill common needs of the society. The level of govt. expenditure is determined by govt. policy. Govt. demand may be guided by the motive of people’s welfare as against the profit motive of private investment.

Net Exports (Export-Imports): It is the difference between export of goods & services and import of goods & services during a given period. It refers to the demand of foreign countries for our goods and services over our demand for foreign countries goods & services. Thus, net exports show expected net foreign demand.

16. Concept of Inflationary Gap with measures to correct itMeaning of Inflationary GapIt refers to a gap which arises when aggregate demand exceeds aggregate supply at full-employment equilibrium. In the above diagram income is shown along x-axis & AD is shown along y-axis. AS is upward sloping 45° line curve showing that consumption expenditure & income both increases in the same proportion. AD is Aggregate demand which is not beginning from origin because of some consumptions went at zero level of income (autonomous income). Both the curve intersects each other at point E where EM is equilibrium level of output & OM is equilibrium level of income. With increase in AD the new AD curve. The new demand curve intersects AS curve at point E1 where a gap EB (E1M1 – EM) arises which is known

as inflationary gap.

Reasons for Excess Demand & Inflationary Gap(i) Increase in household consumption demand due to rise in propensity to consume - (ii) Increase in private investment demand because of rise in credit facilities.(iii) Increase in public (Govt.) expenditure.(iv) Increase in export demand.

Measures to Control Situation of Excess Demand

O

4 5 °

Y

X

AD (actual)

A D

A S

MO u tp u t & In co m e

M 1

Full-employmentEquilibrium PointTo

tal e

xpe

ndi

ture

(o

r AD

)

In fla tio n a ry g ap (E B )

E

BE1

(i) Fiscal Measures (ii) Monetary Measures

(i) Fiscal Measures: It refers to the revenue & expenditure policy of the govt. to control the situation of credit of the economy. Its important tools are as follows:

(a) Expenditure Policy: During the situation of excess demand Govt. reduces its expenditure on various types of public work, which reduces the disposable income of the consumer and the effective demand for goods & services get reduced by that amount in the economy.

(b) Revenue Policy: During the situation of excess demand, the Govt. increases the tax rates as a result of which disposable income gets reduced. This further helps in reducing effective demand for goods and services.

(c) Deficit Financing: It refers to the process of printing of new currency notes by Govt. During the situation of Excess Demand, Govt. discourages deficit financing, as a result money circulation in the economy falls and thus the effective demand for goods and services gets reduced in the economy.

(d) Public Borrowings: During the situation of Excess Demand, Govt encourages public borrowings through various attractive schemes. This helps in reducing the consumption expenditure by the individuals and thus effective demand for goods and services gets reduced.

(ii) Monetary Measures: It refers to the policy of Central Bank of a country to control the situation of credit in the country. Its tools are.

Quantitative Measures Qualitative Measures(1) Bank Rate (1) Moral Suasion(2) Open Market Operations (2) Marginal Requirements(3) Cash Reserve Ratio(4) Statutory Liquidity Ratio

Quantitative Measures

(1) Bank Rate (Discount Rate) : It refers to the rate at which Central Bank lends loan to the commercial banks. During excess demand Central bank raises Bank Rate, which makes the credit expensive and reduces the lending capacity of Commercial Banks and thus the effective demand for goods & services gets reduced in the economy.

(2) Open Market Operations: It refers buying & selling of govt. securities by the Central Bank. During excess demand Central Bank sells securities to the commercial banks thereby reducing their lending capacity and thus the effective demand for goods & services gets reduced.

(3) Cash Reserve Ratio: It refers to the minimum amount of Cash Balance that has to be maintained by all commercial Banks with the Central Bank. During excess demand Central Bank raises CRR thereby reducing their lending capacity and thus the effective demand for goods & services gets reduced.

(4) Statutory Liquidity Ratio: It refers to the minimum amount of liquid assets that has to be maintained by all commercial banks with the central bank. During excess demand central bank raises SLR thereby reducing their lending capacity and thus the effective demand for goods & services gets reduced.

Qualitative Measures

(1) Moral Suasion: It refers to the written & oral advice by Central Bank to the Commercial Banks. During excess demand Central Bank advises for credit restriction i.e. not to lend loans for unproductive activities thereby reducing the effective demand for goods & services.

(2) Marginal Requirements: It refers the amount of security which has to be offered as collateral security for getting the loans. During excess demand Central Bank raises Marginal requirements which makes the credit expensive and discourages people to take loans. As a result effective demand for goods & services gets reduced in the economy.

17. Concept of Deflationary Gap with measures to correct it

18. Working of Investment Multiplier

19. Deriving saving curve from consumption curve

20. Determination of level of income and employment through AD and AS Approach