Introduction to Economics

INTRODUCTION #

“Economics is the science which studies human behavior as a relationship between ends and scarce means which have alternative uses.”

— LionelRobbins

Economics is the “study of how societies use scarce resources to produce valuable commodities and distribute them among different people..”

— Paul. A. Samuelson

Economics is about how the society deals with the problem of scarcity. Scarcity of resources which indicates that all wants cannot be satisfied. Hence we have to make choices among innumerable wants. Economics is the study as to how we make choices or how we choose to use resources. Resources include the time and abilities people have, land, buildings, equipment and know – how of creating useful products and services. In short, economics is the study of labour, land, investments, money, income and production and of taxes and government expenditures. It helps in solving basic problems of what goods and services to produce, how to produce and for whom to produce. The supply and demand force in the market or the price mechanism helps the society to solve these problems and allocate resources to different economic activities.

The act of choosing and resource allocation to the various activities like food production, construction building, production of commodities like clothes, telephones etc. takes place at different levels. A firm has to allocate the available resources for produc- tion in the best possible way so as to maximize its sales and profit. Likewise, a consumer spends his

income in a manner that most of his needs are met and he derives maximum satisfaction. The study of individual firm or the behaviour of a consumer is the subject matter of Microeconomics. Microeconomics offers detailed treatment of economic behaviour of an individual unit ignoring the relationship of it with the rest of the economy for the sake of simple anal- ysis. Macroeconomics is the explanation of overall interactions in an economy.

The working of an economy which is a com- plex system is explained by economics, it addresses the collective behaviour of economic players like consumers and producers, businesses and industries, governments and countries, and the globe as a whole. Hence, the financial system, public finance, planning and development, different sectors of economy, international economics etc, become important in the study of economics. The objective of the study material is to provide basic knowledge regarding importantaspects ofaneconomy and itsfunctioning ingeneral andparticularly about Indian economy.

Important Factopedia #

Micro and Macro Economics

Micro Economics	Micro means small.Micro economics is the study of par- ticular markets, and segments of the economy.
Macro Economics	Macro means large. Macroe- conomics is the study of the whole economy. It looks at ‘aggregate’ variables, such as aggregate demand, national output and inflation.

Central Problems of an Economy

What is produced and in what quan- tities?	Whether to produce more agricultural goods or indus- trial products and services.
How are these goods produced?	How much of which of the resources to use. Whether to use more labour or more machines.
For whom are these goods produced?	How should the produce of the economy be distributed among the individuals in the economy?

How does a firm decide how much to produce?

Maximum Profit	A firm is a profit maxi- mizer. So, the amount that a firm produces and sells in the market is that which maximizes its profit.
Equilibrium	Where market supply equals market demand equilibrium.
equilibrium price	at which equilibrium is reached.
equilibrium quantity	quantity bought and sold at equilibrium price.
Price change	Whenever market supply is not equal to market demand, there will be a tendency for the price to change.
price will rise	If demand increases and supply remains the same.
price will fall	If supply increases and demand remains the same.

T h e Centrally Planned Economy Where the government or the central authority plans all the important activ- ities in the economy. M i x e d economies In reality, all economies are mixed economies where some important decisions are taken by the government and the economic activities are by and large conducted through the market.

Type of Economy

The	Where all the central problems are
Market/	solved with the help of price mech-
capitalist	anism.The basis of price mechanism
Economy	is that every commodity/service has
	a price which is determined with the
	help of supply and demand.If the
	buyers demand more of a certain
	good, the price of that good will rise.
	This will send a signal to the producer
	of that good that the society wants
	more of that good and the producers
	of that good, are likely to increase
	their production.In this way, prices
	of goods and services send important
	information to all the individuals
	across the market and help achieve
	coordination in a market system.

Substitutes and Complements

Substitutes	Goods like tea and coffee are not consumed together. They are sub- stitutes for each other.Since tea is a substitute for coffee, if the price of coffee increases, the consumers can shift to tea.On the other hand, if the price of coffee decreases, the consumption of tea is likely to go down.Thus demand for a good usually moves in the direction of the price of its substitutes.
Complements	Goods which are consumed together are called complementary goods. e.g. tea and sugar, pen and ink.Since tea and sugar are used together, an increase in the price of sugar is likely to decrease the demand for tea and a decrease in the price of sugar is likely to increase the demand for tea.Hence, the demand for a good moves in the opposite direction of the price of its complementary goods.

Monopoly and Oligopoly

Monopoly

When there is a single producer of a particular commodity; no other commodity works as a substitute for this commodity.

Oligopoly	When market of a particular com- modity consists of more than one seller but the number of sellers is few.
Duopoly	The special case of oligopoly where there are exactly two sellers.

Four factors of production

Joint efforts	Production of goods and services is a result of joint efforts of four factors of production.
1. Land (i.e. natural resources)	remuneration for which is called rent.
2. Labour	remuneration for which is called wages.
3. Capital	remuneration for which is called interest.
4. Entrepreneurship	remuneration of which is profit.

MACROECONOMICS #

Macroeconomics is a branch of economics dealing with the overall working of an economy. It deals with all the sectors of the economy, national income, inflation, unemployment, international trade etc. Generally the economy of a country is classified into different sectors such as Public Sector, Private Sector, Joint Sector and Foreign Sector. Public Sector is the sector where everything is managed, controlled and majority of the stake belongs to the government e.g: Railways; Oil and Natural Gas Corporation. Under Private Sector, everything is managed and controlled by private individuals e.g: Infosys, Wipro etc. In Joint Sector activities are taken up together by Public and Private sector as joint venture. The imports and exports of a country; foreign investments etc., come under foreign sector.

CLASSIFICATION OF ECONOMY #

An economy is also classified as Primary, Secondary and Tertiary Sector. Primary Sector constitutes agriculture, mining, fisheries, forestry and other related activities which are considered as primary economic activities. Industrial and manu- facturing activities come under secondary sector. Tertiary sector which is also called as Service Sector constitute banking, insurance transportation etc.

ESTIMATING NATIONAL INCOME #

Usually while estimating National Income the classification of Primary, Secondary and Tertiary sector is taken into consideration. The National income derived from each of these sectors is cal- culated.

National Income (NI) or Gross National Prod- uct (GNP) is generally defined as the value of the aggregate of final goods and services produced in an economy during a particular period of time which is usually one year.

Net National Product (NNP): It is GNP minus depreciation or capital consumption allowances. NNP = GNP – D.

Depreciation is deducted from GNP to arrive at NNP, since capital stock wears out in the process of production.

Gross Domestic Product (GDP): It relates to the product of the factors of production (land, labour, capital and entrepreneurship) during a year, employed within the political boundary of a country i.e., what is produced within domestic territory. GDP estimated at current year price is called as nominal GDP. GNP is the output produced by the nationals of a country including net return on assets owned abroad, Therefore, GDP = GNP – Net income from abroad or

GNP = GDP + Net income from abroad Similarly, Net Domestic Product = NNP – net

income from abroad.

Real GDP is the GDP stated in the base-year’s price level. The effect of, inflation are the rising prices on GPD level and can thus be adjusted with the help of real GDP. The real GDP reflects the actual growth rate of GDP after adjusted for infla- tion.

Gross Value Added (GVA) Vs. GDP #

Gross value added (GVA) is defined as the value of output less the value of intermediate consumption. Value added represents the contribution of labour and capital to the production process. When the value of taxes on products (less subsidies on products) is added, the sum of value added for all resident units gives the value of gross domestic product (GDP).

Thus, Gross Domestic Product (GDP) of any nation represents the sum total of gross value added (GVA) (i.e, without discounting for capital consumption or depreciation) in all the sectors of that economy during the said year after adjusting for taxes and subsidies.

Introduction of GVA at basic prices in India

In India, GDP is estimated by Central Statistical Office (CSO). Under the Fiscal Responsibility and Budget Management Act 2003 and Rules thereun- der, Ministry of Finance uses the GDP numbers (at current prices) to peg the fiscal targets. For this purpose, Ministry of Finance makes their own projections about GDP for the coming two years while specifying future fiscal targets.

In the revision of National Accounts statistics done by Central Statistical Organization (CSO) in January 2015, it was decided that sector-wise wise estimates of Gross Value Added (GVA) will now be given at basic prices instead of factor cost. In simple terms, for any commodity the basic price is the amount receivable by the producer from the purchaser for a unit of a product minus any tax on the product plus any subsidy on the product. How- ever, GVA at basic prices will include production taxes and exclude production subsidies available on the commodity. On the other hand, GVA at factor cost includes no taxes and excludes no subsidies and GDP at market prices include both production and product taxes and excludes both production and product subsidies.

The relationship between GVA at Factor Cost and GVA at Basic Prices and GDP at market prices and GVA at basic prices is shown below:

GVA at factor cost + (Production taxes less Production subsidies) = GVA at basic prices

GDP at market prices = GVA at basic prices

+ Product taxes – Product subsidies

Production taxes or production subsidies are paid or received with relation to production and are inde- pendent of the volume of actual production. Some examples of production taxes are land revenues, stamps and registration fees and tax on profession. Some production subsidies include subsidies to

Railways, input subsidies to farmers, subsidies to village and small industries, administrative subsidies to corporations or cooperatives, etc. Product taxes or subsidies are paid or received on per unit of product. Some examples of product taxes are excise tax, sales tax, service tax and import and export duties. Product subsidies include food, petroleum and fertilizer subsidies, interest subsidies given to farmers, households, etc. through banks.

The concept of GVA at basic prices follows from the United Nation’s System of National Accounts (SNA) introduced in 1993 and carried forward in an identical fashion in SNA 2008 as a part of revision of compilation and classification systems. This has been adopted by CSO in its base revision carried out in January 2015.

Personal Income (PI) is defined as the income received by the households before the payment of personal income taxes. From National Income, undivided corporate profit (Ucp), corporate income taxes (CIT) corporate saving (Cs) and social security contribution (SS) made by individual and the trans- fer payment (TP) are added since they increase the income of individuals.

PI = NI + TP – Ucp – CIT – CS – SS.

Transfer Payments are payments for which no productive activity is made. They are merely transferred of purchasing power from one person or organization to others such as old age pension, lottery, gifts, gambling, unemployment allowance, widow relief and other social security contributions from the government.

Disposable Income (DI) is the income left with the public or what actually gets into public hands, to dispose as it pleases for consumption or saving. It is defined as personal income minus personal income taxes (Tpi).

DI = PI – TpI

Per-Capita Income (pCI) is National Income of a country divided by its total population.

PCI for 2018 = NI of 2018

Almost all the countries of the world take up the task of National Income Accounting, as it indicates the growth level of an economy.

NATIONAL INCOME ACCOUNTING IN INDIA #

In India, the National Income Unit of the Central Statistical Organization (CSO) estimates a major part of the National Income by using product method. Product Method takes into account the value of final goods and services produced in the country. Eg: Agriculture, animal husbandry, forestry, fishing, mining and factory establishments. Income Method is applied to estimate National Income in other sectors, where the income earned by the people in the form of rent, wages, salaries, interest and profit are considered. Eg: banking and other services. Through annual estimates of national income, the annual growth rate of an economy can be calculated.

Annual Growth Rate of an economy is the annual percent change of National Income. In other words, the annual growth rate is the percent change in National Income over the previous year. The level of savings and investments determine the amount of fund available for investment in the country. Higher the saving higher will be investment and hence higher growth rate. Usually saving in an economy are derived from government sector, corporate sector and the house hold sector.

Investment is the total amount of capital (money) invested to take up different economic activities. The efficiency of capital or the investment in an economy is calculated with the help of Capital-Output Ratio and Incremental Capital Output Ratio.

Capital-Output Ratio is the ratio which indicates the units of capital needed to produce one unit of output. If the value of capital-output ratio is high (for eg -7: l) then the efficiency of capital is very low. It means, to produce one unit of output seven units of capital is needed.

Incremental Capital Output Ratio (ICOR) is the number of units of investment needed to generate one unit of additional output in the future. The income level in a country will be high with high investments and high employment level and low unemployment level.

Employment refers to making use of one’s labour and getting in return some income. Whereas, unemployment is not making use of one’s labour

though available, and hence no income. It is the state where supply of labour is excess over the demand for labour.

There could be different types of Unemployment #

Under Open Unemployment many persons are left without a job though they are willing to work and are fit both physically and mentally. Agricultural Unemployment can take the form of disguised, under employmcnt or seasonal unemployment. Disguised Unemploymcnt is not easily recognized. More peo- ple are employed than the actual requirement. This results in low productivity of the labour For eg: An agricultural plot requires labour of five persons whereas ten persons might be actually working. A person can be said to be under employed if he has a job where his capacities are not utilized fully or which he thinks is not adequate for his purpose. In other words, the job may not be commensurate with his training or qualification. Under Seasonal Unem- ployment agricultural labourers are employed only during certain seasons like sowing and harvest. In other seasons they are left unemployed. People who are educated to certain levels and are left without job belong to enclosed unemployed class.

Usually there is a trade-off between the unem- ployment level and inflation in the economy. That is, if the government wants to control inflation, unem- ployment in the economy increases and vice-versa. But sometimes the economy experiences stagnation or unemployment along with a high rate of inflation. This situation is called as Stagflation. Stagflation is derived from words Stagnation arid Inflation.

Inflation is the continuous rise in the general price level of the economy. In other words, it is too much of money chasing too few goods. It is usually associated with increased supply of money in the economy. One of the major reasons for inflation is the existence of Black money in the economy. Black Money is the money which is not accounted for. It is the unaccounted or illegitimate transactions of production, consumption and investment. It runs parallel with the accounted economy, hence also referred as parallel economy. The Black Money can be in the form of money, gold, precious stones, land and building assets.

The generation of black money can be due to:

• High rates of taxation where people try to evade taxes and hence do not disclose their actual income.
• The unofficial market for foreign exchange dealing in illicit transactions like smuggling of goods, under invoicing of exports and over invoicing of imports lead to accumulation of unaccounted foreign exchange balances and there by increased dealings in hawala market.
• The Regime of Quantitative Restrictions like controls, permits, quotas, licenses (Permit Raj) etc has also contributed to the generation of black money.
• The other reasons could be Transactions in Real Estate Property, Donations to political parties, Inflation and weaknesses in the enforcement of tax laws.

High levels of inflation lead to certain drastic effects in the economy like high cost of living, lowered standard of life etc. Hence, government tries to control inflation in an economy. Monetary Measures are taken up where credit is controlled by controlling the supply of credit in the economy. It is taken up by Reserve Bank of India. Inflation is also controlled through demonetization of currency of higher denominations. It is usually adopted when there is abundance of black money in the economy.

To control inflation Fiscal Measures are adopted by way of reduction in unnecessary government expenditure, increase in taxes, and increase in sav- ings where the government should float public loans carrying high rates of interest, start saving schemes with prize money, or lottery for long periods, etc. It should also introduce compulsory provident fund, provident fund-cum-pension schemes etc compulso- rily. By way of Surplus Budget as Deficit financing is an inflationary budget policy. Therefore at infla- tionary periods government should give up deficit financing and go for surplus budgeting that is having more revenues and spending less. The government should stop repayment of public debt and postpone it to some future date till inflationary pressures are controlled within the economy. Instead, it should borrow more to reduce money supply in the country.

The inflation rate in the economy can be known with the help of movements in the general price level. It is difficult to find out the general movements in prices by examining changes of price in individual commodities. In a market economy price changes are common depending on the demand for and sup- ply of goods and services. Therefore, the concept of General Price level is used to find out the overall impact of individual price movements. The general price level can be known through Price Index and gives an idea as to whether there is price stability or not in the economy. Price Stability is the relative stability in the general price level in an economy and not the stability of individual prices or fixed prices.

The general price level is measured by a statis- tical tool called as Price Index. Price Index is the weighted average of prices of selected goods and services. The weights are assigned to each commod- ity based on their relative importance in the group of commodities that have been selected. In common terms, the group of commodities is referred as Bas- ket of goods. Two main types of price indices in an economy are Consumer Price Index and Wholesale Price Index.

Consumer Price Index (CPI) is the most widely used price indices. Consumer Price indices measure the general movements of prices of a representative basket of goods and services. Based on the survey of the spending patterns of consumers, goods and ser- vices are included in the basket and relative weights are assigned according to their relative importance. The relative importance is found out through the proportion of expenditure incurred on each item. That is, goods and services that account for larger portions of the total expenditure of consumers are assigned greater weights.

Wholesale Price Index (WPI) indicates the gen- eral price level with reference to Wholesale Prices. WPI is developed for various groups of commodities like primary articles (consumer), fuel and power, manufactured products and also in general for all type of commodities. There will be movements in the general price level as per the fluctuations in the economic activities.

Business Cycle or Economic Cycle or Trade Cycle refers to the periodic fluctuations in the economy over a period of time. It involves peri- ods of relatively rapid growth of output (recovery

and prosperity) alternating with periods of relative decline or stagnation (contraction or recession).

These fluctuations have serious implications on Business community as they have to face drastic effects during recession (decline in economic activity, deflation) and depression. They should be ready to cope with the effects of depression. Deflation is the continuous fall in the general price of the economy. Money supply during deflationary periods will be usually low in the economy. Continuous existence of deflation leads to Depression, the stage of lowest economic activity. Production, Price Level, Income, Profits etc., will be lowest. But during the period of recovery and prosperity (rapid expansion of economic activity, inflation) the business community reaps high profits due to increasing price levels in the economy.

Poverty is the condition of people or social phenomenon where there is lack of even basic neces- sities of life like food, shelter and clothing. People stricken with poverty are deprived of facilities like health, education, employment etc.

Apart from poverty estimates, there are other indicators which indicate the quality and the stand- ard of living of the population like Demographic Indicators including Gender Empowerment Measure and Human Development Index.

DEMOGRAPHIC INDICATORS IN- CLUDE #

Infant Mortality Rate (IMR) is the number of infants who die per 1000 live births.

Maternal Mortality Rate (MMR) is the number of mothers who die at the time of delivery per 1000 live births.

Life Expectancy at Birth or longevity is the expected life span of the population in years, from birth to death.

Literacy Rate (Percentage of population who are able to read and write).

Sex Ratio is the number of females per 1000 males.

Gender Empowerment Measure (GEM) – In 1995 the United Nations Development Program (UNDP) introduced a new index to quantify the economic and political position of women relative to men in a given society. It identifies the percentage of women occupying administrative and managerial

posts, working in professional and technical occu- pations and holding seats in parliament, as well as their level of earned income relative to men.

Human Development Index (HDI) #

The UNDP has been using the index on human development since 1990, with the publication of First Human Development Report.

The HDI is a composite index of three social indicators namely life expectancy or longevity, adult literacy rate, years of schooling and real GDP per capita.

Important Factopedia #

Key economic indicators – GVA & GDP at Constant prices (Base year 2011-12)

Issued	Monthly
Issued by	The Central Statistics Office (CSO) (Ministry of Statistics and Program Implementation). CSO also releases Quarterly Estimates of National Income/ GDP at constant price (Base 2011-12).
Gross     Domestic Product (GDP)	Market value of all final goods and services taking place within the domestic economy during a year.Or GDP at market price = Gross Value Added (GVA) at basic price + Indirect tax- Subsidies
Gross       National Product (GNP)	GDP Add: Income earned by the domestic factors of production employed in the rest of the world. (i.e. Indians or Indian companies abroad). Less: Income earned by the factors of production of the rest of the world employed in the domestic economy. ( i.e. profit earned by MNCs in India e.g. Google, IBM). Hence, GNP = GDP + Net factor income from abroad.
Net National Prod- uct (NNP)	NNP = GNP – Depreciation.

NNP at factor cost or National Income

All above variables are evaluated at market prices. But market price includes indirect taxes. Indirect taxes accrue to the government. National Income = NNP at market prices – Indirect taxes + Subsidies.

ECONOMIC POLICY #

Before discussing economic policy and its crite- ria, it is important to understand what is economic policy?

Actions taken by a government to influence its economy are termed as economic policy.

In India, the perfect example of economic policy is planning and the resulting five year plans. India adopted a mixed economy where both public sector and private sector would play a role in the economy. Thus, our industrial policy resolution, 1948 and later 1956, revolved around that philosophy. The second five year plan was centered around industrialization and the country opened 4 steel plans in collaboration with foreign countries.

In 1965, India embarked on green revolution and resulted in improving the agriculture sector tremen- dously. At the same time, it solved the problem of food security for India. All these are actions taken by the government that has influenced the economy in some way or the other. Influence is a word that may not do justice to what these policies have done. They have defined Indian economy, developed the path of its future and its growth.

The following section talked about the formula- tion of economic policy and the principles guiding the policy makers.

Economic theory helps us to understand how the world works, but the formulation of economic policy requires much more. It needs to have objectives. What do we want to change? What is good and what is bad about the way the system is operating? Can we make it better?

The following four criterions are often applied on making such judgments:

• Efficiency: means allocative efficiency. An

efficient economy is one that produces what people want at the least possible cost. If the system allocates resources to the production of things that nobody wants, it is inefficient. Suppose, majority of people in a city want a flyover constructed but the government chooses to build a BRT, then it is an ineffi- cient allocation.

• Equity: implies a more equal distribution of income and wealth. It is difficult to define equity. Equity may imply poverty allevia- tion, but the extent to which the poor should receive cash benefits from the government is the subject of enormous disagreement.
• Growth: is often defined in terms of economic growth. Economic growth is an increase in the total output of an economy. If output grows faster than the population, output per capita rises and, standards of living increase. Defin- ing growth in terms of economic growth has drawn criticism of various economists. Other ways of defining growth are discussed later.
• Stability: refers to the condition in which national output is growing steadily, with low inflation and full employment of resources.

MARKET   FORCES   OF   DEMAND AND SUPPLY #

When monsoons fail in India, the prices of food rise throughout the country. As the mercury levels rise in Delhi, prices of hotel rooms in Shimla rise. During the summer holidays of children, the prices of air tickets rise. What do all these events have in common? They all show the working of demand and supply.

Supply and demand are the two words econo- mists use most often. They determine the quantity of each good produced and the price at which it is sold. If one wants to know how any event or policy will affect the economy, one must think first about how it will affect supply and demand. This is the theory of demand and supply. It considers how buyers and sellers behave and how they interact with one another. It shows how supply and demand determine prices in a market economy and how prices, in turn, allocate the economy’s scarce resources.

DEMAND #

The quantity demanded of any good is the amount of the good that buyers are willing and able to purchase. Many things determine the quantity demanded of any good, but when analyzing how markets work, one determinant plays a central role – the price of good. If the price of the ice cream rose to Rs. 100 per scoop, you would buy less ice cream. If the price of ice cream fell to Rs. 10 per scoop, you would buy more. Because the quantity demanded falls as the price rises and rises as the price falls, we say that the quantity demanded is negatively related to the price. This relationship between price and quantity demanded is true for most goods in the economy and, in fact, is so pervasive that economists call it the law of demand.

Other things equal, when the price of a good rises, the quantity demanded of the good falls, and when the price falls, the quantity demanded rises.

The downward-sloping line relating price and quantity demanded is called the demand curve.

Shift in the Demand Curve #

Any change that increases the quantity demanded at every price shifts the demand curve to the right and is called an increase in demand. Any change that reduces the quantity demanded at every price shifts the demand curve to the left and is called à decrease in demand.

There are many variables that can shift the demand curve. These are as follows;

• Income: In order to understand the effect of an increase or decrease in income we first need to distinguish between normal goods’ and inferior goods.
• Normal goods: good for which, other things equal, an increase in income leads to an increase in demand for example: ice cream. Thus, if the income falls, the demand for ice cream will fall and the demand curve will shift toward left and vice versa.
• Inferior goods: A good for which, other things equal an increase in income leads to a decrease in demand. For example, bus rides. As your income falls, you are less likely to buy a car or take a cab and more likely to ride in a bus.

• Prices of Related Goods: In order to under- stand the effect of an increase or decrease in price of related goods we first need to distin- guish between substitutes and complements.
• Substitutes: Two goods for which increase in the price of one leads to an increase in the demand for the other: For example ice cream and frozen yogurt. If the price of frozen yogurt rises, then people will demand less and less of yogurt and the demand for its nearest substitute i.e. ice cream will increase.
• Complements: Two goods for which an increase in the price of one leads to a decrease in the demand for the other. For example, suppose that price of hot fudge falls. Accord- ing to the law of demand, people will buy more hot fudge. Yet in this case the demand for ice cream will also increase because hot fudge and ice cream is used together. Other example can be petrol and car, computers and software etc.
• Tastes: The most obvious determinant of demand is the taste of an individual. If an individual likes ice cream, then he will buy more of it. Thus, change in taste shifts the demand curve as well.
• Expectations: Expectations about the future may affect the demand for a good or service today. For example, if one expects to earn a higher income next month, one may choose to save less now and spend more of current income on buying ice-cream. .
• Number of buyers: Because market demand is derived from individual demands, it depends on all those factors that influence individual demand (the factors mentioned above). In addition, it also depends on num- ber of buyers. If Sahil, another consumer of ice cream was to join Amit and Neha, the quantity demanded in the market would be higher at every price, ‘and the demand curve would shift to the right.

EXCEPTION   TO    THE   LAW   OF DEMAND #

Giffen goods are the goods that do not comply with the law of demand. It is a good for which

demand increases as the price increases and falls when the price decreases. A Giffen good has an upward-sloping demand curve, which is contrary to the fundamental law of demand, which states that quantity demanded for a product falls as the price increases, resulting in a downward slope for the demand curve. A Giffen good is typically an inferior product that does not have easily available substitutes.

The most commonly cited example of a Giffen good is that of the Irish potato famine in the 19th century. During the famine, as the price of potatoes impoverished consumers had little money left for more nutritious but expensive food items like meat (the income effect). So even though they would have preferred to buy more meat and fewer potatoes (the substitution effect), the lack of money led them to buy more potatoes and less meat.

• Natural calamities: Natural calamities give rise to emergency situations. In situations like flood and famine people usually stock up the goods to avoid any shortages even though when there may be a price increase. The most recent example that we can give is that of the Uttarakhand calamity in India. Here the people were in grave need of food and water and during such times prices hardly matter.
• Latest fashion trends: Youngsters everywhere generally follow the latest that are in fashion. Products in vogue are bought by consumers even witness price increase. Also out of fash- ion products do not find many takers, even when their prices are cut.
• Anticipation of prices: If the consumers are expecting the prices to rise further then they will buy more in present to avoid buying at higher prices in the near future. Similarly if the prices are falling then the consumers will buy-less to enjoy the advantages of reduced prices later on.

SUPPLY #

The quantity supplied, of any good or service is the amount that sellers are and able to sell. There are many determinants of quantity supplied, but once again, price plays a special role in our analysis. When the price of ice cream is high, sell ice cream is profitable, and so the quantity supplied is large.

By contrast, when the price of ice cream is low, the business is less profitable, and so sellers produce less ice-cream. At a low price some sellers may even choose to shut down, and their quantity supplied falls to zero. Because the quantity supplied rises as the price rises and falls as the price falls, we say that the quantity supplied is positively related to the price of the good. The relationship between price and quantity supplied is called the law of supply:

Other things equal, when the price of a good rises, the quantity supplied of the good also rises, and when the price falls, the quantity supplied falls as well.

Shifts in the Supply Curve #

Any change that raises quantity supplied at every price, shifts the supply curve to the right and is called an increase in supply. Similarly, any change that reduces the quantity supplied at every price shifts the supply curve to the left and is called a decrease in supply. The important variables that shift the supply curve are as follows:

• Input Prices: To produce its output of ice cream, sellers use various inputs:

cream, sugar, flavouring, ice – cream machines, the buildings in which the ice cream is made, and the labour of workers to mix the ingre- dients and operate the machines. When the price of one or more of these inputs rises, producing ice cream is less profitable, and firms supply less ice cream.If input prices rise substantially, a firm might shut down and supply no ice cream at all. Thus, the supply of a good is negatively related to the price of the inputs used to make the good.

• Technology: The technology for turning inputs into ice cream is another determinant of supply. The invention of the mechanised ice- cream machine, for example, reduced the amount of labour necessary to make ice cream. By reducing firms’ cost, the advance in technology raised the supply of ice cream.
• Expectations: The amount of ice cream a firm supplies today may depend on its expectations of the future. For example, if a firm expects the price of ice cream to rise

in the future, it will put some of its current production into storage and supply less to the market today.

• Numbers of Sellers: Market supply depends on all those factors that influence the supply of individual sellers, such as the price of inputs used to produce the good, the available technology, and expectations. In addition, the supply in a market depends on the number of sellers.

Exceptions To Law Of Supply #

What if there is decrease in quantity supplied with rise in price and vice versa?

Such situations are called as exceptions to the law of supply simply because they do not follow this law. Following are the exceptions to the law of supply:

• Expectations regarding future prices: When the sellers expect the prices to rise in the future then they may adopt wait and watch policy and withhold their supply of goods. Even though the price may be higher the sellers may want to supply the goods when the prices rise even more which would fetch them good returns. Also if the sellers expect the prices to fall in the coming days then they may sell off their goods at existing lower prices in order to avoid losses.
• Farm produce: In case of farm products, weather plays an important role. Such prod- ucts may not obey the law of supply as they may not react to changes in prices due to heavy dependency on weather conditions.
• Perishable commodities: The commodities fall in different classes and not all of them can be stored for a longer period of time. Certain commodities have very short shelf life and they need to be made available in the market before they perish. The common examples of perishable goods are fruits, sea produce, flowers, meat, and vegetables and so on. So for such goods the sellers cannot simply wait for a longer time and supply these in the market even when the prices are not rising.

• Out of fashion goods: When goods are in fashion then the sellers can command a high price. But there are certain goods that go out of fashion and are no longer in demand. Such goods are supplied by the sellers at low prices in order to clear these goods.
• Economic Slowdown: The businesses pass through different phases and the sellers have to adapt to these changes. During the low economic phases the sellers may not have advantage of high prices and hence during such tough times goods are sold even when they do not witness price rise in order to recover their costs. So the law of supply is not applicable in this case.
• Change in business: It may happen that the seller may plan to enter into an entirely new area of business by exiting the current one. So when the present business is on the verge of closure then the seller may sell the goods at lower prices simply to clear them off. So here too the law of supply is not followed.
• Immediate requirement of funds: The seller may face a time when he is in immediate need of funds. In such situation he may supply the goods in the market even at lower prices.
• Supply of labour: Another fine example of the exception to the law of supply is the labour supply. The workers are interested in high wages till a certain point. Once that point is achieved they may like to devote their time to leisure activities. So after a particular point the workers may no longer be interested in higher wages. This simply means that initially the supply of labour is directly related to the wages but after a certain level the relation between wages and supply of labour becomes inversely related.

There is one point at which the supply and demand curves intersect. This point is called the market’s equilibrium. The price at this intersection is called the equilibrium price, and the quantity is called the equilibrium quantity. At the equilibrium price, the quantity of the good that buyers are willing and able to buy exactly balances the quantity that sellers are willing and able to sell. The equilibrium

price is sometimes called the market- clearing price because, at this price, everyone in the market is sat- isfied. Buyers have bought all they want to buy, and sellers have sold all they want to sell. The actions of buyers and sellers naturally move markets towards the equilibrium of supply and demand.

There is surplus of the goods: Suppliers are unable to sell all they want at the going price. A surplus is something called a situation of express supply. They respond to the surplus by cutting their prices. Falling prices, in turn, increase the quantity demanded and decrease the quantity supplied. Prices continue to fall until the market reaches the equilibrium.

Suppose now that the market price is below the equilibrium price, then there is a shortage of the good: Demanders are unable to buy all they want at the going price. A shortage is sometimes called a situation of excess demand. With too many buyers chasing too few goods, sellers can respond to the shortage by raising their prices without losing sales. As the price rises, the quantity demanded falls, the quantity supplied rises, and the market once again moves toward the equilibrium. The activities of the many buyers and sellers automatically push the market price toward the equilibrium price.

Elasticity of Demand #

The law of demand states that a fall in the price of good raises the quantity demanded. The price elasticity of demand measures how much the quantity demanded responds to a change in price.

Elasticity of demand = Percentage change in quantity demanded/percentage change in price

The price elasticity of demand is always negative as price and quantity move in opposite directions (law of demand). Demand for a good is said to be elastic if the quantity demanded responds substan- tially to changes in the price. Demand is said to be inelastic if the quantity demanded responds only slightly to changes in the price.

The price elasticity of demand for any good measures how willing consumers are to move away from the good as its price rises. Thus, the elasticity reflects the many economic, social and psycholog- ical forces that shape consumer tastes. Based on experience, however, we can state some general

rules about what determines the price elasticity of demand.

Availability of Close Substitute #

Goods with close substitute tend to have more elastic demand because it is easier for consumer to switch from that good to others. For example, tea and coffee are easily substitutable. A small increase in the price of tea, assuming the price of coffee is held fixed, causes the quantity of tea sold to fall by a large amount.

Necessities versus Luxuries #

Necessities tend to have inelastic demands, whereas luxuries have elastic demands. When the price of a visit to the doctor rises, people will not dramatically alter the number of times they go to the doctor. By contrast, when the price of televi- sion rises, the quantity of televisions demanded falls substantially. The reason is that most people view doctor visits as a necessity and television as a luxury. Whether a good is a necessity or a luxury depends not on the intrinsic properties of the good but on the preference of the buyer.

The Horizon #

Goods tend to have more elastic demand over longer time horizons. When the price of petrol rises, the quantity of petrol demanded falls only slightly in the few months. Over time, however, people buy more fuel- efficient cars, switch to public transpor- tation, and move closer to where they work. Within several years, the quantity of petrol demanded falls substantially.

ELASITICITY OF SUPPLY AND ITS DETERMINANTS #

The law of supply states that higher prices raise the quantity supplied. The price elasticity of supply measures how much the quantity supplied responds to a change in price. Supply for a good is said to be elastic if the quantity supplied responds substantially to changes in the price. Supply ¡s said to be inelastic if the quantity supplied responds only slightly to changes in the price.

Elasticity of supply = Percentage change in quantity supplied/percentage change in price.

The price elasticity of supply depends on the flexibility of sellers to change the amount of the good they produce. For example, beachfront land has an inelastic supply because it is almost impossible to produce more of it. By contrast, manufactured goods such as books, cars and televisions have elastic supplies because firms that produce them can run their factories longer in response to a higher price.

In most markets, a key determinant of the price elasticity of supply is the time period being consid- ered. Supply is usually more elastic in the long run than in the short run. Over short periods of time, firms cannot easily change the size of their factories to make more or less of a good. Thus, in the short run, the quantity supplied is not very responsive to the price. By contrast, over long periods of time, firms can build new factories or close old ones. In addition, new firms can enter the market, and old firms can shut down. Thus, in the long run, the quantity supplied can respond substantially to price changes.

TYPES OF MARKET #

Perfectly Competitive Market #

The meaning of Competition: Acompetitive market, sometimes called a perfectly competitive market, has two characteristics:

• There are many buyers and many sellers in the market
• The goods offered by the various sellers are largely the same.

As a result of these conditions, the actions of any single buyer or seller in the market have a negligible impact on the market price. Each buyer and seller takes the market price as given.

As an example, consider the market for milk. No single consumer of milk can influence the price of milk because each buyer purchases a small amount relative to the size of the market. Similarly, each dairy farmer has limited control over the price because many other sellers are offering milk that is essentially identical. Because each seller can sell all he wants at the going price, he has little reason to charge less, and if he charges for more, buyers will go elsewhere. Buyers and sellers in competitive markets must accept the price the market determines

and, therefore, are said to be price takers.

In addition to the foregoing two conditions for competition, there is a third condition sometimes thought to characterize perfectly competitive markets.

Firms can freely enter or exit the market. If, for instance, anyone can decide to start a dairy firm, and if any existing dairy farmer can decide to leave the dairy business, then the dairy industry would satisfy this condition.

MONOPOLY #

If you own a personal computer, it probably uses some version of Windows, the operating system sold by the Microsoft Corporation. When Microsoft first designed Windows many years ago, it applied for and received a copyright from the government. The copyright gives Microsoft the exclusive right to make and sell copies of the Windows operating sys- tem. So if a person wants to buy a copy of Windows, he or she has little choice but to give Microsoft the approximately same price that the firm has decided to charge for its product. Microsoft is said to have a monopoly in the market for Windows.

A monopoly such as Microsoft has no close competitors and, therefore, can influence the market price of its product. While a competitive firm is a price taker, a monopoly firm is a price maker.

Why Monopoly arises? #

A firm is a monopoly if it is the sole seller of its product and if its product does not have close substitutes. The fundamental cause of monopoly is barrier to entry: A monopoly remains the only seller in its market because other firms cannot enter the market and compete with it. Barriers to entry, in turn, have three main sources:

• A Key source is owned by a single firm.
• The government gives a single firm the exclu- sive right to produce some good or service.
• The costs of production make a single producer more efficient than a large number of producers.

Natural Monopolies #

An industry is a natural monopoly when a single firm can supply a good or service to an entire market at a lower cost than could two or more firms. An

example of a natural monopoly is the distribution of water. To provide water to the residences of a town; a firm must build a network of pipes throughout the town. If two or more firms were to complete in the provision of this service, each firm would have to pay the fixed cost of building a network. Thus, the average total cost of water is lowest if a single firm serves the entire market.

IMPERFECT MARKETS #

If you go to a store to buy shampoo in India, it is likely that you will come home with one of three brands: P&G, HUL and Khadi. These three companies make almost all of the shampoos sold in India. Together, these firms determine the quantity of shampoo produced and, given the market demand curve, the prices at which shampoos are sold. How can we describe the market for shampoo?

In a competitive market, each firm is so small compared to the market that it cannot influence the price of its product and, therefore, takes the price as given by market conditions. In a monopolized market, a single firm supplies the entire market for a good, and that firm can choose any price and quantity on the market demand curve.

The market for shampoo fits neither the com- petitive nor the monopoly model. Competition and monopoly are extreme forms of market structure. Firms in these industries have competitors but, at same time, do not face so much competition that they are price takers. Economists call this situation imperfect competition.

The first type of imperfectly competitive market is an oligopoly, which is a market with only a few sellers, each offering a product similar or identical to the others. The market for shampoo is one example, but there are many others such as airline industry, mass media, pharmaceuticals etc.

A second type of imperfectly competitive market is called monopolistic competition. This describes a market structure in which there are many firms selling products that are similar but not identical. Examples include the markets for novels, movies, CDs and computer games.

In a monopolistically competitive market, each firm has a monopoly over the product it makes, but many other firms make similar products that compete

for the same customers. In order to establish in such an industry, the seller has to incur high advertising costs.

ECONOMIC PLANNING #

Under this topic we will be discussing two types of economic planning i.e. imperative and indicative planning India had imperative planning, before 1991 but after the watershed reforms of 1991, we have indicative planning.

Imperative Planning #

Under this type of planning, economic decisions are made through a central planning authority. Allocated of resources, the mix of output and the distribution of output among the people i.e., ‘What, How and for whom’ problems are determined centrally accordance with the pre-determined plans and targets. In India, this was done by the Planning commission and Industrial Policy Resolution, 1948 laid out all rules to be followed by the industrial sector.

Advantages:

Imperative planning is comprehensive as it includes the entire facet of an economy. Thus, economic activities, under imperative planning, are carried out so as to maximize production and welfare of the people.

Deficiencies:

It is often argued that under this kind of planning neither consumers nor producers enjoy any free- dom and sovereignty. They behave in the way the state wants. Further, imperative planning based on bureaucratic controls and regulations and direction can lead to corruption and red-tapism (as was the case in India).

Indicative Planning #

Under indicative planning those industries and sectors are identified where future growth is to be encouraged. Its endeavor is to develop the core sector through allocation and optimal utilization of funds. The plan must provide the broad blueprint for achieving the essential social and economic objectives and indicate the direction in which the entire economy as well as its various sectors and sub- sectors should be moving. Thus, identification

of these areas and channeling the resources to those areas are an integral part of planning.

Indicative planning is the planning by induce- ment. Thus, the essence of indicative planning is that it recognizes not only consumers’ sovereignty but also producers’ freedom so that the target and priorities of the plans are achieved. It then involves a middle path of planning mechanism and market mechanism a kind of coordination between private and public activities.

India’s Eighth plan was unique in the sense that it attempted to manage the transition from a centrally planned economy, to a market-oriented economy and oriented itself to the indicative planning.

Indicative planning provides a broad framework but gives widespread freedom to private sector to define own course of growth. Thus, it provides adequate incentives to all the participants in the economy to grow and eventually increasing overall welfare in the economy.