Economic For Managers E-Book

Economics Amity Directorate of
for
Distance & Online
Managers Education
Economics is essentially the study of logic, tools and techniques of
making optimum use of the available resources to achieve the ends.
Economics thus provides analytical tools and techniques that managers
need to achieve the goals of the organization they manage. Therefore, a
working knowledge of economics, not necessarily a formal degree, is
essential for mangers. Managers are essentially practicing economists.
MBA 2yrs
Semester -I
C O N T EN T S
Module 1: Introduction To Economic Analysis
1.1. Objectives
1.2. Introduction
1.3.
Nature and scope of and its relationship with other disciplines
1.4. Scarcity and Efficiency

1.5. Basic Concepts and Principles of Micro-economic analysis
1.5.1.
Marginalism
1.5.2.
Opportunity Cost
1.5.3.
Discounting Time Perspective
1.5.4.
Risk and Uncertainty
1.6. Summary
1.7. Check Your Progress
1.8. Questions and Exercises
1.9. Further Readings
Module 2:
2.1. Objectives
2.2. Introduction
2.3. Demand Function
2.4. Determinants of demand
2.5. Law of Demand
2.6. Exceptions to the Law of Demand
2.7. Shift of Demand v/s Expansion or Contraction of Demand
2.8. Demand Elasticity
2.9. Types of Elasticity
2.10. Methods of measuring elasticity and its significance
2.11. Demand Forecasting
2.12. Supply Function
2.13. Factors affecting Supply
2.14. Elasticity of Supply
2.15. Budget Constraint
2.16. Indifference Curves Analysis

2.17. Consumer Equilibrium and Consumer Surplus
2.18. Summary
Module 3: Cost and Production Analysis

3.1. Objectives
3.2. Introduction
3.3. Production Functions
3.4. Law of Variable Proportion or Law of Diminishing Returns to Factors.
3.5. Difference between Returns to a Factor and Returns to Scale
3.6. Isoquants
3.7. Isocost Line or Equal Cost Line
3.8. Marginal Rate of Technical Substitution
3.9. Choices of Input Combination (Optimal Input combination)
3.10. Theory of Cost
3.11. Cost Functions
3.12. Various types of Costs
3.13. Relationship between AC and MC
3.14. Long and Short Run Cost Curves
3.15. Cost and Output Relationship (Cost Function)
3.16. Short Run and Long Run
3.17. Economies / Dis-economies of Scale
3.18. The Theory of firm (Profit Maximization Model)
3.19. Break-even and Shut-down Point
3.20. Managerial Theories of the Firm
3.21. Baumols Model
3.22. Marris Model.
3.23. Summary

Module 4: Market Structure Analysis

4.1. Objectives
4.2. Introduction: - Perfect Competition
4.2.1.
Assumptions of perfect competition:
4.2.2.
Short run equilibrium
4.2.3.
Long Run Equilibrium
4.3. Monopoly: Price Discrimination

4.3.1.
Monopoly
4.3.2. Price and Quantity Determination in Short Run

4.3.2.1. Supernormal Profit
4.3.2.2. Normal Profit
4.3.2.3. Subnormal Profit or Loss
4.3.3.
Price and Quantity Determination in Long Run
4.3.4. Price Discrimination

4.4. Monopolistic Competition
4.5. Oligopoly-Mutual Interdependence
4.5.1.
Non-collusive Oligopoly
4.5.2.
Sweezys Model of Kinked Demand Curve
4.5.3.
Collusive Oligopoly
4.5.4.
Price Leadership
4.6. Prisoners Dilemma

4.7. Summary
Module 5: Capital Budgeting and Risk and Uncertainty Analysis

5.1 Objectives
5.2 Introduction
5.3 Investment Analysis
Managerial
Economics
5.3.1
Project valuation
5.3.2
Capital Budgeting Techniques
5.4 Risk and Investment Analysis- Decision Tree Analysis

5.5 Concept of Behavioral Economics
NOTES
5.6 Summary
5.7 Check Your Progress

5.8 Questions and Exercises
5.9 Further Readings
Module 6: Macro-economics Analysis

6.1. Objectives
6.2 Introduction
6.3. Basic Concept Circular Flow of Income and Money
6.4. National Income and Keynesian Model
6.5. Saving and Consumption Function
6.6. Investment Multiplier
6.7. Inflation
6.8. Monetary and Fiscal Policies
6.9. International Economics Fixed and Flexible Exchange Rates
6.10. Spot and forward Exchange Rates
6.11. Current and Capital Account Convertibility a case study of India.
6.12. Summary
Amity School of Distance Learning
UNIT 1 Introduction To
Economic Analysis
STRUCTURE
NOTES
1.1. Objectives
1.2. Introduction
1.3. Nature and scope of and its relationship with other disciplines
1.4. Scarcity and Efficiency
1.5. Basic Concepts and Principles of Micro-economic analysis
1.5.1.
Marginalism
1.5.2.
Opportunity Cost
1.5.3.
Discounting Time Perspective
1.5.4.
Risk and Uncertainty
1.6. Summary
1.1 OBJECTIVES
The primary purpose of this chapter is to define and explain the scope of economics and
the methodology economists use in solving problems. A unique feature of this chapter is
that it explains the economic way of thinking and shows the student how to apply the
tools of economic thinking to everyday decisions. Graphs are used consistently in this
module, so the student will need a good knowledge of how a graph is constructed and
how to interpret its lines. It would be best to follow the examples in the appendix so that
the student has both the text and class notes to review. Stress that the concept of scarcity
is a key element in all economic analysis and a link to the rest of the course.
Key Terms
Scarcity, resources, land, labor, capital, opportunity costs, marginalism, risk and
uncertainty, discounting time perspective
1.2 INTRODUCTION
Economics is essentially the study of logic, tools and techniques of making optimum use
of the available resources to achieve the ends. Economics thus provides analytical tools
and techniques that managers need to achieve the goals of the organization they manage.
Therefore, a working knowledge of economics, not necessarily a formal degree, is essential
for mangers. Managers are essentially practicing economists.
In performing his functions, a manager has to take a number of decisions in conformity
with the goals of the firm. Many business decisions are taken under the condition of
uncertainty and risk. Uncertainty and risk arise mainly due to uncertain behavior of the
market forces, changing business environment, emergence of complexity of the modern
business world and social and political, external influence on the domestic market and
NOTES
social and political changes in the country. The complexity of the modern business world
adds complexity to business decision-making. However, the degree of uncertainty and
risk can be greatly reduced if market conditions are predicted with a high degree of reality.
The prediction of the future course of business environment alone is not sufficient. It is
important equally to take appropriate business decisions and to formulate a business
strategy in conformity with the goals of the firm.
1.3. NATURE AND SCOPE OF AND ITS RELATIONSHIP WITH

OTHER DISCIPLINES
Taking appropriate business decisions requires a clear understanding of the technical and
environmental conditions under which business decisions are taken. Application of economic
theories to explain and analyze the technical conditions and the business environment
contributes a good deal to the rational decision-making process. Economic theories have,
therefore, gained a wide range of application in the analysis of practical problems of
business. With the growing complexity of business environment, the usefulness of
economic theory as a tool of analysis and its contribution to the process of decisionmaking has been widely recognized.
Baumol has pointed out three main contributions of economic theory to business economics.
First, one of the most important things which the economic (theories) can contribute to
the management science is building analytical models, which help to recognize the
structure of managerial problems, eliminate the minor details, which might obstruct decisionmaking and help to concentrate on the main issue. Secondly, economic theory contributes
to the business analysis a set of analytical methods which may not be applied directly to
specific business problems, but they do enhance the analytical capabilities of the business
analyst. Thirdly, economic theories offer clarity to the various concepts used in business
analysis, which enables the managers to avoid conceptual pitfalls.
Scope of
The problems in business decision-making and forward planning can be grouped into four
categories as follows:
z
Problems of Resource Allocation: Source resources are to be used with utmost

efficiency to get the optimal results. These include production programming and problems of transportation, etc.
Inventory and Queuing Problems: Inventory problems involve decisions about holding
of optimal levels of stocks of raw materials and finished goods over a period. These
decisions have to be taken by considering demand and supply conditions. Queuing
problems involve decisions about installation of additional machines or not hiring
labor, against the cost of such machines or labor.
Pricing Problems: Fixing prices for the products of the firm are important decisionmaking problems. Pricing problems involve decisions regarding various methods of
pricing to be followed.
Investment Problems: It is related of allocating resources over time. These normally

relate to: investing new plants, how much to invest, expansion programs for the future, sources of funds, etc.
(ME) seeks solutions to these problems. So, there is a wide spectrum of topics that
fall under ME and they are as follows:
10
1.
Profit Analysis.
2.
Cost Analysis
3.
Production Possibility Chart
4.
Pricing theory and policies
5.
Demand Analysis
6.
Market penetration studies
7.
Economic Forecasting
8.
Sales Forecasting
9.
Marginal analysis
10. Break-even analysis
11. Competitive market studies
12. Anti-Trust issues
13. Plant location studies
14. Mergers and Acquisitions
15. Labor cost studies
16. Inventory problem
17. Investment analysis
18. Capital Budgeting
19. Cost of Capital
20. Government regulations
NOTES
Out of the above lists, there are some major areas, which are very much important for
management, they are as follows:
z
Demand analysis and forecasting,
Production and cost,
Competition,
Pricing and output, and
Investment and capital budgeting.
1.4. SCARCITY AND EFFICIENCY

Economics is the study of how economic agents or societies choose to use scarce
productive resources that have alternative uses to satisfy wants which are unlimited and
of varying degrees of importance. The main concern of economics is economic problem:
its identification, description, explanation and solution. The source of any economic problem
is scarcity. Scarcity of resources forces economic agents to choose among alternatives.
Therefore, economic problem can be said to be a problem of choice and valuation of
alternatives. The problem of choice arises because limited resources with alternative
uses are to be utilized to satisfy unlimited wants, which are of varying degrees of importance.
Scarcity is a relative concept. It can be define as excess demand, i.e., demand more than
the supply. For example, unemployment is essentially the scarcity of jobs. Inflation is
essentially scarcity of goods.
The job of any efficient manager is of economic one. Decision-making is the main job of
management. Decision-making involves evaluating various alternatives and choosing the
best among them. For example, a marketing manager is to allocate his / her advertising
budget among various media in such a way so as to maximize the reach.
1.5. BASIC CONCEPTS AND PRINCIPLES OF MICRO-ECONOMIC

ANALYSIS
deals with firms, more especially with the environment in which firms operate, the
decisions they take and the effects of such decisions on themselves and their
stakeholders like customers, competitors, employees and the society in which they
operate. The key economic concepts and principles that constitute the broad framework
of are explained here.
11
1.5.1. Marginalism
NOTES
The root cause of all economic problems is scarcity. So, all should be careful about the
utilization of each and every additional unit of resources. In order to decide whether to use
an additional unit of resource you need to know the additional output expected there from.
Economists use the term marginal for such additional magnitude of output. Marginalism
concept will help to know the additional output expected from an additional unit of resource.
Therefore, marginal output of labour is the output produced by the last unit of labour.
1.5.2. Opportunity Cost

Economic decision is choosing the best alternative among available alternatives. Before
choosing best alternative you rank them all based on their priority and probable return.
This choice implies sacrificing the other alternatives. The cost of this choice can be
evaluated in terms of the sacrificed alternatives. If the best alternative was not chosen
then you could have chosen the second best alternative. So, the cost of this particular
best choice is the benefit of the next best alternative foregone. This is called Opportunity
Cost.
1.5.3. Discounting Time Perspective

Discounting principle refers to time value of money, i.e., the fact that the value of money
depreciates with time. The core discounting principle is that a rupee in hand today is
worth more than a rupee received tomorrow. One rationale of discounting is uncertainty
about tomorrow, i.e., future. Even if there is no uncertainty, it is necessary to discount
future rupee to make it equivalent to current day rupee. In business situations, most of the
decisions relate to outflow and inflow of money and resources that take place at different
point of time. Most outflows normally occur in the current period, whereas inflows occur
only in future, therefore, in order to take the right decision it is necessary to discount
future inflows to their present value level. The simple formula for discounting is:
PVF = 1 / (1+rn)
Where PVF = present value of fund, n= period (year, etc.) and r = rate of discount.
1.5.4. Risk and Uncertainty

The uncertainty is due to unpredictable changes in the business cycle, structure of the
economy and government policies. This means that the management must assume the
risk of making decisions for their organizations in uncertain and unknown economic
conditions in the future. Firms may be uncertain about production, market-prices, strategies
of rivals, etc. Under uncertain situation, the consequences of an action are not known
immediately for certain. Economic theory generally assumes that the firm has perfect
knowledge of its costs and demand relationships and its environment. Uncertainty is not
allowed to affect the decisions. Uncertainty arises because producers simply cannot
foresee the dynamic changes in the economy and hence, cost and revenue data of their
firms with reasonable accuracy. Dynamic changes are external to the firm and they are
beyond the control of the firm. The result is that the risk from unexpected changes in a
firms cost and revenue cannot be estimated and therefore the risk from such changes
cannot be insured. The managerial economists have tried to take account of uncertainty
with the help of subjective probability. The probabilistic treatment of uncertainty requires
formulation of definite subjective expectations about cost, revenue and the environment.
1.6. SUMMARY
The can be viewed as an application of that part of microeconomics that focuses on such
topics as risk, demand, production, cost, pricing and market structure.
12
Understanding these principles will help to develop a rational decision-making perspective

and will sharpen the analytical framework that the managers must bring to bear on managerial
decisions.
CHECK YOUR PROGRESS
NOTES
1. Uncertainty and risk arise mainly due to

(a) Uncertain behavior of the market forces,
(b) Changing business environment,
(c)
Emergence of complexity of the modern business world and social and

political, external influence on the domestic market and social and political
changes in the country,
(d) All above

2. Source resources are to be used with utmost efficiency to get
(a) The optimal results,
(b)
The Sub-optimal results,
(c) The Normal results,
(d)
All the above.
(a) Over-population,
(b)
Scarcity,
(c) Capital
(d)
Poor management
(a) Time value of interest,
(b)
Time value of money,
(c) Time value of investment,
(d)
Time value of capital.
3. The root cause of all economic problems is
4. Discounting principle refers to
Questions and Exercises

1.1. is an integration of economic theory, decision science and business
management. Comment.
1.2. Economics is a science of choice when faced with unlimited ends and scarce
resources having alternative uses. Comment.
1.3. uses the theories of economics and the methodologies of the decision sciences
for managerial decision-making. Elaborate.
1.4. Discuss the salient features and significance of .
1.5. Highlight the role and responsibilities of a business / managerial economist.
1.6. Write short notes on the followings:
1.6.1.
The Nature of .
1.6.2.
Functions of Managerial Economist.
1.6.3.
Decision Making under Uncertainty.
1.6.4.
Opportunity Cost.
1.6.5.
Marginal Analysis.
1.6.6.
Discounting Principles
13
Fundamental Questions
NOTES
1.
What is economics?
2.
What are opportunity costs?
3.
How are specialization and opportunity costs related?
4.
What is Marginalism?
5.
What is Risk and Uncertainty?
6.
What is Discounting Time Perspective?
Skill Development
i)
Prepare a mini case study of a business expansion strategy of a Laptop dealer in

your area.
ii)
Prepare a hypothetical case study for an automobile firm in India to deal with would
be problem of launching of small cars like NANO.
Further Readings
z
Hirschey, Economics for Managers, Cengage Learning
Baumol, Microeconomics: Principles & Policies, 9th editions, Cengage Learning
Froeb, : A Problem Solving Approach, Cengage Learning
Mankiw,
Economics: Principles and Applications, Cengage Learning
14
Gupta, G.S. 2006, , 2nd Edition,Tata McGraw Hill
Peterson, H.C and Lewis, W.C. 2005, , 4th Edition, Prentice

Hall of India
R Ferguson, R., Ferguson, G.J and Rothschild,R.1993 Business Economics

Macmillan.
Varshney, R.Land Maheshwari, 1994 Manageriaql; Economics, S Chand and Co.
Chandra, P.2006, Project: Preparation Appraisal Selection Implementation and

Review, 6th Edition, Tata McGraw Hill.
UNIT 2 Consumer Behavior

STRUCTURE
2.1. Objectives
2.2. Introduction
NOTES
2.3. Demand Function

2.4. Determinants of demand
2.5. Law of Demand
2.6. Exceptions to the Law of Demand
2.7. Shift of Demand v/s Expansion or Contraction of Demand
2.8. Demand Elasticity
2.9. Types of Elasticity
2.10. Methods of measuring elasticity and its significance
2.11. Demand Forecasting
2.12. Supply Function
2.13. Factors affecting Supply
2.14. Elasticity of Supply
2.15. Budget Constraint
2.16. Indifference Curves Analysis
2.17. Consumer Equilibrium and Consumer Surplus
2.18. Summary
2.1. OBJECTIVES
The objective of this chapter is to define and analysis of . The chapter also focuses on
the Demand Function, Determinant of Demand, Law of Demand and Exceptions,
Elasticities of Demand and their Measurements, Demand Forecasting Methods,
Supply Function, Elasticities of Supply, Indifference Curve Analysis, Consumer
Equilibrium and Consumer Surplus. Graphs are used consistently in this chapter for
understanding the subject matter easily.
Key Terms
Demand, Demand Function, Determinant of Demand, Law of Demand, Elasticity, Demand
Forecasting Methods, Supply, Supply Function, Indifference Curve, Consumer Equilibrium
and Consumer Surplus.
2.2. INTRODUCTION
The amount of good that a consumer is willing to buy and able to purchase over a period
of time, at a certain price is known as the quantity demanded of that good. The quantity
desired to be purchased may be different from the quantity of good actually bought by the
consumer. Quantity demanded is a flow concept, so the relevant time dimension has to
be mentioned which will indicate the quantity demanded per unit of time.
15
2.3. DEMAND FUNCTION

Demand is a relationship between the price and the quantity demanded, other things
remaining the same. If X1 denotes the quantity demanded and P1 its price per unit of the
good, then other things remaining constant, the demand function is;
NOTES
X1 = f (P1 ),
Which shows that quantity demanded depends on the price. This means that any change
in price will result in a corresponding change in the quantity demanded.
2.4. DETERMINANTS OF DEMAND

The determinants of demand for a product and the nature of relationship between demand
and its determinants are very important factors for analyzing and estimating demand for
the product. The most important determinants are as follows:
1. Price of the product.
2. Price of the related goods Complements and Supplements.
3. Level of consumers income.
4. Customers taste and preference.
5. Advertisement of the product.
6. Consumers expectations about future price and Supply position.
7. Demonstration effect and Band-Wagon effect.
8. Consumer-credit facility.
9. Population of the country (Goods for mass consumption).
10. Distribution pattern of the National Income.
2.5. LAW OF DEMAND

The law of demand states that other things being constant, price and quantity demanded
have an inverse relationship; i.e. as price of a product increases quantity demanded
decreases and vice versa. This law states that there is an inverse relationship between
price and quantity demanded, as price increases, quantity demanded will decrease. The
law of demand can be explained in terms of substitution and income effects resulting from
price changes. The substitution effect reflects changing opportunity costs. When price of
good increases, its opportunity cost in terms of other goods is also increases. Consequently,
consumers may substitute other goods for the good that has become more expensive.
2.6. EXCEPTIONS TO THE LAW OF DEMAND

Though normally law of demand applies to all situations, but there are few cases where
the law does not hold goods, therefore these are regarded as exceptions to the law. These
are the goods which are demanded less at low price and more at high price. Let us
discuss some such exceptions here.
Giffen goods: the case of Giffen Goods needs a little bit of story telling! In early Ireland it
was observed that the poor population consumed two goods: meat (which was costly)
and bread (which was cheap). A very strange phenomenon was observed when the price
of the bread was increased, it made a large drain on the resources of the poor people and
raised their marginal utility of money to such an extent that they were forced to curtail
16
there consumption of meat and buy more of bread, which was still the cheapest food. This
implied that quantity demand of bread (an inferior good) increased with the increase in its
price. Sir Robert Giffin, an economist, was the first to give an explanation to this situation.
Hence such goods which display direct price demand relationship are called Giffin Goods.
These goods are considered inferior by the consumer, but they occupy a significant place
in the individuals consumption basket. It so happens that people in this case, with the
rise of price of this good (say rice), are forced to reduce their purchase of other expensive
goods (say, chicken) and increase the purchase of that good (rice) in larger quantity to
supplement the reduction in luxury food item (chicken). These goods categorically are
those on which major portion of consumers income is spent, hence they are termed as
inferior.
NOTES
Snob Appeal: opposite to Giffen Goods, there are certain goods which have snob value,
for which the consumer measures the satisfaction derived from there commodities not by
their utility value, but by their social status. The consumer of this particular commodity
wants to show it off to others, and as a result they buy less of it at lower prices and more
at higher prices. Thus in this case, price and quantity move in the same direction.
Diamond or antique works of art, latest model of mobile phones, sports cars, and designer
clothes are example of such goods. Higher is the price of diamond, higher is the snob
value attached to it and higher is its demand. These goods are sometimes also known as
Vevlen Goods after the economist Thorstein Vevlen.
2.7. SHIFT OF DEMAND V/S EXPANSION OR CONTRACTION OF

DEMAND
Demand curve shows the relationship between price of a commodity and demand at that
price, ceteris paribus. If the price changes, the demand will also change along the same
demand curve. Thus movement along the same demand curve is known as a contraction
or expansion in quantity demanded, which occurs due to rise or fall in price of the
commodity.
17
When price of a good remain the same but any one of the other determinants changed
then we will get a new demand curve. So, when demand increases without any change in
price of that good, the demand curve will shift to the right and with a reduction in demand,
the demand curve will shift to the left.
NOTES
2.8 DEMAND ELASTICITY

Law of demand gives us the direction of change in demand if the price of the product
changes. But this information is not of much practical use since we know only the direction
of change in the demand for a given change in the price. For decision making, we need the
magnitude of this demand and elasticity of demand can gives this changes. The elasticity
of demand helps to understand the extent to which the quantity demanded will rise (fall)
due to fall (rise) in the price of the same good or a related good or due to rise (fall) in the
income of the consumer. This involves an analysis of demand sensitivity with respect to
prices of goods and income which helps the business to forecast market trends for the
future.
2.9 TYPES OF ELASTICITY

There are many types of elasticity but the main and important types are as follows.
i)
Price elasticity of demand
ii)
Income Elasticity of Demand
iii) The Cross-price Elasticity of demand iv) Advertising Elasticity of Demand
2.10METHODS OF
SIGNIFICANCE
MEASURING
ELASTICITY
AND
ITS
There are many types of elasticity of demand like determinants. But here we will discuss
the most important three elasticity a) Price Elasticity of Demand, b) Income Elasticity of
Demand, c) Cross-price Elasticity of Demand d) Advertising Elasticity of Demand.
18
Price elasticity of demand (ep)

ep = percentage change in quantity demanded resulting from one percent change in the
price of the good, other things remaining constant.
ep =
percentage change in quantity demanded

percentage change in price
Percentage change in quantity demanded = [change in quantity demanded / original

quantity demanded] * 100
NOTES
Percentage change in price = [change in price / original price] *100

Combining the above two, we have,
ep =
change in quantity demanded/original quantity demanded

change in price/original price
= [Q / P] * [P / Q],
Where,
Q = Infinitesimal change in quantity,

P = Infinitesimal change in price,
P = original price and Q = original quantity demanded of the good.
Some important concepts
z
Perfectly elastic demand: A very small amount of change in the price will result in a
change in the quantity demanded to the extent of infinity. Ep =
Perfectly inelastic demand: A change in price, however large it may be, causes no
change in quantity demanded. Ep = 0.
Unit elasticity of demand: When a given change in the price causes an equally proportionate change in the quantity demanded the value of price elasticity of demand id
unitary. Ep = 1.
Relatively elastic demand: Here a change in the price results in more than proportionate change in the quantity demanded. Ep > 1.
Relatively inelastic demand: Here a change in the price results in less than proportionate change in the quantity demanded. Ep < 1.
Unitary Elastic
% Q = % P
Ep = 1.
Relatively Elastic
% Q > % P
Ep > 1.
Perfectly Elastic
% P = 0
Ep = .
Relatively Elastic
% Q < % P
Ep < 1.
Perfectly Inelastic
% Q = 0
Ep = 0.
Income Elasticity of Demand

It is defined as the proportionate change in the quantity demanded resulting from a
proportionate change in income.
Ey = [Q / Q] / [Y / Y] = [Q / Y] * [Y / Q]
It is clear that the sign of the elasticity depends on the sign of the derivative KQ / KY as
both of the expressions Q and Y are positive, i.e., Q>0 & Y>0. The income elasticity is
19
positive for normal goods. A commodity is considered to be a luxury if its income elasticity
is greater than unity. A commodity is considered to be a necessity if its income elasticity
is less than unity.
The main determinants of income elasticity are:
1.
The nature of the need that the commodity covers: the percentage of income spent on
food declines as income increases.
2.
The initial level of income of a country: for example, a TV set is a luxury in an

underdeveloped and poor country, while it is a necessity in a country with high percapita income.
NOTES
3. The time period: consumption patterns adjust with a time lag to changes in income.
The Cross-price Elasticity of demand

The cross-price elasticity of demand is defined as the proportionate change in the quantity
demanded of product i resulting from a proportionate change in the price of the product j.
Symbolically the cross-price elasticity is:
Ecij = [Percentage change in the quantity demanded of the ith good / Percentage change
in the price of the jth good]
= [(Qi / Qi)*100] / [(Pj / Pj)*100]
= [Qi / Pj] * [Pj / Qi],
As price and quantity values cannot be negative terms, the sign of the cross price elasticity
is determined by the sign of the derivative Qi / Pj.
The sign of cross price elasticity is negative if i and j are complementary goods, and is
positive if i and j are substitute goods. The higher the value of the cross-price elasticity the
stronger will be the degree of substitutability or complementarities of i and j. The main
determinant of the cross elasticity is the nature of the commodities relative to their uses.
If two commodities can satisfy equally well the same need, the cross elasticity is high
and vice versa.
Advertising Elasticity of Demand

It is defined as the rate of change in the quantity demanded of a good due to change in the
advertisement expenditure of the product.
Ey = [Q/Q] / [ADexp/ADexp] = [Q/KADexp] *
[ADexp/Q]
It measures the response of quantity demanded to change in the expenditure on
advertisement. It has been seen that some goods are more responsive to advertising, i.e.,
cosmetics.
2.11. DEMAND FORECASTING

There are so many methods for forecasting demand. Here we will discuss the main
methods. Broadly they are divided into two groups:
1. Survey Methods.
2. Statistical Methods.
1. Survey Methods.
Survey methods are generally used where the purpose is to make short-run forecast of
demand. Under the survey methods there are two types of survey: I) Consumer Survey
Methods Direct Interviews, and ii) Opinion Poll Methods
20
i)
Consumer Survey Methods Direct Interviews
The customer survey method of demand forecasting involves of the potential consumers.
It may be in the form of:
a) Complete enumeration,
b) Sample survey,
c) End-use method.
NOTES
a) Complete enumeration method

By this method, almost all potential users of the product are contacted and are asked
about their plan of purchasing the product in question. The quantities indicated by the
consumers are added together to obtain the probable demand for the product. The main
limitation of this method is that it can be used successfully only in case of those products
whose consumers are concentrated in a certain region or locality.
b) Sample survey
In this method, only a few potential consumers and users selected from the relevant
market through a sampling method are surveyed. Method of survey may be direct interview
or mailed questionnaire to the sample-consumers. This method is generally used to estimate
short-term demand from business firm, government department and agencies and also by
the households who plan their future purchases.
c) End-use method
This method of demand forecasting has a considerable theoretical and practical value,
especially in forecasting demand for inputs. This method requires building up a schedule
of probable aggregate future demand for inputs by consuming industries and various other
sectors. This method has two exclusive advantages. First, it is possible to work out the
future demand for an industrial product in considerable details by types and size. Second,
in forecasting demand by this method, it is possible to trace and pinpoint at any time in
future as to where and why the actual consumption has deviated from the estimated
demand.
ii) Opinion Poll Methods

The opinion poll methods aim at collecting opinions of those who are suppose to possess
knowledge of the market, i.e., sales representatives, professional marketing experts and
consultants. This method includes;
a) Expert-opinion method.
b) Delphi Method.
c) Market studies and experiments.
a) Expert-opinion method
The estimates of demand can obtain from different regions are added up to get the overall
probable demand for a product. The firms are not having this facility; gather similar
information about the demand for their products through the professional markets experts
or consultants, who can, through their experience and expertise, predict the future demand.
This is called opinion poll method.
b) Delphi Method
This method of demand forecasting is an extension of the simple expert opinion poll
method. Under this method, the experts are provided information on estimates of forecasts
of their experts along with the underlying assumptions. The experts may revise their own
estimates in the light of forecasts constitutes the final forecast.
21
c) Market studies and experiments

It is an alternative method of collecting necessary information regarding demand is to
carry out market studies and experiments on consumers behavior under actual, though
controlled, market conditions. This method is known in common parlance as market
experiment method.
NOTES
2. Statistical Methods
This method is utilizes historical (time-series) and data for estimating long-term demand.
This method is considered superior techniques of demand forecasting for the following
reasons:
z
In this method, the elements of subjectivity are minimum.
Method of estimation is scientific.
Estimates are relatively more reliable.
It involves smaller cost.
Statistical methods of demand projection include the following techniques;

1. Trend Projection Methods.
2. Barometric Methods.
3. Econometric Method.
2.12. SUPPLY FUNCTION

Supply of a good refers to the various quantities of the good which a seller is willing and
able to sell at different prices in a given market, at a particular point of time, other things
remaining the same. Supply is related to scarcity. It is only the scarce goods which have
a supply price. On the other hand, goods which are available freely have no supply price,
i.e., air is available freely and hence does not have supply price. The law of supply states
that other things remaining the same, more of a good are supplied at a higher price and
less of it is supplied at a lower price.
The law of supply takes into account only the most important determinant of supply, viz.,
the price of the good. So, the supply function is;
Sx = f(Px), other things remaining the same,
where,
Sx = Amount of good X supplied,
Px = Price of good X.
2.13. FACTORS AFFECTING SUPPLY

The followings are the major factors affecting the supply of the good;
i) Price of the Good.
iv) State of Technology.
ii) Prices of other goods. iii) Prices of factors of Production.
2.14. ELASTICITY OF SUPPLY

Price Elasticity of Supply refers to the percentage change in quantity supplied due to one
percentage change in the price of that good.
Es = [Percentage change in quantity supplied / Percentage change in the price]
22
= [Qs/Qs] / [P/P] = [Qs/P] *

[P/Qs] Where,
Qs = Original quantity supplied, P = Original price,
Qs = Change in quantity supplied,
P = Change in price.
2.15. BUDGET CONSTRAINT
NOTES
The consumer has a given income which sets limits to his maximizing behaviour. Income
acts as a constraint in the attempt for maximizing utility. The income constraint, in the
case of two commodities, may be as:
Y = PX QX+ PYQY
The income constraint graphically present by the budget line, whose equation is derived
as,
1
PX
QYQXYPY
PY
Assigning successive values of Q X, we may find the corresponding values of QY. Thus, if QX
= 0, the consumer can buy Y/ PY units of good y. Similarly, if QY = 0, the consumer can buy
Y/ PX units of good x.
2.16. INDIFFERENCE CURVES ANALYSIS

The consumer behaviour analysis was expanded to new horizons with the introduction of
indifference curve analysis by J.R. Hicks and R.G.D. Allen. In this analysis, the utility is
ordinally measurable. If we plot the quantities of two commodities on the two axes, then
we get a set of points that would present alternative combination of the two commodities,
between which the consumer would be indifferent. The curve joining such points is known
as an indifference curve. So, indifference curve is the locus of points which show the
different combinations of two commodities a consumer is indifferent about the points A or
B or C or D.
23
NOTES
2.17. CONSUMER EQUILIBRIUM AND CONSUMER SURPLUS

The consumer is in equilibrium when he maximizes his utility, given his income and
market prices. Two conditions must be fulfilled for the consumer to be in equilibrium. The
first condition is that the marginal rate of substitution be equal to the ratio of commodity
prices
MUx
Px
MRSx,y=
MU y
Py
This is a necessary but not sufficient condition for equilibrium. The second condition is
that the indifference curves be convex to the origin. This condition is fulfilled by the axiom
of diminishing MRSx,y, which states that the slope of the indifference curve decreases as
we move along the curve from left to right.
24
At the point of tangency the slopes of the budget line and of the indifference curve are
equal:
MUx
Px
=
MU y
Py
Thus the first-order condition is denoted graphically by the point of tangency of the two
relevant curves. The second-order condition is implied by the convex shape of the indifference
curve. The consumer maximizes his utility by buying Xe and Ye amount of the two
commodities.
NOTES
The concept of consumer surplus was first introduced by Marshal. Consumer surplus is
the difference between the price consumers are willing to pay and what they actually pay.
The amount that the consumer is willing to pay for the first unit of good he buys is termed
as consumers marginal value. The marginal value decreases as more and more units are
bought. A consumer who maximizes marginal value will buy to that extent where marginal
value equals price. A graphically presentation of consumer surplus is given below.
AB is the demand curve of a consumer. The consumer is willing to pay a price of q 1p 1 for
q1 units of goods. For q2 units of goods he will be willing to pay q2p2. And for Q, he will be
willing to pay QN and so on. Now, suppose that the market price is OP, which the consumer
can decide about the quantity of good he would like to demand. With the demand curve
AB, he will demand OQ. Here, the consumer actually pays OP per unit of the good, but he
was willing to pay more than OP for any unit to the left of Q. For the quantity q1, the
consumer is willing to pay q1p1, but he actually pays q1r1. Hence, the consumer surplus is
(q1p1 - q1r1) = r1p1. In the same way for q2, the consumer surplus is r2p2 and for Q, it is zero. If
the quantities are finally divisible, the total amount that the consumer is willing to pay is
the area OANQ, whereas what he actually pays is the area OPNQ and the consumers
surplus is the area APN.
2.18. SUMMARY
Demand refers to the number of units of a good or service that consumers are willing and
able to buy at each price during a specified interval of time. Changes in demand can be
caused by changes in tastes and preferences, income and prices of other goods and
services also. Marginal revenue is the change in total revenue per unit change in demand.
25
Total revenue is increasing when marginal revenue is positive. Marginal revenue is zero at
the maximum point of total revenue and total revenue is declining when marginal revenue
is negative. Elasticity measures the responsiveness of demand to various factors. Price
elasticity of demand is defined as the percentage change in quantity demanded per 1
percent change in price.
NOTES
CHECK YOUR PROGRESS

1. Which of the following statements is true?
(a) When the supply increases, both the price and the quantity will increase,
(b) When the supply increases, the supply curve shifts towards the left,
(c) A shift in the supply curve towards the right results in a fall in the price,
(d) A decrease in the quantity supplied results in shifting of the supply curve
towards the left.
2. Which of the following statements is false?
(a) An increase in tax will affect the customers more than the producers if the
supply schedule is inelastic,
(b) An increase in tax will affect the customers more than the producers if the
demand schedule is inelastic,
(c) Both (a) and (d) above,
(d) An increase in tax will affect the customers less than the producers if the
demand schedule is inelastic.
3. For complementary goods, the cross elasticity of demand will be
(a) Zero,
(b)
Infinity,
(c) Positive but less than one,
(d)
Negative.
4. When the income elasticity of demand for a good is negative, the good is
(a) Normal good,
(b)
Luxury good,
(c) Inferior good,
(d)
Giffen good.
5. If both income and substitution-effects are strong, this region of the demand
curve must be
(a) Relatively price elastic,
(b)
Relatively price inelastic,
(c) Unit-elastic,
(d)
Perfectly inelastic.

1. Explain the utility analysis for understanding consumer behaviour and demand.
26
2.
What is the Law of Diminishing Marginal Utility? Explain law with empirical example.
3.
State and explain the properties of Indifference Curve.
4.
Explain the Law of Diminishing Marginal Rate of Substitutions.
5.
State the law of demand with some exceptions.
6.
The law of demand is always applicable to marginal buyers and is usually applicable
to intra-marginal buyers. Comment.
7.
Distinguished between substitutes and complements with examples. How does this
distinction of goods help in business decision making?
8.
If price of milk increases, what do you think will happen to the demand for cornflakes?
9.
What are the factors that cause the demand curve to shift?
NOTES
10. If the demand is fixed but supply of a product increases, what happens to equilibrium
price and quantity?
11. If the market demand curve is given by Q d = 15 8P and the market supply curve Qs
= 2P, find the equilibrium price and quantity graphically and mathematically.
12. Why is it said that the market equilibrium is a highly unstable one?
13. Given the following demand and supply functions, find the equilibrium price and quantity
in the market: Demand Qd = 100 P and Supply P = 10 + 2Qs.
14. Differentiate between the following on the basis of elasticity of demand.
i)
Superior Goods and Inferior Goods.
ii)
Complements and substitutes.
1. What is demand?
2. What are determinants of demand?
3. What are the different elasticities of demand?
4. What are the different measures of demand forecasting?
5. What is supply?
6. How do we measure supply elasticity?
7. How do you apply indifference curve analysis in analysis?
8. What is consumer surplus?
Skill Development
i)
In the context of demand analysis, review the air-fare season wise of Indigo Airlines
and Kingfisher Airline.
ii)
Choose a branded cosmetic product (Shampoo, Hair Dye, Talcum Power etc.), collect monthly price-demand (sales) / advertising expenditure sales revenue data on
an average over a period of six months and measure the point and arc price and
promotional elasticity of demand.
Further Readings
z
Mankiw,

z

Hall of India
R Ferguson, R., Ferguson, G.J and

Rothschild,R.1993 Business Economics Macmillan.
z
27
NOTES
28
Varshney,R.Land Maheshwari, 1994 Manageriaql; Economics, S Chand and Co.
Koutsoyiannis,A. Modern Economics, Third Edition.
Chandra, P.2006, Project: Preparation Appraisal Selection Implementation and Review, 6th Edition, Tata McGraw Hill.
Goldfield,S.M and Chandler,L.V. The Economics of Money and Banking.
UNIT 3 COST AND PRODUCTION

ANALYSIS
STRUCTURE
Cost And Production Analysis
NOTES
3.1. Objectives
3.2. Introduction
3.3. Production Functions
3.4. Law of Variable Proportion or Law of Diminishing Returns to Factors.
3.5. Difference between Returns to a Factor and Returns to Scale
3.6. Isoquants
3.7. Isocost Line or Equal Cost Line
3.8. Marginal Rate of Technical Substitution
3.9. Choices of Input Combination (Optimal Input combination)
3.10. Theory of Cost
3.11. Cost Functions
3.12. Various types of Costs
3.13. Relationship between AC and MC
3.14. Long and Short Run Cost Curves
3.15. Cost and Output Relationship (Cost Function)
3.16. Short Run and Long Run
3.17. Economies / Dis-economies of Scale
3.18. The Theory of firm (Profit Maximization Model)
3.19. Break-even and Shut-down Point
3.20. Managerial Theories of the Firm
3.21. Baumols Model
3.22. Marris Model.
3.23. Summary
3.1. OBJECTIVES
The objective of this chapter is to define and application of the production and cost. The
chapter also focuses on the Production Function, Total Product, Average Product, Marginal
Product; Law of Variable Proportion or Law of Diminishing Returns to Factors, Returns to
a Factor and Returns to Scale, Isocost and Isoquant, Marginal Rate of Technical Substitution
(MRTS), Model of Profit Maximization, Sales Revenue Maximisation Model by Baumol,
Managerial Utility Models, Growth Maximisation Models, Total Cost (TC), Total Fixed
Cost (TFC), Total Variable Cost (TVC), Average Fixed Cost (AFC), Average Variable Cost
(AVC), Average Total Cost (ATC) and Marginal Cost (MC), Long and Short Run Cost
Curves, Cost and Output Relationship, Economies / Dis-economies of Scale, Break-even
and Shut-down Point, Baumols Model and Marris Model. Graphs are used consistently
for understanding the subject matter easily.
29
Key Terms
NOTES
Production, Production Function, Total Product, Average Product, Marginal Product, Law
of Diminishing Returns to Factors, Returns to a Factor, Returns to Scale, Isocost, Isoquant,
Marginal Rate of Technical Substitution (MRTS), Total Cost (TC), Total Fixed Cost (TFC),
Total Variable Cost (TVC), Average Fixed Cost (AFC), Average Variable Cost (AVC), Average
Total Cost (ATC), Marginal Cost (MC), Long and Short Run Cost Curves, Cost and Output
Relationship, Economies / Dis-economies of Scale, Break-even and Shut-down Point.
3.2. INTRODUCTION
Production is basically an activity of transformation which transfers inputs into outputs.
Firms use land, labour, seeds and small amount of capital as inputs to produce output
like corn. Similarly, a flour mill uses inputs like wheat, labour, capital for machinery,
factory building to produce output like wheat flour. So, an input is the goods or services
which produce an output. The firm generally uses many inputs to produce an output.
Output of any firm may be the inputs of other firms, e.g., steel is an output of the steel
producer, but this steel is also an input of automobile or rail coach manufacturing or
refrigeration manufacturing or air-condition manufacturing industries. The transforming
process of inputs into output can be three types: i) change in form (output should be new
form compared to inputs, for example cloth as output and thread as input) ii) change in
space (transportation) and iii) change in time (storage). The transformation process or
production increases the consumer usability of goods and services.
3.3. PRODUCTION FUNCTIONS

A production function is the technical relationship between inputs and outputs. A commodity
may be produced by various methods using different combinations of inputs with given
state of technology. Take the e.g. of cloth, it may be produced using cotton or silk or
polymer as raw materials with handloom, power loom or computerized machines. You
can see various types of raw materials and technology options will create several possible
ways of producing the same product. Hence there can be several technically efficient
methods of production. Production function includes all such technically efficient methods.
It can be said that production function is purely a technological relationship between
physical inputs and physical outputs over a given period of time; production is a function
of inputs, their quality and quantity and interrelation, i.e., complementarities and
substitutability. Hence it can be said that production function is:
z
Always related to a given time period
z
Always related to a certain level of technology
z
Depends upon relation between inputs
Production function shows the maximum quantity of the commodity that can be produced
per unit of time for each set of alternatives inputs, and with a given level of production
technology. A given amount of output can be produced by different combinations of inputs
and each of these combinations may be technically efficient. Technical efficiency is defined
as a situation when using more of one input with either the same amount or more of the
other input must increase output.
Normally a production function is written as;
Q = f (x 1, x 2, xn) ..(i)
Where, Q is maximum quantity of output of a good being produced, and x1, x 2,. xn are
the quantities of various inputs used in production. If we replace x 1, x 2,x n in (i) by the
factors of production discussed above, the production function may be;
30
Q = f (L, K, I, R, E) .. (ii)
Where,
Q =output and the inputs are L, K, I, R, E;
L= labour,
K = capital,
I =land,
R =raw material
E = efficiency parameter
NOTES
In short run, some inputs like plant, size, and machine equipments cannot be changed,
so a producer trying to increase output in the short run will have to do so by increasing
only the variable inputs. On the contrary in the long run input options are very wide. On the
basis of such characteristics of inputs, production functions are normally divided into two
broad categories :( i) with one variable input or variable proportion production function (ii)
with two variable inputs or constant proportion production function
Production Function with One Variable Input: In short run producers have to optimize
with only one variable input. Let us consider a situation in which there are two inputs,
capital and labour, capital is fixed and labour is variable input. You will notice as the
amount of capital is kept constant and labour is increased to increase output, the ratio in
which these two inputs are used will also change. Therefore any change in output can be
manifested only through a change in labour input only.
Such a production function is also termed as variable proportion production function; its
essentially a short term production function in which production is planned with variable
input. The short run production function shows the maximum output a firm can produce
when only one of its inputs can be varied, other inputs remaining fixed. It can be written
as:
Q = f (L, K0)..(iii)
Where, Q is output, L is labour and K0 denotes the fixed capital. This also implies that it
is possible to substitute some of the capital by labour. It is easy to understand that as
units of the variable input are increased, the proportion of use between fixed input and
variable input also changes. Therefore short run production function is governed by law of
variable proportions. To explain the concepts of average and marginal products of factor
inputs consider the production function given in equation (iii), Assuming capital to be
constant and labour to be variable, total product is a function of labour and is given as:
TPL = f (K0, L)..(iv)
31
If instead labour is fixed in the short run, the total product of the capital function can be
similarly expressed as:
TPK = f (L0, K) .(v)
NOTES
Average Product (AP) is total product per unit of variable input; therefore it can be expressed
as:
APL = TP/L..(vi)
If instead labour is fixed in the short run, average product of the capital function(APK )can
be similarly expressed as:
APK = TP / K..(vii)
Marginal Product (MP) is defined as addition in total output per unit change in variable
input. Thus marginal product of labour (MP L) would be:
MPL = TP / L ....(viii)
Production Function with Two Variable Inputs: Most simplistic form of production
function with two variable inputs, labour (L) and capital (K), and a single output, Q, is as
follows;
Q = f (L, K) .(ix)
This production function is constructed based on the assumption that the state of the
technology is given and output can be increased by increasing inputs. When the state of
technology changes, the production function itself changes. Further, it is assumed that
the inputs are utilized in the best possible way, i.e., optimum utilization of inputs. The
best utilization of any particular input combination is a technical, not an economic problem.
Selection of best input combination for the production of a particular output level depends
upon the input and output prices and is subject of economic analysis.
3.4. LAW OF VARIABLE PROPORTION OR LAW OF DIMINISHING

RETURNS TO FACTORS.
The slope of the total product curve is determined from the law of diminishing returns. The
law of diminishing returns, being empirical in nature, states that with a given state of
technology if the quantity of one factor input increased, by equal increments, the quantities
of other factor inputs remaining fixed, the resulting increment of total product will first
increase and then decrease after a particular point.
32
The law is also known as diminishing returns to factors. It states that as more and more
one factor of production is employed, other factor remaining the same, its marginal
productivity will diminishing after some time. For example, if we increase labour input and
capital input remaining the same, then the marginal productivity of labour first increased,
reaches maximum and then decreases. The law of diminishing returns to factors is
depending on three assumptions.
i) It is assumed that the state of technology is given.
ii) It is assumed that one factor of production must always be kept constant at certain
level.
iii) This law is not applicable when two inputs are used in a fixed proportion and the law
is applicable only to varying ratios between the two inputs.
NOTES
3.5. DIFFERENCE BETWEEN RETURNS TO A FACTOR AND

RETURNS TO SCALE
The law of diminishing returns factors states that as more and more one factor of production
is employed, other factor remaining the same, its marginal productivity will start diminishing
after some time, e.g., if we increase one factor of production i.e., labour and other factor
of production i.e., capital remaining the same, then the marginal productivity of labour first
increased, reaches maximum and then decreases. So, returns to a factor (variable factor)
of production is first increasing in the initial level of production and then decreasing if we
increase the amount of that variable factor of production. But, if we increase more and
more of that variable factor then the returns to the variable factor is negative.
In the very first stage of production, if additional units of labour are employed, the total
output increases more than proportionately; so marginal product rises. In the following
figure, stage I would begin from the origin and continue to a point where AP L attains its
maximum value. In this stage, MP L > 0, and MPL > APL. This stage is called as increasing
returns to the variable factor.
33
In the second stage, the total product increases but less than proportionate to increase in
labour. In this stage, marginal product of labour falls and this stage is called as diminishing
returns to variable factors. Here, MPL > 0 and MPL < APL.
The stage three is a technically inefficient stage of production and a rational producer will
never produce in this stage. Here, MPL < 0 and total product is decreasing.
NOTES
The law of returns to scale refers to the long run analysis of production. It refers to the
effects of scale relationships which implies that in the long run output can be increased by
changing all factors by the same proportion, or by different proportions. If the production
function is Q0 = f (K, L) and we increase all the factors of production by the same proportion
p. So, the new production function is Q* = f (p.K, p.L).
If Q* increases in the same proportion as the factors of production, p, then we can say
there are Constant Returns to Scale (CRS).
If Q* increases less than proportionately with an increase in the factors of production, p,
then we can say there are Decreasing Returns to Scale (DRS).
If Q* increases more than proportionately with an increase in the factors of production, p,
then we can say there are Increasing Returns to Scale (IRS).
3.6. ISOQUANTS
An isoquant is the firms counterpart of the consumers indifference curve. It is a curve
representing the various combinations of two inputs that produce the same amount of
output. It is also known as iso-product curve or equal product curve or production indifferent
curve. It is the collection of inputs in the form of factors of production labour (L) and
capital (K), which yield the same output. For a definite level of output, i.e., for Q 0, say
1000 units of output or for Q1, say 2000 units of output, the equation of production function
is
Q0 = f (L, K) or Q1 = f (L 1, K1)
Where, Q 0 and Q1 are parameters.
34
NOTES
The locus of all the combinations of L and K which satisfy the above equation forms an isoquant.
Since the production function is continuous, an indefinite number of input combinations will lie
on each and every isoquant. The two factors of production are substitutable and can employ
more of one input and less of another input to get the same level of output. A higher level of
output is represented by a higher isoquant. If we assume that that the marginal productivities of
both the factors of production are positive and decreasing as more of them are used, the
isoquant will be downward sloping and convex to the origin.
Types of Isoquant: Isoquants are various shapes depending on the degree or elasticity of
substitutability of inputs. These are as follows;
i)
Linear Isoquant: This type assume perfect substitutability between factors of production, i.e., a given output can be produced by using only capital or only labor or by
a large number of combinations of capital or labor.
35
ii) Input-Output Isoquant: It assume strict complementary or zero substitutability

between the factors of production, we get input-output isoquant.
NOTES
iii) Kinked Isoquant: This assume limited substitutability of capital and labor. Since
there are only a few processes available for producing any commodity, substitutability of factors is possible only at kinks. This form is also called activity analysis
isoquant or linear programming isoquant.
iv) Smooth Convex Isoquant: This form assumes continuous substitutability of capital
and labor only over a certain range, beyond which factors can not be substituted for
each other. Such an isoquant appears as a smooth curve convex to the origin.
36
NOTES
An isoquant is a curve showing all combinations of inputs that can be used to produce a
given output. The characteristics of isoquant are as follows.
Isoquants are Downward Sloping: Technological efficiency connotes that an isoquant
must slope downwards from left to right, which implies that using more of one input to
produce the same level of output must imply using less of the other input. Thus if more of
labour is used in the production process, then less of capital must be used to produce the
same level of output. Slope of the isoquant is equal to: K/L, ratio of capital and labour.
37
NOTES
A higher Isoquant represents a higher output: In the panel I of above figure, if we

consider point A on the curve Q1 and the point C on Q2, it can follow that C has more of
both labour and capital as compared to A. Thus as per given technology, more of both
factors should produce greater output. However you should learn that it is not necessary
than on a higher isoquant a point will have greater quantity of at least one of the two inputs
as in case of A and B. Hence a greater quantity of any one of the two inputs will render a
higher level of output. In short, using more of both inputs and more of either of the inputs
must increase output given the state of technology. Hence a higher isoquant Q2 would
represent a higher output than isoquant Q1 .
Isoquants do not intersect each other: An isoquant represents the same level of outputs
with different units of two inputs: intersection of two isoquants would signify single input
combinations producing two levels of output. This is explained by Panel II of above figure.
Let A and B be two different points on Q1 and Q2 respectively. Suppose two isoquants Q1
and Q2 interested each other at point C. At point B and C of isoquant Q1 the firm produces
the same level output Q1. Again points A and C of isoquant Q2 denote the same level of
output Q2 any the firm. Thus it follows that at points A and B, the same level of output
should be produced. But from the fig it is clear that point A denotes a higher level of output
than B; this is contradictory, and hence we conclude that isoquants cannot intersect
each other.
Convex to the origin: Given substitutability between factor inputs, as the firm continues
to employ more of one input say labour and less of other say capital, a situation comes
when it becomes difficult to substitute labour for capital. Since labour and capital are not
perfect substitutes, therefore as capital (K) is kept fixed to produce additional units of
outputs only by increasing laour (L), it would require successively increasing units of
labour. This is better understood with the help of the law of the marginal technical
substitution (MRTS). The absolute slope of the isoquant falls as we move down the isoquant
and the declining MRTSlk determining the convexity of an isoquant.
3.7. ISOCOST LINE OR EQUAL COST LINE

The cost equation of the firm is Co = w.L + r.K, where w is the cost of labour, i.e., wages
and r is the cost of another input capital, i.e., rate of interest. This equation will be satisfied
by different combinations of L and K. the locus of all such combinations is called the
equal cost line or isocost line.
38
NOTES
In the above figure, if the firm spend entire amount of money i.e., C0 in hiring lanour, the
firm will get OB units of labour which is equal to C0 / w. On the other hand, if the firm
spends the entire money in purchasing capital, the firm will get OA units of K which is
equal to C0 / r. By joining the two points A and B we get the isocost line C0 . With the given
cost C0 the firm can purchase any combination of labour and / or capital on the line AB.
3.8. MARGINAL RATE OF TECHNICAL SUBSTITUTION

Marginal Rate of Technical Substitution (MRTS) measures the reduction in per unit of one
input, due to unit increase in the other input that is just sufficient to maintain the same
level of output. Thus for the same quantity of output, marginal rate of technical substitution
of labour (L) for capital (K) (MRTSLK) would be willing to give up for an additional unit of
labour. Similarly, marginal rate of technical substitution of capital for labour (MRTS KL)
would be the amount of labour that firm would be willing to give up for an additional unit of
capital.
Consider the isoquant Q1 of above figure, MRTSLK would measure the downward vertical
distance (representing the amount of capital that the producer is willing to sacrifice) per
39
unit of the horizontal distance (representing additional units of labour).In other words,
MRTS is expressed as the ratio between rates of change in L and K, down the isoquant.
Thus:
NOTES
MRTS LK =
'.
'L
MRTS of labour for capital is equal to the slope of the isoquants, it is also equal to the
ratio of the marginal product of one input to the marginal product of other input. Since
output along an isoquant is constant, if 'K units of labour are substituted for 'K units of
capital, then the increase in output due to increase in , i.e (x ) should match with the
decrease in output due to decrease in i.e., (-x MPK). In other words:
'L x MPL = -'Kx MPK
Or,
'.
'L
MPL / MPK = 'K- / 'L

A change in the level of output can be expressed as change in total output (Q) equals to
the sum of change in labour input ('L) times MP of labour and change in capital input
('K) times MP of capital.
In other words:
'Q = MPL x + MPK x 'K
However, along a given isoquant, output remains unchanged, ie. 'Q = 0.
Hence we have
MPL x + MPK x 'K= 0
Or,
=
MPL / MPK - / 'K- / 'L
=> MRTSLK = MPL / MPK
So, the marginal rate of technical substitution between two inputs is equal to the ratio of
the marginal physical products of the inputs.
3.9. CHOICES OF INPUT COMBINATION (OPTIMAL INPUT

COMBINATION)
Maximization of Output Subject to the Cost Constraint:
Let us suppose that the production function of the firm is given as Q = f(L,K), given the
factor prices w and r for labor and capital, respectively. The firm is in equilibrium when it
maximizes its output given its total cost outlay. Suppose that the firm decides on a given
cost level Co. With this cost the firm can purchase different combinations of the two
factors of production. All these combinations will lie on the isocost line AB in following
figure. The objective of the firm is to maximize the level of output while remaining on the
given isocost line.
In the figure we see that the firm remains on the isocost line AB and purchase any
combination of the two inputs lying on the line AB. All the points on the isocost line AB
represent equally costly combinations. When the firm is moving from E3 to E1, it can
increase its output, since E1 is on a higher isoquant compared to E3. Similarly, by
moving from E1 to E, the firm can again increase the level of its output further. E is also
40
the highest possible point that can be attained by a firm while increasing its output at a
given cost constraint that can be attained by a firm while increasing its output at a given
cost constraint of Co. The movement from E to E2 and further to E4 is not desirable by the
firm as by moving to these points the firm decreases its level of output and shift to lower
isoquants. The geometric interpretation of the objective of the firm to maximize output
subject to the cost constraint, is that the firm tries to attain the highest possible isoquant
with the given cost constraint. This happens only when the isoquant is tangent to the
isocost line.
NOTES
The necessary condition for the maximization of output given the factor prices is that the
isoquant line must be tangent to one of the isoquants. This means that the slope of the
particular isoquant must be equal to the slope of the isocost line. We know that the slope
of the isoquant is given by the ratio of the marginal productivities, i.e.-(MP L/MPK) also
known as the MRTSL, K and the slope of the isocost line is given as the ratio of the factor
prices, i.e.- w/r. So at the point of tangency we have
MPL/MPK = w/r,
i.e., the ratio of the marginal products is equal to the ratio of the factor prices. The above
condition can also be written in the form:
fL / fK = w / r,
Where, fL is marginal productivity of labour and fK is the marginal productivity of capital.
Rearranging the above equation,
we have
fL / w = fK / r.
Now, fL / w is the amount of output that can be obtained by spending one unit of money in
purchasing the factor labor. Similarly, f K / r is the amount of output that can be attained by
spending one unit of money in purchasing the factor capital.
When these two expressions are equal it means that the firm gets the same amount of
output by spending one unit of money either in labor or in capital. In any case, if the
equality does not hold, e.g; when fL / w > fK / r the firm will get more output in spending one
unit of money on labor than that on capital. Reallocation of the factors of production
continues in this way until a point is reached where total output cannot be increased
further by such reallocation of expenditure between labor and capital. At such a point total
output is maximum.
41
So, in a nutshell, the necessary condition of output maximization can be mathematically

represented as
MPL / w = MPK / r
NOTES
An underlying assumption to the fulfillment of the above condition is the isoquants must
be convex to the origin. However, if the isoquants are concave to the origin, the tangency
solution will give us the lowest possible output level. This is because, in the case of
concave isoquants the marginal productivity of the factors of production are negative. So,
obviously, the highest attainable point on a concave isoquant will rise to the lowest possible
output level.
Minimization of cost for a given level of output: Least Cost Conditions:
In the above part, we have seen how output can be maximized for a given cost constraint.
Here we will discuss how the firm minimizes its cost of production for a particular level of
output. The conditions of equilibrium of the firm are formally the same as in the previous
section.
As the level of output is fixed, we will be having only one isoquant and different levels of
cost combinations. For equilibrium, there must be tangency of the given isoquant and the
lowest possible isocost line, the shape of the isoquant being convex to the origin. However,
the problem is conceptually different in the case of cost minimization. The entrepreneur,
in this case wants to produce a given level of output (e.g., a bridge, a building, or q tons of
a particular commodity Q) with the minimum possible cost outlay. In this case we will
have a single isoquant denoted by Q o which represents the desired level of output, but we
have a set of isocost lines denoted by AB, CD and GH in the above figure.
Lines closer to the origin will show a lower total cost outlay and vice-versa. The isocost
lines are parallel because they are drawn on the assumption of constant prices of the
factors of production. The level of output Q o can be produced by different combinations of
the two factors of production. The locus of all such combinations is an isoquant for the
output level Qo. The problem of the firm is to select a point on the isoquant which is least
costly. The firm can produce at any point such as, E 2, E 1, E, E 3, E 4, etc. If we proceed
from the points E2 or E4 towards the point E we see that the level of cost at E is much less
then the points like E 1, E 2, E 3, or E 4. Here E is the point which corresponds to the lowest
possible isoquant line. When we move from E2 to E1 we substitute labor for capital. Such
a substitution is possible since total cost is reduced as a result of the substitution.
Similarly, as we move from the point E4 to point E3 we substitute capital for labor. Once
42
the point E is reached further substitution is no more possible, as any deviation from this
point implies an increase in the cost of production. Hence at point E, the cost of production
the output level Qo is the minimum.
Points below the point E are desirable because they show lower cost, but are not attainable
for the output level Qo . Points above the E, shows higher costs. Hence the point E is the
least cost point for the output level Qo. The least cost combination is fulfilled when the
given isoquant Qo is tangent to the lowest possible isocost line AB, i.e; the slope of the
isoquant is equal to the slope of the isocost line, i.e; the ratio of the marginal productivities
must be equal to the ratio of the factor prices. This is given as follows:
NOTES
MPL/MPK = w / r,
which is the same necessary condition, that we had deduced for output maximization
given the cost constraint.
3.10. THEORY OF COST

Cost is a sacrifice or foregoing that has occurred or has potential to occur in future,
measured in monetary terms. Cost results in current or future decrease in cash or other
assets, or a current or future increase in liability. Cost is determined by various factors
and each of this has significant implications for cost decisions. An increase in any of
these will affect cost pattern. The most important determinant is price(s) of factor(s) of
production, which are uncontrollable, as they are largely determined by the external
environment of any business. The marginal efficiency and productivity of these factors is
strongly related to their cost, higher the productivity or efficiency, lower will be the cost of
the production, other things remaining the same. Technology is the third important
determinant and has the same relationship with the cost as the efficiency of inputs. Other
things remaining the same, better the technology enhances productivity and reduces the
cost of production.
Production and cost analysis constitute the supply side of the market. The production
analysis deals with the supply side in terms of physical units of inputs and output, the
cost analysis is concerned with the supply side in terms of physical units of output and
the cost of production as expressed in nominal terms.
3.11. COST FUNCTIONS

Cost functions are derived functions. They are derived from the production function, which
describes the availability of efficient methods of production at any one time. Economic
theory distinguishes between short-run costs and long-run costs. Short-run costs are the
costs over a period during which some factors of production (usually capital equipment
and management) are fixed. The long-run costs are the costs over a period long enough to
permit the change of all factors of production. In the long run all factors become variable.
Both in the short run and in the long run, total cost is a multivariable function, that is, a
total cost is determined by many factors. Symbolically we may write the long run cost
function as
C= f (X, T, Pf)
And the short run cost function as
C = f (X, T, Pf, K)
Where C = total costs
X = output
43
T = technology
Pf = prices of factors
K = fixed factor(s)
NOTES
Graphically, costs are shown on two-dimensional diagrams. Such curves imply that cost
is a function of output, C = f (X), ceteris paribus. The clause ceteris paribus implies that
all other factors which determine costs are constant. If these factors do change, their
effect on costs is shown graphically by a shift of the cost curve. This is the reason why
determinants of costs, other than output, are called shift factors. Mathematically there is
no difference between the various determinants of costs. The distinction between
movements along the cost curve (when output changes) and shifts of the curve (when the
other determinants change) is convenient only pedagogically, because it allows the use of
two-dimensional diagrams. But it can be misleading when studying the determinants of
costs. It is important to remember that if the cost curve shifts, this does not imply that the
cost function is indeterminate.
3.12. VARIOUS TYPES OF COSTS

In economic analysis, the following types of costs are considered in studying costs data
of a firm:
z
Total Cost (TC)
Total Fixed Cost (TFC)
Total Variable Cost (TVC)
Average Fixed Cost (AFC)
Average Variable Cost (AVC)
Average Total Cost (ATC). and
Marginal Cost (MC)
Total Cost (TC)

Total cost is the aggregate of expenditures incurred by the firm in producing a given level
of output. Total cost is measured in relation to the production function by multiplying
factors of prices with their quantities.
If the production functions is: Q = f (a, b, c.n), then total cost is TC = f (Q) which means
total cost varies with output.
For measuring the total cost of a given level of output, thus, we have to aggregate the
product of factors quantities multiplied by their respective prices.
Conceptually, total cost includes all kinds of money costs, explicit as well as implicit.
Thus, normal profit is included in total cost. Normal profit is an implicit cost. It is a normal
reward made to the entrepreneur for his organizational services. It is just a minimum
payment essential to retain the entrepreneur in a given line of production. If this normal
return is not realized by the entrepreneur in the long run, he will stop his present business
and will shift his resources to some other industry.
Now, an entrepreneur himself being the paymaster, he cannot pay himself, so he treats
normal profit as implicit costs and adds to the total cost.
In the short run, total costs may be bifurcated into total fixed cost and total variable cost.
Thus, total cost may be viewed as the sum of total fixed cost and total variable cost at
each level of output. Symbolically, TC=TFC + TVC.
44
Total Fixed Cost (TFC)

Total fixed cost corresponds to fixed inputs in the short run production function. It is
obtained by summing up the product of quantities of the fixed factors multiplied by their
respective unit prices. TFC remains the same at all levels of output in the short run.
Suppose a small furniture shop proprietor starts his business by hiring a shop at a monthly
rent of Rs. 1,000 borrowing Rs. 50,000 from a bank at an interest rate of 10% and buys
capital equipment worth Rs. 2,000. Then his monthly total cost is estimated to be:
Rs. 1,000
(Rent)
Rs. 2,000
+
(Equipment cost)
Rs.500
(Monthly interest on th loan)
NOTES
= Rs. 3,500
Total Variable Cost (TVC)

Corresponding to variable inputs in the short-run production is the total variable cost. It is
obtained by summing up the product of quantities of input multiplied by their prices.
Again, TVC = F (Q) which means, total variable cost is an increasing function of output.
Suppose, if a shop proprietor starts with the production of chairs and he employs a
carpenter on a wage of Rs. 200 per chair. He buys wood worth Rs. 2,000 rexine sheets
worth Rs. 1,500, spends Rs. 400 for other requirements to produce 3 chairs. Then this
total variable cost for producing 3 chairs is measured as Rs. 2,000 (wood price) + Rs.
1500 (rexine cost) + Rs. 400 (allied cost) + Rs. 600 (labour charges) = Rs. 4,500.
Average Fixed Cost (AFC)

Average fixed cost is total fixed cost divided by total units of output.
AFC = TFC / Q
Where,
Q stands for the number of units of the product.
Thus, average fixed costs are the fixed cost per unit of output.
In the above example, thus, when TFC = Rs. 3,500 and Q = 3.
Therefore AFC = 3,500 /3 = Rs. 1,166.67
Average Variable Cost (AVC)

Average variable cost is total variable cost divided by total units of output.
AVC = TVC / Q where, AVC means average variable cost.
Thus, average variable cost is variable cost per unit of output. In the above example, TVC
= Rs. 4,500 for Q = 3,
Therefore AVC = 4,500 / 3 = Rs. 1,500
Average Total Cost (ATC)

Average Total Cost or average cost is total cost divided by total units of output. Thus:
ATC or AC = TC / Q
In the short run, since
TC = TFC + TVC
ATC = TC / Q = TFC + TVC / Q = (TFC / Q) + (TVC / Q)
Since = TFC / Q = AFC and TVC /Q = AVC,
Therefore ATC = AFC + AVC.
Hence, average total cost can be computed simply by adding average fixed cost and
average variable cost at each level of output. To take the above example, thus
ATC = Rs. 1,166.67 + Rs. 1,500 = Rs. 2,666.67 pr chair.
45
Marginal Cost (MC)

The marginal cost is also per unit cost of production. It is the addition made to the total
cost by producing one more unit of output. Symbolically, MCn = TCn TCn 1, that is, the
marginal cost of the nth unit of output is the total cost of producing n units minus the total
cost of producing n 1 (i.e. one less in the total) units of output.
NOTES
Suppose the total cost of producing 4 chairs (i.e. n = 4) is Rs. 10,000 while that for 3
chairs (i.e. n 1 is Rs. 8,000. Marginal cost of producing the 4th chair, therefore, works out
as under:
MC4 = TC4 TC3 = Rs. 10,000 Rs. 8,000 = Rs. 2,000.
Marginal cost is the cost of producing an extra unit of output. In other words, marginal
cost may be defined as the change in total cost associated with a one unit change in
output. It is also an extra unit cost or incremental cost, as it measures the amount by
which total cost increases when output is expanded by one unit. It can also be calculated
by dividing the change in total cost by the one unit change in output.
Symbolically, thus, MC = 'TC / '1Q where, ' denote change in output assumed to
change by 1 unit only.
Therefore, output change is denoted by '
1.
It must be remembered that marginal cost is the cost of producing an additional unit of
output and not of average product. It indicates the change in total cost of producing an
additional unit.
3.13. RELATIONSHIP BETWEEN (AVERAGE COST) AC AND

(MARGINAL COST) MC
Economists have observed a unique relationship between the two as follows:
z
When AC is minimum, the MC is equal to AC. Thus, MC curve must intersect at the
minimum point of ATC curve.
When AC is falling, MC is also falling initially, after a point MC may start rising but AC
continues to fall. However AC is greater that MC (AC > MC). Hence ultimately at a
point both costs will be equal. Thus, when MC and AC are failing, MC curve lies below
the AC curve.
Once MC as equal to AC, then the output increases AC will start rising and MC
continues to rise further but now MC will be greater than AC. Therefore, when both the
costs are rising, MC curve will always lie above the AC curve.
The above stated relationship is easy to see through geometry of AC and MC curves, as
shown in following figure.
It can be seen that
46
Initially, both MC and AC curve are sloping downward; MC curve lies below AC.
When AC curve is rising, after the point of intersection, MC curve is above it.
It follow thus when MC is less than AC, it exerts a downward pull on the AC curve.
When MC us more than AC it exerts an upward pull on the AC curve. Consequently,
MC must equal AC, while AC is at the minimum. Hence, MC curve intersects at the
lowest point of AC curve. It may be recalled that MC curve also intersects the lowest
point of AVC curve. Thus, it is a significant mathematical property of MC curve that it
always cuts both the AVC and ATC curve at their minimum points.
In the following figure, the MC curve crosses the AC curve at point P. At this point, for OQ
level of output the average cost of PQ which is minimum.
NOTES
It should be noted that no such relationship can ever be traced between the MC curve and
the AFC curve simply because by definition, the MC curve is independent. Further, the
area underlying the MC curve is equal to the total variable cost of the given output. In fact,
the point on each average cost curve measures the average cost but the area underlying
them denote total costs as under:
z
Total, area underlying the AFC curve measures the total fixed cost.
The area underlying the AVC curve measures the total variable cost.
The area underlying the MC curve measures the total variable cost.
The area underlying the ATC curve measures the total cost.
Finally, the MC curve is important because it is the cost concept relevant to rational
decision making. It has greater significance in determining the equilibrium of the firm. In
fact, the increasing MC due to diminishing returns sets a limit to the expansion of a firm
during the period. Further, it is the MC curve which acts on the supply curve of the firm.
From the above discussion of cost behavior we may conclude that short run average cost
curves (AVS, ATC and MC curves) are U shaped, except then AFC curve, which is an
asymptotic and downward sloping curve.
3.14. LONG AND SHORT RUN COST CURVES

In the long run, all inputs (factors of production) are variable and firms can enter or exit any
industry or market. Consequently, a firms output and costs are unconstrained in the
sense that the firm can produce any output level it chooses by employing the needed
quantities of inputs (such as labor and capital) and incurring the total costs of producing
that output level.
The Long Run Average Cost (LRAC) curve of a firm shows the minimum or lowest average
total cost at which a firm can produce any given level of output in the long run (when all
inputs are variable).
47
In the long run, a firm will use the level of capital (or other inputs that are fixed in the short
run) that can produce a given level of output at the lowest possible average cost.
Consequently, the LRAC curve is the envelope of the short run average total cost (SR
ATC) curves, where each SR ATC curve is defined by a specific quantity of capital (or other
fixed input).
NOTES
In the short run, because at least one factor of production is fixed, output can be
increased only by adding more variable factors. Hence we consider both fixed and
variable costs. Fixed costs are business expenses that do not vary directly with the level
of output i.e. they are treated as independent of the level of production.
Examples of fixed costs include the rental costs of buildings; the costs of leasing or
purchasing capital equipment such as plant and machinery; the annual business rate
charged by local authorities; the costs of full-time contracted salaried staff; the costs of
meeting interest payments on loans; the depreciation of fixed capital (due solely to age)
and also the costs of business insurance.
48
Amity School of Distance Learni ng
Fixed costs are the overhead costs of a business. They are important in markets where
the fixed costs are high but the variable costs associated with making a small increase in
output are relatively low. We will come back to this when we consider economies of
scale.
z
Total fixed costs (TFC) remain constant as output increases,
Average fixed cost (AFC) = total fixed costs divided by output
NOTES
Average fixed costs must fall continuously as output increases because total fixed
costs are being spread over a higher level of production. In industries where the ratio of
fixed to variable costs is extremely high, there is great scope for a business to exploit
lower fixed costs per unit if it can produce at a big enough size. Consider the new Sony
portable play station. The fixed costs of developing the product are enormous, but these
costs can be divided by millions of individual units sold across the world. A change in fixed
costs has no effect on marginal costs. Marginal costs relate only to variable costs!
3.15. COST AND OUTPUT RELATIONSHIP (COST FUNCTION)

Cost- output functional relationship is expressed by the cost function. Thus:
C = f (Q),
Where,
C = total cost,
Q = output Quantity
The cost function of the firm gives the functional relationship between total cost and total
output. The same level of output can be produced with the help of different cost
combinations. The cost function gives the least cost combinations for the production of
different levels of output.
3.16. SHORT RUN AND LONG RUN

The short run is a period during which one of the factors of production is considered to be
constant (assuming that there are only two factors of production labour and capital) and
the other is variable. Usually it is assumed that capital is the fixed factor in the short run.
All costs are variable in the long run since factors of production, size of plant, machinery
and technology are all variable. This in turn implies radical changes in the cost structure
of the firm. The long run cost function is often referred to as the planning cost function
and the long run average cost (LAC) curve is known as the planning curve. As all cost are
variable, only the average cost curve is relevant to the firms decision-making process in
the long run. The long run consists of many short runs, e.g., a week consists of seven
days and a month consists of four weeks and so on. So, the long run cost curve is the
composite of many short run cost curves.
3.17. ECONOMIES / DIS-ECONOMIES OF SCALE

The LAC curve is the mirror image of the returns to the scale in the long run. It is apparent
that since returns to the scale are based on the internal economies and the diseconomies
of scale, the long run average cost curve traces these economies of scale. As a matter of
fact increasing returns to scale can be largely traced to the economies which become
available to a firm when it expands its scale of operations. As a result of these economies,
the firm enjoys a number of cost advantages and return in terms of total output. Thus,
economies of scale explain the falling segment of the LAC curve. This shows that the
49
decline average cost of output in the long run is due to economies of large scale enjoyed
by the firm. Increasing LAC is attributed to the diseconomies of scale after a certain point
of further expansion.
NOTES
In short economies and diseconomies of large scale play a significant role in determining
the shape of the LAC curve. Again the structure of an industry is also affected by the cost
consideration which is conditioned by the economies and diseconomies of scale. Of the
many determinants of the number and size of firms in an industry , the, cost consideration
and relevant economies and diseconomies are a significant determining factor.
Increasing average costs in the long run, attributed to the growing diseconomies of scale,
set a limit to the further expansion of the firm.
Economies and diseconomies of scale reflect upon the behavior of LAC curve. Analytically
speaking the downward slope of the LAC curve may be attributed to the internal economies
of scale. Similarly, the upward slope of the LAC curve is caused by the internal
diseconomies of scale. And the horizontal slope of the LAC curve may be explained in
terms of the balance between internal economies and diseconomies.
In short, the internal economies and diseconomies have their significance in determining
the shape of the LAC curve of a firm. However, the shift in the LAC curve may be attributed
to the external economies and diseconomies. External economies reflect in reducing the
overall cost function of the firm. Thus, a downward shift in the LAC may be caused by
external economies as shown in following Figure.
In above figure, ABCD is the LAC curve. Its AB portion the downward slope is subject
to the internal economies. Its BC portion the horizontal slope is due to the balance
between economies and diseconomies. Its CD portion the upward slope is subject to
internal diseconomies.
In following figure, the original LAC 1 curve shifts downward as LAC2 on account of external
economies.
50
NOTES
Similarly, an upward shift in the LAC curve may be attributed to the external diseconomies,
as shown in following figure.
In above figure, the original LAC 1 curve shifts up as LAC2 owning to the external
diseconomies.
3.18. THE THEORY OF FIRM (PROFIT MAXIMIZATION MODEL)

Economists have been using the model of profit maximization for a long time. The theory
of firm has been developed on the basis of the assumption that rational firms pursue the
objective of profit maximization, subject to the technical and market constraints. The
basic propositions of the theory of firm may be summed up as:
51
(a) Firm is a unit which transforms valued inputs into outputs of a higher value, given the
state of technology.
(b) The firm strives towards the achievement of its goal- usually profit maximization.
(c) The market conditions (like competition, monopoly, etc.) for a firm to operate are
given.
NOTES
(d) While choosing between alternatives, the firm prefers the alternative which helps it to
consistently achieve profit maximization.
(e) The primary concern of the theory of firm is to analyze changes in the price and
quantity of inputs and outputs.
Taking these as central points, the theory of firm has been carried to varying degrees of
elaboration and refinement. Before taking it up in detail, let us note the basic assumptions
on which this theory rests.
Assumptions of the Model:
1. The firm has a single goal , viz., to maximize profit( Motivational assumption)
2.
The firm acts rationally to pursue its goal. Rationality implies perfect knowledge of all
relevant variables at the time of decision-making.
3. The firm is a single ownership one, i.e; run by its owner, called the entrepreneur.
The Model: The term profit maximization is usually taken to mean the generation of
largest absolute amount of profits over the time period being analyzed. This then leads us
to defining the term time period. Economists have suggested two broad time period: the
short-run and long-run; consequently, there is short-run and long-run profit maximization.
The short run is defined as a period where adjustments to changed conditions are only
partial, e.g.; if defined for the product for a firm increases, in the short run it can meet the
increased demand through changes in man-hours and intensive use of existing machinery,
but it cannot increase its production capacity. On the other hand, long-run is a period
where adjustment to changed circumstances is complete. For example, the above
mentioned firm can meet the increased demand in the long-run by making changes in its
production capacity or by setting up an additional plant, besides changes in man-hours
and intensive use of its existing machinery. Thus, in the short-run there are certain
constraints (physical or financial) on expansion. As time passes, these constraints can
gradually be overcome. And, when all the constraints are overcome, the long-run is reached.
No calendar time can be specified for short-run or long-run. It depends upon the nature of
production. For example, a furniture workshop can increase its capacity and make complete
adjustments within a matter of months, while a firm manufacturing automobile may take
years to do so. The long-run will, therefore, be a matter of months in case of furniture
workshop and a matter of years for an automobile firm.
Relationship between Short-run and Long-run Profit Maximization: We know that
the long-run consists of a number of short-run periods. But, it implies that if the firm
maximizes profit in the short-run, it must be found to maximize in the long-run also. It
depends upon the two following conditions;
1.
Assumption of independence of periods. Is each short-run period considered in isolation, in the sense that a short-run period has no effect which link this period to the
next period?
2.
Assumption of period-linkages- Each short-run period is linked to the next short-run

period.
Under the assumption of independence of periods, the short-run and long-run profit
maximization is consistent. On the other hand, with the assumption of period-linkages,
52
the profit maximization in the two periods may conflict. For example, a firm which dominates
the market may decide to restrict supplies in order to change higher price to maximize
profits. This would, in the long-run, attract rival firms into the industry, thus forcing a
reduction in the price and profits of the dominant firm. Had the firm not attended to maximize
profits in the short-run the rival would not possible have been attracted to the industry,
thus allowing the dominant firm to achieve long-run profit maximization. Here the short-run
profit maximization policy results in the defeat of long-run profit maximization. Several
instances may be cited where a conflict between the profit maximization in the two periods
may exist, like:
NOTES
(a) Higher profits in the short-run may in the long-run induce workers to demand higher
wages.
(b) Maximization of profits in the short-run may give an impression of being exploitative,
thus inviting legal or government intervention which would affect long run profits adversely.
(c
A firm trying to build up its reputation by charging low prices and supplying quality
products in the short run would be able to make long run profits.
It may however be noted that the assumptions of independence of period are not found
tenable in practice. On the other hand the period linkage are considerably affected by the
condition of uncertainty since the dependence of one period on the other involves future
reactions, there remains an element of uncertainty. The extent of uncertainty increases
the further we go into the future. This perhaps is the reason why firm prefer short run profit
maximization to the long run. There is however a major problem if the firms prefer long run
rather than short run profit maximization. In such cases almost any decision can be
defended on the basis that it aims at long run profit maximization, e.g. extravagancy in
the reception facilities may be defended on the grounds of improving firms public image
which would contribute to long run profits.
Determination of profit maximizing output and price
The approach of the traditional economic theory is that the firm compares the cost and
revenue implication of different output levels and fix up the output level that maximizes the
absolute difference between the two. Let TR and TC be the total revenue and total cost at
a given level of output X .then profit () at that level of output would be,
=TR-TC
For to attain the maximum value, the firm shall produce that level of output where the
following two marginal conditions are satisfied:
53
which implies that the slope of MR curve is less than the slope of MC curve.
An output level (X) which satisfies both the above conditions would be the profit-maximizing
level of output.
NOTES
Since profit () is the difference between total revenue (TR) and total cost (TC), the profitmaximizing output will occur when the gap between TR and TC is maximum. In Fig. 3.1,
TR and TC curves represent the total cost and total revenue for different output levels. The
gap between TR and TC is maximum at output Oq* where the slopes of the two curves are
equal. Since slopes of total cost and total revenue curves are marginal cost (MC) and
marginal revenue (MR) respectively, it implies that profit is maximized at that output level
where MR=MC.
Limitations: The traditional theory suggests a number of reasons as to why do a firm
want to maximize profits. All these reasons essentially fall into the following categories:
1.
Traditional economic theory assumes that the firm is owner-managed, and therefore
maximizing profit would imply maximizing the income of the owner. Owner would like
to have adequate return for his activity as an entrepreneur. Maximizing-profits for a
given amount of effort will, therefore, be quite a rational behavior for him.
2.
The very survival of the firm depends upon the entrepreneurs ability to maximize
profits in the long run. The goal of profit maximization is, in fact, forced upon him by
the impact of the competing firms. By maximizing profits the firm can accumulate
financial assets which allow it to grow faster than those firms which pursue goals
other than profit maximization share of the latter gradually shrinks and such firms
eventually get eliminated. In case of monopoly situation, where there are no rivals to
force him to maximize profits, he would like to pursue this goal to achieve the maximum return for his efforts.
3. Firm may pursue goals other than profit-maximization, but they can achieve these
subsidiary goals much easier if they aim for profit-maximization.
These justifications of profit-maximization have been subjected to severe criticism and
certain alternative goals have been suggested by economists. Some of the main points of
criticism are the following:
1.
54
In the context of real business situation the assumption of profit-maximization is of

doubtful validity. There is no reason to believe that all businessmen pursue the same
goal. They may aim at sales maximization, expansion of market share, etc.
2.
The assumption of traditional theory that firms are owner-managed is not valid in the
modern business world where firm is a complex organization run by salaried managers whose interests may, and often do, differ from those of the shareholders who want
maximum profits.
3.
In the absence of usually incomplete information all the business decisions may not
be optimal. This lack of information may be of two types: a) Since business decisions
always, directly or indirectly, relate to the future, and since future is always uncertain,
the businessmans decisions may not always be what he wants them to be. b) Further, the lack of information also results from the failure or inability of the firm to
collect the adequate information and to use the information it already possesses.
Former results due to expensiveness of collection of information, and the latter due to
the difference in what the business firm collects and what it actually needs.
4.
The modern business firm divides itself into separate departments, each having a
considerable degree of autonomy in its operations. Under these conditions it is not
possible for those at the top of the firm to ensure that decisions taken in particular
departments or functions fit in with the overall policy of the firm and whether these
decisions lead to the overall optima for the whole firm. It will be more appropriate to
say that given the organization of the modern firm and its problems, firms are often
too complex for any individual or group to be able to see them as a whole.
5.
One cannot say that in non-competitive situations the firms that do not maximize
profits will be driven out of business; and that, under such a situation a profit-earning
firm need not quickly adjust to changes in the economic environment. It is also not
true that these adjustments will be done in the direction which economic theory has
predicted. For example, if there is a large group of firms, demand for whose products
remains at a very high level for a long period of time, any firm in this group, however
inefficient, will be able to survive. It has been found that where profits are easy to
come the keen quest for profits will be abandoned in many cases. Such a situation
was there in advanced countries during the long period of inflation and full employment after World War II. Further, the firms might enter into open or tacit agreement to
avoid some kinds of competition, especially price competition. These agreement are
found quite often in markets like those for automobiles, aircrafts, detergents and
chemicals. Thus, while the assumption of profit maximization has served economics
well for many years, it is clear that it needs supplementing by other assumptions.
6.
It has been observed in the modern business world that the emerging dominant market structure is oligopoly, where a few large firms dominate the market. The small
firms often have to follow these large firms in fixing the price. Under such circumstances how can these small firms (which are generally in majority) are expected to
pursue the goal of profit-maximizations?
7.
Lack of predictive power of managers, and they generally being risk-averse, results in
firms settling with less-than-maximum profit as their goal. Firms are prevented to
maximize profits also because they generally suffer from lack of proper intra-firm
communication.
NOTES
Literature criticizing profit-maximization hypothesis is extensive and much of it is of

considerable economic and philosophical subtlety. However, the attack on profit-maximizing
hypothesis is threefold:
a) Firms cannot have profit maximization as their goal as they lack the necessary information and ability to do so.
b) Even if the firms could, they do not want to pursue profit-maximizations. There are
multiplicity of goals a modern firm pursues and profit-maximizations may be only one
of them; and,
55
c)
Firms do not maximize profits but face some bind of minimum profit constraint. The
management has discretion in setting goals subject to minimum profit constraint.
Some alternatives suggested

Economists have suggested the following alternatives to the goal of profit-maximization:
NOTES
1.
Papandreou argues that organizational objectives grow out of interaction among the
various participants in the organization.
2.
Baumol argues that firms seek to maximize sales (i.e., total revenue) subject to a
profit constraint.
3.
Rothschild suggests that the primary motive of enterprise is long-run survival. Decisions, therefore, aim to maximize the security of the organization. Feller has similarly
argued that firms are interested in safety margins.
4.
Scitovsky argues that the entrepreneur chooses between greater profit and more
leisure.
5.
Cooper suggests that businesses (mainly banks) attempt to maintain liquidity sufficient to assure the firms financial position and retention of control.
6.
The other objectives suggested include the maintenance of the firms share of the
market, payment of good wages and the welfare of employees, growth of firm, excellence of a product, and the maintenance of good public relations.
These alternatives emphasize goals other than profits, though most of them do not exclude
profit as a constraint within which firms pursue these goals. Some empirical studies point
out that firms have a profit goal but that they do not attempt to maximize profits. But in
defense of the goal of profit maximization, one may say that from the array of alternative
goals suggested to dispense with the profit motive, no single goal has gained wide
acceptance. It would be more appropriate to say that these alternative goals are not so
much intended to replace the profit maximization hypothesis as to deny its primary
importance. Business goals are probably multiple. Moreover, though profits enter into the
calculations of every business, it is more difficult to sustain the views that firms do maximize
profits. In a complex environment, where information is lacking and uncertainties prevail
maximization of profits is generally unattainable.
It may, therefore, be safe to conclude that there is no universally acceptable objective for
business policy and, therefore, it is impossible to point out a single, simple, obvious
criterion of business efficiency. Each business must define its own objectives, which may
have to satisfy the needs of those groups whose co-operation makes the continued
existence of business possible; the shareholders, management, employees and
customers. Businesses have multiple goals and the needs of survival, goodwill, security
or growth commonly call for some sacrifice of short-term profits. In short, though profit is
not the only goal of the business, it is an extremely important one.
3.19. BREAK-EVEN AND SHUT-DOWN POINT

Breakeven point is the point where total cost just equals to the total revenue; it is the no
profit no loss point. It is an important application of cost analysis. It examines the relation
between total revenue, total cost and total profits of a firm at different levels of output. This
analysis is about determining profit at various projected levels of sales, identifying the
breakeven point, and making a managerial decision regarding the relationship between
likely sales and the breakeven point. Break-even analysis is used synonymously with
Cost Volume Profit Analysis, though many are of opinion that finding the breakeven point
is just the first step in any planning decision. There are several approaches of breakeven
56
analysis, but here we would explain graphical method only. Total revenue and total cost
measured in the vertical axis and output is measured in the horizontal axis. Here, total
cost (TC) is total fixed cost (TFC) plus total variable cost (TVC); i.e., TC = TFC +TVC.
Total revenue (TR) is 45o line, which starts from origin, where output (Q) is zero and TR is
also zero. In the following figure, at point E, the total revenue is equal to total cost, i.e.,
TR=TC, that means no loss no profit case. In this case, the total output is OQe units. So,
the breakeven point is E and Breakeven amount of output is OQe units.
NOTES
The fixed cost is that cost which is occurs irrespective of output, which means the firm
has to bear this TFC even when the production is stopped. To get normal profit or zero
profit, the firm has to cover TC (TFC + TVC). But if the firm is not able to cover this TC then
also the firm will continue to produce up to the level where the loss amount is equal to
TFC. Because, the firm is identical in both the cases, i.e., if stopped production then the
maximum amount of loss is TFC or if they produce then also they can bear the same
amount of loss (equal to TFC). So, in the following figure, the shut-down point is S and
shut-down output is OQs.
3.20. MANAGERIAL THEORIES OF THE FIRM

The main argument of managerial theories is that in modern large firms, ownership and
control are divorced. Managers, therefore, have a primary role in the effective control of the
firm. The firm, then, seems to behave so as to maximize managerial objectives rather
than shareholders profits. Like the traditional theory of firm the managerial theories are
also optimizing theories, though what is maximized differs: in the theory of firm it is the
profit maximization, while in the managerial theories it is the maximization of managerial
utility. Different managerial theories of the firm view managerial utility as a function of
different combinations of variable like, salary, status, power, growth and job security.
Managerial theories may be broadly classified into three categories:
1. Sales Revenue Maximization Model by Baumol,
2. Managerial Utility Models, and
3. Growth Maximization Models.
57
3.21. BAUMOLS MODEL

Baumol pointed out that the oligopolistic firms aim is to maximize their sales revenue not
profit maximization. According to him, the reasons behind this are as follows:
z
NOTES
z
Financial institutions judge the health of a firm largely in terms of the rate of growth of
its sales revenue.
Salaries of top management are correlated more closely to the firms sales than with
its profits.
Growing sales help in keeping a healthy personnel policy, thus keeping employees
happy by giving them higher salaries and better terms.
Managers prefer the steady performance with satisfactory profits than spectacular
profit-maximization projects. This is so because if the managers declare their aim as
spectacular profit maximization but, for obvious reasons, cannot give the spectacular
profit year after year, they shall be penalized for the non-achievement of the goal.
Large and growing sales by maintaining or increasing the market share of the firm
increases the competitive power of the firm.
Assumptions: The firms while pursuing the goal of sales maximization cannot completely
ignore the shareholders. The goal of the firm is, thus, the maximization of sales revenue
subject to a minimum profit constraint. The profit constraint is determined by the expectation
of the shareholders and to enable it to raise new capital at a future date. The assumptions
are follows.
1. Goal of the firm is sales maximization subject to minimum profit constraint.
2.
Advertisement is a major instrument of the firm as non-price competition is the typical

form of competition in oligopolistic markets.
3. Production costs are independent of advertisement.

4. Advertisement will always result in creating favourable conditions for the product.
5. Price of the product is assumed as constant.
The Single-Period model: According to Baumol, it is only after the profit constraint has
been satisfied that profits became subordinate to sales in the firms hierarchy of goals. In
the following figure, the profit constraint is shown by a line . Obviously, sales maximiser
will keep on selling till the MR remains positive. So, the sales maximisers level of output
would be OQ1 where MR (dTR / dQ) equal to zero. If the minimum profit constraint (0 ) is
above the level of profits where MR=0 (at point K1), the sales revenue maximiser is
constraint to stop at OQ3 output where minimum profit constraint 0 is met. On the other
hand, if minimum profit constraint is (which is less than the profits where MR=0) then
the sales revenue maximiser will face no profit constraint and would, therefore, produce
OQ1 output. Thus, if the minimum profit constraint is less than the maximum profit, the
sales maximiser will produce a greater output than the profit maximiser.
58
TC
NOTES
Implications of Baumols Model: If both the profit maximiser and a constrained sales
maximiser face the same demand curve, the later will charge a lower price to sell the
extra output (Q3 Q1 ). A sales maximiser will spend more on advertisement than does a
profit-maximiser firm. Baumol assumes that advertisement does not affect the products
price but it does lead to increased output sold. It is also assumed that advertisement will
always lead to a rise in TR; MR will never become negative. This is shown in the following
figure. Since, advertisement will always increase TC; the management will increase
advertisement until prevented by the profit constraint (0 ).
59
3.22. MARRIS MODEL
NOTES
Marris tried to improve upon Baumols model. He offered a variation of Baumols model
that stressed the maximization of growth subject to the security of managements position.
Marris hypothesis is that executive actions are limited by the need for management to
protect itself from dismissal or takeover raids in the event of failure. Like Williamson,
Marris approach is also based on the fact that ownership and control of the firm is in the
hands of two different sets of people. He, like Williamson, also suggested that manager
have a utility function in which salary, status, power, prestige and security are important
variables. Owners of the firm (i.e.; shareholders) are, however, more concerned about
profits, market share, output etc. In other words, goals of the managers and shareholders
differ from each other. The utility function of managers (Um) and that of the owners (Uo)
may, therefore, be defined as:
Um = f (salaries, power, status, job security)
And, Uo = f (profits, market share, output, capital, public esteem).
In contrast to Williamson, Robin Marris believes that most of the variables entering into
the utility function of managers and owners are strongly correlated with a single variable:
the size of the firm. He, therefore, postulates that the managers would be mainly concerned
about the rate of the growth of size. However, various measures of size exist, like capital,
output, revenue, and market share. Marris defines size in terms of corporate capital,
which is measured as the sum total of the book value of assets, inventory and short-term
assets including cash revenue. Further, it may be noted that managers aim to maximize
rate of growth of size rather than absolute size, as the managers generally wish to stay in
the concern and grow rather than move from a smaller size firm to a bigger size firm.
Moreover, maximizing the rate of growth of size also satisfies the owners, while absolute
size may not. Thus, the attraction of the growth rate of size stems from the fact that not
only it has a positive effect upon the prospects of promotion of the managers, but it also
keeps the shareholders satisfied.
Marris recognizes that the drive for the rate of growth of size is not, however, without
constraints. He lists mainly two constraints to the achievement of maximization of the
rate of growth:
(a) Marris adopts Penroses thesis of the existence of a sure limit on the rate of managerial expansion. In other words, the capacity of the managerial team in fact determines
the upper limits to the growth of the firm. There is a high possibility that management
would lose control over a rapidly growing firm. There is a limit to output increase by
hiring new managers due to their lack of experience. And the time-lag involved in their
acquiring the specific corporate culture and developing coordination with the existing
managerial team. The ability of manager to find and successfully launch new products to take the place of old ones is also subject to a limit. Similarly, the research and
development department cannot be expected to produce expanding flow of products
continuously. All these factors are strong enough to set a limit to the rate of growth of
size of the firm.
(b) The second constraint on the rate of the growth stems from the voluntary slowing
down process by the management itself. This slowing down process comes from the
desire of the management for job-security. The management which holds high the
consideration of job security would grow in such a way that it remains safe on the
financial side. For example, in case management aims to achieve growth at any cost,
it should not hesitate to borrow large sum of money from the capital market for investment purpose. But increased rate of borrowing may give out an impression of follow-
60
ing a less prudent financial policy, thus inviting take-over bid by another firm. This
would definitely be real danger to the job-secure motivation of the managers. Obviously, there is definite disutility of risk and the managers would like to seek the job
security through the adoption of a cautious and prudent financial policy which would
consist of: non-involvement in risky investments; financing growth mainly from the
profit levels being generated by the present set of products. The ratio of external to
internal finance is not allowed to grow significantly.
NOTES
To judge the prudent of a financial policy, Marris proposes the concept of financial constraint
(a) which is mainly determined by the risk attitude of the top management. A risk-loving
management would prefer a high value of a, while a risk-averting management would
prefer a low value of a. Marris defines a as the weighted average of the following three
security ratios:
Liquidity Ratio (a1) = Liquid Assets/Total Assets;
Leverage Ratio (a2) = Value of Debts/Total Assets;
Profit-Retention Ratio (a 3) = Retained Profits/Total Profits.
Low liquidity ratio implies the possibility of insolvency of the firm. High liquidity, of course
increases the security, but a too high liquidity ratio has an adverse impact on rate of
growth. To ensure security the management has, therefore to choose a level of a1 which is
neither too high nor too low. The leverage ratio relates to the extent of reliance on borrowing
for expansion purposes. A high and growing leverage ratio would invite takeover bids and
increase the rate of failure, while a too low leverage ratio would retard growth. Retained
profits are perhaps the most important financial source for the growth of capital. But, a
high level of retained profits is perhaps the most important financial source for the growth
of the capital. But a high level of retained profits cannot keep the shareholders happy and
a too high a3 would mean that management is taking a risk of displeasing the shareholders.
As is obvious from the discussion above, value of the financial constraint (a) would increase
if either a2 or a3 are increased or a1 is reduced. That is, liquidity ratio and profit-retention
ratio are positively related. Marris further postulates that there is a negative relationship
between job-security and the financial constraint: job security of managers is reduced if a
is increased and job security increases if a is reduced. Thus, financial security constraint
determines the level of job security and therefore limits the rate of growth of the capital
supply and thereby the rate of growth of size of firm.
Model: Merris argues that the managers would aim to have a balanced growth, in the
sense that growth in demand (stemming mainly from new products) would be matched by
growth in capital (making available the investible funds for launching and producing these
products). That is, the managers would want to maximize balance growth rate (g), which
is equal to the growth rate of demand for the product (gd) and growth rate of capital supply
(gc):
Max. g = gd= gc
By this process the managers achieve maximization of their own utility as well as that of
the shareholders. In case the management wants to expand too rapidly (by undertaking
highly risky projects, resorting to heavy borrowing for expansion, etc.), it runs the risk of
job security. On the other hand, if it wants to expand too slowly (due to lack of initiative
in finding new market and products, keeping excessive reserves by high profit-retention
ratio but shying away from new investment projects), it would be considered as an inefficient
management, again impairing job-security.
The first step to achieve balanced growth rate would be to identify the factors that go in to
determining gd and gc. According to Marris, these determinants can be expressed in
terms of two variables:
61
1. Diversification rate(d);
2. Average profit margin (m).
NOTES
Both these variables can be however determined only after the management has decided
about its financial policy, a. The diversification rate can be chosen either by changes in
style of the existing products or by expanding the range of products. Given the price of the
product and the production cost, the average profit margin would be affected by the levels
of advertising and R&D. Higher the expenditure on advertisement (A) as well as R&D,
lower would be average profit margin (m). Thus, the Marris firm has three policy variables:
a, d and m.
Marris also points out that there can be a conflict between managers objective of
maximizing growth and stockholders objective of maximizing profits. Therefore, if the
growth maximizing solution does not generate sufficient profits, growth rate will have to be
reduced to increase dividend to meet shareholders expectations.
In brief in Marris model the management, whose actions are limited by the motivation to
protect itself from dismissal or take over bids, takes to the following course:
1.
The management must walk on a knife-edge between debt/assets ratio high enough
to stimulate growth but not low enough to suggest financial imprudence.
2.
The management must also maintain a low liquidity ratio, i.e; liquid asset/total assets. But this ratio must not be so low that it endangers paying all obligations on
time.
3.
The management must try to keep a high retention ratio, viz., retained earnings/total
profits. But this ratio should not be so high that shareholders are not paid satisfactory
dividend.
3.23. SUMMARY
The theory of cost is a fundamental concern of . The best measure of resource cost is the
value of that resource in its highest-valued alternative use. The cost of a long-lived asset
during the production period is the difference in the value of that asset between the
beginning and end of the period. The cost function relates cost to specify rates of
output. The basis for the cost function is the production function and the price of the
inputs. In the short run, the rate of one input is fixed. The cost associated with that
input is called fixed cost. In the long run, all costs are variable. The long-run average cost
curve is the envelope of a series of short run average cost curves. The long run cost
functions are used for planning the optimal scale of plant size.
Check Your Progress

1. If a change in all inputs leads to a proportional change in the output, it is a case of
(a) Increasing returns to scale,
(b)
Increasing returns to scale,
(c) Diminishing returns to scale,
(d)
Variable returns to scale
(a) Equal cost lines,
(b)
Equal product lines,
(c) Equal revenue lines,
(d)
Equal total utility lines
2. Isoquants are
62
3. When average product is highest

(a) Total product is maximum,
(b)
Total product is maximum,
(c) Marginal product is zero,

(d) Marginal product is equal to average product
NOTES
4. If marginal product is negative, it means that the

(a) Total product is at maximum,
(b)
Average product is at maximum,
(c) Average product is falling,
(d)
Total product is increasing
5. Which of the following curves is called envelope curve?

(a) Long run total cost curve,
(b)
Long run average total cost curve,
(c) Long run marginal cost curve,
(d)
Long run average variable cost curve

1. Explain the concept of Production Function with the help of a two-input and oneoutput case.
2. What is the law of diminishing return as applied to any production system?
3. Define returns to scale. What is the significance of increasing, decreasing and constant returns to scale?
4. What are Isoquants? Describe the characteristics of Isoquants.
5. What is Isocost Line? How do they help in finding the least cost combination of
inputs?
6.
Define and explain expansion path.
7.
The various possible combinations of two inputs, labour and capital, which can produce 100 units of output are given as below:
L
20
15
12
10
If the prevailing prices of labour and capital are Rs. 15 per unit and Rs. 12 per unit, find
out the least cost combination of these inputs.
8.
The behaviour of costs is determined by several factors. Comment.
9. Explain the short-run cost-output relationship with the help of a hypothetical example.
How do the different costs behave with the changes in output?
10. Long-run cost-output relationship is an envelope of the family of short-run cost curves.
Give your comment.
11. Explain economies and diseconomies of scale. Are these short-run and long-run
phenomena?
12. Discuss in details the factors that cause economies and diseconomies of scale.
1. What is production?
2. What are factors of production?
3. What are the difference between short run and long run?
63
4. What are the inputs and outputs?

5. What is cost?
6. How do we define total, average and marginal product of labour?
7. What is Marginal Rate of Technical Substitution (MRTS)?
NOTES
8. What is Law of Variable Proportion?

9. What are economies of scale?
10. What are the basic features of profit maximization model?
11. Why long run average cost curve is the envelope of short run average cost curves?
12. Why marginal cost curve passes through the minimum point of average cost curve?
Further Readings
z
Mankiw,

z

Hall of India

z
64
UNIT 4 MARKET STRUCTURE

ANALYSIS
STRUCTURE
Market Structure Analysis
NOTES
4.1. Objectives
4.2.
Introduction: - Perfect Competition

4.2.1.
Assumptions of perfect competition:
4.2.2.
Short Run Equilibrium
4.2.3.
Long Run Equilibrium
4.3. Monopoly: Price Discrimination

4.3.1.
Monopoly
4.3.2.
Price and Quantity Determination in Short Run

4.3.3.
Price and Quantity Determination in Long Run
4.3.4.
Price Discrimination
4.4. Monopolistic Competition

4.5. Oligopoly-Mutual Interdependence
4.5.1.
Non-collusive Oligopoly
4.5.2.
Sweezys Model of Kinked Demand Curve
4.5.3.
Collusive Oligopoly
4.5.4.
Price Leadership
4.6. Prisoners Dilemma

4.7. Summary
4.1. OBJECTIVES
The objective of this chapter is to define and application of market structure. The chapter
also focuses on the Perfect Competition, Assumptions of perfect competiton, Short Run
and Long Run Equilibrium, Monopoly, Price Discrimination, Price and Quantity Dtermination
in short Run, Supernormal Profit, Normal Profit, Subnormal Profit or Loss, Price and
Quantity Determination in Long Run, Price Discrimination, Monopolistic Competition,
Oligopoly, Mutual Interdependence, Non-collusive Oligopoly, Sweezys Model of Kinked
Demand Curve, Collusive Oloigopoly, Price Leadershuip, Prisoners Dilemma. Graphs are
used consistently for understanding the subject matter easily.
Key Terms
Perfect Competition, Assumptions, Short Run and Long Run Equilibrium, Monopoly, Price
Discrimination, Price and Quantity Determination in Short Run, Supernormal Profit, Normal
65
Profit, Subnormal Profit or Loss, Price and Quantity Determination in Long Run, Price
Discrimination, Monopolistic Competition, Oligopoly, Mutual Interdependenc, Non-Collusive
Oligoply, Sweezys Model of Kinked Demand Curve, Collusive Oligopoly, Price Leadership,
Prisoners Dilemma.
NOTES
4.2. INTRODUCTION: PERFECT COMPETITION

Perfect competition is a market structure characterized by a complete absence of rivalry
among the individual firms. Thus perfect competition in economic theory has a meaning
diametrically opposite to the everyday use of this term. In practice businessmen use the
word competition as synonymous to rivalry. In theory perfect competition implies no rivalry
among firms.
4.2.1. Assumptions of perfect competition:

Large number of sellers and buyers: the industry or market includes a large numbers
firms (and buyers), so that each individual firm, however large, supplies only a small part
of the total quantity offered in the market. The buyers are also numerous so that no
monopsonistic can affect the working of the market. Under these conditions each fund
alone cannot affect the price in the market by changing its output.
Product homogeneity:
The industry is defined as a group of firms producing a homogenous product. The technical
characteristics of the product as well as the services associated with its sale and delivery
are identical. There is no way in which a buyer could differentiate among the products of
different firms. If the products were differentiated the firm would have some discretion in
setting its price. This is ruled out ex hypothesis in perfect competition. The assumption of
large number of sellers and of product homogeneity imply that the individual firm in pure
competition is a price taker, its demand card is infinitely elastic, indicating that the firm
can sell any amount of output at the prevailing market price. The demand card of the
individual firm is also its average revenue and its marginal revenue carves.
66
Free entry and free exit of the firm:
There is no barrier to entry or exit from the industry. Entry or exit may take time but the
firms have freedom of movement in and out of the industry.
Profit maximization:
The only goal of all firms is profit maximization.
NOTES
No government regulation:
There is no government intervention in the market. Here the firm is a price-taker and have
and infinitely elastic demand curve.
The market structure in which the above assumptions are fulfilled is called pure competition,
which is different from perfect competition. Perfect competition requires two more
assumptions.
Perfect mobility of factors of production:

The factors of production are free to move from one firm to another in the market. It is also
assumed that workers can move between different jobs which imply that skills can be
learned easily. The raw materials and other factors are not monopolized and labor is not
unionized.
Perfect knowledge:
It is assumed that all sellers and buyers have complete knowledge of the conditions of
market. This knowledge refers not only to the prevailing conditions in the current period
but in all future periods as well. Information is free and costless. In this market situation
uncertainty about future developments in the market is ruled out.
4.2.2. Short Run Equilibrium

In the short run, individual firm under perfect competition may either earn supernormal
profit or normal profit or can incur losses. This depends on the short run cost curves.
These three possibilities are shown by the three short run equilibrium of a firm.
Supernormal profit: In the short run a perfectly competitive firm can earn supernormal
profits which means revenue more than cost. The average cost (AC) and marginal cost
(MC) curves are the usual short run cost curves. As the firm maximizes profits at the point
where MR = MC and also where MC cuts MR from below, the point of equilibrium of the
firm in figure is at point E, output at this price is OQ* and equilibrium price is P*. The total
revenue earned by the firm is given by the rectangular area OP* EQ*. to produce this
output, the total cost incurred by the firm is given by the rectangular area OABQ*. Therefore,
profit earned by the firm is given by the rectangular region AP*EB. This is the supernormal
profit earned by the firm in the short run, because the market price is greater than the
average cost.
67
NOTES
Normal profit: In the short run, it is not possible to earn supernormal profit by all the
firms, some of them may also earn normal profits, which means revenue is equal to cost.
Like pervious case, the equilibrium of the firm is shown as E in the figure, the output that
maximizes is OQ*. The total revenue earn by the firm is the rectangular area OP* EQ*,
which is also the total cost of producing the equilibrium output OQ*. Therefore, in this
case, the firm makes normal profit which means no profits. This is possible because the
average cost curve is tangent to the average revenue line.
Loss or Subnormal profit: Here also the equilibrium point E determines the equilibrium
level of output OQ* and price OP*. The total revenue is given by rectangular area OP* EQ*
and total cost is the rectangular OABQ*, which is more than the total revenue by the
amount is equivalent to the rectangular area P*ABE. This extra amount of cost incurred
by the firm is called loss or profit, which occurs in the short run because the average cost
is more than the market price.
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NOTES
4.2.3. Long Run Equilibrium

In the long run perfectly competitive firms earn only normal profits. This is due to the
unrestricted entry into and exit of firms from the industry in the long run. Let us explain
this with two extreme possibilities: first, when existing firms enjoy supernormal profits in
the short run, and next, when the existing firms incur losses in the short run. If some of
the existing firms earn supernormal profit, this attracts new firms to the industry to share
the profits. With the entry of new firms, the supply of goods increases in the market.
Assuming no change in the demand side, this extra supply of the good lowers the price of
the good. This process of adjustment continues till the price becomes equal to the long
run average cost. Due to this, supernormal profit of the existing firms is squeezed until all
the firms in the industry earn normal profit.
Alternatively, if the firms are making losses in the short run, then they may not be able to
sustain for long time and as a result they will exit from the industry. After this exit, the
supply of the product in the industry reduces and as a result the equilibrium price in the
industry rises. This process of adjustment continues up to the point where the marginal
firms no longer earn losses. Thus perfectly competitive firms earn only normal profit in the
long run where P= MC=MR=LAC = AR.
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4.3. MONOPOLY PRICE DISCRIMINATION

4.3.1. Monopoly:
NOTES
Monopoly is a market in which a single seller sells a product or service which has no
substitute. Economists distinguished between pure monopoly and monopoly. Pure
monopoly is that market situation in which there is absolutely no substitute of the product,
and the entire market is under control of a single firm. A monopoly exist if there is no close
substitute to the product and also when there is a single producer and seller of the
product, like Indian Railways, but it has a very remote substitute in the market, like Buss
services, Flights etc.
The features of monopoly are Single Seller, Single Product, No Difference between Firm
and Industry, Independent Decision Making of the Firm and Restricted Entry.
The monopolist can not set both the price and quantity at its own will. A monopolist firm is
able to independently determine an optimal combination of price and quantity, and has a
normal demand curve with a negative slope. The reason behind the negative slope is that
although a monopoly firm is in total control of the market price, but it can sell more only
when it reduces the price of its product. Here both the MR and AR curves are downward
sloping. The reason is that, a monopoly firm faces a normal demand curve which is highly
inelastic, therefore AR curve would be downward sloping and the MR curve would lie below
the AR curve. This is because of fact that the monopolist has to lower the price of all units
of products for selling an additional unit.
4.3.2. Price and Quantity Determination in Short Run

A monopolist firm will be in equilibrium where MR = MC and MC is rising. Like perfectly
competitive firms, monopolist firm also may earn supernormal profit or normal profit or
subnormal profit (loss) in the short run.
In the above diagram, a monopolist firm is in equilibrium at point E where MR equal to

MC and MC is rising. In equilibrium, the firm sells OQ amount of output at price OP, so
the total revenue is equal to the area OPCQ. The total cost is the area OABQ and
70
the total profit (supernormal) is the difference of total revenue and total cost, i.e. the area
APCB.

In the diagram given below, a monopolist firm is in equilibrium at point E where MR equal
to MC and Mc is rising. In equilibrium, the firm sells OQ amount of output at price OP, so
the total revenue is equal to the area OPCQ, which is also the total cost of the firm and the
total profit (normal) is the difference of total revenue and total cost, i.e. here nil or zero.
NOTES
In the above diagram, a monopolist firm is in equilibrium at point E where MR equal to MC

and MC is rising. In equilibrium, the firm sells OQ amount of output at price OP, so the
total revenue is equal to the area OPCQ. The total cost is the area OABQ which is greater
than the total revenue, so the total loss (subnormal) is the difference of total cost and total
revenue, i.e. the area PABC.
71
4.3.3. Price and Quantity Determination in Long Run
NOTES
In the long run, a monopolist firm has full control of the market price, so the firm would not
continue to incur loss. It would instead try to reduce its cost of production by increasing
control of raw materials etc., else it would it would close down in the long run. Therefore,
the monopolist firm would try to earn at least normal profit in the long run and may earn
supernormal profit due to entry restrictions in the market. So, a monopolist firm would
either earn normal or supernormal profit, but would not incur loss in the long run.
4.3.4. Price Discrimination

Price discrimination is the practice of discriminating among buyers on the basis of the
price charged for the same good or service. Market imperfection and control are prerequisite
for price discrimination. The monopoly market structure is the ideal market condition for
price discrimination. There are three situations where price discrimination is possible: i)
discrimination owing to consumers peculiarities, ii) discrimination owing to nature of the
good, iii) discrimination owing to the distance and frontier barriers. There are many forms
of price discrimination, but mainly three types or degrees of discrimination and they are
First-degree, Second-degree and Third-degree discrimination. The first-degree price
discrimination involves charging the maximum price possible for each unit of output. Thus
the consumer who attaches the greatest value to the product is identified and charged a
price of P1. Similarly, the consumers are willing to pay P 2 for second unit and P3 for third
unit. Here, the MR curve coincides with the demand curve and the profit maximizing
output is where MC and the demand curve intersect, i.e., at point B.
Second-degree price discrimination involves pricing based on the quantities of output

purchased by individual consumers. In the following diagram, the first Q1 units sold at P1
price and the next (Q 2-Q 1) units sold at P 2 price etc.
72
Third-degree price discrimination is the most common form of price discrimination. It

involves separating consumers or markets in terms of their price elasticity of demand.
This segmentation can be based on several factors. Often third degree price discrimination
occurs in the markets that are geographically separated. Let us consider an example. It
is often seen that books of US publication are sold in other countries at a lower price
compared to US evidently; buyers in other countries have greater elasticity of demand
than do US buyers. At the same time, cost of collecting and shipping books make it
unprofitable for other firms to buy in foreign countries and resell in the United States.
NOTES
Discrimination can also be based on the nature of use. Telephone customers are classified
as either residential or business customers. The monthly charge for a phone located in a
business usually is somewhat higher than for a telephone used in a home.
Finally, markets can be segmented based on personal characteristics of consumers. Age
is a common basis for price discrimination. For example, most movie theatres charge for
adults, though the cost of providing service to the two groups in the same.
4.4. MONOPOLISTIC COMPETITION

Monopolistic competition is a market structure quite similar to perfect competition in that
vigorous price competition among a large number of firms and individuals is present. The
major difference between these two market structures is that at least some degree of
product differentiation is present in monopolistically competitive markets. As a result,
firms have at least some discretion in setting prices. However, the presence of many
close substitutes limits the price-setting ability of individual firms, and drives profits down
to a normal rate of return in the long-run. As in the case of perfect competition, abovenormal profits are only possible in the short-run before rivals are able to take effective
counter measures.
Examples of monopolistically competitive market structures include a broad range of
industries producing clothing, consumer financial services, professional services,
restaurants, and so on. The conditions which prevail in a monopolistic competitive market
can be summarized as follows:
1.
There are relatively large numbers of firms, each satisfying a small, but not microscopic, share of the market demand for similar, but not identical, products.
2.
The product of each firm is not a perfect substitute for the products of product group
represents several closely related, but not identical, products that serve the same
general purpose for consumers. The sellers in each product group can be considered
competing firms within the industry.
3.
The firms in the market do not consider the reactions of their rivals when choosing
their product prices or annual sales targets.
4.
Relative freedom of entry and exit of firms exist in monopolistically competitive markets.
5.
Neither the opportunity nor the incentive exists for the firms in the market to cooperate in ways that decrease competition.
Equilibrium
A firm in this market has limited control over the prices of their products. Generally, the
consumers prefer the products of specific sellers and are ready to pay more, but within
specific limit, to satisfy their preferences. The condition for the equilibrium of a firm is that
it maximizes profit and the group or industry will be in equilibrium when each firm within
73
the group is in equilibrium earning normal profits and there is no tendency to enter into or
exit from the group.
NOTES
Let us first consider the equilibrium of a single firm. A single firm may be regarded as a
monopolist. Its equilibrium condition can, therefore, be determined by the same way as in
case of a monopolist. Its AR (same as the demand curve) curve is downward sloping and
the MR curve lies below the AR curve. The firm will be in equilibrium where MR=MC to
maximize profits. At the equilibrium point, the firm may be earning normal profits or more
than normal profits or less than normal profits as it happens in the case of a monopolist.
In the above figure, let AR1 and MR1 be the AR and the MR curves of the first firm and
MC1 be the MC curve of the firm. The equilibrium level of output is OQ1 and the equilibrium
price level is OP1. The firm maximizes total profits. But under group equilibrium, the
equality of MR and MC is not the sufficient condition for profit maximization though it is
the necessary condition. Industry equilibrium is possible only when each firm is earning
only normal profits, that is, the point where AR=AC for each firm. This is so because, if the
existing firms earn more than normal profits, new firms will enter into the industry. This will
reduce the volume of abnormal profits of the existing firms. Entry will continue until all the
firms earn only normal profits. The situation of the group equilibrium can be analyzed with
the help of the figure given below.
74
In the above figure the firm is in equilibrium at point E where the AR curve is tangent to the
LAC curve and the output level of OQ1 . It can be proved that at the output level where AR
is tangent to AC. MR must be equal to MC. We know that,
MR = AR + Q. dAR/dQ and MC = AC + Q. dAC/dQ, where, Q is the level of output. Now,
when the level of output is the same, if AR = AC and it is such that dAR/dQ = dAC/dQ i.e.
AR is tangent to AC, MR will be equal to MC. Note that each firm will be in equilibrium at
a point on the AC curve which is to the left of its minimum point, F. if the firm operates
under perfect competition, equilibrium will be achieved at the lowest point of the AC curve,
where the level of output is OQ2 and the price is OP2. The long run equilibrium point under
monopolistic competition (E) must be at the falling portion of the AC curve because here
AR is falling and such an AR curve can be tangent to the AC curve only at the latters
downward sloping portion.
NOTES
This property of equilibrium under monopolistic competition is known as the excess capacity
theorem. This means that under monopolistic competition excess capacity remains in
each firm in the sense that more output can be produced at a lower cost. Suppose that
the number of firms is reduced but the output level of each firm is increased so that the
total output of the industry remains the same. In this case, each firm will produce the
output at a lower cost and hence total cost of obtaining the same level of output by
eliminating some firm will be lower. Thus excess capacity remains under monopolistic
competition and this capacity can be utilized by eliminating some firms form the industry.
For social standpoint, monopolistic competition is inferior to perfect competition. Under
perfect competition, capacity is fully utilized. Production takes place at the minimum
point of the average cost curve. But this condition is not fulfilled under monopolistic
competition.
4.5. OLIGOPOLY-MUTUAL INTERDEPENDENCE

Oligopoly is a market structure, in which a few sellers dominate the sales of a product and
the entry of new sellers is difficult or impossible. The product can be either differentiated
or standardized. Automobiles, cigarettes, beer and chewing gum are examples of
differentiated products, whose market structures are oligopolistic. Oligopolistic markets
are characterized by high market concentration.
In oligopolistic market, at least some firms can influence price by virtue of their large
shares of total output produced. Sellers in oligopolistic markets know that when they or
their rivals change their prices of output, the profit of all firms in the market will be affected.
The sellers are aware of their interdependence. They know that a change in one firms
price or output will cause a reaction by competing firms. The response an individual seller
expects from his rival is crucial determinant of his choices.
In this market:
1.
Only a few firms supply the entire market with a product that may be standardized or
differentiated.
2.
At least some firms have a large market shares and thus can influence the price of
product.
3.
The firms in the oligopolistic market are aware of their interdependence and always
consider their rivals reactions when selecting prices, output goals, advertising budgets and other business policies.
4.
One more feature of the oligopoly market is the indeterminacy of the demand curve
facing an oligopolistic firm. The demand curve face by an oligopolistic firm represents
different quantities of output that the firm can sell at different prices. These quantities
75
cannot be definitely determined because the quantities will be different depending on

the different reaction patterns of the rivals. When any firm changes its own price,
rivals will also change their prices and as a result the demand curve faces by an
oligopolist firm loses its definiteness.
5.
NOTES
The oligopoly market is concerned with group behaviour. There is no generally accepted theory on group behaviour. It basically depends on the behaviour of the members of the group. For example, it may happen that the members of the group may
compete with one another (Non-Collusive oligopoly), or it may happen that the members come to an understanding (Collusive oligopoly) among themselves and form a
general body to promote their common interests. It may also happen that there is a
leader in the group and other members of the group follow the leader (Price Leadership), etc.
In oligopoly market, there exists interdependence among different forms. Due to this
interdependence there is an uncertainty about the reaction patterns of the rivals. A wide
variety of reaction patterns become possible and accordingly a large variety of models of
price-output determination may be constructed. The actual solution is, therefore,
indeterminate unless we specify a particular reaction pattern of the rivals.
4.5.1. Non-collusive Oligopoly

The common characteristic of non-collusive oligopoly is that they assume a certain pattern
of reaction of competitors, in each period and despite the fact that the expected does not
in fact materialize, the firms continue to assume that the initial assumption holds. In other
words, firms are assumed never to learn from past experience which makes their behavior
at least nave.
4.5.2. Sweezys Model of Kinked Demand Curve

The concept of kinked demand curve was originally used to explain why, in an oligopoly
market, the price which has been determined on the basis of average cost principle,
would tend to remain rigid. The basic postulate of the average cost pricing is that the firm
sets the price equal to average total cost which includes not only average variable cost
but also a gross profit margin. The yield is a normal profit. However, the kinked demand
curve, used by Paul Sweezy, explained the observed rigidity of price in an oligopoly
market.
The kinked demand curve model is based on the following assumptions.
a. There are many firms in the oligopolistic industry.
b. Each produces a product which is close substitute for that of the other firm.
c. Product qualities are constant, advertising expenditures are zero.
d.
Each oligopolist believes that if he lowers the price of his product, his rivals will also
lower the prices of their products and that if he raises, they will maintain the prices at
the existing levels.
Given these assumptions, the demand curve faced by any individual seller has a kink at
the initial price-quantity combination. The kinked shape of the demand curve is based on
the assumption that the rivals react differently to a rise in price or to a fall in price. It is also
assumed that when an individual seller increases the price of his product other sellers will
not increase their prices so that the sales of the seller increasing the price will be reduced
considerably. This means that the demand curve is relatively elastic for a rise in price. On
the other hand, it is assumed that when a single seller reduces the price, other sellers will
also reduce the price so that the seller who reduces the price first cannot gain much for a
76
fall in the price. The kinked demand curve is, therefore based on the assumption that a
rise in price by one seller will not be followed by a rise in the price of the other sellers,
while a fall in the price of one seller will be followed by the corresponding fall in the price
by others. A kinked demand curve is shown in the following figure.
NOTES
Suppose that we have drawn two demand curves dd and DD. The demand curve dd is
drawn on the assumption that when one seller changes his price, the other sellers do not
change their prices and keep their prices unaffected. The demand curve DD is drawn on
the assumptions that when one seller changes his price, the other sellers also change
their price is the same direction. The demand curves dd and DD intersect at the point P.
In the kinked demand curve analysis it is assumed that the rise in price will be unmatched
while a fall in the price will be matched. Hence the demand curve is dPD which has a kink
at the point P. Let us consider a situation where price is reduced from OP1 to OP2. If the
other sellers also reduce the price, the quantity sold by this seller will increase by QR.
But if the sellers do not reduce prices the quantity sold will increase by QS. Similarly,
when the price is increased form OP1 to OP3 the quantity demanded will be reduced by
PQ (if other sellers do not increase their prices) and the quantity demanded will be
reduced by PR if other sellers also increase their prices. Since it is assumed that price
decrease by a firm will be matched by a price reduction by rivals but an increase in the
price is not matched by the rivals, the relevant demand curve has a higher price elasticity
than the lower part. The position of the curve is determined by the location of OP1, the
price at which the oligopolist now happens to be selling his product. The price OP1 is the
datum and it is not determined in the model.
Consider now the implication of a kink in the demand curve faced by the seller in the
market. If the demand curve is kinked, the corresponding MR curve will be discontinuous.
This is seen in the following figure. In this figure dA portion of the MR curve corresponds to
the dP portion of the demand curve, while the BC portion of the MR curve corresponds to
the PD portion of the demand curve. The length of the discontinuity is equal to AB. The
point P on the demand curve has two elasticities of demand. If we think that P is a point
on DD we get another elasticity of demand.
77
NOTES
The greater the difference between the two elasticities of demand, the greater will be the
length of the discontinuity. This is so because, we know from the relation between the
MR, price and the absolute value of the demand elasticity (e) that MR = price [1-1/e].now
at that point P, both the demand curves DD and dd have the same output level. The MR
will therefore be different because of the differences in the elasticities are equal at point P,
the discontinuous range will disappears.
Suppose now that the MC curve of the firm passes through the discontinuous range of the
MR curve, in this case, we cannot say that MR equals MC at the equilibrium point.
Equality of MR and MC is not possible. All that we can say is that MR cannot be less than
MC. In this situation the price and quantity remain the same at the kink point. Even if the
MC curve shifts but passes through the discontinuous range B, the price-quantity
combination remains constant.
The price-quantity combination given by the point of the kink remains more or less stable
in the oligopoly market. The price rise or the price fall is not profitable for a single seller
because of the asymmetrical behavior of the sellers for a price rise or a price fall. The
equilibrium of the firm is defined by the point of the kink because for any output level less
than OM, MC is below MR, while for any output level greater than OM, MC is greater than
MR. thus total profit is maximized at the kink through the profit maximizing condition
(MR=MC) is not fulfilled at the kink point.
The discontinuity of A and B of the MR curve implies that there is a range within which
costs may change without affecting the equilibrium price and output of the firm. This level
of price and output is compatible with a wide range of costs. Thus the kink can explain
why the price and output will not change despite changes in cost within the range AB.
If the demand curve is kinked, a shift in the market demand upwards or downwards, will
affect the volume of output but not the level of price, so long as the MC curve passes
through the discontinuous range of MR curve. In this case the demand curve shifts but the
kink point lies on the horizontal straight line. As the market expands, the firm will not raise
its price, although output will increase.
In conclusion it can, therefore, be said that the kinked demand analysis as a method of
price-output determinations not analytically sound. But it can be accepted as a reasonable
explanation for the rigidity of price and output in the oligopolistic markets.
78
4.5.3. Collusive Oligopoly

An important characteristic of oligopoly is collusion in which rival firms enter into an
agreement in mutual interest on various accounts such as price, market share, etc. Firms
either openly declare their decision of collusion, or may collude tacitly. Basic oligopoly
characteristics like interdependence of firms, constant consciousness of rivals action,
fear of price war, etc., create a good opportunity for collusion. You must be wondering as
to why firms would collude after all. Give it a thought; it does make sense the companies
come together in order to get better control over market. When a number of producers (or
sellers) enter into such an agreement formally, it is called explicit collusion; on the other
hand, collusion which is not overt is known as tacit collusion. The most commonly found
form of explicit collusion is known as cartels. The aim of such collusion is to reduce
competition and increase profits of individual members. However governments do not
encourage collusions because it creates monopoly like situation and make various laws
to identity and break up cartels. This has lead to the development of tacit collusion, in
which firms do not document agreements to collude.
NOTES
4.5.4. Price Leadership

The agreed upon price under collusion may have been fixed on the basis of going rate or
the price charged by the largest or the most sophisticated player. Such kind of price
determination is known as price leadership. What is this going rate? It is price which
prevails in the market and existing players as well as new entrants agree to sell their
product at this price. Now the next question is that how is this price determined? You will
learn about this very unique aspect of oligopoly in the following sections.
Dominant Firm
Often an oligopoly market is dominated by few firms, among which one may be the
largest player. There can be numerous such examples, Google among search engines,
Intel in the micro chips market, Nokia in mobile phones and IBM in the PC segment.
Specific to Indian context, we can look at Bajaj Auto in the two wheeler market, Maruti in
cars and Godrej in steel furniture. The highlight of this situation is that other companies
acknowledge the leadership of this largest firm for price determination. The basis of such
dominance is that a firm may emerge as a leader in terms of either market share, or
presence in all market segments, or just being the pioneer in the particular product category.
Normally the leader is very large in size and earns economies of scale; it produces
optimum output at which it is able to maximize returns. This dominant firm may be either
a benevolent firm or an exploitative firm.
A benevolent leader is one which allows other firms to exist by fixing a price at which
small firms may also sell. This price is higher than marginal cost of the overall market so
that firms operating at higher cost of production may also survive. There are two major
reasons behind the creation of a benevolent firm: (i) it lets others exist so that it does not
have to face allegations of monopoly creation; (ii) it earns sufficient margin at this price
and still retains market leadership. However, there is one limitation of this aspect and that
is, the success of this type of leadership exists on the assumption that others will follow
the leader. However, there may be a possibility that another rival takes advantage of the
benevolence of the dominant firms leadership. Therefore in some cases the dominant firm
acts exploitative, i.e., it fixes a price at which small inefficient players may not survive and
thus it gains large share of the market.
79
Barometric Firm
NOTES
Some markets may be such that no single player is so large to emerge as a leader, but
there may be a firm which has a better understanding of the markets. This firm acts like a
barometer for the market; it has better industry intelligence and can preempt and interpret
its external environment in an effective manner. For example if the Indian Rupee is
appreciating against US Dollar, how will it affect the market of a particular good, say
television? A barometric firm would be able to see the link of this phenomenon with its
impact on cost of production, on the demand for the product or on the general price index.
If the appreciation of Rupee is likely to increase the cost of production, then the barometric
firm will initiate a price rise with the declaration that due to rise in cost the price is being
increased. Since all the firms in the industry are facing this threat in the same manner,
they will also follow the barometric firm and will dissuade from price war.
4.6. PRISONERS DILEMMA

In 1984, Axelrod gave a new dimension to game theory by presenting Prisoners Dilemma
which talks of importance of cooperation. The two players in the game can choose between
two moves, either cooperate or defect. The idea is that each player gains when both
cooperate, but if only one of them cooperates, the other one, who defects, will gain more.
If both defect, both lose (or gain very little) but not as much as the cheated cooperator,
whose cooperation is not returned.
The game of Prisoners Dilemma needs a bit of story telling! This is a story of two prisoners.
There are two criminals who have been arrested for stealing a car but the attorney suspects
that they were also involved in a big bank robbery. However the evidence is not adequate
to make the robbery charge stand unless one or both confess. Now car stealing is
comparatively a lesser offense, and hence has punishment as compared to bank robbery.
Thus the attorney keeps the two prisoners in separate cells so that no communication is
possible between the two. Each prisoner is told that if he and his accomplice confess
their imprisonment will only be five years but if only one confesses and others remain
silent then the one who confess will get one year jail and the rest ten years jail. The
prisoners know that if they both remain silent then they will get only two years jail which
is the punishment for car stealing.
In the table representing the payoff matrix, the two prisoners are the players, and the
years of imprisonment are the payoffs. Each of the players is having two strategies, either
to betray or confess, or not to confess and remain silent. Thus the outcome of each
choice depends on the choice of the accomplice. But neither partner knows the choice of
the accomplice. You know that each of them will try to reduce their term for jail but neither
of them has any means of knowing that his accomplice will not betray.
Prisoner B Stays Silent
Prisoner A Stays Silent
Prisoner B Confesses
Both serve 2 years
A serves 10 years
(Win-win)
B serves 1 year
A loses, B wins
Prisoner A Confesses
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B serves 10 years
Both serve 5 years
A serves 1 year
Lose-lose
A wins, B loses
(Nash Equilibrium)
By your understanding of game theory and Nash equilibrium you can easily infer that both
the prisoners will confess and thus would serve five years imprisonment. This is because
each of the prisoners knows that both the dominant strategy of the opponent is to confess,
hence each will confess, while his accomplice keeps his strategy intact. This dominant
strategies equilibrium is a special case of Nash equilibrium.
Similarly if either A or B adopts maxmin or max-min strategy, the outcome in both the
cases would be the same.
NOTES
4.7. SUMMARY
Market structures can be characterized on the basis of four characteristics; i) number and
size of distribution of sellers, ii) number and size distribution of buyers, iii) product
differentiation and iv) ease of entry and exit. The model of perfect competition assumes a
large number of small buyers and sellers, undifferentiated products, and ease of entry and
exit. The profit maximization output for the perfectly competitive firm occurs where price
equals to marginal cost. The monopolist is a single seller of a differentiated product. Entry
into the market is difficult or prohibited. As a single seller, the monopolist has power over
price. Chamberlins model for monopolistic competition assumes ease of entry and exit
and a large number of small sellers. It differs from perfect competition by viewing sellers
as providing products that are slightly differentiated. Thus, firms have some control over
price. Oligopolistic market structures have many buyers but only few sellers dominate the
market. The product may be differentiated or undifferentiated. Entry into this industry is
somehow difficult.
Check Your Progress

1. In perfect competition, a firm maximizing its profits will set its output at that level
where
(a) Average variable cost = price
(b)
Marginal cost = price
(c) Fixed cost = price
(d)
Average fixed cost = price
2. Which of the following curves resembles supply curve under perfect competition
in the short run?
(a) Average cost curve above break even point
(b) Marginal cost curve above shut down point
(c) Marginal utility curve
(d)
Average utility curve
3. Which of the following is not a feature of perfect competition?

(a) Low price
(b) No one is large enough to influence the market price
(c) Homogeneous products
(d)
Horizontal demand curve
4. In the long run, a perfectly competitive firm earns only normal profits because of
(a) Large number of seller and buyer in the industry
(b) Large number of seller and buyer in the industry
(c) Free entry and exit of industry
(d)
Both (a) and (b) above
5. The horizontal demand curve for a firm is one of the characteristic features of
(a) Oligopoly
(b)
Monopoly
(c) Monopolistic competition
(d)
Perfect competition
81

1. What are the assumptions required for perfect competition model?
2. Write down the differences between pure competition and perfect competition.
3. Explain the short run equilibrium of the firm in the perfectly competitive market.
NOTES
4. Explain the long run equilibrium of monopolist firm.

5. Write down the effects of price discrimination by a monopolist firm.
6.
Does product differentiation always refer to real difference between products? Use an
example to explain your answer.
7.
Basically, perfectly competitive firms and monopolists use the same rule to determine the profit maximizing outputs. Explain.
8.
Firms in a perfectly competitive market do not have to compete with the other individual firms in the market. True or False? Explain.
9. How is dead weight loss from monopoly affected by the slope of the demand curve?
10. Do non-profit institutions such as universities; ever engage in rent seeking behaviour?
Give an example.
11. The equilibrium price in a perfectly competitive market is $10. The marginal cost
function is given by MC = 4 + 0.2Q the firm is presently producing 40 units of outputs
per period. To maximize profit, should the output rate be increased or decreased?
Explain.
12. A consultant estimates that the demand for the output of Marston Chemical is represented by the equation Q=2000-50P
a.
If the mangers of Marston decide to maximize total revenue instead of profit, at what
output rate should the firm operate? What is the revenue maximizing price?
b.
Will the revenue maximizing output be greater than or less than the profit maximizing output rate? Explain
13. Explain cartels aiming at joint-profit maximization.

14. Explain the price leadership model.
Further Readings
z
Mankiw,

z

Hall of India

z
82
UNIT 5 CAPITAL BUDGETING AND

RISK AND UNCERTAINTY
ANALYSIS
Capital Budgeting and Risk and

Uncertainty Analysis
NOTES
STRUCTURE
5.1 Objectives
5.2 Introduction
5.3 Investment Analysis
5.3.1
Project valuation
5.3.2
Capital Budgeting Techniques
5.4 Risk and Investment Analysis- Decision Tree Analysis

5.5 Concept of Behavioral Economics
5.6 Summary
5.7 Check Your Progress
5.8 Questions and Exercises
5.9 Further Readings
5.1 OBJECTIVES
The primary objective of this chapter is to define and explain the Investment Analysis, i.e.,
Project valuation and Capital Budgeting Techniques. The chapter also covers the Risk
and Investment Analysis part, which includes Decision Tree Analysis and Concept of
Behavioral Economics. A unique feature of this chapter is that it explains the very important
concept of economics, i.e., Behavioral Economics. In most of the cases, explanations
are incorporated with mathematical examples.
5.2 INTRODUCTION
Any type investment is risky and investment decision is also difficult to make. It depends
on availability of money and information of the economy, industry and company and the
share prices ruling and expectations of the market and also of the companies. For making
such decision the common investors may have to depend more upon a study of fundamentals
rather than technical, although technical is also important. Otherwise they will burn their
fingers as happened in 1992 following the Harshad Mehta Scam and in 2001 following
Ketan Parekh Scam. For this purpose, a study of companys performance, past record
and expected future performance are to be looked into. It is necessary for a common
investor to study the balance sheet and annual report of the company or analyze the
quarterly or half yearly results of the company and decide on whether to buy that companys
share or not. This is called fundamental investment analysis.
5.3 INVESTMENT ANALYSIS

5.3.1 Project valuation
Investment projects are classified as follows. According to project size, the investment
83
analysis is executed. Small projects may be approved by departmental managers. More

careful analysis and Board of Directors approval is needed for large projects of, say, half
a million dollars or more.
Similarly, according to type of benefit to the firm, they are as follows.
z
NOTES
an increase in cash flow, ? a decrease in risk, and ? an indirect benefit (showers for
workers, etc).
According to degree of dependence, they are,

z
mutually exclusive projects (can execute project A or B, but not both),
complementary projects: taking project A increases the cash flow of project B,
substitute projects: taking project A decreases the cash flow of project B.
According to degree of statistical dependence,

z
Positive dependence,
Negative
dependence
z
Statistical independence.
According to type of cash flow,

z
Conventional cash flow: only one change in the cash flow sign,
Non-conventional cash flows: more than one change in the cash flow sign,
Project valuation analysis stipulates a decision rule for accepting or rejecting Investment
projects
5.3.2 Capital Budgeting Techniques

Capital budgeting is the process most companies use to authorize capital spending on
long-term projects and on other projects requiring significant investments of capital.
Because capital is usually limited in its availability, capital projects are individually evaluated
using both quantitative analysis and qualitative information. Most capital budgeting analysis
uses cash inflows and cash outflows rather than net income calculated using the accrual
basis. Some companies simplify the cash flow calculation to net income plus depreciation
and amortization. Others look more specifically at estimated cash inflows from customers,
reduced costs, and proceeds from the sale of assets and salvage value, and cash outflows
for the capital investment, operating costs, interest, and future repairs or overhauls of
equipment.
The Cottage Gang is considering the purchase of $150,000 of equipment for its boat
rentals. The equipment is expected to last seven years and has a $5,000 salvage value at
the end of its life. The annual cash inflows are expected to be $250,000 and the annual
cash outflows are estimated to be $200,000.
Payback technique
The payback measures the length of time it takes a company to recover in cash its initial
investment. This concept can also be explained as the length of time it takes the project
to generate cash equal to the investment and pay the company back. It is calculated by
dividing the capital investment by the net annual cash flow. If the net annual cash flow is
not expected to be the same, the average of the net annual cash flows may be used.
For the Cottage Gang, the cash payback period is three years. It was calculated by
Capital investment
Cash Payback Period =
Average annual net cash flow
dividing the $150,000 capital investment by the $50,000 net annual cash flow ($250,000
inflows - $200,000 outflows)
84
The shorter the payback period, the sooner the company recovers its cash investment.
Whether a cash payback period is good or poor depends on the companys criteria for
evaluating projects. Some companies have specific guidelines for number of years, such
$150,000
$50,000

= 3.0 years
NOTES
as two years, while others simply require the payback period to be less than the assets
useful life.
When net annual cash flows are different, the cumulative net annual cash flows are used
to determine the payback period. If the Turtles Co. has a project with a cost of $150,000,
and net annual cash inflows for the first seven years of the project are: $30,000 in year
one, $50,000 in year two, $55,000 in year three, $60,000 in year four, $60,000 in year five,
$60,000 in year six, and $40,000 in year seven, then its cash payback period would be
3.25 years. See the example that follows.
The cash payback period is easy to calculate but is actually not the only criteria for
choosing capital projects. This method ignores differences in the timing of cash flows
during the project and differences in the length of the project. The cash flows of two
projects may be the same in total but the timing of the cash flows could be very different.
For example, assume project LJM had cash flows of $3,000, $4,000, $7,000, $1,500, and
$1,500 and project MEM had cash flows of $6,000, $5,000, $3,000, $2,000, and $1,000.
Both projects cost $14,000 and have a payback of 3.0 years, but the cash flows are very
different. Similarly, two projects may have the same payback period while one project
lasts five years beyond the payback period and the second one lasts only one year.
Net present value

Considering the time value of money is important when evaluating projects with different
costs, different cash flows, and different service lives. Discounted cash flow techniques,
such as the net present value method, consider the timing and amount of cash flows. To
use the net present value method, you will need to know the cash inflows, the cash
outflows, and the companys required rate of return on its investments. The required rate
of return becomes the discount rate used in the net present value calculation. For the
following examples, it is assumed that cash flows are received at the end of the period.
85
Managerial Economics
NOTES
Using data for the Cottage Gang and assuming a required rate of return of 12%, the net
present value is $80,452. It is calculated by discounting the annual net cash flows and
salvage value using the 12% discount factors. The Cottage Gang has equal net cash
flows of $50,000 ($250,000 cash receipt minus $200,000 operating costs) so the present
value of the net cash flows is computed by using the present value of an annuity of 1 for
seven periods. Using a 12% discount rate, the factor is 4.5638 and the present value of
the net cash flows is $228,190. The salvage value is received only once, at the end of the
seven years (the assets life), so its present value of $2,262 is computed using the Present
Value of 1 table factor for seven periods and 12% discount rate factor of .4523 times the
$5,000 salvage value. The investment of $150,000 does not need to be discounted because
it is already in todays dollars (a factor value of 1.0000). To calculate the net present value
(NPV), the investment is subtracted from the present value of the total cash inflows of
$230,452. See the examples that follow. Because the net present value (NPV) is positive,
the required rate of return has been met.
Present Value of 1
Period 2%
4%
5%
0.980
0.961
4
2
10
11
12
86
6%
8%
10%
12%
14%
16%
18%
20%
22%
0.952 0.943
0.925
0.909
0.892
0.877
0.862
0.847
0.833
0.819
0.961
0.924
0.907 0.890
0.857
0.826
0.797
0.769
0.743
0.718
0.694
0.671
0.942
0.889
0.863 0.839
0.793
0.751
0.711
0.675
0.640
0.608
0.578
0.550
0.9238 0.8548 0.8227 0.7921 0.7350 0.6830 0.6355 0.5921 0.5523 0.5158 0.4823
0.451
0.905
0.821
0.783 0.747
0.680
0.620
0.567
0.519
0.476
0.437
0.401
0.370
0.888
0.790
0.746 0.705
0.630
0.564
0.506
0.455
0.410
0.370
0.334
0.303
0.870
0.759
0.710 0.665
0.583
0.513
0.452
0.399
0.353
0.313
0.279
0.248
0.853
0.730
0.676 0.627
0.540
0.466
0.403
0.350
0.305
0.266
0.232
0.203
0.836
0.702
0.644 0.591
0.500
0.4241 0.360
0.307
0.263
0.225
0.193
0.167
0.820
0.675
0.613 0.558
0.463
0.385
0.322
0.269
0.226
0.191
0.161
0.136
0.804
0.649
0.584 0.526
0.428
0.350
0.287
0.236
0.195
0.161
0.134
0.112
0.788
0.624
0.556 0.497
0.397
0.318
0.256
0.207
0.168
0.137
0.112
0.092
13
14
15
16
17
18
19
20
0.773
0.600
0.530 0.468
0.367
0.289
0.229
0.182
0.145
0.116
0.093
0.075
0.757
0.577
0.505 0.442
0.340
0.263
0.204
0.159
0.125
0.098
0.077
0.061
0.743
0.555
0.481 0.417
0.315
0.239
0.182
0.140
0.107
0.083
0.064
0.050
0.728
0.533
0.458 0.393
0.291
0.217
0.163
0.122
0.093
0.070
0.054
0.041
0.714
0.513
0.436 0.371
0.270
0.197
0.145
0.107
0.080
0.060
0.045
0.034
0.700
0.493
0.415 0.350
0.250
0.179
0.130
0.094
0.069
0.050
0.037
0.027
0.686
0.474
0.395 0.330
0.231
0.163
0.116
0.082
0.059
0.043
0.031
0.022
0.673
0.456
0.376 0.311
0.214
0.148
0.103
0.072
0.051
0.036
0.026
0.018
Cash Outflows

NOTES
Cash Inflows
Project Cost
$150,000
Cash from Customers (1) $250,000
Operating Costs (2)
200,000
Salvage Value
Estimated Useful Life
7 years
Minimum Required Rate of Return
12%
Annual Net Cash Flows ($250,000 - $200,000)
$50,000
5,000
(1) - (2)
Present Value of Cash Flows

Annual Net Cash Flows ($50,000 4.5638)
Salvage Value ($5,000 .4523)
Total Present Value of Net Cash Inflows
$228,190
2,262
230,452
Less: Investment Cost
(150,000)
Net Present Value
$ 80,452
When net cash flows are not all the same, a separate present value calculation must be
made for each periods cash flow. A financial calculator or a spreadsheet can be used to
87
calculate the present value. Assume the same project information for the Cottage Gangs
investment except for net cash flows, which are summarized with their present value
calculations below
NOTES
Period
Estimated Annual Net Cash Flow (1)
12% Discount Factor (2)
Present Value (1) (2)
$ 44,000
.8929
$ 39,288
55,000
.7972
43,846
60,000
.7118
42,708
57,000
.6355
36,224
51,000
.5674
28,937
44,000
.5066
22,290
39,000
.4523
17,640
Totals
$350,000
$230,933
The NPV of the project is $83,195, calculated as follows:

Annual Net Cash Flows
$230,933
Salvage Value ($5,000 .4523)
2,26
Total Present Value of Net Cash Inflows
233,195
Less: Investment Cost
(150,000)
Net Present Value
$ 83,195
The difference between the NPV under the equal cash flows example ($50,000 per year
for seven years or $350,000) and the unequal cash flows ($350,000 spread unevenly over
seven years) is the timing of the cash flows.
Most companies required rate of return is their cost of capital. Cost of capital is the rate
at which the company could obtain capital (funds) from its creditors and investors. If there
is risk involved when cash flows are estimated into the future, some companies add a risk
factor to their cost of capital to compensate for uncertainty in the project and, therefore, in
the cash flows.
Most companies have more project proposals than they do funds available for projects.
They also have projects requiring different amounts of capital and with different NPVs. In
comparing projects for possible authorization, companies use a profitability index. The
index divides the present value of the cash flows by the required investment. For the
88
Cottage Gang, the profitability index of the project with equal cash flows is 1.54, and the
profitability index for the project with unequal cash flows is 1.56.
Profitability Index =


Required Investment
Equal Cash Flows = $ 230,452 / $ 150,000 = 1.54, and

Unequal Cash Flows = $ 233,195 / $ 150,000 = 1.56
NOTES
Internal rate of return

The internal rate of return also uses the present value concepts. The internal rate of return
(IRR) determines the interest yield of the proposed capital project at which the net present
value equals zero, which is where the present value of the net cash inflows equals the
investment. If the IRR is greater than the companys required rate of return, the project
may be accepted. To determine the internal rate of return requires two steps. First, the
internal rate of return factor is calculated by dividing the proposed capital investment
amount by the net annual cash inflow. Then, the factor is found in the Present Value of an
Annuity of 1 table using the service life of the project for the number of periods. The
discount rate of the factor is the closest to is the internal rate of return. A project for
Knightsbridge, Inc., has equal net cash inflows of $50,000 over its seven-year life and a
project cost of $200,000. By dividing the cash flows into the project investment cost, the
factor of 4.00 ($200,000 $50,000) is found. The 4.00 is looked up in the Present Value of
an Annuity of 1 table on the seven-period line (it has a seven-year life), and the internal
rate of return of 16% is determined.
89
NOTES
Annual rate of return method

The three previous capital budgeting methods were based on cash flows. The annual
rate of return uses accrual-based net income to calculate a projects expected profitability.
The annual rate of return is compared to the companys required rate of return. If the
annual rate of return is greater than the required rate of return, the project may be accepted.
The higher the rate of return, the higher the project would be ranked.
The annual rate of return is a percentage calculated by dividing the expected annual net
income by the average investment. Average investment is usually calculated by adding
the beginning and ending project book values and dividing by two.
Annual Rate of Return =
Estimated Annual Net Income

Average Investment
Assume the Cottage Gang has expected annual net income of $5,572 with an investment
of $150,000 and a salvage value of $5,000. This proposed project has a 7.2% annual rate
of return ($5,572 net income $77,500 average investment).
Annual Rate of Return = Estimated Annual Net Income/Average Investment
7.2% = $5,572 / $77,500
(1)
(2)
90

NOTES
The annual rate of return should not be used alone in making capital budgeting decisions,
as its results may be misleading. It uses accrual basis of accounting and not actual cash
flows or time value of money.
5.4 RISK AND INVESTMENT ANALYSIS- DECISION TREE ANALYSIS

Decision Trees are useful tools for helping you to choose between several courses of
action. They provide a highly effective structure within which you can explore options, and
investigate the possible outcomes of choosing those options. They also help you to form
91
a balanced picture of the risks and rewards associated with each possible course of
action. This makes them particularly useful for choosing between different strategies,
projects or investment opportunities, particularly when your resources are limited.
Uses:
NOTES
You start a Decision Tree with a decision that you need to make. Draw a small square to
represent this on the left hand side of a large piece of paper, half way down the page.
From this box draw out lines towards the right for each possible solution, and write a short
description of the solution along the line. Keep the lines apart as far as possible so that
you can expand your thoughts.
At the end of each line, consider the results. If the result of taking that decision is uncertain,
draw a small circle. If the result is another decision that you need to make, draw another
square. Squares represent decisions, and circles represent uncertain outcomes. Write
the decision or factor above the square or circle. If you have completed the solution at the
end of the line, just leave it blank.
Starting from the new decision squares on your diagram, draw out lines representing the
options that you could select. From the circles draw lines representing possible outcomes.
Again make a brief note on the line saying what it means. Keep on doing this until you
have drawn out as many of the possible outcomes and decisions as you can see leading
on from the original decisions.
Once you have done this, review your tree diagram. Challenge each square and circle to
see if there are any solutions or outcomes you have not considered. If there are, draw
them in. If necessary, redraft your tree if parts of it are too congested or untidy. You should
now have a good understanding of the range of possible outcomes of your decisions.
An example of the sort of thing you will end up with is shown in Figure 1:
Figure 1
5.5 CONCEPT OF BEHAVIORAL ECONOMICS

The main features of Concept of Behavioral Economics are as follows.
z
Fastest growing field in economics
z
92
Behavioral economics is concerned with the ways in which the actual decision-making process influences the decisions that are made in practice; combines psychology and economics
Assumes bounded rationality meaning that people have limited time and capacity
to weigh all the relevant benefits and costs of a decision.
Decision making is less than fully rational. People are prone to make predictable and
avoidable mistakes.
At the same time, decision making is systematic and amenable to scientific study.

Six Key Ideas from Behavioral Economics

1.
Framing. Allowing the way a decision is presented to affect the choice that is selected even though the marginal benefit and marginal cost are unaffected.
2.
Letting Sunk Costs Matter. Allowing sunk costs, which have already been paid and
do not affect marginal costs regardless of which option is chosen, to affect a decision.
3.
Faulty discounting. Being too impatient when it comes to decisions that involve
benefits that are received in the future or discounting future benefits inconsistently
depending on when the delay in receipt of benefits occurs.
4.
Overconfidence. Believing you will know what will happen in the future to a greater
extent than is justified by available information.
5.
Status Quo Bias. It is a tendency to make decisions by accepting the default option
instead of comparing the marginal benefit to the marginal cost.
6.
Desire for Fairness and Reciprocity. It is also a tendency, to punish people who
treat you unfairly and to reward those who treat you fairly, even if you do not directly
benefit from those punishments and rewards. Behavioral Economics recognizes that
people respond to incentives, but their response is not always a rational one.
NOTES
5.6 SUMMARY
Investment is very risky decision, so it needs priory analysis before finalizing. It depends
on availability of money and information of the economy, industry and company and the
share prices ruling and expectations of the market and also of the companies. For making
investment decision the investors are depend more on a study of fundamentals rather
than technical. It is necessary for a common investor to study the balance sheet and
annual report of the company or analyze the quarterly or half yearly results of the company
and decide on whether to buy that companys share or not. This is called fundamental
investment analysis. Capital budgeting is the process of spending capital on long-term
projects and on other projects requiring significant investments of capital. Capital is usually
limited in its availability. So, capital budgeting is individually evaluated using both quantitative
analysis and qualitative information. Most of the capital budgeting analysis uses cash
inflows and cash outflows rather than net income calculated using the accrual basis.
Decision Trees analysis is also useful tools for choosing best one among available several
courses of actions. This makes them particularly useful for choosing between different
strategies, projects or investment opportunities, particularly when your resources are
limited.
Check Your Progress

1. Capital budgeting analysis uses
(a) Cash inflows,
(b)
Cash outflows,
(c) Cash inflows and cash outflows,
(d)
None of the above
2. Cost of capital is the rate at which the company could obtain

(a) Capital (funds) from its creditors and investors,
(b) Capital (funds) from its bankers,
(c) Capital (funds) from its employees,
(d)
All the above.
93
3. Decision Trees are useful tools for helping you to choose between several courses
of
NOTES
(a) Process,
(b)
Action,
(c) Plan,
(d)
Management
4. Behavioral economics is concerned with the ways in which the actual decisionmaking process influences
(a)
Decisions that are made in practice; combines psychology and mathematical,
(b)
Decisions that are made unpracticed; combines psychology and economics,
(c) The decisions that are made in practice,

(d) The decisions that are made in practice; combines psychology and
economics.

1. Explain how the investment analysis will help to achieve the target of the company.
2. What do you mean by capital budgeting? Explain with examples.
3. The payback measures the length of time it takes a company to recover in cash its
initial investment, comment on it.
4. Most companies required rate of return is their cost of capital, explain with suitable example.
5. Why Decision Trees are useful tools for helping you to choose between several courses
of action?
6. Write down the main features of Behavioral Economics.
7. Explain Six Key Ideas of Behavioral Economics.
8. Explain with example the Internal Rate of Return.
Further Readings
z
Mankiw,

z

Hall of India

z
94
UNIT 6 MACRO-ECONOMICS
ANALYSIS
STRUCTURE
Macro-economics Analysis
NOTES
6.1. Objectives
6.2 Introduction
6.3. Basic Concept Circular Flow of Income and Money
6.4. National Income and Keynesian Model
6.5. Saving and Consumption Function
6.6. Investment Multiplier
6.7. Inflation
6.9. International Economics Fixed and Flexible Exchange Rates
6.10. Spot and forward Exchange Rates
6.11. Current and Capital Account Convertibility a case study of India.
6.12. Summary
6.1. OBJECTIVES
The purpose of this chapter is to enable the student to follow the development of
macroeconomic analysis and to finalize them with a number of basic concepts. Here, we
highlight the main concept of macroeconomic variables, i.e., National Income and Keynesian
Model, Saving and Consumption Function, Investment Multiplier, Inflation, Monetary and
Fiscal Policies, International Economics Fixed and Flexible Exchange Rates, Spot and
forward Exchange Rates and Foreign Exchange Rates.
6.2 INTRODUCTION
Microeconomics is the study of human behavior and choices as they relate to relatively
small units, such as an individual, a firm, an industry, or a single market. Macroeconomics
is the study of human behavior and choices as they relate to an entire economy. Economic
analysis attempts to explain why problems arise in the economy and how these problems
can be dealt with. It is, therefore, indispensable for formulating and conducting economic
policy. However, before studying macroeconomic theory and policy, one must know the
macroeconomic goals of the economy. There is no point in formulating a policy without
definite objectives. Macroeconomic policy operates within a framework of goals and
constraints. The most important goals of economic policy are;
i.
Full employment full utilization of human and non-human resources
ii.
High living standards
iii. Price Stability

iv.
Reduction of economic inequality and removal of poverty
95
v.
Rapid economic growth
vi. External balance vs overall balance in economic relations with the rest of the world.
6.3. BASIC CONCEPT CIRCULAR FLOW OF INCOME AND MONEY
NOTES
Stock and Flows

When studying economics, one must be sure whether the variable being studied is a
stock variable. Failure to do so can cause faulty economic reasoning. Stocks and flows
are both variables that may increase and decrease with time. The crucial difference between
the two is that one is measured at a specified point of time, whereas the other is measured
for a specified period of time. For example, the total number of persons employed in India
is a stock variable, whereas the number of persons who get new jobs is a flow variable.
The balance sheet of a company is a stock statement, whereas the profit and loss account
is a flow statement. Form macroeconomics, money supply, consumer price index,
unemployment level, foreign exchange reserves, etc. are examples of stock variables.
GDP, inflation, exports, imports, consumption, investment, etc. are examples of flow
variables.
Some flow macroeconomic variables have a direct counterpart stock macroeconomic
variable, for examples, investment and capital stock, and inflation and price index. Flow
variables which do not have direct stock counterpart are exports, wages, taxes, etc.
Though these variables may not have direct stock counterparts, they could indirectly
affect other stocks.
Although a stock can change only as a result of flows, the flows themselves may be
determined in part by changes in stock. For example, a countrys capital stock is determined
by the level of investment. However, the flow of investment itself may depend partly on the
size of the capital stock. In many theories of the business cycle, a critical factor explaining
the business downturns is the decrease in the investment brought on by an excessive
stock of capital resulting from an earlier, prolonged upsurge in investment.
Equilibrium and Disequilibrium

In physical sciences, equilibrium is a state of balance between opposing forces or actions.
The meaning of equilibrium in economic theory is exactly the same as it is in physical
sciences. Again, in both the fields, disequilibrium means the absence of equilibrium.
Values of economic variable usually keep changing over time; therefore, the state of
balance that defines equilibrium may perhaps be better expressed as a state of no change
over time. One must bear in mind that economic equilibrium does not mean a motionless
state in which no action takes place; rather, it is a state in which there is action, but the
action is of a repetitive nature. Each time period exactly duplicates the preceding time
period. Even though the forces acting on the system may be in a continuous state of
change, the state of equilibrium is maintained as long as the net effect of these changing
forces does not disturb the established position of equilibrium.
National Product and Domestic Product

A modern economy produces literally thousands of different goods and services. Some of
these goods and services such as rice, wheat, shirts, shoes, cooking gas, doctors services,
electricity, passenger transport, etc. are directly consumed by the population; some such
as steel, fertilizers, raw cotton, cement, heavy chemicals, etc. enter as inputs in the
production of other goods which may be directly used or further processed; finally some
96
goods such as machine tools, furnaces, railway wagons, factory buildings, etc. augment
the productive capacity of the economy. Intermediate goods such as steel and cement
are not desired in themselves but only as inputs in producing other goods. The ultimate
aim of all economic activity is to make available goods and services for consumption now
and for augmenting productive capacity so that consumption in future can be maintained
or increased. Gross National Product (GNP) and Gross Domestic Product (GDP) and
other variants are measures of aggregate production of all goods and services which
either afford consumption now or add to productive capacity.
NOTES
Aggregate Consumption
This is the aggregate of all expenditures on current consumption of goods and services
i.e. those which are consumed during the period. Living standards are usually correlated
to per capita consumption of goods and services. This is obtained by dividing aggregate
consumption by population. Current consumption is normally the proximate goal of
economic activity. At low levels of income almost all of it has to be spent on current
consumption food, clothing, rent, fuel, education, etc. As income levels rise it is possible
to set aside some income for saving. The relationship between aggregate consumption
expenditures and aggregate income of household sector is known as the consumption
function, that is C = C(Y). Consumption expenditure may be related to either national
income or disposable income. It is one of the most important relationships in
macroeconomics.
Gross Domestic Savings

Income not devoted to current consumption is saved. In an economy during a particular
year some units will consume less than their income while some will spend more than
their income. Gross domestic savings is the difference between GDP and aggregate
consumption. It is interesting to note that while most of the consumption can be attributed
to the household sector, saving is done by various sectors of the economy. This is because
part of the income generated in the productive process does not reach the households.
Retained profits remain with the business units where they are generated. They constitute
part of business savings. Government takes away some income in the form of taxes
which constitutes bulk of government revenue .By not spending all of it on current goods
and services government can generate savings. Gross Domestic Savings is the total of
savings done by all sectors of the economy.
The relationship between aggregate savings(S) and income (Y) is known as the saving
function, i.e. S= S(Y). Saving may be related to either national or disposable income. The
properties of the saving function are the inverse of those of the consumption function,
since Y= C + S.
Gross Domestic Capital Formation

Production requires services of fixed assets such as machinery, equipment and structures
as well as working capital i.e. stocks of raw materials, work in process, finished goods
etc. The act of replacing worn out assets and creating new assets is capital formation.
Gross Domestic Capital Formation (GDCF) consists of
1. Making good the depreciation on existing fixed assets
2. Adding to the stock of fixed assets
3. Adding to inventories.
Sometimes the first two of these together are called gross fixed investment while the third
is called inventory investment. The word investment can be misleading. When you buy a
97
NOTES
corporate share on the secondary market i.e. an existing share you are making an
investment in the popular sense of the word. However this may lead to any capital
formation at all; the person who sells the shares might spend the entire proceeds on
current consumption. All that has happened is ownership of a part of existing assets has
changed hands. We are concerned with replacement and new additions to neither physical
assets not merely financial assets nor transfer of ownership of existing assets.
Bulk of domestic capital formation is financed from gross domestic savings (GDS). However,
GDS need not equal GDCF. Domestic savings may be loaned to foreigners and contribute
to capital formation abroad; conversely, foreigners may loan their savings to us for capital
formation here. In the former case GDS will exceed GDCF; in the latter case GDCF will
exceed GDS.
The Circular Flow of Income

1. The circular flow of income in a simple economy where all income is consumed.
The operation of forces in an economy can be expressed in the form of a circular flow of
incomes and spending between households and firms. A household is a group of people
(consumers) earning incomes and spending them on goods and services produced by the
firms. Money passes from households to firms in return for goods and services produced
by firms and money passes from firms to households in return for factor services provided
by households. The simple notion that the money value of the income of household must
equal to the money value of output of firms and the money value of household expenditures
to purchase this output provides the basis for national income accounting.
In this simple economy we assume that the household spends all income. This spending
on consumer goods (termed consumption (C) is the only component of aggregate demand
(AD) in this simple economy.
Income (Y)
Rs. 1000
This economy is in equilibrium because:

Y = AD
Y=C
If Y is greater than C, Y will fall; if Y is less than C, Y will rise.
98
2. The circular flow of income in a closed economy:

A closed economy exists when there is no international trade. We shall also assume that
in this particular closed economy there is no government spending or taxation. Here,
households have two alternative uses of the income they can consume it or they can
save it. Savings are (S). AD aggregate demand consists of consumption (C) and savings
(S). Savings are lost to Y and will reduce the level of Y. However, some (if not all) of S will
be used to finance investment (I). I is the creation of real capital goods such as machinery
and factories, and adds to Y. If S = I, then Y is in equilibrium.
NOTES
i.e. income (Y)

Rs. 1000
In this economy
Y = AD
Therefore,
Y=C+I
In equilibrium S = I
However, if S is greater than I, AD and Y will fall. If I is greater than S, AD and Y will rise.
3. The circular flow of income in an open economy:
An open economy is one in which international trade exists. Assume also that there is
government spending and taxation.
Thus, households need not consume all of their income. Some may be saved (S), spent
on imports (M), or taxed (T). So the savings (S) and imports (M) and taxes imposed (T)
are known as withdrawals (W) or Leakages from the actual flow. An increase in withdrawals
(W) will reduce the level of output and income (Y).
However, Y will be added to investment (I), government spending (G) and money spent by
foreigners on exports (X). These are known as injections (J).
In an open economy the size of Y is determined by the size of AD, which is determined by
C + I + G + X.
99
Income (Y)
Rs. 1000
NOTES
Injections (J) Rs 200
Withdrawals (W) Rs 200
Over a period of time there are withdrawals (W) from the income flow. If individuals save,
then the income is taken out of the circular flow. If an economys income is Rs. 1000 and
it saves Rs.200, then only Rs. 800 is passed on as expenditure. Other withdrawals are
taxes and imports. The later represents a loss of income from the domestic economy to
some overseas economy. Alongside withdrawals there are also injections (J) into the flow
of income. These are in the form of investment, government spending and exports, savings
withdrawn and used to finance investment, either directly through the purchase of capital
goods or indirectly via financial institutions such as Banks. Thus, the original withdrawal
or savings ends up as an injection elsewhere in the system. Taxes end up as government
spending on goods and services. Exports and financed from spending made by other
countries. This spending enters into the circular flow as an injection of income.
In this economy, Y = AD
Therefore,
Y=C+I+G+X
= C + J,
Where, J equals injections i.e. I, G and X.

For equilibrium we require all withdrawals to equal all injections i.e. W = J. If injections are
greater than withdrawals then the level of national income (i.e. total incomes) will rise and
vice versa.
6.4. NATIONAL INCOME AND KEYNESIAN MODEL

The most important aspects that shape the economy is the nations capacity to produce
goods and services and keep various factors of production employed. The GNP growth
rate, the most important indicator of the nations income, shows whether the nations
income is expanding or contracting, and thus, it is the broadest statistical aggregate of
our economic output and growth. The estimates of GNP and national income provide the
policy makers and business community with the most useful tool for analyzing an
economys economic performance, both in the short term and long term periods. However,
it is crucial to prepare the accurate and reliable estimates of the nation product for purposes
of meaningful economic analysis and reliable forecasting.
In simple terms, GNP is the sum of all final goods and services produced during a specified
time period usually a year, with each class of goods services measured at its market
100
value i.e. at price usually paid. If the same is estimated in terms of factor cost i.e. at the
sum of all income earned by factors of production (i.e. wages and salary, rents, interest
and profits), then the aggregate is GNP at factor cost. In the definition stated above the
term final is used to avoid the possibility of double counting and to ensure that only the
value of final goods and services is counted in GNP. Why? Because of the value of an
intermediate class of goods is embodied within the value of final goods and services. The
term gross refers to the fact that depreciation (or capital consumption) of structures and
equipment is not deducted from the value of output. Moreover, the aggregate GNP is a
flow concept. It is typically measured in terms of an annual rate i.e. over a period of time.
For instance, Indias GDP was Rs 14, 13,200 crore in 1997-98. This means that Rs 14,
13,200 crore worth of final goods and services were produced during 1997-98. Thus GDP
is a device designed to measure the market value of production that flows through countrys
various industries and shops per year.
NOTES
When measuring GNP, or any other aggregate of nation product, we are interested in final
value of goods and services. In other words, we are only interested in value added in each
stage of production process. Value added is difference between the value of goods and
services as they leave one stage of production and their cost when they entered that
stage. We will consider one example- production of bread- to explain the concept clearly.
As shown in the figure below, there are many stages in production of wheat by the farmer
to milling of wheat into the flour, the baking of bread by the baker and its final sale to the
customer by the retail shop owner.
Value added in different stages of bread production
Stage:1
Stage:2
Value added value added by
Stage:3
Stage:4
Stage:5
value added by
value added
final value
by farmer=
by Miller =
by baker=
by retailer=
baked bread=
Rs 0.80
Rs. 1.50
Rs. 1.80
Rs 0.20
Rs. 4.30
As indicated in the diagram given below between one stage and another, value is added to
the product in terms of cost incurred at each stage of production. The final value of the
bread is the sum total of value added at each stage. If we add up all the prices at each
stage, it would be a gross mistake of double counting. This will distort the actual value of
the product in a specified period.
101
Relationship among eight variants of national product
NOTES
The distinction between national product at market prices and national product at factor
cost, based on whether or not net indirect taxes have been included and there is also a
distinction between gross or net national product according to which whether investment
is inclusive of capital consumption or not. Further, a distinction has been drawn between
domestic and national product, according to whether we are measuring net factor income
from abroad or whether we are measuring what is produced within the domestic economy.
This implies that there are eight combinations of national product aggregates as shown
below.
Gross Domestic Product (GDP) at Market Price (MP)
at Factor Cost (FC)
Gross National Product (GNP)
at Market Price (MP)

at Factor Cost (FC)
Net Domestic Product (NDP)
at Market Price (MP)

at Factor Cost (FC)
Net National Product (NNP)
at Market Price(MP)
at Factor Cost (FC)
The way that these national product aggregates are related to each other be understood
from the figure given below.
We can sum up the differences between gross and net marketing prices and factor cost
and national and domestic concepts in the following way:
Gross
= Net + Depreciation
Market Prices
102
= factor cost + [indirect taxes subsidies]
National
= Domestic + Net factor income from abroad.
There are some national product aggregates that are more frequently met with and we
have several ways to ordering them. One of these is as follow:
Gross domestic product at market price + net factor income from abroad
equals
Gross national product at market price net indirect taxes (indirect taxes- Subsidies)
NOTES
equals
Gross national product at factor cost capital consumption (depreciation)
equals
Net national product at factor cost, which is popularly known as national Income
REAL Vs. NOMINAL GNP

Its important to distinguish between real and nominal values of macroeconomics
aggregates. When comparing data at different points in time, economists often use terms
such as real wage, real income or real GNP. The real refers to the fact that data have
been adjusted for change in level of prices. Thus real GNP is the GNP in current rupees
deflated for changes in the prices of the items included in the GNP. In contrast, nominal
GNP (or money GNP, as they are often called) is expressed in current rupees. It measures
the value of output in given period in the price of that period, or as it is some times put in
current rupees. Over a period of time, nominal values reflect changes both in a) the real
size of an economics variable and b) the general level of prices. In contrast, real values
eliminate the impact changes in the price level. Stated another way, real economic data
are adjusted for changes in purchasing power of the rupee.
Perhaps an example will clarify the difference between real and nominal values. In 199899 the nominal GNP in India was Rs 16, 01,065 crore, compared to only Rs. 7, 69,265
crore in 1993-94. Does this mean we produce two times as much output in 1993-94? Not
hardly. In 1998-99 the general level of price was higher than the level of prices in 1993-94.
Measured in terms of price level in 1993-94, real GNP in 1998-99 was worth Rs. 10,
71,073.
Nominal GNP will increase either if a) more goods and services are produced or if b)
prices rise. Often both a) and b) contribute to an increase in GNP. Since we are really
interested in comparing only the output or actual production during two intervals, GNP
must be adjusted for the changes in prices.
A price index called GNP deflator is constructed to a price index to reveal the cost of
purchasing the items included in GNP during the period relative to the cost of purchasing
those same items during a base year (say 1993-94). Since the base year is assigned the
value of 100, as the GNP deflator takes on values greater than 100, it indicates that prices
have risen. The central statistical organization (CSO) estimates how much of each item
included in GNP has been produced during a year. This bundle of goods will include
automobiles, houses, office buildings, medical services, bread and all other goods included
in GNP, in qualities actually produced during the current year. The agency then calculates
the ratios of a) the cost of purchasing this representative bundle of goods at current price
divided by b) the cost of purchasing the same bundle at the prices that were present
during a designated base year. The base year chosen is given the value 100. The GNP
deflator is equal to the calculated ratio multiplied by 100. If prices are, on average, higher
during the current period than they were during the base year, the GNP deflator will
exceed 100. The relative size of the GNP deflator is measure of the current price level
compared to price level during the base year.
103
Changes in prices and the real GNP
NOTES
The above table illustrates how real GNP is measured and why it is important to adjust for
price changes. Between 1987-88 and 1991-92, nominal GNP increased 83.09%. However,
a large portion of this increase in nominal GNP reflected higher prices rather than a larger
rate of output. The GNP deflector in 1991-92 was 147.08 compared 100 in 1987-88.
Prices rose by 47.08% between 1987-88 and 1991-92. Determining the real GNP for
1991-92 in terms of 1987-88 prices,
Real GNP (1991-92) =Nominal GNP (1991-92) x [GNP deflator (1987-88)] /
[GNP deflator (1991-92)].
Because prices were rising, the letter ratio is less than one. In terms of 1987-88 prices,
the GNP in 1991-92 was Rs. 3, 63,785 crore, only 24.49% more than in 1987-88. So,
although money GNP expanded by 83.09%, real GNP increased by only 24.49%.
A change in nominal GNP tell us nothing about what is happening to rate of real production
unless we also know what is happening to prices. Money income could double while
production actually declines, if prices more than double. On the other hand, money income
could remain constant while real GNP increases, if prices fall during a time period. Data
on money GNP and price changes are both essential for a meaningful duration a time
period. Data on money GNP and price changes are both essential for a meaningful
comparison of real income between two time periods. So we look at real rather than
nominal GNP as basic measure for comparing output in different years.
The measurement of national income: output, expenditure and income methods of
measurement
There are three methods of calculating national income, and they are all conceptually
equivalent to each other. These are: the output method, the income method and the
expenditure method. These three measures give rise to several different ways of describing
the various macro-aggregates employed in compiling the national accounts and these are
described and illustrated in tables.
1. The output method: The output method is followed either by valuing all final good
and services produced during a year or by aggregating the value imparted to the intermediate
products at each stage of production by the industries and productive enterprises in the
economy. The sum of these values added gives the gross domestic product at factor cost
which after a similar adjustment to include net factor income from abroad gives gross
national product at factor cost.
This approach is used to estimate gross and value added in the primary sector- Ex.
Agriculture, and allied activities, forestry and logging, fishing, registered manufacturing,
etc.-of the Indian Economy.
104
The output (value added) method

The agricultural and extractive industries
10
Plus
Manufacturing industries
40
Plus
Services and construction
40
Equals
Gross Domestic Product at factor cost
90
Plus
Net factor income from abroad

(=income received from abroad- income paid abroad)
NOTES
10
Equal
Gross National Product at factor cost
100
Less
Capital consumption or depreciation
-20
Equals
NNP at factor cost or national income
80
2. The Expenditure method: The expenditure method aggregates all money spent by
private citizens, firms and the government within the year, to obtain total domestic
expenditure at market prices. This includes consumer spending and investment i.e. total
domestic spending. It aggregates only the value of final purchases and excludes all
expenditures on intermediate goods. However, since final expenditure at market price
includes both the effects of taxes and subsidies and our expenditures on imports while
excluding the value of our exports, all these transactions have to be taken into account
before we obtain gross national product by this method.
For instance, in case of private consumption expenditure, quantities of goods and services
entering private consumptions are estimated by deducting from quantities produced,
quantities used up in intermediate uses, purchased by government, etc. Similarly several
items of machinery and equipment are identical and market values of their output are
together to estimate capital in from of machinery and equipment.
The Expenditure Method
Consumers expenditure(C)
70
Plus
20
Plus
Plus
Government current expenditures on goods and services (G)

Gross domestic fixed capital formation (I)
Value of physical increase in stocks and work in progress (I)
Equals Total domestic expenditure at market prices
20
10
120
Plus
Exports and factor income from abroad (E)
20
Less
Imports and factors income paid abroad (M)
-30
Equals GNPMP
110
Less
Indirect taxes
-20
Plus
Subsidies
Equals Gross national product at factor cost
10
100
105
NOTES
3. The Income Method: The income approach to measuring national income does not
simply aggregate all incomes. It aggregates only those of those residents of the nation,
corporate and individual, that obtain income directly from the current production of goods
and services. It aggregates money payments made to the different factors of production
i.e. factors income and excludes all incomes which cannot be concerned as payment for
current services to production (i.e. Transfer incomes and which therefore do not enter
national income). What is factor payment for the producers is factor income for factor
owners. It includes wages and salaries (W), rent (R), interest (I) and profits (P). The last
includes the profits of companies and surpluses of public corporations. Thus, the total of
all factor income gives total domestic income which once adjusted stock appreciation
gives gross domestic product at factor cost. If we then add on net factor income from
abroad we have obtained one measure of gross national income or more properly known
as gross national product.
The Income Method
Income from employment
50
Plus
Income from self-employment
10
Plus
Gross Trading profits of companies
10
Plus
Gross Trading surplus of public corporations
10
Plus
Rent
10
Equals Gross domestic product at factor cost
90
Plus
10
Net factor income from abroad
Equals Gross national product at factor cost
100
According to above table, conceptually whatever may be the method followed for the
measurement of national income, with appropriate adjustments all three methods will give
the same result. Hence, the three methods give rise to estimates of GNP which once
adjusted to take account of capital consumption (depreciation) provides the measurement
of national income by different methods, the consistency and accuracy of the national
income estimates can be cross checked.
Other measures of national output
There are five alternative measures of national product and income:
1. Gross national product
2. Net National income
3. National income
4. Personal income
5. Disposable income
The bar chart given below explains the relationship among five alternative measures of
national product. The alternatives range from GNP, which is the broadest measures of
output, to disposable income, which indicates the funds available to households for either
personal consumption or saving.
106
Five alternative measures of income
NOTES
GNPs measured through expenditure method is the sum of consumption (C), Gross
Private Domestic Investment (I), Government Purchases (G), and Net Export (E-M). Exports
include factor income received from abroad and factor income paid abroad is included in
imports. Therefore, net exports include net factor income from abroad (NFIA). By deducting
depreciation from abroad net indirect taxes from NNP MP, we get NNPFC, widely known as
National Income.
Through income method, national income can also be calculated by summing up payments
to all factors production: Land, Labor, Capital and Entrepreneurship. Factor payments to
land are rents, to labor wages, to capital interest payments and to entrepreneurship
profits. Therefore national income computed through income method is equally to sum of
rents, wages, interests and profits. Total profits can be either from incorporated business
or unincorporated business. Profits of incorporated are corporate profits and profits of
unincorporated business (like self-employment, small scale industries, etc.) are proprietors
income.
Personal income is the total income received by individuals that is available for
consumptions, saving and payment of personal taxes. When we subtract income that is
earned but not directly received from and add income that is received but not earned
during the current period to national income we get personal income. Thus, corporate
profits (Profit before Taxes) which are equal to corporate profit taxes plus retained earnings
plus dividends and social insurance taxes are deducted and transfer payments, net interest
and dividends are added to national income to get personal income.
Disposable income is the income available to individuals after personal taxes i.e. Disposable
income = personal income minus personal taxes. It can be either spent on consumption
or saved.
Difficulties in measuring the national income in India
There are some conceptual and statistical problems in measuring national product. Some
items are excluded from the national income accounting, even though they would be
properly classified as current production of goods and services. Sometimes production
leads to harmful side effects which are not taken into consideration. A brief discussion of
some of these limitations of national products is given below.
1. Non-market production
The national product fails to account house hold production because such production
107
does not involve a market transaction. As a result the house hold services of millions of
people are exactly from the national income accounts. e.g. house work done by housewives is not included but the same work done by paid servant is.
2. Imputed values
NOTES
Some self supplied goods and services are given as imputed values for their inclusion in
national income accounts, for examples, owner-occupied houses and the value for food
consumed by the farmers themselves. Sometimes this may results in overestimation or
underestimation of national income.
3. The underground economy
There are many transactions that go unreported because they involve either illegal activities
or taxes evasion. Most of these underground activities produce goods and services that
are valued by the purchasers. However, these activities are unreported and not included in
national income accounts. They do not figure in our product estimate.
4. Side-effects and economic bads
National income accounts make no adjustment for harmful side effects that sometime
arise from several productive activities and the events of nature. If they do not involve
market transactions, economic bads are not deducted from national product. When
private rights are not defined properly, air and water pollution are sometimes side effects
of the process of economic activity and reduce our future production possibilities. Similarly
the growing defense and the greater outputs of military equipment might increase the
national product but the moot point is whether the country has become better off or not.
Since national accounts ignore these negative aspects of growth and development, it
tends to over state a real national output.
5. Leisure and human cost
According to Simon Kuznets, the failure to fully include leisure and human costs is one of
the grave oddities of national income accounting. National income accounts exclude
leisure, a commodity that is valuable to everybody. Similarly national product also fails to
take into account human cost of employment in terms of the physical and mental strains
associated with many jobs. On an average, jobs today are relatively less strenuous and
less exhausting than they were some forty years ago, but they have become perhaps
more monotonous. These limitations reduce the significance of national product
comparisons in the long run.
3. Double counting
There is a possibility that some output may be counted twice. Thereby the measure of
national product is exaggerated. We must exclude the value of inputs if they have already
been accounted for. Because, the distinction between intermediate product and final product
is vital in connection with the welfare significance of the national product measure.
To calculate real national income or national income at constant prices for year X:
National income at market prices x
100(base year price index)
Price index of year X

National income must be related to the size of population. When national income is
divided by the total population, this gives per capita national income.
The uses of national income statistics
National income statistics have four main uses:
1) As an instrument of economic planning and review.
2) As a means of indicating changes in a countrys standard of living.
108
3) As a means of comparing the economic performance of different countries.
4) To indicate changes in the economic growth of a country.

1) As an instrument of economic planning and review
The statistics provide important background information on which the government can
base its decisions. Private corporate sector can also use the statistics to assess future
prospects. The figures help in answering numerous questions, such as whether the
economy is growing and at what rate. Which industries are declining and which are
expanding? What is happening to consumer spending, savings and the economy as a
whole?
NOTES
2) As a means of indicating changes in a countrys standard of living.

National income statistics are used to assess changes in the standard of living within a
country. If the national income increases, it is normally assumed that the standard of
living has improved. However, this may not be the case and certain factors have to be
taken into account to understand why the living standard has not improved:
z
National income statistics may be expressed in market or current prices and therefore show an increase due to inflation. Real national income or national income at
constant prices, where statistics are expressed as an index of prices, is a more
reliable indicator.
Another problem, however, is that this says nothing about the distribution aspects of
a national income.
The increase in national income may be accompanied by high social costs such as
pollution, congestion and damage to the environment. There may be less leisure
time, too.
The national income increase may be due to more exports and fewer goods for home
consumption or more defense spending. Both these situations may not improve citizens standard of living.
National income statistics say nothing about the quality of output.
3) To indicate changes in the economic growth of a country

The best indicator of economic growth is changes in real national income per capita.
However, usually growth is expressed in terms of percentage changes in GNP. Economic
growth is usually thought to be desirable because it means a better standard of living for
citizens and more wealth to be allocated. More money can be spent on social overheads
such as education, health, etc. It is a fact that our economic growth during the past two
decades has been disappointing compared to that of other developing and newly
industrialized countries such as China, Taiwan, South Korea, etc.
The reasons for this may include:
z
Poor management of public and private sector undertakings;
Damage done by industrial disputes and frequent lockouts;
Education not fitting industrys needs and requirements;
Lack of investment in new technology;
Propping up old and declining industry;
Government taxation policy reducing the amount of money corporate sector has for
investment;
Constant changes in government economic policy- high interest rates, high exchange
rates, inflations followed by changes in administered prices, budget deficits, etc.
109
NOTES
Low quality of labor;
Low level of productivity;
Lack of consistency in managing the economy and policy; and
Fragile Balance of payments (BOP) situation
4) As a means of comparing the economic performance of different countries

National income statistic gives a guide to the standard of living in two different countries.
However, there again some difficulties:
z
The statistic may be calculated differently.
To avoid the effect of inflation and population size, the statistics are best presented as
real national per capita.
The distribution aspect of national income does not fit into the statistics.
There is the problem of the exchange rate between the currencies of two countries.
The size and composition of unrecorded transactions may differ between the tow
countries.
The two countries may have different cultures and climates, therefore commodities
required in one country are not in demand in other.
National income statistics tell us nothing about the number of doctors per head of
population, the availability of leisure activities, the climate rate or the number of people
physically or mentally ill.
6.5. SAVING AND CONSUMPTION FUNCTION

Consumption expenditure is a very important part of aggregate demand, generally the
largest component of aggregate demand. Of the many variables influencing consumption
expenditure, income is the most important. The relationship between consumption and
income is described by consumption function.
We assume that consumption demand increases linearly with increase in level of income:
C = a+ bY;
a>0,
0<b<1
The consumption function is shown in the following figure:
110
The intercept a on the consumption axis gives the consumption when the level of income
is Zero. The slope of the consumption function is equal to b. It indicates the marginal
propensity to consume (MPC). The marginal propensity to consume is the increase in
consumption per unit increase in income.
In a two sector economy, income is either spent or saved; there are no other uses to
NOTES
which it can be put. It follows that any theory that explains consumption is equivalently
explaining the behavior of saving.
Let us derive the savings function from the consumption function. Income can be spent
or saved. Thus,
Y= C + S
This gives us
S=Y-C
Making use of consumption function, we get
S = Y C = Y a bY = -a + (1 b) Y
From the above savings function, it can be seen that when consumption increases linearly
with income, so do savings. (1 b) gives the marginal propensity to save (MPS), which
gives the increase in savings per unit increase in income. The sum of MPC and MPS has
to be equal to one. For instance, if MPC = 0.8, than MPS = 0.2.
Planned Investment (I), Government Purchases (G) and Net Exports (NX)
We have now specified one component of aggregate demand, the consumption demand.
For the time being, assume that the other components of aggregate demand I, G and NX
are constant and independent of the level of income. Let the constant levels of investment,
government purchases and net exports be indicated by
Now that we have all the components of aggregate demand defined, let us derive the
equation of demand in terms of income.
AD = C + I + G +NX
= a + bY + + G + NX
=(a + + G + NX )
=+bY
Where = a + + G + NX and is a constant.
111
NOTES
In the figure, we have both the consumption function and the aggregate function. Here AD
line is parallel to the consumption line because the other components of aggregate demand
are assumed to be constant. Part of aggregate demand is independent of the level of
income, or autonomous and the other part bY is dependent on income and output.
Equilibrium Income: The next step is to use the aggregate demand function, AD, to
determine the equilibrium level of income and output. Equilibrium level of income is that
level of income for which aggregate demand equals output. The 45 line serves as a
reference line that translates any horizontal distance into equal vertical distance.
Thus, anywhere on the 45 line, the level of aggregate demand is equal to the level of
output. The level of income at which aggregate demand line cuts the 45 line is the
equilibrium income. In figure, at Y, aggregate demand is equal to income and thus is the
equilibrium income and output. At any income level below Y, firms find that demand exceeds
output and their inventories are declining. In order to make up for the decline in inventories,
firm increases production. For the levels above Y, firm find inventories piling up (I > 0) and
therefore cut production. As the arrows shows, this process leads to output level Y, at
which current production equals planned aggregate spending and unintended inventory
changes are equal to zero. Let us derive the formula for equilibrium output. At equilibrium,
output is equal to aggregate demand.
112
NOTES
6.6. INVESTMENT MULTIPLIER

The multiplier tells what the increase in the level of equilibrium income, would be for the
unit of decrease in autonomous spending.
113
NOTES
(1-b) is the marginal propensity to save.

Thus = 1
, i.e. the value of the multiplier is the reciprocal of the marginal
(MPS)
MPS (Propensity to save).

The larger the marginal propensity to consume, the lower is the marginal propensity to
save and thus larger is the value of the multiplier. Since MPS is less than one, the
multiplier, in the model, is greater than one.
However, it may be noticed that when we extend our model, there may be circumstances
in which the multiplier is less than one.
THE GOVERNMENT SECTOR
The government can affect the equilibrium output in two ways, i), by changing its expenditure
on goods and services, and ii), by changing the income tax rate. So far, we have assumed
that consumption expenditure is directly dependent on income. A better assumption would
be to make a function of disposable income.
By making consumption directly dependent on disposable income rather than on income,
we will be able to study the role of taxes in the determination of income.
Let us first see how the government can influence the level of output by varying its
expenditure on goods and services. Assume as before that, the government expenditure
is autonomous expenditure. If the autonomous government expenditure is raised, it would
shift the aggregate demand function upwards and thereby result is an increase in the
equilibrium income would be equal to change in times multiplier (). If the government
reduces its expenditure, the opposite would happen.
114
It should be noted that equilibrium output is not the same as full employment output and
thus the two need not be equal.
Equilibrium output depends on the slope and the position of the AD curve. If the total
autonomous expenditure () or the marginal propensity to consume (b) or both are less
than what is required to achieve an equilibrium level that is equal to full employment
output, we would have a situation of unemployment (of labor and other factors of production).
What can government do to raise the equilibrium output to the level of full employment
output? Obviously, by raising autonomous government expenditure. But by how much?
From figure it is seen that the gap in equilibrium output and full employment output is.
This should be the increase in income as a result of an increase in government expenditure.
NOTES
115
= a+ b (Y-T) + I + G
= [a- bT + I + G] / (1-b)
With this the budget of government is balanced in the sense that tax revenue (T) is
equivalent government expenditure.
NOTES
What is the affect of this budget on the Y?

Government expenditure increases the Y by [G/(1-b)]
At the same time T reduces the Y by
[{- b/ (1-b)} x T]
Hence the net affect is
[G/ (1-b)] + [{- b/ (1-b)} x T]
= [{1/ (1-b)} {b/ (1-b)}] x G
= [(1-b)/ (1-b)] x G
=G
And multiplier is (1-b)/ (1-b) = 1
6.7. INFLATION
Inflation is an increase in general level of price in an economy that is sustained over a
period of time. The emphasis is on the general price level which is sustained over a period.
Therefore increase in price level is not called inflation. Inflation is measure for the basket
of goods and services. Within the basket, prices of some of the goods and services may
rise and prices of some of the goods and services may fall. When the overall price of the
defined basket increases it is called inflation.
116
NOTES
Depending on the rate at which the prices rise, inflation is classified into three categories:
creeping inflation, galloping inflation and hyperinflation. When the increase in prices is
small it is called creeping inflation. When inflation reaches double- or triple- digits, it is
called galloping inflation. When price rise is very large and accelerating, it is called
hyperinflation.
Measuring inflation
Inflation is rate at which change in the price level in current year is P1 and in the previous
year P0. The inflation for current year is [(P 1-P 0) / P0] x 100. For example, the price level
in India for the year 1996-97 is 314.6 and for the year 1997-98 is 329.8. The rate of inflation
for the year 1997-98 is [(329.8-314.6)/314.6]x 100 = 4.8%.
Economic impacts of inflation

Inflation is a major concern of government world over. The effect of inflation on the economy
is widespread in its reach, ranging from redistribution of income and wealth among different
sections to the society to the worsening of balance of payments positions. Here, we will
explain the effect of inflation on redistribution of income and wealth, and output and growth.
Monetary policy
These are two main macroeconomic policy tools the government uses to keep the economic
growth at a reasonable rate, with low inflation. Fiscal policy has its initial impact in the
goods market, and monetary policy has its initial impact mainly in the assets market.
But, because the goods and the assets markets are closely interconnected, both monetary
and fiscal policies have effects on both the level of output and interest rates. The monetary
policy of any country refers to the regulatory policy, whereby the monetary authority
maintains its control over the supply of money for the realization of general economic
objectives, such as stability of employment and prices, economic growth and balance of
payments. This involves manipulation of the supply of money, the level and structure of
117
NOTES
interest rate and other conditions affecting the availability of credit. In the context of
developing countries like India, monetary policy acquires a still wider role and it has to be
designed to meet the particular requirements of the economy. This involves not merely the
restriction of credit expansion to curb inflation, but also the provision of adequate funds to
meet the legitimate requirements of industry and trade and curbing the use of credit for
unproductive and speculative purposes. In India, the three major objectives of economic
policy are growth, social justice and price stability. So, price stability is perhaps one that
can be pursued most effectively by the monetary authority of the country. Therefore,
monetary policy is required to facilitate the fulfillment of the basic objectives of planning
and is also required to play the difficult role of a countervailing force. The monetary policy
of any economy operates through three important instruments, i.e., the regulation of
money supply, control over aggregate credit and the interest rate policy.
Salient features of monetary policy
Let us now see a bit more closely how monetary policy works.
The initial equilibrium at point E is on the initial LM schedule that corresponds to a real
money supply. Suppose now that the nominal quantity of money is increased, for example
by open market operations. Given a constant price level, when real quantity of money
increases due to nominal quantity of money increases. As a result of the increase in the
real quantity of money, the LCM schedule shifts to LM1.
For the new schedule LM1, the equilibrium will be at point E1 with a lower rate of interest
and a higher level of income.
Let us see a bit more closely how with an expansion in real money supply the economy
moves from the original equilibrium at E to a new equilibrium at E1. At economy moves
from the original equilibrium point, E, the increase in money creates an excess supply of
money. The public tries to adjust to the excess supply of money by buying financial
assets. As a result of the increase in demand, the price of financial assets rises, and thus
the yield decline. The adjustment process in the assets markets is much more rapid than
that in the goods market and, therefore, we move immediately to point E1 when the money
supply increases. At E1, however, there is an excess demand for goods. The decline in
118
the interest rate, given the initial income level and thus causes Y0 , raises aggregate
demand inventories to run down. In response, the output expands and we start moving up
the LM1 schedule. As output expands, the interest rate rises (after the immediate decline
in interest rate when money supply is increased) because increase in output raises the
demand for money and the increase in demand for money has to be checked by higher
interest rates.
NOTES
The Transmission Mechanism

The mechanism by which the changes in monetary policy affect aggregate demand is
called transmission mechanism. Two stages in transmission mechanism are important.
First is that an increase in real money supply causes portfolio disequilibrium at the prevailing
interest rate and level of income, i.e. people are holding more money than they wants.
They try to get rid of the excess money they are holding by financial assets. This action
of theirs pushes up the price of financial assets. This action of theirs pushes up the price
of financial assets and thus causes the interest rate to fall.
The second stage of the transmission process occurs when the change in interest rate
affects aggregate demand. The fall in interest rates induces an increase in investment
expenditure, and also possibly consumption expenditure, thereby increasing the aggregate
demand and ultimately the income.
Fiscal policy
An increase in Government Spending:
Let us examine how an increase in government spending affects the interest rate and the
level of income. When government spending increases, at unchanged interest rates, the
level of aggregate demand increases. To meet the increased demand for goods, outputs
must rise as shown by a shift in the IS schedule in the figure
If the economy is initially at point E, an increase in government spending would shift the
economy to point E11 if the interest rate remained constant. At E11 , the goods market is in
equilibrium but the money market is no longer in equilibrium. Because of the increase in
income, the quantity of money demanded goes up, which in turn pushes up the interest
rate. With interest rate rising, firms planned investment spending declines and the
aggregate demand begins to fall from the high level it reaches immediately on increase in
119
the government spending. The economy finally reaches its new equilibrium at point E1
where both the goods market and the money market are in equilibrium. As compared to
point E, at point E1 the level of income is higher and so is the interest rate. Thus, an
increase in government spending results in an increase in the level of income and an
increase in the interest rate.
NOTES
Crowding Out
Point E11 corresponds to the equilibrium when we neglect the impact of interest rates on
economy. In comparing E11 and E1, it becomes clear that the interest rates and their
impact on aggregate demand dampen the expansionary affect of government spending.
Income, instead of increasing to the level Y11, rises only to Yo 1. This happens because the
increase in interest rate from in to i1 reduces the level of investment spending. We say that
the increase in government spending crowds on investment spending. Crowding out occurs
when expansionary fiscal policy causes interest rates to rise, thereby reducing private
spending, particularly investment. Is there a way to avoid crowding out of private investment
as a result of expansionary fiscal policy? Yes, there is. The key is to prevent
6.9. INTERNATIONAL ECONOMICS FIXED AND FLEXIBLE

EXCHANGE RATES
It is now more than a decade since the world abandoned the system of fixed but adjustable
exchange rates which was the center-piece of the old Bretton Woods system. That system
collapsed in 1973 with no official agreement on what was to replace it, and the major
currencies were set afloat in world currency markets. These arrangements, which at first
had no official international sanction, were later legitimised by the Second Amendment to
the Articles of Agreement of the IMF in 1978 which allowed members to adopt exchange
rate arrangements of their choice.
The new system, which has called a non-system, is characterized by a mix of exchange
rate arrangements. Major currencies float relatively freely in world currency markets. The
countries forming the European Monetary System float as a group against other major
currencies and maintain a form of managed floating within adjustable margins against
each other, with well defined rules of intervention backed by currency swap arrangements.
The developing countries have not resorted to independent floating but have ether pegged
their currencies to one of the major currencies or, increasingly to a basket of currencies.
Whatever the exchange rate arrangements adopted, all countries face a world in which
exchange rates vary considerably and often unpredictably. In the ten years and more that
the new system has been in operation, considerable experience has been gained and a
degree of consensus has emerged on the functioning of the system and its short-comings.
The object is to review the main elements of this consensus and to identify the outstanding
issues in this area which remain on the agenda of international monetary reform.
The Experience with Floating Rates

In evaluating the experience with floating rates we must avoid the temptation to lay entirely
the blame for the dismal state of the world economy in recent years on the exchange rate
system. It is clear that world production and world trade grew much more rapidly under
the old Bretton Woods system than they have during the period of floating rates. It is also
true that developing countries on the whole have experienced much greater difficulty in
almost all dimensions under the new regime. This does not however establish that the
exchange rate arrangements were the prime cause of the difference in performance. There
is a multitude of factors which affect world trade and production growth, and within that,
120
the prospects and performance of the developing countries. The exchange rate system is
an important part of the totality of influences on the functioning of the world economy, but
it is not the only influence, and we certainly cannot assume that the world would have
been a better place, ceteris paribus. if only the old fixed rate system had remained in
place. On the contrary, one of the elements on which there is a wide consensus is the
view that structural developments in the international economy in the two decades after
Bretton Woods had made the fixed rate system unworkable. It is important to understand
the reason why the fixed rate system became infeasible since any recommendation
regarding exchange rate arrangements in the future must deal with these structural
developments as given.
NOTES
Infeasibility of Fixed Rates

The proximate cause of the breakdown of the Bretton Woods system was the inability to
maintain the fixed dollar price for gold. The United States did not take effective corrective
action when the dollar came under increasing pressure in the late sixties, by when the
dollar shortage of the fifties had been converted into a dollar glut. This in turn has been
attributed to the fundamental asymmetry in the Bretton Woods institutional arrangements
in which there were no effective disciplinary instruments that could be used for surplus
countries and the key reserve currency country.
6.10. SPOT AND FORWARD EXCHANGE RATES

When two parties agree to exchange the currency and execute the deal immediately, the
transaction is referred to as a spot exchange. Exchange rate governing such on the spot
rates is referred to as spot exchange rates. The spot exchange rate is the rate at which a
foreign exchange dealer converts one currency into other on a particular day. Thus, when
US tourist in Edinburgh goes to bank to convert her dollars into pounds, the exchange
rate is spot rate for the day.
Spot exchange rate is reported daily in the financial pages of newspaper. Table 10.1
shows dollar exchange rate for currencies traded in the New York foreign exchange market
as of noon January 11, 2005. An exchange can be quoted in two ways: as the amount of
foreign currency one US dollar will buy, or as the value of dollar for one unit of foreign
currency. Thus, one US dollar bought .759821 on January 11, 2005, and one euro bought
$1.3161.
Spot rate changes continually, often on a day to day basis. The value of a currency is
determined by the interaction between the demand and supply of that currency relative to
the demand and supply of other currencies. For example, if lots of people want US dollars
and dollars are in short supply, and few people want British pounds and pounds are in
plentiful supply, the spot exchange for converting dollars into pounds will change.
Foreign Exchange Quotations for U.S Dollar, January 11, 2005
Foreign currency per
1USD
Dollar per unit of

foreign currency
Australian Dollar
1.30856
0.764199
Brazilian Real
2.712
0.368732
British Pound
.532028
1.8796
Canadian Pound
1.2142
0.823588
121
NOTES
Chinese Yuan
8.2765
0.120824
Danish Krone
5.653
0.176897
Euro
0.759821
1.3161
Hong Kong Dollar
7.7955
0.128279
Indian Rupees
43.68
0.02289380
Japanese Yen
103.42
0.00966931
Malaysian Ringgit
3.8
0.263158
Mexican Peso
11.217
0.0891504
New Zealand Dollar
1.42816
.700202
Norwegian Kroner
6.2278
0.16057
Singapore Dollar
1.6363
0.611135
South African Rand
5.955
0.167926
South Korean Won
1045
0.000956938
Sri lanka Rupees
98.1
0.0101937
Swedish Krona
6.8616
0.145739
Swiss Franc
1.1758
0.850485
Taiwan Dollar
31.98
0.0312695
Thai Baht
39
0.025641
Venezuelan Bolivar
1915.2
.000522139
The dollar is likely to appreciate against the pound. Imagine the spot exchange rate is
pound 1=$1.50 when market opens. As the day progresses, dealers demand more dollars
and fewer pounds. By the end of the day, the spot exchange rate might be pound 1=$1.48.
Each pound now buys few dollars than at the start of the day. The dollar has appreciated
and the pound has depreciated.
Forward Exchange Rates

As we saw in the opening case, changes in spot exchange rates can be problematic for
an international business. For example, a US company that imports laptop computers
from Japan knows that in 30 days it must pay yen to the japans suppliers when a shipment
arrives. The company will pay the Japanese supplier yen 200,000 for each laptop computer.
And the current dollar/yen spot exchange rate is $1=yen120.At this rate , each computer
cost the importer dollar 1,667. The importer knows that she can sell the computers the
day they arrive for $2000 each, which yields a gross profit of $333on each computer.
However, the importer will not have funds to pay the Japanese suppliers until computers
have been sold. If over the next 30 days the dollar unexpectedly depreciates against the
yen say, to $1=yen 95, the importer will still have to pay the Japanese company yen
200,000 per computer, but in dollar terms that would be equivalent to $2,105 per computer,
which is more than she can sell the computers for. A depreciation is the value of dollar
against the yen from $1=yen 120 to $1=yen 95 would transform a profitable deal into
unprofitable one.
To avoid this risk, the US importer might want to engage a forward exchange. A forward
exchange occurs when two parties agree to exchange currency and execute the deal at
122
some specific date in the future. Exchange rates governing such future transactions are
referred to as foreign exchange rates. For most major currencies, foreign exchange rates
are quoted for 30 days, 90 days and 180 days into the future
In some cases, it is possible to get forward exchange rate for several years into the future.
Returning to our computer importer example, let us assume the 30 day forward exchange
rate for converting dollars into yen is $1=yen 110. The importer enters into 30 days forward
exchange rate transaction with a foreign exchange dealer at this rate and is guaranteed
that she will have to pay no more than $1,818 for each computer. This guarantees her a
profit of $182 per computer. She also insures herself against the possibility that the
unanticipated change in the dollar/yen exchange rate will turn a profitable deal into an
unprofitable one.
NOTES
In this example, the spot exchange rate and forward exchange rate differ. Such differences
are normal; they reflect the expectation of the foreign exchange market about future
currency movements. In our example, the fact that $1 bought more yen with a spot
exchange than with a 30 day forward exchange indicates foreign exchange dealers expected
the dollar to depreciate against the yen in the next 30 days. When this occurs, we say
dollar is selling at a discount on the 30 day forward market. Of course, the opposite can
also occur. If the 30 day forward exchange rate were $1 = yen 130, for example, $1 would
buy more yen with a forward exchange than with a spot exchange. In such a case, we say
the dollars selling at a premium on 30 day forward market. This reflects the foreign exchange
dealers expectation that the dollar will appreciate against the yen over the next 30 days.
In sum, when a firm enters into a foreign exchange contract, it is taking out insurance
against the possibility that future exchange rate movements will make a transaction
unprofitable by the time that transaction has been executed. Although many firms routinely
enter into forward exchange contracts to hedge their foreign exchange risk, there are
some spectacular examples of what happens when firms dont take out this insurance.
6.11 CURRENT AND CAPITAL ACCOUNT CONVERTIBILITY A

CASE STUDY OF INDIA.
Currency convertibility: Currency convertibility means the freedom to convert one
currency into other internationally accepted currencies. There are two popular categories
of currency convertibility, namely:
z
Convertibility for current international transactions; and
Convertibility for international capital movements.
Currency convertibility implies the absence of exchange controls or restrictions on foreign

exchange transactions.
Current Account Convertibility: Current account convertibility is popularly defined as
the freedom to buy or sell foreign exchange for:a.
The international transactions consisting of payments due in connection with foreign

trade, other current businesses including services and normal short-term banking
and credit facilities
b. Payments due as interest on loans and as net income from other investments
c. Payment of moderate amounts of amortisation of loans for depreciation of direct investments
d. Moderate remittances for family living expenses
e. Authorised Dealers may also provide exchange facilities to their customers without
prior approval of the RBI beyond specified indicative limits, provided, they are satisfied
123
about the bonafides of the application such as, business travel, participation in overseas conferences/seminars, studies/ study tours abroad, medical treatment/checkup and specialised apprenticeship training.
Capital Account Convertibility in India- Special Feature
NOTES
Convertibility of a currency implies that a currency can be transferred into another currency
without any limitations or any control. A currency is said to be fully convertible, if it can be
converted into some other currency at the market price of that currency. If currency has to
be convertible, it shall not be subjected to these restrictions.
Current account convertibility refers to currency convertibility required in the case of
transactions relating to exchange of goods and services, money transfers and all those
transactions that are classified in the current account.
On the other hand, capital account convertibility refers to convertibility required in the
transactions of capital flows that are classified under the capital account of the balance of
payments.
At present, Indian rupee is partly convertible on current account. In 1997, the Tarapore
Committee on Capital Account Convertibility (CAC), constituted by the Reserve Bank,
had indicated the preconditions for Capital Account Convertibility. The three crucial
preconditions were fiscal consolidation, a mandated inflation target and, strengthening of
the financial system. India adopted a gradualist approach while initiating a process of
gradual capital account liberalisation in the early 1990s. In 2003, the RBI Governor
outlined issues related to capital account convertibility in India.
Prime Minister Manmohan Singh on 18th March 2006 said there was merit in India moving
towards fuller capital account convertibility. He asked Finance Minister and the Reserve
Bank of India to revisit the subject and come out with a road map on capital account
convertibility based on current realities.
In response to Prime Ministers statement, Reserve Bank of India on 20th March 2006,
announced Committee to set out Roadmap towards Full Capital Account Convertibility.
Capital Account Convertibility: Tarapore Committee on Capital Account Convertibility
appointed in February, 1997 defines Capital Account Convertibility as the freedom to
convert local financial assets into foreign financial assets and vice versa at market determined
rates of exchange. In other terms we can say Capital Account Convertibility (CAC)
means that the home currency can be freely converted into foreign currencies for acquisition
of capital assets abroad and vice versa.
Background of Capital Account Convertibility:
Foreign exchange transactions are broadly classified into two types: current account
transactions and capital account transactions. In the early nineties, Indias foreign
exchange reserves were so low that these were hardly enough to pay for a few weeks of
imports. To overcome this crisis situation, Indian Government had to pledge a part of its
gold reserves to the Bank of England to obtain foreign exchange. However, after reforms
were initiated and there was some improvement on FOREX front in 1994, transactions on
the current account were made fully convertible and foreign exchange was made freely
available for such transactions. But capital account transactions were not fully convertible.
The rationale behind this was clear that India wanted to conserve precious foreign exchange
and protect the rupee from volatile fluctuations.
By late nineties situation further improved, a committee on capital account convertibility
was setup in February, 1997 by the Reserve Bank of India (RBI) under the chairmanship of
former RBI deputy governor S.S. Tarapore to lay the road map to capital account
convertibility. The committee recommended that full capital account convertibility be
124
brought in only after certain preconditions were satisfied. These included low inflation,
financial sector reforms, a flexible exchange rate policy and a stringent fiscal policy.
However, the report was not accepted due to Asian Crisis.
The five-member committee has recommended a three-year time frame for complete
convertibility by 1999-2000. The highlights of the report including the preconditions to be
achieved for the full float of money are as follows:Pre-Conditions Set By Tarapore Committee:
z
NOTES
Gross fiscal deficit to GDP ratio has to come down from a budgeted 4.5 per cent in
1997-98 to 3.5% in 1999-2000.
A consolidated sinking fund has to be set up to meet governments debt repayment
needs; to be financed by increased in RBIs profit transfer to the govt. and disinvestment proceeds.
Inflation rate should remain between an average 3-5 per cent for the 3-year period
1997-2000
Gross NPAs of the public sector banking system needs to be brought down from the
present 13.7% to 5% by 2000. At the same time, average effective CRR needs to be
brought down from the current 9.3% to 3%.
RBI should have a Monitoring Exchange Rate Band of plus minus 5% around a neutral Real Effective Exchange Rate. RBI should be transparent about the changes in
REER.
External sector policies should be designed to increase current receipts to GDP ratio
and bring down the debt servicing ratio from 25% to 20%.
Four indicators should be used for evaluating adequacy of foreign exchange reserves
to safeguard against any contingency. Plus, a minimum net foreign asset to currency
ratio of 40 per cent should be prescribed by law in the RBI Act. Phased liberalisation
of capital controls.
The Committees recommendations for a phased liberalization of controls on capital outflows

over the three year period which have been set out in detail in a tabular form in Chapter 4
of the Report, inter alia, include:(i)
Indian Joint Venture/Wholly Owned Subsidiaries (JVs/WOSs) should be allowed to

invest up to US $ 50 million in ventures abroad at the level of the Authorised Dealers
(ADs) in phase 1 with transparent and comprehensive guidelines set out by the RBI.
The existing requirement of repatriation of the amount of investment by way of dividend etc., within a period of 5 years may be removed. Furthermore, JVs/WOs could
be allowed to be set up by any party and not be restricted to only exporters/exchange
earners.
(ii) Exporters/exchange earners may be allowed 100 per cent retention of earnings in
Exchange Earners Foreign Currency (EEFC) accounts with complete flexibility in
operation of these accounts including cheque writing facility in Phase I.
(iii) Individual residents may be allowed to invest in assets in financial market abroad up
to $ 25,000 in Phase I with progressive increase to US $ 50,000 in Phase II and US$
100,000 in Phase III. Similar limits may be allowed for non-residents out of their nonrepatriable assets in India.
(iv) SEBI registered Indian investors may be allowed to set funds for investments abroad
subject to overall limits of $ 500 million in Phase I, $ 1 billion in Phase II and $ 2 billion
in Phase III.
(v) Banks may be allowed much more liberal limits in regard to borrowings from abroad
125
and deployment of funds outside India. Borrowings (short and long term) may be
subject to an overall limit of 50 per cent of unimpaired Tier 1 capital in Phase 1, 75 per
cent in Phase II and 100 per cent in Phase III with a sub-limit for short term borrowing.
In case of deployment of funds abroad, the requirement of section 25 of Banking
Regulation Act and the prudential norms for open position and gap limits would apply.
NOTES
(vi) Foreign direct and portfolio investment and disinvestment should be governed by
comprehensive and transparent guidelines, and prior RBI approval at various stages
may be dispensed with subject to reporting by ADs. All non-residents may be treated
on part purposes of such investments.
(vii) In order to develop and enable the integration of forex, money and securities market,
all participants on the spot market should be permitted to operate in the forward
markets; FIIs, non-residents and non-resident banks may be allowed forward cover to
the extent of their assets in India; all India Financial Institutions (FIs) fulfilling requisite
criteria should be allowed to become full-fledged ADs; currency futures may be introduced with screen based trading and efficient settlement system; participation in
money markets may be widened, market segmentation removed and interest rates
deregulated; the RBI should withdraw from the primary market in Government securities; the role of primary and satellite dealers should be increased; fiscal incentives
should be provided for individuals investing in Government securities; the Government
should set up its own office of public debt.
(viii) There is a strong case for liberalising the overall policy regime on gold; Banks and FIs
fulfilling well defined criteria may be allowed to participate in gold markets in India and
abroad and deal in gold products.
The assumption of the committee was that these pre-conditions would take care of possible
problems created by unseen flight of capital. Given a sound fiscal and financial set-up, the
flight of capital was unlikely to be large, particularly in the short run, as capital would be
invested and not all of it would be in a liquid form.
Present Status:
The process of opening up the Indian economy has proceeded in steady steps.
z
126
First, the exchange rate regime was allowed to be determined by market forces as
against the fixed exchange rate linked to a basket of currencies.
Second, this was followed by the convertibility of the Indian rupee for current account
transactions with India accepting the obligations under Article VIII of the IMF in August 1994.
Third, capital account convertibility has proceeded at a steady pace. RBI views capital account convertibility as a process rather than as an event.
Fourth, the distinct improvement in the external sector has enabled a progressive
liberalisation of the exchange and payments regime in India. Reflecting the changed
approach to foreign exchange restrictions, the restrictive Foreign Exchange Regulation Act (FERA), 1973 has been replaced by the Foreign Exchange Management Act,
1999.
NOTES
Thus, at present in India we have restricted capital account convertibility. Indian entities
(i.e. individuals, companies or otherwise) are allowed to invest or acquire assets outside
India or a foreign entity remit funds for investment or acquisition of assets with specified
cap on such investments and for specific purpose. A full convertibility will allow free
movement of funds in and out of India without any restrictions on purpose and amount.
Thus, after full convertibility is allowed, residents in India will be able to transfer money
abroad and receive from other entities across the world. However, government will certainly
make rules and regulations to ensure these do not lead to money laundering or funding for
illegal activities.
Prime Minister Manmohan Singh on 18th March 2006 said that the countrys economic
position internally and externally had become far more comfortable and it was worth
looking into greater capital account convertibility. In a speech at the Reserve Bank of India
(RBI) in the countrys financial hub Mumbai, Prime Minister Manmohan Singh said he
would ask the Finance Minister and RBI to come out with a roadmap to greater convertibility
based on current realities. PM also said Given the changes that have taken place over
the last two decades, there is merit in moving towards fuller capital account convertibility
within a transparent framework, Singh said.
RBI in its circular issued in March, 2006 has laid down that economic reforms in India
have accelerated growth, enhanced stability and strengthened both external and financial
sectors. Our trade as well as financial sector is already considerably integrated with the
global economy. Indias cautious approach towards opening of the capital account and
viewing capital account liberalisation as a process contingent upon certain preconditions
has stood India in good stead.
Given the changes that have taken place over the last two decades, however, there is
merit in moving towards fuller capital account convertibility within a transparent framework.
There is, thus, a need to revisit the subject and come out with a roadmap towards fuller
Capital Account Convertibility based on current realities. In consultation with the Government
of India, the Reserve Bank of India has appointed a committee to set out the framework for
fuller Capital Account Convertibility.
The Committee consists of the following:
i.
Shri S.S Tarapore Chairman
ii.
Dr. Surjit S. Bhalla Member
iii. Shri M.G Bhide Member

iv.
Dr. R.H. Patil Member
v.
Shri A.V Rajwade Member
vi. Dr. Ajit Ranade Member
127
The terms of reference of the Committee will be:
NOTES
i.
To review the experience of various measures of capital account liberalisation in India,
ii.
To examine implications of fuller capital account convertibility on monetary and exchange rate management, financial markets and financial system,
iii. To study the implications of dollarisation in India of domestic assets and liabilities
and internationalisation of the Indian rupee,
iv.
To provide a comprehensive medium-term operational framework, with sequencing

and timing, for fuller capital account convertibility taking into account the above implications and progress in revenue and fiscal deficit of both centre and states,
v.
To survey regulatory framework in countries which have advanced towards fuller capital account convertibility?
vi. To suggest appropriate policy measures and prudential safe- guards to ensure monetary and financial stability, and
vii. To make such other recommendations as the Committee may deem relevant to the
subject.
Factors Which Are Critical / Of Concern In Adopting Capital Account Convertibility:
There are number of issues which are of concern for adopting capital account convertibility.
128
The impact of allowing unlimited access to short-term external commercial borrowing

for meeting working capital and other domestic requirements is manifold. In respect
of short-term external commercial borrowings, there is already a strong international
consensus that emerging markets should keep such borrowings relatively small in
relation to their total external debt or reserves. Many of the financial crises in the
1990s occurred because the short-term debt was excessive. When times were good,
such debt was easily accessible. The position, however, changed dramatically in
times of external pressure. All creditors who could redeem the debt did so within a
very short period, causing extreme domestic financial vulnerability. The occurrence of
such a possibility has to be avoided, and we would do well to continue with our policy
of keeping access to short-term debt limited as a conscious policy at all times good
and bad.
Providing unrestricted freedom to domestic residents to convert their domestic bank

deposits and idle assets (such as, real estate), in response to market developments
or exchange rate expectations. The day-to-day movement in exchange rates is determined by flows of funds, i.e. by demand and supply of spot or forward transactions
in the market. Now, suppose the exchange rate is depreciating unduly sharply (for
whatever reasons) and is expected to continue to do so for the near future. Now,
further suppose that domestic residents, therefore, that they should convert a part or
whole of their stock of domestic assets from domestic currency to foreign currency.
This will be financially desirable as the domestic value of their converted assets is
expected to increase because of anticipated depreciation. And, if a large number of
residents so decide simultaneously within a short period of time, as they may, this
expectation would become self-fulfilling. A severe external crisis is then unavoidable.
Although at present our reserves are high and exchange rate movements are, by and
large, orderly. However, there can be events like Kargil war or Pokhran Test, which
creates external uncertainty, Domestic stock of bank deposits in rupees in India is
presently close to US $ 290 billion, nearly three and a half times our total reserves. At
the time of Kargil or Pokhran or the oil crises, the multiple of domestic deposits over
reserves was in fact several times higher than now. One can imagine what would have
had happened to our external situation, if within a very short period, domestic resi-
dents decided to rush to their neighborhood banks and convert a significant part of
these deposits into sterling, euro or dollar. No emerging market exchange rate system can cope with this kind of contingency. This may be an unlikely possibility today,
but it must be factored in while deciding on a long term policy of free convertibility of
stock of domestic assets. Incidentally, this kind of eventuality is less likely to occur
in respect of industrial countries with international currencies such as Euro or Dollar,
which are held by banks, corporates, and other entities as part of their long-term
global asset portfolio (as distinguished from emerging market currencies in which
banks and other intermediaries normally take a daily long or short position for purposes of currency trade).
NOTES
Impact of Capital Account Convertibility

After full convertibility is adopted by India, it will lead to acceptance of Indian Rupee
currency all over the world.
In case of two convertible currencies, Forward Exchange Rates reflect interest rate
differentials between these two currencies. Thus, we can say that the Forward Exchange
Rate for the higher interest rate currency would depreciate so as to neutralize the interest
rate difference. However, sometimes there can be opportunities when forward rates do
not fully neutralize interest rate differentials. In such situations, arbitrageurs get into the
act and forward exchange rates quickly adjust to eliminate the possibility of risk-less
profits.
Capital account convertibility is likely to bring depth and large volumes in long-term INR
currency swap markets. Thus for a better market determination of INR exchange rates,
the INR should be convertible.
Bimal Jalan: Exchange rate management - an emerging consensus?

Address by Dr Bimal Jalan, Governor of the Reserve Bank of India, at the 14th National
Assembly of the Forex Association of India, Mumbai, 14 August 2003.
I am very happy to be here with you on the occasion of the 14th National Assembly. This
annual gathering of our Forex specialists is a very special occasion for everyone interested
in the evolution of forex market in India - not only the dealers and market participants, but
also the RBI, Government and outside experts interested in appropriate macro-economic
management for higher growth and the greater good of our people. It provides all of us with
an opportunity to review recent developments in forex markets against the background of
global developments in a fast changing world economic scenario and modify our own
policy and approach. I am, therefore, delighted to be with you once again.
As you know, RBI is in regular touch, formally and informally, with your association to
review market developments. My senior colleagues and I have also benefited from your
advice and, as you are aware, a large number of measures have now been put in place to
liberalise our regulations in respect of foreign exchange transactions. With your permission,
today, on this special occasion, I would like to deal briefly with some of the longer term
policy issues in respect of exchange rate and reserves management. Several of these
issues have also been debated in various international fora. In the context of upsurge in
our reserves in recent years and the appreciating trend in the external value of the rupee,
there has also been considerable domestic discussion of these issues.
You will recall that the last time I had addressed your Association was in December 2000
- nearly 2 years ago - on the occasion of the 21st Asia Pacific Forex Congress. That
meeting was taking place against the background of the Asian crisis in 1997-98. The
Asian region had just come out of the forex crisis of a very destabilising kind. I had used
that occasion to review the on-going debate on management of the external sector,
129
particularly the appropriate exchange rate systems, the appropriate intervention policy,
and the foreign exchange reserve policy. Soon after the Asian crisis, these subjects had
figured very prominently in the discussions on International Financial Architecture in various
fora, such as IMF, the World bank, G20, Financial Stability Forum and the Bank for
International Settlements.
NOTES
At that time, while reviewing the state of the debate, I had mentioned that a worldwide
consensus on several issues was still evolving. Today, while .consensus. may be too
strong a word, I believe that there is a fair degree of convergence in the dominant international
opinion among experts and various specialised institutions on many of these issues. Let
me summarise some of the main conclusions which have emerged in the last 2 or 3 years
on the management of the external sector. Once again, I should emphasise that, given
widely different economies of the world that we are talking about, there is no global
consensus as such or unity of views. However, at present, as I see it, there is certainly a
dominant. view of what is right and appropriate, which is increasingly commanding
international acceptance.
Thus, on the question of the appropriate exchange rate regime, a fixed exchange rate
regime (even with a Currency Board) is clearly out of favour. The Brazilian and Argentinian
crisis, after the Asian crisis, came as a rude shock. Even strong Currency Board type
arrangements of a fixed peg vis--vis dollar were found to be unviable. You will recall that,
soon after the Asian crisis, the widely accepted theoretical position was that a country
had the choice of either giving up monetary independence and setting up a Currency
Board or giving up the stable currency objective and letting the exchange rate float freely
so that monetary policy could then be directed to the objectives of inflation control. There
is a shift in this paradigm. The possibility of having a viable fixed rate mechanism has
been generally discarded, and the dominant view now is that, for most countries floating
or flexible rates are the only sustainable way of having a less crisis-prone exchange rate
regime.
In regard to the desirable degree of flexibility in exchange rates, opinions and practices
vary. But a completely .free. float, without intervention, is clearly out of favour except
perhaps in respect of a few global or reserve currencies. And, in respect of these currencies
also (say, Euro and Dollar), concerns are expressed at the highest levels if the movement
is sharp in either direction - recently, for example, when Euro was strengthening at a fast
pace. Studies by the IMF and several experts also show that by far, the most common
exchange rate regime adopted by countries, including industrial countries, is not 2 BIS
Review 36/2003 a free float. Most of the countries have adopted intermediate regimes of
various types, such as, managed floats with no pre-announced path, and independent
floats with foreign exchange intervention moderating the rate of change and preventing
undue fluctuations. By and large, barring a few, countries have .managed. floats and
Central Banks intervene periodically. This has also been true of industrial countries. In the
past, the U.S., the EU and the U.K. have also intervened at one time or another. Thus,
irrespective of the pure theoretical position in favour of a free float, the external value of the
currency continues to be a matter of concern to most countries, and most central banks.
The reason why intervention by most central banks in forex markets has become necessary
from time to time is primarily because of two reasons. A fundamental change that has
taken place in recent years is the importance of capital flows in determining exchange
rate movements as against trade deficits and economic growth, which were important in
the earlier days. The latter do matter, but only over a period of time. Capital flows, on the
other hand, have become the primary determinants of exchange rate movements on a
day-to-day basis. Secondly, unlike trade flows, capital flows in gross.
130
terms which affect exchange rate can be several times higher than .net. flows on any day.
These are also much more sensitive to what everybody else is saying or doing than is the
case with foreign trade or economic growth. Therefore, herding becomes unavoidable. I
am sure you will agree that all dealers prefer to be wrong with everyone else rather than
being wrong alone!
A related issue, which is a corollary of the prevalent intermediate regimes in respect of
exchange rates, concerns the need, if any, for foreign exchange reserves. In a regime of
free float, it could be argued that there was really no need for reserves. If demand for
foreign exchange is higher than supply, exchange rates will depreciate and equilibrate
demand and supply over time. If supply exceeded demand, exchange rates will appreciate
and sooner or later, the two will equalise at some price. However, today in the light of
volatility induced by capital flows and the self-fulfilling expectations that this can generate,
there is now a growing consensus that emerging market countries should, as a matter of
policy, maintain .adequate. reserves. How adequacy is to be defined is also becoming
clearer. Earlier, the rule used to be defined in terms of number of months of imports. Now,
increasingly it is felt that reserves should at least be sufficient to cover likely variations in
capital flows or the liquidity-at-risk. (However, there is as yet no consensus on the upper
limit for reserves. Even after an adequate level is reached, reserves may continue to
increase if capital inflows are strong and central banks decide to intervene in order to
moderate the degree of appreciation.)
NOTES
To sum up, it seems that the debate on appropriate policies relating to forex markets has
now converged around some generally accepted views. Among these, as I mentioned are:
(a) exchange rates should be flexible and not fixed or pegged; (b) countries should be able
to intervene or manage exchange rates - to at least some degree - if movements are
believed to be destablising in the short run; and (c) reserves should at least be sufficient
to take care of fluctuations in capital flows and liquidity at risk.
Let me now briefly deal with some issues of practical importance in the management of
forex markets in India, which have figured prominently in the media and expert commentary.
I will first take up 2 or 3 matters which are rather straight-forward and on which our policy
stance is also equally unambiguous. and clear-cut. Then I will move to, and conclude
with, a discussion of the appropriate exchange rate policy for India in the current situation.
A frequently discussed question is about Capital Account Convertibility (CAS), i.e. when
is India going to move to full CAC? As you are aware, we have already liberalized and
deregulated a whole host of capital account transactions. It is probably fair to say that for
most transactions which are required for business or personal convenience, the rupee is,
for all practical purposes, convertible. In cases, where specific permission is required for
transactions above a high monetary ceiling, this permission is also generally forthcoming.
It is also the declared policy of the Government and the RBI to continue with this process
of liberalization. In this sense, Capital Account Convertibility continues to be a desirable
objective for all investment and business related transactions and India should be able to
achieve this objective in not too distant a future.
There are, however, two areas where we would need to be extremely cautious - one is
unlimited access to short-term external commercial borrowing for meeting working capital
and other domestic requirements. The other area concerns the question of providing
unrestricted freedom to domestic residents to convert their domestic bank deposits and
idle assets (such as, real estate), in response to market developments or exchange rate
expectations.
In respect of short-term external commercial borrowings, there is already a strong
international consensus that emerging markets should keep such borrowings relatively
131
small in relation to their total BIS Review 36/2003 3 external debt or reserves. Many of the
financial crises in the 1990s occurred because the short-term debt was excessive. When
times were good, such debt was easily accessible. The position, however, changed
dramatically in times of external pressure. All creditors who could redeem the debt did so
NOTES
within a very short period, causing extreme domestic financial vulnerability. The occurrence
of such a possibility has to be avoided, and we would do well to continue with our policy
of keeping access to short-term debt limited as a conscious policy at all times - good and
bad.
So far as the free convertibility of domestic assets by residents is concerned, the issues
are somewhat more fundamental. It has to do with the differential impact of .stock. and
.flows. in determining external vulnerability. The day-to-day movement in exchange rates
is determined by .flows. of funds, i.e. by demand and supply of spot or forward transactions
in the market. Now, suppose the exchange rate is depreciating unduly sharply (for whatever
reasons) and is expected to continue to do so for the near future. Now, further suppose
that domestic residents, therefore, decide - perfectly rationally and reasonably - that they
should convert a part or whole of their stock of domestic assets from domestic currency
to foreign currency. This will be financially desirable as the domestic value of their converted
assets is expected to increase because of anticipated depreciation. And, if a large number
of residents so decide simultaneously within a short period of time, as they may, this
expectation would become self-fulfilling. A severe external crisis is then unavoidable.
Consider India.s case, for example. Today, our reserves are high and exchange rate
movements are, by and large, orderly. Now, suppose there is an event which creates
external uncertainty, as for example, what actually happened at the time of the Kargil or
the imposition of sanctions after Pokhran, or the oil crises earlier. Domestic stock of bank
deposits in rupees in India is presently close to US$ 290 billion, nearly three and a half
times our total reserves. At the time of Kargil or Pokhran or the oil crises, the multiple of
domestic deposits over reserves was in fact several times higher than now.
One can imagine what would have had happened to our external situation, if within a very
short period, domestic residents decided to rush to their neighbourhood banks and convert
a significant part of these deposits into sterling, euro or dollar.
No emerging market exchange rate system can cope with this kind of contingency. This
may be an unlikely possibility today, but it must be factored in while deciding on a long
term policy of free convertibility of .stock. of domestic assets. Incidentally, this kind of
eventuality is less likely to occur in respect of industrial countries with international
currencies such as Euro or Dollar, which are held by banks, corporates, and other entities
as part of their long-term global asset portfolio (as distinguished from emerging market
currencies in which banks and other intermediaries normally take a daily long or short
position for purposes of currency trade).
Another issue, which has figured prominently in the current debate, relates to foreign
exchange reserves. As is well known, India.s foreign exchange reserves have increased
substantially in the past few years and are now among one of the largest in the world. The
fact that most of the constituents of India.s balance of payments are showing positive
trends - on the current as well as capital accounts - is a reflection of the increasing
competitiveness of the Indian economy and strong confidence of the international community
in India.s growth potential. For the first time after our Independence 56 years ago, the
fragility of the balance of payments is no longer a concern of policy makers. This is a
highly positive development and regarded as such by the country at large.
Nevertheless, there are two concerns that have been expressed by expert commentators
- one is about the .cost. of additional reserves, and second concerns the impact of .arbitrage.
132
in inducing higher inflows. So far as the cost of additional reserves is concerned, it needs
to be borne in mind that the bulk of additions to reserves in the recent period is on account
of non-debt creating inflows. India.s total external debt, including NRI (Non-Resident Indian)
deposits, has increased relatively slowly as compared with the increase in reserves,
particularly in the last couple of years. In fact, India pre-paid more than $ 3 billion of
external debt earlier this year. It may also be mentioned that rates of interest paid on NRI
deposits and multilateral loans in foreign currency are in line with or lower than prevailing
international interest rates.
NOTES
On NRI rupee deposits, interest rates in the last couple of years have been in line with
interest rates on deposits by residents, and are currently even lower than domestic interest
rates. So far as other non-debt creating inflows (i.e., foreign direct investment, portfolio
investment or remittances) are concerned, such inflows by their very nature are commercial
in nature and enjoy the same returns and risks, including exchange rate risk, as any other
form of domestic investment or remittance by residents. The cost to the country of such
flows is the same whether they are added to reserves or are matched by equivalent foreign
currency outflow on account of higher imports or investments abroad by 4 BIS Review 36/
2003 residents. On the whole, under present conditions, it seems that the .cost. of additional
reserves is really a non-issue from a broader macro-economic point of view.
Indian interest rates have come down substantially in the last three or four years. They
are, however, still higher than those prevailing in the U.S., Europe, U.K. or Japan. This
provides an arbitrage opportunity to holder of liquid assets abroad, who may take advantage
of higher domestic interest rates in India leading to a possible short-term upsurge in
capital flows. However, there are several considerations, which indicate that .arbitrage.
per se is unlikely to have been a primary factor in influencing remittances or investment
decisions by NRIs or foreign entities in the recent period. Among these are:
The minimum period of deposits by NRIs in Indian rupees is now one year, and the
interest rate on such deposits is subject to a ceiling rate of 2.5 per cent over Libor. This is
broadly in line with one-year forward premium on the dollar in the Indian market (interest
rates on dollar deposits by NRIs are actually below Libor).
Outside of NRI deposits, investments by Foreign Institutional Investors (FIIs) in debt funds
is subject to an overall cap of only $ 1 billion in the aggregate. In other words, the possibility
of arbitrage by FIIs in respect of pure debt funds is limited to this low figure of $ 1 billion
(excluding investments in a mix of equity and debt funds).
Interest rates and yields on liquid securities are highly variable abroad as well as in India,
and the differential between the two rates can change very sharply within a short time
depending on market expectations. It is interesting to note that the yield on 10 year
Treasury bills in the U.S. had risen to about 4.4 per cent as compared with 5.6 per cent on
Government bonds of similar maturity in India at the end of July 2003. Taking into account
the forward premia on dollars and yield fluctuations, except for brief period, there is likely
to be little incentive to send large amounts of capital to India merely to take advantage of
the interest differential.
On the whole, it is likely that external flows into India have been motivated by factors other
than pure arbitrage. Figures on sources of reserve accretion available upto the end of last
year (2002-03) confirm this view. It is also pertinent to note that domestic interest rates
among industrial countries also vary considerably. For example, in Japan, they are close
to zero. In the U.K., they are above 4 per cent, and in the U.S. about 1.5 per cent. There
is no evidence that capital has been moving out of U.S. to U.K. or Europe merely on
account of interest differential. Within a certain low range, capital flows are likely to be
more influenced by outlook for growth and inflation than pure arbitrage even among industrial
countries with full CAC.
133
NOTES
Another point which has been forcefully put forward by several experts in the context of
rising reserves, is that India should use its reserves for increasing investment for further
development of the country rather than keep them as liquid assets. It is argued that it is
paradoxical for a developing country to have a current and capital account surplus, and
thereby add to its reserves, rather than use foreign savings to enhance the rate of investment
in the economy.
In principle, this point is valid. There is no doubt that in our present situation, maximum
support has to be given to increasing the level of investment, particularly in the infrastructure
sector. It is for this reason that RBI in the recent period has been following a soft interest
rate policy in an environment of low inflation. However, at the same time, it must be
emphasized that there is very little that RBI, (or, for that matter, Government) can directly
do to use additional reserves for investment. The equivalent rupee resources have already
been released by the RBI to recipients of foreign exchange, and equivalent rupee
liquidity has already been created. The decision on whether to invest, consume or deposit
these additional rupee resources lies with recipients, and not with the RBI. By all means,
let us urge them to invest, but there is not much of a case for pointing a finger at
additional reserves as a cause. of lower than desirable level of investment activity in the
economy.
Let me now come to my last point, which is of considerable present-day interest in India
in the context of high and rising reserves, easy liquidity, low interest rates and the weakening
dollar, i.e., what should be the correct or right policy stance for the management of exchange
rate in India in the present environment? In RBI.s periodic credit policy statements, as
well as other public statements, RBI has highlighted the main pillars of its strategy for the
management of the exchange rate. These are: RBI does not have a fixed .target. for the
exchange rate which it tries to defend or pursue over time; RBI is prepared to intervene in
the market to dampen excessive volatility as and when necessary; RBI.s purchases or
sales of foreign currency are undertaken through a number of banks and are generally BIS
Review 36/2003 5 discreete and smooth; and market operations and exchange rate
movement should, in principle, be transaction-oriented rather than purely speculative in
nature.
It is perhaps fair to say that the actual results of the exchange rate policy followed by the
RBI, since the Asian crisis in particular, have been highly positive so far. In addition to
sharp increase in reserves and generally .orderly. movements in exchange rates with
lower volatility, the confidence level of domestic and foreign investors in the Indian external
sector policies is strong. India.s policies have also been described by the IMF as being
comparable to the global best practices. in a recent study of 20 select industrial and
developing countries. Interestingly, a leading global news agency, in an international journal,
has recently described India.s currency model as being .ideal. for Asia. India is now one
of the very few developing countries which has set up its own clearing house for dollarrupee transaction with the concurrence of the Federal Reserve System, New York.
In the last few months, however, when the dollar has been depreciating against major
currencies, and rupee has been appreciating against the dollar (albeit slowly), a number
of suggestions have been made by experts and others calling for a shift in RBI.s exchange
rate policies. There are, in the main, three alternative approaches that have been suggested
for consideration:
One view advanced by several distinguished economists, including Prof. Kenneth Rogoff
of IMF during his recent visit to India, is that rupee should be allowed to appreciate freely
in line with market trends. According to this view, there is no strong case for RBI.s further
intervention as reserves are already very high. RBI.s purchases create substantial additional
domestic liquidity, which may be destabilising in the long run. There is also no evidence,
134
in their opinion, that unconstrained appreciation or volatility would affect growth prospects
or lead to any other macro-economic problem.
An exactly opposite view, which, among others, has been recently articulated by an
important all-India industry association, is that RBI should intervene more aggressively in
the market to further reduce the degree of appreciation. The main argument in favour of
this view is that India must maintain its global .competitiveness., particularly in relation to
China which has a fixed exchange rate with the dollar and whose currency has been
depreciating along with it.
NOTES
A third view, which has been recently put forward by a leading economic journal, among
others, is that RBI should pursue what it has referred to as a policy of calculated volatility.
It has been argued that the present policy of controlled volatility has provided virtually riskless gain to market participants since the rupee has been expected to appreciate
substantially and continuously over the past few months. According to this view, in order
to prevent excessive capital inflows during this period, RBI should have allowed the
exchange rate to overshoot. quickly the targeted exchange rate of, say, Rs. 46.20 (or any
other number) to, say, Rs. 45.50. Thereafter, it should have allowed the rupee to depreciate
slowly, but not necessarily smoothly, to the above targeted number over a period of next
few months. In essence, this proposal is akin to a policy of (announced or unannounced)
fixed exchange rate within a wider band.
The RBI welcomes the current debate. Reserves, at present, are certainly at a level which
is more than enough to meet any foreseeable contingency. It is also clear that, in the
present period, capital inflows and remittances have been strong, requiring continuous
domestic liquidity management. In principle, therefore, it would be nice if an alternative
viable exchange rate management system could be put in place which would avoid
excessive build-up of reserves and domestic liquidity and, at the same time, maintain
India.s external competitiveness with low inflation and low interest rates.
In theory, each of the above alternative approaches has some merit. However, it is not
entirely clear that they can be put into practice without causing substantial instability or
uncertainty and possible emergence of macro-economic problems which are worse than
what they are trying to solve. An implicit assumption in two of the above alternatives is
that there is a level at which, after initial fast appreciation, the exchange rate will either
stabilise or turn around. A further implicit assumption is that the level (whatever it is) is
either already known or will become known to the market as it is approached.
RBI.s past experience does not suggest that these assumptions are valid. It would be
recalled that there have been periods when rupee exchange rates have been relatively
more volatile and movements have been sharper. However, during periods of sharper
appreciation, instead of inflows declining and demand for foreign currency rising, it was
noticed that actual market behaviour was the 6 BIS Review 36/2003 opposite. The opposite
was true during periods of sharp depreciation. Exchange rate expectations had their own
momentum and were often self-fulfilling. There must, of course, be a level where these
expectations will reverse. However, if that level, because of momentum. trading in imperfect
and thin markets happens to be significantly out of line with fundamentals., considerable
instability and substantial overvaluation (or under valuation) may result Such an outcome
may do more harm than good to continued confidence in a countrys exchange rate system.
The third suggestion to hold the rates at current levels, and not to allow it to appreciate
any further, even if inflows are strong, is also likely to be unsustainable over any length of
time. It virtually amounts to adopting a fixed or a near-fixed exchange rate system with a
floor. Past experience suggests that this system can work well, as it did in East Asia prior
to the crisis, when the economy is doing well and inflows are strong, but it comes under
extreme pressure when there are unfavourable domestic or external developments.
135
Abandonment of a system of .fixed. exchange rates (or a system with a known floor) then
becomes unavoidable. Such a change, when it occurs under pressure, can result in
considerable instability which is likely to be spread over a fairly long period. At the end of
this process, the country then has no option but to revert to a more flexible exchange rate
system.
NOTES
It is by no means a mere coincidence that all countries affected by external crises in the
1990s had a fixed or near-fixed exchange rate systems. China at present is an exception
to the rule in view of its persistent trade surpluses over a long period combined with very
high levels of foreign direct investment. It is not certain how long into the future this
situation will prevail. In any case, China.s special characteristics are difficult to replicate
in other emerging markets with lower volume of trade and foreign investment.
The desirability of maintaining the-overall competitiveness of an economy can hardly be
questioned. However, the long-run competitiveness of an economy needs to be measured
in relation to a multiple currency basket, and in relation to major trading partners over a
reasonably long period of time.
Exchange rate fluctuations among major currencies are now an everyday fact of life, and
it is important for all entities with foreign exchange exposures to resort to .hedging. with
appropriate risk management of assets and liabilities.
On balance, the benefits of the suggested alternatives to the present system are not very
clear. The present system is by no means an ideal one. However, like the old cliche about
virtues of democracy, it is probably better in the long run than all the available alternatives.
In view of behavioural and market complexities in this area, as well as multiple economic
policy objectives, solutions which seem ex-ante. optimal may turn out to be disastrous ex
-post - after the event - as happened in Argentina recently and East Asia and Mexico
some years ago.
Nevertheless, as I said a while ago, RBI welcomes the present debate. As a contribution
to this debate, I have tried to deal with some relevant issues, and indicate our present
views on them. These views are, of course, subject to change in the light of domestic and
international experience and further academic insights.
We look forward to your deliberations and hope to benefit from them.
136
Exchange Rate Management : Dilemmas, Inaugural Address by

Dr. Y.V. Reddy, Deputy Governor, Reserve Bank of India
Inaugural Address by Dr. Y.V. Reddy, Deputy Governor, Reserve Bank of India at XIth
National Assembly Forex Association of India at Hotel Cidade De Goa, Goa, on August
15, 1997
Exchange Rate Management : Dilemmas
NOTES
Mr Chairman and friends,

I am thankful to the organisers of the XI th National Assembly of the Forex Association of
India for giving me an opportunity to share with you the dilemmas that we face in foreign
exchange management. The fifty years since independence have seen significant changes
in our exchange rate regime. The exchange rate policy has evolved from the rupee being
pegged to the pound sterling until 1975, pegged to an undisclosed currency basket until
1992 and after a years experience with dual exchange rate system to a market-related
system by March 1993. This has helped to bring about flexibility in exchange rate
management. A couple of years ago, my predecessor, distinguished Dr. S. S. Tarapore,
addressed this Assembly on some of the burning issues of foreign exchange markets.
Last year, my colleague, Mrs. Usha Thorat gave an authentic and analytical account of
the recent developments in forex markets and on the role of authorised dealers (ADs) in
forex markets. Today, I will address the dilemmas that we, as policy makers face, in the
conduct of exchange rate policy.
International Parity
2. I will briefly as a backdrop, revisit the four parity conditions, that you are familiar with.
First, the Purchasing Power Parity (PPP) which links the spot exchange rate and inflation.
Secondly, the International Fisher Relation which links interest rates and inflation. Thirdly,
the Foreign Exchange Expectations which link forward exchange rates and expected
future spot exchange rates. Fourthly, the Interest Rate Parity, which links spot exchange
rates, forward exchange rates and interest rates. The four parity relations could be combined
in several ways to throw light on the four critical variables that are often used in exchange
rate management policies, viz., the interest rate differential, the inflation differential, the
forward discount/premium, and the exchange rate movement. The theories built around
the parity relations help us to understand the foreign exchange markets better, but, they
rarely give us ready made solutions to the problems that arise in day-to-day, say, minuteto-minute operations in the exchange markets.
3. What could be the explanation for such a phenomenon? In the real world, expectations
cannot be easily subjected to definitive formulae; goods cannot be transferred across
countries simultaneously; shipping and other transactions costs can turn out to be much
different from the initial conditions; trade and other restrictions often exist, distorting prices.
Even in the most efficient markets, ideal conditions do not exist, and forward premia as
a result, have not been able to predict future spot rates accurately. The actual exchange
rates are usually overvalued or undervalued in terms of the purchasing power parity. Under
Indian conditions, however, there are some additional questions. For instance, which is
the correct risk-free interest rate to be compared while calculating interest rate differentials?
Should we consider the 91-Day T-Bill rate or some other short-term rate? The theoretical
forward premia could vary depending on the interest rate chosen. In the quest for answers
to some questions, dilemmas do arise.
Objectives and Purposes of Exchange Rate Management

4. The main objective of Indias exchange rate policy is to ensure that economic
fundamentals are reflected in the external value of the rupee. Subject to this predominant
137
objective, the conduct of exchange rate policy is guided by three major purposes.
First, to reduce excess volatility in exchange rates, while ensuring that the market correction
of overvalued or undervalued exchange rate is orderly and calibrated.
Second, to help maintain an adequate level of foreign exchange reserves.
NOTES
Third, to help eliminate market constraints with a view to the development of a healthy
foreign exchange market.
Let us relate the above approach to the current context.
Current Context
5. The elements of continuity, contextual response and change would be present in the
conduct of any policy, including the exchange rate policy. In this address, I would be
focusing on the contextual response. After all, exchange rate policy will form part of the
overall macroeconomic policy and will, therefore, have to be subservient to overall
macroeconomic targets. The conduct of exchange rate policy during 1996-97 was primarily
guided by market conditions resulting from the contraction in the current account deficit
and resurgence of capital inflows. Foreign exchange reserves (including gold) scaled a
peak of US$ 26.4 billion by end-March 1997, without sacrificing exchange rate stability. In
regard to 1997-98, the exchange rate policy needs to be seen in the context of the
Monetary Policy Statement of April 15, 1997. The Statement indicates, given the real
GDP growth for 1997-98 of 6.0 - 7.0 per cent, the expansion in M3 would be sought to be
maintained in the range of 15.0 - 15.5 per cent to keep the inflation rate at around 6.0 per
cent. Monetary policy would, in other words, continue to be directed towards maintaining
a stable financial environment in relation to price, interest rate and exchange rate.
6. Against these broad parameters, we have to look at the variables that have a bearing on
contemporary exchange rate management. Some of the crucial variables at this juncture
apart from price stability and money supply which are always dominant are, in my view,
the revenue and expenditure position of the Government, the oil pool deficit, the buoyancy
in industrial activity, the progress in infrastructure sector, and the developments in trade
and capital flows. Besides, leads and lags operate, affecting the market. Moreover, major
players in the market influence exchange rate movements and thereby the perceptions
about policy. Let me illustrate this point with reference to the oil pool deficit. IOC has, in
the recent past, increasingly resorted to foreign currency borrowing rather than domestic
borrowing to finance the deficit, presumably in view of the lower cost and the perceived
stability of the rupee. To the extent IOC resorts to additional overseas borrowing for oil
purchases, the demand in the forex market is depressed leading to pressure on the rupee
to appreciate even further. There would be an exactly opposite effect, when IOC starts
reducing the exposure to short term borrowing, simultaneously making the cash payment
for current purchases, with implications for exchange rate management.
External Value of the Rupee

7. The deceleration in export growth during 1996-97 has emerged as an area of policy
concern and exchange rate is often blamed for that. The slow down in export growth
during 1996-97 could as well be attributed to the decline in world trade coupled with
sluggishness in manufacturing goods prices in the global market, variations in crosscurrency exchange rates and deceleration in domestic industrial activities. However, we
should accept that, beyond a point, real appreciation of a currency can hurt exports.
Given the disparate movements over time, of the exchange rates of the domestic currency
and the domestic inflation rate relative to important trading partners, the Real Effective
Exchange Rate (REER) is reckoned as one of the most important determinants of the
countrys external competitiveness. Using the trade based REER (1985=100), the REER
138
was 61.02 per cent in August 1993 and 65.78 per cent in August 1995, i.e. an appreciation
of 7.8 per cent. In August 1995, the volatility in the exchange rate of the rupee started and
in the following months, the rupee depreciated and corrected for real appreciation by
January 1996 when the REER was 59.32. For most of 1996, the REER remained stable.
However, with the sharp appreciation of the US dollar vis-a-vis other major currencies
since the last quarter of 1996, the rupee also appreciated in real terms. In August 1996,
the trade based REER (1985=100) was 62.26 which rose to 65.41 in April 1997, i.e. an
appreciation of around five per cent. Over January 1996, the appreciation in April 1997 was
10.3 per cent. There is a considerable discussion as to whether the rupee is overvalued or
not. As per the REER, it would certainly appear so, irrespective of the base chosen. The
overvaluation has got exacerbated with the sharp appreciation of the US $ against other
major currencies, viz., the DM and the Yen. The relative cheapening of imports may not
have resulted in increasing imports and larger current account deficits. This is because
imports are relatively less responsive to exchange rate changes and are more sensitive to
the level of economic activity. There could be a potential larger current account deficit as
industrial activity rebounds - even at the present exchange rates and if oil demand picks
up, a correction cannot be ruled out.
NOTES
The optimal size of the external current account deficit, of course, depends upon the
degree of openness of the economy. In the Indian context, the ratio of current receipts to
GDP of 15 per cent, as at present, could sustain a current account deficit of the order of
two per cent of GDP and would still enable a decline in the debt service ratio from the
present level of 25 per cent. A current account deficit of two per cent of GDP in conjunction
with the domestic saving rate of 25- 26 per cent could ensure an investment rate of around
28 per cent which, even with ICOR of around 4.0 should be able to sustain a real GDP
growth of seven per cent per annum. Since 1991-92, however, the current account deficit
has averaged around only one per cent of GDP.
Thus, enlargement of current account deficit beyond the present level is sustainable.
Volatility
8. The Reserve Bank has been intervening in both the spot and forward markets to prevent
undue fluctuations. In the context of large capital flows (inflows as well as outflows) within
a short period, it may not be possible to prevent movements in the exchange rate away
from the fundamentals. Hence, the management of rate fluctuations becomes passive,
i.e., one of preventing undue appreciation in the context of large inflows and providing
supply of dollars in the market to prevent sharp depreciation. But, the correction, if any,
has to be gradual and not sudden.
Level of Reserves
9. Adequacy of reserves is, as I mentioned, an important consideration. The level of
foreign exchange reserves rose to US$ 29.8 billion by August 1, 1997, equivalent to seven
months of imports. In the context of the changing interface with the external sector and
the importance of the capital account, we have to evaluate reserve adequacy in terms of
both conventional indicators and non-conventional norms. The present level of foreign
exchange reserves is equivalent of about 30 months of debt service payments and 5.7
months of payments for import and debt service taken together. In the context of mobile
capital flows, it may be useful to assess the level of reserves in terms of the volume of
short-term debt which can be covered by reserves.
At the end of March 1997, the ratio of short-term debt to the level of reserves amounted to
a little over 25 per cent, compared to about 100 per cent for Indonesia, 50 per cent for
Argentina, and 25 per cent for Malaysia. In fact, the level of reserves exceeds the total
139
stock of short-term debt and portfolio flows which, taken together, constitute little less
than 75 per cent of the level of reserves.
The present level of external reserves is a source of comfort as it provides a measure of
insulation against unforeseen external shocks or shocks created by domestic supply
shortages.
NOTES
Besides, it helps to meet the precautionary motive and satisfy the need for liquidity, which
in itself instills confidence in the Indian economy among international investors and financial
markets.
Such confidence has also a bearing on the extent and of course cost of external borrowings.
As the economy becomes more open, external shocks need a cushion which reserves
alone can provide. The volatility of some of the capital flows needs to be kept in mind. It is
true that reserves are not required to meet the transaction motive which is to be taken
care of by changes that will naturally occur in the market determined exchange rates.
But, in a period of transition, when structural shifts can release strong excess demand or
throw up temporary bottlenecks, reserves smoothen the process of change and mitigate
pains of adjustment. So, some addition to reserves, in my view, would give additional
comfort.
Forex Markets
10. Developing exchange markets is another important consideration in exchange rate
management. Recently, several measures were initiated to further integrate the Indian
forex market with the global financial system. Banks were permitted to fix their own
position limits and Aggregate Gap Limits (AGLs) in January 1996. Banks were permitted
in October 1996 to provide foreign currency denominated loans to their customers out of
the pool of FCNR - B deposits.
In order to achieve greater integration between domestic and overseas money markets,
authorised dealers (ADs) were permitted in April 1997 to borrow from their overseas offices/
correspondents as well as to invest funds in overseas money market instruments up to
US $ 10 million. With a view to imparting flexibility to corporates and improving liquidity in
the forward markets for periods beyond six months, ADs were also permitted to book
forward cover for exporters and importers on the basis of a declaration of exposure supported
by past performance and business projection provided the total forward contracts
outstanding at any point of time did not exceed the average export/import turnover of the
last two years. ADs were also allowed to arrange forex-rupee swaps between corporates
and run a swap-book within their open positions/gap limits without prior approval of the
Reserve Bank.
Now, as per the decision taken last week, FIIs are allowed to cover as a first step, their
debt exposures in the forward market.
In order to further facilitate integration between domestic and overseas markets, banks
with adequate capital strength may be encouraged to have higher limits for investments in
overseas markets. This will help in developing further the forward markets.
East Asian Experience: Relevance to India

11. Speaking of correction in external value and of volatility in forex markets, the question
that is often asked is would India go the East Asian way? In the early stages of
development, East Asian countries adopted a conscious policy of export-led growth
stimulated by real depreciation of their currencies. It was only much later, when capital
inflows became strong, after 1992 that their currencies appreciated in real terms.
The currency overvaluation, declining exports, overheated property markets and the fragile
140
banking system had fueled intense foreign currency speculation, as the market participants
felt that the natural course of the currency was to depreciate. Given the huge short-term
borrowings, the fund managers started exiting the economy with the first sign of trouble,
leading to a de facto devaluation of the Thai baht. An important point to be noted here is
that the currency crises in these countries was managed quite efficiently with the help of
reserves which most of these countries had, to defend their currencies. Thailand, as also
other East Asian economies, despite a large current account deficit, are high saving
economies with good underlying growth rate and strong competitiveness.
NOTES
What are the Lessons for India?

12. The recent experience of the emerging economies shows that, any currency could
come under speculative attack if its exchange rate is out of alignment with fundamentals
for a prolonged period of time.
Second, once the speculative attack is launched on any currency, the neighbouring
currencies are also vulnerable, no matter how sound their policies may be.
Third, the overvaluation of a currency acts as a catalyst when there is a run on the
currency as all the market players base their action on the information that the currency
is due for correction.
Presently, compared to March 1993, the appreciation of Indian rupee in real effective
terms is around 14 per cent. The Indian economy does have certain favourable factors in
terms of a moderate CAD/GDP ratio, high foreign exchange reserves and a ratio of shortterm debt to reserves much lower than that of the East Asian countries. Our inflation rate
is also edging downwards. We have a fairly solid banking system despite the NPAs; the
number of NBFCs are not that large; and the financial sector is subject to reasonably
effective regulation by the RBI.
Our financial sector, is therefore, less vulnerable than many of the East Asian economies
notwithstanding the fact that there are corporates operating with unhedged positions.
It is unlikely that any turmoil in South East Asian economies would have a direct impact
upon the Indian rupee as Indias trade with the five countries of the South East Asian
region (Thailand, Indonesia, Malaysia, Philippines and Singapore) constituted only 7.8
per cent in 1996-97. Also, the currencies of this region are more internationally traded,
larger number of hedging products are available, and the central banks of several South
Eastern economies pool their resources to counter any attack on their currencies. It is
possible that the sentiments that govern the interest of investors in these countries are
different from the sentiments of investors coming to India.
In brief, the experience of these countries should provide some lessons for us in terms of
potential risks. Of immediate relevance to us is the impact of their devaluation on export
competitiveness if rupee continues to be appreciated.
Capital Inflows
13. Capital inflows constitute a major factor affecting the value of the rupee now. With the
resurgence in capital inflows, the net surplus on the capital account more than doubled to
about US $ 11,600 million during 1996-97 thereby exceeding the previous peak of US $
9,695 million touched in 1993-94. Reflecting these developments, surplus conditions
prevailed in the foreign exchange market throughout the year. In general, the policy response
has taken the form of partial sterilised intervention through open market operations,
liberalisation of capital outflows, raising of reserve requirements and deepening of the
foreign exchange market by routing increased volumes of transactions through the market.
To prevent appreciation of the rupee, and to protect international competitiveness, the
Reserve Bank made substantial purchases of US dollars in the market. During 1997, the
141
NOTES
RBI intervened in the spot and forward markets, both in the outright and swap segments.
Outright spot and forward purchases of US dollars during 1996- 97 amounted to $ 7.9
billion and $ 0.9 billion, respectively. Swap purchases amounted to $ 2.4 billion. While
spot sale of US dollars was marginal, forward and swap sales amounted to $ 0.3 billion
and $ 3.1 billion, respectively. Thus, net purchases of US dollars during 1996-97 amounted
to $ 7.8 billion.
The influx of capital continues during 1997-98. The Reserve Bank has accumulated US $
3.9 billion of foreign currency assets until August 8, during the current financial year. Total
spot and forward purchases and swap sales of US dollars up to end-July 1997, totalled $
4.3 billion, $ 1.1 billion and 0.9 billion, respectively. Thus, net purchases of US dollars by
the Reserve Bank of India up to end July, during the financial year 1997-98 amounted to
about $ 4.6 billion.
The optimal policy response to capital inflows is very much a function of the anticipated
persistence of capital inflows. The design of policy depends upon the expectation whether
the inflow of capital is temporary or is expected to continue. A temporary increase in
inflow and perceived as such by the public, which may lead to a temporary real appreciation
of the exchange rate, is unlikely to have major effects. Problems, however, arise if the
inflow is temporary, but the public expects the inflow to continue. But, in real life, nobody
knows with confidence, what is temporary, how temporary it is, and what the public
perception is, and indeed how temporary the public perception is! So, let me straightaway
go into the instruments.
Internationally, a number of instruments have been used to sterilise capital inflows, the
chief among them being the sale of government bonds through open market operations.
This policy is useful temporarily and if used for long, leads to renewed inflows. We, in the
Reserve Bank, are however, well equipped with physical stock of government securities.
We have been active in the repo market in recent months to manage temporary liquidity
conditions. The idea is to realise a fine balance in order to achieve the objectives of
sterilisation without putting pressure on yields.
Discount policy, which implies restricting the access of banks to central bank credit or
raising the cost of refinance has also been used by countries to sterilise capital inflows.
This instrument cannot, however, be used in the current context when there is plenty of
liquidity in the money market and there is no borrowing from the central bank. However,
this instrument may go against the long-term objectives of monetary and credit policy.
Varying the reserve requirements is yet another policy tool. Mobilising Government deposits
has served as a variation to absorption of reserves in some countries. Variable deposit
requirements in the nature of interest free deposits with the central bank is another form of
discouraging capital inflows. This measure, while it reduces the need for costly sterilisation
through sale of bonds, may result in misallocation of resources and reduce the facility to
borrowers to take advantage of lower international interest rates. We have used the CRR
successfully in the past, to stem inflows. After the imposition of CRR on incremental NRI
deposits, there has been some deceleration in the growth of foreign currency deposits
during the current financial year.
Entering into foreign currency swaps (spot sell - forward buy) is another way of sterilising
capital inflows. The foreign currency purchased by banks may be used to finance domestic
activities or for investment abroad. Our experience shows that the market is fairly thin and
in such a market, the use of foreign currency swaps for sterilisation only adds volatility to
the forward market unless there is a constant swap window.
Central banks can employ outright forward exchange transaction, i.e., buy outright forward
instead of spot. This will have the desired effect on the spot rate, only if it is not countered
142
by very large spot inflows from participants like FIIs and forward supplies by exporters
who wish to take advantage of the increase in premium.
Taxing on capital inflows is yet another form of dissuading flows. For foreign investors, it
effectively lowers the rate of return on local assets. This instrument also carries the
disadvantage of raising the cost of capital. This option was considered at one time, but
deferred considering its disadvantages.
NOTES
Conclusion
14. I have explained the dilemmas, mainly to show that we are committed to the stated
objectives, and assert that we are equipped to handle the problems - equipped with requisite
will and skill. However, some believe that we are cautious - whether in allowing the rupee
to appreciate or inducing adequate depreciation. Perhaps, some explanation would be in
order.
First, we are going through a process of economic reform. In a democratic federal set up
going through such economic reform, we require a general mandate on essential
complementary policies.
Second, we are vulnerable to supply shocks, especially food stock and oil prices.
Third, the East Asian Countries support each other. The G-10 countries coordinate with
each other. The Latin American countries are generally supported by North America. We
are not members of any blocks. We have gone through the truama of balance of payments
crisis in early 1990s and we cannot ignore the threat to economic sovereignty if we take
undue risks.
Fourth, and most important, price stability is critical to the economy as a whole, to both
the poor and exporters. In fact, as our Governor, Reserve Bank of India, Dr. C. Rangarajan,
mentioned in his address at the Annual Presentation Ceremony of the Engineering Export
Promotion Council earlier this month, containment of domestic price increase has the
same beneficial effect as the depreciation of the nominal exchange rate. If the nominal
exchange rate is stabilised at a certain level by letting the foreign exchange assets of the
central bank to increase, it may have an adverse effect on he exporters through price
increase arising from more than the desired increase in money supply. There can therefore,
be no rigid formula governing exchange rate determination. Monetary authorities need
continually to perform a balancing act between ensuring an exchange rate which will be
supportive of exports and the need to contain monetary expansion within reasonable
limits.
During the current financial year up to August 1, deposits have grown rapidly by 4.1 per
cent (3.7 per cent in the corresponding period last year). M3 has grown by 4.4 per cent up
to July 18 (3.7 per cent last year). The year-on-year growth in M3 is 16.7 per cent. The
positive features during the current year are that interest rates have come down, both in
the short and long end, and so has the inflation rate. The area of concern relates to money
supply. Any further measures in terms of exchange rate should consider the money supply
effect so that the gains already made on interest rate and inflation fronts are not eroded.
This is the critical aspect of the current exchange rate management stance.
Finally, the extent, the pace and the manner of correction of the exchange rate will have to
be taken in conjunction with money supply, since price stability continues to be the
dominant objective of monetary policy. We, in the Reserve Bank, seek your assistance,
advice, cooperation and understanding. For my part, I am happy to announce that,
henceforth the Reserve Bank will make available weekly data relating to its intervention in
the forex market.
Thank you.
143
6.12. SUMMARY
NOTES
Macroeconomics takes as given distribution of output, employment and total spending, is

what microeconomics seeks to explain. Thus, macroeconomic theory has a foundation in
microeconomic theory. There is interdependence between the two. In practice, analysis
of economy is not done separately in two watertight compartments. When macroeconomics
variables are analyzed, one must allow for changes in microeconomic variables that
influence the macroeconomic variables and vice versa. Macroeconomic policy operates
within a framework of goals and constraints. The most important and crucial goals of
economic policy are as follows. Full employment, i.e., full utilization of human and nonhuman resources; High living standards; Price Stability; Reduction of economic inequality
and removal of poverty; Rapid economic growth and External balance vs overall balance in
economic relations with the rest of the world.
Check Your Progress

1. The demand-for-money curve illustrates the
the quantity demanded of money and
relationship between
.
a.
inverse; the interest rate
b.
direct; GDP.
c.
direct; the interest rate
d.
inverse; GDP
2. If the interest rate increases, the opportunity cost of holding money

and the quantity demanded of money
.
a.
does not change; does not change
b.
increases; also increases
c.
decreases; increases
d.
increases; decreases
e.
decreases; also decreases
3. As the interest rate __________, the opportunity cost of holding money

and individuals choose to hold
money.
a.
increases; increases; more
b.
increases; decreases; more
c.
increases; decreases; less
d.
decreases; increases; more
e.
decreases; decreases; more
4. As the interest rate falls, the quantity

a.
demanded of money falls.
b.
demanded of money rises.
c.
supplied of money rises.
d.
supplied of money falls.
5. If the interest rate is below the equilibrium interest rate, then the quantity
of money exceeds the quantity
of money, and there is
a
of money.
a.
supplied; demanded; shortage
b.
supplied; demanded; surplus
c.
demanded; supplied; shortage
d.
demanded; supplied; surplus
6. If the interest rate falls, the opportunity cost of holding money

the quantity demanded of money
.
144
a.
rises, rises
b.
rises, falls
c.
falls, rises
d.
falls, falls
and
7.
8.
9.
A general definition of the transmission mechanism is: the routes or channels

that ripple effects created in the
a.
market for goods and the services travel to affect the money market.
b.
money market travel to affect the market for goods and services.
c.
labor market travel to affect the market for goods and services.
d.
market for goods and services travel to affect the labor market.
e.
none of the above
NOTES
Which best describes the Keynesian transmission mechanism when the money
supply rises?
a.
The interest rate rises; this in turn cuts back investment spending, which in
turn raises total expenditures and shifts the AD curve rightward.
b.
The interest rate falls; this in turn stimulates investment spending, which in
turn raises total expenditures and shifts the AD curve leftward.
c.
turn raises total expenditures and shifts the AD curve rightward.
d.
turn lowers total expenditures and shifts the AD curve leftward.
According to the Keynesian transmission mechanism, a rise in the money supply

will
the interest rate, causing a
in investment demand,
which then
Real GDP.
a.
raise; fall; raises
b.
raise; rise; lowers
c.
raise; fall; lowers
d.
lower; fall; lowers
e.
lower; rise; raises
10. Compared to the Keynesian transmission mechanism, the monetarist transmission

mechanism is
a.
direct.
b.
indirect.
c.
inverse.
d.
elliptical.
e.
none of the above
11. The Keynesian transmission mechanism might get blocked if

a.
investment is insensitive to changes in interest rates.
b.
the goods market is not in equilibrium.
c.
the money supply rises too quickly.
d.
interest rates are too high before they fall.
12. Which scenario best explains the Keynesian transmission mechanism when the
money supply rises while the money market is in a liquidity trap?
a.
The interest rate and investment are not affected; there is no shift in the AD
curve.
b.
The interest rate falls, investment rises, total expenditures rise, and the AD
curve shifts rightward.
145
NOTES
c.
The interest rate falls, investment falls instead of rising, and the AD curve
ends up shifting leftward.
d.
The interest rate falls, but investment does not respond; there is no change
in total expenditures and no shift in the AD curve.
13. If the money market is in the liquidity trap, it is operating in the

segment of the
demand curve.
a.
vertical; investment
b.
vertical; money
c.
horizontal; investment
d.
horizontal; money
14. Which scenario best explains the Keynesian transmission mechanism when the
investment demand curve is vertical?
a.
The interest rate falls, investment falls even more, the AD curve shifts
rightward, but total expenditures do not change.
b.
The interest rate falls, investment rises, total expenditures rise, and the AD
curve shifts rightward.
c.
The interest rate falls, investment falls instead of rising, and the AD curve
ends up shifting leftward.
d.
The interest rate falls, but investment does not respond; there is no change
in total expenditures and no shift in the AD curve.
15. The liquidity trap refers to the

a.
assumption that the money supply curve is vertical as a result of the Feds
control.
b.
problem that occurs when interest rates reach such high levels that no
individuals want to hold their wealth in the form of money.
c.
situation that occurs when an excess supply of money results in people

holding more money than they desire.
d.
possibility that interest rates drop so low that people willingly hold all the
additions to the money supply, rather than use it to buy bonds.
16. Suppose the money market is in the liquidity trap and the Fed increases the
supply of money. We expect that
a.
people will end up willingly holding more money.
b.
the excess money holdings will flow into the loanable funds market and
there will be a decrease in interest rates.
c.
interest rates will increase, since the demand curve for money is upward
sloping in this case.
d.
eventually, via the transmission mechanism, Real GDP will increase.
17. What do Keynesians mean when they say that you cant push on a string?
146
a.
An increase in the supply of goods does not really create its own demand.
b.
If the government reduces taxes in an attempt to increase household

consumption, it will not always work.
c.
An increase in the money supply will not always stimulate the economy.
d.
If the government wants to get something done, the best way is not to force
the issue, but to offer incentives.
e.
If the government puts too much expansionary pressure on the economy, it

will probably overheat.
NOTES
18. If market interest rates increase, the prices of existing bonds will
a.
decrease.
b.
not change.
c.
increase.
d.
decrease if Real GDP decreases and increase if Real GDP increases.
19. An individual buys a bond for $1,000 and sells it one year later for $1,080. What
is the interest rate return that this individual has received?
a.
8.0 percent
b.
80.0 percent
c.
7.4 percent
d.
4.0 percent
20. Suppose that one year ago you purchased a $100 bond with an interest payment
of $10 per year and, at the time, the interest rate was 10 percent. One year later
the interest rate has increased to 10.5 percent, and you still hold the bond. Your
bond is now worth
a.
more than it was before.
b.
less than it was before.
c.
the same as it was before, that is, $100.
d.
More information is necessary to answer the question.
21. Suppose the money market is in the liquidity trap and the Fed increases the
supply of money. Individuals would rather hold
than
because they expect that bond prices can go no
.
a.
bonds; money; higher
b.
bonds; money; lower
c.
money; bonds; higher
d.
money; bonds; lower
22. If a liquidity trap exists, people are likely to be thinking that

a.
bond prices are so low that they have nowhere to go but up; given this, now
is a good time to be holding bonds.
b.
bond prices are so high that they have nowhere to go but down; given this, it
is better not to be holding bonds.
c.
bond prices will soon rise so it is better to get out of bonds now.
d.
interest rates will soon fall.
23. If the money market is in the liquidity trap, then people

a.
do not want to hold money because its value is at its lowest.
b.
want to hold bonds because the interest rate is quite high.
c.
do not want to hold bonds because their price is likely to decrease.
d.
want to hold bonds because their price is high.
e.
a, b and d
147
24. Assuming you want to earn profits, it is best to

expect interest rates are going to
.
NOTES
bonds when you
a.
buy; rise
b.
buy; fall
c.
sell; rise
d.
a and c
e.
b and c
25. Compared to the monetarist transmission mechanism, the Keynesian transmission

mechanism is
a.
indirect and long.
b.
direct and long.
c.
direct and short.
d.
indirect and short.
26. Which of the following statements is true?

a.
In the monetarist transmission mechanism, changes in the money market

directly affect aggregate demand.
b.
In the monetarist transmission mechanism, there is no need for the money

market to affect the loanable funds market or investment before aggregate
demand is affected.
c.
In the monetarist transmission mechanism, if individuals are faced with an

excess supply of money, they spend that money on a wide variety of goods
not just bonds or other assets, as is the case in the Keynesian transmission
mechanism.
d.
a and b
e.
a, b and c
27. According to the monetarist transmission mechanism, a decrease in the supply

of money will result in
a.
individuals initially holding excess bonds.
b.
individuals initially holding excess money.
c.
a leftward shift in the aggregate demand curve.
d.
a and c
28. Monetarists believe that changes in the supply of money

a.
do not affect aggregate demand.
b.
affect aggregate demand through the loanable funds market only.
c.
affect only the investment component of aggregate demand.
d.
affect aggregate demand directly.
29. Monetary policy refers to
148
a.
actions taken by banks and other financial institutions regarding their

approaches to lending, account management, etc.
b.
changes in the money supply to achieve particular economic goals.
c.
changes in government expenditures and taxation to achieve particular

economic goals.
d.
the change in private expenditures that occurs as a consequence of changes

in the money supply.
30. Keynesians are more likely to propose

a.
contractionary monetary policy to eliminate an inflationary gap than

expansionary monetary policy to eliminate a recessionary gap.
b.
contractionary monetary policy to eliminate a recessionary gap than

contractionary monetary policy to eliminate an inflationary gap.
c.
expansionary monetary policy to eliminate a recessionary gap than

d.
none of the above; instead, Keynesians are as likely to propose expansionary

monetary policy to eliminate a recessionary gap as they are to propose
NOTES

1. List and explain the three different approaches used to measure GDP.
2.
Draw an appropriate diagram to represent the business cycle and label each of the
five phases. Provide a brief description of each phase.
3.
With respect to the business cycle, describe the difference between the expansion
phase and the recovery phase.
4. Explain why GDP figures do not necessarily measure happiness or well-being.

5.
Given that GDP is a measure of what is produced in a country, explain how the
expenditure approach can measure GDP. How items are produced, but not yet sold,
accounted for in the expenditure approach?
6.
List and describe four of the six categories of economic exchanges that are omitted
from GDP calculations. Explain why these transactions are not included in GDP and
give an example of each to help support your answer.
7. Describe the process by which banks create money.

8. Describe the circumstances under which the M1 money supply could fall while the
M2 money supply remains constant at the same time.
9. List and describe the three functions of money.
10. Explain why it is not necessary for paper money to be backed by some commodity
(e.g. gold) before it can have value.
Further Readings
z
Mankiw,

z

Hall of India

z
Chandra, P.2006, Project: Preparation Appraisal Selection Implementation and

Review, 6th Edition, Tata McGraw Hill.
149

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Economics Amity Directorate of

Nature and scope of and its relationship with other disciplines

1.4. Scarcity and Efficiency

Discounting Time Perspective

Risk and Uncertainty

2.16. Indifference Curves Analysis

Module 3: Cost and Production Analysis

3.25. Questions and Exercises

Module 4: Market Structure Analysis

Assumptions of perfect competition:

Short run equilibrium

Long Run Equilibrium

4.3. Monopoly: Price Discrimination

4.3.2. Price and Quantity Determination in Short Run

Price and Quantity Determination in Long Run

4.3.4. Price Discrimination

Sweezys Model of Kinked Demand Curve

4.6. Prisoners Dilemma

Module 5: Capital Budgeting and Risk and Uncertainty Analysis

Capital Budgeting Techniques

5.4 Risk and Investment Analysis- Decision Tree Analysis

5.7 Check Your Progress

Module 6: Macro-economics Analysis

Amity School of Distance Learning

Discounting Time Perspective

Risk and Uncertainty

1.3. NATURE AND SCOPE OF AND ITS RELATIONSHIP WITH

Problems of Resource Allocation: Source resources are to be used with utmost

Investment Problems: It is related of allocating resources over time. These normally

Production Possibility Chart

Pricing theory and policies

Market penetration studies

10. Break-even analysis

11. Competitive market studies

12. Anti-Trust issues

13. Plant location studies

14. Mergers and Acquisitions

15. Labor cost studies

16. Inventory problem

17. Investment analysis

18. Capital Budgeting

19. Cost of Capital

20. Government regulations

Demand analysis and forecasting,

Production and cost,

Pricing and output, and

Investment and capital budgeting.

1.4. SCARCITY AND EFFICIENCY

1.5. BASIC CONCEPTS AND PRINCIPLES OF MICRO-ECONOMIC

1.5.2. Opportunity Cost

1.5.3. Discounting Time Perspective

1.5.4. Risk and Uncertainty

Understanding these principles will help to develop a rational decision-making perspective

CHECK YOUR PROGRESS

1. Uncertainty and risk arise mainly due to

Emergence of complexity of the modern business world and social and

(d) All above

The Sub-optimal results,

(c) The Normal results,

All the above.

(a) Time value of interest,

Time value of money,

(c) Time value of investment,