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Business Economics

Board of Studies

Prof. H. N. Verma Prof. M. K. Ghadoliya


Vice- Chancellor Director,
Jaipur National University, Jaipur School of Distance Education and Learning
Jaipur National University, Jaipur
Dr. Rajendra Takale
Prof. and Head Academics
SBPIM, Pune

___________________________________________________________________________________________
Subject Expert Panel

Dr. Daniel J. Penkar Vijayalakshmi R.H


Director, SBS, Sinhgad Subject Matter Expert
Pune

___________________________________________________________________________________________
Content Review Panel

Shreya Saraf
Subject Matter Expert

___________________________________________________________________________________________
Copyright ©

This book contains the course content for Business Economics.

First Edition 2013

Printed by
Universal Training Solutions Private Limited

Address
05th Floor, I-Space,
Bavdhan, Pune 411021.

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.

___________________________________________________________________________________________
Index

I. Content....................................................................... II

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

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

IV. Abbreviations..........................................................IX

V. Case Study ............................................................. 119

VI. Bibliography.......................................................... 123

VII. Self Assessment Answers................................... 126

Book at a Glance

I
Contents
Chapter I........................................................................................................................................................ 1
Basics of Economics...................................................................................................................................... 1
Aim................................................................................................................................................................. 1
Objectives....................................................................................................................................................... 1
Learning outcome........................................................................................................................................... 1
1.1 Introduction............................................................................................................................................... 2
1.2 Meaning and Definition of Economics..................................................................................................... 2
1.3 Economics Basics..................................................................................................................................... 2
1.4 Macroeconomics and Microeconomics.................................................................................................... 2
1.5 The Two Basic Concepts of Economics................................................................................................... 2
1.5.1 Production Possibility Frontier (PPF)....................................................................................... 2
1.5.2 Opportunity Cost....................................................................................................................... 4
1.6 Market Economy....................................................................................................................................... 4
1.7 Command Economy.................................................................................................................................. 4
1.8 Choice as an Economic Problem.............................................................................................................. 5
1.9 Central Problems of an Economy............................................................................................................. 5
1.10 Market Mechanism................................................................................................................................. 5
1.11 Positive Economics and Normative Economics..................................................................................... 5
1.12 Inductive Method and Deductive Method of Economic Analysis.......................................................... 6
Summary........................................................................................................................................................ 8
References...................................................................................................................................................... 8
Recommended Reading................................................................................................................................ 8
Self Assessment.............................................................................................................................................. 9

Chapter II.....................................................................................................................................................11
Business Economics- Meaning, Nature, Scope and Significance.............................................................11
Aim................................................................................................................................................................11
Objectives......................................................................................................................................................11
Learning outcome..........................................................................................................................................11
2.1 Introduction............................................................................................................................................. 12
2.2 Nature of Business Economics............................................................................................................... 12
2.3 Scope of Business Economics................................................................................................................ 12
2.3.1 Demand Analysis and Forecasting.......................................................................................... 12
2.3.2 Cost and Production Analysis................................................................................................. 13
2.3.3 Pricing Decisions, Policies and Practices............................................................................... 13
2.3.4 Profit Management................................................................................................................. 13
2.3.5 Capital Management............................................................................................................... 13
2.4 Significance of Business Economics...................................................................................................... 13
2.5 Theory of Consumer’s Behaviour........................................................................................................... 14
2.5.1 Utility Analysis or Cardinal Approach.................................................................................... 14
2.5.2 Meaning of Utility.................................................................................................................. 14
2.5.3 Concepts of Utility.................................................................................................................. 15
2.5.4 Relationship between total utility and Marginal Utility......................................................... 16
2.6 Laws of Utility Analysis......................................................................................................................... 16
2.6.1 Law of Diminishing Marginal Utility..................................................................................... 16
2.6.2 Law of Equi-Marginal Utility................................................................................................. 19
Summary...................................................................................................................................................... 21
References.................................................................................................................................................... 21
Recommended Reading.............................................................................................................................. 22
Self Assessment............................................................................................................................................ 23

II
Chapter III................................................................................................................................................... 25
Demand, Supply and Product Management............................................................................................ 25
Aim............................................................................................................................................................... 25
Objectives..................................................................................................................................................... 25
Learning outcome......................................................................................................................................... 25
3.1 Introduction............................................................................................................................................. 26
3.2 Concept of Demand................................................................................................................................ 26
3.3 Demand Schedule and Concept.............................................................................................................. 26
3.3.1 Market Demand Curve............................................................................................................ 26
3.3.2 Law of Demand...................................................................................................................... 27
3.4 Price Elasticity of Demand..................................................................................................................... 27
3.4.1 Types of Demand.................................................................................................................... 27
3.5 Factors Affecting Demand...................................................................................................................... 28
3.6 Concept of Supply................................................................................................................................... 28
3.6.1 Supply Schedule and Concept................................................................................................ 28
3.6.2 Market Supply Curve.............................................................................................................. 29
3.6.3 Law of Supply......................................................................................................................... 30
3.6.4 Price Elasticity of Supply....................................................................................................... 30
3.6.5 Types of Supply...................................................................................................................... 30
3.6.6 Factors Affecting Supply........................................................................................................ 30
3.7 Equilibrium in Demand and Supply....................................................................................................... 31
3.8 Equilibrium as per the Change in Demand and Supply.......................................................................... 32
3.9 Tax Impact on Price or Quantity of Goods............................................................................................. 35
3.10 Perfect Competition.............................................................................................................................. 35
3.11 Economic Factors Related to Industry with Perfect Competition......................................................... 36
3.11.1 Marginal Revenue................................................................................................................. 36
3.12 Perfect Competition in Short Run......................................................................................................... 37
3.13 Perfect Competition in Long Run......................................................................................................... 38
3.13.1 Economic Profit and Losses................................................................................................. 38
3.13.2 Zero Economic Profit in Long Run...................................................................................... 38
3.14 Monopoly Market................................................................................................................................. 38
3.15 Characteristics of Monopoly Firm........................................................................................................ 38
3.16 Factors of Monopoly Power.................................................................................................................. 38
3.17 Monopoly and Market Demand............................................................................................................ 39
3.18 Marginal Decision Rule in Monopoly Market...................................................................................... 39
3.19 Oligopoly Market.................................................................................................................................. 40
3.20 Concentration in Oligopoly................................................................................................................... 40
3.21 Game Theory and Oligopoly Behaviour............................................................................................... 41
Summary...................................................................................................................................................... 43
References.................................................................................................................................................... 43
Recommended Reading.............................................................................................................................. 43
Self Assessment............................................................................................................................................ 44

Chapter IV................................................................................................................................................... 46
Analysis of Consumer Choice, Production Analysis and Cost Concept................................................. 46
Aim............................................................................................................................................................... 46
Objectives..................................................................................................................................................... 46
Learning outcome......................................................................................................................................... 46
4.1 Introduction............................................................................................................................................. 47
4.2 Utility Theory.......................................................................................................................................... 47
4.2.1 Total Utility (TU).................................................................................................................... 47
4.2.2 Marginal Utility (MU)............................................................................................................ 47
4.2.3 Budget Constrain.................................................................................................................... 49
4.3 Production Analysis................................................................................................................................ 50
4.4 Short Run Production Function.............................................................................................................. 50

III
4.4.1 Total, Marginal and Average Product..................................................................................... 50
4.5 Cost Concept........................................................................................................................................... 52
4.5.1 Total Cost and Marginal Cost................................................................................................. 52
4.5.2 Average Total Cost.................................................................................................................. 53
4.6 Relationship between Marginal Cost, Average Fixed Cost, Average Variable Cost and Average
Total Cost in Short Run........................................................................................................................... 53
4.7 Cost Concept in Long Run...................................................................................................................... 54
4.8 Economy of Scale, Diseconomy of Scale and Constant Return to Scale............................................... 54
Summary...................................................................................................................................................... 56
References.................................................................................................................................................... 56
Recommended Reading.............................................................................................................................. 56
Self Assessment............................................................................................................................................ 57

Chapter V..................................................................................................................................................... 59
The Nature of Factor Demands................................................................................................................. 59
Aim............................................................................................................................................................... 59
Objectives..................................................................................................................................................... 59
Learning outcome......................................................................................................................................... 59
5.1 Introduction............................................................................................................................................. 60
5.2 Income and Wealth.................................................................................................................................. 60
5.2.1 Income.................................................................................................................................... 60
5.2.2 Wealth..................................................................................................................................... 61
5.3 Input Pricing by Marginal Productivity.................................................................................................. 61
5.4 The Nature of Factor Demands............................................................................................................... 61
5.4.1 Factors Demands and Derivation............................................................................................ 61
5.4.2 Factors Demands are Interdependent...................................................................................... 62
5.5 Distribution Theory and Marginal Revenue Product.............................................................................. 62
5.6 The Demand for Factors of Production.................................................................................................. 63
5.6.1 Rule for Choosing the Optimal Combination of Inputs.......................................................... 63
5.6.2 Least-Cost Rule....................................................................................................................... 63
5.6.3 Marginal Revenue Product and the Demand for Factors........................................................ 63
5.6.4 Substitution Rule..................................................................................................................... 64
5.7 Supply of Factors of Production............................................................................................................. 64
5.8 Determination of Factor Prices by Supply and Demand........................................................................ 65
5.9 The Distribution of National Income...................................................................................................... 67
5.10 Marginal-Productivity Theory with Many Inputs................................................................................. 68
Summary...................................................................................................................................................... 69
References.................................................................................................................................................... 69
Recommended Reading.............................................................................................................................. 69
Self Assessment............................................................................................................................................ 70

Chapter VI................................................................................................................................................... 72
The Markets for Labor, Capital and Land............................................................................................... 72
Aim............................................................................................................................................................... 72
Objectives..................................................................................................................................................... 72
Learning outcome......................................................................................................................................... 72
6.1 The Labor Market.................................................................................................................................... 73
6.2 Fundamentals of Wage Determination.................................................................................................... 73
6.2.1 The General Wage Level......................................................................................................... 73
6.2.2 Demand for Labor................................................................................................................... 73
6.2.3 International Comparisons...................................................................................................... 74
6.3 The Supply of Labor............................................................................................................................... 74
6.3.1 Hours Worked.......................................................................................................................... 74
6.3.2 Labor-force Participation........................................................................................................ 74
6.3.3 Immigration............................................................................................................................ 74

IV
6.4 Wage Differentials.................................................................................................................................... 75
6.4.1 Differences in Jobs: Compensating Wage Differentials.......................................................... 75
6.4.2 Differences in People: Labor Quality...................................................................................... 75
6.4.3 Differences in People: The “Rents” of Unique Individuals................................................... 75
6.4.4 Segmented Market and Noncompeting Groups...................................................................... 75
6.5 Economics of Labor Union..................................................................................................................... 76
6.5.1 Effect of Unions on Wages and Employment......................................................................... 76
6.6 Discrimination by Race and Gender....................................................................................................... 76
6.7 Techniques to Determine Extent of Discrimination................................................................................ 77
6.8 Reducing Labor Market Discrimination................................................................................................. 77
6.9 Land and Rent......................................................................................................................................... 77
6.10 Capital and Interest................................................................................................................................ 77
6.11 Rate of Return on Capital Goods.......................................................................................................... 78
6.12 Financial Assets and Tangible Assets..................................................................................................... 78
6.12.1 Financial Assets and Interest Rates....................................................................................... 78
6.12.2 Real and Nominal Interest Rates........................................................................................... 78
6.13 Present Values of Asset.......................................................................................................................... 79
6.13.1 Present Value for Perpetuities................................................................................................ 79
6.13.2 General Formula for Present Value....................................................................................... 79
6.14 Profits.................................................................................................................................................... 80
6.14.1 Profits as Rewards for Innovation......................................................................................... 80
6.14.2 Uncertainty and Profit........................................................................................................... 80
6.14.3 Profits and Market Structure................................................................................................. 80
6.15 The Theory of Capital and Interest....................................................................................................... 80
6.15.1 Applications of Classical Capital Theory.............................................................................. 81
Summary...................................................................................................................................................... 82
References.................................................................................................................................................... 82
Recommended Reading.............................................................................................................................. 82
Self Assessment............................................................................................................................................ 83

Chapter VII................................................................................................................................................. 85
International Trade . .................................................................................................................................. 85
Aim............................................................................................................................................................... 85
Objectives..................................................................................................................................................... 85
Learning outcome......................................................................................................................................... 85
7.1 Introduction............................................................................................................................................. 86
7.2 Factors Determining Gains from Trade.................................................................................................. 87
7.2.1 Relative Differences in Cost Ratio......................................................................................... 87
7.2.2 Reciprocal Demand................................................................................................................. 87
7.3 The Sources of International Trade in Goods and Services.................................................................... 87
7.4 Comparative Advantage among Nations................................................................................................ 87
7.4.1 Ricardo’s Analysis of Comparative Advantage...................................................................... 88
7.4.2 Autarky Equilibrium............................................................................................................... 88
7.5 Economic Gains from Trade .................................................................................................................. 89
7.6 Extensions to Many Commodities and Countries................................................................................... 90
7.6.1 Triangular and Multilateral Trade........................................................................................... 90
7.7 Protectionism.......................................................................................................................................... 91
7.7.1 Trade Barriers......................................................................................................................... 91
7.7.2 Tariffs...................................................................................................................................... 91
7.7.3 Quotas..................................................................................................................................... 92
7.8 Difference between Tariffs and Quotas................................................................................................... 92
7.9 Unsound Grounds of Tariff..................................................................................................................... 93
7.10 Potentially Valid Arguments for Protection.......................................................................................... 93
7.10.1 The Terms of Trade or Optimal Tariff Argument.................................................................. 94
7.10.2 Infant Industries.................................................................................................................... 94

V
7.10.3 Tariffs and Unemployment................................................................................................... 94
7.10.4 Protection against Dumping.................................................................................................. 94
7.11 Negotiating Free Trade.......................................................................................................................... 94
7.11.1 Multilateral Agreements........................................................................................................ 94
7.11.2 World Trade Organisation (WTO)........................................................................................ 95
Summary...................................................................................................................................................... 96
References.................................................................................................................................................... 96
Recommended Reading.............................................................................................................................. 96
Self Assessment............................................................................................................................................ 97

Chapter VIII................................................................................................................................................ 99
Government, Taxation and Expenditure.................................................................................................. 99
Aim............................................................................................................................................................... 99
Objectives..................................................................................................................................................... 99
Learning outcome......................................................................................................................................... 99
8.1 Types of Economy................................................................................................................................ 100
8.2 The Role of Government in the Economy............................................................................................. 100
8.3 Tools of Government Policy.................................................................................................................. 101
8.4 Importance of Size of Government....................................................................................................... 101
8.5 The Functions of Government.............................................................................................................. 102
8.6 Public Choice Theory............................................................................................................................ 102
8.7 Government Expenditure...................................................................................................................... 103
8.7.1 Nature of Government Expenditure...................................................................................... 103
8.7.2 Objectives of Government Expenditure Classification........................................................ 103
8.8 Economic Aspects of Taxation.............................................................................................................. 104
8.9 Taxes Levied by Central Government................................................................................................... 105
8.9.1 Direct Taxes........................................................................................................................... 105
8.9.2 Indirect Taxes........................................................................................................................ 106
8.10 Taxes Levied by State Governments and Local Bodies...................................................................... 107
8.11 Tax Incidence....................................................................................................................................... 108
8.12 Nature and Relevance of Regulation................................................................................................... 108
8.13 Government Intervention on Public Interest....................................................................................... 109
8.14 Instruments for Regulation...................................................................................................................110
8.14.1 Price Cap Regulation...........................................................................................................110
8.14.2 Revenue Cap Regulation.....................................................................................................110
8.14.3 Rate of Return Regulation...................................................................................................110
8.14.4 Benchmarking......................................................................................................................111
8.15 Effects of Regulation...........................................................................................................................111
8.16 Decline of Economic Regulation.........................................................................................................111
8.17 Deregulation.........................................................................................................................................112
8.18 Antitrust Policies..................................................................................................................................112
8.18.1 Antitrust Policy in US..........................................................................................................112
8.18.2 Indian Scenario....................................................................................................................113
8.19 Mergers: Law and Practice...................................................................................................................113
8.19.1 Merger or Amalgamation.....................................................................................................113
8.19.2 Acquisitions and Takeovers.................................................................................................114
8.19.3 Advantages of Mergers & Acquisitions...............................................................................114
8.20 Efficiency of Competition Laws..........................................................................................................115
Summary.....................................................................................................................................................116
References...................................................................................................................................................116
Recommended Reading.............................................................................................................................116
Self Assessment..........................................................................................................................................117

VI
List of Figures
Fig. 1.1 Production possibility frontier........................................................................................................... 3
Fig. 1.2 Production possibility frontier shifts outward................................................................................... 4
Fig. 1.3 Derivation of Eagle curve for a normal good.................................................................................... 7
Fig. 3.1 Market demand curve...................................................................................................................... 27
Fig. 3.2 Supply curve.................................................................................................................................... 29
Fig. 3.3 Market supply curve........................................................................................................................ 30
Fig. 3.4 Equilibrium in demand and supply.................................................................................................. 31
Fig. 3.5 Decrease in demand curve............................................................................................................... 32
Fig. 3.6 Increase in supply curve.................................................................................................................. 32
Fig. 3.7 Decrease in supply........................................................................................................................... 33
Fig. 3.8 Price ceiling..................................................................................................................................... 34
Fig. 3.9 Price floor........................................................................................................................................ 34
Fig. 3.10 Firm’s demand and industry equilibrium curve............................................................................. 36
Fig. 3.11 Marginal revenue and demand curve............................................................................................. 37
Fig. 3.12 Profit maximisation....................................................................................................................... 37
Fig. 3.13 Perfect competition vs. monopoly................................................................................................. 39
Fig. 3.14 Marginal decision rule in monopoly market.................................................................................. 40
Fig. 3.15 Prisnor’s dilemma rule in organisation.......................................................................................... 42
Fig. 4.1 Total utility....................................................................................................................................... 49
Fig. 4.2 Relation between marginal utility and demand curve..................................................................... 49
Fig. 4.3 Total production curve..................................................................................................................... 51
Fig. 4.4 Relationship between TP, MP and AP............................................................................................. 52
Fig. 4.5 Relationship between MC, AFC, AVC and ATC ............................................................................ 53
Fig. 4.6 Short run and long run average total curve...................................................................................... 54
Fig. 5.1 Factors demands are derived........................................................................................................... 62
Fig. 5.2 Demand for inputs derived through marginal revenue products..................................................... 64
Fig. 5.3 Supply curve for factors of production............................................................................................ 65
Fig. 5.4 Factor supply and derived demand interact to determine factor prices and income distribution.... 66
Fig. 5.5 The markets for surgeons and fast food workers............................................................................. 66
Fig. 5.6 Marginal product principles determine factor distribution of income............................................. 67
Fig. 6.1 Demand for labor reflects marginal productivity............................................................................ 73
Fig. 6.2 As wages rise, workers may work fewer hours................................................................................ 74
Fig. 7.1 Production possibilities of wheat and cloth..................................................................................... 89
Fig. 7.2 With many commodities, there is a spectrum of advantages........................................................... 90
Fig. 7.3 Triangular trades.............................................................................................................................. 90
Fig. 7.4 The impact of protectionist policies................................................................................................ 92
Fig. 7.5 U.S. tariff rates, 1820–2005............................................................................................................. 95
Fig. 8.1 The size of government-growth curve........................................................................................... 101
Fig. 8.2 Classification of Government Expenditure.................................................................................... 103

VII
List of Tables
Table 3.1 Demand schedule and concept...................................................................................................... 26
Table 3.2 Market demand curve.................................................................................................................... 26
Table 3.3 Types of demand........................................................................................................................... 27
Table 3.4 Factors affecting demand.............................................................................................................. 28
Table 3.5 Supply schedule............................................................................................................................ 28
Table 3.6 Market supply curve...................................................................................................................... 29
Table 3.7 Types of supply............................................................................................................................. 30
Table 3.8 Factors affecting supply................................................................................................................ 31
Table 3.9 Equilibrium in demand and supply............................................................................................... 31
Table 3.10 Demand and supply..................................................................................................................... 33
Table 3.11 Tax impact on price or quantity of goods.................................................................................... 35
Table 4.1 Utility of goods............................................................................................................................. 47
Table 4.2 Marginal utility.............................................................................................................................. 48
Table 7.1 Differences between domestic trade and international trade........................................................ 86

VIII
Abbreviations

AFC - Average Fixed Cost


APL - Average Product of Labor
ATC - Average Total Cost
CCI - Competition Commission of India
CRS - Constant Returns to Scale
DTAA - Double Tax Avoidance Agreement
GATT - General Agreement on Trade and Tariffs
GDP - Gross Domestic Product
ITQ - Individual Transferable Quotas
LRAC - Long Run Average Cost
MRTP Act - Monopolies and Restrictive Trade Practices Act, 1969
MP - Marginal Product
PEoD - Price Elasticity of Demand
PEoS - Price Elasticity of Supply
PPF - Production Possibility Frontier
TFC - Total Fixed Cost
TP - Total Product
TVC - Total Variable Cost

IX
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
Business Economics

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

1.2 Meaning and Definition of Economics


Economics 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 Basics


Scarcity 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 Microeconomics


There are two main categories of economics:
Macroeconomics
It 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
It is more specific in its approach and is concerned with individuals and firms within the economy. By analysing
human tendency and behavior, microeconomics shows how individuals respond to changes in price when there is
change in demand and supply.

1.5 The Two Basic Concepts of Economics


The 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.

2
Production Possibility
Frontier PPF

A Y

Product A: Wine
X C

Product B: Cotton

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

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

3
Business Economics

Production Possibility
Frontier PPF
Shifts Outward

A
Y
B

Product A: Wine
X C

Product B: Cotton

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 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). 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 Economy


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. 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 Economy


An 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.

4
Some of the advantages of command economy are:
• In a command economy, government can utilise land, labour and capital to fulfil its economic and political
agendas. So the private players are reluctant to invest in command economy.
• For example, cholera is a widespread common disease in continents like Africa and Asia. Some of the world’s
major pharmaceutical industries like Pfizer and Novartis are not ready to invest in research of Cholera, because
people of Africa and Asia are not in a position to pay full price of drugs. In a command economy, the state can
take the initiative for R&D for the treatment.

1.8 Choice as an Economic Problem


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. 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 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. 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 Mechanism


The 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 Economics


Positive 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.

5
Business Economics

1.12 Inductive Method and Deductive Method of Economic Analysis


Deductive 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).

6
As shown in the following figure we can derive the Engel curve from the ICC.

Quantity of Y

M4 ICC
M3 E4
M2 E3
M1 E2
E1

Quantity of X

X1 X2 X3 X4

Total Income
Engle curve
M4

M3

M2

M1

X1 X2 X3 X4 Quantity of X

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)

7
Business Economics

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

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

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

8
Self Assessment
1. Economics, also called ________ , is an in-depth study of certain aspects of society.
a. dismal science
b. dismal economics
c. economy
d. physiological study

2. ___________ is concerned with total output of a nation and the way that nation allocates its limited resources
of land, labour and capital in an efficient way stock of resources for future course action.
a. Microeconomics
b. Macroeconomics
c. Market economy
d. Opportunity cost

3. What are the important concepts of an economic system?


a. Production possibility frontier and opportunity cost
b. Distribution of goods and services
c. Production of goods and services
d. Quantity of goods and services produced

4. __________is a type of economic system in which the trading and exchange of goods and services and information
takes place in a free market.
a. Command economy
b. Product economy
c. Demand economy
d. Market economy.

5. Which of the following statements is true?


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

6. _________ is the value of what is given up in order to have something else.


a. Opportunity cost
b. Economy cost
c. Market cost
d. Product cost

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Business Economics

7. Which of the following statements is true?


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

8. Which of the following is not scarce resource for individual?


a. Money
b. Time
c. Skill
d. Capital

9. Which of the following is not a scarce resource for a country?


a. Capital
b. Technology
c. Labour force
d. Time

10. ________ are those goods whose demand decrease as the income of the consumer increases.
a. The Angel Curve
b. Price Effect
c. Inferior goods
d. Income Consumption Curve

10
Chapter II
Business Economics- Meaning, Nature, Scope and Significance

Aim
The aim of this chapter is to:

• introduce business economics

• elucidate theory of consumer’s behaviour

• discuss different aspects of business

Objectives
The objectives of this chapter are to:

• elucidate significance of business economics

• define wholesaling

• discuss laws of utility analysis

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

• explain the term of utility

• distinguish between types of wholesalers

• understand relationship between total utility and marginal utility

11
Business Economics

2.1 Introduction
Business Economics, also called Managerial Economics, is the application of economic theory and methodology
to business. Business involves decision-making. Decision making means the process of selecting one out of two or
more alternative courses of action. The question of choice arises because the basic resources such as capital, land,
labour and management are limited and can be employed in alternative uses. The decision-making function thus
becomes one of making choice and taking decisions that will provide the most efficient means of attaining a desired
end, say, profit maximisation.

Different aspects of business need attention of the chief executive. He may be called upon to choose a single option
among the many that may be available to him. It would be in the interest of the business to reach an optimal decision,
the one that promotes the goal of the business firm. A scientific formulation of the business problem and finding its
optimal solution requires that the business firm is he equipped with a rational methodology and appropriate tools.
Business economic meets these needs of the business firm.

It may be that business economics serves as a bridge between economic theory and decision-making in the context
of business. According to Mc Nair and Meriam, “Business economic consists of the use of economic modes of
thought to analyse business situations.” Siegel man has defined managerial economic (or business economic) as “the
integration of economic theory with business practice for the purpose of facilitating decision-making and forward
planning by management.” We may, therefore, define business economic as that discipline which deals with the
application of economic theory to business management. Business economic thus lies on the borderline between
economic and business management and serves as a bridge between the two disciplines.

2.2 Nature of Business Economics


Traditional economic theory has developed along two lines; viz., normative and positive. Normative focuses on
prescriptive statements, and help establish rules aimed at attaining the specified goals of business. Positive, on the
other hand, focuses on description it aims at describing the manner in which the economic system operates without
staffing how they should operate.

The emphasis in business economics is on normative theory. Business economic seeks to establish rules which
help business firms attain their goals, which indeed is also the essence of the word normative. However, if the firms
are to establish valid decision rules, they must thoroughly understand their environment. This requires the study
of positive or descriptive theory. Thus, Business economics combines the essentials of the normative and positive
economic theory, the emphasis being more on the former than the latter.

2.3 Scope of Business Economics


As regards the scope of business economics, no uniformity of views exists among various authors. However, the
following aspects are said to generally fall under business economics.
• Demand Analysis and Forecasting
• Cost and production Analysis
• Pricing Decisions, policies and practices
• Profit Management
• Capital Management

These various aspects are also considered to comprise the subject matter of business economic.

2.3.1 Demand Analysis and Forecasting


A business firm is an economic organisation which transforms productive resources into goods to be sold in the
market. A major part of business decision making depends on accurate estimates of demand. A demand forecast
can serve as a guide to management for maintaining and strengthening market position and enlarging profits.
Demands analysis helps identify the various factors influencing the product demand and thus provides guidelines
for manipulating demand. Demand analysis and forecasting provided the essential basis for business planning and
occupies a strategic place in managerial economic.

12
It includes:
• Demand Determinants
• Demand Distinctions
• Demand Forecasting

2.3.2 Cost and Production Analysis


A study of economic costs, combined with the data drawn from the firm’s accounting records, can yield significant
cost estimates which are useful for management decisions. An element of cost uncertainty exists because all the
factors determining costs are not known and controllable. Discovering economic costs and the ability to measure
them are the necessary steps for more effective profit planning, cost control and sound pricing practices. Production
analysis is narrower, in scope than cost analysis. Production analysis frequently proceeds in physical terms while
cost analysis proceeds in monetary terms. Cost and production analysis can be expanded in various terms such as:
Cost concepts and classification, Cost-output Relationships, Economics and Diseconomies of scale, Production
function and Cost control.

2.3.3 Pricing Decisions, Policies and Practices


Pricing is an important area of business economic. In fact, price is the genesis of a firm’s revenue and as such its
success largely depends on how correctly the pricing decisions are taken. The important aspects dealt with under
pricing include. Price Determination in Various Market Forms, Pricing Method, Differential Pricing, Product-line
Pricing and Price Forecasting.

2.3.4 Profit Management


Business firms are generally organised for purpose of making profits and in the long run profits earned are taken
as an important measure of the firm’s success. If knowledge about the future were perfect, profit analysis would
have been a very easy task. However, in a world of uncertainty, expectations are not always realised so that profit
planning and measurement constitute a difficult area of business economic. The important aspects covered under
this area are as follows.
• Nature and Measurement of profit
• Profit policies and Technique of Profit Planning like Break-Even Analysis

2.3.5 Capital Management


Among the various types business problems, the most complex and troublesome for the business manager are those
relating to a firm’s capital investments. Relatively large sums are involved and the problems are so complex that
their solution requires considerable time and labour. Often the decision involving capital management is taken by
the top management. Briefly Capital management implies planning and control of capital expenditure. The main
topics dealt with are: Cost of capital Rate of Return and Selection of Projects.

The various aspects outlined above represent major uncertainties which a business firm has to reckon with viz.,
demand uncertainty, cost uncertainty, price uncertainty, profit uncertainty and capital uncertainty. We can therefore,
conclude that the subject matter of business economic consists of applying economic principles and concepts to
deal with various uncertainties faced by a business firm.

2.4 Significance of Business Economics


The significance of business economics can be discussed as under.
• Business economics is concerned with those aspects of traditional economics which are relevant for business
decision making in real life. These are adapted or modified with a view to enable the manager take better
decisions. Thus, business economic accomplishes the objective of building a suitable tool kit from traditional
economics.
• It also incorporates useful ideas from other disciplines such as psychology, sociology, etc. If they are found
relevant to decision making. In fact, business economics takes the help of other disciplines having a bearing on
the business decisions in relation various explicit and implicit constraints subject to which resource allocation
is to be optimised.

13
Business Economics

• Business economics helps in reaching a variety of business decisions in a complicated environment. Certain
examples are:
‚‚ What products and services should be produced?
‚‚ What input and production technique should be used?
‚‚ How much output should be produced and at what prices it should be sold?
‚‚ What are the best sizes and locations of new plants?
‚‚ When should equipment be replaced?
‚‚ How should the available capital be allocated?
• Business economics makes a manager a more competent model builder. It helps him appreciate the essential
relationship characterising a given situation.
• At the level of the firm. Where its operations are conducted though known focus functional areas, such as finance,
marketing, personnel and production, business economics serves as an integrating agent by coordinating the
activities in these different areas.
• Business economics takes cognizance of the interaction between the firm and society, and accomplishes the key
role of an agent in achieving its social and economic welfare goals. It has come to be realised that a business,
apart from its obligations to shareholders, has certain social obligations. Business economics focuses attention
on these social obligations as constraints subject to which business decisions are taken. It serves as an instrument
in furthering the economic welfare of the society through socially oriented business decisions.

2.5 Theory of Consumer’s Behaviour


The theory of consumer’s behaviour seeks to explain the determination of consumer’s equilibrium. Consumer’s
equilibrium refers to a situation when a consumer gets maximum satisfaction out of his given resources. A consumer
spends his money income on different goods and services in such a manner as to derive maximum satisfaction. Once
a consumer attains equilibrium position, he would not like to deviate from it. Economic theory has approached the
problem of determination of consumer’s equilibrium in two different ways:
• Cardinal Utility Analysis and
• Ordinal Utility

2.5.1 Utility Analysis or Cardinal Approach


The Cardinal Approach to the theory of consumer behaviour is based upon the concept of utility. It assumes that
utility is capable of measurement. It can be added, subtracted, multiplied, and so on. According to this approach,
utility can be measured in cardinal numbers, like 1,2,3,4 etc. Fisher has used the term ‘Util’ as a measure of utility.
Thus in terms of cardinal approach it can be said that one gets from a cup of tea 5 units, from a cup of coffee 10
units, and from a rasgulla 15 units worth of utility.

2.5.2 Meaning of Utility


The term utility in Economics is used to denote that quality in a good or service by virtue of which our wants are
satisfied. In, other words utility is defined as the want satisfying power of a commodity. According to, Mrs. Robinson,
“Utility is the quality in commodities that makes individuals want to buy them.” According to Hibdon, “Utility is
the quality of a good to satisfy a want.” Utility has the following main features:
• Utility is Subjective: Utility is subjective because it deals with the mental satisfaction of a man. A commodity
may have different utility for different persons. Cigarette has utility for a smoker but for a person who does not
smoke, cigarette has no utility. Utility, therefore, is subjective.
• Utility is Relative: Utility of a good never remains the same. It varies with time and place. Fan has utility in the
summer but not during the winter season.
• Utility and usefulness: A commodity having utility need not be useful. Cigarette and liquor are harmful to health,
but if they satisfy the want of an addict then they have utility for him.
• Utility and Morality: Utility is independent of morality. Use of liquor or opium may not be proper from the
moral point of views. But as these intoxicants satisfy wants of the drunkards and opium eaters, they have utility
for them.

14
2.5.3 Concepts of Utility
There are three concepts of utility:
• Initial Utility: The utility derived from the first unit of a commodity is called initial utility. Utility derived from
the first piece of bread is called initial utility. Thus, initial utility, is the utility obtained from the consumption
of the first unit of a commodity. It is always positive.
• Total Utility: Total utility is the sum of utility derived from different units of a commodity consumed by a
household.

According to Left witch, “Total utility refers to the entire amount of satisfaction obtained from consuming various
quantities of a commodity.” Consider an example, a consumer has four units of apples. If the consumer gets 10 units
from the consumption of first apple, 8 units from second, 6 units from third, and 4 units from fourth apple, then the
total utility will be 10+8+6+4 = 28

Accordingly, total utility can be calculated as


TU = MU1 + MU2 + MU3 + _________________ + MUn

or
TU = EMU
Here TU = Total utility and MU1, MU2, MU3, + __________ MUn = Marginal Utility derived from first, second,
third __________ and nth unit.

• Marginal Utility: Marginal Utility is the utility derived from the additional unit of a commodity consumed. The
change that takes place in the total utility by the consumption of an additional unit of a commodity is called
marginal utility.

According to Chapman, “Marginal utility is the addition made to total utility by consuming one more unit of
commodity. Supposing a consumer gets 10 units from the consumption of one mango and 18 units from two mangoes,
and then the marginal utility of second mango will be 18-10=8 units. Marignal utility can be measured with the help
of the following formula MUnth = TUn – TUn-1.

Here MUnth = Marginal utility of nth unit,


TUn = Total utility of ‘n’ units,
TUn-l = Total utility of n-i units,

Marginal utility can be:


• Positive Marginal Utility: If by consuming additional units of a commodity, total utility goes on increasing,
marginal utility will be positive.
• Zero Marginal Utility: If the consumption of an additional unit of a commodity causes no change in total utility,
marginal utility will be zero.
• Negative Marginal Utility: If the consumption of an additional unit of a commodity causes fall in total utility,
the marginal utility will be negative.

15
Business Economics

2.5.4 Relationship between total utility and Marginal Utility


The relationship between total utility and marginal utility may be better understood with the help of a utility schedule
and a diagram as shown below:

No. of units Marginal Total Utility Consumed Utility


0 0 -
1 10 10
2 18 18
3 24 6
4 26 2
5 26 0
6 24 -2
7 21 -3

The relationship between total utility and marginal utility can be explained with the help of the above table and
diagram based thereon.
• Total utility, initially, increases with the consumption of successive units of a commodity. Ultimately, it begins
to fall.
• Marginal Utility continuously diminishes.
• As long as marginal utility is more than zero or positive, total utility increases, total utility is maximum when
marginal utility is zero. It falls when marginal utility is negative.
• When marginal utility is zero or total utility is maximum, a point of saturation is obtained.

2.6 Laws of Utility Analysis


Utility analysis consists of two important laws.

2.6.1 Law of Diminishing Marginal Utility


Law of Diminishing Marginal Utility is an important law of utility analysis. This law is related to the satisfaction
of human wants. All of us experience this law in our daily life. If you are set to buy, say, shirts at any given time,
then as the number of shirts with you goes on increasing, the marginal utility from each successive shirt will go on
decreasing. It is the reality of a man’s life which is referred to in economics as law of Diminishing Marginal Utility.
This law is also known as Gossen’s First Law.

According to Chapman, “The more we have of a thing, the less we want additional increments of it or the more
we want not to have additional increments of it.” According to Marshall, “The additional benefit which a person
derives from a given stock of a thing diminishes with every increase in the stock that he already has.” According to
Samuelson, “As the amount consumed of goods increase the marginal utility of the goods tends to decrease.” In short,
the law of Diminishing Marginal Utility states that, other things being equal, when we go on consuming additional
units of a commodity, the marginal utility from each successive unit of that commodity goes on diminishing.

Assumptions
Every law in subject to clause “other things being equal” This refers to the assumption on which a law is based. It
applies in this case as well. Main assumptions of this law are as follows:
• Utility can be measured in cardinal number system such as 1, 2, 3 _______ etc.
• There is no change in income of the consumer.
• Marginal utility of money remains constant.
• Suitable quantity of the commodity is consumed.
• There is continuous consumption of the commodity.
• Marginal Utility of every commodity is independent.

16
• Every unit of the commodity being used is of same quality and size.
• There is no change in the tastes, character, fashion, and habits of the consumer.
• There is no change in the price of the commodity and its substitutes.

Explanation of the Law


The Law of Diminishing Marginal Utility can be explained with the help of Table and Figure.

No. of Breads Marginal Utility


1 8
2 6
3 4
4 2
5 0point of Satiety
6 -2

It is clear from the above Table that when the consumer consumes first unit of bread, he get marginal utility equal
to 8. Marginal utility from the consumption of second, third and fourth bread is 6, 4 and 2 respectively. He gets zero
marginal utility from the consumption of fifth bread. This is known as point of satiety for the consumer. After that he
gets negative utility i.e. -2 from the consumption of sixth unit of bread. Thus, the table shows that as the consumer
goes on consuming more and more units of bread, marginal utility goes on diminishing.

Pricing Decision
A retailer’s price policy is a crucial positioning factor and must be decided in relation to its target market, its product
and service assortments and its competition. This involved the decisions regarding the price lilies to be earned and
overall markdown or sale policies:

Promotion Decision
Retailers use the promotional tools - advertising, personal selling, sales promotion and public relations to reach.
Customers Personal selling requires careful training of sales people in how to greet customers, meet their needs
and handle their complaints.

The Future of Retailing


Present scenario of retailing is that retailer’s margins are very low. They are able to survive on low margins due to
remarkable capacity for thrift. In many traditional shops the family provides much of the labour. He performs several
functions distribution, finance and risk taking. When there is keen competition, retailers tend to undercut each other.
They compensate themselves by taking higher margins on other products, or by increasing the turnover.

Wholesaling
Wholesaling is the sale, and all activities directly related to the sale, of goods and services, to business and other
organisations for:
• Resale
• Use in producing other goods and services
• Operating an organisation

Wholesalers buy mostly from producers and sell mostly to retailers, industrial consumers and other wholesalers.

Nature and Importance of Wholesaling


Here we will focus on firms engaged primarily in wholesaling. Retailers may also be occasionally being involved in
wholesale transaction. Manufacturers small or big cannot establish their own direct link with retailers or customers.
It is not cost effective to them. At the other end of the distribution channel, most retailers and final users buy in small

17
Business Economics

quantities and have only a limited knowledge of the market and source of supply. Thus there is gap; a wholesaling
middleman can fill this gap by providing services of value to manufacturers and or to the retailers. Wholesaling
brings to the total distribution system the economies of skill, scale and transactions.

Wholesaling skills are efficiently concentrated in a relatively few hands. This saves the duplication of effort that would
occur if many producers had to perform wholesaling function themselves. Economics of Scale are there because of
the specialisation of who leasing function that might otherwise require several small departments run by producing
firms. Wholesalers typical can perform wholesaling functions more efficiently than most manufacturers can.

Function of Wholesalers
Wholesalers perform number of functions. They facilitate the task of producer and retailer by performing one or
more of the following channel functions.
• Selling and promoting: Wholesalers’ sales force help manufacturers reach many small customers at low cost.
The wholesalers have more contacts and are often more trusted by the buyer than the distant manufacturer.
• Buying and assorting: Wholesalers can select items and build assortments needed by their customers, thereby
saving the consumers much work.
• Warehousing: Wholesalers hold inventories, thereby reducing the inventory costs and risks of suppliers and
customers.
• Transportation: Wholesalers can provide quicker delivery to buyers because they are closer than the
producers.
• Financing: Wholesalers finance their customers by giving credit and they finance their suppliers by ordering
early and paying bills in time.
• Risk bearing: Wholesalers absorb risk of the manufacturers by taking title and bearing the cost of theft damage,
spoilage and obsolescence.
• Market information: Wholesalers give information to suppliers and customers about competitors’ new product
and price developments.
• Management services and advice: Wholesalers often help retailers train their sale clerks, improve store layouts
and displays and setup accounting and inventory control systems.

Types of Wholesalers
Wholesalers can be broadly divided into three broad categories Merchant wholesaler, Agent wholesaling middleman
and Manufacturers’ Sales facility.

Merchant Wholesalers
A merchant wholesaler is independently owned business that takes title to the merchandise it handles. Merchant
wholesalers include Full service, Truck jobbers, Drop Shippers.
• Full service wholesalers: Full service wholesalers provide a full set of services, such as carrying stock, using a
sales force, offering credit, making deliveries and providing management assistance. They are either wholesale
merchants or industrial distributors. Wholesale merchants sell mostly to retailers and provide a full range of
services. Industrial distributors are merchant wholesalers that sell to producers rather than to retailers.
• Truck Jobbers: They perform a selling and delivery function. They carry a limited line of goods (such as milk,
bread or snack food) that they sell for cash as they make their rounds of supermarkets, small groceries, hospitals
etc.
• Drop Shippers: They operate in bulk industries such as coal and heavy equipment. They do not carry inventory
or handle the product. Once an order is received, they find a producer who ships the goods directly to the
customer.

Agent wholesaling middleman


It is an independent firm that engaged primarily in wholesaling by actively negotiating the sale or purchase of
products or behalf of other firms but that does not take little to the products being distributed.

18
• Manufacturers Agents: Agents represent buyers a seller on a more permanent basis. Manufacturers’ agents
represent two or more manufacturers of related lilies. They have a formal agreement with each manufacturer
covering prices, territories, order handling procedures, delivery and warranties and commission rates. They
know each manufacturer’s product line and use their wide contact to sell the products.
• Brokers: A broker brings buyer and sellers together and assists in negotiations. The parties hiring them pay
brokerage. They do not carry inventory, get involved in financing or assume risk. Examples are: Food brokers,
real estate brokers, insurance brokers and security brokers.

Rupees M.U. of Apples M.U. of Bananas


1 10 8
2 8 6
3 6 4
4 4 2
5 2 1

It is clear from the Table that if the consumer, spends Rs.3 on apples and Rs.2 on bananas, the marginal utility lie
gets from the last rupee on both becomes equal i.e. 6. In this way he gets maximum satisfaction. The total utility
from both the commodities will be 10+8+6+8+6 = 38, which is maximum. In case the consumer spends his income
in any other manner, he will act lesser total utility.

In this diagram units of money are shown on ox-axics and marginal utility on oy-axics. It indicates that if the income
of the consumer is Rs. 5.00, he will spend Rs. 3.00 on apples and Rs. 2.00 on bananas, because third rupee spent on
apples and second rupee spent on banana yield him equal marginal utility, i.e., 8 units. By distributing his income
on apples and bananas in this manner, the consumer gets total utility of 38 units. It will be the maximum total utility
derived by the consumer out of his expenditure of Rs. 5.00. So by spending his income in this manner the consumer
will get maximum satisfaction.

If the, consumer spends his income on apples and bananas in any other manner, his total utility will be less than the
maximum as shown in diagram. It is evident from the above figure that by spending one rupee less on apples the
loss will be equal to ABCD and by spending one rupee more on bananas the gain win be equal to EFGH. It is clear
that (ABCD) < (EFGH), hence loss is more than gain.

2.6.2 Law of Equi-Marginal Utility


The importance of the law of equi-marginal utility can be explained as follows:
• Consumption: If a consumer spends his income, as suggested by this law, on different commodities in such a
way that the last unit of money spent on them yields him equal marginal utility, he will be getting maximum
satisfaction out of his income.
• Production: Every producer aims at earnings maximum profit. To achieve this objective he must utilise different
factors of production in such a way that the marginal productivity of each factor is equal.
• Exchange: Acting upon the law of equi-marginal utility, every person will go on substituting goods giving more
utility for the ones giving less utility, till the marginal utility of all becomes equal. Exchange will stop at that
point.
• Distribution: It refers to the distribution of national income among the factors of production, i.e., land, labour,
capital, etc. Distribution is done in such a way that in the long-run every factor gets its share out of national
income according to its marginal productivity.
• Public Finance: At the time of levying taxes, finance minister takes the help of this law. He levies taxes in such
a manner that the marginal sacrifice of each tax-payer is equal. Then only it will have the least burden on all
tax-payers. To achieve this objective, a finance minister may substitute one tax for the other.

19
Business Economics

Criticism of the Law


This law has been subjected to the following criticism.
• Cardinal measurement of utility is not possible: Measurement of utility is not possible. How can a consumer
say that he would get 10 units of utility from first apple and 8 units, of utility from the second? Unless marginal
utility is estimated, application of the law will remain dubious.
• Consumers are not fully rational: The assumption that consumers are fully rational is not correct. Some consumers
are idle by nature, and so to satisfy their habits and customs, they sometimes buy goods yielding less utility.
Consequently, they do not get maximum satisfaction.
• Shortage of Goods: If goods giving more utility are not available in the market, the consumer will have to
consume goods yielding less utility.
• Ignorance of the consumer: Consumer is ignorant about many things concerning consumption. Many a times,
he is ignorant about the right price of the goods. He is ignorant about the less expensive substitutes that may be
way available in the market. He is also ignorant about the different uses of goods. On account of this ignorance,
the consumer fails to spend his income in a manner that may yield him maximum satisfaction.
• Influence of Fashion, Customs and Habits: Actual expenditure of every consumer is influenced by fashion,
customs, and habits. Under their influence, many a times the consumer buys more of such goods which give less
utility. Consequently, he buys less of those goods which give more utility. Hence he fails to spend his income
according to this law.
• Constant Income and Price: An important assumption of the law is that the income of the consumer and the
price of the goods should remain constant. Income of the consumer is limited; as such he cannot increase his
satisfaction beyond a particular limit. Likewise, prices being constant, he will get only as much of satisfaction as
the amount of goods that he can buy with limited income. He cannot extend his satisfaction beyond this limit.
• Change in the Marginal Utility of Money: The assumption that marginal utility of money remains constant is also
unrealistic. In actual life, marginal utility of money may increase or decrease. Due to increase in the marginal
utility of money, a consumer will have to rearrange his expenditure on different goods.
• Complementary Goods: The law does not apply to complementary goods. It is so because complementary goods
are used in a fixed proportion. By using less of one commodity, use of the other cannot be increased.

20
Summary
• Business Economics, also called Managerial Economics, is the application of economic theory and methodology
to business.
• Different aspects of business need attention of the chief executive. He may be called upon to choose a single
option among the many that may be available to him.
• Business economic consists of the use of economic modes of thought to analyse business situations.
• Business economic seeks to establish rules which help business firms attain their goals, which indeed is also
the essence of the word normative.
• A business firm is an economic organisation which transforms productive resources into goods to be sold in
the market.
• Demands analysis helps identify the various factors influencing the product demand and thus provides guidelines
for manipulating demand.
• An element of cost uncertainty exists because all the factors determining costs are not known and
controllable.
• Pricing is an important area of business economic.
• Business firms are generally organised for purpose of making profits and in the long run profits earned are taken
as an important measure of the firm’s success.
• Relatively large sums are involved and the problems are so complex that their solution requires considerable
time and labour.
• Business economics makes a manager a more competent model builder.
• Business economics takes cognizance of the interaction between the firm and society, and accomplishes the key
role of an agent in achieving its social and economic welfare goals.
• The theory of consumer’s behaviour seeks to explain the determination of consumer’s equilibrium.
• The Cardinal Approach to the theory of consumer behaviour is based upon the concept of utility.
• The term utility in Economics is used to denote that quality in a good or service by virtue of which our wants
are satisfied.
• The utility derived from the first unit of a commodity is called initial utility.
• According to Chapman, “Marginal utility is the addition made to total utility by consuming one more unit of
commodity.
• Law of Diminishing Marginal Utility is an important law of utility analysis.
• A retailer’s price policy is a crucial positioning factor and must be decided in relation to its target market, its
product and service assortments and its competition.

References
• Sivagnanam, 2010. BUSINESS ECONOMICS, Tata McGraw-Hill Education.
• Reddy, J. R., Advanced Business Economics, APH Publishing.
• Dr. Khanchi, M.S., Business Economics- Meaning, Nature, Scope and significance [Pdf] Available at: <http://
www.ddegjust.ac.in/studymaterial/bba/bba-103.pdf> [Accessed 18 June 2013].
• UNIT –I: BUSINESS ECONOMICS AN INTRODUCTION [Pdf] Available at: <http://www.b-u.ac.in/sde_book/
bcom_be.pdf> [Accessed 18 June 2013].
• Economics for Business Lecture 1 [Video online] Available at: <http://www.youtube.com/watch?v=f6bSmaMUkIc>
[Accessed 18 June 2013].
• Econ110 Instruction: #6 Equimarginal Rule – Procedural [Video online] Available at: <http://www.youtube.
com/watch?v=xf4GTVqMjp0> [Accessed 18 June 2013].

21
Business Economics

Recommended Reading
• Venugopal, K., 2006. Business Economics Volume - I, Volume 1, New Age International.
• Kumar, A. & Sharma, R., 1998. Managerial Economics, Atlantic Publishers & Dist.
• Basu, 1998. Business Organisation And Management, Tata McGraw-Hill Education.

22
Self Assessment
1. Match the following
1. Business Economics A. Demand Distinctions
2. Emphasis in business economics B. Serves as a guide to management
3. Demand forecast C. Normative theory
4. Demand analysis and forecasting D. Managerial Economics
a. 1-D, 2-C, 3-B, 4-A
b. 1-A, 2-C, 3-D, 4-B
c. 1-C, 2-B, 3-A, 4-D
d. 1-B, 2-A, 3-C, 4-D

2. ____________ means the process of selecting one out of two or more alternative courses of action.
a. Normative theory
b. Demand Analysis
c. Decision making
d. Traditional economics

3. A ___________ is an economic organisation which transforms productive resources into goods to be sold in
the market.
a. market
b. resource
c. company
d. business firm

4. Which of the following statements is false?


a. Production analysis is narrower, in scope than cost analysis.
b. Cost and production analysis can be expanded in various terms.
c. Pricing is the only important area of business economic.
d. The theory of consumer’s behaviour seeks to explain the determination of consumer’s equilibrium.

5. The Cardinal Approach to the theory of consumer behaviour is based upon the concept of ___________.
a. utility
b. profit
c. approach
d. cost

6. Why utility is subjective?


a. Utility is independent of morality.
b. Utility is subjective because it deals with the mental satisfaction of a man.
c. Utility is subjective because utility of a good never remains the same.
d. Utility is subjective because a commodity having utility need to be useful.

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Business Economics

7. The utility derived from the first unit of a commodity is called __________.
a. total utility
b. marginal utility
c. initial utility
d. positive marginal utility

8. Which utility is derived from the additional unit of a commodity consumed?


a. Marginal Utility
b. Total utility
c. Initial utility
d. Negative Marginal Utility

9. Which of the following statements is true?


a. Total utility, initially, increases with the consumption of successive units of a buyer.
b. If the consumption of an additional unit of a commodity causes no change in total utility, marginal utility
will be more than 100.
c. Marginal utility of money keeps changing.
d. When marginal utility is zero or total utility is maximum, a point of saturation is obtained.

10. ____________ represent buyers a seller on a more permanent basis.


a. Brokers
b. Agents
c. Merchants
d. Retailers

24
Chapter III
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

25
Business Economics

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

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

3.2 Concept of Demand


In 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.

3.3 Demand Schedule and Concept


A 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 50
3,50,000 40
5,50,000 30
7,00,000 20

Table 3.1 Demand schedule and concept

3.3.1 Market Demand Curve


The 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 Quantity Demanded


(per unit) Tom Mary Market (i.e. Tom + Mary)
30 2 1 3
20 4 3 7
15 6 5 11
12 8 7 15
10 10 9 19

Table 3.2 Market demand curve

26
Demand Curve for Tom Demand Curve for Mary Market Demand Curve

30 30 30

20 20 20

10 10 10

0 0 0
2 4 6 8 10 1 3 5 7 9 5 10 15 20

Fig. 3.1 Market demand curve


(Source: http://www.econweb.com/MacroWelcome/sandd/notes.html)

The slope implies that price and quantity are inversely related.

3.3.2 Law of Demand


In 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.

3.4 Price Elasticity of Demand


It measures the rate of quantity demanded due to price change. The formula for PEoD (Price Elasticity of Demand) is
PEoD = (% 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)

3.4.1 Types of Demand


The given table describes the various types of demand:

Types of demand Description

Elastic Demand Here the price elasticity of demand is more than 1


Here the change in demand is less in comparison to change in
Inelastic Demand
price that means price elasticity of demand is less than 1
Unit Elastic Demand Here change in demand and price, both are equal

Perfectly Elastic Demand Here the value for price elasticity of demand is infinity

Perfectly Inelastic Demand Here demand doesn’t change with change in time

Table 3.3 Types of demand

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Business Economics

3.5 Factors Affecting Demand


Factors which affect demand of goods are mentioned below:
Factors Description with Examples
Price of substitute Consumers switch towards the substitute product when there is a price reduction
product 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 3.4 Factors affecting demand

3.6 Concept of Supply


Supply 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.

3.6.1 Supply Schedule and Concept


A 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)


230 100
220 90
210 80
200 70

Table 3.5 Supply schedule

28
Supply curve shows the relationship of above mentioned data.

230 Supply Curve


Price (Rupees)

220

210

200

0 X
50 60 70 80 90 100
Quantity Supplied (Units)

Fig. 3.2 Supply curve


(Source: http://www.econweb.com/MacroWelcome/sandd/notes.html)

3.6.2 Market Supply Curve


It 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.

Quantity Supplied
Price
(per unit) Market
B N
(i.e. B + N)
10 2 3 5
18 4 5 9
28 6 8 14
40 8 10 18
50 10 11 21

Table 3.6 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.

29
Business Economics

Supply curve for B Supply curve for N Market Supply Curve

50 50 50

30 30 30

10 10 10

0 0 0 5 10 15 20
2 4 6 8 10 3 5 7 9 11
a

Fig. 3.3 Market supply curve


(Source: http://www.econweb.com/MacroWelcome/sandd/notes.html)

3.6.3 Law of Supply


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.

3.6.4 Price Elasticity of Supply


Price 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)

3.6.5 Types of Supply


Study the table below to learn types of supply

Types of supply Description

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

When the Price Elasticity of Supply is in between 0 and 1, supply is inelastic in


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

Table 3.7 Types of supply


3.6.6 Factors Affecting Supply

30
Factors which affect supply of goods are mentioned in the following table.

Factors Description with Examples


Price of input cost like labour, machines, etc. have a greater impact on supply side. For
Input cost
example, if the input cost is more for any organisation then the supply of product is reduced.
Technology enhances the production of goods. If advanced and efficient technology is used
Technology
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 3.8 Factors affecting supply

3.7 Equilibrium in Demand and Supply


Equilibrium 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/Deficit


5.0 5000 7000 2000
4.5 6000 8000 2000
4.0 7000 9000 2000
3.5 8000 8000 Nil
3.0 9000 7000 -2000
2.5 10000 8000 -2000
2.0 11000 8000 -3000

Table 3.9 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 3.9 the graph is mentioned below.

Y
Demand Curve
Supply curve

E
Price

3.5 Equilibrium Point

X
8000
Quantity

Fig. 3.4 Equilibrium in demand and supply


(Source: http://www.econweb.com/MacroWelcome/sandd/notes.html)

31
Business Economics

3.8 Equilibrium as per the Change in Demand and Supply


There 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.

Increased Demand
Y
S

50,000 E1
Price

30a,000 E0 D2

D1

0 X
200 500
Quantity

Fig. 3.5 Decrease in demand curve


(Source: http://www.econweb.com/MacroWelcome/sandd/notes.html)

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

Increase in Supply

Y S1
S2
Price

D
0 X
Quantity

Fig. 3.6 Increase in supply curve


(Source: http://www.econweb.com/MacroWelcome/sandd/notes.html)

32
Decrease in supply
• The supply curve will shift leftward with decrease in supply.
• This will lead to decrease in quantity demand and increase in price, as shown.

Decrease in Supply

S2
Y S1

Price

D
0 X
Quantity

Fig. 3.7 Decrease in supply


(Source: http://www.econweb.com/MacroWelcome/sandd/notes.html)

Table 3.10 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 Quantity


Increases Decreases , or no change

Decreases Increases , or no change

Increases Increases , or no change

Decreases Decreases , or no change

Table 3.10 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.

33
Business Economics

Price Ceiling
S
Y

2.50

Price
2
D
Shortage

0 QS QO Qd X
Quantity

Fig. 3.8 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.

Price Floor
S
Y
Surplus
3

2.50

0 X
Qd QO QS

Fig. 3.9 Price floor


(Source: http://www.econweb.com/MacroWelcome/sandd/notes.html)

34
3.9 Tax Impact on Price or Quantity of Goods
Table shows the tax impact on goods in various situations.

Various Demand
Tax paid by Description Graph
and Supply
Perfectly Elastic Supplier The entire tax is S1

Demand absorbed by supplier P S2


as demand is Tax
perfectly elastic in
nature. The supplier D

cannot increase the


price of the good
because any hike
in price will reduce 0 Q
demand to Zero.
Perfectly Inelastic Buyer The entire tax portion P
D S1
Demand is absorbed by buyer.
In this case, demand S2
remains constant Tax
irrespective of price
of goods.

0
Q

Perfectly Elastic Buyer The entire tax portion D2


D1
Supply is absorbed by buyer. P
Suppliers are ready to
sell at a specific price
and any tax burden Tax S
on them will lead
supply to Zero.

0 Q

Perfectly Inelastic Supplier The suppliers are D2 S


D1
Supply ready to supply goods P
irrespective of price.
They will pay for
entire tax portion. Tax

0 Q

Table 3.11 Tax impact on price or quantity of goods

3.10 Perfect Competition


Perfect 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.

35
Business Economics

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

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

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

3.11 Economic Factors Related to Industry with Perfect Competition


Following 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.

Market
Supply
S
Price (Rs.)

Price (Rs.)

Market
10 Demand 10 d
D

0 2,000 Quantity
100 Quantity
Industries
Single firm

Fig. 3.10 Firm’s demand and industry equilibrium curve


(Source: http://www.econweb.com/MacroWelcome/sandd/notes.html)

3.11.1 Marginal Revenue


To 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;

36
Marginal Revenue = Change in Total Revenue / Change in Quantity
Or
MR = ∆TR / ∆Q
Total Revenue = Price X Quantity
Where,
MR - Marginal Revenue
∆TR - Change in Total Revenue
∆Q - Change in Quantity
By the above equation, the Marginal Revenue of the product is, MR = [(1, 1010 – 1,000) / (101 - 100)] = 10, i.e.
Rs 10.

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

Price (Rs.) d1 MR

1 2 3 4

Quantity

Fig. 3.11 Marginal revenue and demand curve


(Source: http://www.econweb.com/MacroWelcome/sandd/notes.html)

3.12 Perfect Competition in Short Run


In 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. 3.12, the firm is in equilibrium at E, but at F there is a possibility for the firm to earn profit equivalent
to the shaded half, i.e. PQ amount.

MC

F E
Profit & Cost

MR

0
P Q
Quantity

Fig. 3.12 Profit maximisation


(Source: http://www.econweb.com/MacroWelcome/sandd/notes.html)

37
Business Economics

3.13 Perfect Competition in Long Run


In 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.

3.13.1 Economic Profit and Losses


Economic 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.

3.13.2 Zero Economic Profit in Long Run


Given 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.”

3.14 Monopoly Market


We 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.

3.15 Characteristics of Monopoly Firm


Some 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

3.16 Factors of Monopoly Power


Some 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
‚‚ 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

38
• Sometimes monopoly power is the result of location. Sellers in markets isolated by distance from their nearest
rivals have a degree of monopoly power, for example, doctors, first run movies, etc. in a small town.

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

3.17 Monopoly and Market Demand


The 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.

Panel (a) Panel (b)


Perfect Compatition Monopoly
S
Price marginal cost

MC

P d P1
Demand
Price

P2

P3

Q Q 1 Q2 Q3
Quantity per period
Quantity per period

Fig. 3.13 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.

3.18 Marginal Decision Rule in Monopoly Market


Profit 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 > MC

To determine the profit maximisation output, we can see that the point where firm’s marginal revenue intersects
firm’s marginal cost, as shown in point Qm in Fig. 3.14.

We read up from Qm to the demand curve to find the price Pm at which the firm can sell Qm units per period. The
profit maximising price and output are given by point E on the demand curve.

39
Business Economics

Thus, we can determine a monopoly firm’s profit maximising price and output by following three steps:
• Determine the demand, marginal revenue, and marginal cost curves
• Select the output level at which the marginal revenue and marginal cost curves intersect
• Determine from the demand curve the price at which that output can be sold

Price, marginal revenue, marginal cost,


Marginal
cost
E Average total cost
Pm
and average total cost.

F
ATCm
Monopoly
profit
G
Marginal Demand
revenue

Qm
Quantity per period

Q- Quantity per period

Fig. 3.14 Marginal decision rule in monopoly market


(Source: http://www.econweb.com/MacroWelcome/sandd/notes.html)

Computing Monopoly Profit


• The 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. 3.2

3.19 Oligopoly Market


In 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.

3.20 Concentration in Oligopoly


As 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 4
The concentration ratio often is expressed as CRm, i.e., CR4.
Then, the concentration ratio can be expressed as:
CRm = s1 + s2 + s3 + ... ... + sm
Where s = Market share of firm

40
If the concentration ratio is high then the few firms make out the entire industry, and if it is low then more than a
few sellers actually make up the industry.

3.21 Game Theory and Oligopoly Behaviour


Oligopoly 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 choice
Y Choice Refuse to confess If confesses
X will get 1 and half year jail X will get six months jail
Y will get 1 and half year jail Y will get 2 years jail
X will get 2 years jail X will get 1 year jail
Y will get six months jail Y will get 1 year jail

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

41
Business Economics

Firm A

Partnership
Refuses
Refuses Partnership Accept Partnership

A wil get the profit of Rs. 10,000 A will get the profit of Rs 20,000
B will get the profit of Rs. 10,000 B will get the profit of Rs 5,000

A will get the profit of Rs 5,000 A will get the profit of Rs. 20,000
Partnership

B will get the profit of Rs 20000a B will get the profit of Rs 20,000
Accept
Firm B

Fig. 3.15 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.

42
Summary
• The entire demand concept is based on price, if the price of a commodity increases, then the demand will
decrease and vice versa.
• The Market Demand Curve is obtained by plotting the graph of sum of the individual demand curve of a particular
goods in the market, at the same price, within a time period.
• The direct relationship between price and quantity supplied is called Law of Supply. In other words, if the price
is high then supply is also high or vice versa.
• It elaborated the main concept of equilibrium as per change in demand and supply and also the role of the
government in setting prices.
• Two basic concepts, called Price Ceiling and Price Floor are used for high and low price, respectively. If the
price of a product is unfairly high, the government can set a price ceiling, or legal maximum price a seller may
charge for a product.
• If the price of a product is unfairly low, the government can set a price floor or minimum fixed price that sellers
can charge.
• A choice based on the recognition that the actions of others will affect the outcome of the choice and that takes
these possible actions into account is called a Strategic Choice.
• Game theory is an analytical approach through which strategic choices can be assessed.

References
• Walter, N., Microeconomic Theory: Basic Principles and Extensions. 9th ed.
• Robert, S. P. and Daniel, L.R., Microeconomics. 3rd ed, Prentice Hall.
• Rittenberg, L. and Tregarthen, T., 2010. Principles of Microeconomics, [Online] Available at: <http://www.
web- books.com/eLibrary/NC/B0/B63/018MB63.html> [Accessed 25 October 2010].
• Swanson, M. 2010. Diminishing Marginal Utility, [Online] Available at: <www.ehow.com/how_5993061_
calculate-diminishing-marginal-utility.html> [Accessed 25 October 2010].
• MIT, Lecture 9., 2012. Principles of Microeconomics [Video online] Available at: <http://www.youtube.com/
watch?v=Q4iKuKAjzK0>[Accessed 25 October 2010].
• RegisUniversity., 2010. .Aggregate Demand/Aggregate Supply Macro Model.[Video online] Available at: <http://
www.youtube.com/watch?v=5D06HqwsVtM> >[Accessed 25 October 2010].

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

43
Business Economics

Self Assessment
1. Which of the following will lead to decrease in quantity demand and increase in price?
a. Decrease in supply
b. Increase in demand
c. Demand remain same
d. Decrease in demand

2. A ___________ is one which people consume more of as price rises.


a. Substitute good
b. Complement good
c. Giffen good
d. Normal good

3. In economics, the relationship between price and quantity is called as ___________.


a. Law of Supply
b. Law of Demand
c. Law of Command
d. Law of Economics

4. In which of the following demand does not change with change in time?
a. Perfectly Inelastic Demand
b. Perfectly Elastic Demand
c. Inelastic Demand
d. Elastic Demand

5. Which one of the following is the main goal of Price Floor?


a. Sufficient income to certain group of producers
b. Government will be paid by supplier in terms of tax
c. Consumer will be paid by Government
d. Supplier will be paid by consumer

6. Which of the following statements is true for Inelastic Demand?


a. The change in demand is less in comparison to change in price
b. The change in demand is equal to change in price
c. The change in price is less than change in demand
d. The change in quantity is less than change in demand

7. Which of the following statements is true ?


a. Equilibrium is a price where there is no surplus and deficit of goods
b. Demand is more when the price is more
c. Law of Demand is applicable to Giffen goods
d. Law of Demand is not applicable to Substitute goods

44
8. In Perfectly Elastic Demand who will take the full burden of tax?
a. Buyer
b. Supplier
c. Government
d. Public

9. __________ is a model of market based on the assumption that a large number of firms are producing the
identical goods and services, which is consumed by large number of buyers.
a. Perfect competition
b. Marginal revenue
c. Market Demand curve
d. Price ceiling

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

45
Business Economics

Chapter IV
Analysis of Consumer Choice, Production Analysis and Cost Concept

Aim
The aim of this chapter is to:

• 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

• compare the relationship between demand curve and marginal utility

46
4.1 Introduction
Why do people buy goods and services? The answer could be, all the goods and services provide satisfaction to
people, and economists call this satisfaction as utility. People have unlimited demands but limited resources and
the consumption patterns differ as per the individual income level. The buying patterns maximise the satisfaction
level and people will prefer one good over the other.

4.2 Utility Theory


Utility 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 4.1 Utility of goods

4.2.1 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

4.2.2 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 4.2.

47
Business Economics

Number of Glass Marginal Utility Total Utility


1 100 100
2 75 175
3 10 185

Table 4.2 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 4.3 and Fig. 4.1) graph and schedule.

Number of Apples Consumed Marginal Utility Total Utility


0 0 0
1 7 7
2 4 11
3 2 13
4 1 14
5 0 14
6 -1 13

Table 4.3 Marginal and total utility

• From the above table (Table-4.3), when a person does not consume any apple, he gets no satisfaction. Total
utility becomes zero.
• When he consumes one apple per day, total utility become seven.
• In case he consumes second apple then the marginal utility will increase to four. Thus, giving him total utility of 11.
• The marginal utility will fall to two when the total utility is 13 that is (7 + 4 + 2).
• If consumer takes fifth apple, then his marginal utility will fall to zero and the total utility is maximum that is
14.If sixth apple is consumed, the marginal utility is reduced to negative (13 – 14 = -1).

48
The curve showing total utility and marginal utility is plotted in the figure below.

Point where Total


Utility is Maximum
16 M
b
Total Utility / Marginal Utility

TU
12 a

8
d

0
1 2 3 4 5 6 MU
-2 Apples consumed (per day)
Fig. 4.1 Total utility
(Source: http://ecoarun.blogspot.in/2010/07/6-diffrent-total-curves-total.html)

4.2.3 Budget Constrain


The 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.,

Y
Y MUx / Px

MU
MU1 P1
Marginal Utility

De

De
m

m
an

an

P2
Price

MU2
d

d
Cu

Cu
rv

rv
e

MU3 P3

0 Q1 Q2 Q3 X 0 Q1 Q2 Q3 X
Quantity Quantity
(a) (b)

Fig. 4.2 Relation between marginal utility and demand curve


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

49
Business Economics

As per the Law of Diminishing Marginal Utility, an increase in quantity consumed results in a decreasing marginal
utility. Thus, the consumer needs to increase the consumption of goods. The left hand side of Fig. 4.2 shows the
Diminishing Marginal Utility of goods. The next diagram shows the demand curve in terms of price and quantity.

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

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

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

4.3 Production Analysis


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.

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.

4.4 Short Run Production Function


Firms 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)

4.4.1 Total, Marginal and Average Product


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. 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).

50
12 H
G I
F
10
E
8
D

Production
6

per day
Total
product
4
C
2
B
A
0 1 2 3 4 5 6 7 8
Units of labor per
day

Fig. 4.3 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 /∆L
Where, ∆Q = Change in Output
∆L = Change in units of Labour

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

APL = Q / L
Where, Q = Number of output
L = Number of units of Labour

• In Fig. 4.2, the Marginal Product rises as the slope of the total curve increases, falls as the slope of the Marginal
Product curve declines and reaches Zero when the Total Product curve achieve the maximum value. When the
Total Product curve moves downward it becomes negative.
• Also, one can notice that the Marginal Product curve intersects the Average Product curve at maximum point
on Average Product curve. When marginal product is above average product, then average product is rising and
when marginal product is below average product, the average product is falling.
• For example, as a student you can use your own experience to understand the relationship between marginal and
average values. Your Grade Point Average (GPA) represents the average grade you have earned in all your course
work so far. When you take an additional course, your grade in that course represents the marginal grade.
• What happens to your GPA when you get a grade that is higher than your previous average? It rises.
• What happens to your GPA when you get a grade that is lower than your previous average? It falls.
• If your GPA is a 3.0 and you earn one more B, your marginal grade equals your GPA and your GPA remains
unchanged.

51
Business Economics

Panel (a)
12 G H I
F
10 E

slope = 0.3

slope = 0.5
slope = 0.7
8 D

slope = 10
Production
per day
6 Total

slope = 2.0
product
4
C

slope = 4.0
2 B

slope = 2.0
A

slope = 1.0
4
Marginal product
avarage product
Panel (b)
3
Avrage
2 product
1
Marginal
0 product
-0.5
1 2 3 4 5 6 7 8
Units of labor per day

Fig. 4.4 Relationship between TP, MP and AP


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

4.5 Cost Concept


Production 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.

4.5.1 Total Cost and Marginal Cost


The 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

52
4.5.2 Average Total Cost
The second important concept of cost is Average Total Cost (ATC). It is a firms total cost divided by quantity that
is firm’s total cost per unit of output.
ATC = TC / Q

Where,
ATC = Average Total Cost
TC = Total Cost
Q = Output produced

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

ATC = AVC + AFC


Where,
ATC = Average Total Cost
AVC = Average Variable Cost
AFC = Average Fixed Cost

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

AVC = TVC / Q

Where,
AVC = Average Variable Cost
TVC = Total Variable Cost
Q = Output produced

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

AFC = TFC / Q

Where,
AFC = Average Fixed Cost
TFC = Total Fixed Cost
Q = Output Produced

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

$200
AFC, AVC, ATC, and MC

MC
AFC
150
ATC
100
AVC
50

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

Fig. 4.5 Relationship between MC, AFC, AVC and ATC


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

53
Business Economics

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

4.7 Cost Concept in Long Run


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

$9

8 ATC20 ATC50
7 ATC30
Cost per unit

ATC40
6
B D
5
C

0 5 10 15 20 25 30 35 40 45 50

Thousand of CDs per week

Fig. 4.6 Short run and long run average total curve
(Source: http://ecoarun.blogspot.in/2010/07/6-diffrent-total-curves-total.html)

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

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

4.8 Economy of Scale, Diseconomy of Scale and Constant Return to Scale


In 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.

54
A firm is said to experience diseconomies of scale when long-run average cost increases with expansion of output.
Constant returns to scale occur when long-run average cost stays the same over an output range.

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

55
Business Economics

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

References
• Samuelson, P. A., 2002. Economics, Tata McGraw-Hill Publishing Co.Ltd.
• Robert, S. P. and Daniel, L. R., Microeconomics. 3rd ed, Prentice Hall.
• Rittenberg, L. and Tregarthen, T., 2010. Principles of Microeconomics. [Online] Available at: <http:// www.
web-books.com/eLibrary/NC/B0/B63/018MB63.html> [Accessed 25 October 2010].
• Swanson, M., 2010. Diminishing Marginal Utility, [Online] Available at: <www.ehow.com/how_5993061_
calculate-diminishing-marginal-utility.html> [Accessed 25 October 2010].
• 2010. Introduction to Microeconomics 101 [Video online] Available at: <http://www.youtube.com/
watch?v=gfiQ1xZfqV4> [Accessed 14 August 2012].
• About.com., 2011. What is Microeconomics? [Video online] Available at: <http://www.youtube.com/
watch?v=I2GH1MESQ5w>[Accessed 14 August 2012].

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

56
Self Assessment
1. Which of the following approaches to utility theory?
a. Cardinal and ordinal approach
b. Systematic and unsystematic approach
c. Fundamental and sequential approach
d. Constant and variable approach

2. Total utility increases as more goods are consumed, marginal utility usually decreases with each additional
increase in the consumption of goods, this decreasing part is called ______________.
a. Law of Diminishing Return
b. Law of utility
c. Law of Total utility
d. Law of Diminishing Marginal Utility

3. A person consumes five units of commodity and derives U1, U2, U3, U4 and U5 utility from the successiveunits
of goods, the total utility will be __________.
a. U1 + U2 – U3 + U4 + U5
b. U1 + U2 + U3 + U4 + U5
c. U1- U3 + U2 – U4 + U5
d. U1 – U4 + U2 + U3 + U5

4. The additional satisfaction or amount of utility gained from each extra unit of consumption, is called
_________.
a. Total Utility
b. Average Utility
c. Marginal Utility
d. Utility Theory

5. Which of the following entities is a part of Marginal Utility?


a. Change in total utility
b. Change in satisfaction level
c. Change in demand curve
d. Quantity demand

6. _________ is the aggregate of some of the satisfaction or benefits that the individual gains by consuming given
amount of goods and services in an economy.
a. Marginal utility
b. Budget constrain
c. Total utility
d. Average production

7. The utility gained by spending an additional rupee on good x is _______.


a. MUx / Px
b. ∆Q / ∆P
c. ∆U / ∆P
d. Pa / MUa

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Business Economics

8. Which of the following occurs if the total utility will be maximum?


a. Marginal utility will increase
b. Marginal utility will decrease
c. Marginal utility will zero
d. Average utility will increase

9. Which of the following is an abstract concept rather than a concrete, observable quantity?
a. Law of Diminishing Marginal Utility
b. Utility
c. Law of Diminishing Marginal Return
d. Marginal Utility

10. Consumption of more amounts of goods and services up to certain extent is acceptable beyond that saturation
point will come which causes the reduction of _______.
a. Marginal Utility
b. Total Utility
c. Average Utility
d. Mixed Utility

58
Chapter V
The Nature of Factor Demands

Aim
The aim of this chapter is to:

• 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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Business Economics

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

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

5.2 Income and Wealth


The 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.

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

Personal distribution
Personal distribution of income means the distribution of national income among the various members of the society.
These persons perform various kinds of activities and are paid according to their services. For example, workers,
teachers, clerks and other officers get salaries, and professionals like advocates, chartered accountants and physicians
doing private practice charge fees for their services. Since these services do not require the same skill and are not
uniformly productive, earnings of different persons engaged in these activities differ. Incomes of a large number
of people are not from one source only. Some people get salary for the work which they do in offices and also earn
interest on their bank deposits and dividend on their investments in shares.

Functional distribution
In functional distribution, an attempt is made to examine how wages, rent, interest and profit are determined. It refers
to the mechanism whereby different factors are rewarded for the services they render to the productive process.
According to modem economists, rent, wages, interest and profit are the prices for the services rendered by land,
labour, capital and enterprises respectively in the production process. The principles which determine commodity
prices are used to determine prices of various factors of production. As a result, the factors of production are
considered as part of the price theory.

The Role of Government


• Government 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.

60
5.2.2 Wealth
Wealth is the net worth of a person, household, or nation, that is, the value of all assets owned net of all liabilities
owed at a point in time. Wealth is a stock, while income is a flow per unit of time. A household’s wealth includes
its tangible items (house, car and other consumer durable goods and land) and its financial holdings (such as cash,
savings accounts, bonds, and stocks). All items that are of value are called assets, while those that are owed are
called liabilities. The differences between total assets and total liabilities are called wealth and net worth.

5.3 Input Pricing by Marginal Productivity


• The 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 factors
‚‚ The 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.”

5.4 The Nature of Factor Demands


The demand for factors differs from that for consumption goods in two important respects:
• Factor demands are derived demands
• Factor demands are interdependent demands

5.4.1 Factors Demands and Derivation


Following 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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Business Economics

(a) Commodity Demand (b) Derived Factor Demand

D D

Rent of Cornland
Price of Corn

P P

D D
O O
Cornland
Corn

Fig. 5.1 Factors demands are derived


(Source: http://www.managementstudyguide.com/consumer-demand.htm)

5.4.2 Factors Demands are Interdependent


Production 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.

5.5 Distribution Theory and Marginal Revenue Product


The fundamental point about distribution theory is that the “demands for the various factors of production are
derived from the revenues that each factor yields on its marginal product.” 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 MPA
and so forth.
Under conditions of perfect competition, because P=MR

Marginal revenue product


(MRPi) = P X MPi
for each input.

62
5.6 The Demand for Factors of Production
To determine the demand of production factor we need to analyse how a profit-oriented firm chooses its optimal
combination of inputs.

5.6.1 Rule for Choosing the Optimal Combination of Inputs


To 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 rate


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

5.6.2 Least-Cost Rule


Least-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 = 1


Price 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.

5.6.3 Marginal Revenue Product and the Demand for Factors


Demand 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.

63
Business Economics

d
60

Marginal revenue product of labor (thou-


50

sands of dollars per worker)


40

30

20

10

d L
0 1 2 3 4 5
Labor inputs (workers)

Fig. 5.2 Demand for inputs derived through marginal revenue products
(Source: http://www.managementstudyguide.com/consumer-demand.htm)

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

5.6.4 Substitution Rule


An outcome of the least-cost rule is the substitution rule. It states that, “If the price of one factor rises while other
factor prices remain fixed, the firm will profit from substituting more of the other inputs for the more expensive
factor”. 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.

5.7 Supply of Factors of Production


A 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

64
Determinants of capital depend upon:
• Past investments made by businesses, households and governments.

The different possible elasticity’s for the supply of factors are illustrated by the supply curve below:

PF S

Factor price B

S
QF
Factor quantity

Fig. 5.3 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.

5.8 Determination of Factor Prices by Supply and Demand


The 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. 5.4
shows a general demand curve for a factor of production as the DD curve.

65
Business Economics

PF
D S

Factor price
E

S
QF
Factor quantity

Fig. 5.4 Factor supply and derived demand interact to determine factor prices and income distribution
(Source: http://www.managementstudyguide.com/consumer-demand.htm)

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

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

(a) Market for Surgeons (b) Market for Fast-Food Workers


Ss
W Ds W

Ws Es
Hourly earnings

DF
Hourly earnings

Ds

EF
WF SF
DF
L L
Ls Labor supply LF
Labor supply

Fig. 5.5 The markets for surgeons and fast food workers
(Source: http://www.managementstudyguide.com/consumer-demand.htm)

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

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

The supply of surgeons is severely limited by the need for medical licensing and the length and cost of education
and training. Demand for surgery is growing rapidly along with other health-care services. Moreover, an increase
in demand will result in a sharp increase in earnings with little increase in output.
At the other end of the earnings scale are fast-food workers. These jobs have no skill or educational requirements
and are open to virtually everyone. The supply is highly elastic. Wages are close to minimum, because of the ease
of entry into this market. The major difference between the earning powers is because of the quality of labor and
not the quantity of hours.

66
5.9 The Distribution of National Income
How market allocates national income among the many factors of production can be well understood by Factor-
Income Distribution Theory* by John Bated Clark. It can be applied to competitive markets for any number of final
products and factor inputs. This can be understood through “real” units in terms of goods. The goods can be corn
or a basket of different goods and services; we will term it as Q and price it equal to 1.The value of output being Q
and with the wage rate being the real wage in terms of goods or Q. In this situation, a production function tells how
much Q is produced for each quantity of labour-hours, L, and for each quantity of acres of homogeneous land, A.
Note: P=1, under perfect competition MRP=MPXP= MPX1=MP, the wage is therefore equal to MPL

Under prefect competition


Landlords 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.

W
S
D
Marginal
product of
Marginal product, wage rate

labor

E
N
D

S
L
0
Quantity of labor

Fig. 5.6 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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Business Economics

5.10 Marginal-Productivity Theory with Many Inputs


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. In the simplified case where factors
are paid in terms of the single output, we get:

Wage = marginal product of labour


Rent = 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.

68
Summary
• Income is the consumption and savings opportunity gained by an entity within a specified time frame, which is
generally expressed in monetary terms.
• Wealth is the net worth of a person, household, or nation, that is, the value of all assets owned net of all liabilities
owed at a point in time.
• The Theory of Income Distribution or Distribution Theory studies how incomes are determined in an
economy.
• The Marginal Productivity Theory of income states that, “the marginal revenue productivity of a factor reveals
the demand for that factor”.
• The demand for factors differs from that for consumption goods in two important respects: Factor demands are
derived demands and Factor demands are interdependent demands.
• The fundamental point about distribution theory is that the “demands for the various factors of production are
derived from the revenues that each factor yields on its marginal product”.
• To determine the demand of production factor we need to analyse how a profit-oriented firm chooses its optimal
combination of inputs.
• An outcome of the least-cost rule is the substitution rule. It states that, “If the price of one factor rises while
other factor prices remain fixed, the firm will profit from substituting more of the other inputs for the more
expensive factor”.
• The distribution of income combines the supply and demand for factors of production.
• The marginal-productivity theory is a great step forward in understanding the pricing of different inputs. In
competitive markets, the demand for inputs is determined by the marginal products of factors.

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

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

69
Business Economics

Self Assessment
1. _________states that, “if the price of one factor rises while other factor prices remain fixed, the firm will profit
from substituting more of the other inputs for the more expensive factor.”
a. Substitution Rule
b. Least-Cost Rule
c. Marginal revenue product
d. Income distribution theory

2. The________ studies how income is determined in an economy.


a. theory of income distribution
b. theory of production
c. theory of demand
d. theory of supply

3. Which of the following statements is false?


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

4. MRP schedule for an input, we can determine the relationship between the __________ of the input and the
quantity demanded of that input.
a. supply
b. price
c. quality
d. demand

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

6. The money collected through tax is spent or given away by the government through ______ that are not made
in return for current goods or services.
a. transfer payments
b. social service
c. insurance
d. subsidies

70
7. Wealth is a stock while income is a flow per unit of _________.
a. rupee
b. dollar
c. time
d. capital

8. _________of a factor reveals the demand for that factor .


a. Marginal revenue productivity
b. Marginal revenue product
c. Marginal revenue price
d. Marginal revenue production

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

10. The equilibrium price of the input in a competitive market comes at that level where the quantities supplied
and demanded are ______.
a. unrelated
b. different
c. equal
d. varying

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Business Economics

Chapter VI
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

72
6.1 The Labor Market
Our economy is primarily designed to provide people with good jobs with high wages so that they can sustain
themselves. The distribution of income between labor and property, and within different labor groups, has been a
continual source of social strife and political uproar. With the flow of the chapter, we will discuss how wages are
set in a market economy.

6.2 Fundamentals of Wage Determination


A "wage determination" is the listing of wage rates and fringe benefit rates for each classification.

6.2.1 The General Wage Level


In 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.

6.2.2 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
Marginal product, real wage (dollars per unit labor

20

L
0
10
Labor inputs

Fig. 6.1 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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Business Economics

6.2.3 International Comparisons


The 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.

6.3 The Supply of Labor


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.

6.3.1 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.

w
s

c
Wage rate

s
0 L

Fig. 6.2 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.

6.3.2 Labor-force Participation


One 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.

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

74
6.4 Wage Differentials
Wage differentials play an important role in the analysis of the general wage level for different countries and times. In
practice, wage rates differ enormously therefore it is hard to define average wage for an average person. In addition,
there is a wide range of wage rates among broad industry groups. But within major sectors there are large variations
that depend on worker skills and market conditions- for instance, fast-food workers make much less than doctors
though they all provide services.

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

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

6.4.1 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.

6.4.2 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.

6.4.3 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.

6.4.4 Segmented Market and Noncompeting Groups


There 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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Business Economics

6.5 Economics of Labor Union


• Unions 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.

6.5.1 Effect of Unions on Wages and Employment


Wages
Unions 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.

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

The lump of labor fallacy


When 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.

6.6 Discrimination by Race and Gender


Racial, ethnic, and gender discrimination has been a pervasive feature of human societies since the beginning of
recorded history.

Economic Explanation of Discrimination


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

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

76
Economic Discrimination against Women
• In countries around the world, women have a documented disadvantage in earned income relative to men. The ILO
reports that women earn 20-30% less than men worldwide. The causes for this difference are varied, but they
are linked to labor market segregation, in which women and men tend to predominate in distinct fields, and the
phenomenon of the glass ceiling, in which women are clustered in the lower rungs of the employment ladder.
• Wage based discrimination is a major factor as well. Wage based discrimination occurs when work of equal
and. comparable value is treated differently in terms of remuneration.

6.7 Techniques to Determine Extent of Discrimination


Following 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.

6.8 Reducing Labor Market Discrimination


Discrimination 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.

6.9 Land and Rent


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. 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.

6.10 Capital and Interest


Capital (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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Business Economics

6.11 Rate of Return on Capital Goods


• One 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.

6.12 Financial Assets and Tangible Assets


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

6.12.1 Financial Assets and Interest Rates


The 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.

6.12.2 Real and Nominal Interest Rates


Generally, 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.

78
• Now suppose the inflation rate is 3% for that year. We can buy a basket of goods today and it will cost $100,
or we can buy that basket next year and it will cost $103. If we buy the bond with a 6% nominal interest rate
for $100, sell it after a year and get $106, buy a basket of goods for $103, we will have $3 left over. So after
factoring in inflation, our $100 bond will earn us $3 in income; a real interest rate of 3%.
• The relationship between the nominal interest rate, inflation, and the real interest rate is described by the Fisher
Equation:
Real Interest Rate = Nominal Interest Rate - Inflation

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

6.13 Present Values of Asset


Capital 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.

6.13.1 Present Value for Perpetuities


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

Calculating Perpetuity
The present value (V), at the interest rate I % per year, where the present value is the amount of money invested today
that would yield exactly $N each year, can be calculated as, V=$N/i
Where, V= present value of the land ($)
$N= perpetual annual receipts ($ per year)
I= interest rate in decimal terms (e.g. 0.005 or 5/100 per year)
• This says that if the interest rate is always 5% per year, an asset yielding a constant stream of income will sell
for exactly 20 (= 1÷ 5/100) times its annual income. Which means, at a 5% interest rate, its present value would
be $2000 (=$100÷0.005)

6.13.2 General Formula for Present Value


In 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 2


then 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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Business Economics

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

6.14.1 Profits as Rewards for Innovation


Schumpeter 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).

6.14.2 Uncertainty and Profit


Frank 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.

6.14.3 Profits and Market Structure


Some 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.

6.15 The Theory of Capital and Interest


The 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.

80
Diminishing returns and the demand for capital
More generally, as capital accumulates, diminishing returns set in and the rate of return on the investments tends
to fall. The rate of return on capital has not fallen markedly over the course of the last two centuries, even though the
capital stocks have grown many folds.

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

Determination of interest and the return on capital


According 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

6.15.1 Applications of Classical Capital Theory


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

Uncertainty and expectations


• Risks 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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Business Economics

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

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

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

82
Self Assessment
1. By the law of diminishing returns, each additional unit of labor input will add a .
a. smaller slab of output
b. smaller slab of returns
c. larger slab of output
d. larger slab of returns

2. Which is not a key element for labor supply?


a. Hours worked
b. Family
c. Immigration
d. Labor force participation

3. ________________ refers to the number of hours that the population desires to work in gainful activities.
a. Demand supply
b. Labor supply
c. Demand activities
d. Labor activities

4. Which factor leads to rise in marginal productivity of labor?


a. Better monetary gains
b. Better work environment
c. Better work teams
d. Better capital goods

5. Which of the following is not the reason for differences in wages across industries and the individuals?
a. Differences in work place- work environment
b. Differences in jobs-Compensating wage differentials
c. Differences in people-Labor quality
d. Differences in People-The “Rents” of Unique Individuals

6. Labor markets are segmented into__________________.


a. competing groups
b. noncompeting groups
c. labor groups
d. skill groups

7. The theory of non competing groups helps to understand labor market and_________.
a. wages
b. skills
c. competition
d. discrimination

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Business Economics

8. What determines the wages and fringe benefits of unionised workers?


a. Collected gains
b. Collected wages
c. Collective bargaining
d. Unions

9. The amount of work to be done is fixed is which of the following approaches?


a. Lump of wage fallacy
b. Lump of labor fallacy
c. Cluster of labor
d. Cluster of wage discrimination

10. Which is one of the technique to determine extent of discrimination?


a. Regression analysis
b. Aggression analysis
c. Discrimination analysis
d. Gender bias

84
Chapter VII
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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7.1 Introduction
Increased trade has meant greater choice of what to buy and often at lower prices. The relatively free trade that
exists today provides us with expanded choices. Our gains are being experienced worldwide because the winds
of international trade have blown generally freer in the past decades. Nations all over the world have dramatically
lowered the barriers they impose on the products of other countries.

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

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

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

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

Following are the major differences between domestic and international trade:

Factors Domestic Trade International Trade


Mobility in Factor of Production Free to move around factors Quite restricted
of production like land, labor,
capital and labor capital and
entrepreneurship from one state to
another within the same country

Movement of goods Easier to move goods without much Restricted due to complicated custom
restriction. May need to pay sales tax procedures and trade barriers like
and so on tariff, quotas or embargo
Usage of different currencies Same type of currency used Different currencies for different
countries
Broader markets Limited market due to limits in
population, and so on Broader markets

Language and cultural barriers Speak same language and practice Communication challenges due to
same culture language and cultural barriers

Table 7.1 Differences between domestic trade and international trade

86
7.2 Factors Determining Gains from Trade
The extent of gain from trade is determined by many factors, as discussed under the following heads

7.2.1 Relative Differences in Cost Ratio


The 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.

7.2.2 Reciprocal Demand


Reciprocal 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.

7.3 The Sources of International Trade in Goods and Services


Nations 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.

7.4 Comparative Advantage among Nations


Following 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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Business Economics

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

7.4.1 Ricardo’s Analysis of Comparative Advantage


Economists 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.

7.4.2 Autarky Equilibrium


Since 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.

88
Wheat

A
60

P
W

B
0 C 100 Cloth

Fig. 7.1 Production possibilities of wheat and cloth


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

7.5 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 production


Division 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 selling
It 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 production


We 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 quality


Because 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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Business Economics

7.6 Extensions to Many Commodities and Countries


Many Commodities
When 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. 7.2 With many commodities, there is a spectrum of advantages


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

The above Fig. 7.2 shows that America’s CA is to produce and export aircrafts, while Europe’s advantage is in
production and export of apparel. But the dividing line depends on the demand and supplies of different goods.

Many Countries
Introducing many countries does not change the above analysis. As far as a single country is concerned, all the other
nations can be lumped together as one group as “the rest of the world.” The advantages of trade have no special
relationship to national boundaries. The principles developed apply between groups of countries and also to regions
within a country.

7.6.1 Triangular and Multilateral Trade


Triangular 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

Oil
Developing Japan
Countries

Computers Consumer
Electronics

America

Fig. 7.3 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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7.7 Protectionism
In spite of the strong theoretical case that can be made for free international trade; every country has established
some barriers to trade. A protectionist policy is one in which a country restricts the import of some goods and
services produced in foreign countries. Trade restrictions are typically undertaken in an effort to protect companies
and workers in the home economy from competition by foreign firms.

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

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

7.7.1 Trade Barriers


It 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.

7.7.2 Tariffs
Tariffs are usually associated with protectionism, the economic policy of restraining trade between nations. For
political reasons; tariffs are usually imposed on imported goods, although they may also be imposed on exported
goods. A Prohibitive tariff is so high that nearly no one imports any of those items. A Non- prohibitive tariff is a
lower tariff that would injure but not kill off trade. It tends to raise price, lower the amounts consumed and imported,
and raise domestic production.

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Business Economics

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

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

7.8 Difference between Tariffs and Quotas


Following is the difference 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 Costs
The cost of moving bulky and perishable goods has the same effect as tariffs, reducing the extent of beneficial
regional specialisation.

Impact of Protectionist Policies


Protectionist 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

S2 S1
Price of good or service

P2

P1

D1

Q2 Q1

Quantity of good or service per period

Fig. 7.4 The impact of protectionist policies


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

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Economic Costs of Tariff
There are three effects:
• The domestic producers can expand production
• Consumers are faced with higher prices and therefore reduce consumption
• Government gains tariff revenue

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

7.9 Unsound Grounds of Tariff


Mercantilism, 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 outsourcing


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

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

7.10 Potentially Valid Arguments for Protection


Arguments 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.

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Business Economics

7.10.1 The Terms of Trade or Optimal Tariff Argument


The 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
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.

7.10.2 Infant Industries


A 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.

7.10.3 Tariffs and Unemployment


A 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.

7.10.4 Protection against Dumping


Dumping 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.

7.11 Negotiating Free Trade


The 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.

7.11.1 Multilateral Agreements


The 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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7.11.2 World Trade Organisation (WTO)
WTO started functioning from January 1, 1995 and has substantially increased powers to enforce International Trade
Agreements. The WTO is different from and an improvement over the GATT in the following respects:
• The WTO is more global in its membership.
• The WTO has introduced commercial activities into the multilateral trading system.
• GATT provisions in case of disputes were time-consuming; GATT could levy penalties only through
unanimous decision, which were virtually impossible.
‚‚ Under WTO, unanimous decisions are no longer desired; all disputes are to be settled within 18 months.
‚‚ WTO has one-country one-vote principle, unlike in the World Bank and IMF where the economic strength
of rich countries translates into a voting majority. 60
Tariff of
Abominations Morrill and Civil Smooath-Hawley
Ratio of duties collected to dutiable imports %

(1820) War Tariffs 1861-


60
1864 Tariff 1930
55
50
Trade Agreements Act.
45
40
(1934)
35
30
25
20
Tariff Underwood
15 Tariff
10
(1913)
(1913)
5

1820 1840 1860 1880 1900 1920 1940 1960 1980 2000

Year

Fig. 7.5 U.S. tariff rates, 1820–2005


(Source: http://www.web-books.com/eLibrary/NC/B0/B63/087MB63.html)

As shown in Fig. 7.5, tariff rates on “dutiable imports” have fallen dramatically over the course of U.S. history.
• The World Trade Organisation (WTO) was established to “help trade flow smoothly, freely, fairly and predictably”
among member nations.
• In 2008, it had 153 member countries. Since World War II, the General Agreement on Tariffs and Trade
(GATT)- WTO’s predecessor - and WTO have generated a series of agreements that slashed trade restraints
among members.
• These agreements have helped propel international trade, which in 2006 was more than 35 times its level in
1950, but the negotiations leading to these agreements have always been protracted and tumultuous and issues
of nationalism and patriotism are often not far from the surface.
• The imposition of trade barriers such as tariffs, antidumping proceedings, quotas, or voluntary export restrictions
raises the equilibrium price and reduces the equilibrium quantity of the restricted good. Although there are many
arguments in favor of such restrictions on free trade, economists generally are against protectionist measures
and support free trade.

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Business Economics

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

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

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

96
Self Assessment
1. Which of the trade is the exchange of goods and services between countries?
a. Barrier trade
b. No-trade
c. International trade
d. Multilateral trade

2. The relative ______________________ of demand of both countries will determine gains from trade.
a. strength and elasticity
b. production and efficiency
c. strength and efficiency
d. production and elasticity

3. Which of the following statements is false?


a. Production possibilities depend on natural resources
b. In identical production possibilities, countries engage in trade, for different taste of goods
c. Production depends on lower average cost
d. Countries always produce all things required

4. According to principal of comparative advantage, which of the following is true?


a. Each country will benefit if it specialises in the production and export of those goods that it can produce at
relatively lower cost.
b. Each country will benefit if it specialises in the production and import of those goods that it can produce at
relatively lower cost.
c. Each country will benefit if it specialises in the production and export of those goods that it can produce at
relatively higher cost.
d. Each country will benefit if it specialises in the production and import of those goods that it can produce at
relatively higher cost.

5. According to __________, labor is the only source of value of goods.


a. David Raymond
b. David Ricardo
c. Haykins
d. Simpson

6. Which of the following statements is false?


a. Tariffs are usually associated with protectionism
b. A prohibitive tariff is one so high that nearly no one imports any of those items
c. Protective tariff tends to raise price, lower the amounts consumed and imported, and raise domestic
production
d. Tariff is the economic policy of enhancing trade between nations

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Business Economics

7. A quota is a direct restriction on the total quantity of a good or service that may be _______ during a specified
period.
a. imported
b. exported
c. restricted
d. traded

8. Which of the following is not an argument for protectionism?


a. The infant argument
b. Quota
c. Distortion in the labor market
d. Optimum tariff argument

9. The imposition of trade barriers such as tariffs the equilibrium price and reduces the equilibrium quantity
of the restricted good.
a. maintains
b. restricts
c. raise
d. reduces

10. _______ are usually associated with protectionism, the economic policy of restraining trade between nations.
a. Tarrifs
b. Quotas
c. Goods
d. Trade

98
Chapter VIII
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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Business Economics

8.1 Types of Economy


The 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.

8.2 The Role of Government in the Economy


To understand the role of government, it will be useful to distinguish four broad types of government involvement
in the economy.

Regulatory role
The basic objective of regulating business is to:
• Prevent the market structure from becoming monopolistic
• Flourish small and new entrepreneurs,
• Promote welfare of weaker sections of the society.

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

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

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

Promotional role
Following are the various functions of the government in promoting the business operations:
• To maintain public utilities
• To encourage the developmental attitude among various sectors
• To make economic resources productive and progressive
• To ensure the effective utilisation of various resources
• To equally distribute wealth and income
• To bring about equitable balance between various regions
• To control the quantity of money available in terms of developmental needs

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

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

8.3 Tools of Government Policy


There 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.

8.4 Importance of Size of Government


Government 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. 8.1 illustrates the relationship between size of government and economic growth, assuming that governments
undertake activities based on their rate of return. As the size of government, measured on the horizontal axis, expands
from zero (complete anarchy), initially the growth rate of the economy—measured on the vertical axis—increases.
The A to B range of the curve illustrates this situation. As government continues to grow as a share of the economy,
expenditures are channeled into less productive (and later counterproductive) activities, causing the rate of economic
growth to diminish and eventually decline. The range of the curve beyond B illustrates this point.

9
Growth Rate

6
B

3 A

0
Size of Government (percent of GDP)

Fig. 8.1 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).

8.5 The Functions of Government


There 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 inequality


Economic 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 policies


• Government 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 policy


• Government 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.

8.6 Public Choice Theory


The 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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8.7 Government Expenditure
The economy of a country is greatly influenced by the level of government or public expenditure. It helps in
overcoming the inefficiencies of the market system in the allocation of economic resources. It also helps in
smoothing out cyclical fluctuations in the economy and ensures a high level of employment and price stability. Thus,
government expenditure plays a crucial role in the economic growth of a country.

8.7.1 Nature of Government Expenditure


Public 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.

8.7.2 Objectives of Government Expenditure Classification


The 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)

Functional/Budget Economic Cross Accounting

Revenue and Developmental and Plan and


Capital Non- developmental Non-plan

Fig. 8.2 Classification of Government Expenditure


(Source: http://egyankosh.ac.in/bitstream/123456789/8955/1/ Unit-5 (complete).pdf)

Functional/Budget GE
Functional classification establishes adequate links between budget and account heads and the plan heads of
development. It facilitates obtaining information of progressive expenditure on plans, programs and projects. The
principle adopted in the new accounting classification is that, all expenditures on a function, program or activity
should be recorded under the appropriate major, minor or subhead. Functional classification has facilitated the
monitoring and analysis of expenditure on functions, programs and activities to aid the management function.

Economic GE
Economic classification refers to the resources allocated by government to various economic activities. It involves
arranging the public expenditures and receipts by significant economic categories, distinguishing current expenditure
from capital outlays, spending for goods and services from transfers to individuals and institutions, tax receipts by
kind from other receipts and from borrowing and inter-governmental loans, grants, etc. This classification brings out
such important aggregates as public expenditure of the consumption kind, public investment and the draft of public
authorities on public savings for financing the development outlays in the public sector.

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

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

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

8.8 Economic Aspects of Taxation


Following 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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8.9 Taxes Levied by Central Government
Following are the taxes levied by central government:
• Direct Taxes
‚‚ Tax on Corporate Income
‚‚ Capital Gains Tax
‚‚ Personal Income Tax
‚‚ Tax Incentives
‚‚ Double Taxation Avoidance Treaty
• Indirect Taxes
‚‚ Excise Duty
‚‚ Customs Duty
‚‚ Service Tax
‚‚ Securities Transaction Tax

8.9.1 Direct Taxes


Taxes 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 tax


• Tax 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 Tax


• Personal 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 Incentives
• Government of India provides tax incentives for:
‚‚ Corporate profit
‚‚ Accelerated depreciation allowance
‚‚ Deductibility of certain expenses subject to certain conditions
• These tax incentives are subject to specified conditions and available for new investment in:
‚‚ Infrastructure
‚‚ Power distribution
‚‚ Certain telecom services
‚‚ Developing or operating industrial parks or special economic zones (SEZs)
‚‚ Production or refining of mineral oil
‚‚ Companies carrying on R&D
‚‚ Developing housing projects
‚‚ Undertakings in certain hill states
‚‚ Handling of food grains
‚‚ Food processing
‚‚ Rural hospitals etc.

Double Tax Avoidance Treaty


• India 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%.

8.9.2 Indirect Taxes


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

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

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

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

Securities Transaction Tax


Transactions 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%

8.10 Taxes Levied by State Governments and Local Bodies


Following 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 Taxes


• Stamp 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

8.11 Tax Incidence


Tax 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.

8.12 Nature and Relevance of Regulation


Government 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.

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

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8.13 Government Intervention on Public Interest
Following are the situations under which government intervention is necessary:
Imperfect Competition
• It is a market structure that does not meet the conditions of a perfect competition. Under perfect competition,
price is equal to marginal cost (P = MC) while in the presence of monopoly power, price is higher than marginal
cost (P > MC).
• Thus, perfect competition is considered as an ideal condition and any deviation from it is seen as a loss of social
welfare.

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

Common Property Resources


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

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

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

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

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8.14 Instruments for Regulation


Regulation 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.

8.14.1 Price Cap Regulation


Price 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.

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

8.14.2 Revenue Cap Regulation


Revenue 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.

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

8.14.3 Rate of Return Regulation


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

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

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

8.15 Effects of Regulation


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

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

8.16 Decline of Economic Regulation


Following 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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8.17 Deregulation
The trend towards deregulation is spreading throughout the world after it has become quite apparent that
the economic conditions in market economies are generally better than economies heavily regulated by the
government.

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

8.18 Antitrust Policies


Competition 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.

8.18.1 Antitrust Policy in US


The 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 Act


• The 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.

112
Clayton Antitrust Act
• The Clayton Antitrust Act of 1914 was enacted in United States to add further substance to the U.S. antitrust
law regime by seeking to prevent anti competitive practices in their incipiency. That regime started with the
Sherman Antitrust Act of 1890, the first Federal law outlawing practices considered harmful to consumers
(monopolies and cartels).
• The Clayton act specified particular prohibited conduct, the three-level enforcement scheme, the exemptions,
and the remedial measures. The act is still active today in a growing interconnected market and merging of the
industries.

8.18.2 Indian Scenario


2009 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.

8.19 Mergers: Law and Practice


Companies 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.

8.19.1 Merger or Amalgamation


A 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 Absorption
Absorption 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 Consolidation


A 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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Business Economics

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

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

8.19.2 Acquisitions and Takeovers


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.’ 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.

8.19.3 Advantages of Mergers & Acquisitions


The 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.

114
• Synergy implies a situation where the combined firm is more valuable than the individual firms. It refers to
benefits other than those related to economies of scale. Operating economies are one form of synergy benefits,
but apart from it, synergy may also arise from enhanced managerial capabilities, creativity, innovativeness,
R&D and market coverage capacity due to the complementarities of resources and skills and a widened horizon
of opportunities.
• Diversifying the risks of the company, particularly when it acquires those businesses whose income streams
are not correlated. It results in reduction of total risks through substantial reduction of cyclicality of operations.
The combination of management and other systems strengthen the capacity of the combined firm to withstand
the severity of the unforeseen economic factors which could otherwise endanger the survival of the individual
company.
• A merger may result in financial synergy and benefits for the firm in many ways like:
‚‚ By eliminating financial constraints
‚‚ By enhancing debt capacity. This is because a merger of two companies can bring stability of cash flows
which in turn reduces the risk of insolvency and enhances the capacity of the new entity to service a larger
amount of debt
‚‚ By lowering the financial costs. Due to financial stability, the merged firm is able to borrow at a lower rate
of interest.
• Limiting the severity of competition by increasing the company’s market power. A merger can increase the
market share of the merged firm. This improves the profitability of the firm due to economies of scale. The
bargaining power of the firm vis-à-vis labor, suppliers and buyers is also enhanced. The merged firm can exploit
technological breakthroughs against obsolescence and price wars.

8.20 Efficiency of Competition Laws


It 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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Business Economics

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

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

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

116
Self Assessment
1. What are the tools of government policy?
a. Taxes, income, progress
b. Taxes, expenditure, progress
c. Taxes, expenditure, regulation
d. Expenditure, taxes, entrepreneurship

2. Which of the following is not an objective of regulating business?


a. Prevent the market structure from becoming monopolistic
b. Promote welfare of weaker sections of the society
c. Flourish small and new entrepreneurs
d. Hand economic powers to leading businesses

3. Entrepreneurial role means that the government itself becomes entrepreneur by taking the ownership in its hand,
which is also called as .
a. emergence of public sector
b. emergence of private sector
c. emergence of joint sector
d. emergence of co-operative sector

4. Which among the following is not amongst the functions of government to regulate the economy?
a. Reducing economic inequality
b. Stabilising the economy through microeconomic policies
c. Conducting international economic policy
d. Improving economic efficiency

5. Direct taxes do not include ________.


a. Tax incentives
b. Capital gains tax
c. Personal income tax
d. Customs duty

6. Securities transaction tax is a part of .


a. Indirect taxes
b. Direct taxes
c. Tax levied by state government
d. Tax levied by local body

7. is levied by municipal or local authority.


a. Service tax
b. Property tax
c. Income tax
d. Corporate income tax

117
Business Economics

8. The decision whether the consumer or producer will pay the price of new tax is stated by .
a. tax benefit
b. tax evasion
c. tax incidence
d. pubic choice theory

9. Which is not the objective of classification of general expenditure?


a. Economic growth
b. Financial control
c. Public satisfaction
d. Estimation of revenues and expenditures

10. involves regulating the business and economic activities of the country by the
government.
a. Entrepreneurial role
b. Promotional role
c. Planning role
d. Regulatory role

118
Case Study I
Coke and Pepsi both are trying to gain market share in the beverage market, which is valued at over $30 billion a
year. The facts are that, each company is coming up with new products and ideas in order to increase their market
share. The creativity and effectiveness of each company’s marketing strategy will ultimately determine the winner
with respect to sales, profits, and customer loyalty. Not only these two companies are constructing new ways to sell
Coke and Pepsi, but they are also thinking of ways to increase market share in other beverage categories. Although
the goals of both companies are same, the two companies form different marketing strategies. Pepsi has always
taken the lead in developing new products, but Coke also learned their lesson and started to do the same. Coke
hired marketing executives with good track records. Coke also implemented cross training of managers so it would
be more difficult to form groupism. On the other hand, Pepsi has always taken risks, acted rapidly and developed
new marketing ideas.

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

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

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

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

Questions
1. Which type of competition is seen in this case study? Give reasons.
Answer
In this case study, Perfect Competition is seen. The factors that are present in the perfect competition are as
follows:
• Coke and Pepsi are the two competitors which sell an identical product
• The industries are characterised by freedom of entry and exit
• The firms have relatively small market share

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

119
Business Economics

3. In perfect competition, how can a company achieve complete market share?


Answer
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. 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.

4. How Coke has been successful in foreign market?


Answer
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.

120
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).

Questions
1. What are the three vital components of organisational architecture?
2. What does assignment of decision rights involves?
3. What does methods

121
Business Economics

Case Study III


NIKE- Failure in Demand Forecasting
The 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%20


Studies/Operations/CLOM008.html> [Accessed 4 June 2013]).

Questions
1. What were the likely reasons that resulted in such a huge gap between demand and supply at Nike? What, in
your opinion, could have been done to avoid this situation?
2. What strategies were followed by Nike to capture the market share again?
3. What is the relationship between demand and supply?
4. Why was Reebok not able to sustain in the competition?

122
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Business Economics

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• Basu, 1998. Business Organisation And Management, Tata McGraw-Hill Education.
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Business Economics

Self Assessment Answers


Chapter I
1. a
2. b
3. a
4. d
5. b
6. a
7. d
8. d
9. a
10. c

Chapter II
1. a
2. c
3. d
4. c
5. a
6. b
7. c
8. a
9. d
10. b

Chapter III
1. a
2. c
3. b
4. a
5. a
6. a
7. a
8. b
9. b
10. a

Chapter IV
1. a
2. d
3. b
4. c
5. a
6. c
7. a
8. c
9. d
10. b

126
Chapter V
1. a
2. a
3. a
4. b
5. a
6. a
7. c
8. a
9. b
10. c

Chapter VI
1. a
2. c
3. b
4. d
5. a
6. b
7. d
8. c
9. b
10. a

Chapter VII
1. c
2. a
3. d
4. a
5. b
6. d
7. a
8. b
9. c
10. a

Chapter VIII
1. c
2. d
3. a
4. c
5. d
6. a
7. b
8. c
9. c
10. d

127