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Page 1: Managerial Economics - jnujprdistance.comjnujprdistance.com/assets/lms/LMS JNU/MBA/MBA - Retail Manageme… · 2.1 Introduction ... Managerial Economics. Managerial Economics. 5

Managerial Economics

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Copyright © 2013 by Universal Training Solutions Pvt. Ltd., Pune, Maharashtra (uts)This book contains the course content for Managerial Economics.

First Edition 2013

Printed & Published byutsBavdhan, Pune - 411021

Website: www.utsglobal.edu.in

All rights reserved. This book or any portion thereof may not, in any form or by any means including electronic or mechanical or photocopying or recording, be reproduced or distributed or transmitted or stored in a retrieval system or be broadcasted or transmitted without the prior written permission of the publisher & author i.e. uts.

uts makes reasonable endeavors to ensure content is current and accurate. uts reserves the right to alter the content whenever the need arises and to vary it at any time without prior notice.

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Index

Content ........................................................................ II

List of Figures .......................................................... VII

List of Tables .......................................................... VIII

Abbreviations ............................................................IX

Case Study .............................................................. 115

Bibliography ............................................................ 119

Self Assessment Answers ........................................ 122

Book at a Glance

I

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II

Contents

Chapter I ....................................................................................................................................................... 1Basics of Economics ..................................................................................................................................... 1Aim ................................................................................................................................................................ 1Objectives ...................................................................................................................................................... 1Learning outcome .......................................................................................................................................... 11.1 Introduction .............................................................................................................................................. 21.2 Meaning and Definition of Economics .................................................................................................... 21.3 Economics Basics .................................................................................................................................... 21.4 Macroeconomics and Microeconomics ................................................................................................... 21.5 The Two Basic Concepts of Economics................................................................................................... 2 1.5.1 Production Possibility Frontier (PPF) ...................................................................................... 2 1.5.2 Opportunity Cost ...................................................................................................................... 41.6 Market Economy ...................................................................................................................................... 41.7 Command Economy ................................................................................................................................. 41.8 Choice as an Economic Problem ............................................................................................................. 51.9 Central Problems of an Economy ............................................................................................................ 51.10 Market Mechanism ................................................................................................................................ 51.11 Positive Economics and Normative Economics .................................................................................... 51.12 Inductive Method and Deductive Method of Economic Analysis ......................................................... 6Summary ....................................................................................................................................................... 8References ..................................................................................................................................................... 8Recommended Reading ............................................................................................................................... 8Self Assessment ............................................................................................................................................. 9

Chapter II ....................................................................................................................................................11Demand, Supply and Product Management ............................................................................................11Aim ...............................................................................................................................................................11Objectives .....................................................................................................................................................11Learning outcome .........................................................................................................................................112.1 Introduction ............................................................................................................................................ 122.2 Concept of Demand ............................................................................................................................... 122.3 Demand Schedule and Concept ............................................................................................................. 12 2.3.1 Market Demand Curve ........................................................................................................... 12 2.3.2 Law of Demand ..................................................................................................................... 132.4 Price Elasticity of Demand .................................................................................................................... 13 2.4.1 Types of Demand ................................................................................................................... 132.5 Factors Affecting Demand ..................................................................................................................... 142.6 Concept of Supply .................................................................................................................................. 14 2.6.1 Supply Schedule and Concept ............................................................................................... 14 2.6.2 Market Supply Curve ............................................................................................................. 15 2.6.3 Law of Supply ........................................................................................................................ 16 2.6.4 Price Elasticity of Supply ...................................................................................................... 16 2.6.5 Types of Supply ..................................................................................................................... 16 2.6.6 Factors Affecting Supply ....................................................................................................... 172.7 Equilibrium in Demand and Supply ...................................................................................................... 172.8 Equilibrium as per the Change in Demand and Supply ......................................................................... 182.9 Tax Impact on Price or Quantity of Goods ............................................................................................ 212.10 Perfect Competition ............................................................................................................................. 212.11 Economic Factors Related to Industry with Perfect Competition ........................................................ 22 2.11.1 Marginal Revenue ................................................................................................................ 222.12 Perfect Competition in Short Run ........................................................................................................ 232.13 Perfect Competition in Long Run ........................................................................................................ 24 2.13.1 Economic Profit and Losses ................................................................................................ 24

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III

2.13.2 Zero Economic Profit in Long Run ..................................................................................... 242.14 Monopoly Market ................................................................................................................................ 242.15 Characteristics of Monopoly Firm ....................................................................................................... 242.16 Factors of Monopoly Power ................................................................................................................. 242.17 Monopoly and Market Demand ........................................................................................................... 252.18 Marginal Decision Rule in Monopoly Market ..................................................................................... 252.19 Oligopoly Market ................................................................................................................................. 262.20 Concentration in Oligopoly .................................................................................................................. 262.21 Game Theory and Oligopoly Behaviour .............................................................................................. 27Summary ..................................................................................................................................................... 29References ................................................................................................................................................... 29Recommended Reading ............................................................................................................................. 29Self Assessment ........................................................................................................................................... 30

Chapter III .................................................................................................................................................. 32Analysis of Consumer Choice, Production Analysis and Cost Concept ................................................ 32Aim .............................................................................................................................................................. 32Objectives .................................................................................................................................................... 32Learning outcome ........................................................................................................................................ 323.1 Introduction ............................................................................................................................................ 333.2 Utility Theory ......................................................................................................................................... 33 3.2.1 Total Utility (TU) ................................................................................................................... 33 3.2.2 Marginal Utility (MU) ........................................................................................................... 33 3.2.3 Budget Constrain ................................................................................................................... 353.3 Production Analysis ............................................................................................................................... 363.4 Short Run Production Function ............................................................................................................. 36 3.4.1 Total, Marginal and Average Product..................................................................................... 363.5 Cost Concept .......................................................................................................................................... 38 3.5.1 Total Cost and Marginal Cost ................................................................................................ 38 3.5.2 Average Total Cost ................................................................................................................. 393.6 Relationship between Marginal Cost, Average Fixed Cost, Average Variable Cost and

Average Total Cost in Short Run ........................................................................................................... 393.7 Cost Concept in Long Run ..................................................................................................................... 403.8 Economy of Scale, Diseconomy of Scale and Constant Return to Scale .............................................. 40Summary ..................................................................................................................................................... 42References ................................................................................................................................................... 42Recommended Reading ............................................................................................................................. 42Self Assessment ........................................................................................................................................... 43

Chapter IV .................................................................................................................................................. 45The Nature of Factor Demands ................................................................................................................ 45Aim .............................................................................................................................................................. 45Objectives .................................................................................................................................................... 45Learning outcome ........................................................................................................................................ 454.1 Introduction ............................................................................................................................................ 464.2 Income and Wealth ................................................................................................................................. 46 4.2.1 Income ................................................................................................................................... 46 4.2.2 Wealth .................................................................................................................................... 474.3 Input Pricing by Marginal Productivity ................................................................................................. 474.4 The Nature of Factor Demands .............................................................................................................. 47 4.4.1 Factors Demands and Derivation ........................................................................................... 47 4.4.2 Factors Demands are Interdependent ..................................................................................... 484.5 Distribution Theory and Marginal Revenue Product ............................................................................. 484.6 The Demand for Factors of Production.................................................................................................. 49 4.6.1 Rule for Choosing the Optimal Combination of Inputs ......................................................... 49

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IV

4.6.2 Least-Cost Rule ...................................................................................................................... 49 4.6.3 Marginal Revenue Product and the Demand for Factors ....................................................... 49 4.6.4 Substitution Rule .................................................................................................................... 504.7 Supply of Factors of Production ............................................................................................................ 504.8 Determination of Factor Prices by Supply and Demand ....................................................................... 514.9 The Distribution of National Income ..................................................................................................... 534.10 Marginal-Productivity Theory with Many Inputs ................................................................................ 54Summary ..................................................................................................................................................... 55References ................................................................................................................................................... 55Recommended Reading ............................................................................................................................. 55Self Assessment ........................................................................................................................................... 56

Chapter V .................................................................................................................................................... 58The Markets for Labor, Capital and Land .............................................................................................. 58Aim .............................................................................................................................................................. 58Objectives .................................................................................................................................................... 58Learning outcome ........................................................................................................................................ 585.1 The Labor Market ................................................................................................................................... 595.2 Fundamentals of Wage Determination ................................................................................................... 59 5.2.1 The General Wage Level ........................................................................................................ 59 5.2.2 Demand for Labor .................................................................................................................. 59 5.2.3 International Comparisons ..................................................................................................... 605.3 The Supply of Labor .............................................................................................................................. 60 5.3.1 Hours Worked ......................................................................................................................... 60 5.3.2 Labor-force Participation ....................................................................................................... 60 5.3.3 Immigration ........................................................................................................................... 605.4 Wage Differentials ................................................................................................................................... 61 5.4.1 Differences in Jobs: Compensating Wage Differentials ......................................................... 61 5.4.2 Differences in People: Labor Quality ..................................................................................... 61 5.4.3 Differences in People: The “Rents” of Unique Individuals .................................................. 61 5.4.4 Segmented Market and Noncompeting Groups ..................................................................... 615.5 Economics of Labor Union .................................................................................................................... 62 5.5.1 Effect of Unions on Wages and Employment ........................................................................ 625.6 Discrimination by Race and Gender ...................................................................................................... 625.7 Techniques to Determine Extent of Discrimination ............................................................................... 635.8 Reducing Labor Market Discrimination ................................................................................................ 635.9 Land and Rent ........................................................................................................................................ 635.10 Capital and Interest ............................................................................................................................... 635.11 Rate of Return on Capital Goods.......................................................................................................... 645.12 Financial Assets and Tangible Assets .................................................................................................... 64 5.12.1 Financial Assets and Interest Rates ...................................................................................... 64 5.12.2 Real and Nominal Interest Rates .......................................................................................... 645.13 Present Values of Asset ......................................................................................................................... 65 5.13.1 Present Value for Perpetuities ............................................................................................... 65 5.13.2 General Formula for Present Value ....................................................................................... 655.14 Profits ................................................................................................................................................... 66 5.14.1 Profits as Rewards for Innovation ........................................................................................ 66 5.14.2 Uncertainty and Profit .......................................................................................................... 66 5.14.3 Profits and Market Structure ................................................................................................ 665.15 The Theory of Capital and Interest ...................................................................................................... 66 5.15.1 Applications of Classical Capital Theory ............................................................................. 67Summary ..................................................................................................................................................... 68References ................................................................................................................................................... 68Recommended Reading ............................................................................................................................. 68Self Assessment ........................................................................................................................................... 69

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V

Chapter VI .................................................................................................................................................. 71International Trade ................................................................................................................................... 71Aim .............................................................................................................................................................. 71Objectives .................................................................................................................................................... 71Learning outcome ........................................................................................................................................ 716.1 Introduction ............................................................................................................................................ 726.2 Factors Determining Gains from Trade ................................................................................................. 73 6.2.1 Relative Differences in Cost Ratio ........................................................................................ 73 6.2.2 Reciprocal Demand ................................................................................................................ 736.3 The Sources of International Trade in Goods and Services ................................................................... 736.4 Comparative Advantage among Nations ............................................................................................... 73 6.4.1 Ricardo’s Analysis of Comparative Advantage ..................................................................... 74 6.4.2 Autarky Equilibrium .............................................................................................................. 746.5 Economic Gains from Trade ................................................................................................................. 756.6 Extensions to Many Commodities and Countries .................................................................................. 76 6.6.1 Triangular and Multilateral Trade .......................................................................................... 766.7 Protectionism ......................................................................................................................................... 77 6.7.1 Trade Barriers ........................................................................................................................ 77 6.7.2 Tariffs ..................................................................................................................................... 77 6.7.3 Quotas .................................................................................................................................... 786.8 Difference between Tariffs and Quotas .................................................................................................. 786.9 Unsound Grounds of Tariff .................................................................................................................... 796.10 Potentially Valid Arguments for Protection ......................................................................................... 79 6.10.1 The Terms of Trade or Optimal Tariff Argument ................................................................. 79 6.10.2 Infant Industries ................................................................................................................... 80 6.10.3 Tariffs and Unemployment .................................................................................................. 80 6.10.4 Protection against Dumping ................................................................................................. 806.11 Negotiating Free Trade ......................................................................................................................... 80 6.11.1 Multilateral Agreements ....................................................................................................... 80 6.11.2 World Trade Organisation (WTO) ....................................................................................... 81Summary ..................................................................................................................................................... 82References ................................................................................................................................................... 82Recommended Reading ............................................................................................................................. 82Self Assessment ........................................................................................................................................... 83

Chapter VII ................................................................................................................................................ 85Government, Taxation and Expenditure ................................................................................................. 85Aim .............................................................................................................................................................. 85Objectives .................................................................................................................................................... 85Learning outcome ........................................................................................................................................ 857.1 Types of Economy ................................................................................................................................. 867.2 The Role of Government in the Economy .............................................................................................. 867.3 Tools of Government Policy ................................................................................................................... 877.4 Importance of Size of Government ........................................................................................................ 877.5 The Functions of Government ............................................................................................................... 887.6 Public Choice Theory ............................................................................................................................. 887.7 Government Expenditure ....................................................................................................................... 89 7.7.1 Nature of Government Expenditure ....................................................................................... 89 7.7.2 Objectives of Government Expenditure Classification .......................................................... 897.8 Economic Aspects of Taxation................................................................................................................ 907.9 Taxes Levied by Central Government .................................................................................................... 91 7.9.1 Direct Taxes ............................................................................................................................ 91 7.9.2 Indirect Taxes ......................................................................................................................... 927.10 Taxes Levied by State Governments and Local Bodies ....................................................................... 937.11 Tax Incidence ........................................................................................................................................ 94

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VI

7.12 Nature and Relevance of Regulation .................................................................................................... 947.13 Government Intervention on Public Interest ........................................................................................ 957.14 Instruments for Regulation ................................................................................................................... 96 7.14.1 Price Cap Regulation ........................................................................................................... 96 7.14.2 Revenue Cap Regulation ..................................................................................................... 96 7.14.3 Rate of Return Regulation ................................................................................................... 96 7.14.4 Benchmarking ...................................................................................................................... 977.15 Effects of Regulation............................................................................................................................ 977.16 Decline of Economic Regulation ......................................................................................................... 977.17 Deregulation ......................................................................................................................................... 987.18 Antitrust Policies .................................................................................................................................. 98 7.18.1 Antitrust Policy in US .......................................................................................................... 98 7.18.2 Indian Scenario .................................................................................................................... 997.19 Mergers: Law and Practice ................................................................................................................... 99 7.19.1 Merger or Amalgamation ..................................................................................................... 99 7.19.2 Acquisitions and Takeovers ................................................................................................ 100 7.19.3 Advantages of Mergers & Acquisitions.............................................................................. 1007.20 Efficiency of Competition Laws ........................................................................................................ 101Summary ................................................................................................................................................... 102References ................................................................................................................................................. 102Recommended Reading ........................................................................................................................... 102Self Assessment ........................................................................................................................................ 103

Chapter VIII ............................................................................................................................................. 105Natural Resource Management .............................................................................................................. 105Aim ............................................................................................................................................................ 105Objectives .................................................................................................................................................. 105Learning outcome ...................................................................................................................................... 1058.1 Introduction .......................................................................................................................................... 1068.2 Population and Resource Limitation .................................................................................................... 1068.3 Pollution, Environment and Development ........................................................................................... 1068.4 Natural Resource Economics ............................................................................................................... 1078.5 Conservation and Allocation of Natural Resources ............................................................................. 1088.6 Natural Resource Management ............................................................................................................ 1088.7 Environmental Economics ................................................................................................................... 1088.8 Externalities ......................................................................................................................................... 1098.9 Market Inefficiency .............................................................................................................................. 1098.10 Correcting Externalities ......................................................................................................................110 8.10.1 Coase Theorem ...................................................................................................................110 8.10.2 Cap and Trade .....................................................................................................................110 8.10.3 Individual Transferable Quotas (ITQs) ...............................................................................110 8.10.4 Economic Incentives and Disincentives (India) ..................................................................1108.11 Globalisation and Environment ...........................................................................................................111Summary ....................................................................................................................................................112References ..................................................................................................................................................112Recommended Reading ............................................................................................................................112Self Assessment ..........................................................................................................................................113

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VII

List of Figures

Fig. 1.1 Production possibility frontier .......................................................................................................... 3Fig. 1.2 Production possibility frontier shifts outward .................................................................................. 4Fig. 1.3 Derivation of Eagle curve for a normal good ................................................................................... 7Fig. 2.1 Market demand curve ..................................................................................................................... 13Fig. 2.3 Market supply curve ....................................................................................................................... 16Fig. 2.4 Equilibrium in demand and supply ................................................................................................. 17Fig. 2.5 Decrease in demand curve .............................................................................................................. 18Fig. 2.6 Increase in supply curve ................................................................................................................. 18Fig. 2.7 Decrease in supply .......................................................................................................................... 19Fig. 2.8 Price ceiling .................................................................................................................................... 20Fig. 2.9 Price floor ....................................................................................................................................... 20Fig. 2.10 Firm’s demand and industry equilibrium curve ............................................................................ 22Fig. 2.11 Marginal revenue and demand curve ............................................................................................ 23Fig. 2.12 Profit maximisation ...................................................................................................................... 23Fig. 2.13 Perfect competition vs. monopoly ................................................................................................ 25Fig. 2.14 Marginal decision rule in monopoly market ................................................................................. 26Fig. 2.15 Prisnor’s dilemma rule in organisation ......................................................................................... 28Fig. 3.1 Total utility ...................................................................................................................................... 35Fig. 3.2 Relation between marginal utility and demand curve .................................................................... 35Fig. 3.3 Total production curve .................................................................................................................... 37Fig. 3.4 Relationship between TP, MP and AP ............................................................................................ 38Fig. 3.5 Relationship between MC, AFC, AVC and ATC ........................................................................... 39Fig. 3.6 Short run and long run average total curve ..................................................................................... 40Fig. 4.1 Factors demands are derived .......................................................................................................... 48Fig. 4.2 Demand for inputs derived through marginal revenue products .................................................... 50Fig. 4.3 Supply curve for factors of production ........................................................................................... 51Fig. 4.4 Factor supply and derived demand interact to determine factor prices and income distribution ... 52Fig. 4.5 The markets for surgeons and fast food workers ............................................................................ 52Fig. 4.6 Marginal product principles determine factor distribution of income ............................................ 53Fig. 5.1 Demand for labor reflects marginal productivity ........................................................................... 59Fig. 5.2 As wages rise, workers may work fewer hours ............................................................................... 60Fig. 6.1 Production possibilities of wheat and cloth .................................................................................... 75Fig. 6.2 With many commodities, there is a spectrum of advantages .......................................................... 76Fig. 6.3 Triangular trades ............................................................................................................................. 76Fig. 6.4 The impact of protectionist policies ............................................................................................... 78Fig. 6.5 U.S. tariff rates, 1820–2005 ............................................................................................................ 81Fig. 7.1 The size of government-growth curve ............................................................................................ 87Fig. 7.2 Classification of Government Expenditure ..................................................................................... 89Fig. 8.1 Economic view of environment .................................................................................................... 109

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VIII

List of Tables

Table 2.1 Demand schedule and concept ..................................................................................................... 12Table 2.2 Market demand curve ................................................................................................................... 12Table 2.3 Types of demand .......................................................................................................................... 13Table 2.4 Factors affecting demand ............................................................................................................. 14Table 2.5 Supply schedule ........................................................................................................................... 14Table 2.6 Market supply curve ..................................................................................................................... 15Table 2.7 Types of supply ............................................................................................................................ 16Table 2.8 Factors affecting supply ............................................................................................................... 17Table 2.9 Equilibrium in demand and supply .............................................................................................. 17Table 2.10 Demand and supply .................................................................................................................... 19Table 2.11 Tax impact on price or quantity of goods ................................................................................... 21Table 3.1 Utility of goods ............................................................................................................................ 33Table 3.2 Marginal utility ............................................................................................................................. 34Table 6.1 Differences between domestic trade and international trade ....................................................... 72Table 8.1 Increasing trend in the resource usage, buildups and the effects on environment ...................... 107

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IX

Abbreviations

AFC - Average Fixed CostAPL - Average Product of LaborATC - Average Total CostCCI - Competition Commission of IndiaCRS - Constant Returns to ScaleDTAA - Double Tax Avoidance AgreementGATT - General Agreement on Trade and TariffsGDP - Gross Domestic ProductITQ - Individual Transferable Quotas LRAC - Long Run Average CostMRTP Act - Monopolies and Restrictive Trade Practices Act, 1969MP - Marginal ProductPEoD - Price Elasticity of Demand PEoS - Price Elasticity of SupplyPPF - Production Possibility FrontierTFC - Total Fixed CostTP - Total ProductTVC - Total Variable Cost

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Chapter I

Basics of Economics

Aim

The aim of this chapter is to:

define the basic concepts of economics•

explain scarce resources in terms of individual and nation•

explicate the concepts of macroeconomics and microeconomics•

Objectives

The objectives of the chapter are to:

elucidate the concept of scarce resources •

define PPF (Production Possibility Frontier) and opportunity cost•

explain market economy and command economy•

Learning outcome

At the end of this chapter, you will be able to:

understand the application of economics in real life scenario•

recognise the advantages of command economy•

identify market economy•

1

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1.1 IntroductionThe motive behind studying economics could be anything like, to make money, understand and be adept at the concepts of economics for in-general usage, or may be due to curiosity to know how technological revolutions and economic reforms give a new direction to our society.

1.2 Meaning and Definition of EconomicsEconomics may appear as study of complicated tables, charts, statistics and numbers, but more specifically, it is the study of optimum utilisation of scarce resources and constitutes the rational human behavior in the attempt to fulfil needs and wants.

With limited resources at hand, a common man, on a daily basis, has to make certain choices in tune with his budget to fulfil wants and needs. Economists are interested in the ‘choices’ that person makes, and inquire into why, for instance, one might choose to spend one’s money on a new DVD player instead of replacing the old TV. Economics, also called ‘Dismal Science’, is an in-depth study of certain aspects of society.

1.3 Economics BasicsScarcity is the concept between our limited resource and unlimited want and it is different for both individual and for country. Scarce resource for an individual is money, time and skill and for a country it is capital, labour force and technology.

All the resources are limited in comparison to all our wants and needs. So individuals and nation must take the decision on what goods and services they can afford. For example, if one chooses to buy an Air Conditioner, as opposed to four air coolers, that means one is in favour of high quality of technology rather than going for large quantity of cheap air coolers.

Each individual and nation will have different set of values and due to different level of scarce resources; their decision on utilisation of those resources is also different. Furthermore, because of scarcity, people and an economy must decide on how to allocate resources. In other words, we can say that Economics is a study that deals with the decision and allocation of the resources.

1.4 Macroeconomics and MicroeconomicsThere are two main categories of economics:MacroeconomicsIt is concerned with total output of a nation and the way that nation allocates its limited resources of land, labour and capital in an efficient way.

MicroeconomicsIt is more specific in its approach and is concerned with individuals and firms within the economy. By analysing human tendency and behavior, microeconomics shows how individuals respond to changes in price when there is change in demand and supply.

1.5 The Two Basic Concepts of EconomicsThe two basic concepts of economics are as follows:

Production Possibility Frontier (PPF)• Opportunity Cost•

1.5.1 Production Possibility Frontier (PPF)Under the category of macroeconomics, it represents the point at which an economy is producing goods and services more efficiently, therefore allocating resources in the best way possible. One can clearly understand the concept of PPF with the help of following figure.

Managerial Economics

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Product B: Cotton

Prod

uct A

: Win

e

Production PossibilityFrontier PPF

C

B

X

YA

Fig. 1.1 Production possibility frontier(Source:http://www.investopedia.com/terms/p/productionpossibilityfrontier.asp)

Imagine one economy that produces only wine and cotton. According to PPF, points A, B and C all appearing • on the curve, represents most efficient use of resources by the economy.Point X represents the most inefficient use of resources, while point Y represents the goal that an economy • cannot attain with the present levels of resources.From the chart, we can see that if an economy produces more wine, it must give up some resources used for • cotton production. If the economy starts producing more cotton (represented by points B and C), it would have to divert from wine production.If the economy moves from point B to C, wine output significantly reduces with small increase in cotton • production.Every nation must find out the ways for optimum allocation of resources so that they can achieve the PPF.• If the demand for wine is more than the cost of increasing its output is proportional to the cost of decreasing • cotton production.

In another scenarioIf there is change in technology, while the level of land, labour and capital remains same then the time required • in production of cotton and wine will decrease.Point X shows the most inefficient way of utilisation of resources.• When PPF shifts outward, as shown in the figure below, then we know that there is a growth in economy.•

When it shifts inwards, it indicates that the economy is shrinking as a result of decline in efficient allocation of resources.

3

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Product B: Cotton

Prod

uct A

: Win

e

Production PossibilityFrontier PPF

Shifts Outward

C

B

X

AY

Fig. 1.2 Production possibility frontier shifts outward(Source:http://www.investopedia.com/university/economics/economics2.asp)

An economy producing on the PPF curve is more theoretical than practical. In reality, an economy constantly struggles to reach an optimal production capacity. As scarcity compels an economy to give up one choice for another, the slope of the PPF will always be negative. Hence, if the production of A increases then for B it will decrease or vice versa.

1.5.2 Opportunity CostOpportunity cost is the value of what is given up in order to have something else. It is unique for each individual and determined by his or her needs, wants, time and resources (income). It is an important part of PPF because a country will decide how to best allocate its resources according to its opportunity cost.

For example, assume that an individual has a choice between two telephone services. If he or she were to buy the most expensive service, that individual may have to reduce the number of times he or she goes to the movies each month. Giving up these opportunities to go to the movies may be a cost that is too high for this person, leading him or her to choose the less expensive service.

Opportunity cost is different for each individual and nation. Thus, what is valued more than something else will vary among people and countries when decisions are made about how to allocate resources.

1.6 Market EconomyMarket Economy is a type of economic system in which the trading and exchange of goods and services and information takes place in a free market, and hence it is also called as free market economy. Free market is based on law of supply and demand and prices of goods and services. Producers decide which goods are to be produced in what quantity, depending on consumer demand.

For example, for years 2004-07, there was a huge rush in IT sector because of demand for IT professionals. There was phenomenal growth in various IT sector with many IT education firms flourishing to cater the needs. This shows how the demand factor influenced the economy. In the year 2009, there was a sharp decline in growth of various industries, which resulted in recession in all sectors. Eventually, the demand for IT professional also declined. For this reason, market economy is also called as Demand Driven Economy.

1.7 Command EconomyAn economy which is controlled by the government is called Command Economy. Here, the decisions what, when, how and from whom to produce, and so on, are taken by the centralised authority.Some of the advantages of command economy are:

In a command economy, government can utilise land, labour and capital to fulfil its economic and political •

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agendas. So the private players are reluctant to invest in command economy.For example, cholera is a widespread common disease in continents like Africa and Asia. Some of the world’s • major pharmaceutical industries like Pfizer and Novartis are not ready to invest in research of Cholera, because people of Africa and Asia are not in a position to pay full price of drugs. In a command economy, the state can take the initiative for R&D for the treatment.

1.8 Choice as an Economic ProblemHuman wants are unlimited but the means or resources to satisfy these wants are limited or scarce. Resources are not only scarce but they have alternative uses. This gives rise to the problem of choice in economics. For example, iron can be used for making tanks, it can be used for making trains, it can also be used for building houses. It is because of the various alternative uses of the resources that we have to decide about the best allocation of resources. Thus, economics develops principles for making the best use of available resources. (If our wants are limited or the resources are unlimited, or if the resources have no alternative uses, then there would have been no economic problem at all).

1.9 Central Problems of an EconomyHuman wants are unlimited but the means or resources to satisfy these wants are limited or scarce. Resources are not only scarce but they have alternative uses. This gives rise to the central problems of an economy. These are:

What to produce and in what quantities? This involves the allocation of scarce resources in relation to the • composition of total output in the economy.How to Produce? Whether to use labour intensive or capital intensive techniques of production• For Whom to Produce? This involves the distribution of national income among the members of the society.• How efficiently are the Resources being utilised? This is the problem of economic efficiency or welfare • maximisation where there has to be no wastage or misuse of resources.Problem of Full Employment: An economy must try to achieve full employment not only of labour but of all • its resources.Problem of Growth: An economy must make sure that it keeps expanding or developing so that it maintains • conditions of stability.

1.10 Market MechanismThe market mechanism, works through supply and demand in a free market economy. It acts as the principal organising force for economic efficiency. It solves all the central problems of an economy by efficiently allocating scarce resources among alternative uses.

It determines what to produce and how much to produce according to the criterion of maximum profit.• It allocates the different factors of production among their various uses according to the criterion of maximising • their incomes.It brings about an equitable distribution of income by causing resources to be allocated in the right directions.• It works to ration out the existing supplies of goods and services, utilises the economy’s resources fully and • provides the means for economic growth.

1.11 Positive Economics and Normative EconomicsPositive economics is concerned with ‘what is’ whereas Normative economics is concerned with ‘what ought to be’. Positive economics describe economic behaviours without any value judgment while normative economics evaluate them with moral judgment. Positive economics is objective while normative economics is subjective. The statement, “Price rise as demand increase” is related to positive economics, whereas the statement,” “Rising prices is a social evil” is related to normative economics.

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1.12 Inductive Method and Deductive Method of Economic AnalysisDeductive method involves reasoning or inference from the general to the particular or from the universal to the individual. Deduction involves four steps:

Selecting the problems • Formulating the assumptions • Formulating the hypothesis through the process of logical reasoning whereby inferences are drawn and • Verifying the hypothesis.•

Inductive method involves reasoning from particulars to the general or from the individual to the universal. This method derives economic generalisations on the basis of experiments and observations. In this method detailed data are collected on certain economic phenomenon and effort is then made to arrive at certain generalisations which follow from the observations collected. (The Engel’s Law and the Malthusian Theory of Population have been derived from inductive reasoning).

Giffen goods: Giffen goods may be any inferior commodity much cheaper than its superior substitutes, consumed mostly by the poor households as an essential consumer good. If price of such goods increases, its demand increases instead of decreasing because in case of a Giffen good the income effect of a price rise is greater than its substitution effect. Thus, the law of demand does not apply in case of Giffen goods. This phenomenon is known as Giffen paradox.

Consumer Surplus: The difference between the price a consumer is willing to pay and the price which he actually pays is consumer’s gain which is referred to as consumer’s surplus. The concept of consumer’s surplus may also be explained in terms of utility. Since, Marshall assumes constant MU of money, what a consumer is willing to pay for a commodity indicates his expected utility and what he actually pays measures the actual cost in terms of utility of money. The difference between the utility gained and the utility lost in acquiring the commodity is consumer’s satisfaction which Marshall calls the ‘consumer’s surplus’.

Income-Consumption Curve (ICC): The income-consumption curve may be defined as the locus of points representing various equilibrium quantities of two commodities consumed by a consumer at different levels of income, all other things remaining the same.

Price-Effect: The price-effect may be defined as the total change in the quantity consumed of a commodity due to a change in its price. Price effect is composed of two effects:

Income-Effect: The income-effect arises due to change in real income caused by the change in price of the • goods consumed by the consumer.Substitution-Effect: The substitution effect arises due to the consumer’s inherent tendency to substitute cheaper • goods for the relatively expensive ones.

Inferior goods: Inferior goods are those goods whose demand decrease as the income of the consumer increases. That is, the income-effect on inferior goods is negative.

The Engel Curve: The Engel curve shows the relationship between consumer’s income and his money expenditure on a particular good. The shape of the Engel curve depends on the shape of the income-consumption curve (ICC).

As shown in the following figure we can derive the Engel curve from the ICC.

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M1

M1

M2

M2

M4

M4

X1

X1

X2

X2

X3

X3

X4

X4

Quantity of X

Quantity of X

Engle curve

Quantity of Y

Total Income

ICCE4E3E2E1

M3

M3

Derivation of Eagle curve for a Normal Good

Fig. 1.3 Derivation of Eagle curve for a normal good(Source:http://www.investopedia.com/university/economics/economics2.asp)

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SummaryEconomics, also called ‘Dismal Science’, is an in-depth study of certain aspects of society.• Macroeconomics is concerned with total output of a nation and the way that nation allocates its limited resources • of land, labour and capital in an efficient way.Microeconomics is more specific in its approach and is concerned with individuals and firms within the • economy. Two basic concepts of economics are Production Possibility Frontier and Opportunity Cost.• Opportunity cost is the value of what is given up in order to have something else. It is unique for each individual • and determined by his or her needs, wants, time and resources (income).Market Economy is a type of economic system in which the trading and exchange of goods and services and • information takes place in a free market, and hence it is also called as free market economy.An economy which is controlled by the government is called Command Economy.• Human wants are unlimited but the means or resources to satisfy these wants are limited or scarce. Resources • are not only scarce but they have alternative uses.The market mechanism, works through supply and demand in a free market economy. It acts as the principal • organising force for economic efficiency.Positive economics is concerned with ‘what is’ whereas Normative economics is concerned with ‘what ought • to be’.Deductive method involves reasoning or inference from the general to the particular or from the universal to • the individual.

ReferencesRittenberg, L. and Tregarthen, T., 2008. • Principles of Microeconomics. Samuelson, P. A., 2002. • Economics, Massachusetts Institute of Technology. Tata McGraw-Hill Publishing Co.Ltd.David, A. D.,2004. • Introduction to Microeconomics E201, [Pdf] Available at: <http://new.ipfw.edu/dotAsset/142427.pdf>[Accessed 14 August 2012].Frank, A. C., 2004. • Microeconomics Principles and Analysis, [Pdf] Available at: <http://www.railassociation.ir/Download/Article/Books/MicroEconomics-%20Principles%20and%20Analysis.pdf> [Accessed 14 August 2012].2010. • Introduction to Microeconomics 101 [Video online] Available at: <http://www.youtube.com/watch?v=gfiQ1xZfqV4> [Accessed 14 August 2012].About.com., 2011. • What is Microeconomics? [Video online] Available at:<http://www.youtube.com/watch?v=I2GH1MESQ5w>[Accessed 14 August 2012].

Recommended ReadingBernanke, B., 2009. • Principles of Microeconomics, Marginal Decision Rule, Tata McGraw Hill Publication.Dr. Mithani, D. M., 2008. • International Economics, Institute of Business Study and Research, Himalaya Publishing House Pvt. Ltd.Mankiv, N. G., • Economic: Principles and Applications, Cengage Learning Products, Canada, Nelson Education Pvt. Ltd.

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Self Assessment

Economics, also called ________ , is an in-depth study of certain aspects of society.1. dismal sciencea. dismal economics b. economyc. physiological studyd.

___________ is concerned with total output of a nation and the way that nation allocates its limited resources 2. of land, labour and capital in an efficient way stock of resources for future course action.

Microeconomicsa. Macroeconomicsb. Market economyc. Opportunity costd.

What are the important concepts of an economic system?3. Production possibility frontier and opportunity cost a. Distribution of goods and servicesb. Production of goods and servicesc. Quantity of goods and services producedd.

__________is a type of economic system in which the trading and exchange of goods and services and information 4. takes place in a free market

Command economy a. Product economyb. Demand economyc. Market economy.d.

Which of the following statements is true?5. Command economy is a free economy.a. In command economy, government can utilise land, labour and capital to fulfill its political and economic b. agenda.Command economy is based on trading and exchange of goods and services. c. Command economy is a demand driven economy.d.

_________ is the value of what is given up in order to have something else.6. Opportunity costa. Economy costb. Market costc. Product costd.

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Which of the following statement is true?7. When PPF shifts outward, then we know that there is a decline in economy.a. As scarcity compels an economy to give up one choice for another, the slope of the PPF will always be b. positive.An economy producing on the PPF curve is more practical than theoretical.c. Under the category of macroeconomics, PPF represents the point at which an economy is producing goods d. and services more efficiently.

Which of the following is not scarce resource for individual?8. Money a. Timeb. Skillc. Capitald.

Which of the following is not a scarce resource for a country?9. Capitala. Technology b. Labour force c. Timed.

________ are those goods whose demand decrease as the income of the consumer increases.10. The Angel Curvea. Price Effectb. Inferior goodsc. Income Consumption Curved.

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Chapter II

Demand, Supply and Product Management

Aim

The aim of this chapter is to:

define the concept of demand and supply•

explain the price elasticity of demand and price elasticity of supply•

explicate the impact of tax on price and quantity of goods•

Objectives

The objectives of this chapter are to:

explain the concept and change in demand and supply on equilibrium price and quantity•

elucidate various factors affecting demand and supply•

explain the role of the government in setting price•

Learning outcome

At the end of this chapter, you will be able to:

understand the application of economics in real life scenario•

identify the tax impact on price or quantity of goods•

compare the concepts of price elasticity demand and price elasticity supply•

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2.1 IntroductionIn a market economy, individual consumers make plans of consumption and individual firms make plans of production, based on changes in market prices. Economists use the term ‘invisible hand’ to describe the frequent exchanges in the market because everyone (no matter consumer or producer) takes the market price as a signal on trade and makes exchanges with private property rights.

The price system works in market economy only if there is a free choice within the market. The following explains how the market price is determined by the interaction of producer (supply) and consumer (demand).

2.2 Concept of DemandIn economics, demand consists of some of the major concepts like:

Demand is relative to the concept of price. It refers to both, the ability to pay and the willingness to buy, by the • consumer.For example, Toyota is planning its production strategy it wants to know the demand for cars in India. After a • survey, they found out that there are almost 250 million Indians willing to have a car. But that doesn’t mean that the demand for their car is 250 million. People can purchase the car as per their capability and their income.Demand is a flow concept, which means that the change in price will lead to change in demand for goods.• Demands are quantitative expressions of preferences and it is useless to speak demand without referring to • price and time.

2.3 Demand Schedule and ConceptA demand schedule for cars in India at different prices is shown below. Here, the demand is totally based upon price of the car.

Price (Rs) Demands (Units)2,50,000 503,50,000 405,50,000 307,00,000 20

Table 2.1 Demand schedule and concept

2.3.1 Market Demand CurveThe Market demand curve is obtained by plotting the graph of sum of the individual demand curve of a particular good in the market, at the same price, within a time period. This technique is also called as Horizontal Summation.

Price(per unit)

Quantity DemandedTom Mary Market (i.e. Tom + Mary)

30 2 1 320 4 3 715 6 5 1112 8 7 1510 10 9 19

Table 2.2 Market demand curve

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Demand Curve for Tom Demand Curve for Mary Market Demand Curve

30

20

10

02 4 6 8 10

30

20

10

01 3 5 7 9

30

20

10

05 10 15 20

Fig. 2.1 Market demand curve(Source:http://www.econweb.com/MacroWelcome/sandd/notes.html)

The slope implies that price and quantity are inversely related.

2.3.2 Law of DemandIn economics, the relationship between price and quantity is called as “Law of Demand.” If price of any goods or services increases then the demand for that will decrease and vice versa. Though, ‘Giffen goods’ are an exception where Law of Demand doesn’t work. A Giffen good is one which people consume more of as price rises. In such situation, cheaper close substitutes are not available. Because of the lack of substitutes, the income effect dominates, leading people to buy more of the good, even as its price rises.

Some types of premium goods, for example. Expensive French wines, BMW cars are sometimes claimed to be Giffen goods. It is said that, decrease in the price of such high status goods can reduce its demand, as they are no longer perceived to be exclusive or of high status.

2.4 Price Elasticity of DemandIt measures the rate of quantity demanded due to price change. The formula for PEoD (Price Elasticity of Demand) isPEoD = (% Change in Quantity Demanded)/ (% Change in Price)% Change in Quantity Demand = [QDemand (New) – QDemand(Old)] / QDemand(Old)% Change in Price = [Price (New) – Price (Old)] / Price (Old)

2.4.1 Types of DemandThe given table describes the various types of demand:

Types of demand DescriptionElastic Demand Here the price elasticity of demand is more than 1Inelastic Demand Here the change in demand is less in comparison to change in

price that means price elasticity of demand is less than 1Unit Elastic Demand Here change in demand and price, both are equalPerfectly Elastic Demand Here the value for price elasticity of demand is infinityPerfectly Inelastic Demand Here demand doesn’t change with change in time

Table 2.3 Types of demand

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2.5 Factors Affecting DemandFactors which affect demand of goods are mentioned below:

Factors Description with ExamplesPrice of substitute product

Consumers switch towards the substitute product when there is a price reduction in the regular product they use.

For example, previously there was a difference in price and usage of mobile phone and land line. The main objective behind phone is communication but mobile phone is also useful for other multipurpose activities. So, the demand for land line phone came down in comparison to mobile phone.

Income of consumer This is one of the most important aspects which affect the demand for goods in market. Increase in income of a consumer lead to increase in demand for normal goods.

Preference of consumer It refers to the subjective choice of a consumer. The demand of a product may be affected by knowledge, friends, education and culture.

Weather fluctuation The demand for different product varies as per the seasons. For example demand of AC is more during the time of summer but in off seasons the price is less as compared to summer.

Table 2.4 Factors affecting demand

2.6 Concept of SupplySupply consists of some of the major concepts like:

It refers to both, the ability to sell (produce) and the willingness to sell by the producer(s). Supply implies an • effective supply.Supply can be shown by a supply schedule, which illustrates the maximum quantity supplied at different • prices.Supply is also a flow concept. Time is an important factor affecting the condition of supply.•

2.6.1 Supply Schedule and ConceptA supply schedule, as shown below, gives the numerical data regarding price of goods and total unit producers are ready to produce and sell at that price.

Price (Rs. 000) Units (in 000)230 100220 90210 80200 70

Table 2.5 Supply schedule

Supply curve shows the relationship of above mentioned data.

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Quantity Supplied (Units)

Supply Curve

X

Y

230

220

210

200

050 60 70 80 90 100

Pric

e (R

upee

s)

Fig. 2.2 Supply curve(Source:http://www.econweb.com/MacroWelcome/sandd/notes.html)

2.6.2 Market Supply CurveIt refers to supply of goods by all producers or firms in the market, within a time period. The example below gives a supply schedule in a market consisting of only 2 firms, B & N.

Price(per unit)

Quantity Supplied

B N Market(i.e. B + N)

10 2 3 518 4 5 928 6 8 1440 8 10 1850 10 11 21

Table 2.6 Market supply curve

Like the market demand curve, the market supply curve is obtained by summing up the individual supply curves in the market. The technique is also known as Horizontal Summation.

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2 4 6 8 10

Supply curve for B Supply curve for N Market Supply Curve

3 5 7 9 11 5 10 15 20

50

30

10

0

50

30

10

0

50

30

10

0

Fig. 2.3 Market supply curve(Source:http://www.econweb.com/MacroWelcome/sandd/notes.html)

2.6.3 Law of SupplyThe direct relationship between price and quantity supplied is called Law of Supply. In other words, if the price is high then supply is also high or vice versa.

2.6.4 Price Elasticity of SupplyPrice elasticity of supply measures the rate of response to quantity demand due to price change. It is denoted as:

PEoS (Price Elasticity of Supply).

PEoS = (% Change in Quantity Supplied)/ (% Change in Price)

% Change in Quantity Supplied = [QSupply(New) – QSupply(Old)] / QSupply(Old)

2.6.5 Types of SupplyStudy the table below to learn types of supply

Types of supply Description

Elastic Supply Here the Price Elasticity of Supply is more than 1 but less than infinity. Change in supply is more than proportionate to change in the price of goods.

Inelastic SupplyWhen the Price Elasticity of Supply is in between 0 and 1, supply is inelastic in nature. It means change in supply will be less than proportionate to change in the price of goods.

Unit Elastic Supply When the coefficient is equal to one, supply is called unit elastic.

Perfectly Elastic Supply

When Price Elasticity of Supply is equal to infinity, it is called as perfectly Elastic Supply.

Perfectly Inelastic Supply

When Price Elasticity of Supply is equal to zero, it is called as perfectly Inelastic Supply.

Table 2.7 Types of supply

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2.6.6 Factors Affecting SupplyFactors which affect supply of goods are mentioned in the following table.

Factors Description with Examples

Input cost Price of input cost like labour, machines, etc. have a greater impact on supply side. For example, if the input cost is more for any organisation then the supply of product is reduced.

Technology Technology enhances the production of goods. If advanced and efficient technology is used in any organisati=on, then supply of the product will more.

Weather Weather usually affects the agricultural goods and also products like AC, water heaters, etc.

Table 2.8 Factors affecting supply

2.7 Equilibrium in Demand and SupplyEquilibrium is a price where there is no surplus and deficit of goods. That means total demand and total supply in market is equal. One can understand the concept easily with the help of following example.

Price Demand Supply Surplus/Deficit5.0 5000 7000 20004.5 6000 8000 20004.0 7000 9000 20003.5 8000 8000 Nil3.0 9000 7000 -20002.5 10000 8000 -20002.0 11000 8000 -3000

Table 2.9 Equilibrium in demand and supply

From the above table we can see that, there is only one point i.e., 3.5 where both demand and supply is equal. As per the table 2.9 the graph is mentioned below.

Quantity

3.5

X

E

Y

8000

Equilibrium Point

Supply curve

Demand Curve

Pric

e

Fig. 2.4 Equilibrium in demand and supply(Source:http://www.econweb.com/MacroWelcome/sandd/notes.html)

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2.8 Equilibrium as per the Change in Demand and SupplyThere are four possible conditions for equilibrium:

Increase in Demand• Decrease in Demand• Increase in Supply• Decrease in Supply•

The demand curve move towards right due to increase in demand. It will have an impact on current equilibrium. New equilibrium for increased demand will have the higher price.

For example, there is a demand for 200 motor bikes, each costing Rs.30,000. Due to increase in population, the demand for motorbikes increases from 200 to 500. This increased demand changed equilibrium price level from Rs. 30,000 to Rs. 50,000.

Quantity

Increased Demand

Pric

e

2000

30,000

50,000

YS

X

E1

E0 D2

D1

500

Fig. 2.5 Decrease in demand curve(Source:http://www.econweb.com/MacroWelcome/sandd/notes.html)

Increase in supplyThe supply curve will shift rightward with increase in supply.• This will lead to increase in quantity demand and increase in price, as shown•

Quantity

Increase in Supply

Pric

e

0

YS2

S1

XD

Fig. 2.6 Increase in supply curve(Source:http://www.econweb.com/MacroWelcome/sandd/notes.html)

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Decrease in supplyThe supply curve will shift leftward with decrease in supply.• This will lead to decrease in quantity demand and increase in price, as shown.•

Quantity

Decrease in Supply

Pric

e

0

YS2

S1

XD

Fig. 2.7 Decrease in supply(Source:http://www.econweb.com/MacroWelcome/sandd/notes.html)

Table 2.10 shows the changes in price and quantity when there is a change in demand and supply.

Change in Supply Change in Demand Change in Price Change in QuantityIncreases Decreases , or no changeDecreases Increases , or no changeIncreases Increases , or no changeDecreases Decreases , or no change

Table 2.10 Demand and supply(Source: The McGraw-Hill Companies, Inc.)

In most of the markets, prices are free to rise or fall as per the demand from consumers. Sometimes it happens • that the price in market is either “too high” or “too low”.At this point, the Government plays a crucial and applies some legal limits on how high or how low may price • go, as high price may be unfair to the buyer and low price may be unfair to the seller.Two basic concepts, called Price Ceiling and Price Floor are used for high and low price, respectively.• If the price of a product is unfairly high, the government can set a price ceiling, or legal maximum price a seller • may charge for a product. Similarly, if the price of a product is unfairly low, the government can set a price floor or minimum fixed price that sellers can charge.In price ceiling, the consumers can afford some essential goods or services that they could not afford at the • equilibrium price as it was too high before, which can create shortage of goods.

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Quantity

Shortage

Price Ceiling

Pric

e

2.50

2

YS

0 X

D

QS QOQd

Fig. 2.8 Price ceiling(Source:http://www.econweb.com/MacroWelcome/sandd/notes.html)

The main goal of price floor is to provide a sufficient income to a certain group of resource suppliers or producers, so that people from all classes and group can afford the goods or services which will create surplus of goods.

Surplus

Price Floor

2.50

3

YS

0 X

D

QSQOQd

Fig. 2.9 Price floor(Source:http://www.econweb.com/MacroWelcome/sandd/notes.html)

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2.9 Tax Impact on Price or Quantity of GoodsTable shows the tax impact on goods in various situations.

Various Demand and Supply

Tax paid by Description Graph

Perfectly Elastic Demand

Supplier The entire tax is absorbed by supplier as demand is perfectly elastic in nature. The supplier cannot increase the price of the good because any hike in price will reduce demand to Zero.

D

Tax

P

Q0

S1

S2

Perfectly Inelastic Demand

Buyer The entire tax portion is absorbed by buyer. In this case, demand remains constant irrespective of price of goods.

D

Tax

P

Q0

S1

S2

Perfectly Elastic Supply

Buyer The entire tax portion is absorbed by buyer. Suppliers are ready to sell at a specific price and any tax burden on them will lead supply to Zero.

STax

P

Q0

D1

D2

Perfectly Inelastic Supply

Supplier The suppliers are ready to supply goods irrespective of price. They will pay for entire tax portion.

S

Tax

P

Q0

D1

D2

Table 2.11 Tax impact on price or quantity of goods

2.10 Perfect CompetitionPerfect competition is a model of market based on the assumption that a large number of firms are producing the identical goods and services, which is consumed by large number of buyers.

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The main behavior of a perfectly competitive market is based on the following two factors;Quantity of good to be produced by a firm• Price to be charged for the goods•

One of the new concepts called “Price Takers” is very commonly used in perfect competition market. In other words, we can say that perfect competition is the world of price takers. Individual or firms who must take the market price as given are called as Price Takers. In a perfectly competitive environment, the seller is so small in caparison to market that it cannot affect the market price; hence it simply takes the price as given. The price of any commodity depends entirely upon the supply and demand, and each firm and consumer is a price taker.

Price-taking consumer assumes that he or she can purchase any quantity at the market price, without affecting the price. Price-taking firm assumes that it can sell whatever quantity it wishes at the market price, without affecting the price.

2.11 Economic Factors Related to Industry with Perfect CompetitionFollowing factors must be satisfied for perfect competition:

All firms should produce and sell an identical product• The industry is characterised by freedom of entry and exit• The firms have relatively small market share•

All above requirements are rarely found in any one industry. As a result, perfect competition is difficult to find in reality. Most products have some degree of differentiation, like in case of mineral water; the difference can vary in methodology of purification. That’s why the price of Himalaya Mineral Water is twice than any other mineral water like Aquafina. In the figure, we can see that in equilibrium, the price remains unaffected with variation in output that the firm find feasible to produce. If the perfectly competitive firm tries to change the price that is higher than the equilibrium price, then the consumer will move to the near substitute product and the firm would lose its existing customer.

S

D

0

d10

10

Industries2,000 100Quantity Quantity

MarketSupply

MarketDemand

Pric

e (R

s.)

Pric

e (R

s.)

Single firm

Fig. 2.10 Firm’s demand and industry equilibrium curve(Source:http://www.econweb.com/MacroWelcome/sandd/notes.html)

2.11.1 Marginal RevenueTo elaborate the concept of Marginal Revenue, suppose 100 units of a product are purchased by buyers, each costing Rs 10, totalling the price to Rs 1,000. Now say, the firm sells another unit of product so the total count of product becomes 101 and the price becomes 1,010. Then the firm’s marginal revenue becomes;

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Marginal Revenue = Change in Total Revenue / Change in QuantityOr

MR = ∆TR / ∆QTotal Revenue = Price X Quantity

Where,MR - Marginal Revenue∆TR - Change in Total Revenue∆Q - Change in QuantityBy the above equation, the Marginal Revenue of the product is, MR = [(1, 1010 – 1,000) / (101 - 100)] = 10, i.e. Rs 10.

Thus, we can say that price equals to the marginal revenue (P = MR). So the marginal revenue curve is same as the demand curve because price is equal to marginal revenue.

Price (Rs.)

Quantity

d1 MR

1 2 3 4

Fig. 2.11 Marginal revenue and demand curve(Source:http://www.econweb.com/MacroWelcome/sandd/notes.html)

2.12 Perfect Competition in Short RunIn short run, a perfectly competitive firm will continue its quantity of output, till the point its marginal revenue equals marginal cost. Thus, the firm will stop producing or increasing its production when such a point is reached.

The profit maximising rule says,Marginal Revenue (MR) = Marginal Cost (MC)

As per the Fig. 2.12, the firm is in equilibrium at E, but at F there is a possibility for the firm to earn profit equivalent to the shaded half, i.e. PQ amount.

Profi

t & C

ost

F E

MC

0 P Q

MR

Quantity

Fig. 2.12 Profit maximisation(Source:http://www.econweb.com/MacroWelcome/sandd/notes.html)

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2.13 Perfect Competition in Long RunIn long run, a firm is free to adjust all its input. New firms can enter any market and existing firms can leave their market. We shall see in this section that the model of perfect competition predicts that, at a long-run equilibrium, production takes place at the lowest possible cost per unit and that all economic profits and losses are eliminated.

2.13.1 Economic Profit and LossesEconomic profits and losses play a crucial role in the model of perfect competition. The existence of economic profits in a particular industry attracts new firms to the industry in the long run. As new firms enter, the supply curve shifts to the right, price falls, and profits falls too. Firms continue to enter the industry until economic profits fall to zero.

If firms in an industry are experiencing economic losses, some will leave. The supply curve shifts to the left, increasing price and reducing losses. Firms continue to leave until the remaining firms are no longer suffering losses until economic profits fall to zero.

2.13.2 Zero Economic Profit in Long RunGiven our definition of economic profits, we can easily see why, in perfect competition, they must always equal zero in the long run. Suppose there are two industries in an economy, and that firms in Industry A are earning economic profits. By definition, firms in Industry A are earning a return greater than the return available in Industry B. That means that firms in Industry B are earning less than they could in Industry A. Firms in Industry B are experiencing economic losses.

Given easy entry and exit, some firms in Industry B will leave it and enter Industry A to earn the greater profits available there. As they do so, the supply curve in Industry B will shift to the left, increasing prices and profits there. As former Industry B firms enter Industry A, the supply curve in Industry A will shift to the right, lowering profits in A. The process of firms leaving Industry B and entering A will continue until firms in both industries are earning zero economic profit. Thus, we can say that, “Economic profits in a system of perfectly competitive markets will, in the long run, be driven to zero in all industries.”

2.14 Monopoly MarketWe will find that a monopoly firm is likely to produce less and charge more for what it produces than the firms in a competitive industry. So, the various government policies and agencies deal with monopoly firm. Monopoly firm is entirely opposite to the perfect competition firm and has no rivals as it is the only firm in its industry.

2.15 Characteristics of Monopoly FirmSome of the important characteristics of a monopoly firm are:

It does not take the market price, but determines its own price• A firm sets and put the price as per the output it generates, so it is called as a Price Setter• It is very difficult to enter into monopoly market• Market share is more in monopoly market• Some of the markets are dominated by a single firm•

2.16 Factors of Monopoly PowerSome of the factors mentioned below act as barrier to entre into the monopoly market:Economics of Scale

A firm that confronts economies of scale over the entire range of outputs demanded in its industry is a natural • monopoly. For example, distribution of natural gas, water and electricity are some of the examples of natural monopoly.In a natural monopoly, the LRAC (Long Run Average Cost) of any one firm intersects the market demand curve • where long-run average costs are falling or are at a minimum. So,

One firm in the industry will expand to exploit the economies of scale available to it �

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As the firm will have lower unit costs than its rivals; it can drive them out of the market and gain monopoly �control over the industry Location

Sometimes monopoly power is the result of location. Sellers in markets isolated by distance from their nearest • rivals have a degree of monopoly power, for example, doctors, first run movies, etc. in a small town.

Sunk CostAn expenditure that has already been made and cannot be recovered is called a sunk cost. For example, an entry into a particular industry requires extensive advertising to make consumers aware of the new brand. Should the effort fail, there is no way to recover the expenditures for such advertising.

2.17 Monopoly and Market DemandThe figure “Perfect Competition vs. Monopoly,” compares the demand situations faced by a monopoly and a perfectly competitive firm.

In Panel (a), the equilibrium price for a perfectly competitive firm is determined by the intersection of the • demand and supply curves. The market supply curve is found simply by summing the supply curves of individual firms.In the perfectly competitive model, one firm has nothing to do with the determination of the market price. Each • firm in a perfectly competitive industry faces a horizontal demand curve defined by the market price.

dP

S

Q

MC

Panel (a)Perfect Compatition

Quantity per period

Pric

e m

argi

nal c

ost

Panel (b)Monopoly

Quantity per period

Pric

e Demand

Q1

P1

P2

P3

Q2 Q3

Fig. 2.13 Perfect competition vs. monopoly(Source:http://www.econweb.com/MacroWelcome/sandd/notes.html)

From Panel (b) we can find out that, for a perfectly competitive firm all the commodities and services are sold at the going market price, where as in monopolistic market a greater quantity can be sold only by cutting its price.

2.18 Marginal Decision Rule in Monopoly MarketProfit maximisation is always based on Marginal Decision Rule. As per this rule, additional unit of goods should be produced as marginal revenue of additional unit exceeds the marginal cost. That is,

Marginal Revenue > Marginal Cost

MR > MCTo determine the profit maximisation output, we can see that the point where firm’s marginal revenue intersects firm’s marginal cost, as shown in point Qm in Fig. 2.14.

We read up from Qm to the demand curve to find the price Pm at which the firm can sell Qm units per period. •

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The profit-maximising price and output are given by point E on the demand curve.Thus, we can determine a monopoly firm’s profit-maximising price and output by following three steps:•

Determine the demand, marginal revenue, and marginal cost curves �Select the output level at which the marginal revenue and marginal cost curves intersect �Determine from the demand curve the price at which that output can be sold �

Pric

e, m

argi

nal r

even

ue, m

argi

nal c

ost,

an

d av

erag

e to

tal c

ost.

Quantity per period

Average total cost

Marginal cost

Monopoly profit

Marginal revenue

Demand

ATCm

E

F

G

Qm

Pm

Q- Quantity per period

Fig. 2.14 Marginal decision rule in monopoly market(Source:http://www.econweb.com/MacroWelcome/sandd/notes.html)

Computing Monopoly ProfitThe Average Total Cost (ATC) at an output of Qm units is ATCm.•

The firm’s profit per unit is thus, Pm - ATCm. �Total profit is found by multiplying the firm’s output, Qm, by profit per unit, so total profit equals, Qm(Pm �- ATCm), the area of the shaded rectangle in Fig. 2.2

2.19 Oligopoly MarketIn 2005, General Motors Company (GMC) offered “employee discount pricing” to all of its customers. This new marketing strategy affected the sales of competitors like Ford, Toyota and other car manufacturers. Ford and Toyota implemented the same strategy, but Chrysler announced that it was looking for some more option, but in real sense it was waiting for GMC’s next move. Ultimately, Chrysler also offered employee discount pricing.

In an Oligopoly, the market is dominated by a few firms, and each of these firms is recognised by their own action, which produce a response from its rivals and that response has its own effects.

2.20 Concentration in OligopolyAs we have already discussed that the entire market is dominated by few firms, but the important question is that “what is the measurement of this few?” So there is only one way to measure the degree to which output in an industry is concentrated among a few firms, i.e. “Concentration Ratio.”

The concentration ratio is the percentage of market share owned by the largest firms in an industry.m = specified number of firms, say its value is 4The concentration ratio often is expressed as CRm, i.e., CR4.

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Then, the concentration ratio can be expressed as:CRm = s1 + s2 + s3 + ... ... + smWhere s = Market share of firm

If the concentration ratio is high then the few firms make out the entire industry, and if it is low then more than a few sellers actually make up the industry.

2.21 Game Theory and Oligopoly BehaviourOligopoly presents a problem in which decision makers must select strategies by taking into account the responses of their rivals, which they cannot know for sure in advance. A choice based on the recognition that the actions of others will affect the outcome of the choice and that takes these possible actions into account is called a Strategic Choice. Game theory is an analytical approach through which strategic choices can be assessed. For example, an airline’s decision to raise or lower its fares; or to leave them unchanged is a strategic choice. The other airlines’ decision to match or ignore their rival’s price decision is also a strategic choice. Once the firm implements a strategic decision there will be an output. This output is called as payoff. In general, the payoff in an oligopoly game is the change in economic profit to each firm. The firm’s payoff depends partly on the strategic choice it makes and partly on the strategic choices of its rivals. Here, we will take one application to explain the basic concept of game theory, which is called The Prisoners’ Dilemma.

Suppose two men, named X and Y, have been arrested and charged for committing a crime jointly. Both are kept in separate cells and each is offered the following deal:

If you confess the crime, whereas the other does not, you will get minimum sentence of six months.• If other confess, where as you do not confess, you will get sentence of 2 years.• If both parties refuse to confess, then each of them will get the sentence of one and half year.• If both confess, then each will get the sentence of 1 year.•

The matrix structure of the above condition is mentioned below:

X choiceY Choice Refuse to confess If confesses

X will get 1 and half year jail X will get six months jailY will get 1 and half year jail Y will get 2 years jailX will get 2 years jail X will get 1 year jailY will get six months jail Y will get 1 year jail

From the above matrix structure it is easily understood that, if both confess, each of them will get 1 year jail. This is the outcome of game theory. Similarly, from the industry perspective, if two firms have been given choices to remain in partnership or to break the partnership, then the following matrix structure for this situation is shown below.

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Refuses Partnership Accept PartnershipA wil get the profit of Rs. 10,000B will get the profit of Rs. 10,000

A will get the profit of Rs 20,000B will get the profit of Rs 5,000

A will get the profit of Rs 5,000B will get the profit of Rs 20000

A will get the profit of Rs. 20,000B will get the profit of Rs 20,000

Firm A

Firm

B Acc

ept

Part

ners

hip

Ref

uses

Part

ners

hip

Fig. 2.15 Prisnor’s dilemma rule in organisation(Source:http://www.econweb.com/MacroWelcome/sandd/notes.html)

From the above structure, we can find that both the firms A and B want more profit, so both will accept the partnership.

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SummaryThe entire demand concept is based on price, if the price of a commodity increases, then the demand will • decrease and vice versa.The Market Demand Curve is obtained by plotting the graph of sum of the individual demand curve of a particular • goods in the market, at the same price, within a time period.The direct relationship between price and quantity supplied is called Law of Supply. In other words, if the price • is high then supply is also high or vice versa.It elaborated the main concept of equilibrium as per change in demand and supply and also the role of the • government in setting prices.Two basic concepts, called Price Ceiling and Price Floor are used for high and low price, respectively. If the • price of a product is unfairly high, the government can set a price ceiling, or legal maximum price a seller may charge for a product.If the price of a product is unfairly low, the government can set a price floor or minimum fixed price that sellers • can charge.A choice based on the recognition that the actions of others will affect the outcome of the choice and that takes • these possible actions into account is called a Strategic Choice.Game theory is an analytical approach through which strategic choices can be assessed•

ReferencesWalter, N., • Microeconomic Theory: Basic Principles and Extensions. 9th ed.Robert, S. P. and Daniel, L.R.• , Microeconomics. 3rd ed, Prentice Hall.Rittenberg, L. and Tregarthen, T., 2010. • Principles of Microeconomics, [Online] Available at: <http://www.web- books.com/eLibrary/NC/B0/B63/018MB63.html> [Accessed 25 October 2010].Swanson, M. 2010. • Diminishing Marginal Utility, [Online] Available at: <www.ehow.com/how_5993061_calculate-diminishing-marginal-utility.html> [Accessed 25 October 2010].MIT, Lecture 9., 2012. • Principles of Microeconomics [Video online] Available at: <http://www.youtube.com/watch?v=Q4iKuKAjzK0>[Accessed 25 October 2010].RegisUniversity., 2010. .• Aggregate Demand/Aggregate Supply Macro Model.[Video online] Available at: <http://www.youtube.com/watch?v=5D06HqwsVtM> >[Accessed 25 October 2010].

Recommended ReadingBernanke, B., 2009. • Principles of Microeconomics, Marginal Decision Rule, Tata McGraw Hill Publication.Mithani, D., 2008. • International Economics. Institute of Business Study and Research, Himalaya Publishing House Pvt. Ltd.Dr. Mithani, D. M., 2008. • International Economics, Institute of Business Study and Research, Himalaya Publishing House Pvt. Ltd.

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Self Assessment

Which of the following will lead to decrease in quantity demand and increase in price?1. Decrease in supply a. Increase in demandb. Demand remain samec. Decrease in demandd.

A ___________ is one which people consume more of as price rises.2. Substitute gooda. Complement good b. Giffen goodc. Normal goodd.

In economics, the relationship between price and quantity is called as ___________.3. Law of Supply a. Law of Demandb. Law of Commandc. Law of Economicsd.

In which of the following demand does not change with change in time?4. Perfectly Inelastic Demand a. Perfectly Elastic Demandb. Inelastic Demandc. Elastic Demandd.

Which one of the following is the main goal of Price Floor?5. Sufficient income to certain group of producersa. Government will be paid by supplier in terms of tax b. Consumer will be paid by Governmentc. Supplier will be paid by consumerd.

Which of the following statements is true for Inelastic Demand?6. The change in demand is less in comparison to change in price a. The change in demand is equal to change in priceb. The change in price is less than change in demandc. The change in quantity is less than change in demandd.

Which of the following statements is true ?7. Equilibrium is a price where there is no surplus and deficit of goodsa. Demand is more when the price is moreb. Law of Demand is applicable to Giffen goodsc. Law of Demand is not applicable to Substitute goodsd.

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In Perfectly Elastic Demand who will take the full burden of tax?8. Buyera. Supplierb. Government c. Publicd.

__________ is a model of market based on the assumption that a large number of firms are producing the 9. identical goods and services, which is consumed by large number of buyers.

Perfect competitiona. Marginal revenueb. Market Demand curvec. Price ceilingd.

The rate of quantity demanded due to price change is called _____________.10. Price Elasticity of Demand a. Price Elasticityb. Price Elasticity of Supply c. Price Inelasticityd.

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Chapter III

Analysis of Consumer Choice, Production Analysis and Cost Concept

Aim

The aim of this chapter is to:

define the utility theory and its two basic approaches•

explain the relationship between demand and the utility theory•

introduce the basics of marginal utility and total utility•

Objectives

The objectives of this chapter are to:

enlist the approaches of utility theory called cardinal approach and ordinal approach•

explain the concept of marginal utility and total utility•

elucidate the fundamentals of budget constrain•

Learning outcome

At the end of this chapter, you will be able to:

understand the fundamentals of budget constrain•

identify the concepts of marginal utility and law of diminishing marginal utility •

comapre the relationship between demand curve and marginal utility•

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3.1 IntroductionWhy do people buy goods and services? The answer could be, all the goods and services provide satisfaction to people, and economists call this satisfaction as utility. People have unlimited demands but limited resources and the consumption patterns differ as per the individual income level. The buying patterns maximise the satisfaction level and people will prefer one good over the other.

3.2 Utility TheoryUtility is an abstract concept rather than a concrete, observable quantity. We prefer goods/services having a higher satisfaction level in comparison to the ones with lower satisfaction level. In real sense there is no particular formula or measurement for utility. It varies from person to person.

There are two approaches to utility:Cardinal Approach - Here utility can be measured numerically.• Ordinal Approach - Here also utility can be measured numerically but in the rank format. For example, utility • of the available goods like – chocolate, junk foods and rice are here:

Goods Cardinal (Numerical) Ordinal (Rank)

Chocolate 15 1st

Junk Foods 10 2nd

Rice 8 3rd

Table 3.1 Utility of goods

3.2.1 Total Utility (TU)Total utility is the aggregate of some of the satisfaction or benefits that the individual gains by consuming a given amount of goods and services in an economy. Consumption of more amounts of goods and services up to certain extent is acceptable, beyond which a saturation point will be reached which may reduce the total utility. For example, if a person consumes five units of commodity and derives U1, U2, U3, U4 and U5 utility from the successive units of goods, then his total utility (TU) will be,

TU = U1 + U2 + U3 + U4 + U5

3.2.2 Marginal Utility (MU)Marginal utility is the additional satisfaction or amount of utility gained from each extra unit of consumption. Although total utility increases as more goods are consumed, marginal utility usually decreases with each additional increase in the consumption of good.

This decreasing part is called “Law of Diminishing Marginal Utility”.• There is a certain limit of satisfaction level, beyond which a consumer will no longer enjoy the same pleasure • as compared to previous one.For example, during summers, you returned home from shopping at around 3 p.m. and wish to quench your • thirst with chilled water. The first glass of water that you consume will give you the utility of 100, but the next glass of water will have utility of 75. This utility comes down to 10 when you go for third glass of water. So the marginal utility of chilled water decreased gradually from 100 to 75 to 10.The concept of Total Utility and Marginal Utility can be understood more clearly with the help of Table 3.2.•

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Number of Glass Marginal Utility Total Utility1 100 100

2 75 175

3 10 185

Table 3.2 Marginal utility

From the above table, one can figure out that, marginal utility comes down with an additional consumption while total utility goes up. The Law of Diminishing Marginal Utility helps an economist to understand the law of demand and the negative slope of the demand curve. The less something is had, the more satisfaction is gained from each additional unit consumed and the marginal utility gained from that product is high because of higher willingness to pay for it.

The formula for marginal utility (MU) is,MU = Change in Total Utility / Unit Change in Consumption

The marginal utility comes to zero when the total utility is maximum. The relationship between marginal utility and total utility is explained with the help of following (Table 3.3 and Fig. 3.1) graph and schedule.

Number of Apples Consumed Marginal Utility Total Utility0 0 01 7 72 4 113 2 134 1 145 0 146 -1 13

Table 3.3 Marginal and total utility

From the above table (Table-3.3), when a person does not consume any apple, he gets no satisfaction. Total • utility becomes zero.When he consumes one apple per day, total utility become seven.• In case he consumes second apple then the marginal utility will increase to four. Thus, giving him total utility of 11.• The marginal utility will fall to two when the total utility is 13 that is (7 + 4 + 2).• If consumer takes fifth apple, then his marginal utility will fall to zero and the total utility is maximum that is • 14.If sixth apple is consumed, the marginal utility is reduced to negative (13 – 14 = -1).

The curve showing total utility and marginal utility is plotted in the figure below.

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Point where Total Utility is Maximum

Apples consumed (per day)

TU

M

MU

b

a

c

d

-21 2 3 4 5 6

16

12

8

4

0

Tota

l Util

ity /

Mar

gina

l Util

ity

Fig. 3.1 Total utility(Source:http://ecoarun.blogspot.in/2010/07/6-diffrent-total-curves-total.html)

3.2.3 Budget ConstrainThe Total Utility Curve in the figure above reaches maximum at the point M where the value is 14. We assume that the goal of each consumer is to maximise the total utility. But, in general, it is not really possible. Consumption is based upon the income level and every individual has some budget constrain which represents the combination of goods and services that an individual can purchase given current prices.

If a consumer decides to spend more on one good, he or she must spend less on another in order to satisfy the • budget constrain.The utility gained by spending another rupee on a good (x) can be calculated by dividing marginal utility of • the goods by its price (P), i.e.,

Quantity(a)

YY

MU

MU1

MU2

MU3

0

P1

P2

P3

0

Mar

gina

l Util

ity

Pric

e

Q1 Q2 Q3Q1 Q2 Q3X X

Quantity(b)

Demand Curve

Demand Curve

MUx / Px

Fig. 3.2 Relation between marginal utility and demand curve(Source:http://ecoarun.blogspot.in/2010/07/6-diffrent-total-curves-total.html)

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As per the Law of Diminishing Marginal Utility, an increase in quantity consumed results in a decreasing marginal utility. Thus, the consumer needs to increase the consumption of goods. The left hand side of Fig. 3.2 shows the Diminishing Marginal Utility of goods. The next diagram shows the demand curve in terms of price and quantity.

The price of goods OP1 equilibrium is possible at quantity OQ1 where MU1 = OP1. Now suppose price comes down to OP2, then the equilibrium will definitely change.

Marginal utility will be definitely less than the MU1. So we can state this as,

Quantity Increase - Demand Decline- Price Decline - Marginal Utility Decline

3.3 Production AnalysisThe processes and methods which convert tangible inputs (manpower, raw materials, and semi finished goods) and intangible inputs (ideas, information) into goods and services is called as production.

Wages in China are relatively low for both skilled and unskilled labour to produce any goods. Where as, in United States the labour cost is very high so they use more machinery and less labour. All types of production require the choices in the use of uFactors of Production. This chapter gives the analysis of such choices.

The analysis of production and cost begins with a period called Short Run. The Short Run is defined in economics as, a period of time where at least one factor of production or variable is fixed, i.e., it cannot be changed. For example, the various capital inputs like plant and machinery is fixed and that can be changed by supplier by altering the variable inputs such as labour, components, raw materials and energy inputs.

3.4 Short Run Production FunctionFirms use production factor to produce products. The relationship between production factor and output is called as Production Function. For example, TATA requires 100 pounds of plastics and 50 man hours to make one unit of car. Then the production function will be;

1 unit = f (50 man hours + 100 pounds of plastics)We can say it as,

Quantity = f (Labour man hours + Capital used)

3.4.1 Total, Marginal and Average ProductA total product curve shows the quantity of outputs that can be obtained from different amount of variable factor of Production, assuming that the Factors of Production are fixed. In the figure below, when the Total Product (TP) curve is between 0 and 3, which means the labour required is 0 and 3 units per day, the curve becomes steeper. When the curve is between 3 and 7 workers, the curve continues to slope upward but afterward the slope diminishes. After 7th labour the production starts to decline and the curve slopes downward. The slope of Total Product Curve for labour is equal to change in output (∆Q) divided by change in units of labour (∆L).

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1210

8

6

4

2

A1 2 3 4 5 6 7 8

Totalproduct

Units of labor per day

Prod

uctio

n pe

r day

B

C

0

D

EF

G HI

Fig. 3.3 Total production curve(Source:http://ecoarun.blogspot.in/2010/07/6-diffrent-total-curves-total.html)

Factors of Production: In economics Factor of Productions are any commodity or services used to produce goods and services:

The slope of Total Product curve for any variable factor is a measure of change in output associated with change • in amount of variable factor, with all other factors held constant.The amount by which output rises with addition of one extra unit of a variable factor is the Marginal Product • of the variable factor like labour. We can also derive Marginal Product of Labour (MPL), from mentioned formula below;

MPL = ∆Q /∆LWhere, ∆Q = Change in Output∆L = Change in units of Labour

We can also define Average Product of variable factor, which is the output per unit of variable factor. The Average • Product of Labour (APL) is the ratio of output to the number of units of labour.

APL = Q / LWhere, Q = Number of outputL = Number of units of Labour

In Fig. 3.2, the Marginal Product rises as the slope of the total curve increases, falls as the slope of the Marginal • Product curve declines and reaches Zero when the Total Product curve achieve the maximum value. When the Total Product curve moves downward it becomes negative.Also, one can notice that the Marginal Product curve intersects the Average Product curve at maximum point • on Average Product curve. When marginal product is above average product, then average product is rising and when marginal product is below average product, the average product is falling.For example, as a student you can use your own experience to understand the relationship between marginal and • average values. Your Grade Point Average (GPA) represents the average grade you have earned in all your course work so far. When you take an additional course, your grade in that course represents the marginal grade.What happens to your GPA when you get a grade that is higher than your previous average? It rises.• What happens to your GPA when you get a grade that is lower than your previous average? It falls.• If your GPA is a 3.0 and you earn one more B, your marginal grade equals your GPA and your GPA remains • unchanged.

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BA

DE

C

F G H I

slop

e =

1.0

slop

e =

2.0

slop

e =

4.0

slop

e =

2.0

slop

e =

10

slop

e =

0.7

slop

e =

0.3

slop

e =

0.5

1 2 3 4 5 6 7 8

12108642

43210

-0.5

Avrageproduct

Marginalproduct

Panel (a)

Panel (b)

Totalproduct

Prod

uctio

npe

r day

Units of labor per day

Mar

gina

l pro

duct

av

arag

e pr

oduc

t

Fig. 3.4 Relationship between TP, MP and AP(Source:http://ecoarun.blogspot.in/2010/07/6-diffrent-total-curves-total.html)

3.5 Cost ConceptProduction process of any firm is associated with the cost, which include variable cost and fixed cost. The cost associated with the use of variable factors such as materials, manpower, semi-finished goods, etc. are called as Variable Cost.

While, the cost related with the use of fixed factors like plant, buildings is called as Fixed Cost. The fixed costs are incurred by company irrespective of the level of production, as it is fixed in nature. For example, the rent of the factory premises or machinery or insurance premium all falls under fixed cost. Sometimes, the salary of top management may also be counted as fixed cost.

3.5.1 Total Cost and Marginal CostThe Total Cost (TC) of any firm is the summation of Total Variable Cost (TVC) and Total Fixed Cost (TFC), that is,

TC = TVC + TFC

We have already discussed the concept of total product and marginal product. Similar to it, Marginal Cost is the change in Total Cost that arises when the quantity produced changes by one unit. The marginal cost plays an important role for evaluation of occurrence of cost in the firm. Marginal cost shows the additional cost of each addition unit of output a firm produces. The formula to determine marginal cost is:

MC = ∆T / ∆Q

Where,MC = Marginal Cost

∆T = Change in Total Cost∆Q = Change in output

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3.5.2 Average Total CostThe second important concept of cost is Average Total Cost (ATC). It is a firms total cost divided by quantity that is firm’s total cost per unit of output.

ATC = TC / Q

Where,ATC = Average Total CostTC = Total CostQ = Output produced

The Average Total Cost is the summation of Average Variable Cost (AVC) and Average Fixed Cost (AFC)

ATC = AVC + AFCWhere,ATC = Average Total CostAVC = Average Variable CostAFC = Average Fixed Cost

Average Variable Cost is Total Variable Cost (TVC) per unit of output.

AVC = TVC / Q

Where,AVC = Average Variable CostTVC = Total Variable CostQ = Output produced

Similarly, in case of Short Run, where at least one production factor is fixed, the Average Fixed Cost (AFC) becomes the Total Fixed Cost (TFC) divided by quantity.

AFC = TFC / Q

Where,AFC = Average Fixed CostTFC = Total Fixed CostQ = Output Produced

3.6 Relationship between Marginal Cost, Average Fixed Cost, Average Variable Cost and Average Total Cost in Short Run

0 1 2 3 4 5 6 7 8 9 10 11

$200

150

100

50AVC

ATC

AFCMC

AFC

, AVC

, ATC

, and

MC

Quantity Produced

Fig. 3.5 Relationship between MC, AFC, AVC and ATC (Source:http://ecoarun.blogspot.in/2010/07/6-diffrent-total-curves-total.html)

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In the above figure, the marginal cost curve intersects the average total cost and average variable cost curves at their lowest points. When marginal cost is below average total cost or average variable cost the average total and average variable cost curve slopes downward. When marginal cost is greater than short-run average total cost or average variable cost; then the average cost curve slopes towards upward. The logic behind the relationship between marginal cost and average total cost and variable cost is the same as it is for the relationship between marginal product and average product.

3.7 Cost Concept in Long RunIn Long Run, there are no fixed inputs and as a result there is no fixed cost too. So, in long run a firm has a greater level of flexibility than in short run. Long Run Average Cost (LRAC) curve shows a firm’s lowest cost per unit at each level of output, assuming that all factors of production are variable. The costs it shows, therefore, are the lowest costs possible for each level of output. Though, this does not mean that the minimum points of each short-run ATC curve will lie on the LRAC curve.

Fig. 3.6 below shows the relationship between the short run and long run average total curve.

$9

8

7

6

5

4

0 5 10 15 20 25 30 35 40 45 50

Thousand of CDs per week

ATC30 ATC40

ATC50ATC20

B

C

DCos

t per

uni

t

Fig. 3.6 Short run and long run average total curve(Source:http://ecoarun.blogspot.in/2010/07/6-diffrent-total-curves-total.html)

The LRAC curve assumes that the firm has chosen the uoptimal factor combination for producing any level of output. Therefore, the cost it shows is the lowest cost possible for each level of output. In the figure above, the Platinum Disc Corporation manufactures CDs by using capital and labour.

If it has 30 units of capital, then the average total cost associated with the curve is ATC30. In long run, the firm can examine the ATC with varying level of capitals. The relevant curves are labelled as ATC20, ATC30, ATC40, ATC50 etc., as per capital invested. The LRAC curve is derived from the set of short-run curves by finding the lowest ATC associated with each level of output. Here, we can notice that LRAC curve is U Shaped and it is surrounded by various shot run curves.

3.8 Economy of Scale, Diseconomy of Scale and Constant Return to ScaleIn figure above, the slope of the curve first moves downward and then upward. This kind of shape of curve represents that the effect on average cost with changes in firm’s scale of operations. A firm experiences economies of scale when long-run average cost declines as the firm expands its output.

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A firm is said to experience diseconomies of scale when long-run average cost increases with expansion of output. Constant returns to scale occur when long-run average cost stays the same over an output range.

Optimal factor combination: Where the factors of production cost as little as possible and produce as more as possible. In other words it has to minimise costs while maximising output.

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SummaryUtility is an abstract concept rather than a concrete, observable quantity.• Total utility is the aggregate of some of the satisfaction or benefits that the individual gains by consuming a • given amount of goods and services in an economy.Marginal utility is the additional satisfaction or amount of utility gained from each extra unit of consumption.• The marginal utility comes to zero when the total utility is maximum• The processes and methods which convert tangible inputs (manpower, raw materials, and semi finished goods) • and intangible inputs (ideas, information) into goods and services is called as production.Firms use production factor to produce products. The relationship between production factor and output is • called as Production Function.A total product curve shows the quantity of outputs that can be obtained from different amount of variable factor • of Production, assuming that the Factors of Production are fixed.The cost associated with the use of variable factors such as materials, manpower, semi-finished goods, etc. is • called as Variable Cost.The Total Cost (TC) of any firm is the summation of Total Variable Cost (TVC) and Total Fixed Cost (TFC).• The second important concept of cost is Average Total Cost (ATC). It is a firms total cost divided by quantity • that is firm’s total cost per unit of output.In Long Run, there are no fixed inputs and as a result there is no fixed cost too. So, in long run a firm has a • greater level of flexibility than in short run.A firm experiences economies of scale when long-run average cost declines as the firm expands its output.•

ReferencesSamuelson, P. A., 2002. • Economics, Tata McGraw-Hill Publishing Co.Ltd.Robert, S. P. and Daniel, L. R., • Microeconomics. 3rd ed, Prentice Hall.Rittenberg, L. and Tregarthen, T., 2010. • Principles of Microeconomics. [Online] Available at: <http:// www. web-books.com/eLibrary/NC/B0/B63/018MB63.html> [Accessed 25 October 2010].Swanson, M., 2010. • Diminishing Marginal Utility, [Online] Available at: <www.ehow.com/how_5993061_calculate-diminishing-marginal-utility.html> [Accessed 25 October 2010].2010. • Introduction to Microeconomics 101 [Video online] Available at: <http://www.youtube.com/watch?v=gfiQ1xZfqV4> [Accessed 14 August 2012].About.com., 2011.• What is Microeconomics? [Video online] Available at: <http://www.youtube.com/watch?v=I2GH1MESQ5w>[Accessed 14 August 2012].

Recommended ReadingMankiw, N. G., 2008. • Economics: Principles and Applications, Cengage Learning Products, Canada, Nelson Education Pvt. Ltd.Samuelson, P. A., 2002. • Economics, Massachusetts Institute of Technology, Tata McGraw-Hill Publishing Company.Bernanke, B., 2009. • Principles of Microeconomics, Marginal Decision Rule, Tata McGraw Hill Publication.

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Self Assessment

Which of the following approaches to utility theory?1. Cardinal and ordinal approacha. Systematic and unsystematic approach b. Fundamental and sequential approach c. Constant and variable approachd.

Total utility increases as more goods are consumed, marginal utility usually decreases with each additional 2. increase in the consumption of goods, this decreasing part is called ______________.

Law of Diminishing Return a. Law of utilityb. Law of Total utilityc. Law of Diminishing Marginal Utilityd.

A person consumes five units of commodity and derives U1, U2, U3, U4 and U5 utility from the successiveunits 3. of goods, the total utility will be __________.

U1 + U2 – U3 + U4 + U5 a. U1 + U2 + U3 + U4 + U5 b. U1- U3 + U2 – U4 + U5c. U1 – U4 + U2 + U3 + U5d.

The additional satisfaction or amount of utility gained from each extra unit of consumption, is called 4. _________.

Total Utilitya. Average Utilityb. Marginal Utility c. Utility Theoryd.

Which of the following entities is a part of Marginal Utility?5. Change in total utilitya. Change in satisfaction level b. Change in demand curvec. Quantity demandd.

_________ is the aggregate of some of the satisfaction or benefits that the individual gains by consuming given 6. amount of goods and services in an economy.

Marginal utilitya. Budget constrain b. Total utilityc. Average productiond.

The utility gained by spending an additional rupee on good x is _______.7. MUx / Px a. ∆Q / ∆Pb. ∆U / ∆Pc. Pa / MUad.

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Which of the following occurs if the total utility will be maximum?8. Marginal utility will increase a. Marginal utility will decrease b. Marginal utility will zeroc. Average utility will increased.

Which of the following is an abstract concept rather than a concrete, observable quantity?9. Law of Diminishing Marginal Utility a. Utilityb. Law of Diminishing Marginal Returnc. Marginal Utilityd.

Consumption of more amounts of goods and services up to certain extent is acceptable beyond that saturation 10. point will come which causes the reduction of _______.

Marginal Utility a. Total Utilityb. Average Utility c. Mixed Utilityd.

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Chapter IV

The Nature of Factor Demands

Aim

The aim of this chapter is to:

explain the approaches of income distribution•

elucidate input pricing•

explicate about the nature of factor demands•

Objectives

The objectives of the chapter are to:

explain the distribution theory•

describe marginal revenue product•

elucidate the application of marginal revenue product and the demand for factors•

Learning outcome

At the end of this chapter, you will be able to:

understand the importance of supply of factors of production•

understand the distribution of national income•

identify the marginal productivity theory with various inputs•

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4.1 IntroductionDemand for a commodity refers to the quantity of the commodity that people are willing to purchase at a specific price per unit of time, other factors (such as price of related goods, income, tastes and preferences, advertising, etc) being constant. Demand includes the desire to buy the commodity accompanied by the willingness to buy it and sufficient purchasing power to purchase it. For instance-Everyone might have willingness to buy “Mercedes-S class” but only a few have the ability to pay for it. Thus, everyone cannot be said to have a demand for the car “Mercedes-s Class”.

Demand may arise from individuals, household and market. When goods are demanded by individuals (for instance-clothes, shoes), it is called as individual demand. Goods demanded by household constitute household demand (for instance-demand for house, washing machine). Demand for a commodity by all individuals/households in the market in total constitutes market demand.

4.2 Income and WealthThe vast array of products that we enjoy does not simply surge from the earth. They are produced by workers who are equipped with machines housed in factories. These inputs result into productive process that earns factor income like wages, profits, interest, and rent.

4.2.1 IncomeIncome is the consumption and savings opportunity gained by an entity within a specified time frame, which is generally expressed in monetary terms. There are two main approaches to examine the income distribution:

Personal distributionPersonal distribution of income means the distribution of national income among the various members of the society. These persons perform various kinds of activities and are paid according to their services. For example, workers, teachers, clerks and other officers get salaries, and professionals like advocates, chartered accountants and physicians doing private practice charge fees for their services.

Since these services do not require the same skill and are not uniformly productive, earnings of different persons engaged in these activities differ. Incomes of a large number of people are not from one source only. Some people get salary for the work which they do in offices and also earn interest on their bank deposits and dividend on their investments in shares.

Functional distributionIn functional distribution, an attempt is made to examine how wages, rent, interest and profit are determined. It refers to the mechanism whereby different factors are rewarded for the services they render to the productive process.

According to modem economists, rent, wages, interest and profit are the prices for the services rendered by land, labour, capital and enterprises respectively in the production process. The principles which determine commodity prices are used to determine prices of various factors of production. As a result, the factors of production are considered as part of the price theory.

The Role of GovernmentGovernment is the major source of income for the millions of people they employ. Moreover, government • rents millions of square feet of office space and are responsible, directly and indirectly, for billions in profits to corporations that do business with them.Government also has a direct role in incomes that it collects through taxation and other levies. The money • collected through tax is spent or given away by the government through transfer payments that are not made in return for current goods or services. These transfer payments include unemployment insurance, farm subsidies, and welfare payment and so on.

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4.2.2 WealthWealth is the net worth of a person, household, or nation, that is, the value of all assets owned net of all liabilities owed at a point in time. Wealth is a stock, while income is a flow per unit of time. A household’s wealth includes its tangible items (house, car and other consumer durable goods and land) and its financial holdings (such as cash, savings accounts, bonds, and stocks). All items that are of value are called assets, while those that are owed are called liabilities. The differences between total assets and total liabilities are called wealth and net worth.

4.3 Input Pricing by Marginal ProductivityThe Theory of Income Distribution or Distribution Theory studies how incomes are determined in an economy. • There is vast difference in the incomes of different families. Distribution theory is a special case of the theory of prices where:

Wages are really only the price of labour �Rents are similarly the price for using land �The prices of factors of production are primarily set by the interaction between supply and demand for �different factorsThe prices of goods are largely determined by the supply and demand for goods �

Concepts of demand and supply are first step towards the economic understanding. What lies behind demand • and supply is explained by the Marginal Productivity Theory of incomes. It states that, “the marginal revenue productivity of a factor reveals the demand for that factor. This demand together with the supply of the factor determine the factor price which, in ‘a perfectly competitive market, is naturally equal to the marginal revenue productivity of the factor.”

4.4 The Nature of Factor DemandsThe demand for factors differs from that for consumption goods in two important respects:

Factor demands are derived demands• Factor demands are interdependent demands•

4.4.1 Factors Demands and DerivationFollowing are the factors for demand and derivation:

Let’s consider the demand for an office space by a firm which produces computer software. A software company • will rent office space for its programmers, customer service representatives, and other workers. In this case there will be a downward-sloping demand curve for office space linking the rental being charged by land-lords to the amount of office space desired by companies (the lower the price, the more space companies will want to rent).There is an essential difference between ordinary demands by consumers and the demand by firms for inputs. • Consumer demands final goods because of the direct enjoyment or utility these consumption goods provide. In contrast to this, a business does not pay for inputs because they yield direct satisfaction. Rather, it buys inputs because of the production and revenue that it can gain from employment of those factors.The satisfaction that consumers get from playing the computer games determines how many games the software • company can sell, how many order takers it needs, and how much office space it must rent. The more successful its software is, the greater is its demand for office space.The firm’s demand for inputs is derived indirectly from the consumer demand for its final product. The demand • for productive factors is known as derived demand. This means that when firms demand an input, they do so because that input permits them to produce a good which consumers may desire now or in future. Figure below shows how the demand for a given input, such as fertile corn land, must be regarded as being derived from the consumer demand curve for corn.

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D

D

P

OCorn

Pric

e of

Cor

n

(a) Commodity Demand

D

D

P

OCornland

Ren

t of C

ornl

and

(b) Derived Factor Demand

Fig. 4.1 Factors demands are derived(Source:http://www.managementstudyguide.com/consumer-demand.htm)

4.4.2 Factors Demands are InterdependentProduction is a team effort. The productivity of one factor, such as labor, depends upon the amount of other factors available to work with. Therefore it is difficult to quantify the output created by a single input. The different inputs interact with one another. It is this interdependence of productivities of land, labour, and capital goods that makes the distribution of income. This interdependence of factors is further explained by the distribution theory and marginal revenue product as given below.

4.5 Distribution Theory and Marginal Revenue ProductThe fundamental point about distribution theory is that the “demands for the various factors of production are derived from the revenues that each factor yields on its marginal product.” Few terms that are used to define the theory are explained below.

Marginal Revenue Product: It is the money value of the additional output generated by an extra unit of input. • For example, the marginal revenue product of input A is the additional revenue produced by an additional unit of input A.Perfectly Competitive Case: It is easy to calculate marginal revenue product when product markets are perfectly • competitive. In this case, each unit of the worker’s marginal product (MPL) can be sold at the competitive output price (P). Moreover, with prefect competition in mind, the output price is unaffected by the firm’s output, and price therefore equals marginal revenue (MR).Imperfect Competition: Here, the marginal revenue received from each extra unit of output sold is less than the • price, because the firm must lower its price on previous units to sell an additional unit. Each unit of marginal product will be worth MR< P to the firm. Marginal revenue product represents the additional revenue a firm earns from using an additional unit of an input, with other inputs held constant. It is calculated as the marginal revenue obtained from selling an extra unit of output. This holds for labour (L), land (A), and other inputs.

Marginal revenue product of labour,(MRPL) = MR X MPL

Marginal revenue product of land,(MRPA) = MR X MPAand so forth.Under conditions of perfect competition, because P=MR

Marginal revenue product(MRPi) = P X MPifor each input.

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4.6 The Demand for Factors of ProductionTo determine the demand of production factor we need to analyse how a profit-oriented firm chooses its optimal combination of inputs.

4.6.1 Rule for Choosing the Optimal Combination of InputsTo maximise profits, firms should add inputs up to the point where the marginal revenue product of the input equals the marginal cost or price. For perfectly competitive factor markets, the rule is even simpler.

Under perfect competition the marginal revenue product equals price times marginal product, i.e., MRP = P * MP

The profit maximising combination of inputs for a perfectly competitive firm comes when the marginal product times the output price equals the price of the input:

Marginal product of labour X output price = Price of labour = Wage rateMarginal product of land X output price = Price of land = Rent and so forth.

4.6.2 Least-Cost RuleLeast-Cost Rule states that, “costs are minimised when the marginal product per rupee of input is equalised for each input.” This holds for both perfect and imperfect competitors in product markets. We can restate the condition much more generally in a way that applies to both perfect and imperfect competition in product markets (as long as factor markets competitive). Reorganising the basic conditions shown above, profit maximisation implies:

Marginal product of labour = Marginal product of land = 1Price of labour Price of land Marginal revenue

For instance, suppose you own a cable television monopoly for a particular area. If you want to maximise profits, you will want to choose the best combination of workers, land easements for your cables, trucks, and testing equipment to minimise costs. If a month’s truck rental costs Rs. 10,000 while monthly labour costs are minimised to Rs.2000, costs are minimised when the marginal products per rupee of input are the same. Since trucks cost 5 times as much as labour, trucks MP must be 5 times the labour MP.

4.6.3 Marginal Revenue Product and the Demand for FactorsDemand for factors of production can be explained better with the derivation of MRP for different factors (as done above). We have seen that a profit-maximising firm would choose input quantities such that the price of each input equalled the MRP of that input.

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60

50

40

30

20

10

0 1 2 3 4 5Labor inputs (workers)

Mar

gina

l rev

enue

pro

duct

of l

abor

(th

ousa

nds o

f dol

lars

per

wor

ker)

Ld

d

Fig. 4.2 Demand for inputs derived through marginal revenue products(Source:http://www.managementstudyguide.com/consumer-demand.htm)

With the MRP schedule for an input, we can determine the relationship between the price of the input and the quantity demanded of that input. This relationship is called demand curve. The MRP schedule for each input gives the demand schedule of the firm for that input.

4.6.4 Substitution RuleAn outcome of the least-cost rule is the substitution rule. It states that, “If the price of one factor rises while other factor prices remain fixed, the firm will profit from substituting more of the other inputs for the more expensive factor”.A rise in the labour’s price, PL, will reduce MPL/PL. Firms will respond by reducing employment and increasing land use until equality of marginal products per rupee of input is restored-thus lowering the amount of needed L and increasing the demand for land acres. A rise in land’s price, PA, alone will, by the same logic, cause labor to be substituted for more expensive land. Like the least-cost rule and the derived demand for factors apply to both, the perfect and imperfect competition in product markets.

4.7 Supply of Factors of ProductionA complete analysis of the determination of factor prices and of incomes combines both the demand for inputs and the supplies of different factors. In a market economy, most factors of production are privately owned. People control the use of labor, but this human capital can only be rented not sold. Capital and land are generally privately owned by households and by businesses.

Labour supply is determined by many economic and noneconomic factors. The important determinants of labour supply are:

Price of labour (wage rate)• Demographic factors like age, gender, education and family structure•

Determinants of quantity of land and other natural resources are:Geology• Quality of land depends upon conservation, settlement patterns•

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Determinants of capital depend upon:Past investments made by businesses, households and governments.The different possible elasticity’s for the supply of factors are illustrated by the supply curve below:

Fact

or p

rice

Factor quantityQF

PF

S

S

A

B

Fig. 4.3 Supply curve for factors of production(Source:http://www.managementstudyguide.com/consumer-demand.htm)

Supplies of factors of production depend upon characteristics of the factors and the preferences of their owners. Generally, supply will respond positively to price, as in the region below A. For factors that are fixed in supply, like land, the supply curve will be perfectly inelastic, as from A to B. In special cases, where a higher price of the factor increases the income of its owner greatly, as with labour or oil, the supply curve may bend backward, as in the region above A.

4.8 Determination of Factor Prices by Supply and DemandThe distribution of income combines the supply and demand for factors of production. To obtain the market demand for inputs, we will add up the individual demands of each of the firms.

Thus, at a given price of land, we add together all the demands for land of all the firms at that price, and we do the same at every price of land. We add horizontally the demand curves for land of all the individuals firms to obtain the market demand curve for land. This procedure is followed to get the market demand for each input. Here the derived demand for the input is based on the marginal revenue product of the input under consideration. Fig. 4.4 shows a general demand curve for a factor of production as the DD curve.

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Fact

or p

rice

Factor quantity

QF

PF

S

S

D

D

E

Fig. 4.4 Factor supply and derived demand interact to determine factor prices and income distribution(Source:http://www.managementstudyguide.com/consumer-demand.htm)

Factor prices and quantities are determined by the interaction of factor supply and demand. The equilibrium price of the input in a competitive market comes at that level where the quantities supplied and demanded are equal. This is illustrated in figure above, where the derived demand curve for a curve for a factor intersects its supply curve at point E. Only at this price will the amount that owners of the factor willingly supply just balances the amount that the buyers willingly purchase.

The figure below shows the markets for two kinds of labour – surgeons and fast-food workers

Hou

rly e

arni

ngs

Labor supplyLs

Ds

SsW

(a) Market for Surgeons

L

Ds

EsWs

Hou

rly e

arni

ngs

Labor supply

(b) Market for Fast-Food Workers

WF

W

LF

SF

EF

DF

DF

L

Fig. 4.5 The markets for surgeons and fast food workers(Source:http://www.managementstudyguide.com/consumer-demand.htm)

For (a), we see the impact of a limited supply of surgeons: small amount and high earnings per surgeon.

For (b), open entry and low skill requirements imply a highly elastic supply of fast-food workers. Wages are beaten down and employment is high.

The supply of surgeons is severely limited by the need for medical licensing and the length and cost of education and training. Demand for surgery is growing rapidly along with other health-care services. Moreover, an increase in demand will result in a sharp increase in earnings with little increase in output.

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At the other end of the earnings scale are fast-food workers. These jobs have no skill or educational requirements and are open to virtually everyone. The supply is highly elastic. Wages are close to minimum, because of the ease of entry into this market. The major difference between the earning powers is because of the quality of labor and not the quantity of hours.

4.9 The Distribution of National IncomeHow market allocates national income among the many factors of production can be well understood by Factor- Income Distribution Theory* by John Bated Clark. It can be applied to competitive markets for any number of final products and factor inputs. This can be understood through “real” units in terms of goods. The goods can be corn or a basket of different goods and services; we will term it as Q and price it equal to 1.The value of output being Q and with the wage rate being the real wage in terms of goods or Q. In this situation, a production function tells how much Q is produced for each quantity of labour-hours, L, and for each quantity of acres of homogeneous land, A.Note: P=1, under perfect competition MRP=MPXP= MPX1=MP, the wage is therefore equal to MPL

Under prefect competitionLandlords will hire a worker if the market wage exceeds that worker’s marginal product. So competition will ensure that all the workers receive a wage rate equal to the marginal product of the last worker This will lead to surplus of total output over the wage bill because earlier workers had higher MPS than the last worker. The excess will remain with the land lord as their residual earnings, which we will later call rent. Each landowner is a participant in the market for land and rents the land for its best price. Just as workers compete with worker for jobs, landowner competes with market for workers.

The following marginal product curve of labour gives the demand curve of all employers in terms of real wages.

Quantity of labor

Marginal product of

labor

Mar

gina

l pro

duct

, wag

e ra

te

LS

S

D

D

W

N

0

E

Fig. 4.6 Marginal product principles determine factor distribution of income(Source:http://www.managementstudyguide.com/consumer-demand.htm)

Factor-income distribution theory refers to the way total input or income is distributed among individuals or • among factor of production (land, labour and capital).Each vertical slice represents the marginal product of that unit of labour. Total national output ODES is found by • adding all the vertical slices of MP up to the total supply of labour at S. The distribution of output is determined by marginal product principles. Total wages are the lower rectangle (equal to the wages are ON times the quantity of labour OS). Land rents get the residual upper triangle NDE.Labour-supply factors determine the supply of labour (shown as SS). The equilibrium wage comes at E. The • total wages paid to labour are given by W X L; this is shown by the dark area of the rectangle, OSEN.NDE in figure measures all the surplus output which was produced but was not paid out in wages. The size of • the rent triangle is determined by how much the MP labor declines as additional labour is added.

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4.10 Marginal-Productivity Theory with Many InputsThe marginal-productivity theory is a great step forward in understanding the pricing of different inputs. In competitive markets, the demand for inputs is determined by the marginal products of factors. In the simplified case where factors are paid in terms of the single output, we get:

Wage = marginal product of labourRent = Marginal product of land and so forth for any factor.

This distributes 100 % of output among all the factors of production. The aggregate theory of the distribution of income is compatible with the competitive pricing of any number of goods produced by any number of factors.

While the market can work wonders in producing a growing array of goods and services in the most efficient manner, there is no visible hand which ensures that a Laissez-faire* economy will produce a fair and equitable distribution of income and property.

* Laissez-faire is an economy that relies chiefly on market forces to allocate goods and resources and to determine prices.

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SummaryIncome is the consumption and savings opportunity gained by an entity within a specified time frame, which is • generally expressed in monetary terms.Wealth is the net worth of a person, household, or nation, that is, the value of all assets owned net of all liabilities • owed at a point in time.The Theory of Income Distribution or Distribution Theory studies how incomes are determined in an • economy.The Marginal Productivity Theory of income states that, “the marginal revenue productivity of a factor reveals • the demand for that factor.”The demand for factors differs from that for consumption goods in two important respects: Factor demands are • derived demands and Factor demands are interdependent demandsThe fundamental point about distribution theory is that the “demands for the various factors of production are • derived from the revenues that each factor yields on its marginal product.”To determine the demand of production factor we need to analyse how a profit-oriented firm chooses its optimal • combination of inputsAn outcome of the least-cost rule is the substitution rule. It states that, “If the price of one factor rises while • other factor prices remain fixed, the firm will profit from substituting more of the other inputs for the more expensive factor”.The distribution of income combines the supply and demand for factors of production.• The marginal-productivity theory is a great step forward in understanding the pricing of different inputs. In • competitive markets, the demand for inputs is determined by the marginal products of factors.

ReferencesSamuelson, P., 2002. • Economics: Massachusetts Institute of Technology, Tata McGraw-Hill Publishing Co.Ltd.Pindyck, R. and Rubinfeld, D., 2008. • Microeconomics, Prentice Hall, 7th ed., Pages 768.Ana, B.A., 2012.• Advanced Microeconomics Production, [Pdf] Available at: <http://homepage.univie.ac.at/ana-begona.ania-martinez/vorlagen/Microeconomics_B_WS11_04_Production.pdf > [Accessed 21 August 2011].Kenneth, J. M., 2006. • Principles of Microeconomics, [Pdf] Available at: <http://econ.hunter.cuny.edu/microprin/Handouts/21Marginal%20Productivity%20Theory%20of%20Distribution.pdf> [Accessed 21 August 2011].Lec 8, Introduction to Producer Theory, • MIT. 2012. Principles of Microeconomics [Video online] Available at: <http://www.youtube.com/watch?v=A6FOBdtbcz4> [Accessed 21 August 2011].Lec 18, Factor Market,MIT. 2012. Principles of Microeconomics • [Video online] Available at: <http://www.youtube.com/watch?v=IuQjBqzmUKA>[Accessed 21 August 2011].

Recommended ReadingColander, D., 2009. • Microeconomics, 8th ed., McGraw-Hill/Irwin.Besanko, D. and Braeutigam, R., 2007. • Microeconomics, 3rd ed.,Wiley.Krugman, P. and Wells, R., 2010. • Microeconomics, Worth Publishers.

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Self Assessment

_________states that, “if the price of one factor rises while other factor prices remain fixed, the firm will profit 1. from substituting more of the other inputs for the more expensive factor.”

Substitution Rulea. Least-Cost Ruleb. Marginal revenue productc. Income distribution theoryd.

The________ studies how income is determined in an economy.2. theory of income distributiona. theory of productionb. theory of demandc. theory of supplyd.

Which of the following statements is false?3. The distribution of income combines the supply and demand for factors of production.a. In competitive markets, the demand for inputs is determined by the marginal products of supplyb. The equilibrium price of the input in a competitive market comes at that level where the quantities supplied c. and demanded are equalSupplies of factors of production depend upon characteristics of the factors and the preferences of their d. owners

MRP schedule for an input, we can determine the relationship between the __________ of the input and the 4. quantity demanded of that input.

supplya. priceb. qualityc. demandd.

Marginal revenue product represents the additional ______ that a firm earns from using an additional unit of 5. an input, with other inputs held constant.

revenue a. demand b. resourcec. outputd.

The money collected through tax is spent or given away by the government through ______ that are not made 6. in return for current goods or services.

transfer paymentsa. social serviceb. insurance c. subsidiesd.

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Wealth is a stock while income is a flow per unit of _________.7. rupee a. dollar b. timec. capitald.

_________of a factor reveals the demand for that factor .8. Marginal revenue productivity a. Marginal revenue productb. Marginal revenue pricec. Marginal revenue productiond.

Which of the following is the money value of the additional output generated by an extra unit of input?9. Marginal Cost Producta. Marginal Revenue Product b. Marginal Demand Product c. Marginal Supply Productd.

The equilibrium price of the input in a competitive market comes at that level where the quantities supplied 10. and demanded are ______.

unrelateda. differentb. equalc. varyingd.

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Chapter V

The Markets for Labor, Capital and Land

Aim

The aim of this chapter is to:

explain the fundamentals of wage determinations•

introduce the nature of factor demands•

elucidate input pricing•

Objectives

The objectives of the chapter are to:

explain • distribution theory and marginal revenue product

elucidate the application of marginal revenue product and the demand for factors•

explicate the theory of capital and interest•

Learning outcome

At the end of this chapter, you will be able to:

understand the importance of supply of factors of production•

understand the distribution of national income•

identify financial assets and tangible• assets

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5.1 The Labor MarketOur economy is primarily designed to provide people with good jobs with high wages so that they can sustain themselves. The distribution of income between labor and property, and within different labor groups, has been a continual source of social strife and political uproar. With the flow of the chapter, we will discuss how wages are set in a market economy.

5.2 Fundamentals of Wage DeterminationA "wage determination" is the listing of wage rates and fringe benefit rates for each classification.

5.2.1 The General Wage LevelIn analysing labor earnings, economists tend to look at the average real wage, which represents the purchasing power of an hour’s work, or the money wages divided by the cost of living.

5.2.2 Demand for Labor

Marginal Productivity Differences• To study general wage level, we have to analyse the factors underlying the demand for labor. At a given time • and with a given state of technology, there exists a relationship between the quantity of labor inputs and the amount of output. By the law of diminishing returns, each additional unit of labor input will add a smaller and smaller slab of output.For instance, as shown in the figure, at 10 units of labor, the competitively determined general wage level will• be Rs.100 per unit.

D

L

10

20

0

Mar

gina

l pro

duct

, rea

l wag

e (d

olla

rs p

er u

nit l

abor

Labor inputs

D

Fig. 5.1 Demand for labor reflects marginal productivity(Source:http://ebooks.narotama.ac.id/files/Exploring%20Economics%20%285th%20Edition%29/Chapter%20

16%20The%20Markets%20for%20Labor,%20Capital,%20and%20Land.pdf)The marginal productivity of labor will rise if workers have more or better capital goods to work with. Marginal • productivity of better-trained or better-educated workers will generally be higher than that of workers with less human capital.Wages are high in United States and other industrial countries because these nations have accumulated substantial • capital stocks, along with the vast improvements in technologies. The quality of labor inputs is another factor determining the general wage level.

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5.2.3 International ComparisonsThe differences in the wage levels across the globe, is not because of the governments of those countries, but because of the operation of the supply and demand for labor. For example, Mexican wage is lower than the US wage, principally because the Mexican demand curve for labor is far lower as a result of the low marginal productivity of labor in Mexico. The most important factor lies in the quality of the workforce. The average educational level of Mexico falls far short of the American standard, with a substantial fraction of the population illiterate, and moreover Mexico has much less capital to work with. All these factors make labor’s marginal productivity low and tend to reduce wages.

5.3 The Supply of LaborLabor supply refers to the number of hours that the population desires to work in gainful activities. The three key elements for labor supply are.

5.3.1 Hours Worked

The work hours depend upon the nature of job as well as the willingness of the labor. The wages paid per also • contribute in the hours worked.Suppose the wages rise. Figure below shows the supply curve of labor with the increase in wage rate. The supply • curve rises at first in a northeast direction; then at the critical point C, it begins to bend back in a northwest direction. It gives rise to two situations for the worker, who has just been offered higher hourly rates and is free to choose the number of hours to be worked.

ws

c

Wag

e ra

te

s

0 L

Fig. 5.2 As wages rise, workers may work fewer hours(Source:http://ebooks.narotama.ac.id/files/Exploring%20Economics%20%285th%20Edition%29/Chapter%20

16%20The%20Markets%20for%20Labor,%20Capital,%20and%20Land.pdf)As per the substitution effect, since each hour of work is now better paid and each hour of leisure has become • more expensive, thus the labor have an incentive to substitute extra work for leisure.Against the substitution effect is the income effect, which says that with the higher wage, income is higher.• With the higher income, you will want to buy more goods and services, and, in addition, you will want more leisure time. You can afford to take longer vacations or to retire earlier than you otherwise would.

5.3.2 Labor-force ParticipationOne of the most important developments in recent times has been the sharp influx of women into workforce. It can be partly explained because of the rising real wages, which have made working more attractive for women. At the same time that more women have entered the labor force, the participation rate of older men has fallen sharply.

5.3.3 ImmigrationImmigration has always played an important role in labor-force supply. The flow of legal immigrants is controlled by an intricate quota system which favors skilled workers and their families, as well the close relatives of the country citizens and permanent residents.

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5.4 Wage DifferentialsWage differentials play an important role in the analysis of the general wage level for different countries and times. In practice, wage rates differ enormously therefore it is hard to define average wage for an average person. In addition, there is a wide range of wage rates among broad industry groups. But within major sectors there are large variations that depend on worker skills and market conditions- for instance, fast-food workers make much less than doctors though they all provide services.

To understand wage differentials, let’s consider first a perfectly competitive labor market, one in which there are large numbers of workers and employers, none of which has the power to affect wage rates appreciably. If all jobs and all people are identical in a perfectly competitive labor market, competition will cause the hourly wage rates to be exactly equal.

The differences in wages across industries and the individuals also have other reasons to it, as listed below:

5.4.1 Differences in Jobs: Compensating Wage Differentials

Some of the tremendous wage differentials observed in everyday life arises because of differences in the quality • of jobs. Wage differentials that serve to compensate for the relative attractiveness or non monetary differences among jobs are called compensating differences.Jobs that involve hard physical labor, low social prestige, irregular employment, seasonal layoff and so on tend • to be less attractive.

5.4.2 Differences in People: Labor Quality

One key to wage disparities lies in the tremendous qualitative differences among people, differences traceable • to variations in innate mental and physical abilities, upbringing, education and training, experience, etc.While many of the differences in labor quality are determined by noneconomic factors, the decision to • accumulate human capital can be evaluated economically. The term human capital refers to the stock of useful and valuable skills and knowledge accumulated by people in the process of their education and training. Groups with higher education start out with higher incomes and enjoy more rapid growth in incomes than do less-educated groups.

5.4.3 Differences in People: The “Rents” of Unique Individuals

The extremely talented people have a particular skill that is highly valued in today’s economy. Outside their • special field they might earn, but a small fraction of their high incomes. Moreover, their labor supply is unlikely to respond perceptibly to wages that are 20 or even 50 percent higher or lower.Economist refers to the excess of these wages above those of the next best available occupation as a pure • economic rent; these earnings are logically equivalent to the rents earned by fixed land. If this trend continues, and labor rents raises further, the income gap between the winners and the runner’s-up may widen even further in the years to come.

5.4.4 Segmented Market and Noncompeting GroupsThere is more to the differences we have just discussed regarding the wage differentials.

Even in a perfectly competitive world where people could move easily from one occupation to another, substantial • wage differentials would appear. The major reason for the difference is that labor markets are segmented into noncompeting groups. The reason for wage differences among groups is clear after we realise that different sub markets exist for the labor market.The labor market is divided in to many non competing groups because:•

It takes a large investment of time and money for professionals and skilled people to become proficient. �Once people specialise in a particular occupation, they become part of a particular labor sub market. They �are therefore subject to the supply and demand for that skill.The theory of non competing groups helps to understand labor market and discrimination. �

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5.5 Economics of Labor UnionUnions negotiate collective-bargaining agreements, which specify who can fill different jobs, what they will be • paid, and what the work rules are. Unions can decide to go on strike, withdraw their labor supply completely in order to win a better deal from an employer.The study of unions is an important part of understanding the dynamics of labor markets. The wages and fringe • benefits of unionised workers are determined by collective bargaining. This is the process of negotiation between representatives of firms and of workers for the purpose of establishing mutually agreeable conditions of employment. The centerpiece is the economic package. The other issue is that of the work rules.

5.5.1 Effect of Unions on Wages and EmploymentWagesUnions gain market power by obtaining a legal monopoly on the provision of labor services to a particular firm or industry. Using this monopoly, they compel firms to provide wages, benefits, and working conditions that are above competitive level. Economists have analysed that although unions succeed in raising their wages; their gains come at the expense of the wages of non union workers.

EmploymentEconomists suggest that when an economy gets locked in to real wages that are too high, high levels of unemployment may result. The unemployment will not respond to the traditional macroeconomic policy of increasing aggregate spending, but will require remedies that lower real wages.

The lump of labor fallacyWhen unemployment is high, people often think that the solution lies in spreading existing work more evenly among the labor force. This view, that the amount of work to be done is fixed, is called the lump of labor fallacy. Economists opine that work is not a lump that must be shared among the potential workers. Labor market adjustments can adapt to shifts in the supply and demand for labor through changes in the real wage and through migration of labor and capital.

5.6 Discrimination by Race and GenderRacial, ethnic, and gender discrimination has been a pervasive feature of human societies since the beginning of recorded history.

Economic Explanation of DiscriminationWhen economic differences arise because of irrelevant personal characteristics such as race, gender, sexual • orientation, or religion, it is called as discrimination. Discrimination typically involves:

Disparate treatment of people on the basis of personal characteristics �

Practices (such as tests) that have an adverse impact on certain groups �

Discrimination by ExclusionThe most • pervasive form of discrimination is to exclude certain groups from employment or housing. Exclusion lowers the incomes of the groups that are targets of discrimination.

Statistical DiscriminationOne of the most interesting variants of discrimination occurs because of the interplay between incomplete • information and perverse incentives. This is known as statistical discrimination, in which individuals are treated on the basis of the average behavior of members of the group to which they belong rather than on their personal characteristics.Statistical discrimination leads to economic inefficiencies because it reinforces stereotypes and reduces the • incentives of individual members of a group to develop skills and experience.

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Economic Discrimination against WomenIn countries around the world, women have a documented disadvantage in earned income relative to men. The ILO • reports that women earn 20-30% less than men worldwide. The causes for this difference are varied, but they are linked to labor market segregation, in which women and men tend to predominate in distinct fields, and the phenomenon of the glass ceiling, in which women are clustered in the lower rungs of the employment ladder.Wage based discrimination is a major factor as well. Wage based discrimination occurs when work of equal • and. comparable value is treated differently in terms of remuneration.

5.7 Techniques to Determine Extent of DiscriminationFollowing are the techniques to determine extent of discrimination:

Regression analysis:• It is the traditional approach and uses statistical procedures to separate wage differences in to differences in human capital.Audits: In audits, people are actually observed in the act of discrimination.•

5.8 Reducing Labor Market DiscriminationDiscrimination can be combated by encouraging employers to pay more attention to personal performance. It should be noted that, in those industries where individual performances are more easily measured such as athletics and entertainment, women and minorities are highly paid than in those sectors where skills and marginal products are harder to measure and there is consequently more room for statistical and personal discrimination. Discrimination is a complex social and economic process. It is rooted in social customs and even after equality under law was established, social and economic stratification prevails.

In capitalist economy like US, the capital, land and assets are largely privately owned. By contrast, in socialist countries like China most of the land and capital is owned by government, and there are no superrich individuals as such. Under capitalism, individuals and private firms do most of the saving, own most of the wealth, and get most of the profits on these investments. The study of factor markets for land and capital, market for land, supply and demand for capital is necessary.

5.9 Land and RentThe price of using a piece of land for a period of time is called as its Rent. In capitalist economy, the supply curve for land is completely inelastic that is vertical, because the supply of land is fixed. Because of this, land will always work for whatever it can earn. Thus, the value of the land derives entirely from the value of the product, and not vice-versa.

5.10 Capital and InterestCapital (or capital goods) consists of those durable, produced goods that are in turn used as productive inputs for further production. Some capital goods might last a few years, while others might last for a century or more. But the essential property of a capital good is that it is both input and output.Categories of capital goods:

Structures: such as factories and homes• Equipment: such as automobiles and computers• Inventories of inputs and outputs: such as cars in • dealers’ lot

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5.11 Rate of Return on Capital GoodsOne of the important tasks of any economy is to allocate its capital across different possible investments. In • deciding upon the best investment, we need a measure for that yield or return for capital. One important measure is the rate of return on capital.To decide on the best investments to make with available capital, a useful approach is to compare the rates of • return on capital of the different investments.

To calculate rate of return, � Calculate the cost of capital good

� Estimate net annual receipts or rentals yielded by the asset

The ratio of the annual net rental to the cost �

For example, a person buys grape juice for $10 and sells it a year later as wine for $11. If there is no other expense, the rate of return on this investment is $1/$10, i.e., 10 percent per year.

5.12 Financial Assets and Tangible AssetsFinancial Assets

Financial assets include cash and bank accounts plus securities and investment accounts that can be readily • converted into cash.Excluded are illiquid physical assets such as real estate, automobiles, art, jewelry, furniture, collectibles and so • on which are included in calculations of Net Worth.

Tangible AssetsTangible assets include equipment, machinery, plant, property anything that has long-term physical existence • or is acquired for use in the operations of the business and not for sale to customers.In the balance sheet of the business, such assets are listed under the heading ‘Plant and Equipment’ or ‘Plant, • Property and Equipment.’Tangible assets, unlike intangible assets, can be destroyed by fire, hurricane, or other disasters or accidents.• However, they can be used as collateral to raise loans, and can be more readily sold to raise cash in • emergencies.Tangible assets are essential parts of an economy because they increase the productivity of other factors, whereas • financial assets are crucial because of a mismatch between savers and investors. A vast financial system of banks, insurance companies etc serve to the channel the funds from those who are saving to those who are investing.

5.12.1 Financial Assets and Interest RatesThe expected return on savings is the interest rate or the financial return on funds, or the annual return on borrowed funds.There are many varieties of interest rates, like long-term and short-term interest rates, fixed and variable interest rates.

5.12.2 Real and Nominal Interest RatesGenerally, a real variable, such as the real interest rate, is one where the effects of inflation have been factored in.

A nominal variable is one where the effects of inflation have not been accounted for. A few examples illustrate • the difference:Suppose, we buy a 1 year bond for face value that pays 6% at the end of the year. We pay $100 at the beginning • of the year and get $106 at the end of the year. Thus the bond pays an interest rate of 6%. This 6% is the nominal interest rate, as we have not accounted for inflation. Whenever people speak of the interest rate they’re talking about the nominal interest rate, unless they state otherwise.

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Now suppose the inflation rate is 3% for that year. We can buy a basket of goods today and it will cost $100, • or we can buy that basket next year and it will cost $103. If we buy the bond with a 6% nominal interest rate for $100, sell it after a year and get $106, buy a basket of goods for $103, we will have $3 left over. So after factoring in inflation, our $100 bond will earn us $3 in income; a real interest rate of 3%.The relationship between the nominal interest rate, • inflation, and the real interest rate is described by the Fisher Equation:

Real Interest Rate = Nominal Interest Rate - Inflation

If inflation is positive, which generally is, the real interest rate is lower than the nominal interest rate. If we have deflation and the inflation rate is negative, then the real interest rate will be larger.

5.13 Present Values of AssetCapital goods are durable assets that produce a stream of rentals or receipts over time. The present value is the monetary value today of a stream of income over time. It is measured by calculating how much money invested today would be needed, at the going interest rate, to generate the assets future stream of receipts.

For example, a person sells a bottle of wine that matures exactly after a year and can then be sold at exactly $11.• Assuming that the market interest rate is 10%, what is the present value of wine? The answer is $10, because • $10 invested today at the market interest rate of 10% will be worth $11 in 1 year.

5.13.1 Present Value for PerpetuitiesPerpetuity: It is an asset like land that lasts for ever and pays $N each year from now to eternity.

Calculating PerpetuityThe present value (V), at the interest rate I % per year, where the present value is the amount of money invested today that would yield exactly $N each year, can be calculated as, V=$N/iWhere, V= present value of the land ($)$N= perpetual annual receipts ($ per year)I= interest rate in decimal terms (e.g. 0.005 or 5/100 per year)

This says that if the interest rate is always 5% per year, an asset yielding a constant stream of income will sell • for exactly 20 (= 1÷ 5/100) times its annual income. Which means, at a 5% interest rate, its present value would be $2000 (=$100÷0.005)

5.13.2 General Formula for Present ValueIn case of present value, the future payments are worth less than current payments and they are therefore discounted relative to the present. Future payments are worth less than current payments just as distant objects look smaller than nearby ones. The interest rate produces a similar shrinking of time perspective.

Calculating Present Value:First evaluate the present value of each part of the stream of future recipients, giving due allowance for the discounting required by its payment date. Then simply add together all these separate present values. This summation will give the asset’s present value.

Present Value (V) is,

V= N1/ (1+i) + N2/ (1+i) 2+…….Where, i - the one period market interest rate (assumed constant) N1 - the net receipts in period 1

N2 - the net receipts in period 2then the stream of payments (N1, N2….) will have the present value, V, given by the formula.

Acting to maximise present value: present value must be calculated from each possible decision and action must be taken to maximise the present value

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5.14 ProfitsAccountants define profits as, the difference between total revenues and total costs. Economists have, over the years, developed several theories regarding profits. For example, Joseph Schumpeter attributed profits to innovation. But Frank Knight associated them with uncertainty.

5.14.1 Profits as Rewards for InnovationSchumpeter regards profit as a phenomenon, which is related to a dynamic economy only. He identifies five types of changes that lead to economic development or make the society dynamic. These changes are:

Introduction of new products• Introduction of new methods of production• Discovery of new raw materials• Discovery of new markets• Introduction of new forms of organisation•

Schumpeter is of the opinion that one who innovates is able to earn more profits, and thus gets more incentive to innovate further. He/She will soon attract followers or imitators. These people very soon catch up with original innovator. As a consequence, he/she makes more efforts to stay ahead. Thus, innovation leads to profits; and profits make it possible to innovate (acting as incentive).

5.14.2 Uncertainty and ProfitFrank Knight defined profit as the difference between selling price and costs. In such situation, profit emerges as a residual. Selling price and costs depend on a host of factors. Some of those can be covered by ‘risk’. Such risks can be anticipated and provisions can be incorporated into the cost structure. Most of predictable risks are ‘insurable’ as well. Hence, company can get an appropriate insurance policy to cover such risks. The premium paid for such policy is included in cost of production.

Whereas wage, rent interests are all payments, which have been agreed to and settled in advance, profits cannot be put on a similar footing. Uncertainty leads to fluctuation in both costs and revenue. They may not balance. Thus, ultimately profits are the ‘surplus’ that remains after meeting the entire contractual payment obligation.

5.14.3 Profits and Market StructureSome economists insist that profit, as one generally understood, is essentially a result of market imperfections. If perfect competition prevailed, every producer will use same technology; will have perfect knowledge about product, cost and market condition. Such a scenario leads to cost minimisation for all the production. They sell at going market price. All the cost and revenue determinants are perfectly certain. Hence, entrepreneurship is just organisation or day-to-day supervision only. So, profits should drop down to bare minimum or ‘normal’ compensation for supervision etc.However, if market is not perfect, firm can determine quantities or prices in such a manner that suits best. It may involve breaching the condition of perfect information.

5.15 The Theory of Capital and InterestThe theory of capital and interest is discussed below:Roundaboutness

Investment in capital goods involves indirect or roundabout production. That investment in capital goods • involves forgoing present consumption to increase future consumption. Capital is productive because by forgoing consumption today, there is more consumption for future.Thus, by sacrificing current consumption and building capital goods today, societies can increase their • consumption in future.

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Diminishing returns and the demand for capitalMore generally, as capital accumulates, diminishing returns set in and the rate of return on the investments tends to fall. The rate of return on capital has not fallen markedly over the course of the last two centuries, even though the capital stocks have grown many folds.

Rates of return have remained high because innovation and technological change have created profitable new opportunities as rapidly as past investment has annihilated them.

Determination of interest and the return on capitalAccording to Irving Fisher, the quantity of capital and the rate of return on capital are determined by:

The interaction between people’s impatience to consume now rather than accumulate more capital goods for • future consumption.Investment opportunities that yield higher or lower returns to such accumulated capital.•

To understand interest rates and the return on capital, consider an idealised case of a closed economy with perfect competition and without risk or inflation. In deciding whether to invest, a profit maximising firm will always compare its cost of borrowing funds with the rate of return on capital. If the rate of return is higher than the market interest rate at which the firm can borrow funds, it will undertake the investment. If the interest rate is higher than the rate of return on investment, the firm will not invest. In a competitive economy without risk or inflation, the competitive rate of return on capital would be equal to the market interest rate.

The market interest rate serves two functions:It rations out society’s scarce supply of capital goods for the uses having highest rates of return•

It includes people to sacrifice current consumption in order to increase the stock of capital•

5.15.1 Applications of Classical Capital TheoryApplications of classical capital theory is discussed as below:Taxes and inflation

Inflation tends to reduce the quantity of goods we can buy with money.• Another important feature is taxes. Part of our income goes to the government to pay for public goods and other • government programs. Therefore investors focus on the post tax return on investments.

Technological disturbancesHistorical studies show that inventions and discoveries raise the return on capital and there by affect equilibrium • interest rates. Indeed, the tendency toward falling interest rates via diminishing returns has been just about canceled out by inventions and technological progress.

Uncertainty and expectationsRisks exist in all investment • decisions. All investments, resting as they do on estimates of future earnings, must necessarily involve guesses about future costs and pay offs.Economists emphasise that a free market in capital and land will promote high rates of saving and investment, • rapid economic growth, and healthy productivity growth. At the same time, many people worry that this same free market will lead the rich to become richer while the poor will fall behind.

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SummaryThe distribution of income between labor and property, and within different labor groups, has been a continual • source of social strife and political uproar. Labor supply refers to the number of hours that the population desires to work in gainful activities. The three • key elements for labor supply are: hours worked, labor-force participation and immigration.Regression Analysis is the traditional approach and uses statistical procedures to separate wage differences in to • differences in human capital.In audits, people are actually observed in the act of discrimination.• Discrimination is a complex social and economic process. It is rooted in social customs and even after equality • under law was established, social and economic stratification prevails.The price of using a piece of land for a period of time is called as its Rent.• In capitalist economy, the supply curve for land is completely inelastic that is vertical, because the supply of land • is fixed.Capital (or capital goods) consists of those durable, produced goods that are in turn used as productive inputs • for further production.Financial assets include cash and bank accounts plus securities and investment accounts that can be readily • converted into cash.Tangible assets include equipment, machinery, plant, property anything that has long-term physical existence • or is acquired for use in the operations of the business and not for sale to customers.Investment in capital goods involves indirect or roundabout production. That investment in capital goods • involves forgoing present consumption to increase future consumption. Capital is productive because by forgoing consumption today, there is more consumption for future.

ReferencesSamuelson, P. and Nordhaus, W., 2001. • Economics, New Delhi: Tata McGraw-Hill Publishing Co. Ltd.Tewari, D. D. and Katar, S., 2003.• Principles of Microeconomics.New Age International Publishers.Labor Market Discrimination against Women – at Home and Abroad. • A UNIFEM Briefing Paper. [Pdf] Available at: <http://www.unifemeseasia.org/projects/migrant/HR%20Protections%20Applicable%20to%20WMW/Part%20 3%20Labour%20market%20discrimination.pdf> [Accessed 30 October 2010].Lectures in Labour Market Policy Studies: Labour Economics• , [Pdf] Available at :<http://www.lmps.gofor.de/Labour%20economics.pdf> [Accessed 30 October 2010].Mindbitesdotcom., 2011. • Economics:The Labor Market. [Video online] Available at:<http://www.youtube.com/watch?v=ZXt99pqTNZ0> [Accessed 30 October 2010].Mindbitesdotcom., 2011. • Economics:Minimum Wages in Labor Markets. [Video online ] Available at:<http://www.youtube.com/watch?v=nnq6mXYm_LQ>[Accessed 30 October 2010].

Recommended ReadingBecker, G., 1971. • The Economics of Discrimination (Economic Research Studies), 2nd ed . , University Of Chicago Press.Boeri, T., and Ours, J.,2008. • The Economics of Imperfect Labor Markets [Paperback], Publisher: Princeton University Press.Kaufman, B. and Hotchkiss J., 2005. • The Economics of Labor Markets (with Economic Applications and InfoTrac Printed Access Card) , 7th ed., South-Western College Pub.

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Self Assessment

By the law of diminishing returns, each additional unit of labor input will add a 1. .smaller slab of output a. smaller slab of returns b. larger slab of outputc. larger slab of returnsd.

Which is not a key element for labor supply?2. Hours worked a. Familyb. Immigrationc. Labor force participationd.

________________ refers to the number of hours that the population desires to work in gainful activities.3. Demand supply a. Labor supplyb. Demand activitiesc. Labor activitiesd.

Which factor leads to rise in marginal productivity of labor?4. Better monetary gainsa. Better work environment b. Better work teamsc. Better capital goodsd.

Which of the following is not the reason for differences in wages across industries and the individuals?5. Differences in work place- work environmenta. Differences in jobs-Compensating wage differentials b. Differences in people-Labor qualityc. Differences in People-The “Rents” of Unique Individualsd.

Labor markets are segmented into__________________.6. competing groupsa. noncompeting groups b. labor groupsc. skill groupsd.

The theory of non competing groups helps to understand labor market and7. _________.wages a. skillsb. competitionc. discriminationd.

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What determines the wages and fringe benefits of unionised workers?8. Collected gainsa. Collected wagesb. Collective bargainingc. Unionsd.

The amount of work to be done is fixed is which of the following approaches?9. Lump of wage fallacy a. Lump of labor fallacy b. Cluster of laborc. Cluster of wage discriminationd.

Which is one of the technique to determine extent of discrimination?10. Regression analysis a. Aggression analysisb. Discrimination analysis c. Gender biasd.

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Chapter VI

International Trade

Aim

The aim of this chapter is to:

explain the nature of international trade•

explicate the principle of comparative advantage among nations•

determine approaches to multilateral trade negotiations•

Objectives

The objectives of the chapter are to:

explain different arguments on protectionism•

elucidate different trade barriers•

describe Ricardo’s analysis of comparative advantage among nations•

Learning outcome

At the end of this chapter, you will be able to:

understand triangular and multilateral trade•

identify the economic and non economic trade barriers•

compare between domestic and international trade•

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6.1 IntroductionIncreased trade has meant greater choice of what to buy and often at lower prices. The relatively free trade that exists today provides us with expanded choices. Our gains are being experienced worldwide because the winds of international trade have blown generally freer in the past decades. Nations all over the world have dramatically lowered the barriers they impose on the products of other countries.

TradeTrade, also called commerce or transaction, is the voluntary, often asymmetric, exchange of goods, services, or money. A mechanism that allows trade is called a market. The original form of trade was barter, the direct exchange of goods and services.

Domestic tradingTrading that is aimed at a single market, the firm’s domestic trade, is referred to as domestic trading. In domestic trading, the firm faces only one set of competitive, economic, and market issue, and essentially must deal with only one set of customers, although the company may have several segments in one market.

International tradeInternational trade is the exchange of goods and services between countries. This type of trade gives rise to a world economy, in which, prices, supply and demand affect and are affected by global events.

Trade facilitates the flow of capital and speed up the acquisition of new technology. Exports not only contributedirectly to economic growth but also permit more imports, and a rapid modernisation of production.

Following are the major differences between domestic and international trade:

Factors Domestic Trade International TradeMobility in Factor of Production Free to move around factors

of production like land, labor, capital and labor capital and entrepreneurship from one state to another within the same country

Quite restricted

Movement of goods Easier to move goods without much restriction. May need to pay sales tax and so on

Restricted due to complicated custom procedures and trade barriers like tariff, quotas or embargo

Usage of different currencies Same type of currency used Different currencies for different countries

Broader markets Limited market due to limits in population, and so on Broader markets

Language and cultural barriers Speak same language and practice same culture

Communication challenges due to language and cultural barriers

Table 6.1 Differences between domestic trade and international trade

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6.2 Factors Determining Gains from TradeThe extent of gain from trade is determined by many factors, as discussed under the following heads

6.2.1 Relative Differences in Cost RatioThe extent of gain from trade is determined by the relative differences in cost ratios. If a country has greater differences in cost ratios it will gain more because, if the differences are marginal then gains will also be marginal.

Thus, gains are directly related to productivity and efficiency conditions prevailing in a country. Higher the productivity and efficiency greater will be the gains from trade.

6.2.2 Reciprocal DemandReciprocal demand also determines the extent of gain. For example, if country A demands more and country B is not willing to supply at the existing rate, then rate will change in favor of B. Or, if country A demands less and country B is willing to supply more then the terms of trade will favor country A.

The relative strength and elasticity of demand of both the countries will determine the gains from trade. High efficiency in production will result in greater gains. Further, income and nature of the commodity, which will influence the demand, will also influence the gain.

As more than one country is involved in trade, we have to consider the relative capability and demand of both the countries. It can be said that the gains to a small country will be relatively larger, because, a small country faces many obstacles and limitations in large scale production.

6.3 The Sources of International Trade in Goods and ServicesNations find it beneficial to participate in international trade for several reasons:

Diversity in productive possibilities among countries: In part, these differences reflect endowments of natural • resources. One country may be blessed with a supply of petroleum while another may have a large amount of fertile land.Preferences: Even if the conditions of production were identical in all regions, countries might engage in trade • if their tastes for goods are different.Differences among countries in production costs: For example, manufacturing processes enjoy economies of • scale that is they tend to have lower average costs of production as the volume of output expands. So when a particular country gets a head start in particular product, it can become the high-volume-low-cost producer. The economies of scale give a significant cost and technological advantage over other countries, who find it cheaper to buy from the leading producer than to make the product.

6.4 Comparative Advantage among NationsFollowing are the comparative advantages among nations:

Trade, whether within a country or between countries, is an act of exchange. Countries normally do not produce • each and everything and thus exchange one thing for another.Only under restrictive assumption of a closed economy, where we do not have external trade and economic • relations, almost all the commodities are produced within a country and exchange or barter takes place within the country.People exchange things as they cannot produce everything efficiently and at a lower cost. Similarly, a country, • which has, for example, mineral resources only and limited cultivable land, is bound to import agricultural commodities.Thus, like individuals, countries also differ in factor endowments. As a result, some countries can produce • other commodities more efficiently at a lower cost. There is a possibility that a country can produce most of the commodities at a lower cost as compared to many others. But the level of efficiency will not be the same for all goods, but of different degrees.

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The principle of comparative advantage• holds that each country will benefit if it specialises in the production and export of those goods that it can produce at relatively lower cost. Conversely, each country will benefit if it imports those goods, which it produces at relatively high cost.

6.4.1 Ricardo’s Analysis of Comparative AdvantageEconomists like David Ricardo, believed that labor is the only source of value of goods in the economy. This does not mean that no other inputs are required in production, but since the other inputs such as raw materials and capital goods are also produced by labor, ultimately it is the labor which determines the relative valuation of goods.

Consider the following example: Assume that it takes 3 hours of labor to make one yard of cloth and 5 hours of labor to 10 kilogram of wheat. The wheat and cloth markets are perfectly competitive and labor is free to move from wheat production to cloth production and vice versa. This implies that the wage rate (W) will be same in the cloth and wheat industries. Then the average costs (cost per unit, one unit of cloth is one yard and one unit of wheat is 10 Kg) in cloth and wheat production will be respectively 3W and 5W. These will also be the prices of cloth and wheat respectively, because under perfect competition price is equal to average cost. Thus the relative price of cloth in term of wheat is 3W/5W or 3/5 which simply means that 3/5th of a unit of wheat will buy one unit of cloth, or 6 kg wheat will be exchanged for one yard of cloth. In the terminology of classical economics, this exchange ratio is known as the value which is determined only by labor and nothing else.

6.4.2 Autarky EquilibriumSince we do not intend to introduce money in the model, it is the relative price or the exchange ratio, which will determine the production and demand in the two industries.

In the above example, we would, of course, assume that the labor requirements per unit of wheat or cloth (5, 3) remain the same, no matter how many units of both goods the economy produces. This assumption is known as the Constant Returns to Scale (CRS). CRS means that the labor productivities are independent of the scale of output.What are the labor productivities in cloth and wheat production?

These are 1/3 and 1/5 respectively, one hour of labor will produce 1/3 yard of cloth and 1/5 x 10 = 2 Kg of wheat.Labor productivity is just the reciprocal of the unit labor requirement. With 300 hours of labor available and fully employed at one time in an economy, the production possibility frontier is shown as AB.

Note that if all labor is devoted to the production to cloth, then 100 units of cloth will be produced and that if all labor go into wheat production, then 60 units of wheat will be produced. Thus the slope of the production possibility frontier is 60/1 00 = 3/5, which is the exchange ratio.

In Autarky Equilibrium, the economy’s consumers will choose a point like P on the production frontier in such a way that their welfare is maximised. Thus in equilibrium, OW and OC are the quantities of wheat and cloth respectively, both demanded and supplied. The point P, in other words, represents a general equilibrium in the economy where demand and supply in each of the two markets are equal.

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Wheat

60

W

0 C 100B

Cloth

A

P

Fig. 6.1 Production possibilities of wheat and cloth(Source:http://catalog.flatworldknowledge.com/bookhub/reader/21?e=rittenberg-ch17_s04)

6.5 Economic Gains from Trade Some of the important gains are as follows: Optimum use of resources With division of labor there will be optimum allocation of resources and maximum production within a country and also between countries. Thus, we can say that if the countries trade within and at the international level, there will be optimum use of resources.

Advantage of large scale productionDivision of labor is limited by the size of the market. If a country has limited demand then production will be less. International trade removes this limitation of the market. Now, a country will produce not only for self, but also for the consumers of different countries. Due to increase in the size of the market, economies of large scale production will be operating.

These economies can be listed as following:Economy in large scale buying and sellingIt is a common experience that when we make bulk purchases, there is economy in expenses. Similarly, the cost of selling per unit will decrease. Thus, there will be economy in large scale buying and selling.

Gains accruing due to indivisibility of a factor of productionWe can say that due to trade, production will increase and machines or productive units will be producing to the optimum level and as a result the cost will decrease.

Improvement in the qualityBecause of large scale production and competition in the market, the quality of commodities will increase. In fact, consumers will buy goods of better quality with a lower price. Therefore in order to secure the market, entrepreneurs (producers) will like to improve the quality of commodities. Continuous research and development will become a part of the business unit.

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6.6 Extensions to Many Commodities and CountriesMany CommoditiesWhen two regions or countries produce many commodities at constant costs, the goods can be arranged in order according to the Comparative Advantage (CA) or individual cost.

Aircraft Computers Wheat Automobiles Wine Apparel

America’s CA Europe’s’Comparative

Advantage (CA)

Fig. 6.2 With many commodities, there is a spectrum of advantages(Source:http://catalog.flatworldknowledge.com/bookhub/reader/21?e=rittenberg-ch17_s04)

The above Fig. 6.2 shows that America’s CA is to produce and export aircrafts, while Europe’s advantage is in production and export of apparel. But the dividing line depends on the demand and supplies of different goods.

Many CountriesIntroducing many countries does not change the above analysis. As far as a single country is concerned, all the other nations can be lumped together as one group as “the rest of the world.”

The advantages of trade have no special relationship to national boundaries. The principles developed apply between groups of countries and also to regions within a country.

6.6.1 Triangular and Multilateral TradeTriangular trade usually evolves when a region has export commodities that are not required in the region from which its major imports come. Triangular trade thus provides a method for rectifying trade imbalances between the above regions

Developing Countries

Japan

America

Computers Consumer Electronics

Oil

Fig. 6.3 Triangular trades(Source:http://catalog.flatworldknowledge.com/bookhub/reader/21?e=rittenberg-ch17_s04)

Multilateral trading system is one in which a large number of nations interact with each other. By and large, a multilateral trading system is like a large free market with physical boundaries removed as far as the transactions and movement of goods are concerned.

Goods flow freely between nations. Goods produced in a country compete freely for the consumer’s dollars with the goods produced in any other country.

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6.7 ProtectionismIn spite of the strong theoretical case that can be made for free international trade; every country has established some barriers to trade. A protectionist policy is one in which a country restricts the import of some goods and services produced in foreign countries. Trade restrictions are typically undertaken in an effort to protect companies and workers in the home economy from competition by foreign firms.

No trade equilibriumAn equilibrium position with domestic demand equal to domestic supply for an autarkic state. For example, • consider the clothing market in America. To easily analyse supply and demand, assume that America is a small part of the market and therefore cannot affect the world price of clothing. The supposed price of clothing is determined in the world market and is equal to $4 per unit. Although transactions in international trade are carried out in different currencies, for now we can simplify by converting the foreign supply schedule into a dollar supply curve by using the current exchange rate.Presume that transportation costs or tariffs for clothing were prohibitive.•

Where would the no trade equilibrium lie?In this case the American market for clothing would be at the intersection of domestic supply and demand. At this no-trade point, prices would be relatively high at $8 per unit, and domestic producers would be meeting all the demand.

Free tradeFree trade among nations assures that the resources available are put to their best possible use.The model of free trade is based on the assumption that all the nations have a global view of the use of resources.

6.7.1 Trade BarriersIt is a general term that describes any government policy or regulation that restricts international trade.The barriers can take many forms, including the following terms that include many restrictions in international trade within multiple countries that import and export any items of trade:

Trades•

Import licenses•

Export licenses•

Import quotas•

Subsidies•

Non-tariff barriers to trade and so on•

Most trade barriers work on the same principle; the imposition of some sort of cost on trade that raises the price of those products.

6.7.2 TariffsTariffs are usually associated with protectionism, the economic policy of restraining trade between nations. For political reasons; tariffs are usually imposed on imported goods, although they may also be imposed on exported goods.

A Prohibitive tariff is so high that nearly no one imports any of those items.A Non- prohibitive tariff is a lower tariff that would injure but not kill off trade. It tends to raise price, lower the amounts consumed and imported, and raise domestic production.

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6.7.3 QuotasA quota is a direct restriction on the total quantity of a good or service that may be imported during a specified period.

Quotas restrict total supply, and therefore increase the domestic price of the good or service on which they are imposed. Quotas generally specify that an exporting country’s share of a domestic market may not exceed a certain limit.

6.8 Difference between Tariffs and QuotasFollowing is the diffrence between tariffs and quotas:

An important distinction between quotas and tariffs is that quotas do not increase costs to foreign producers; • tariffs do.In the short run, a tariff will reduce the profits of foreign exporters of a good or service. A quota, however, raises • price but not costs of production and thus may increase profits.Because the quota imposes a limit on quantity, any profits it creates in other countries will not induce the entry • of new firms that ordinarily eliminates profits in perfect competition. By definition, entry of new foreign firms to earn the profits available in the United States is blocked by the quota.

Transportation CostsThe cost of moving bulky and perishable goods has the same effect as tariffs, reducing the extent of beneficial regional specialisation.

Impact of Protectionist PoliciesProtectionist policies reduce the quantities of foreign goods and services supplied to the country that imposes the restriction. As a result, such policies shift the supply curve to the left for the goods or services whose imports are restricted.

As shown here, the supply curve shifts to S2, the equilibrium price rises to P2, and the equilibrium quantity falls to Q2

Quantity of good or service per period

Q2 Q1

P2

P1

Pric

e of

goo

d or

serv

ice

S2 S1

D1

Fig. 6.4 The impact of protectionist policies(Source:http://catalog.flatworldknowledge.com/bookhub/reader/21?e=rittenberg-ch17_s04)

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Economic Costs of TariffThere are three effects:

The domestic producers can expand production• Consumers are faced with higher prices and therefore reduce consumption• Government gains tariff revenue•

Non-economic GoalsNational security is one of the major non-economic goals in trade policy. A nation should not sacrifice its liberty,culture, and human rights for some extra income.

6.9 Unsound Grounds of TariffMercantilism, basically, is a theory that says a nation’s power is based on its wealth.It suggests that the ruling government should advance these goals by playing a protectionist role in the economy by encouraging exports and discouraging imports, notably through the use of subsidies and tariffs, respectively.

Cheap foreign labor and outsourcingA particularly controversial issue in industrialised economies is outsourcing, in which firms in a developed country transfer some of their activities abroad in order to take advantage of lower labor costs in other countries. Generally speaking, the practice of outsourcing tends to reduce costs for the firms that do it. These firms often expand production and increase domestic employment.

Retaliatory tariffsIt usually leads other nation to raise their tariffs higher and is rarely an efficient bargaining chip for multi lateral tariff reduction.

Import reliefIt is any of several measures, imposed by a government, to temporally restrict imports of a product or commodity to protect domestic producers from competition. Or, any of several measures such as subsidies, educational and training assistance to workers, low interest loans, tax relief and so on to strengthen domestic producers.

6.10 Potentially Valid Arguments for ProtectionArguments for protection can be summarised as follows:

First, there is a category of purely economic arguments that comprise all those arguments for protection as a • means of increasing real output or income, above what it would otherwise be. These include:

The infant argument, to allow industries to reap their optimum size in terms of minimum average cost of �production.The existence of external economies in production, where the social cost of production is less than the �private cost.Distortion in the labor market, which makes the social cost of using labor less than the private cost; and �International distortion, which causes the domestic rate of transformation between goods to diverge from the �foreign rate of transformation due to, for example, monopoly power in international trade. This argument for protection is often referred to as the optimum tariff argument.

Secondly, there is a category of non-economic arguments for protection which comprise arguments for protection • for its own sake rather than to increase output or income, above what it would otherwise be. For example, industrialisation at any price, or self-sufficiency for strategic reasons, would be arguments of this type.

6.10.1 The Terms of Trade or Optimal Tariff ArgumentThe idea is that, when a large country levies tariffs on its imports, it will reduce the world price of its imports while increasing the prices of its exports. Such a change will be an improvement in the terms of trade. For example, by shifting the terms of trade in its favor, the United States can export less wheat and fewer aircraft in order to pay

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for imports of oil and cars. The set of tariffs that maximises domestic real incomes is called the optimal tariff. The possibility that a tariff could improve national welfare for a large country in international markets was first noted by Robert Torrens (1844). Since the welfare improvement occurs only if the terms of trade gain exceeds the total deadweight losses, the argument is commonly known as the Terms of Trade Argument for protection.

6.10.2 Infant IndustriesA new domestic industry with potential economies of scale is called an infant industry. One argument for trade barriers is that they serve as a kind of buffer to protect fledgling domestic industries. Initially, firms in a new industry may be too small to achieve significant economies of scale and could be clobbered by established firms in other countries.

Consider a situation in which firms in a country are attempting to enter a new industry in which many large firms already exist in the international arena. The foreign firms have taken advantage of economies of scale and have, therefore, achieved relatively low levels of production costs. New firms, facing low levels of output and higher average costs, may find difficult to compete. The infant industry argument suggests that by offering protection during an industry’s formative years, a tariff or quota may allow the new industry to develop and prosper.

6.10.3 Tariffs and UnemploymentA powerful motive for protection has been the desire to increase employment during a period of recession.Protection creates jobs by raising the price of imports and diverting demand towards domestic production.

6.10.4 Protection against DumpingDumping is said to occur when firms sell goods at significantly lower prices in export markets than in their domestic markets, in a bid to capture a larger share of the foreign market.

Economic theory provides an insight into why dumping occurs in the first place. It can be shown that when markets are imperfectly competitive, firms have an incentive to carry out price discrimination whenever they face segmented markets for their products.

6.11 Negotiating Free TradeThe world trade had badly suffered on account of the restrictive trade practices adopted by the different countries during the World War II.Countries were keen to set a new system of world trade, where dangerous protective practices could be avoided and the world community could have the benefits of free trade.

6.11.1 Multilateral AgreementsThe General Agreement on Trade and Tariffs (GATT) was concluded in Havana in 1947, after a series of negotiations between the participating countries. The membership of the GATT as on April, 1995, was 121, which together accounted for about 90 percent of world trade.The member-countries have entered into agreements in respect of the following:

The principles of ‘most favored nations’ (MFN) have been adopted. This means that any concession which a • country may give to any of the members would, with certain exception, be automatically given to other member-countries as well.Protection to domestic industries should not be given on the basis of quantitative restrictions such as quota, • exchange controls and so on. Only tariffs should be imposed to protect the domestic industries.The contracting parties should sort out their differences by utilising the good offices of the GATT. They themselves • should not adopt or initiate retaliatory action against each other.All the member-countries should jointly try to expand world trade along with healthy lines.•

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6.11.2 World Trade Organisation (WTO)WTO started functioning from January 1, 1995 and has substantially increased powers to enforce International Trade Agreements. The WTO is different from and an improvement over the GATT in the following respects:

The WTO is more global in its membership.•

The WTO has introduced commercial activities into the multilateral trading system.• GATT provisions in case of disputes were time-consuming; GATT could levy penalties only through • unanimous decision, which were virtually impossible.

Under WTO, unanimous decisions are no longer desired; all disputes are to be settled within 18 months. �WTO has one-country one-vote principle, unlike in the World Bank and IMF where the economic strength �of rich countries translates into a voting majority. 60

1820 1840 1860 1880 1900 1920 1940 1960 1980 2000

Year

60555045403530252015105

Tariff of Abominations

(1820)Morrill and

Civil War Tariffs 1861-1864

UnderwoodTariff(1913)

Tariff(1913)

Smooth-Hawley Tariff 1930

Trade Agreements Act.(1934)

Rat

io o

f dut

ies c

olle

cted

to d

utia

ble

impo

rts %

Fig. 6.5 U.S. tariff rates, 1820–2005(Source:http://www.web-books.com/eLibrary/NC/B0/B63/087MB63.html)

As shown in Fig. 6.5, tariff rates on “dutiable imports” have fallen dramatically over the course of U.S. history.The World Trade Organisation (WTO) was established to “help trade flow smoothly, freely, fairly and predictably” • among member nations.In 2008, it had 153 member countries. Since World War II, the General Agreement on Tariffs and Trade • (GATT)- WTO’s predecessor - and WTO have generated a series of agreements that slashed trade restraints among members.These agreements have helped propel international trade, which in 2006 was more than 35 times its level in • 1950, but the negotiations leading to these agreements have always been protracted and tumultuous and issues of nationalism and patriotism are often not far from the surface.The imposition of trade barriers such as tariffs, antidumping proceedings, quotas, or voluntary export restrictions • raises the equilibrium price and reduces the equilibrium quantity of the restricted good. Although there are many arguments in favor of such restrictions on free trade, economists generally are against protectionist measures and support free trade.

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SummaryTrade, also called commerce or transaction, is the voluntary, often asymmetric, exchange of goods, services, • or money.Trading that is aimed at a single market, the firm’s domestic trade, is referred to as domestic trading.• International trade is the exchange of goods and services between countries. This type of trade gives rise to a • world economy, in which, prices, supply and demand affect and are affected by global events.• The extent of gain from trade is determined by the relative differences in cost ratios.• Trade, whether within a country or between countries, is an act of exchange. Countries normally do not produce • each and everything and thus exchange one thing for another.Triangular trade usually evolves when a region has export commodities that are not required in the region from • which its major imports come.A protectionist policy is one in which a country restricts the import of some goods and services produced in • foreign countries.Trade barriers are a general term that describes any government policy or regulation that restricts international • trade.Tariffs are usually associated with protectionism, the economic policy of restraining trade between nations. • For political reasons; tariffs are usually imposed on imported goods, although they may also be imposed on exported goods.An important distinction between quotas and tariffs is that quotas do not increase costs to foreign producers; • tariffs do.The General Agreement on Trade and Tariffs (GATT) was concluded in Havana in 1947, after a series of • negotiations between the participating countries.

ReferencesSamuelson, P. and Nordhaus, W., 2001. • Economics, New Delhi, Tata McGraw-Hill Publishing Co. Ltd.Atkinson, A. B., 1996.• Economics in a Changing World:Microeconomics Vol 2 (International Economic association).John, P., 2002. • Microeconomics [Online] Available at :<http://www.peoi.org/Courses/Coursesen/mic/fram15.html> [Accessed 20 October 2010].Heakal, Reema, • What is International Trade? [Online] Available at: <http://www.investopedia.com/articles/03/112503. asp> [Accessed 20 October 2010].Mindbitesdotcom., 2011. • Economics:Analysing the Labor Market.[Video online] Available at: <http://www.youtube.com/watch?v=5ReW_bzaqHk>[Accessed 20 October 2010].KnowledgeOneInc., 2011. • Introduction to Microeconomics. [Video online] Available at: <http://www.youtube.com/watch?v=2Jou2u3CVDU>>[Accessed 20 October 2010].

Recommended ReadingRalph, H. F. and lvlichael, W. and John, A. S., 2008• . lnternaiional Trade and Economic Relations in a Nutshell, 4th ed.Jagdish, B., Arvind, P. and Srinivasan, T. N., 1998. • Lectures on International Trade, 2nd ed., The lV ITPress.Robert, C. F., 2003. • Advanced International Trade. Theory and Evidence. Princeton University Press.

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Self Assessment

Which of the trade is the exchange of goods and services between countries?1. Barrier trade a. No-tradeb. International tradec. Multilateral traded.

The relative ______________________ of demand of both countries will determine gains from trade.2. strength and elasticitya. production and efficiencyb. strength and efficiencyc. production and elasticityd.

Which of the following statements is false?3. Production possibilities depend on natural resourcesa. In identical production possibilities, countries engage in trade, for different taste of goods b. Production depends on lower average costc. Countries always produce all things requiredd.

According to principal of comparative advantage, which of the following is true?4. Each country will benefit if it specialises in the production and export of those goods that it can produce at a. relatively lower cost.Each country will benefit if it specialises in the production and import of those goods that it can produce at b. relatively lower cost.Each country will benefit if it specialises in the production and export of those goods that it can produce at c. relatively higher cost.Each country will benefit if it specialises in the production and import of those goods that it can produce at d. relatively higher cost.

According to5. __________, labor is the only source of value of goods.David Raymond a. David Ricardob. Haykinsc. Simpsond.

Which of the following statements is false?6. Tariffs are usually associated with protectionisma. A prohibitive tariff is one so high that nearly no one imports any of those itemsb. Protective tariff tends to raise price, lower the amounts consumed and imported, and raise domestic c. productionTariff is the economic policy of enhancing trade between nationsd.

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A quota is a direct restriction on the total quantity of a good or service that may be _______ during a specified 7. period.

imported a. exported b. restricted c. tradedd.

Which of the following is not an argument for protectionism?8. The infant argument a. Quotab. Distortion in the labor marketc. Optimum tariff argumentd.

The imposition of trade barriers such as tariffs9. the equilibrium price and reduces the equilibrium quantity of the restricted good.

maintains a. restrictsb. raisec. reducesd.

_______ are usually associated with protectionism, the economic policy of restraining trade between nations.10. Tarrifsa. Quotasb. Goodsc. Traded.

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Chapter VII

Government, Taxation and Expenditure

Aim

The aim of this chapter is to:

explicate the control of government on the economy•

explore the public choice theory•

examine the economic aspects of taxation•

Objectives

The objectives of the chapter are to:

explain the nature of government expenditures•

enlist different types of government expenditure•

explain taxation system and its relation to country’s economy•

Learning outcome

At the end of this chapter, you will be able to:

understand the importance of different types of government expenditures•

identify the various taxes levied by government•

understand the concept of tax incidence•

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7.1 Types of EconomyThe ownership of the means of production, in any economy, rests either with the individual or with the government or partly in the hands of both. When the production units are, by and large, in the hands of the private individuals, the economy is termed as a capitalist economy, when these are in the hands of the state that is the government, the economy is termed as a socialist economy. UK, USA, Germany, France are some examples of capitalist economies, while China and North Korea are some of the socialist economies.

When both, private individuals and government, hold significant proportion of production units, the economy is termed as a mixed economy. In reality, the major proportion of production activity in a mixed economy is carried out by the private sector and a smaller but significant proportion by the government. As such, it is sometimes referred to as a mixed capitalist economy. Most of the developing countries of Asia, including India, and other regions of the world are a mixed economy.

7.2 The Role of Government in the EconomyTo understand the role of government, it will be useful to distinguish four broad types of government involvement in the economy.

Regulatory roleThe basic objective of regulating business is to:

Prevent the market structure from becoming monopolistic•

Flourish small and new entrepreneurs,•

Promote welfare of weaker sections of the society.•

Regulatory role involves regulating the business and economic activities of the country by the government. It includes controls through which general norms and standards are laid down by the government. This could be done by putting limitations on public utility profits, ceiling on dividends and imposition of excess profit tax. Through regulation, undue concentration of economic power in fewer hands and concentration of business in fewer regions is also controlled. It also aims at settling the conflicts between management and the labor.

Entrepreneurial roleEntrepreneurial role means that the government itself becomes entrepreneur by taking the ownership in its hand. This is called as the emergence of public sector.

Heavy and basic industries involve high risk and since they do not yield attractive return, they are ignored by the private enterprises. Then there are certain industries where considerable time duration is involved between their establishment and beginning of production and sales. Therefore, in the beginning, there might be chances of losses. But from the national point of view, at the macro level, they are of vital importance. The government comes forward and takes entrepreneurial lead in this direction. Steel, minerals, chemicals, engineering, irrigation, power and heavy electrical plants are the examples of industries where public sector is assigned the entrepreneurial role.

Promotional roleFollowing are the various functions of the government in promoting the business operations:

To maintain public utilities•

To encourage the developmental attitude among various sectors•

To make economic resources productive and progressive•

To ensure the effective utilisation of various resources• To equally distribute wealth and income• To bring about equitable balance between various regions• To control the quantity of money available in terms of developmental needs•

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To push up investment climate in the country• To provide incentives for the promotion of foreign trade• The promotional role of the government thus encompasses fiscal, monetary and budgetary incentives for the • fast expansion and development of priority sectors of the economy.

Planning rolePlanning role implies that the government has to plan in a way that limited resources are directed to right objects, with a view to achieve the defined objectives in the interest of all concerned.

7.3 Tools of Government PolicyThere are three major tools that the government uses to influence private economy:

Taxes on income, goods and services. These reduce private income, there by reducing private expenditures • and providing resources for public expenditures. The tax system also serves to discourage certain activities by taxing them more heavily (such as cigarettes).Expenditures on certain goods or services (such as roads, education, etc.) along with transfer payments (like • health care subsidies, etc.) that provide resources to individuals.Regulations or controls that direct people to perform or refrain from certain economic activities.•

7.4 Importance of Size of GovernmentGovernment provision of both, an infrastructure for the operation of a market economy and a limited set of public goods, can provide a framework conducive for economic growth. However, as the size of government continues to grow, the disincentive effects of higher taxes and borrowing, diminishing returns, and a slowing of the discovery and wealth-creation process will become more and more important. Eventually, these factors will dominate and the marginal government expenditures will exert a negative impact on growth.

Fig. 7.1 illustrates the relationship between size of government and economic growth, assuming that governments undertake activities based on their rate of return. As the size of government, measured on the horizontal axis, expands from zero (complete anarchy), initially the growth rate of the economy—measured on the vertical axis—increases. The A to B range of the curve illustrates this situation. As government continues to grow as a share of the economy, expenditures are channeled into less productive (and later counterproductive) activities, causing the rate of economic growth to diminish and eventually decline. The range of the curve beyond B illustrates this point.

9

6

3

0

A

B

Size of Government (percent of GDP)

Gro

wth

Rat

e

Fig. 7.1 The size of government-growth curve(Source:http://egyankosh.ac.in/bitstream/123456789/8955/1/ Unit-5 (complete).pdf)

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If government undertakes activities in the order of their productivity, at first government expenditures would promote economic growth (moves from A to B above), but additional expenditures would eventually retard growth (moves along the curve to the right of B).

7.5 The Functions of GovernmentThere are four major functions of government to regulate the economy:Improving economic efficiency

A central economic purpose of government is to assist in the socially desirable allocation of resources. The • microeconomic policies differ among countries according to customs and political philosophies. Some countries emphasise a hands-off, laissez-faire approach, leaving most decisions to the market. Other countries lean toward heavy government regulation, or even public ownership of business, in which production decisions are made by government planners.Government often deploys its weapons to correct important market failures, of which the most important are: • The breakdown of perfect competition: When monopolies or oligopolies collude to reduce rivalry or drive firms out of business, government may apply antitrust policies or regulation.Externalities and public goods: Government can use its influence to control harmful externalities or to fund • programs in science and public health. Government can levy taxes on activities which impose external public costs or subsidise socially beneficial activities.Imperfect information: Unregulated markets tend to provide too little information for consumers to make • well-informed decisions.

Reducing economic inequalityEconomic inequality can be reduced by income redistribution, which is usually accomplished through taxation • and spending policies, though regulation sometimes plays a role as well.

Stabilising the economy through macroeconomic policiesGovernment has the responsibility of preventing business depressions by the proper use of monetary and fiscal • policy, as well as close regulation of the financial system.Government tries to smooth ups and downs of the business cycle, in order to avoid large-scale unemployment • at the bottom of the cycle.

Conducting international economic policyGovernment plays an important role in representing the country in the international economy. In recent years, • this has meant that government tries to facilitate international trade by limiting tariff and quota barriers.Macroeconomic policies are coordinated across governments in order to make them more effective and attention • is given to resolve international environmental problems through the cooperation of multiple countries. Wealthy nations have developed programs to aid poorer countries, particularly in times of crisis.

7.6 Public Choice TheoryThe public choice theory examines the way different voting mechanisms can function and shows that there are no ideal mechanisms to sum up individual preferences into social choices.

This approach also analyses government failures, which arise when state actions fail to improve economic efficiency or when the government redistributes income unfairly. A careful study of government failures is crucial for understanding the limitations of government and ensuring that government programs are not exclusively intrusive or wasteful.

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7.7 Government ExpenditureThe economy of a country is greatly influenced by the level of government or public expenditure. It helps in overcoming the inefficiencies of the market system in the allocation of economic resources. It also helps in smoothing out cyclical fluctuations in the economy and ensures a high level of employment and price stability. Thus, government expenditure plays a crucial role in the economic growth of a country.

7.7.1 Nature of Government ExpenditurePublic expenditure is incurred in the form of purchases of goods and services, transfer payments and lending Purchase of goods and services is intended to carry out governmental activities by the direct utilisation of economic resources, for example, purchase of articles from the market right from paper clips to military aircraft.

Transfer payments and lending are intended to provide enterprises and households with purchasing power to enable them to buy goods and services in the market. In many developed countries, transfer payments for social welfare constitute a sizeable portion of government budgets.

7.7.2 Objectives of Government Expenditure ClassificationThe classification of government expenditure is done mainly to achieve the objectives of government i.e., financial control, estimation of revenues and expenditures of government, allocation of funds to the various sectors of the economy, economic growth, etc.

Government expenditure

(GE)

Revenue and Capital

Developmental and Non- developmental Plan and Non-plan

AccountingCrossEconomicFunctional/Budget

Fig. 7.2 Classification of Government Expenditure(Source:http://egyankosh.ac.in/bitstream/123456789/8955/1/ Unit-5 (complete).pdf)

Functional/Budget GEFunctional classification establishes adequate links between budget and account heads and the plan heads of development. It facilitates obtaining information of progressive expenditure on plans, programs and projects.

The principle adopted in the new accounting classification is that, all expenditures on a function, program or activity should be recorded under the appropriate major, minor or subhead. Functional classification has facilitated the monitoring and analysis of expenditure on functions, programs and activities to aid the management function.

Economic GEEconomic classification refers to the resources allocated by government to various economic activities. It involves arranging the public expenditures and receipts by significant economic categories, distinguishing current expenditure from capital outlays, spending for goods and services from transfers to individuals and institutions, tax receipts by

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kind from other receipts and from borrowing and inter-governmental loans, grants, etc. This classification brings out such important aggregates as public expenditure of the consumption kind, publicinvestment and the draft of public authorities on public savings for financing the development outlays in the public sector.

Cross or economic-cum-functional GEUnder a scheme of cross classification, functional classification of expenditure can be analysed according to its economic character and economic classification of expenditure can be analysed according to the functions performed by it.

The two types of classification therefore supplement each other and give a clear picture of the total transactions of government.

Accounting GEAccounting classification of government expenditure can be analysed under:

Revenue and capital: Revenue expenditure is for the normal running of government departments and various • services, interest charges etc. On the other hand, capital expenditure or at least some portion of it, results in creation of assets in the economy.Developmental and non- developmental: Developmental expenditure leads to economic growth, whereas Non- • Developmental expenditure does not. Developmental expenditure comprises the expenditure incurred on social and community services and economic services. Non-developmental expenditure comprises the expenditure incurred on general services.Plan and non-plan: The classification of government expenditure into “Plan” and “Non-Plan” is purely an • administrative classification and is not related to economic or national accounting principles. Plan expenditure refers to the expenditure incurred by the Central Government on programs/projects, which are recommended by the Planning Commission. Non-Plan expenditure, on the contrary, is a generic term used to cover all expenditure of government not included in the plan. This classification is found useful by the Planning Commission and Finance Commission for determining the central assistance to states for planning schemes from time to time.

7.8 Economic Aspects of TaxationFollowing are the economic aspects of taxation:

Taxes in India are levied by the Central Government and the State Governments. Some minor taxes are also • levied by the local authorities such as the Municipality or the Local Council.The authority to levy a tax is derived from the Constitution of India which allocates the power to levy various • taxes between the Centre and the State. An important restriction on this power is Article 265 of the Constitution which states, “No tax shall be levied or collected except by the authority of law.” Therefore each tax levied or collected has to be backed by an accompanying law, passed either by the Parliament or the State Legislature.India has a well-developed tax structure with clearly demarcated authority between Central and State Governments • and local bodies. Central Government levies taxes on income (except tax on agricultural income, which the State Governments can levy), customs duties, central excise and service tax.Value Added Tax (VAT), (Sales tax in States where VAT is not yet in force), stamp duty, state excise, land • revenue and tax on professions are levied by the State Governments. Local bodies are empowered to levy tax on properties, octroi and for utilities like water supply, drainage etc.In last 10-15 years, Indian taxation system has undergone tremendous reforms. The tax rates have been rationalised • and tax laws have been simplified resulting in better compliance, ease of tax payment and better enforcement. The process of rationalisation of tax administration is ongoing in India. Since April 01, 2005, most of the State Governments in India have replaced sales tax with VAT.

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7.9 Taxes Levied by Central GovernmentFollowing are the taxes levied by central government:

Direct Taxes• Tax on Corporate Income �

Capital Gains Tax �

Personal Income Tax �

Tax Incentives �

Double Taxation Avoidance Treaty �

Indirect Taxes• Excise Duty �

Customs Duty �

Service Tax �

Securities Transaction Tax �

7.9.1 Direct TaxesTaxes on Corporate Income

Companies resident in India are taxed on their worldwide income arising from all sources in accordance with the • provisions of the Income Tax Act. Non-resident corporations are essentially taxed on the income earned from a business connection in India or from other Indian sources. A corporation is deemed to be resident of India if it is incorporated in India or if it’s control and management is situated entirely in India.Domestic corporations are subject to tax at a basic rate of 35% and a 2.5% surcharge. Foreign corporations • have a basic tax rate of 40% and a 2.5% surcharge. In addition, an education Cess at the rate of 2% on the tax payable is also charged. Corporates are subject to wealth tax at the rate of 1%, if the net wealth exceeds Rs.1.5 million ($33333 approx).Domestic corporations have to pay dividend distribution tax at the rate of 12.5%; however, such dividends • received are exempt in the hands of recipients.Corporations also have to pay for Minimum Alternative Tax at 7.5% (plus surcharge and education ) of book • profit as tax, if the tax payable as per regular tax provisions is less than 7.5% of its book profits.

Capital gains taxTax is payable on capital gains on sale of assets. Long-term Capital Gains Tax is charged if;•

Capital assets are held for more than three years �

In case of shares, securities listed on a recognised stock exchange in India, units of specified mutual funds, � the period for holding is one year

Long-term capital gains are taxed at a basic rate of 20%. However, long-term capital gains from sale of equity • shares or units of mutual funds are exempt from tax.Short-term capital gains are taxed at the normal corporate income tax rates. Short-term capital gains arising on • the transfer of equity shares or units of mutual funds are taxed at a rate of 10%.Long-term and short-term capital losses are allowed to be carried forward for eight consecutive years. Long- • term capital losses may be offset against taxable long-term capital gains and short-term capital losses may be offset against both long term and short-term taxable capital gains.

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Personal Income TaxPersonal income tax is levied by Central Government and is administered by Central Board of Direct Taxes • under Ministry of Finance, in accordance with the provisions of the Income Tax Act.Every entity whose income (computed in accordance with the Income Tax Act and the Income Tax Rules, etc.) is • more than the tax free limit as prescribed by the relevant Finance Act, is required to pay tax.Recognising the diversity and the need for standardisation of the sources of income, the Income Tax Act has • identified five heads of income. They are salaries, income from house property, profits and gains from business or profession, capital gains and income from other sources.

Tax IncentivesGovernment of India provides tax incentives for:•

Corporate profit �

Accelerated depreciation allowance �

Deductibility of certain expenses subject to certain conditions �

These tax incentives are subject to specified conditions and available for new investment in:• Infrastructure �

Power distribution �

Certain telecom services �

Developing or operating industrial parks or special economic zones (SEZs) �

Production or refining of mineral oil �

Companies carrying on R&D �

Developing housing projects �

Undertakings in certain hill states �

Handling of food grains �

Food processing �

Rural hospitals etc. �

Double Tax Avoidance TreatyIndia has entered into Double Tax Avoidance Agreement (DTAA) with 65 countries including the US, UK, • Japan, France, Germany, etc. In case of countries with which India has DTAA, the tax rates are determined by such agreements.Domestic corporations are granted credit on foreign tax paid by them while calculating tax liability in India. In • the case of the US, dividends are taxed at 20%, interest income at 15% and royalties at 15%.

7.9.2 Indirect TaxesExcise Duty

Manufacture of goods in India attracts Excise Duty under the Central Excise Act, 1944 and the Central Excise • Tariff Act, 1985. Herein, the term “manufacture” means bringing into existence a new article having a distinct name, character, use and marketability and includes packing, labeling, etc.Most of the products attract excise duties at the rate of 16%. Some products also attract special excise duty/and • an additional duty of excise at the rate of 8% above the 16% excise duty. 2% education cess is also applicable on the aggregate of the duties of excise. Excise duty is levied on ad valorem basis or based on the maximum retail price in some cases.

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Customs DutyThe levy and the rate of customs duty in India are governed by the Customs Act, 1962 and the Customs Tariff Act, 1975. Imported goods in India attract basic customs duty, additional customs duty and education. The rates of basic customs duty are specified under the Tariff Act. The peak rate of basic customs duty has been reduced to 15% for industrial goods. Additional customs duty is equivalent to the excise duty payable on similar goods manufactured in India.

Education cess at 2% is leviable on the aggregate of customs duty on imported goods. Customs duty is calculated on the transaction value of the goods. Rates of customs duty for goods imported from countries with whom India has entered into free trade agreements such as Thailand, Sri Lanka, South Asian countries, etc. are provided on the website of CBEC. Customs duties in India are administrated by Central Board of Excise and Customs under the Ministry of Finance.

Service TaxService tax is levied at the rate of 10% (plus 2% education cess) on certain identified taxable services provided in India by specified service providers. Service tax on taxable services rendered in India are exempt, if payment for such services is received in convertible foreign exchange in India and the same is not repatriated outside India.

The CENVAT (the Central value added tax) Credit Rules allow a service provider to avail and utilise the credit of additional duty of customs/excise duty for payment of service tax. Credit is also provided on payment of service tax on input services for the discharge of output service tax liability.

Securities Transaction TaxTransactions in equity shares, derivatives and units of equity-oriented funds entered in a recognised stock exchange attract Securities Transaction Tax at the following rates:

Delivery base transactions in equity shares or buyer and seller each units of an equity-oriented fund – • 0.075%

Sale of units of an equity-oriented fund to the seller mutual fund – 0.15%•

Non delivery base transactions in the above – 0.015%•

Derivatives (futures and options) seller – 0.01%•

7.10 Taxes Levied by State Governments and Local BodiesFollowing are the taxes levied by state governments and local bodies:Sales Tax/VAT

Sales tax is levied on the sale of movable goods. Most of the Indian states have replaced sales tax with a new • Value Added Tax (VAT) from April 01, 2005.VAT is imposed on goods only, and not on services. Other indirect taxes such as excise duty, service tax, etc., • are not replaced by VAT. VAT is implemented at the state level by State Governments.VAT is applied on each stage of sale with a mechanism of credit for the input VAT paid. There are four slabs • of VAT:-

0% for essential commodities �1% on bullion and precious stones �4% on industrial inputs and capital goods and items of mass consumption �All other items 12.5% �

Petroleum products, tobacco, liquor etc., attract higher VAT rates that vary as per state. A Central Sales Tax at • the rate of 2% is also levied on inter-state sales and would be eliminated gradually.Octroi/Entry Tax: Some municipal jurisdictions levy octroi/entry tax on entry of goods•

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Other State TaxesStamp duty on transfer of assets• Property/building tax levied by local bodies• Agriculture income tax levied by State Governments on income from plantations• Luxury tax levied by certain State Government on specified goods•

7.11 Tax IncidenceTax incidence reveals which group, the consumers or producers, will pay the price of a new tax. For example, the demand for cigarettes is fairly inelastic, which means that despite changes in price, the demand for cigarettes will remain relatively constant.

Let’s imagine, the government decided to impose an increased tax on cigarettes. In this case, the producers may increase the sale price by the full amount of the tax. If consumers still purchased cigarettes at the increased in price, then it would be said that the tax incidence fell entirely on the buyers.Thus, people demand government participation in three areas of economic activity:

First, people may want correction of market failure involving public goods, external costs and benefits, and • inefficient allocation created by imperfect competition. In each case of market failure, the shift from an inefficient allocation to an efficient one has the potential to eliminate or reduce deadweight losses.Second, people may seek government intervention to expand consumption of merit goods and to reduce • consumption of demerit goods.Third, people often want government to participate in the transfer of income. Therefore, people and • government move ahead and progress with each others cooperation.

7.12 Nature and Relevance of RegulationGovernment regulation in an economy has been quite varied depending upon the nature of commodity or activity in question and prevailing business environment.There are two basic types of policies that the government follows:

Command and control measures•

Market-based incentives•

Regulation can be seen as a process, which continues over time and changes according to need of the hour and perception of the policy makers.Secondly, regulation is often seen as a red tape as it may lead to poor governance and corruption. Thus, in recent years there is a process of de-regulation operating world over. Both developed and developing countries have modified their policy towards economic liberalisation, emphasising on free trade of goods and services.

In Western Europe, particularly the European Union (EU) geographical boundary of a country has become insignificant as there is a common currency and free movement of not only goods and services but also of labor across member countries of EU. The process, popularly known as globalisation, has minimised the role of the government. Market mechanism has come to the forefront over government regulation.

RelevanceThe market mechanism has brought in competitiveness to the industry. Firms equipped with better technology and better quality products come up everyday. Economic growth has accelerated and there is a general atmosphere of optimism around. However, market mechanism and the process of change have not been able to take care of problems such as poverty and inequality.

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7.13 Government Intervention on Public InterestFollowing are the situations under which government intervention is necessary:Imperfect Competition

It is a market structure that does not meet the conditions of a perfect competition. Under perfect competition, • price is equal to marginal cost (P = MC) while in the presence of monopoly power, price is higher than marginal cost (P > MC).Thus, perfect competition is considered as an ideal condition and any deviation from it is seen as a loss of social • welfare.

ExternalitiesExternalities imply inadequate expression of costs or benefits in prices and economic decision-making. In all • the cases of externalities, both positive and negative, there is no incentive on the part of the economic agent to restrict his/her equilibrium production/consumption to socially optimum level.In the presence of externalities, the economy produces less of what is desired and more of undesired!• For goods with positive externalities social benefit is higher than private benefit. Thus, social optimum is at a • higher level than the equilibrium achieved on the basis of private benefit. On the other hand, for goods involving negative externalities, private cost is lower than social cost. Thus equilibrium realised on the basis of private cost is higher than social optimum.

Common Property ResourcesThe property rights are not defined in the case of common property resources, and hence goods are overexploited• and degraded.• For example, Forests get bared, common grazing land gets eroded, and air and water bodies get polluted due • to production and consumption activities.

Transaction CostsOne of the basic assumptions, under perfect competition, is the availability of complete information on the part • of both the parties entering into a contract or transaction. Procurement of information, however, involves cost, which is ignored in traditional economic theory.Transaction costs such as search, measurement, inventory, and decision-making costs are considered important. • However, traditional economic theory assumes away these costs in the garb of perfect information.Secondly, once a contract is undertaken, its enforcement and litigation (in the event of breach of contract) should • also be considered while deciding on costs of production. If these costs are not taken into account, socially optimum output and consumption levels cannot be achieved.

Asymmetric InformationIn certain cases, there is asymmetric information available to the contracting parties. For example, purchase of life insurance policies. While purchasing life insurance policy the insured knows better about his/her health than the insurance company.

Adverse SelectionAsymmetric information may give rise to ‘adverse selection’.• It refers to a market process in which bad results occur due to information asymmetries between buyers and • sellers.

Organisational FailuresIn economics, the problem of motivating one party to act on behalf of another is known as ‘the principal-agent • problem’.The principal-agent problem arises when a principal compensates an agency for performing certain acts that • are useful to the principal and costly to the agent, and where there are elements of the performance that are costly to observe.

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7.14 Instruments for RegulationRegulation can take many forms, ranging from general guidelines to total ban on an activity; and can be used in inputs and technology, marketing operations, financing and pricing. In many cases regulation is not sensitive to changing market conditions. In pricing of product, however, the nature of regulation is quite important. Monopoly retains the potential to exercise its market power and charge higher prices. Governments have devised means of controlling monopoly prices over the years. There are four approaches to regulating the overall price level in an economy, viz.,

Price cap regulation• Revenue cap regulation• Rate of return (or cost of service) regulation• Bench-marking (or yardstick).•

Some examples of regulatory bodies for fixing prices of products, particularly of services in India are Telecom Regulatory Authority of India, Central Electricity Regulatory Commission, etc.

7.14.1 Price Cap RegulationPrice cap regulation, also known as ‘RPI-X regulation’, is widely prevalent across countries, both developed and developing.It allows a firm to increase its price level according to the rate of inflation. The regulator takes an index which represents an inflation measure (in symbol I) and productivity offset (X).

The regulator usually fixes the price of the goods or services by constructing an index (I-X). The price index (I) could be the average increase in prices of a comparable basket of goods and services. The X-efficiency could measure productivity increase in the firms.

AdvantagesIt protects the consumer from excessive price increase by producers• It provides an incentive for firms to reduce costs of production•

7.14.2 Revenue Cap RegulationRevenue cap regulation is similar to price cap regulation in the sense that the regulator establishes an I-X index, which, in this case, is called revenue cap index. It allows the firm to change prices as long as the percentage change in revenue does not exceed the revenue cap index.

Revenue cap regulation is more appropriate than price cap regulation in situations where costs do not vary appreciably with unit of sales. For example, for electricity supply the major cost is distribution lines. Increase in supply of electricity to one more household in the colony does not increase cost remarkably.

AdvantagesRevenue cap regulation does not require monitoring of prices; to see whether the service provider is over- • charging or not.It is beneficial in cases where cost variation is low with unit of sales.•

7.14.3 Rate of Return RegulationThe rate of return regulation adjusts overall price levels according to the firm’s accounting costs and investment. In most cases, the regulator reviews the costs to examine the claim by the firm that it is receiving less than its cost of capital. It can also review the assertion by a group of consumers that the actual rate of return is higher than the cost of capital.

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DisadvantagesThe rate of return regulation is criticised on the ground that it encourages cost-padding and if the allowed rate of return is too high it encourages adoption of an inefficiently high capital-labor ratio. This is called Averch- Johnson effect.

7.14.4 BenchmarkingIn benchmarking, a firm is compared to similar firms in other markets while fixing prices.On the basis of relative cost efficiency, rewards or penalties are given to the firm. The firm is expected to perform at par with other firms in similar conditions.

Here, the difficult task is identification of similar firms as the markets are different. Statistical techniques are used while comparing the performance of firms so that the control for dissimilar variables can be taken into account.

7.15 Effects of RegulationRegulation has both positive and negative effects. The studies on the effect of regulation have mostly been on a case-to-case basis. The fact that government regulation in has declined over the years, points to the limitations of regulation. The problem of red-tape and corruption in economies pursuing command and control policies is high.

The liberalisation measures in China appear to have yielded results and the Chinese economy is showing high growth rate for several years now. The disintegration erstwhile USSR also points to the deficiencies in controlled economies. The rationale behind traditional theory of regulation is that it serves public interest by correcting some form of market failure, typically natural monopoly.

The public interest theory, however, is based on the assumption that perfectly informed decision makers are either managing the regulation or running the regulated firms. Such an assumption may not be true in many cases.

Costs of RegulationEconomists have studied the impact of regulation to weigh its costs and benefits. The effects of regulation include both, efficiency gains or losses and income redistribution.

Most studies suggest that the main effects of economic regulation are losses in efficiency and large amounts of income redistribution. However, it is likely that the overall burden of regulation today is lower with the declining barriers to trade, deregulation of industries, etc.

7.16 Decline of Economic RegulationFollowing is the decline of economic regulation:

The Indian Government liberalised its economic regulatory reforms, the impact of which can be gauged from • the fact that total foreign investment (including foreign direct investment, portfolio investment, and investment raised on international capital markets) in India grew from a minuscule US $132 million in 1991–92 to $5.3 billion in 1995–96.Cities like Gurgaon, Bangalore, Hyderabad, Pune and Ahmedabad have risen in prominence and economic • importance and have become centres of rising industries and prominent destination for foreign investment and firms.Annual growth in GDP per capita has accelerated from just 1¼ per cent in the three decades after Independence • to 7½ per cent currently, a rate of growth that will double average income in a decade.In service sectors where government regulation has been eased significantly or is less burdensome—such • as communications, insurance, asset management and information technology—output has grown rapidly, particularly with exports of information technology enabled services going strong. The infrastructure sectors which have been opened to competition, such as telecoms and civil aviation, the private sector has proven to be extremely effective with phenomenal growth.

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7.17 DeregulationThe trend towards deregulation is spreading throughout the world after it has become quite apparent that the economic conditions in market economies are generally better than economies heavily regulated by the government.

India is one of the growing countries that have followed the lead of the U.S. in freeing industries and allowing them to compete in domestic as well as in global markets. Since 1991, the Indian government has been pursuing economic liberalisation, focusing particularly on short term problems such as low foreign exchange reserves, implementing structural reforms to bolster competitiveness and rein in inflation, and aligning India with the global economy. Success in a deregulated marketplace is likely to be achieved by Indian companies that can spot the signs of deregulation early and are prepared to maximise this advantage. However, as deregulation sweeps through the economy, it is wise to recall that the government still has an important role to play in monitoring the economy and setting the rules of the road.

7.18 Antitrust PoliciesCompetition law, known in the United States as antitrust law, promotes or maintains market competition by regulating anti-competitive conduct.

Competition law, or antitrust law, has three main elements:Prohibiting agreements or practices that restrict free trading and competition between businesses. This includes, • in particular, the repression of free trade caused by cartels.Banning abusive behavior by a firm dominating a market, or anti-competitive practices that tend to lead to • such a dominant position. Practices controlled in this way may include predatory pricing, tying, price gouging, refusal to deal, and many others.Supervising the mergers and acquisitions of large corporations, including some joint ventures. Transactions • that are considered to threaten the competitive process can be prohibited altogether, or approved subject to “remedies” such as an obligation to divest part of the merged business or to offer licenses or access to facilities to enable other businesses to continue competing.

Substance and practice of competition law varies as per the jurisdiction. Protecting the interests of consumers (consumer welfare) and ensuring that entrepreneurs have an opportunity to compete in the market economy are often treated as important objectives. Competition law is closely connected with law on deregulation of access to markets, state aids and subsidies, the privatisation of state owned assets and the establishment of independent sector regulators. In recent decades, competition law has been viewed as a way to provide better public services.

7.18.1 Antitrust Policy in USThe American term ‘antitrust’ arose not because the US statutes had anything to do with ordinary trust law, but because the large American corporations used trusts to conceal the nature of their business arrangements. Big trusts became synonymous with big monopolies. The perceived threat to democracy and the free market from these trusts led to the formation of Sherman and Clayton Acts.

The Sherman ActThe Sherman Act was passed in 1890 and was named after its author, Senator John Sherman, an Ohio Republican • and the chairman of the Senate Finance Committee.The Act was aimed at regulating businesses; however, its application was not limited to the commercial side • of business. Its prohibition of the cartel was also interpreted to control illegal labor union activities. This is because, unions were characterised as cartels as well (cartels of laborers). This persisted until 1914, when the Clayton Act created exceptions for certain union activities.

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Clayton Antitrust ActThe Clayton Antitrust Act of 1914 was enacted in United States to add further substance to the U.S. antitrust • law regime by seeking to prevent anti competitive practices in their incipiency. That regime started with the Sherman Antitrust Act of 1890, the first Federal law outlawing practices considered harmful to consumers (monopolies and cartels).The Clayton act specified particular prohibited conduct, the three-level enforcement scheme, the exemptions, • and the remedial measures. The act is still active today in a growing interconnected market and merging of the industries.

7.18.2 Indian Scenario2009 saw India embrace its new competition regime with the twin ex post dimensions of the Competition Act,2002, namely the prohibition on ‘anti-competitive agreements’ and ‘Abuse of dominant position’, being brought into force. The Competition Commission of India (CCI) has commenced its enforcement and regulatory functions in these spheres. The third component of the Act, dealing with the ex ante regulation of combinations (merger control) is expected to be notified once the relevant regulations are fine-tuned.

The Monopolies and Restrictive Trade Practices Act 1969 (MRTP Act) has now been repealed and the MRTP Commission has been dissolved.The central government also established the Competition Appellate Tribunal (Appellate Tribunal) to hear appeals against orders passed by the CCI.

In order to create awareness and to educate stakeholders, the CCI has put in the public domain a series of advocacy booklets and the findings of several market studies, which were undertaken to gain better understanding of the market structures and anti-competitive practices prevailing therein.

7.19 Mergers: Law and PracticeCompanies can gain market power through growth. But a much easier way to gain market share, or simply to get bigger, is to merge with another company. Mergers and acquisitions are strategic decisions taken for maximisation of a company’s growth by enhancing its production and marketing operations.

7.19.1 Merger or AmalgamationA merger is a combination of two or more businesses into one business. Laws in India use the term ‘amalgamation’ for merger. The Income Tax Act, 1961 [Section 2(1A)] defines amalgamation as the merger of one or more companies with another or the merger of two or more companies to form a new company, in such a way that all assets and liabilities of the amalgamating companies become assets and liabilities of the amalgamated company and shareholders not less than nine-tenths in value of the shares in the amalgamating company or companies become shareholders of the amalgamated companies.

Thus, mergers or amalgamations may take two forms: Merger through AbsorptionAbsorption is a combination of two or more companies into an ‘existing company’. All companies except one lose their identity in such merger. For example, absorption of Tata Fertilizers’ Ltd (TFL) by Tata Chemicals Ltd. (TCL).

TCL, an acquiring company (a buyer), survived after merger while TFL, an acquired company (a seller), ceased to exist. TFL transferred its assets, liabilities and shares to TCL.

Merger through ConsolidationA consolidation is a combination of two or more companies into a ‘new company’. In this form of merger, all companies are legally dissolved and a new entity is created. Here, the acquired company transfers its assets, liabilities and shares to the acquiring company for cash or exchange of shares. For example, merger of Hindustan Computers Ltd, Hindustan Instruments Ltd, Indian Software Company Ltd and Indian Reprographics Ltd into an entirely new company called HCL Ltd.

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A fundamental characteristic of merger (either through absorption or consolidation) is that the acquiring company(existing or new) takes over the ownership of other and combines their operations with its own.

Besides, there are other three major types of mergers:Horizontal MergerIt is a combination of two or more firms in the same area of business. For example, the combining of two book publishers to gain dominant market share.

Vertical MergerIt is a combination of two or more firms involved in different stages of production or distribution of the same product. For example, joining of a TV manufacturing (assembling) company and a TV marketing company. Vertical merger may take the form of forward or backward merger. When a company combines with the supplier of material, it is called backward merger and when it combines with the customer, it is known as forward merger.

Conglomerate MergerIt is a combination of firms engaged in unrelated lines of business activity. For example, the merging of differen businesses, like manufacturing of cement products, fertilizer products, etc.

7.19.2 Acquisitions and TakeoversAn acquisition may be defined as, ‘an act of acquiring effective control by one company over assets or management of another company without any combination of companies.’ Thus, in an acquisition, two or more companies may remain independent, separate legal entities, but there may be a change in control of the companies. When an acquisition is ‘forced’ or ‘unwilling’, it is called a takeover. In an unwilling acquisition, the management of ‘target’ company would oppose a move of being taken over. But, when managements of acquiring and target companies mutually and willingly agree for the takeover, it is called acquisition or friendly takeover.

Under the Monopolies and Restrictive Practices Act, takeover meant acquisition of not less than 25 percent of the voting power in a company. While in the Companies Act (Section 372), a company’s investment in the shares of another company in excess of 10 percent of the subscribed capital can result in takeovers. An acquisition or takeover does not necessarily entail full legal control. A company can also have effective control over another company by holding a minority ownership.

7.19.3 Advantages of Mergers & AcquisitionsThe most common motives and advantages of mergers and acquisitions are:

Accelerating a company’s growth, particularly when its internal growth is constrained due to paucity of • resources.The company can acquire existing company or companies with requisite infrastructure and skills and grow • quickly.Enhancing profitability, because a combination of two or more companies may result in more than average • profitability due to cost reduction and efficient utilisation of resources. This may happen because of:Economies of scale arise when increase in the volume of production leads to a reduction in the cost of production • per unit. This is because, with merger, fixed costs are distributed over a large volume of production causing the unit cost of production to decline. Economies of scale may also arise from other indivisibilities such as production facilities, management functions and resources and systems. This is because, a given function, facility or resource is utilised for a large scale of operations by the combined firm.Operating economies arise because; a combination of two or more firms may result in cost reduction due• to operating economies. In other words, a combined firm may avoid or reduce over-lapping functions and consolidate its managerial functions such as manufacturing, marketing, R&D and thus reduce operating costs. For example, a combined firm may eliminate duplicate channels of distribution, or create a centralised training centre, or introduce an integrated planning and control system.

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Synergy implies a situation where the combined firm is more valuable than the individual firms. It refers to • benefits other than those related to economies of scale. Operating economies are one form of synergy benefits, but apart from it, synergy may also arise from enhanced managerial capabilities, creativity, innovativeness, R&D and market coverage capacity due to the complementarities of resources and skills and a widened horizon of opportunities.Diversifying the risks of the company, particularly when it acquires those businesses whose income streams • are not correlated. It results in reduction of total risks through substantial reduction of cyclicality of operations. The combination of management and other systems strengthen the capacity of the combined firm to withstand the severity of the unforeseen economic factors which could otherwise endanger the survival of the individual company.A merger may result in financial synergy and benefits for the firm in many ways like:•

By eliminating financial constraints �

By enhancing debt capacity. This is because a merger of two companies can bring stability of cash flows � which in turn reduces the risk of insolvency and enhances the capacity of the new entity to service a larger amount of debtBy lowering the financial costs. Due to financial stability, the merged firm is able to borrow at a lower rate � of interest.

Limiting the severity of competition by increasing the company’s market power. A merger can increase the • market share of the merged firm. This improves the profitability of the firm due to economies of scale. The bargaining power of the firm vis-à-vis labor, suppliers and buyers is also enhanced. The merged firm can exploit technological breakthroughs against obsolescence and price wars.

7.20 Efficiency of Competition LawsIt is unclear whether competition policy is a sensible role for government in developing, particularly low-income countries. In these countries, the markets are usually very small and fragmented so that developing scale, sufficient to raise competitiveness and engage in international markets, is a major challenge. The bigger problem is, however, poor governance in societies with widespread corruption, inadequate public finances, and weak judiciary and oversight institutions, competition policy may become another tool for capture by vested interests - becoming in itself a barrier to entry.

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SummaryTo understand the role of government, it will be useful to distinguish four broad types of government involvement • in the economy.Regulatory role involves regulating the business and economic activities of the country by the government. It • includes controls through which general norms and standards are laid down by the government.Entrepreneurial role means that the government itself becomes entrepreneur by taking the ownership in its hand.• This is called as the emergence of public sector.The promotional role of the government thus encompasses fiscal, monetary and budgetary incentives for the • fast expansion and development of priority sectors of the economy.Planning role implies that the government has to plan in a way that limited resources are directed to right objects,with • a view to achieve the defined objectives in the interest of all concerned.Tax incidence reveals which group, the consumers or producers, will pay the price of a new tax.• Regulation has both positive and negative effects. The studies on the effect of regulation have mostly been on • a case-to-case basis.There are three major types of mergers such as vertical, horizontal and conglomerate.• An acquisition may be defined as, ‘an act of acquiring effective control by one company over assets or management • of another company without any combination of companies.’

ReferencesHugh, S. E.and Gravelle, R. R., 2004. • Microeconomics. Publisher, Pearson Education.David, M. K., 1990. • A Course in microeconomic Theory. Financial Times/Prentice Hall.Role of Government in Business, • IGNOU, [Pdf] Available at: <http://egyankosh.ac.in/bitstream/123456789/8955/1/ Unit-5 (complete).pdf> [Accessed on 23 October 2010].Nicholas, E., 2011. • Notes for Microeconomics, [Pdf] Available at: <http://www.stern.nyu.edu/networks/micnotes/micnotes.pdf>[Accessed on 23 October 2010].MIT, • Lecture 9, 2012. Principles of Microeconomics [Video online] Available at: <http://www.youtube.com/watch?v=Q4iKuKAjzK0> [Accessed 25 October 2010].MIT, • Lecture 24. Priciples of Microeconomics, [Video online] Available at: <http://www.youtube.com/watch?v=ni0aX0tUAd0> [Accessed 25 October 2010].

Recommended ReadingSteiner, J. and Steiner, G. • Business, Government and Society: A Managerial Perspective, 12th ed., McGraw-HillIrwin, N. and Mankiw, G., 2008, • Essentials of Economics, 5th ed., South-Western College.Salanie, B., 2003, • The Economics of Taxation, The MIT Press.

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Self Assessment

What are the tools of government policy?1. Taxes, income, progressa. Taxes, expenditure, progressb. Taxes, expenditure, regulationc. Expenditure, taxes, entrepreneurship.d.

Which of the following is not an objective of regulating business?2. Prevent the market structure from becoming monopolistic a. Promote welfare of weaker sections of the societyb. Flourish small and new entrepreneursc. Hand economic powers to leading businesses.d.

Entrepreneurial role means that the government itself becomes entrepreneur by taking the ownership in its hand, 3. which is also called as .

emergence of public sector a. emergence of private sector b. emergence of joint sectorc. emergence of co-operative sectord.

Which among the following is not amongst the functions of government to regulate the economy?4. Reducing economic inequalitya. Stabilising the economy through microeconomic policiesb. Conducting international economic policyc. Improving economic efficiencyd.

Direct taxes do not include 5. ________.Tax incentivesa. Capital gains taxb. Personal income tax c. Customs dutyd.

Securities transaction tax is a part of 6. .Indirect taxes a. Direct taxesb. Tax levied by state governmentc. Tax levied by local bodyd.

7. is levied by municipal or local authority.Service tax a. Property tax b. Income taxc. Corporate income taxd.

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The decision whether the consumer or producer will pay the price of new tax is stated by 8. .tax benefita. tax evasionb. tax incidencec. pubic choice theoryd.

Which is not the objective of classification of general expenditure?9. Economic growth a. Financial controlb. Public satisfactionc. Estimation of revenues and expendituresd.

10. involves regulating the business and economic activities of the country by the government.

Entrepreneurial role a. Promotional roleb. Planning rolec. Regulatory roled.

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Chapter VIII

Natural Resource Management

Aim

The aim of this chapter is to:

explain the resource limitations•

explore environmental economics•

explicate environmental economics•

Objectives

The objectives of the chapter are to:

describe resource categories•

elcidate with approaches to correct externalities•

explain the strategies for conservation•

Learning outcome

At the end of this chapter, you will be able to:

identify the types of natural resources•

enlist the strategies for conservation•

understand policies to correct externalities•

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8.1 IntroductionWe all agree that everyone has a right to clean air, water and unspoiled land, which is our desirable goals. But how much are we willing to pay to achieve our goals? What is the threat to humanity if we fail to respect the limits of our natural environment?

Generally, mainstream economists tend to lie between the environmentalist and the cornucopian extremes. They recognise that humans have been encroaching on the environment for ages. We have to view how economics can be used to understand our environmental problems, and accordingly frame the policies that will help in making our world more habitable.

8.2 Population and Resource LimitationEssentially, what we are contemplating in the form of a relationship is the phenomena of so called ‘over- population’. It depicts a situation, where human population has increased beyond the means of subsistence. Thus, a higher growth area in terms of population does not provide the basic needs of life such as food, cloth and shelter.

The third world countries have become victim of such an eventuality, though the fear of over-population is not new. Economist Malthus, as early as 1798, had expressed strong apprehensions on population growth over-taking output growth. He thought that nature would reduce the excess number by causing calamities and diseases. However, technological inventions subsequently helped increase production and the seriousness of the problem was over-looked for time being.

The implications of population growth resurfaced in recent years with the persistence of poverty and hunger in many parts of world .The over-population perception has given rise to a number of prescriptions that aim at bringing down the growth rate of population in the third world countries. It is asserted that such a move would allow the benefits of economic development to reach the poor masses.

8.3 Pollution, Environment and DevelopmentPollution is defined as, “any undesirable change in the physical, chemical or biological characteristics of environmental components that is air, water and soil that adversely affects the life forms and life support systems of the biosphere directly or indirectly can also be stated as an unfavorable alteration of our environment mainly due to human activities. The agent that contaminates the environmental component is called the pollutant.

We all pollute the environment. We do so not because we get some perverse satisfaction from polluting, but because activities that give us utility, inevitably, pollute the environment. We do not drive our cars in order to dump carbon monoxide into the air but because we gain utility from the transportation and convenience cars provide.

Since the industrial revolution, the most significant development in the human history, we have used our planet’s resources, including living organisms, without worrying about the consequences of our actions. Industrial processes and pace of increase in human population led to the increase in the consumption of energy and natural resources.

Growing exploitation of resources have ensured the steady rise in the emissions of gases, chemicals, wastes and other materials into air, water, soil and eventually in the biosphere. Resources and energy are required by humans for fulfilling their needs as well as greed for food, housing, transportation, entertainment, luxuries and so on. With ever increasing human population, demand for resources and energy sources like wood, minerals, water, soil, coal, oil, gas etc. increases.

In Table 8.1, you can see how during last fifty years of industrialisation there has been an increasing trend in the usage and build up of resources that have affected the environment.

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Items Concentrations in 1950

Concentrations in 1995 Effect on environment

Coal use 884 million tons oil equivalent 2083 million tons

oil equivalent Climate change

Oil production 518 million tons 2953 million tons Climate change

Natural gas production 180 million tons

oil equivalent 2128 million tons

oil equivalent Climate change

Fertilizer use 14 million tons 125 million tons Water pollution

CFC production 42 thousand tons 300 thousand tons Ozone layer depletion

Nuclear Arsenal 304 45100 Global security

Human population 2.55 billion More than 5.6 billion Changed land use and

resource use patterns

Table 8.1 Increasing trend in the resource usage, buildups and the effects on environment(Source:http://www.egyankosh.ac.in/bitstream/123456789/6397/4/Unit%204%20Development%20and%20

Environmental%20Pollution%20%28Final%29.pdf)

Technology has enabled us to overcome adversities of nature to a great extent so that we can live and work anywhere. Subsequently, explosion in human population, urbanisation, deforestation, profit oriented capitalism and technological advances have contributed to the pollution crisis.

Our resource consumption strategies and living styles have compelled us to live in a polluted environment, be it indoors or outdoors. Thus, development has affected the environment and added to the pollution.

8.4 Natural Resource EconomicsNatural resources include everything from oil to sea life to magnificent scenic vistas. The stock of a natural resource is the quantity of the resource with which the earth is endowed. As with capital, we examine the allocation of natural resources among alternative uses across time. By definition, natural resources cannot be produced. Our consumption of the services of natural resources in one period can affect their availability in future. Therefore, when we allocate natural resources, the extent of expected demands of future generations should be taken into account.

From the economist’s point of view, natural resources are most conveniently viewed as stocks of capital, which provide potential flows of services. Time is a crucial that helps us distinguish between different types of resources.

A renewable resource is one that can regenerate itself and hence can supply productive inputs to an economic system indefinitely. For example, water, oxygen, timber, fruit and vegetables, meat, and so on.

A Non-renewable/Exhaustible resource is one with finite stock; once used up, the stock is gone. For example, minerals, coal are exhaustible because they take millions of years for formation. Even for the renewable resource, depending on the rate at which it is harvested over time, the stock size changes.

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8.5 Conservation and Allocation of Natural ResourcesConservation is the wise and careful use of available resources. Following strategies can be applied for the conservation purpose:

Reduction in consumption• More efficient use of existing resources• Substitution of non-renewable resources by renewable ones• Development of new materials and cleaner technologies• Use of more abundant resources in preference to less abundant ones• Recycling and reuse• Judicious use of resources with minimum or zero wastage•

8.6 Natural Resource ManagementNatural resource management aims to provide goods and services and to maintain essential life-support systems. It is not only concerned with the physical or biological functioning of part of the environment (for example, a forest), but also with the allocation of resource products, within the frameworks of particular legal and cultural settings.Natural resource management has three different dimensions, categorised as,

Ecological• Economic• Ethnological (that is social or cultural)•

If a natural resource is to be used, it must be physically possible, economically viable and culturally acceptable.

In practice, natural resources• have to be managed with regard to all three dimensions. The physical management of the resource has to take place within particular economic and cultural climate. Conversely, the management of natural resources, in order to satisfy particular economic or social goals, may have effects on the physical or biological nature of the resource.One solution for appropriate use and management of resources is the reduction of population size and use • resource to the point where potentially renewable common-property resources, at rates below their estimated sustainable yields. Such practice is not easily achieved because people do not like to be told how many children they can have or what types and amounts of resources they can use.There are many other approaches and opinions on an appropriate use and management of resources which have • their advantages and disadvantages to be accepted and practiced by people.

8.7 Environmental EconomicsWe need to take a look at the nature of environmental externalities, and find a reason for economic efficiencies and their remedies.

Market Failure is the central concept of environmental economics. It means that markets fail to allocate resources • efficiently.A market failure occurs when the market does not allocate scarce resources to generate the greatest social welfare. • A wedge exists between what a private person does given market prices and what society might want him or her to do to protect the environment. Such a wedge implies wastefulness or economic inefficiency; resources can be reallocated to make at least one person better off without making anyone else worse off.Common forms of market failure include externalities, non excludability and non rivalry.•

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An Ecnomic View of the Environment

Measuring Society’s well-being

Willingness to pay as ameasure of natural resource value

Classes of environmental values

Circular flow of the economyand environment

Market allocation of naturalresources

Goverment responses tomarket failure

Market Failure

Fig. 8.1 Economic view of environment(Source: http://www.enviroliteracy.org/pdf/EnviroEcon-vol1.pdf)

8.8 ExternalitiesExternalities are unintentional side effects of an activity affecting people other than those directly involved in the activity. A negative externality is one that creates side effects that could be harmful to either the general public directly or through the environment. For example, a factory that pollutes as a result of its production process. This pollution may pose health risks for nearby residents or degrade the quality of the air or water. Either way, the owner of the factory does not directly pay the additional cost to address any health issues or to help maintain the cleanliness of the air or water. In some cases, however, the harmed parties can use legal measures to receive compensation for damages.

A positive externality, on the other hand, is an unpaid benefit that extends beyond those directly initiating the activity. For example, a neighborhood resident who creates a private garden, the aesthetic beauty of which benefits other people in the community. Also, when a group voluntarily chooses to create a benefit, such as a community park, others may benefit without contributing to the project.

8.9 Market InefficiencyAny individuals or groups that gain additional benefits without contributing are known as free riders. Traditionally, both negative and positive externalities are considered to be forms of market failure - when a free market does not allocate resources efficiently.

Arthur Pigou, a British economist best known for his work in welfare economics, argued that the existence of externalities justified government intervention through legislation or regulation. Pigou supported taxes to discourage activities that created harmful effects and subsidies for those creating benefits to further encourage those activities. These are now known as Pigovian Taxes and Subsidies.

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Many economists believe that placing Pigovian taxes on pollution is a much more efficient way of dealing with pollution as an externality than government imposed regulatory standards. Taxes leave the decision of how to deal with pollution to individual sources by assessing a fee or “tax” on the amount of pollution that is generated.

Therefore, in theory, a source that is looking to maximise its profit will reduce, or control, their pollution emissions whenever it is cheaper to do so. Other economists believe that the most efficient solution to externalities is to include them in the cost for those engaged in the activity, thus the externality is “internalised.” Under this framework externalities are not necessarily market failures, which weaken the case for government intervention.

8.10 Correcting ExternalitiesLet us dicuss about correcting externalities.

8.10.1 Coase Theorem

Many externalities (pollution, free rider benefits) can be internalised through the creation of well defined • property rights. Through much of his work, economist Ronald Coase showed that taxes and subsidies were typically not necessary as long as the parties involved could strike a voluntary bargain.According to Coase’s theorem, it does not matter who has ownership, so long as property rights exist and free • trade is possible.

Two methods of controlling negative externalities, loosely related to property rights, include.

8.10.2 Cap and TradeThe cap and trade approach sets a maximum amount of emissions for a group of sources over a specific time period. The various sources are then given emissions allowances which can be traded, bought or sold, or banked for future use, but - over the course of the specified period of time - overall emissions will not exceed the amount of the cap and may even decline. Therefore, individual sources, or facilities, can determine their level of production and/or the application of pollution reduction technologies or the purchase of additional allowances.

8.10.3 Individual Transferable Quotas (ITQs)Individual transferable quotas are a market-based solution that is often used to manage fisheries. The options for dealing with externalities - positive or negative - are numerous, and often depend on the type of externality.The key is to identify the particular tool or policy alternative that will best move the market toward the most efficient allocation of resources.

8.10.4 Economic Incentives and Disincentives (India)Economic incentives and disincentives are the two major categories of instruments that can be harnessed in support of the environmental policies.

Each, in turn, can influence the environment in two ways:Through stimulating adjustment to the allocation of scarce economic resources between sectors; and• Through encouraging the adoption of improved resource management practices•

IncentivesEconomic incentives can be one of the major engines for development of eco-friendly projects. These incentives include:Grants

These can be used to promote resource uses that are both environmentally and economically sound.• In the past, positive environmental results have been achieved through the use of grants and allocations for • specific projects.

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SubsidiesSubsidies in support of commodities and inputs are a common form of incentive through which the government • seeks to benefit a specified, usually private sector of the economy.Both developed and developing countries have been extending subsidies to various sectors of the economy. For • example, U.S. has high subsidies to its agriculture and steel sector. The governments can subsidise environment friendly technologies.

Fiscal Relief and ConcessionsFiscal relief and concessions represent a third avenue for resource use and sustainable development programmes. • Thus, the scope for tax incentives is restricted to the formal and organised sectors, which constitute a relatively small part of the national economy.To encourage the demand for products, the government could provide indirect tax exemption; a sales or excise • tax could be waived, for instance, to assist particular resource use practitioners.

Tariffs or QuotasThis fourth type of incentive is the imposition of tariffs or quotas in order to protect environmental benign • producers. In an economy that is in the process of being gradually liberalised, these instruments could pay a marginal role at best.

PrizesA highly visible form of incentive is the institution of much publicised prize, awarded to those adjudged as the • most successful in undertaking environmentally progressive measures.

DisincentivesLevies, taxes, restrictive tariffs, penalties or fines could be used as disincentives by the government.•

8.11 Globalisation and EnvironmentAt the behest of the UN, a number of initiatives have been made for restricting and reversing environmental damage. Some of the initiatives like the Vienna Convention and the protocols that followed on CFCs control and ozone layer have been very successful but other initiatives like the one on climate change are facing resistance.

There is a growing feeling among many observers that to face the environmental challenges, which are deepened by the present globalisation process, there is a need for a multinational World Environmental Organisation , which should function as effectively on environmental issues as the WTO does in the arena of trade.

After analysing the threats to environment, its economics, and the approaches with which we can manage the crisis, we can state that if we manage our environmental resources wisely, human race can not only survive but thrive for a long time to come.

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SummaryPollution is defined as, “any undesirable change in the physical, chemical or biological characteristics of • environmental components that is air, water and soil that adversely affects the life forms and life support systems of the biosphere directly or indirectly.”Natural resource management• aims to provide goods and services and to maintain essential life-support systems.Natural resource management has three different dimensions, categorised as ecological, economic and • ethnological.Market Failure is the central concept of environmental economics. It means that markets fail to allocate resources • efficiently.Externalities• are unintentional side effects of an activity affecting people other than those directly involved in the activity.According to Coase’s theorem, it does not matter who has ownership, so long as property rights exist and free • trade is possible.The cap and trade approach sets a maximum amount of emissions for a group of sources over a specific time • period.Individual transferable quotas are a market-based solution that is often used to manage fisheries.• Economic incentives and disincentives are the two major categories of instruments that can be harnessed in • support of the environmental policies.Subsidies in support of commodities and inputs are a common form of incentive through which the government • seeks to benefit a specified, usually private sector of the economy.Fiscal relief and concessions represent a third avenue for resource use and sustainable development programmes.• Levies, taxes, restrictive tariffs, penalties or fines could be used as disincentives by the government•

ReferencesSamuelson, P. and Nordhaus, W., 2001. • Economics, New Delhi, Tata McGraw-Hill Publishing Co. Ltd.Mankiw, N. G., 2009. • Principles of Microeconomics, 5th ed,South –Western Cengage Learning.Development and Environment Pollution• , IGNOU, [Pdf] Available at: <http://www.egyankosh.ac.in/bitstream/123456789/6397/4/Unit%204%20Development%20and%20Environmental%20Pollution%20 %28Final%29.pdf> [Accessed 27 October 2010].Environmental Dimensions of Globalization• , IGNOU [Pdf] Available at: <http://www.egyankosh.ac.in/ bitstream/123456789/6220/1/UNIT%201.pdf> [Accessed 27 October 2010].David, Z. 2009. EEP100 Lecture 7, [Video online] Available at: <http://www.youtube.com/watch?v=G0VF7aUZieg> • [Accessed 27 October 2010].Lec 1, MIT., 2012. • Principles of Microeconomics. [Video online] Available at: <http://www.youtube.com/watch?v=Vss3nofHpZI> [Accessed 27 October 2010].

Recommended ReadingCallan, S. J. and Thomas, J. M., 2006. • Environmental Economics and Management: Theory, Policy and Applications, 4th ed., South-Western College Publishers, Hanley, • N, Shogren, J. and White, B., 2007. Environmental Economics: In Theory & Practice, 2nd ed., Palgrave Macmillan.Marchetti, M. P. and Moyle, P. B., 2010. • Protecting Life on Earth: An Introduction to the Science of Conservation, 1st ed., University of California Press.

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Self Assessment

Which of the following is not a conservation strategy?1. Reduction in consumptiona. More efficient use of existing resourcesb. Development of new materials and newer cleaner technologies c. Use of resources in abundanced.

As per Malthus, the problem of over population would be overcome by 2. .natural calamities and diseases a. technological innovationsb. efficient use of resourcesc. ending population growthd.

Industrial revolution has lead to the problem of 3. .Economic instability a. Pollutionb. Population explosionc. Unhealthy Competitiond.

Which is not a dimension of natural resource management?4. Ecological dimension a. Economic dimensionb. Etymological dimensionc. Ethnological dimensiond.

Central concept of environmental economics 5. is Market Failure a. Pollutionb. Populationc. Technologyd.

As per Coase’s theorem, externalities can be internalised by well defined 6. .Ownership laws a. Property b. rights Taxesc. Incentivesd.

Which of the following is not an economic incentive?7. Subsidiesa. Fiscal reliefs b. Tariffsc. Taxesd.

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Any individuals or groups that gain additional benefits without contributing are known as ____________.8. Free traders a. Tax gainers b. Free ridersc. Grants beneficiariesd.

Common forms of market failure do not include 9. Externalitiesa. Non excludability b. Non rivalryc. Market allocationd.

Which of the following statements is false?10. The cap and trade approach sets a maximum amount of emissions for a group of sources over a specific a. time period.The cap and trade approach sets a minimum amount of emissions for a group of sources over a specific b. time period.The market and trade approach sets a maximum amount of emissions for a group of sources over a specific c. time period.The market and tax approach sets a maximum amount of emissions for a group of sources over a specific d. time period.

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Case Study I

Coke and Pepsi both are trying to gain market share in the beverage market, which is valued at over $30 billion a year. The facts are that, each company is coming up with new products and ideas in order to increase their market share. The creativity and effectiveness of each company’s marketing strategy will ultimately determine the winner with respect to sales, profits, and customer loyalty. Not only these two companies are constructing new ways to sell Coke and Pepsi, but they are also thinking of ways to increase market share in other beverage categories. Although the goals of both companies are same, the two companies form different marketing strategies. Pepsi has always taken the lead in developing new products, but Coke also learned their lesson and started to do the same. Coke hired marketing executives with good track records. Coke also implemented cross training of managers so it would be more difficult to form groupism. On the other hand, Pepsi has always taken risks, acted rapidly and developed new marketing ideas.

Both the companies tried to capture the foreign markets. Coke had carried out market research in different regions, and got to know that the customer requirements differ according to their regions. So, Coke has been more successful in foreign markets than Pepsi.

However, after 2-3 years, many changes were made by both the companies; some of the development techniques failed, while some gained profit. For instance, the transformation of Coke into New Coke was a major failure. Pepsi’s failure included Pepsi Light, Pepsi Free, Pepsi AM, and Crystal Pepsi.

To overcome failures, the company has to take next step to develop new products to meet customer requirements. If both companies sell the same product, they will never succeed. Gaining market share is possible if the company knows what the customer wants, and takes one step ahead than the competitor to achieve customer satisfaction. To understand the customer requirement, market research is necessary. The companies should collect feedback from customers, next analyse this data, and then develop the new product based on the data. Thus, once the product is developed it should be in the marketplace at the right time. Therefore, if any company follows these factors, it can achieve the market share.

(Source: Coke Vs. Pepsi Case Study, [Online] Available at: <www.exampleessays.com/viewpaper/84955.html> [Accessed 4 June 2013]‎).

QuestionsWhich type of competition is seen in this case study? Give reasons.1. AnswerIn this case study, Perfect Competition is seen. The factors that are present in the perfect competition are as follows:

Coke and Pepsi are the two competitors which sell an identical product �The industries are characterised by freedom of entry and exit �The firms have relatively small market share �

What are the different marketing strategies adopted by both the companies?2. AnswerCoke hired marketing executives with good track records. Coke also implemented cross training of managers so it would be more difficult to form groupism.On the other hand, Pepsi has always taken risks, acted rapidly and developed new marketing ideas.

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In perfect competition, how can a company achieve complete market share?3. AnswerGaining market share is possible if the company knows what the customer wants, and takes one step ahead than the competitor to achieve customer satisfaction. To understand the customer requirement market research is necessary. Get the feedback from customers, next analyse this data, and then develop the new product based on the data. Thus, once the product is developed it should be in the marketplace at the right time.

How Coke has been successful in foreign market?4. AnswerCoke had carried out market research in different regions, and got to know that the customer requirements differ according to their regions. So, Coke has been more successful in foreign markets than Pepsi.

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Case Study II

Three Aspects of Organisational Architecture

The three vital components of organisational architecture are:assignment of decision rights• methods of rewarding individuals and • structure of systems to evaluate the performance of both individuals and business units. •

First, assignment of decision rights involves giving the responsibility of decision-making to top-level executives. It is imperative that an organisation is able to delegate the duty of making a decision to a manager who has relevant information and knowledge on the internal and external factors that affects the operations and goals of the organisation. The architecture of an organisation and its environment will determine who will be the decision-maker for the company. In some organisations, the top-level executive may have them most relevant information and thus, a centralised decision-making process can be adopted. There are instances when the lower-level employees may have the most relevant information, thus, decision-making rights become decentralised.

Second, methods of rewarding individuals determine how the organisation will provide incentives to its employees. Organisational goals and employee’s productivity play great roles in determining a scheme of remuneration. Some organisations repay their employees through financial rewards such as the monthly wage, and cost of living allowance, and other benefits. Also, some firms offer nonfinancial rewards such as improving the workplace and enhancing the employees’ skills and knowledge through trainings and seminars.

Third, structure of systems to evaluate the performance of both individuals and business units. Every company has its own way of evaluating the performance of each department and employees. Such evaluation system is dependent on how an employee’s productivity contributed to the achievement of organisational goals.

(Source: Managerial Economics Case Study [Pdf] Available at: <http://www.advanceessays.com/samples/Managerial_Economics_Case_Studies.pdf> (Accessed 4 June 2013).

QuestionsWhat are the three vital components of organisational architecture?1. What does assignment of decision rights involves?2. What does methods 3.

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Case Study III

NIKE- Failure in Demand ForecastingThe case provides an overview of Nike as a company and how it grew up to be one of the premier footwear manufacturers of the world. It focuses on how the company failed to prepare an appropriate demand forecasting. The problems that occurred out of this failure to carry out the new technique are also discussed in detail. Finally, the case presents the remedial measures taken by Nike.

Established in 1964, Nike is one of the world’s leading designer, marketer, and distributor of athletic footwear, apparel, equipment, and accessories of sports and other fitness activities. Nike was formed by Philip H. Knight. In January 2006, Fortune magazine listed Nike in the 100 best companies, and in 2005, it had achieved remarkable sales and profitability in the US.

With the increase in athletics, the demand for Nike shoes was increasing, but Nike was not able to supply that much quantity of products as it had never forecasted this massive demand. At the same time, Reebok entered the market with similar range of products. Thus, the demand for Nike came to a standstill when Reebok entered the market. Reebok introduced athletic shoes for women with surplus quantity and captured the market share. They launched new styles and the looks of shoes attracted most of the customers. Thus, the demand for Nike decreased.

Nike had not forecasted demand, and had never analysed any competitor to enter the market with the same products. Thus, Nike started market research and realised that Reebok only had style and appearance of shoes, but was lacking in promotions. Thus, Nike started promoting its products and carried out different marketing strategies like, having slogans Nike’s “Just Do It” Now, Nike had analysed demand and supply and entered the market with surplus quantity and different marketing strategies. Thus, again Nike captured the market share and is still leading it.

(Source: Nike - Failure in Demand Forecasting, [Online] Available at: <http://www.icmrindia.org/Short%20Case%20Studies/Operations/CLOM008.html> [Accessed 4 June 2013]).

QuestionsWhat were the likely reasons that resulted in such a huge gap between demand and supply at Nike? What, in 1. your opinion, could have been done to avoid this situation?What strategies were followed by Nike to capture the market share again?2. What is the relationship between demand and supply?3. Why was Reebok not able to sustain in the competition?4.

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Mindbitesdotcom., 2011. • Economics:Analyzing the Labor Market.[Online video] Available at: <http://www.youtube.com/watch?v=5ReW_bzaqHk> [Accessed 20 October 2010].Mindbitesdotcom., 2011. • Economics:Minimum Wages in Labor Markets. [Online video] Available at: <http://www.youtube.com/watch?v=nnq6mXYm_LQ> [Accessed 30 October 2010].Mindbitesdotcom., 2011. • Economics:The Labor Market. [Online video] Available at: <http://www.youtube.com/watch?v=ZXt99pqTNZ0> [Accessed 30 October 2010].MIT, Lecture 24. • Priciples of Microeconomics. [Online video] Available at: <http://www.youtube.com/watch?v=ni0aX0tUAd0>[Accessed 25 October 2010].MIT, Lecture 9., 2012. • Principles of Microeconomics [Online video] Available at: <http://www.youtube.com/watch?v=Q4iKuKAjzK0> [Accessed 25 October 2010].Marx, K., 1865. • Value, Price andProfit. [Online] Available at: <http://www.marxists.org/archive/marx/works/1865/value-price-profit/index.htm> [Accessed 25 October 2010].MIT, Lecture 9., 2012. • Principles of Microeconomics [Online video] Available at: <http://www.youtube.com/watch?v=Q4iKuKAjzK0>[Accessed 25 October 2010].Nicholas, E., 2011. • Notes for Microeconomics.[Video online] Available at: <http://www.stern.nyu.edu/networks/micnotes/micnotes.pdf>[Accessed 23 October 2010].Pindyck, R. and Rubinfeld, D., 2008, • Microeconomics, 7th ed., Prentice Hall, Role of Government in Business• , IGNOU, [Pdf] Available at: <http://egyankosh.ac.in/bitstream/123456789/8955/1/ Unit-5 (complete).pdf> [Accessed 23 October 2010].RegisUniversity., 2010. • Aggregate Demand/Aggregate Supply Macro Model.[Online video] Available at: <http://www.youtube.com/watch?v=5D06HqwsVtM> >[Accessed 25 October 2010].Rittenberg, L. and Tregarthen, T., 2010. • Principles of Microeconomics, [Online] Available at: <http://www.web- books.com/eLibrary/NC/B0/B63/018MB63.html.> [Accessed 25 October 2010].Rittenberg, L. and Tregarthen, T., 2008. • Principles of Microeconomics, [Online] Available at: <www.flatworldknowledge.com/node/28303#web-28303> [Accessed 28 October 2010].Robert, S.P. and Daniel, L.R., • Microeconomics. 3rd ed., Prentice Hall.Samuelson, P. A., 2002. • Economics, Massachusetts Institute of Technology. Tata McGraw-Hill Publishing Co.Ltd.Samuelson, P. and Nordhaus, W., 2001. • Economics, New Delhi: Tata McGraw-Hill Publishing Co. Ltd.Samuelson, P., 2002. • Economics: Massachusetts Institute of Technology, Tata McGraw-Hill Publishing Co.Ltd.Swanson, M., 2010. • Diminishing Marginal Utility, [Online] Available at: <www.ehow.com/how_5993061_calculate-diminishing-marginal-utility.html> [Accessed 25 October 2010].Tewari, D. D. and Katar, S., 2003.• Principles of Microeconomics. New Age International Publishers.Walter, N., • Microeconomic Theory: Basic Principles and Extensions.9th ed.

Recommended ReadingBecker, G., 1971. • The Economics of Discrimination (Economic Research Studies), 2nd ed., University Of Chicago Press.Bernanke, B., 2009. • Principles of Microeconomics, Marginal Decision Rule, Tata McGraw Hill Publication.Bernard Salanie, 2003. • The Economics of Taxation, The MIT Press.Besanko, D. and Braeutigam, R., 2007. • Microeconomics, 3rd ed., Wiley.Boeri, T., and Ours, J.,2008. • The Economics of Imperfect Labor Markets [Paperback], Publisher: Princeton University Press.Callan, S. J. and Thomas, J. M., 2006. • Environmental Economics and Management: Theory, Policy and Applications, 4th ed., South-Western College Publishers.

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Colander, D., 2009. • Microeconomics, 8th ed., McGraw-Hill/Irwin.Dr. Mithani, D. M., 2008. • International Economics, Institute of Business Study and Research, HimalayaDr. Mithani, D. M., 2008. • International Economics, Institute of Business Study and Research, Himalaya Publishing House Pvt. Ltd.Gregory, M., 2008. • Essentials of Economics, 5th ed., South-Western College.Hanley, N, Shogren, J and White, B., 2007. • Environmental Economics: In Theory & Practice, 2nd ed., Palgrave Macmillan.Jagdish, B., Arvind, P., and Srinivasan, T.N., 1998. • Lectures on International Trade, 2nd ed., The lV ITPress.Kaufman, B. and Hotchkiss J., 2005. • The Economics of Labor Markets (with Economic Applications and InfoTrac Printed Access Card), 7th ed., South-Western College Pub.Krugman, P. and Wells, R., 2010. • Microeconomics, Worth Publishers.Mankiw, N. G., 2008. • Economics: Principles and Applications, Cengage Learning Products, Canada, Nelson Education Pvt. Ltd.Marchetti, M. P. and Moyle, P. B., 2010. • Protecting Life on Earth: An Introduction to the Science of Conservation, 1st ed., University of California Press.Mithani, D., 2008. • International Economics. Institute of Business Study and Research, Himalaya Publishing House Pvt. Ltd.Mankiv, N. G., • Economic: Principles and Applications, Cengage Learning Products, Canada, Nelson Education Pvt. Ltd.Ralph H. F. and lvlichae,l W., John A. S., 2008. • lnternaiional Trade and Economic Relations in a Nutshell, 4th ed.Robert, C. F., 2003. • Advanced International Trade. Theory and Evidence. Princeton University Press.Samuelson, P. A., 2002. • Economics, Massachusetts Institute of Technology, Tata McGraw-Hill Publishing Company.Steiner, J. and Steiner, G. • Business, Government and Society: A Managerial Perspective, 12t ed., McGraw-Hill/Irwin.

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Self Assessment Answers

Chapter Ia1. b2. a3. d4. b5. a6. d7. d8. d9. c10.

Chapter IIa1. c2. b3. a4. a5. a6. a7. b8. a9. a10.

Chapter IIIa1. d2. b3. c4. a5. c6. a7. c8. b9. b10.

Chapter IVa1. a2. b3. b4. a5. a6. c7. a8. b9. c10.

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Chapter Va1. b2. b3. d4. a5. b6. d7. c8. b9. a10.

Chapter VIc1. a2. d3. a4. b5. d6. a7. b8. c9. a10.

Chapter VIIc1. d2. a3. b4. d5. a6. b7. c8. c9. d10.

Chapter VIIId1. a2. b3. c4. a5. b6. d7. c8. d9. a10.

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