Economic Theory: Rajiv Gandhi University

ECONOMIC THEORY
BA [Economics]
First Semester
BECO-101
RAJIV GANDHI UNIVERSITY

Arunachal Pradesh, INDIA - 791 112
BOARD OF STUDIES
1. Prof. K C Kapoor Chairman
Department of Education
Rajiv Gandhi University
2. Prof. J C Soni Member

3. Dr. P K Acharya Member

Rajiv Gndhi University
4. Ms. Moyir Riba Member

Institute of Distance Education
5. Dr. Ashan Riddi Member Secretary

Director, IDE
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About the University
Rajiv Gandhi University (formerly Arunachal University) is a premier institution for higher education in the state
of Arunachal Pradesh and has completed twenty-five years of its existence. Late Smt. Indira Gandhi, the then
Prime Minister of India, laid the foundation stone of the university on 4th February, 1984 at Rono Hills, where the
present campus is located.
Ever since its inception, the university has been trying to achieve excellence and fulfill the objectives as
envisaged in the University Act. The university received academic recognition under Section 2(f) from the
University Grants Commission on 28th March, 1985 and started functioning from 1st April, 1985. It got financial
recognition under section 12-B of the UGC on 25th March, 1994. Since then Rajiv Gandhi University, (then
Arunachal University) has carved a niche for itself in the educational scenario of the country following its
selection as a University with potential for excellence by a high-level expert committee of the University Grants
Commission from among universities in India.
The University was converted into a Central University with effect from 9th April, 2007 as per notification
of the Ministry of Human Resource Development, Government of India.
The University is located atop Rono Hills on a picturesque tableland of 302 acres overlooking the river
Dikrong. It is 6.5 km from the National Highway 52-A and 25 km from Itanagar, the State capital. The campus
is linked with the National Highway by the Dikrong bridge.
The teaching and research programmes of the University are designed with a view to play a positive role
in the socio-economic and cultural development of the State. The University offers Undergraduate, Post-
graduate, M.Phil and Ph.D. programmes. The Department of Education also offers the B.Ed. programme.
There are fifteen colleges affiliated to the University. The University has been extending educational
facilities to students from the neighbouring states, particularly Assam. The strength of students in different
departments of the University and in affiliated colleges has been steadily increasing.
The faculty members have been actively engaged in research activities with financial support from UGC
and other funding agencies. Since inception, a number of proposals on research projects have been sanctioned
by various funding agencies to the University. Various departments have organized numerous seminars, workshops
and conferences. Many faculty members have participated in national and international conferences and seminars
held within the country and abroad. Eminent scholars and distinguished personalities have visited the University
and delivered lectures on various disciplines.
The academic year 2000-2001 was a year of consolidation for the University. The switch over from the
annual to the semester system took off smoothly and the performance of the students registered a marked
improvement. Various syllabi designed by Boards of Post-graduate Studies (BPGS) have been implemented.
VSAT facility installed by the ERNET India, New Delhi under the UGC-Infonet program, provides Internet
access.
In spite of infrastructural constraints, the University has been maintaining its academic excellence. The
University has strictly adhered to the academic calendar, conducted the examinations and declared the results on
time. The students from the University have found placements not only in State and Central Government
Services, but also in various institutions, industries and organizations. Many students have emerged successful
in the National Eligibility Test (NET).
Since inception, the University has made significant progress in teaching, research, innovations in curriculum
development and developing infrastructure.
SYLLABI-BOOK MAPPING TABLE
Economic Theory
Syllabi Mapping in Book
Unit I: Basic Economic Issues Unit 1: Basic Economic Issues

Resource Scarcity, Unlimited Wants, Choice, Opportunity Cost, (Pages 3-30)
Economic Problems of Developing Countries, Low Income,
Resource Constraints, Low Level of Technology, Low Organizational
Ability, Low Degree of Inventiveness and Innovativeness, Low
Level of Human and Physical Capital, Acute Poverty and Inequality
in the Distribution of Income and Opportunities, Economics, Micro
and Macro - their Differences and Subject Matters.
Unit II: Demand Analysis Unit 2: Demand Analysis

Basis of Demand: Utility and Income, Diminishing Marginal Utility, (Pages 31-59)
Income of the Consumer and Her Budget Line, Constrained Utility
Maximization, Demand Curve and Factors Shifting it: Income, Prices
of Related Goods, etc., Elasticity of Demand: Price and Income
Elasticity.
Unit III: Supply Analysis Unit 3: Supply Analysis

Production Function, Returns to a Factor and Returns to Scale, (Pages 61-108)
Marginal and Average Product of Inputs, Short-run Total, Marginal
and Average Cost Curves and their Relationship, Cost Minimization,
Total, Average and Marginal Revenue, Profit Maximizing Output,
Supply Curve, Shifts in Supply Curve, Elasticity of Supply.
Unit IV: Price and Market Structure Unit 4: Price and Market Structure
Demand, Supply and Price Determination, Market Structure - (Pages 109-171)
Features of Perfect Competition and its Limitations, Imperfect
Competition: Monopoly, Duopoly and Oligopoly: Their Features.
Unit V: National Income and its Classical Determination Unit 5: National Income and Its
Gross Domestic Product (GDP), NDP, GNP, NNP and Per Capita Classical Determination
Income, Methods of National Income Estimation - Product, Income (Pages 173-218)
and Expenditure: Circular Flow of Income and Expenditure, Classical
theory of Output and Employment and its Limitations.
Unit VI: Keynesian Model and Macro-Policies Unit 6: Keynesian Model and
Keynesian Determination of Income: Consumption Function, Saving Macro-Policies
Function, Investment Multiplier, Fiscal Policy: Its Objectives and (Pages 219-246)
Instruments.
CONTENTS
INTRODUCTION 1-2
UNIT 1 BASIC ECONOMIC ISSUES 3-30

1.0 Introduction
1.1 Unit Objectives
1.2 Economy and its Basic Problems: Resource Scarcity and Unlimited Wants
1.2.1 Why Does the Problem of Making Choice Arise?
1.2.2 Micro and Macroeconomic Problems
1.2.3 Production Possibilities and Opportunity Cost
1.3 Economic Problems of Developing Countries
1.3.1 Rural Poverty in Developing Countries
1.3.2 Low Income
1.3.3 Inequality in the Distribution of Income and Opportunities
1.3.4 Resource Constraints
1.3.5 Low Level of Technology
1.3.6 Low Degree of Innovativeness
1.3.7 Low Level of Human and Physical Capital
1.4 Micro and Macro Economics
1.4.1 Difference Between Macro and Micro Economics
1.4.2 Microeconomics and Macroeconomics are Interdependent
1.5 Summary
1.6 Key Terms
1.7 Answers to ‘Check Your Progress’
1.8 Questions and Exercises
1.9 Further Reading
UNIT 2 DEMAND ANALYSIS 31-59

2.0 Introduction
2.1 Unit Objectives
2.2 Basis of Demand: Utility and Income
2.2.1 Measurability of Utility
2.2.2 Two Approaches to Consumer Demand Analysis
2.3 Diminishing Marginal Utility
2.4 Income of the Consumer and the Budget Line
2.4.1 Consumer Equilibrium
2.4.2 Constrained Utility Maximization
2.5 Demand Curve and Factors Shifting It
2.5.1 Factors Behind Shifts in the Demand Curve
2.6 Elasticities of Demand
2.6.1 Price Elasticity of Demand
2.6.2 Income Elasticity of Demand
2.7 Summary
2.8 Key Terms
2.11 Further Reading
UNIT 3 SUPPLY ANALYSIS 61-108
3.0 Introduction
3.1 Unit Objectives
3.2 Production Function
3.2.1 Marginal Product
3.2.2 Average Product
3.3 Returns to Factor and Returns to Scale
3.3.1 Short-Run Laws of Production
3.3.2 Returns to Scale
3.4 Cost Concepts
3.4.1 Cost-Output Relations Through Cost Curves
3.4.2 Cost Minimization
3.5 Profit Maximizing Output
3.5.1 Total, Marginal and Average Revenue
3.5.2 Profit Maximization Conditions
3.5.3 Controversy Over Profit Maximization Objective: Theory vs. Practice
3.6 Supply Curve and Shift in Supply Curve
3.6.1 Shift in the Supply Curve
3.6.2 Supply Function
3.6.3 Elasticity of Supply
3.7 Summary
3.8 Key Terms
UNIT 4 PRICE AND MARKET STRUCTURE 109-171

4.0 Introduction
4.1 Unit Objectives
4.2 Market Structure and Degree of Competition
4.2.1 Demand, Supply and Price Determination
4.3 Price Determination under Perfect Competition
4.3.1 Characteristics of Perfect Competition
4.3.2 Price and Output
4.4 Price Determination under Pure Monopoly
4.4.1 Causes and Kinds of Monopolies
4.4.2 Pricing and Output Decision: Short-run Analysis
4.4.3 Monopoly Pricing and Output Decision in the Long-run
4.4.4 Price Discrimination Under Monopoly
4.4.5 Price Discrimination by Degrees
4.4.6 An Algebraic Solution
4.4.7 Measures of Monopoly Power
4.5 Pricing and Output Decisions under Monopolistic Competition
4.5.1 Monopolistic vs. Perfect Competition
4.5.2 Price and Output Decisions in the Short-run
4.5.3 Price and Output Determination in the Long-run
4.5.4 Non-Price Competition: Selling Cost and Equilibrium
4.5.5 Critical Appraisal of Chamberlin’s Theory
4.6 Pricing and Output Decisions under Oligopoly
4.6.1 Oligopoly: Definition, Sources and Characteristics
4.6.2 The Oligopoly Models: An Overview
4.6.3 Cournot’s Duopoly Model
4.6.4 Kinked Demand Curve Analysis of Price Stability: Sweezy’s Model
4.6.5 Price Leadership Models
4.6.6 Collusion Model: The Cartel
4.7 The Game Theory
4.7.1 The Nature of the Oligopoly Problem: The Prisoners’ Dilemma
4.7.2 Application of Game Theory to Oligopolistic Strategy
4.8 Summary
4.9 Key Terms
UNIT 5 NATIONAL INCOME AND ITS CLASSICAL DETERMINATION 173-218

5.0 Introduction
5.1 Unit Objectives
5.2 Measures of National Income
5.2.1 Gross National Product (GNP)
5.2.2 Gross Domestic Product (GDP)
5.2.3 Net National Product (NNP) and Per Capita Income
5.2.4 Net Domestic Product (NDP)
5.3 Methods of National Income Estimation
5.3.1 Net Output or Value Added Method
5.3.2 Factor-Income Method
5.3.3 Expenditure Method
5.4 Circular Flow of Income and Expenditure
5.4.1 Circular Flows in a Simple Economy Model
5.4.2 The Effect of Withdrawals and Injections
5.4.3 Circular Flows of Goods and Money in a Three-Sector Economy
5.4.4 Circular Flows in a Four-Sector Model: A Model with Foreign Sector
5.5 Classical Theory of Output and Employment
5.5.1 Aggregate Output and Employment
5.5.2 Say’s Law of Markets and the Quantity Theory of Money
5.5.3 Classical Theory without Saving and Investment
5.5.4 Rigid Money Wage
5.5.5 Monetary Policy and Full Employment
5.5.6 Classical Theory with Saving and Investment
5.5.7 Limitations of the Theory
5.6 Summary
5.7 Key Terms
UNIT 6 KEYNESIAN MODEL AND MACRO-POLICIES 219-246

6.0 Introduction
6.1 Unit Objectives
6.2 Keynesian Determination of Income
6.2.1 Determination of National Income: Two-Sector Model
6.2.2 The Consumption Function
6.2.3 Derivation of Saving Function
6.2.4 A Formal Model of National Income Determination
6.2.5 Shift in Aggregate Demand Function and the Multiplier
6.2.6 Static and Dynamic Multiplier
6.3 Fiscal Policy: Objectives and Instruments
6.3.1 Fiscal Policy and Economic Activity
6.3.2 Objectives of Fiscal Policy
6.3.3 Monetary and Fiscal Policies are Complementary
6.4 Summary
6.5 Key Terms
6.8 Further Reading
Introduction
INTRODUCTION
Economic theory or analysis furnishes the economists with a set of tools which they use
to analyse the nature of the observed economic phenomena in the real world. Economic NOTES
theory may, therefore, be appropriately defined as a ‘box of tools’ with which the
economists construct economic models in order to study the economic phenomena which
frequently occur in the real world. Although the analytical tools in the kit-bag of an
economist are inadequate to enable him to handle each and every individual economic
occurrence in so far as it reveals its own peculiarities, these nevertheless enable him to
analyse certain common features of individual economic occurrences. Like other
sciences, economic theory also provides us with the general propositions which are
employed in the analysis of economic phenomena within certain limits. The limitations of
these theoretical economic propositions in analysing the individual economic phenomenon
emanate from the assumptions which form the basis of these propositions. Since the
assumptions forming the bedrock of economic theory are very seldom realistic, economic
theory resembling actual reality is a rare occurrence. To the extent that all economic
theories are based on certain assumptions, these theories abstract from reality. The
more general or universal is the economic theory the greater is its abstraction from
reality.
Formally tracing its origin to Adam Smith’s mounmental work entitled An Inquiry
into the Nature and Causes of the Wealth of Nations, first published in 1776, economic
theory can today take pride in calling itself more than two centuries and three decades
old. Its development during this long period, however, has failed in following any set
pattern, being seldom in the same direction. Economic theory, both past and contemporary,
is the product of numerous influences and factors affecting one another. The philosophical
thought of a particular period or of a particular writer has also influenced the kind of
theory which has developed over this period. Its development has also been influenced
by the political biases of writers over the long period of its history. For example, the
classical economic theory was influenced, in no small measure, by the political biases of
the classical economists. Similarly, the Marxian economic theory was couched in Karl
Marx’s political philosophy.
It is doubtful to say if David Ricardo would have developed his theory of
international trade without a strong animus against the landed class. The theory, however,
survives the removal of his prejudices. The development of economic theory has taken
place over several periods with each period marked by certain special features not
found in the other periods. Consequently, economic theory does not belong to any single
individual, country or age. Obviously, its outlook and ownership is essentially cosmopolitan.
There is no unanimity among economists about the nature and purpose of economic
theory. Should economic theory accurately describe its assumptions? Or, should it predict
actual future events? Or, should it predict consequences of certain causes in an ‘ideal’
world? The principal function of an economic theory is to explain the nature of economic
activity and to predict as to what will happen in the economy at a given time in future.
A perfect theory, besides being realistic in its presentation, should be competent
to predict the consequences of certain given events. For instance, assuming that the
producer’s objective function is only to maximize their profits, given the data about the
supply and demand functions and input prices, it should be logically possible to deduce
the total amount of the commodity output which producers will produce and the total
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Introduction amount of net profit earned by them. If the government now imposes an ad valorem
commodity tax on the producers, we can find out its impact on the output, price and
profit. By its very nature, however, economic theory cannot always be descriptively
realistic. The purpose of economic theory is to develop hypotheses which are abstract
NOTES from the essential features of the complex real world. Economic theory should formulate
questions pertaining to an economic phenomenon. It should also indicate the mode of
answering these questions. This book Economic Theory, will deal with the various
aspects of economic theory.
The book, Economic Theory, is written in a self-instructional format and is divided
into six units. Each unit begins with an Introduction to the topic followed by an outline
of the Unit objectives. The content is then presented in a simple and easy-to-understand
manner, and is interspersed with Check Your Progress questions to test the reader’s
understanding of the topic. A list of Questions and Exercises is also provided at the end
of each unit, and includes short-answer as well as long-answer questions. The Summary
and Key Terms section are useful tools for students and are meant for effective
recapitulation of the text.
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Basic Economic Issues
UNIT 1 BASIC ECONOMIC ISSUES

Structure
NOTES
1.0 Introduction
1.1 Unit Objectives
1.2 Economy and its Basic Problems: Resource Scarcity and Unlimited Wants
1.3 Economic Problems of Developing Countries
1.3.2 Low Income
1.4 Micro and Macro Economics
1.5 Summary
1.6 Key Terms
1.9 Further Reading
1.0 INTRODUCTION
Any activity that produces goods and services is productive activity and any activity that
creates goods and services of value is called economic activity. The basic objective
behind all economic activities is to make income, the source of livelihood. An important
feature of economic activities is that they are interrelated and interdependent in the
sense that producers produce what consumers want to consume and consumers can
consume only what producers produce and they produce only as much as consumers
are willing to consume. Similarly, sellers can sell only what buyers are willing to buy and
buyers can buy only what is offered for sale; and so on. This interrelatedness and
interdependence of economic activities are carried out in a self-operated system.
An economy is a social organism in which people act, interact, cooperate
and compete in the process of production and consumption to make their living.
An economy is constituted of interrelated and interdependent economic activities of the
economic players. Economic players include individuals, households, firms, farms,
factories, financial institutions and government. All kinds of economic activities are carried
out within the framework of an economic system. A free economic system is established
and governed by two economic forces—demand for and supply of goods and services.
Demand and supply forces create a market system—called market mechanism. The
interaction between the market forces of demand and supply makes the economic system
of the country. A clear understanding of the economic system and its working is a
necessary condition for making appropriate business decisions.
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Basic Economic Issues This unit will introduce you to the basic problems an economy is always faced
with. The economic problem is one of the basic economic theoretical principles being
employed in the operation of any economy. The economic problem model asserts that
there is resource scarcity, i.e., available resources are not sufficient to satisfy our all
NOTES wants and needs. Three questions arise from this: first, what to produce; second, how
the factors of production, namely capital and labour, are to be allocated to produce it;
and third, for whom those goods or service should produce (a problem of allocation of
resources). Economics revolves around methods and possibilities of solving this
fundamental economic problem.
Developing countries have a unique set of economic problems and challenges to
economic development. Economic problems of these countries include rural poverty,
low income, inequality in the distribution of income and opportunities, resource constraints
and low levels of technology, innovativeness, and human and physical capitals. You will
learn about all these problems in this unit.
1.1 UNIT OBJECTIVES

After going through this unit, you will be able to:
 Discuss the major microeconomic and macroeconomic problems faced by an
economy
 Assess the production possibilities and opportunity cost of an economy
 Describe the various economic problems of developing countries
 Discuss the major differences between macro and micro economics
1.2 ECONOMY AND ITS BASIC PROBLEMS:

RESOURCE SCARCITY AND UNLIMITED
WANTS
Economics as a social science studies economic behaviour of the people and its
consequences. What is economic behaviour? Economic behaviour is essentially the process
of evaluating economic opportunities open to an individual or a society and, given the
resources, making choice of the best of the opportunities. The objective behind this
economic behaviour is to maximize gains from the available resources and opportunities.
In their efforts to maximize their gains from their resources, people have to make a
number of choices regarding the use of their resources and spending their earnings. The
basic function of economics is to observe, explain and predict how people (individuals,
households, firms and the government) as decision-makers make choices about the use
of their resources (land, labour, capital, knowledge and skills, technology, time and space,
etc.) to maximize their income, and how they as consumers decide how to spend the
income to maximize their total utility. Thus, economic is fundamentally the study of
choice-making behaviour of the people. The choice-making behaviour of the people is
studied in a systematic or scientific manner. This gives economics the status of a social
science.
For the purpose of economic analysis, people are classified according to their
decision-making capacity as individuals, households, firms and the society, and according
to the nature of their economic activity as consumers, producers, factor owners and
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economy managers, i.e., the government. As consumers, individuals and households, Basic Economic Issues
with their given income have to decide ‘what to consume and how much to consume’.
They have to make these decisions because consumers are, by nature, utility maximizers
and consuming any commodity in any quantity does not maximize their gains, the
satisfaction. As producers, firms, farms, factories, shopkeepers, banks, transporters, NOTES
etc. have to choose ‘what to produce, how much to produce and how to produce’
because they too are gain maximizers and producing any commodity in any quantity by
any technique will not maximize their gains (profits). As labour, they have to choose
between alternative occupations and places of work because any occupation at any
place will not maximize their earnings. Likewise, the government has to choose how to
tax, whom to tax, how much to spend and how to spend so that social welfare is maximized
at a given social cost. Economics as a social science studies how people make their
choices.
It is this economic behaviour of the individuals, households, firms, government
and the society as a whole which forms the central theme of economics as a social
science. Thus, economics is fundamentally the study of how people allocate their limited
resources to produce and consume goods and services to satisfy their endless wants
with the objective of maximizing their gains.
The need for making choice arises because of some basic facts of economic life. Let us
look at the basic facts of human life in some detail and how they create the problem of
choice-making.
1. Unlimited human wants, desires and aspirations
The history of human civilization bears evidence to the fact that human desire to consume
more and more of better and better goods and services has ever since been increasing.
For example, housing need has risen from a hut to luxury palace, and if possible, a house
in space; the need for means of transportation has gone up from mule and camel to
supersonic jet planes; demand for means of communication has risen from messengers
and postal services to cell phones with camera; need for computational facility from
manual calculation to superfast computers; and so on. For an individual, only the end of
life brings the end to his/her needs. But for homo-sapiens, needs and desires continue to
grow endlessly.
Human wants, desires and needs are endless in the sense that they go on increasing
with increase in people’s ability to satisfy them. The endlessness of human wants can be
attributed to (i) people’s insatiable desire to raise their standard of living, comforts and
efficiency; (ii) human tendency to accumulate things beyond their present need;
(iii) increase in knowledge about inventions and innovations of new goods and services
with greater convenience, efficiency and serviceability; (iv) multiplicative nature of some
want (e.g., buying a car creates want for many other things—petrol, driver, cleaning,
parking place, safety locks, spare parts, insurance, etc.); (v) biological needs (e.g., food,
water, etc.) are repetitive; (vi) imitative and competitive nature of human beings creating
needs due to demonstration and bandwagon effects; and (vii) influence of advertisements
in modern times creating new kind of wants. For these reasons, human wants continue
to increase endlessly.
Apart from being unlimited, another and an equally important feature of human
wants is that they are gradable. In simple words, all human wants are not equally urgent
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Basic Economic Issues and pressing, at a point time or over a period of time. While some wants have to be
satisfied as and when they arise (e.g., food, clothes and shelter) and some can be
postponed, e.g., purchase of a car. Also, while satisfying some wants gives a greater
satisfaction than others. Given their intensity and urgency, human wants can be arranged
NOTES in the order of their priority. The priority of wants, however, varies from person to
person, and from time to time for the same person. Therefore the question arises as to
‘which want to satisfy first’ and ‘which the last’. Thus, the consumers has to make
choice ‘what to consume’ and ‘how much to consume’. Economics studies how consumers
(individuals and household) make choice between their wants and how they allocate
their expenditure between different kinds of goods and services they choose to consume.
2. Resources scarcity
The need for making choice between the various goods that people want to produce and
consume arises mainly because resources that are available to the people at any point of
time for satisfying their wants are scarce and limited. What are the resources?
Conceptually, any thing3 which is available and can be used to satisfy human wants and
desire is a resource. In economics, however, resources that are available to individuals,
households, firms, and societies at any point of time are traditionally classified as follows.
(i) Natural resources (including cultivable land surface, space, lakes, rivers, coastal
range, minerals, wildlife, forest, climate, rainfall, etc.)
(ii) Human resources (including manpower, human energy, talent, professional skill,
innovative ability and organizational skill, jointly called labour)
(iii) Man-made resources (including machinery, equipments, tools, technology and
building, called together capital)
(iv) Entrepreneurship, i.e., the ability, knowledge and talent to put land, labour and
capital in the process of production, and ability and willingness to assume risk in
business
To these basic resources, economists add other categories of resources, viz.,
time, technology and information. All these resources are scarce. Resource scarcity is a
relative term. It implies that resources are scarce in relation to the demand for resources.
The scarcity of resources is the mother of all economic problems. If resources were
unlimited, like human wants, there would be no economic problem and, perhaps, no
economics as a subject of study. It is the scarcity of resources in relation to human
wants that forces people to make choices.
Furthermore, the problem of making choice arises also because resources have
alternative uses and alternative uses have different returns or earnings. For example, a
building can be used to set up a shopping center, business office, a ‘public school’, a
hospital or for residential purpose. But the return on building varies from use to use of
the building. Therefore, a return maximizing building owner has to make choice between
the alternative uses of the building. If the building is put to a particular use, the landlord
has to forego the return expected from its other alternative uses. This is calledopportunity
cost (discussed ahead separately in the unit). Economics as a social science analyses
how people (individuals and society) make their choices between the economic goals
they want to achieve, between the goods and services they want to produce, and between
the alternative uses of their resources with the objective of maximizing their gains. The
gain maximizers evaluates the costs and benefits of the alternatives while deciding on
the final use of the resources. Economics studies the process of making choices between
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the alternative uses. This is what constitutes, according to Robbins, the subject matter of Basic Economic Issues
economics.
3. Gain maximizing attitude
Yet another important aspect of human nature that leads to the choice-making behaviour NOTES
is that most people aim at maximizing their gains from the use of their limited resources.
‘Why people want to maximize their gains’ is no concern of economics? Traditional
economics assumes maximizing behaviour of the people as a part of their rational
economic behaviour. This assumption is based on observed facts. As consumers, they
want to maximize their utility or satisfaction; as producers, they want to maximize their
output or profit; and as factor owners, they want to maximize their earnings. People’s
desire to maximize their gains is a very important aspect of economic behaviour of the
people giving rise to economics. If the people were not to maximize their gains, the
problem of choice making would not arise. Consumers would not bother as to ‘what to
consume’ and ‘how much to consume’; producers would not bother as to ‘what to
produce’, ‘how much to produce’ and ‘how to produce’; and factor owners would not
care as to where and how to use the resources. But, in reality, they do maximize their
gains. Economics studies how people maximize their gains.
The basic problems of an economy lie in the background of all economic decisions, and
also form the basis of economic studies and generalization. The major economic problems
faced by an economy—whether capitalist, socialist or mixed—may be classified into
two broad groups:
(i) Microeconomic problems which are related to the working of the economic system
(ii) Macroeconomic problems related to the growth, employment, stability, external
balance, and macroeconomic policies for the management of the economy as a
whole
We will first discuss the microeconomic problems which are immediately relevant
to our simplified economic system. Macroeconomic problems will be taken up in the
following subsection.
Microeconomic problems
The basic microeconomic problems are:
 What to produce and how much to produce?
 How to produce?
 For whom to produce or how to distribute the social output?
These problems assume a macro nature when considered at the economy level.
However, we will discuss them first at the micro level.
(i) What to Produce?: Problem of Choice between Commodities
The problem ‘what to produce’ is the problem of choice between commodities. This
problem arises mainly for two reasons: (i) scarcity of resources does not permit production
of all the goods and services that people would like to consume; and
(ii) all the goods and services are not equally valued in terms of their utility by the
consumers. Some commodities yield higher utility than the others. Since all the goods
and services cannot be produced for lack of resources, and all that is produced may not
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Basic Economic Issues be bought by the consumers, the problem of choice between the commodities arises.
The problem ‘what to produce’ is essentially the problem of efficient allocation of scarce
resources so that the output is maximum and the output-mix is optimum. The objective is
to satisfy the maximum needs of the maximum number of people.
NOTES The question ‘how much to produce’ is the problem of determining the quantity of
each commodity and service to be produced. This problem too arises due to scarcity of
resources. For, surplus production would mean wastage of scarce resources. This problem
also implies the allocation of resources between various goods and services to be
produced.
The basic economic problem of unlimited wants and limited resources makes it
necessary for an economic system to devise some method of determining ‘what to
produce’ and ‘how much to produce’, and ways and means to allocate the available
resources for the production of goods and services. In a free enterprise economy, the
solution to the problems ‘what to produce’ and ‘how much to produce’ is provided by the
price mechanism.
(ii) How to Produce?: Problem of Choice of Technique
The problem ‘how to produce’ is the problem of choice of technique. Here, the problem
is how to determine an optimum combination of inputs—labour and capital—to be used
in the production of goods or services. This problem too arises mainly because of scarcity
of resources. If labour and capital were available in unlimited quantities, any amount of
labour and capital could be combined to produce a commodity. But, since resources are
scarce, it becomes imperative to choose a technology which uses resources most
economically.
Another very important factor which gives rise to this problem is that a given
quantity of a commodity can be produced with a number of alternative techniques, i.e.,
alternative input combinations. For example, it is always technically possible to produce
a given quantity of wheat with more of labour and less of capital (i.e., with a labour-
intensive technology) and with more of capital and less of labour (i.e., with a capital-
intensive technology). The same is true of most commodities. In the case of some
commodities, however, choices are limited. For example, production of woollen carpets
and other items of handicrafts is by nature labour-intensive, while production of cars,
TV sets, computers, aircraft, etc., is capital-intensive. In the case of most commodities,
however, alternative technology may be available. But, the alternative techniques of
production involve varying costs. Therefore, the problem of choice of technology arises.
In a free market economy, the market system itself provides the solution to the
problem of choice of technology through the price mechanism. The market mechanism
yields a pricing system which determines the prices of both labour and capital. Factor
prices and factor-quantities determine the cost of production for the business firms.
Profit maximizing firms find out an input combination which minimizes their cost of
production. This becomes inevitable for the firms because their resources are limited
and, with given resources, they intend to maximize their profits.
(iii) For Whom to Produce: How to Distribute Social Output
In a modern economy, all the goods and services are produced by business firms. The
total output generated by business firms is known as ‘society’s total product’ or ‘national
output’. The total output ultimately flows to the households. Here a question arises: How
is the national output shared among the households or what determines the share of
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each household? A possible answer to this question is that, in a free enterprise economy, Basic Economic Issues
it is the price-mechanism which determines the distribution pattern of the national output.
Price-mechanism determines the price of each factor in the factor market. Once the
factor price is determined, the income of each household is determined by the quantity
of the factor(s) which it sells in the factor market. Those who possess a large amount of NOTES
highly-priced resources are able to earn higher incomes and consume a larger proportion
of national output than those who possess a small quantity of low-priced resources.
But the problem does not end here. For, other questions then arise: why do some
people have a command over a larger proportion of resources than the others? Why do
those who have more, get more and more? Why do those who have less, get less and
less? In other words, why do the rich get richer and the poor get poorer? Is this distribution
of national production fair? If not, how can disparities in incomes or sources of incomes
be removed, or at least, reduced?
The price mechanism of free enterprise system has not been able to provide a
solution to these questions. These problems have long been debated inconclusively. They
remain as alive today as they were during the days of Adam Smith and David Ricardo.
These questions are the subject of the ‘Theory of Distribution’.
When questions related to production and distribution are looked into from the
efficiency point of view, the economists address themselves to other questions: How
efficient is the society’s production and distribution system? How does it affect the
welfare of the society? How can production and distribution be made more efficient or
welfare oriented? Economists’ attempts to answer these questions has led to the growth
of another branch of economics, i.e., Welfare Economics.
Major macroeconomic problems
The economic problems discussed above are of micro nature. These problems taken
together make up the subject matter of Microeconomic Theory or ‘Price Theory’. Apart
from microeconomic problems, there are certain macroeconomic problems of prime
importance confronted by an economy. These problems may be specified as follows:
1. How to increase the production capacity of the economy: This is essentially
the problem related to the economic growth of the country. The need for increasing
the production capacity of the economy arises for at least two reasons. First, most
economies of the world have realized by experience that their population has grown
at a rate much higher than their productive resources. This leads to poverty, especially
in the less-developed countries. Poverty, in itself, is a cause of a number of socio-
economic problems. Besides, it has frequently jeopardized the sovereignty and
integrity of nations. Colonization of poor nations by the richer and powerful imperialist
nations during the pre-twentieth century period is evidence of this fact. Therefore,
growth of the economy and sparing resources for defence has become a necessity.
Second, over time, some economies have grown faster than others while some
economies have remained almost stagnant. The poor nations have been subjected
to exploitation and economic discrimination. This has impelled the poor nations to
make their economies grow, to protect themselves from exploitation and to give
their people a respectable status in the international community.
While various economies have been facing the problem of growth, economists
have engaged themselves in finding an answer to such questions as: What makes
an economy grow? Why do some economies grow faster than the others? This
has led to the Theories of Economic Growth.
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Basic Economic Issues 2. How to stabilize the economy: An important feature of the free enterprise
system has been the economic fluctuation of these economies. Though economic
ups and downs are not unknown in controlled economies, free enterprise economies
have experienced it more frequently and more severely. Economic fluctuations
NOTES cause wastage of resources, e.g., idleness of manpower or involuntary
unemployment, idle capital stock, particularly during the periods of depression.
Economists have devoted a good deal of attention to explain this phenomenon.
This problem is studied under Trade Cycles or Business Cycles.
3. Other problems of macro nature: In addition to the macro problems mentioned
above, there are many other economic problems of this nature, which economists
have studied extensively and intensively. The most important problems of this
category are the problems of unemployment and inflation. While widespread
unemployment is the biggest problem confronting developing economies, inflation
is a global problem. Another set of macro problems is associated with international
trade. Major questions to which economists have devoted a good deal of their
attention are: What is the basis of trade between the nations? How are the gains
from trade shared between the nations? Why do deficits and surpluses arise in
trade balances? How is an economy affected by deficits or surplus in its balance
of payment position? New problems continue to emerge as an economy passes
through different phases of economic growth.
As noted earlier, societies cannot have all that they want because resources are scarce
and technology is given. In reality, however, both human and non-human resources
available to a country keep increasing over time with technology becoming more and
more efficient and productive. Availability of human resources increases due to a natural
process of increase in population, and non-human resources (especially capital goods
and raw materials) increase due to the creative nature of human beings. Non-human
resources have been increasing due to human efforts to create more and better of
capital goods, to discover new kinds and sources of raw materials, and to create a new
and more efficient technique of production. Such factors bring about a change in production
possibilities and production possibilities frontier of an economy.
In this sub-section, we will describe the production possibilities frontier and
introduce the concept of opportunity cost. To begin with, we will assume a static model
with the following assumptions: (i) a country’s resources consists of only labour and
capital; (ii) availability of labour and capital is given; (iii) the country produces only two
goods—food and clothing; and (iv) production technology for the goods is given.
Apart from showing the possible alternative combinations of two goods, production
possibilities frontier (PPF) also indicates the opportunity cost of one commodity in terms of
the other product. Conceptually, opportunity cost is the benefit foregone to avail the benefit
of another opportunity. In the present context, ‘The opportunity cost of an increase in the
output of some product is the value of the other goods and services that must be foregone
when inputs (resources) are taken away from production in order to increase the output of
the product in question’. In our example, opportunity cost of food production is the quantity
of clothing foregone to produce a certain quantity of food, and vice versa. The concept of
‘opportunity cost’ can be exemplified with the help of alternative options given byPPF. As
can be seen in Fig. 1.1, the movement along the production possibilities frontier,AF, shows
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a decrease in the output of one commodity and increase in the output of the other. For Basic Economic Issues
example, movement from point A to point B shows decrease in food production from 7000
and tons to 6000 tons and increase in the production of clothing from 40 million metres to
55 million metres. It implies that 1000 tons of food can be produced only by sacrificing 55
million metres of clothing. It means that opportunity cost of 1000 tons of food is 15 million NOTES
metres of clothing. You can similarly find the opportunity cost of food and clothing in terms
of one another between any two points on the PPF curve.
Increasing Opportunity Cost and Concavity of PPF
The production possibilities frontier reveals another important fact that opportunity cost
changes along the PPF. In Fig. 1.1, movement from point A downwards to points B, C,
D, E and F shows increasing opportunity cost of clothing in terms of lost output of food.
For example, movement from point A to point B, means transferring resources (labour
and capital) from food production to clothing production. As a result, food production is
lost by 1000 tons for 15 million metres of clothing. It means that the opportunity cost of
15 million metres of clothing is 1000 tons of food. A movement from point B to C shows
that the opportunity cost of only 9 million metres of clothing, a much lower quantity, is the
same 1000 tons of food. It means that opportunity cost of clothing increases as we move
downwards along the PPF.
Fig. 1.1 The Production Possibilities Frontier

Check Your Progress
Why is PPF Concave? It can be seen from Fig. 1.1 that PPF takes the form of
a concave curve. PPF derives its concavity from the fact that opportunity cost increases 1. How can the major
economic problems
along the PPF. Opportunity cost increases due to an economic law, i.e., the law of faced by an
diminishing returns. The law of diminishing returns states that when more and more economy be
units of inputs are used to produce a commodity, the return on the marginal units goes on classified?
diminishing. The movement from one point on the PPF curve to another means transfer 2. Why does the
of resources from the production of one commodity to that of the other. For example, problem ‘what to
produce’ arise?
movement from point A towards point F implies transfer of resources from food production
3. Why cannot
to production of clothing. As more and more resources are employed to produce clothing, societies have all
marginal productivity of resources in terms of clothing goes on diminishing. The result is that they want?
increase in the opportunity cost which causes concavity in the PPF curve.
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1.3 ECONOMIC PROBLEMS OF DEVELOPING
COUNTRIES
NOTES Developing areas, including developing countries and regions, have a unique set of
economic problems and challenges to economic development. Developing countries,
taken as whole, refer to countries characterized by an underdeveloped industrial base,
low per capita income, and widespread poverty. Some of the major economic problems
of developing countries are described in this section.
The causes of rural poverty are complex and multidimensional. They involve, among
other things, culture, climate, gender, markets, and public policy. Likewise, the rural poor
are quite diverse both in the problems they face and the possible solutions to these
problems.
Broad economic stability, competitive markets, and public investment in physical
and social infrastructure are widely recognized as important requirements for achieving
sustained economic growth and a reduction in rural poverty. In addition, because the
rural poor’s links to the economy vary considerably, public policy should focus on issues
such as their access to land and credit, education and health care, support services, and
entitlements to food through well-designed public works programmes and other transfer
mechanisms.
About one-fifth of the world’s population is afflicted by poverty—these people
live on less than $1 a day. Poverty is not only a state of existence but also a process with
many dimensions and complexities. Poverty can be persistent (chronic) or transient, but
transient poverty, if acute, can trap succeeding generations. The poor adopt all kinds of
strategies to mitigate and cope with their poverty.
To understand poverty, it is essential to examine the economic and social context,
including institutions of the state, markets, communities, and households. Poverty
differences cut across gender, ethnicity, age, location (rural versus urban), and income
source. In households, children and women often suffer more than men. In the community,
minority ethnic or religious groups suffer more than majority groups, and the rural poor
more than the urban poor; among the rural poor, landless wage workers suffer more
than small landowners or tenants. These differences among the poor reflect highly complex
interactions of cultures, markets, and public policies.
Rural poverty accounts for nearly 63 per cent of poverty worldwide, reaching 90
per cent in some countries like Bangladesh and between 65 and 90 per cent in sub-
Saharan Africa. (Exceptions to this pattern are several Latin American countries in
which poverty is concentrated in urban areas.) In almost all countries, the conditions—
in terms of personal consumption and access to education, health care, potable water
and sanitation, housing, transport, and communications—faced by the rural poor are far
worse than those faced by the urban poor. Persistently high levels of rural poverty, with
or without overall economic growth, have contributed to rapid population growth and
migration to urban areas. In fact, much urban poverty is created by the rural poor’s
efforts to get out of poverty by moving to cities. Distorted government policies, such as
penalizing the agriculture sector and neglecting rural (social and physical) infrastructure,
have been major contributors to both rural and urban poverty.
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1.3.2 Low Income Basic Economic Issues
The links between poverty, economic growth, and income distribution have been studied
quite extensively in recent literature on economic development. Absolute poverty can be
alleviated if at least two conditions are met: NOTES
 Economic growth must occur—or mean income must rise—on a sustained basis
 Economic growth must be neutral with respect to income distribution or reduce
income inequality
Generally, poverty cannot be reduced if economic growth does not occur. In fact,
the persistent poverty of a substantial portion of the population can dampen the prospects
for economic growth. Also, the initial distribution of income (and wealth) can greatly
affect the prospects for growth and alleviation of mass poverty. Substantial evidence
suggests that a highly unequal distribution of income is not conducive to either economic
growth or poverty reduction. Experience has shown that if countries put in place incentive
structures and complementary investments to ensure that better health and education
lead to higher incomes, the poor will benefit doubly through increased current consumption
and higher future incomes.
The pattern and stability of economic growth also matter. On the one hand,
traditional capital-intensive, import-substituting, and urban-biased growth—induced by
government policies on pricing, trade, and public expenditure—has generally not helped
alleviate poverty. On the other hand, agricultural growth—where there is a low
concentration of land ownership and labour-intensive technologies are used—has almost
always helped reduce poverty. Finally, sharp drops in economic growth—resulting from
shocks and economic adjustments—may increase the incidence of poverty. Even when
growth resumes, the incidence of poverty may not improve if inequality has been worsened
by the crisis.
Low-Income Developing Countries (LIDCs)
The Low-Income Developing Countries (LIDC) group includes all countries that: (a)
fall below a modest per capita income threshold (US$2,500 in 2011, based on Gross
National Income) and (b) are not conventionally viewed as emerging market economies
(EMs). There are 60 countries in this group, accounting for about one-fifth of the world’s
population; sub-Saharan Africa (SSA) accounts for some 57 per cent of the LIDC
population, with a further 28 per cent living in Asia. While sharing characteristics common
to all countries at low levels of economic development, the LIDC group is strikingly
diverse, with countries ranging in size from oil-rich Nigeria (174 million) to fisheries
dependent Kiribati (0.1 million), and in 2013 per capita GDP terms from Mongolia
(US$3,770) to Malawi (US$270). The 10 largest economies in the group account for
two-thirds of total group output.
Inequality in society is not a new phenomenon. And yet it can be fatal. If left unchecked,
it can undermine the very foundations of development and social and domestic peace.
Over the last decades, the world has witnessed impressive average gains against
multiple indicators of material prosperity. For instance, gross domestic product (GDP)
per capita in low- and middle-income countries has more than doubled in real terms
since 1990. In the same period, life expectancy in developing countries has risen from
63.2 years to 68.6 years. However, this is only part of the picture. Although the world is
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Basic Economic Issues globally richer than ever before, more than 1.2 billion people still live in extreme poverty.
The richest 1 per cent of the world population owns about 40 per cent of the world’s
assets, while the bottom half owns no more than 1 per cent. Despite overall declines in
maternal mortality, women in rural areas are still up to three times more likely to die
NOTES while giving birth than women living in urban centres. Social protection has been extended,
yet persons with disabilities are up to five times more likely than average to incur
catastrophic health expenditures. Women are participating more in the work force, but
continue to be disproportionately represented in vulnerable employment. Humanity remains
deeply divided.
Nor are recent trends very encouraging. Over the last two decades, income
inequality has been growing on average within and across countries. As a result, a
significant majority of the world’s population lives in societies that are more unequal
today than 20 years ago. Remarkably, in many parts of the world, income gaps have
deepened—and, with them, the gulf in quality of life between the rich and the poor—
despite the immense wealth created through impressive growth performances. In fact,
the sharpest increases in income inequality have occurred in those developing countries
that were especially successful in pursuing vigorous growth and managed, as a result, to
graduate into higher income brackets. Economic progress in these countries has not
alleviated disparities, but rather exacerbated them.
The world is more unequal today than at any point since Second World War.
However, there are clear signs that this situation cannot be sustained for much longer.
Inequality has been jeopardizing economic growth and poverty reduction. It has been
stalling progress in education, health and nutrition for large swathes of the population,
thus undermining the very human capabilities necessary for achieving a good life. It has
been limiting opportunities and access to economic, social and political resources.
Furthermore, inequality has been driving conflict and destabilizing society. When incomes
and opportunities rise for only a few, when inequalities persist over time and space and
across generations, then those at the margins, who remain so consistently excluded from
the gains of development, will at some point contest the ‘progress’ that has bypassed
them. Growing deprivations in the midst of plenty and extreme differences between
households are almost certain to unravel the fabric that keeps society together. This is
especially problematic when we consider that, often, it is precisely those at the margins
who tend to pay the biggest price for social unrest. But perhaps most important, extreme
inequality contradicts the most fundamental principles of social justice, starting from the
notion, enshrined in the Universal Declaration of Human Rights that ‘all human beings
are born free and equal in dignity and rights’.
There is, however, some good news. There is nothing inevitable about high inequality.
The widening of gaps in income, wealth or other dimensions of well-being is not an
unavoidable price to pay for development. In fact, many countries over the last years
have managed to significantly reduce income and non-income inequality through a
combination of progressive economic and social policies, often accompanied by the
greater participation and empowerment of those who had been left behind by the
development process. Much can be learned from those experiences and applied to other
contexts in which inequality continues to be a concern.
The drivers of excessive inequality are well known. Specific aspects of globalization,
such as inadequately regulated financial integration and trade liberalization processes,
whose benefits have been distributed very unequally across and within countries, have
played a significant role in determining the upward trend observed over the last decades.
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But domestic policy choices, such as interventions that weakened labour market institutions Basic Economic Issues
or resulted in a downsizing of public investments in critical sectors like health, education
and social protection, have also played an important role. Often, various economic, social
and cultural barriers hindering the political participation of various segments of the
population have compounded these processes. In addition, discriminatory attitudes and NOTES
policies that are marginalizing people on the basis of gender or other cultural constructs
such as ethnicity or religious affiliation drive many intergroup inequalities.
The complexity and multi-dimensionality of the drivers of inequality call for a
complex and multi-dimensional response. In fact, only a genuinely holistic approach can
fully address the multiple factors that cause inequality and create the conditions for a
truly inclusive society. Such an approach must shape growth so that market outcomes
do not push households further apart, but deliver shared prosperity. But it must also
address social and fiscal policy in ways that will allow governments to intervene to re-
balance market outcomes through redistribution, when needed, and ensure universal
access to critical services. It must strengthen democratic institutions so that there are
mechanisms for broad-based participation in political and public life. And it must reverse
discriminatory practices so that nobody is excluded because of who he or she is.
The world today is at a critical juncture. The financial and economic crises of
recent years have pushed the international community to reconsider long-held views on
economic priorities and social cohesion is much more widely recognized as a major
factor contributing to resilience and sustainability. The debate on the future of development
and international cooperation has started. In this context, inequality has emerged as a
major issue of concern—not only among development specialists, but also well beyond.
Furthermore, a host of civil society movements have explicitly and forcefully voiced this
concern.
Millions of voices are asking the world’s decision makers to confront rising
inequalities. It is imperative that this demand be met if the ideals of a prosperous, peaceful
and sustainable society are to be realized.
Basic food insecurity still affects 1 billion people, as many as in 1970. However, the
proportion of people who are undernourished declined from about 20 per cent in 1990-
1992 to 15 per cent in 2008-2010. Progress has been uneven across regions and the
2007-2008 food and financial crisis posed additional challenges. Under current conditions,
the target of halving the proportion of people suffering from hunger by 2015 will not be
met in sub-Saharan Africa and South Asia.
Because of low quality and low diversity of available food, the challenge of
malnutrition is broader than the issue of hunger or undernourishment. Individuals may
take in enough calories for daily subsistence, but still suffer from ‘hidden hunger’ with
low levels of micronutrients owing to the lack of diversification of diets. This is a problem
in both developing and developed countries, affecting 30 per cent of the world’s population.
The excess of calories is another rising major global public-health concern, as overweight
and obesity result in more than 2.8 million deaths among adults every year.
Estimates indicate that food production will have to increase 70 per cent globally
to feed an additional 2.3 billion people by 2050. Food demand is anticipated to continue to
shift towards more resource-intensive agricultural products, such as livestock and dairy
products, thereby exerting additional pressure on land, water and biodiversity resources.
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Basic Economic Issues On the supply side, meeting an increasing food demand is a major concern, given
the rise of resource constraints. Current agricultural practices are a leading source of
greenhouse gas emissions, while also leading to other problems, such as loss of soil
fertility and water pollution from run-off. Increased temperatures and more volatile
NOTES weather patterns caused by climate change may already be affecting crop yields, affecting
incomes and agricultural production.
Increased land use for biofuels will increase constraints on the supply side and
may lead to higher food prices, further affecting the most economically disadvantaged.
Similarly, current urbanization trends accelerate the diversion of land use from agricultural
production.
Human Resource Constraint
The serious shortage of health workers across the world has been identified as one of
the most critical constraints to the achievement of health and development goals. The
crisis is impairing provision of essential, life-saving interventions such as childhood
immunization, safe pregnancy and delivery services for mothers and access to prevention
and treatment for HIV/AIDS, malaria and tuberculosis. Health workers are also critical
to our preparedness for and response to the global security threats posed by emerging
and epidemic-prone diseases such as SARS and avian flu and haemorrhagic fevers as
well as the consequences of climate change. Without urgent action, the shortage will
worsen, health systems will be weakened even further and health goals will not be
achieved.
In its 2006 World Health Report, the World Health Organization estimated that
over 4 million more health workers are needed to bridge the gap—with 1.5 million needed
for Africa alone. Across the world, 57 countries have been identified as having ‘critical
shortages’—36 of these are in Africa.
The workforce crisis is made worse by imbalances within countries. There is a
general lack of adequate staffing in rural areas compared to cities. To add further
pressures, priority disease programmes are competing for scarce staff, to the detriment
of integrated health system development. In developed countries, a rise in chronic health
problems among ageing populations and ageing of their own workforces has led to an
ever-growing demand for health workers. The pull of higher salaries in industrialized
countries and the push of poor working conditions at home drive thousands of health
workers to jobs abroad each year. Yet developing countries face an escalating double
burden of both infectious and non-communicable diseases and are in need of massive
scale up of training and retention interventions.
Unfavourable working conditions, widespread shortages and large scale migration
of health workers are the challenges we face today. With new killer diseases and issues
like climate change threatening global security, aging populations and changing work
patterns, there is an ever-growing demand for health workers worldwide.
Technological progress is at the heart of human progress and development. As the 1998
World Development Report on the knowledge economy (World Bank 1998) emphasized,
the understanding of how things are created and the communication of that knowledge
are critical drivers of economic progress. Central to understanding the role of technology
is the recognition that technology and technological progress are relevant to a wide
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range of economic activities, not just manufacturing and computers. For example, some Basic Economic Issues
estimates suggest that technological progress has boosted productivity in agriculture
four times as quickly as in manufacturing (Martin and Mitra 2001). Indeed, seemingly
low-tech products such as corn or flowers can be the result of relatively high-tech
production processes, while in some countries the production of ostensibly high-tech NOTES
products such as computers is an outcome of relatively low-tech assembly activities.
Finally, in many cases technology is embodied in production and management systems
rather than in physical goods or software algorithms. A computer loaded with the latest
software that sits unused on a desk for most of the day is a very different manifestation
of technology than the same computer that is running a production process or managing
an accounts payable system.
This defines technology and technological progress in this wider sense, although
data limitations may give some of the measures developed the flavour of a more narrow,
physical, and manufacturing-oriented definition.
Technology is both a critical determinant and an outcome of rising incomes
Traditionally, economists view the process by which goods and services are produced as
one that combines capital, labour, and other factors of production (land and natural
resources) using a particular technology. The relative efficiency with which a given
economy produces goods and services given a certain quantity of labour and capital is
called total factor productivity (TFP). TFP is commonly interpreted as a measure of the
technology of production and its rate of growth as a measure of technical progress.
International comparisons of TFP suggest that enormous gaps exist between high
income and low- and middle-income countries in the efficiency with which they produce
goods and services. In 2005, the average level of TFP in low-income countries was only
slightly more than 5 per cent of U.S. levels. The technology lower-middle income countries
employed was roughly twice as efficient and that of upper-middle-income countries was
approximately four times as efficient. While these gaps have been narrowing for low-
income and lower-middle-income countries, upper-middle-income countries have only
managed to maintain their relative position in relation to high-income countries. At the
regional level, these gaps have widened or remained stagnant in three of six developing
regions, with TFP growing faster in high income countries than in Latin America and the
Caribbean, the Middle East, and Sub-Saharan Africa.
The relationships between income growth, technological progress, capital
accumulation, and welfare are, of course, much more complex than can be summarized
in a simple measure of TFP, partly because each factor of production and the technology
with which factors are combined are dependent on one another. Capital goods often
embody significant technological progress and there is no simple way to distinguish
between the contribution that each makes to growth. Similarly, technology in the form of
knowledge of business processes and of science and general experience is embodied in
labour. Moreover, the contribution of technology to welfare is only imperfectly measured
by its impact on GDP.
Improving the Flow of Technology in India
India is in a unique position to mount a strong initiative for affordable innovations for
technologies for social and public good by taking advantages of: (a) low expertise costs,
(b) vast talent base and, (c) the residual idealism in the society. However, engagement
of multiple stakeholders and creating Public-Private-Partnership for promoting people-
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Basic Economic Issues centric research is a challenge to address national goals with specific targets in a time
bound manner. While technologies for public, strategic, and social goods would require
collaborative excellence, competitive excellence models for private good would come
from industrial sector, as is the case in most developed countries.
NOTES Food security of India is closely related to development of technologies for
increasing the agriculture outputs through the process of innovations for land saving and
water use. The question is how to develop and deploy new agro-biotechnology tools and
precision agriculture for increasing the output of agricultural sector in the country by
synergizing the strengths of institutions both under public and private sector and adopting
a new approach for agriculture research and extension.
To achieve optimal health for its people, India has unique challenges due to its
large population, demographic transition and vulnerability to all epidemics. Biomedical
devices and instrumentation forms an area of serious gap in the country. Breakthrough
innovations, with appropriate stress on translational research for affordable health care,
are the need of the hour and would call for new models and mechanisms for evaluating
technologies for improving healthcare at individual and public health level, fostering
academia-industry linkage; and linking technology developers with industry for translation
of lead products and processes.
Water challenge is a major national issue in the country both in terms of quality
and availability. Sustainability of research led solutions depends on the interface of
technology with policy and societal behaviour. Water related technologies form an ideal
theme for building state-centre partnerships. The challenge, therefore, is to convert
research outputs from the laboratories into revenue models based solutions in a coordinated
manner among the relevant departments in both states and centre for innovative
deployment under real field conditions.
India is critically dependent upon import of energy supply sources. Energy security
demands integrated approaches and planning. Decoupling energy demand from GDP
growth is also essential for complying with responsibilities towards National Action Plan
on Climate Change. Therefore, the challenge is to increase the share of clean energy
options in the total energy basket of India.
Ministry of Micro Small and Medium Enterprises(MSME) sector in India, which
is a strong pillar of economic growth is characterized by low technology levels with
some exceptions. This acts as a major handicap in the growth of MSME sector in the
emerging global market and is therefore, seen as the next frontier for infusion of
technology, by increasing penetration in the MSMEs. It is thus a challenge as to how the
MSMEs embrace the new technologies to leap forward and contribute significantly in
the inclusive growth process.
The promotion of innovation, in particular technological innovation, in developing countries
is becoming a fashionable subject. The growing interest in the subject stems from a
recognition that it is necessary to go back to basics after experiencing the limits of
traditional economic policies encapsulated in the ‘Washington consensus’ approach. This
set of privatization, liberalization, and deregulation policies have clearly demonstrated
their limits for promoting sustainable growth in the developing world. Similarly, policies
focusing on modernization, in the sense of building infrastructure and institutions with a
more interventionist government, have not yielded the expected fruits. Thus, there has
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18 Material
been a tendency to look into the black box of the engine of economic development— Basic Economic Issues
technology—its creation and diffusion.
Policies supporting technology development are known as ‘innovation policies’.
Although governments have a long practice of promoting innovation by various measures
of both a direct and indirect nature, the explicit formulation of innovation policies began NOTES
about 40 years ago in the 1960s. Since then such policies have been expanded and
improved, while new analytical concepts, such as the concept of ‘national innovation
system’, have been elaborated.
It should be clear that the concept of ‘innovation’ encompasses not only
‘technological innovation’, i.e. the diffusion of new products and services of a technological
nature into the economy, but equally it includes non-technological forms of innovation,
such as ‘organization’ innovations. The latter include the introduction of new management
or marketing techniques, the adoption of new supply or logistic arrangements, and
improved approaches to internal and external communications and positioning.
While there is considerable experience accumulated in the field of innovation
policy in developed/OECD countries, much of this is not directly applicable to developing
countries because of the nature of the challenges the latter are facing. In fact, developing
countries face genuine obstacles to innovation and this is precisely why they remain
underdeveloped. These obstacles derive from inappropriate business and governance
climates and insufficient education. At the same time, there is no choice: innovation
policies should cope with these difficult situations. Thus, there is a need to think about
innovative approaches adapted to the needs and possibilities of developing countries.
The situation is, however, rendered more complicated because the ‘developing
world’ presents very diverse situations in terms of levels of development and culture.
Consequently, innovation policy schemes have to be tailored to countries’ specific
characteristics in line with the recognized fact that ‘one size does not fit all’, and the
recognized need for working much more on national peculiarities in all walks of
development economics and policies.
Innovation Climates in Developing Countries
Major weaknesses in the overall environment: Innovation climates in developing
countries are first hampered by weaknesses of other key elements of knowledge-based
economies as defined in the World Bank Institutes four pillar framework, namely levels
of educational attainment, the business environment and the information infrastructure.
Educational levels are low in developing countries, and, this is a significant barrier
to the development and diffusion of innovation in these countries. In fact, one can establish
a clear relation between educational needs and the different phases of industrialization.
In the pre-industrial phase, educational needs demand only basic literacy. In the industrial
phase, more professional and medium-level skills are required. In the post-industrial
phase, there is a need for a significant share of a population with tertiary education, with
the rest of the population having at least functional literacy.
The influence of the quality of the business environment, linked to governance
conditions, on innovation performances is also clearly demonstrated. However, there is
a need to approach with some caution the appreciation of business environment. The
quality should be seen from the perspective of countries themselves with their own
values and cultural specificities. A lack of financial transparency is not necessarily a
problem in a number of cultures. On the other hand, a bureaucratic climate which forces
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Basic Economic Issues an entrepreneur to obtain a hundred authorizations to establish his enterprise is a problem,
whatever the culture in question. More generally, when judging the quality of a business
environment it is of crucial importance to go beyond the formal appearance of laws and
to examine how laws are applied in practice in taking due account of the more or less
NOTES informal relations regulating transactions among economic agents.
Finally, there is the issue of lack of infrastructure. Of primary importance is, of
course, the telephone infrastructure. The telephone is the most important tool for (potential)
entrepreneurs. Mobile phone technology has transformed the conditions of
telecommunications in developing countries. Yet, the tele-density remains weak in a
number of developing countries, inferior to what may be considered the minimal threshold
for take-off (around 30 per cent). Progress made with mobile phone technology can
lead to rapid improvements in connectivity, however it does not solve the necessity for
greater internet penetration—something which remains quite low in most developing
countries. Infrastructural needs for innovation in developing countries are, however, not
limited to telecommunications. Road and other transport infrastructure are of primary
importance, as well as sanitation, water, and other systems.
Innovation Systems
As a consequence of this overall problematic environment, innovation systems in
developing countries are poorly constructed and are very fragmented. On the enterprise
side, generally a large number of micro-enterprises operate in the informal economy,
and a more or less important number of foreign-based firms, which tend, however, to be
disconnected from the rest of the economy.
On the knowledge side, there is generally a limited research community, operating
usually in an ivory tower, and a university system poorly connected to local realities,
particularly to labour market needs and opportunities. Particularly problematic are the
lack of technological support services and infrastructure (metrology, quality control,
standards, etc.).
Public sector institutions tend to be numerous, including those supporting the
promotion of enterprise development, export and foreign investment. In this often
overcrowded support system, it is not easy to establish new, efficient organizations for
the promotion of innovation.Where this is possible, the organizations are rarely appropriate,
lacking the flexibility and drive crucial for entrepreneurship.
These overall conditions keep innovation systems into a low equilibrium trap.
They are characterized by low levels of R&D in the business sector, with the bulk of
national R&D effort borne by the government, and with questionable relevance for the
economy.
Due to a desire not to upset the status quo and the preference of key actors to
continue benefiting from vested interests and protected situations rather than taking the
risk of unchartered waters, reform is usually difficult.
Classical economists consistently identified three sources and components of national
wealth: land, labour, and capital. By contrast, Western economists of the 20th century
preferred to focus on capital, understood to be human-made physical capital only—the
stock of structures and equipment used for production. Thus, expenses aimed at adding
to this stock were the only expenses categorized as investment. Most other expenses,
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such as those for education or for environmental protection, were considered to constitute Basic Economic Issues
consumption and treated as deductions from potential capital accumulation.
A better understanding of the need for sustainable development first led to attempts
to ‘green’ national accounts—that is, to account for changes in natural capital in
calculations of gross domestic product and gross national product—then to the NOTES
development of statistical methods to account for changes in a country’s human capital.
Although valuation methods for natural and human capital are still imperfect, they allow
experts to explore some critical development issues. These include the changing
composition of a country’s national wealth and operational indicators of sustainable—or
unsustainable—development.
Composition of National Wealth
According to a number of recent World Bank studies, physical capital (produced assets)
is not the main—much less the only—component of a country’s wealth. Most important
for all countries are human resources, which consist of ‘raw labour’, determined mainly
by the number of people in a country’s labour, and human capital. Natural capital is
another important component of every nation’s wealth.
A country’s level of development determines the roles played by the different
components of its national wealth. The dominance of human capital is particularly marked
in the most developed countries, where natural capital is calculated to account for just
2–5 per cent of aggregate wealth. By contrast, in West Africa—one of the world’s
poorest regions—natural capital still prevails over physical capital, and the share of
human resources is among the lowest in the world despite a large population. Comparing
West Africa with Western Europe is particularly indicative because in absolute terms
the two regions have roughly the same per capita value for natural capital. Thus, the
striking difference in the composition of their national wealth can be entirely attributed to
the fact that the average West European has 13–14 times as much human and physical
capital at his or her disposal.
1.4 MICRO AND MACRO ECONOMICS

Like most other sciences, economics is also divided into several branches and sub-
branches. The two major branches of economic theory are the microeconomic theory
and macroeconomic theory.
Check Your Progress
Microeconomic theory or microeconomics, whose literal translation is ‘economics in 4. How is urban
the small,’ studies the economic actions of individuals, firms and groups of individuals poverty created?
and firms in the economy. For example, the determination of equilibrium output and price 5. What is total factor
for a single firm lies in the domain of microeconomic theory. Macroeconomic theory or productivity?
macroeconomics is concerned with the study of economy-wide aggregates, such as the 6. What are innovation
policies?
analysis of the total output and employment, total consumption, total investment, total
7. Name the sources
saving and national product. Thus, while the former analysis presents a microscopic and components of
view of the economy, the latter furnishes us with its macroscopic view. Microeconomic national wealth as
theories are concerned with the partial equilibrium analysis of the firm’s price-output identified by
Classical
determination under different market situations and the allocation of given economic
economists.
resources between their rival uses. Macroeconomic theories, on the other hand, are
interested in the analysis of the levels of national product, total saving and investment,
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Material 21
Basic Economic Issues total employment of economy’s resources and total money supply. Macroeconomic
analysis is the analysis of the economy-wide or aggregate variables. In short, it is the
study of the economy’s aggregate output, investment, saving, money supply, employment,
general price level and such other macroeconomic variables.
NOTES Macroeconomics answers such important and broad questions as: What
determines the levels of aggregate employment and output in the economy? How is the
general price level in the economy determined? What is the relative importance of the
various factors which influence the general price level? What determines the level of
aggregate economic activity in the economy and its expansion or contraction over time?
Why are cyclical fluctuations caused and how do these affect the overall performance
of the economy? On the other hand, the concern of microeconomics is to answer such
questions as: How, ceteris paribus, is the purchasing behaviour of a consumer influenced
by any given change in the price of a commodity? How does a firm, under given market
conditions, determine the output of any given good or service which it will produce and
the price at which it will sell it? How will a firm in equilibrium combine the different
inputs in order to produce any given good or service?
Microeconomic theory employs the technique of partial equilibrium analysis to
study the price-output determination of a single commodity or service in any given market
situation on the assumption of ceteris paribus. It studies the determination of relative
prices of particular products and factors and changes in these prices. Macroeconomic
theory, on the other hand, employs the technique of general equilibrium in order to study
the determination of the general price level, money supply, total employment and output
levels and fluctuations in these aggregate magnitudes. General equilibrium analysis
stresses interdependence between the different markets and sectors in the economy.
Consequently, it studies interdependence between prices and outputs of the entire range
of goods and services produced in the economy. In other words, while microeconomics
studies happenings in a particular market or sector in splendid isolation, macroeconomics
never ignores the fact of close interdependence between economy’s different sectors
with everything depending on everything else in the economy. According to the general
equilibrium approach employed in macroeconomics, a change in any one market or
sector has its ramifications on the other markets or sectors of the economy. In short,
while macroeconomic theory simplifies by aggregation, microeconomic theory simplifies
by assuming ‘other things remaining the same’.
In whatever words it is defined, macroeconomics is concerned with the study of
the functioning of the whole economy, including how the total output of goods and
services and the total employment of resources are determined in the economy and
what causes fluctuations in their size. It analyses why at one time 15 per cent of the total
labour force in the economy is unemployed while at another time only 5 per cent of the
total labour force cannot find employment in the economy. It studies the phenomenon of
inflation and deflation and seeks to explain why the growth rate of the economy at one
time is 8 per cent while at some other time it is only 2 per cent or even less. The Great
Depression of the 30s and the war and post-war hyperinflations are among those economic
phenomena which deeply concern the macroeconomist and to prevent which he strives
hard to find effective solutions reflected in the monetary and fiscal policies of the
government.
According to Gardner Ackley, ‘macroeconomics deals with economic affairs “in
the large”. It concerns the overall dimensions of economic life. It looks at the total size
and shape and functioning of the “elephant” of economic experience, rather than the
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22 Material
studies the character of the forest, independently of the trees which compose it. More Basic Economic Issues
specifically, macroeconomics concerns itself with such variables as the aggregate volume
of the output of an economy, with the extent to which its resources are employed, with
the size of the national income, with the general price level.’ Emphasizing that the subject
matter of macroeconomics is the study of economy-wide aggregates, Edward Shapiro NOTES
has stated that a major task of macroeconomics is the explanation of what determines
the economy’s aggregate output of goods and services. It deals with the functioning of
the economy as a whole including how the economy’s total output of goods and services,
the price level of goods and services and the total employment of resources are determined
and what causes these-magnitudes to fluctuate. According to R. G. D. Allen, ‘the term
“macro-economies”, introduced by Ragnar Frisch in 1933, applies to the study of relations
between broad economic aggregates, as opposed to the decision-taking processes of
individuals and firms which is the subject matter of micro-economics.’
Microeconomics abstracts from the study of these aggregative macroeconomic
variables. Its unit of study is the part and not the whole. Consequently, a micro economist
picks up the problem of determination of the profit-maximizing output of a firm for his
study. He is interested in finding out what particular output, out of the many possible ones,
a firm must produce in order to maximize its total profit function or what particular factor-
combination, out of the many possible ones, a firm should choose in order to produce a
given quantity of output so as to minimize its total cost function. Microeconomic theory
helps him in finding out the equilibrium (most cosy position) of the firm at that level which
corresponds to the point of tangency between the firm’s isoquant and isocost line.
Similarly, microeconomics is concerned with the study of the manner in which an
individual consumer allocates his given income among the many goods and services
available to him so as to maximize his total satisfaction or utility. Assuming the economy’s
total output, total employment and total spending as given, it analyses how the total
output and employment are distributed between the different individual firms and industries
in the economy. According to Gardner Ackley, ‘microeconomics deals with the division
of total output among industries, products, and firms, and the allocation of resources
among competing uses. It considers problems of income distribution. Its interest is in
relative prices of particular goods and services.’
Most, though not all, of the contents of the traditional economic theory, until the
last 70 years, have consisted of microeconomic theory. Price and value theory, the
theory of the household, firm and industry, a major part of protection and welfare theory
all belong to the microeconomic theory. However, monetary theory and business cycle
theory, which have a long history, are clearly macroeconomic analysis. The classical
economic theory was almost wholly macroeconomics while the neoclassical theory was
entirely microeconomics. Macroeconomics staged a grand comeback with John Maynard
Keynes in the later part of thirties and for over a decade virtually replaced microeconomics.
While microeconomics assumes the aggregate output for the economy as a whole
as given, for macroeconomics it is an important variable whose size and changes in that
size it aims to explain. On the other hand, while macroeconomics treats the distribution
of total output, employment and spending among the various individual goods and services
produced by the particular firms and industries as given, these are regarded as variable
by microeconomics. Similarly, with regard to prices, while microeconomics regards the
relative prices of various different goods and services variable treating the general price
level as given, macroeconomics stresses the variability of the general price level treating
the relative prices as given. In the language of a metaphor, while macroeconomics is
concerned with the study of an elephant as a whole, microeconomics studies the working Self-Instructional
Material 23
Basic Economic Issues of the particular parts of it. Macroeconomics studies the forest independently of the
trees which compose it while microeconomics looks at the dimensions and characteristics
of the individual trees which taken together constitute the forest. To alter the metaphor,
while macroeconomics presents a bird’s-eye view of the economy, microeconomics
NOTES presents only a worm’s-eye view confined to some specific part of the economy.
Despite important differences between the microeconomic and macroeconomic theories,
there is considerable overlapping between these two. Consequently, it is difficult to draw
any precise line of demarcation between these two analyses. The two economic analyses
are not mutually exclusive. In practice, the economy is not analysed separately in two
watertight compartments. Consequently, there is only one ‘economics’. Obviously, this
fact should make us aware that macroeconomics has a foundation in microeconomics
and vice versa. In any meaningful analysis of the macroeconomic variables and their
relationships, the role of changes in those microeconomic variables which influence the
macroeconomic variables and vice versa has to be recognized. For instance, if workers
do not move away from the declining industry located in one area to the growing industry
which is located in a different region, the total output and employment would be smaller
than if the workers were mobile. In any meaningful analysis of the economic processes
determining the nation’s economic welfare, both the microeconomic and macroeconomic
aspects of the nation’s economic welfare must be considered.
From macroeconomic consideration alone, the national material welfare will be
higher, if the economy attains fuller utilization of the total economic resources taking the
allocation of these resources as a given. From the microeconomic point of view, the
material welfare of the community will be higher, if the economy is closer to the level of
optimum allocation of its given total resources, given the intensity of utilization of these
resources. It is, therefore, obvious that microeconomic and macroeconomic analyses
are complementary and the maximum national economic welfare will only be achieved
when all the available economic resources are both fully utilized and optimally allocated
between their different competing uses.
Economics is not a schizophrenic subject; it is a unified and cohesive discipline.
As the two branches of economics, macroeconomics and microeconomics differ only in
the degree of aggregation involved. For example, while the economy’s total output and
employment involve aggregation of the output and employment generated in the various
sectors of the economy, the total production of the sugar industry is an aggregate of the
output of different sugar factories composing the sugar industry in the economy. Similarly,
the total consumer demand for sugar is an aggregate of the demands of many household
units. A well-meaning general theory of the economy will, therefore, have to be a
combination of both the microeconomic and macroeconomic theories.
Emphasizing the fact of interdependence and the difficulty of drawing any sharp
line of demarcation between macroeconomic and microeconomic theories, Gardner
Ackley has correctly stated:
Actually, the line between macroeconomic and microeconomic theory cannot
be precisely drawn. A truly ‘general’ theory of the economy would clearly
embrace both: it would explain individual behaviour, individual outputs, incomes
and prices; and the sums or averages of the individual results would constitute
the aggregates with which macroeconomics is concerned. Such a general
theory exists; but its very generality leaves it with little substantive content.
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Although microeconomic and macroeconomic analyses are so closely interrelated Basic Economic Issues
that one draws from the other, yet the two analyses differ from one another. Consequently,
a microeconomic proposition cannot be extended to macroeconomic situations. For
example, an individual can become richer by spending less and saving more out of his
given income. A nation cannot, however, become richer unless it produces more. An NOTES
attempt on the part of all individuals to save more out of their given incomes will not lead
to an increase in total national savings because to the extent one individual spends less,
the incomes of the rest of the people in the economy are reduced. Consequently, their
savings are reduced. In fact, efforts to save more out of the given national income on the
part of all individuals in the community may actually end up in reduced total savings. This
is the so-called famous ‘paradox of thrift’ in macroeconomic theory.
Similarly, an individual can withdraw from his bank account his entire deposit
money without the bank failing. If, however, all the depositors were to withdraw their
bank deposits simultaneously, the bank will certainly fail. Again, a person becomes richer
when he wins prize money in a lottery but the nation does not become richer because to
the extent the winner of the lottery has gained, the other lottery ticket-holders have lost.
Similarly, when one finds a ten-rupee bank note on the road one becomes richer to the
extent of his find but the community’s income remains unchanged because someone’s
gain is someone else’s loss.
Furthermore, while in a fully employed economy it is possible for a single firm to
increase its total output by weaning away inputs from other competing uses by offering
higher factor rewards, it is not possible for the economy to increase the total output by
such resort on the part of some firms because the increase in the output of some firms
is cancelled out by the decrease in the output of others. Moreover, it is possible that in
certain situations the fall in the output of other firms may more than neutralize the
increase in a particular firm’s output resulting in a net fall in the total output.
It is, therefore, obvious that microeconomic statements cannot always be valid
for the macroeconomic decisions. Nor are the macroeconomic statements always reliable
to draw correct microeconomic conclusions. For example, a substantial increase in the
total agricultural output as a result of a bumper crop harvest causes an increase in the
national product causing a substantial increase in the community’s economic welfare. It
does not, however, always follow from this that the economic condition of the agriculturists
Check Your Progress
has also improved although macroeconomic theory lends strong support to this belief. In
fact, since the elasticity of demand for most agricultural products is less than unity (at 8. What does
microeconomic
any rate it is so in the short period), the larger output of bumper harvest will have to be theory study?
sold at more than proportionately reduced price yielding lower total revenue (income) to 9. Fill in the blanks
the farmers. Consequently, the economic condition of the agriculturists would deteriorate with appropriate
rather than improve while the nation as a whole would enjoy larger material well-being terms.
resulting from the bumper harvest. This is known as the familiar ‘fallacy of composition’. (i) Economics is not
a schizophrenic
Again, it would be wrong to say that with the higher gross national product every subject; it is a
one in the economy necessarily becomes richer. Even a higher per capita income is not _______ and
_________
an infallible indicator of the better economic condition of each and every individual living
discipline.
in the country. A higher national product may co-exist with greater mass poverty if in the
(ii) It is obvious
process of producing the larger national product, the distribution of the national product that microeconomic
becomes more skewed. For example, in the oil-producing Gulf countries very high national statements cannot
product and mass poverty coexist as the distribution of national product in these countries always be valid for
the ____________.
is highly skewed.
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1.5 SUMMARY
In this unit, you have learnt that,
NOTES  The basic problems of an economy lie in the background of all economic decisions,
and also form the basis of economic studies and generalization.
 The problem ‘what to produce’ is the problem of choice between commodities.
This problem arises mainly for two reasons: (i) scarcity of resources does not
permit production of all the goods and services that people would like to consume;
and (ii) all the goods and services are not equally valued in terms of their utility by
the consumers.
 The question ‘how much to produce’ is the problem of determining the quantity of
each commodity and service to be produced. This problem too arises due to
scarcity of resources.
 In a modern economy, all the goods and services are produced by business firms.
The total output generated by business firms is known as ‘society’s total product’
or ‘national output’. The total output ultimately flows to the households.
 The need for increasing the production capacity of the economy arises for at
least two reasons. First, most economies of the world have realized by experience
that their population has grown at a rate much higher than their productive
resources. This leads to poverty, especially in the less-developed countries.
 Second, over time, some economies have grown faster than others while some
economies have remained almost stagnant. The poor nations have been subjected
to exploitation and economic discrimination. This has impelled the poor nations to
make their economies grow, to protect themselves from exploitation and to give
their people a respectable status in the international community.
 An important feature of the free enterprise system has been the economic
fluctuation of these economies. Though economic ups and downs are not unknown
in controlled economies, free enterprise economies have experienced it more
frequently and more severely.
 Societies cannot have all that they want because resources are scarce and
technology is given. In reality, however, both human and non-human resources
available to a country keep increasing over time with technology becoming more
and more efficient and productive.
 Apart from showing the possible alternative combinations of two goods, production
possibilities frontier (PPF) also indicates the opportunity cost of one commodity in
terms of the other product.
 Developing areas, including developing countries and regions, have a unique set
of economic problems and challenges to economic development. Developing
countries, taken as whole, refer to countries characterized by an underdeveloped
industrial base, low per capita income, and widespread poverty.
 Broad economic stability, competitive markets, and public investment in physical
and social infrastructure are widely recognized as important requirements for
achieving sustained economic growth and a reduction in rural poverty.
 To understand poverty, it is essential to examine the economic and social context,
including institutions of the state, markets, communities, and households. Poverty
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26 Material
differences cut across gender, ethnicity, age, location (rural versus urban), and Basic Economic Issues
income source.
 Substantial evidence suggests that a highly unequal distribution of income is not
conducive to either economic growth or poverty reduction. Experience has shown
that if countries put in place incentive structures and complementary investments NOTES
to ensure that better health and education lead to higher incomes, the poor will
benefit doubly through increased current consumption and higher future incomes.
 Inequality in society is not a new phenomenon. And yet it can be fatal. If left
unchecked, it can undermine the very foundations of development and social and
domestic peace.
 The world is more unequal today than at any point since Second World War.
However, there are clear signs that this situation cannot be sustained for much
longer. Inequality has been jeopardizing economic growth and poverty reduction.
 The world today is at a critical juncture. The financial and economic crises of
recent years have pushed the international community to reconsider long-held
views on economic priorities and social cohesion is much more widely recognized
as a major factor contributing to resilience and sustainability.
 On the supply side, meeting an increasing food demand is a major concern, given
the rise of resource constraints. Current agricultural practices are a leading source
of greenhouse gas emissions, while also leading to other problems, such as loss of
soil fertility and water pollution from run-off.
 Technological progress is at the heart of human progress and development. As
the 1998 World Development Report on the knowledge economy (World Bank
1998) emphasized, the understanding of how things are created and the
communication of that knowledge are critical drivers of economic progress.
 Policies supporting technology development are known as ‘innovation policies’.
Although governments have a long practice of promoting innovation by various
measures of both a direct and indirect nature, the explicit formulation of innovation
policies began about 40 years ago in the 1960s.
 As a consequence of this overall problematic environment, innovation systems in
developing countries are poorly constructed and are very fragmented.
 Classical economists consistently identified three sources and components of
national wealth: land, labour, and capital.
 A country’s level of development determines the roles played by the different
components of its national wealth. The dominance of human capital is particularly
marked in the most developed countries, where natural capital is calculated to
account for just 2–5 per cent of aggregate wealth.
 Like most other sciences, economics is also divided into several branches and
sub-branches. The two major branches of economic theory are the microeconomic
theory and macroeconomic theory.
 Microeconomic theory or microeconomics, whose literal translation is ‘economics
in the small,’ studies the economic actions of individuals, firms and groups of
individuals and firms in the economy.
 Macroeconomic theory or macroeconomics is concerned with the study of
economy-wide aggregates, such as the analysis of the total output and employment,
total consumption, total investment, total saving and national product.
Self-Instructional
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Basic Economic Issues  While microeconomics assumes the aggregate output for the economy as a whole
as given, for macroeconomics it is an important variable whose size and changes
in that size it aims to explain. On the other hand, while macroeconomics treats the
distribution of total output, employment and spending among the various individual
NOTES goods and services produced by the particular firms and industries as given, these
are regarded as variable by microeconomics.
 Despite important differences between the microeconomic and macroeconomic
theories, there is considerable overlapping between these two. Consequently, it is
difficult to draw any precise line of demarcation between these two analyses.
 Macroeconomics has a foundation in microeconomics and vice versa.
1.6 KEY TERMS

 Society’s total product/National output: The total output generated by business
firms is known as ‘society’s total product’ or ‘national output’.
 Total factor productivity: The relative efficiency with which a given economy
produces goods and services given a certain quantity of labour and capital is
called total factor productivity (TFP).
1.7 ANSWERS TO ‘CHECK YOUR PROGRESS’

1. The major economic problems faced by an economy—whether capitalist, socialist
or mixed—may be classified into two broad groups:
 Microeconomic problems which are related to the working of the economic
system.
 Macroeconomic problems related to the growth, employment, stability, external
balance, and macroeconomic policies for the management of the economy as
a whole.
2. The problem ‘what to produce’ is the problem of choice between commodities.
This problem arises mainly for two reasons: (i) scarcity of resources does not
permit production of all the goods and services that people would like to consume;
and (ii) all the goods and services are not equally valued in terms of their utility by
the consumers.
3. Societies cannot have all that they want because resources are scarce and
technology is given. In reality, however, both human and non-human resources
available to a country keep increasing over time with technology becoming more
and more efficient and productive.
4. Urban poverty is created by the rural poor’s efforts to get out of poverty by
moving to cities.
5. The relative efficiency with which a given economy produces goods and services
given a certain quantity of labour and capital is called total factor productivity
(TFP).
6. Policies supporting technology development are known as ‘innovation policies’.
7. Classical economists consistently identified three sources and components of
national wealth: land, labour, and capital.
Self-Instructional
28 Material
8. Microeconomic theory or microeconomics, whose literal translation is ‘economics Basic Economic Issues
in the small,’ studies the economic actions of individuals, firms and groups of
individuals and firms in the economy.
9. (i) unified; cohesive
NOTES
(ii) macroeconomic decisions
1.8 QUESTIONS AND EXERCISES
Short-Answer Questions
1. What are the basic problems of an economy? How can they be classified?
2. State the basic microeconomic problems faced by an economy.
3. How can the production capacity of an economy be increased?
4. What is meant by opportunity cost? How can it be increased?
5. What are the main contributors to urban and rural poverty?
6. Who are the Low-Income Developing Countries? How can absolute poverty be
alleviated?
7. Write a note on inequality in the distribution of income and opportunities.
8. ‘Technological progress is at the heart of human progress and development.’
Describe.
9. What is the problem of low degree of innovativeness in the developing countries?
10. What is the ‘paradox of thrift’ in macroeconomic theory?
Long-Answer Questions
1. Discuss the major microeconomic problems faced by an economy.
2. Describe the major macroeconomic problems of an economy.
3. Assess the production possibilities of an economy.
4. Assess the problem of poverty, low income and inequality in the distribution of
income and opportunities in the developing countries.
5. Evaluate the problem of resource constraints and low level of technology in the
developing countries.
6. Critically analyse the problem of low degree of innovativeness and low level of
human and physical capital in the developing countries.
7. Discuss the major differences between macro and micro economics.
8. Assess the statement, ‘Microeconomics and macroeconomics are interdependent’.
1.9 FURTHER READING

Dwivedi, D. N. 2002. Managerial Economics, 6th Edition. New Delhi: Vikas Publishing
House.
Keat, Paul G. and K. Y. Philip. 2003. Managerial Economics: Economic Tools for
Today’s Decision Makers, 4th Edition. Singapore: Pearson Education Inc.
Self-Instructional
Material 29
Basic Economic Issues Keating, B. and J. H. Wilson. 2003. Managerial Economics: An Economic Foundation
for Business Decisions, 2nd Edition. New Delhi: Biztantra.
Mansfield, E., W. B. Allen, N. A. Doherty and K. Weigelt. 2002. Managerial Economics:
Theory, Applications and Cases, 5th Edition. NY: W. Orton & Co.
NOTES
Peterson, H. C. and W. C. Lewis. 1999. Managerial Economics, 4th Edition. Singapore:
Pearson Education, Inc.
Salvantore, Dominick. 2001. Managerial Economics in a Global Economy, 4th Edition.
Australia: Thomson-South Western.
Thomas, Christopher R. and Maurice S. Charles. 2005. Managerial Economics:
Concepts and Applications, 8th Edition. New Delhi: Tata McGraw-Hill.
Adhikary, M. 2000. Business Economics. New Delhi: Excel Books.
Baumol, W. J. 1996. Economic Theory and Operations Analysis, 3rd edition. New
Jersey: Prentice-Hall.
Chopra, O. P. 1985. Managerial Economics. New Delhi: Tata McGraw-Hill.
Kautsoyiannis, A. 1991. Modern Microeconomics. New York: Macmillan.
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30 Material
Demand Analysis
UNIT 2 DEMAND ANALYSIS

Structure
NOTES
2.0 Introduction
2.1 Unit Objectives
2.2 Basis of Demand: Utility and Income
2.3 Diminishing Marginal Utility
2.4 Income of the Consumer and the Budget Line
2.4.2 Constrained Utility Maximization
2.5 Demand Curve and Factors Shifting It
2.5.1 Factors Behind Shifts in the Demand Curve
2.6 Elasticities of Demand
2.6.1 Price Elasticity of Demand
2.6.2 Income Elasticity of Demand
2.7 Summary
2.8 Key Terms
2.0 INTRODUCTION
Consumer demand is the basis of all productive activities. Just as ‘necessity is the mother
of invention’, demand is the mother of production. Increasing demand for a product
offers high business prospects for it in future and decreasing demand for a product diminishes
its business prospect. For example, increasing demand for computers, cars and mobile
phones in India has enlarged the business prospect for both domestic and foreign companies
selling these goods. On the other hand, declining demand for black and white TV sets and
manual typewriters is forcing their companies to switch over to modern substitutes or else
go out of business. It is, therefore, essential for business managers to have a clear
understanding of the following aspects of demand for their products:
 What is the basis of demand for a commodity?
 What are the determinants of demand?
 How do the buyers decide the quantity of a product to be purchased?
 How do the buyers respond to change in product prices, their incomes and prices
of the related goods?
 How can the total or market demand for a product be assessed and forecasted?
These questions are answered by the Theory of Demand. The analysis of total
demand for a firm’s product plays a crucial role in business decision-making. The market
demand or the size of the market at a point in time at different prices gives the overall
scope of business; it gives prospects for expanding business; and it plays a crucial role in
planning for future production, inventories of raw materials, advertisement, and setting up
sales outlets. Therefore, the information regarding the magnitude of the current and future
demand for the product is indispensable. Theory of demand provides an insight into these
problems. From the analysis of market demand, business executives can know: Self-Instructional
Material 31
Demand Analysis  The factors that determine the size of demand
 Elasticities of demand, i.e., how responsive or sensitive is the demand to the
changes in its determinants
NOTES  Possibility of sales promotion through manipulation of prices
 Responsiveness of demand to advertisement expenditure
 Optimum levels of sales, inventories and advertisement cost
In this unit, we discuss the basis of demand, diminishing marginal utility, income of
the consumer and the budget line, constrained utility maximization, demand curve and
factors shifting it and elasticities of demand and their measurement.
2.1 UNIT OBJECTIVES

After going through this unit, you will be able to:
 Discuss utility as a basis of consumer demand
 Explain the law of diminishing marginal utility and its necessary conditions
 Assess the income of the consumer and the budget line
 Analyse the concept of consumer equilibrium and constrained utility maximization
 Evaluate the demand curve and the factors shifting the demand curve
 Discuss price elasticity of demand
 Explain the income elasticity of demand and the use of income-elasticity in business
decisions
2.2 BASIS OF DEMAND: UTILITY AND INCOME

The consumers demand a commodity because they derive or expect to derive utility
from that commodity. The expected utility from a commodity is the basis of demand for
it. Though ‘utility’ is a term of common usage, it has a specific meaning and use in the
analysis of consumer demand. We will, therefore, describe in this section the meaning of
utility, the related concepts and the law associated with utility.
Meaning of Utility
The concept of utility can be looked upon from two angles—from the commodity angle
and from the consumer’s angle. From the commodity angle, utility is the want-satisfying
property of a commodity. From the consumer’s angle, utility is the psychological
feeling of satisfaction, pleasure, happiness or well-being which a consumer derives
from the consumption, possession or the use of a commodity.
There is a subtle difference between the two concepts which must be borne in
mind. The concept of a want-satisfying property of a commodity is ‘absolute’ in the
sense that this property is ingrained in the commodity irrespective of whether one needs
it or not. For example, a pen has its own utility irrespective of whether a person is literate
or illiterate. Another important attribute of the ‘absolute’ concept of utility is that it is
ethically neutral because a commodity may satisfy a frivolous or socially immoral
need, e.g., alcohol, drugs or a profession like prostitution.
On the other hand, from a consumer’s point of view, utility is a post-consumption
Self-Instructional phenomenon as one derives satisfaction from a commodity only when one consumes or
32 Material
uses it. Utility in the sense of satisfaction is a ‘subjective’ or a ‘relative’ concept. In the Demand Analysis
subjective sense, utility is a matter of one’s own feeling of satisfaction. In the relative
sense: (i) a commodity need not be useful for all, for example, cigarettes do not have any
utility for non-smokers, and meat has no utility for strict vegetarians; (ii) utility of a
commodity varies from person to person and from time to time; and (iii) a commodity NOTES
need not have the same utility for the same consumer at different points of times, at
different levels of consumption and at different moods of a consumer. In consumer
analysis, only the ‘subjective’ concept of utility is used.
Utility is a psychological phenomenon. It is a feeling of satisfaction, pleasure or happiness.
Is utility measurable quantitatively? Measurability of utility has, however, been a
contentious issue. The classical economists, viz., Jeremy Bentham, Leon Walrus, Carl
Menger and the neo-classical economist, notably Alfred Marshall, believed that utility is
cardinally or quantitatively measurable like height, weight, length, temperature and air
pressure. This belief resulted in the Cardinal Utility concept. The modern economists,
most notably J. R. Hicks and R. G. D. Allen, however, hold the view that utility is not
quantitatively measurable—it is not measurable in absolute terms. Utility can be expressed
only ordinally comparatively or in terms of ‘less than’ or ‘more than’. It is, therefore,
possible to list the goods and services in order of their preferability or desirability. This is
known as the ordinal concept of utility. Let us now look into the origin of the two
concepts of utility and their use in the analysis of demand.
(i) Cardinal measurement of utility: Some early psychological experiments on an
individual’s responses to various stimuli led classical and neo-classical economists to
believe that utility is measurable and cardinally quantifiable. This belief gave rise to the
concept of cardinal utility. It implies that utility can be assigned a cardinal number like 1,
2, 3, etc. The neo-classical economists, especially Marshall, devised a method of measuring
utility. According to Marshall, utility of a commodity for a person equals the amount of
money he is willing to pay for a unit of the commodity. In other words, price one is
prepared to pay for a unit of a commodity equals the utility he expects to derive from the
commodity. They formulated the theory of consumption on the assumption that utility is
cardinally measurable. They coined and used a term ‘util’ meaning ‘units of utility’. In
their economic analysis, they assumed (i) that one ‘util’ equals one unit of money, and
(ii) that utility of money remains constant.
It has, however, been realised over time that absolute or cardinal measurement
of utility is not possible. Difficulties in measuring utility have proved to be insurmountable.
Neither economists nor scientists have succeeded in devising a technique or an instrument
for measuring the feeling of satisfaction, i.e., the utility. Numerous factors affect the
state of consumer’s mood, which are impossible to determine and quantify. Utility is
therefore immeasurable in cardinal terms.
(ii) Ordinal measurement of utility: The modern economists have discarded the concept
of cardinal utility and have instead employed the concept of ordinal utility for analysing
consumer behaviour. The concept of ordinal utility is based on the fact that it may not be
possible for consumers to express the utility of a commodity in numerical terms, but it is
always possible for them to tell introspectively whether a commodity is more or less or
equally useful as compared to another. For example, a consumer may not be able to tell
that a bottle of Pepsi gives 5 utils and a glass of fruit juice gives 10 utils. But he or she can
always tell whether a glass of fruit juice gives more or less utility than a bottle of Pepsi.
This assumption forms the basis of the ordinal theory of consumer behaviour. Self-Instructional
Material 33
Demand Analysis To sum up, the neo-classical economists maintained that cardinal measurement
of utility is practically possible and is meaningful in consumer analysis. The modern
economists, on the other hand, maintain that utility being a psychological phenomenon is
inherently immeasurable quantitatively. They also maintain that the concept of ordinal
NOTES utility is a feasible concept and it meets the conceptual requirement of analysing the
consumer behaviour. However, both the concepts of utility are used in analysing consumer
behaviour.
Based on cardinal and ordinal concepts of utility, there are two approaches to the analysis
of consumer behaviour.
(i) Cardinal Utility Approach, attributed to Alfred Marshall and his followers, is
also called the Neo-classical Approach or Marshallian approach.
(ii) Ordinal Utility Approach, pioneered by J. R. Hicks, a Nobel laureate and R. G.
D. Allen, is also called Hicks-Allen approach or the Indifference Curve Analysis.
The two approaches are not in conflict with one another. In fact, they represent
two levels of sophistication in the analysis of consumer behaviour. Both the approaches
are important for managerial decisions depending on the level of sophistication required.
It is important to note in this regard that in spite of tremendous developments in
consumption theory based on ordinal utility, the neo-classical demand theory based on
cardinal utility has retained its appeal and applicability to the analysis of market behaviour.
Besides, the study of neo-classical demand theory serves as a foundation for understanding
the advanced theories of consumer behaviour. The study of neo-classical theory of
demand is of particular importance and contributes a great deal in managerial decisions.
2.3 DIMINISHING MARGINAL UTILITY

The law of diminishing marginal utility is one of the fundamental laws of economics.
This law states that as the quantity consumed of a commodity increases, the utility
derived from each successive unit decreases, consumption of all other commodities
remaining the same. In simple words, when a person consumes more and more units of
a commodity per unit of time, e.g., rasgullas, keeping the consumption of all other
commodities constant, the utility which he derives from the successive rasgullas he
consumes goes on diminishing. This law applies to all kinds of consumer goods—durable
and non-durable sooner or later.
Check Your Progress
To explain the law of diminishing marginal utility, let us suppose that a consumer
1. Give an important
attribute of the
consumes 6 units of a commodity X and his total and marginal utility derived from various
'absolute' concept units of X are as given in Table 2.1.
of utility.
Table 2.1 Total and Marginal Utility Schedules of X
2. What gave rise to
the concept of No. of units Total Marginal
cardinal utility?
consumed utility utility
3. What are the two
approaches to the 1 30 30
analysis of 2 50 20
consumer 3 60 10
behaviour? 4 65 5
5 60 –5
6 45 – 15
Self-Instructional
34 Material
As shown in Table 2.1, with the increase in the number of units consumed per unit Demand Analysis
of time, the TU increases but at a diminishing rate. The diminishing rate of increase in
the total utility gives the measure of marginal utility. The diminishing MU is shown in the
last column of the table. Fig. 2.1 illustrates graphically the law of diminishing MU. The
rate of increase in TU as the result of increase in the number of units consumed is NOTES
shown by the MU curve in Fig. 2.1. The downward sloping MU curve shows that
marginal utility goes on decreasing as consumption increases. At 4 units consumed, the
TU reaches its maximum level, i.e., 65 utils. Beyond this, MU becomes negative and TU
begins to decline. The downward sloping MU curve illustrates the law of diminishing
marginal utility.
50
Utility–TUx and MUx
40 TUx
30
20
10
0
1 2 3 4 5 6 7
–10
Quantity MUx
Fig. 2.1 Diminishing Marginal Utility
Why the MU Decreases: The utility gained from a unit of a commodity depends on
the intensity of the desire for it. When a person consumes successive units of a commodity,
his need is satisfied by degrees in the process of consumption and the intensity of his
need goes on decreasing. Therefore, the utility obtained from each successive unit goes
on decreasing.
Necessary Conditions: The law of diminishing marginal utility holds only under certain
conditions. These conditions are referred to as the assumptions of the law. The
assumptions of the law of diminishing marginal utility are listed below.
First, the unit of the consumer good must be a standard one, e.g., a cup of tea, a
bottle of cold drink, a pair of shoes or trousers, etc. If the units are excessively small or
large, the law may not hold.
Second, the consumer’s taste or preference must remain the same during the
period of consumption.
Third, there must be continuity in consumption. Where a break in continuity is
necessary, the time interval between the consumption of two units must be appropriately
short.
Fourth, the mental condition of the consumer must remain normal during the
period of consumption. Otherwise, the law of diminishing MU may not apply.
Given these conditions, the law of diminishing marginal utility holds universally. In
some cases, e.g., accumulation of money, collection of hobby items like stamps, old
coins, rare paintings and books, melodious songs, etc. the marginal utility may initially
increase, but eventually it does decrease. As a matter of fact, the law of marginal utility
generally operates universally. Self-Instructional
Material 35
Demand Analysis
2.4 INCOME OF THE CONSUMER AND THE
BUDGET LINE
NOTES Given the indifference curves and indifference map, the consumer is free to choose an
IC curve and opt for any point on the chosen IC. Given the option, the consumer would
like to choose the highest IC. But, he cannot because he faces a budgetary limitation.
Recall that the consumer has a limited income and goods he consumes have a price.
Limited income and prices impose constraints on consumer’s choice, called budgetary
constraints. Given the budgetary constraint, the consumer cannot opt for the highest
IC. Let now see the implications of budgetary constraints on consumer’s choices.
Given the indifference map, a utility maximizing consumer would like to reach the
highest possible indifference curve on his indifference map. But, as noted above, the
consumer is assumed to have a limited income. The limitedness of income acts as a
constraint on how high a consumer can ride on his indifference map. This is known
as budgetary constraint. In a two-commodity model, assuming a limited money income
(M), the budgetary constraint, may be expressed through a budget equation as shown
in Eq. 2.1.
M = Px . Qx + Py . Qy ...(2.1)
where Px and Py are prices of X and Y, respectively; Qx and Qy are their respective
quantities; and M is the consumer’s money income.
The budget equation states that the total expenditure of the consumer on goods X
and Y cannot exceed his total income, M. The total quantity of X and Y that can be
bought with given M, Px and Py can be easily obtained from the budget equation, as
shown below.
M P
Qx = – y Qy ...(2.2)
Px Px
M P
and Qy= – x Qx ...(2.3)
Py Py
These equations are also called budget equations. Given the budget equations, if
M, Px and Py are known, the values of Qx and Qy and different combinations thereof can
be easily calculated by assigning a numerical value to Qy or to Qx. When the values of Qx
and Qy are plotted on the X and Y axes, and joined by a line, it produces a line which is
called the budget line or price line, as shown in Fig. 2.2.
There is a simple method of drawing the Budget Line. Given the Eq. (2.2), find Qx
at Qy = 0. Qx equals M/Px. Mark M/Px as a point on X-axis. Similarly, given Eq. (2.3),
find Qy at Qx = 0. Qy = M/Py. Mark M/Py point at Y-axis. Both M/Px and M/Py points are
shown in Fig. 2.2. By joining those points by a line, we get the budget line. The budget
line shows the quantity-combinations available to the consumer given his income
and the prices of X and Y.
Self-Instructional
36 Material
Y Demand Analysis
M
Py
B
NOTES
Qy
Quantity of Y
=
M
Py
Non-feasible area
–
Px Q
Py
x
A
Budget line
Feasible area
O X
M/Px
Quantity of X
Fig. 2.2 Budget Line and Budget Space
The budget line divides the commodity space into two parts: (i) feasibility area,
and (ii) non-feasibility area. The area under the budget line (including the budget line) is
feasibility area (Fig. 2.2). For, any combination of goods X and Y represented by a point
within this area (e.g., point A) or on the boundary line (i.e., on the budget line) is a
feasible combination, given M, Px and Py. The area beyond the budget line is non-
feasible area because any point falling in this area, e.g., point B, is unattainable (given
M, Px and Py).
Shifts in the Budget Line: The budget line shifts upward or downward or swivels
up and down due to change in the consumer’s income and prices of the commodities. If
the consumer’s income increases, prices remaining the same, the budget line shifts
upwards remaining parallel to the original budget line. Suppose the original budget line is
given by line AB in Fig. 2.3. If money income (M) increases (prices remaining the
same), the budget line AB will make a parallel shift to CD. And, if M decreases by the
same amount, the budget line will shift downward to its original position AB. Income
remaining the same, if prices change, the budget line changes its position. For example,
if M and Py remain constant and Px decreases to a half then the budget line will be AF.
Similarly, M and Px remaining constant, if Py increases, the budget line shifts to EB.
A
Quantity of Y
Qy
E
Q x
O B D F
Quantity of X
Fig. 2.3 Shift in the Budge Space

Self-Instructional
Material 37
Demand Analysis Slope of the Budget Line: Another important aspect of the budget line that matters in
determining a consumer’s equilibrium is its slope. The slope of the budget line (AB) in
Fig. 2.3, is given as:
NOTES Qy OA

Qx OB
Since OA = M/Py (when X = 0) and OB = M/Px (when Y = 0), the slope of the
budget line AB in Fig. 2.3 may be rewritten as:
OA M Py Px
= 
OB M Px Py
Thus, the slope of the budget line is the same as the price ratio of the two goods.
In this section onwards, we take up the main theme of the theory of consumer behaviour
as developed under the ordinal utility approach. The main issue is how a consumer
attains his equilibrium. As noted earlier, a consumer attains his equilibrium when he
maximizes his total utility, given his income and market prices of the goods and services
that he consumes. The ordinal utility approach specifies two conditions for the consumer’s
equilibrium:
 Necessary or the first order condition
 Supplementary or the second order condition
In a two-commodity model, the necessary or the first order condition under
ordinal utility approach is the same as equilibrium condition under cardinal utility
approach. It is given as:
MU x P
 x
MU y Py
Since, by implication, MUx/MUy = MRSx, y, the necessary condition of equilibrium

under ordinal utility approach can be written as:
MU x P
MRSx, y = = x
MU y Py
This is a necessary but not a sufficient condition of consumer’s equilibrium.

The second order or supplementary condition requires that the necessary condition
be fulfilled at the highest possible indifference curve.
Consumer’s equilibrium is illustrated in Fig. 2.4. The indifference curves IC1, IC2
and IC3 present a hypothetical indifference map of the consumer. The line AB is the
hypothetical budget line. Both the budget line AB and the indifference curve IC2 pass
through point E. Therefore, the slopes of the indifference curve IC2 and the budget line
(AB) are equal. Thus, both the necessary and supplementary conditions are fulfilled at
point E. Therefore, consumer is in equilibrium at point E. This point can be proved as
follows.
We know that between any two points on an indifferent curve, MUy of Y =
MUx of X and, therefore, the slope of an indifference curve is given by:
Y MU y
= = MRSx, y
Self-Instructional X MU x
38 Material
We know also that the slope of the budget line is given by: Demand Analysis
OA Py

OB Px
NOTES
As shown in Fig. 2.4, at point E, MRSy, x = Py / Px. Therefore, the consumer is in
equilibrium at point E. The tangency of IC2 with the budget line AB, indicates that IC2 is
the highest possible indifference curve which the consumer can reach, given his budgetary
constraint and the prices. At equilibrium point E, the consumer consumes OQx of X and
OQy of Y, which yield him the maximum satisfaction.
J
Quantity of Y
P M E
Qy
IC3
IC2
K
IC1
O Qx B
Quantity of X
Fig. 2.4 Equilibrium of the Consumer
Although the necessary condition is also satisfied on two other points, J and K
(i.e., the points of intersection between the budget line AB and a lower indifference
curve IC1), these points do not satisfy the second order condition. Indifference curve
IC1 is not the highest possible curve on which the necessary condition is fulfilled. Since
indifference curve IC1 lies below the curve IC2, at any point on IC1, the level of satisfaction
is lower than the level of satisfaction indicated by IC2. So long as the utility maximizing
consumer has an opportunity to reach the curve IC2, he would not like to settle on a
lower indifference curve.
From the information contained in Fig. 2.4, it can be proved that the level of
satisfaction at point E is greater than that on any other point on IC1. Suppose the consumer
is at point J. If he moves to point M, he would be equally well-off because points J and
M are on the same indifference curve. If he moves from point J to M, he will have to
sacrifice JP of Y and take PM of X. But in the market, he can exchange JP of Y for PE
of X. That is, he gets extra ME (= PE – PM) of X. Since ME of X gives him extra utility,
the consumer moves to point E. Since point E falls on a higher IC, it represents a utility
higher than the point M. Therefore, point E is preferable to point M. The consumer will,
therefore, have a tendency to move to point E on a higher IC2 from any other point on
the curve IC1, all other things (taste, preference and prices of goods) remaining the
same.
Another fact which is obvious from Fig. 2.4 is that, due to budget constraint, the
consumer cannot move to an indifference curve placed above and to the right of IC2.
For example, his income would be insufficient to buy any combination of two goods at
the curve IC3. Note that the indifference curve IC3 falls in the infeasibility area.
Self-Instructional
Material 39
Demand Analysis 2.4.2 Constrained Utility Maximization
The central theme of the consumption theory—be it based on ordinal utility or cardinal
utility approach—is the utility maximizing behaviour of the consumer. The fundamental
NOTES postulate of the consumption theory is that all the consumers—individuals and
households—aim at utility maximization and all their decisions and actions as consumers
are directed towards utility maximization. The specific questions that the consumption
theory seeks to answer are:
(i) How does a consumer decide the optimum quantity of a commodity that he or she
chooses to consume, i.e., how does a consumer attain his/her equilibrium in respect
to each commodity?
(ii) How does he or she allocate his/her disposable income between various
commodities of consumption so that his/her total utility is maximized?
The theory of consumer behaviour seeks to answer these questions on the basis
of the postulates that consumers seek to maximize their total utility or satisfaction.
Constrained utility maximization is a process wherein under certain constraints
the highest possible level of utility is obtained through the consumption of goods and
services. This happens when the highest overall level of utility cannot be obtained. The
concept of constrained utility maximization is an alteration of the more general utility
maximization assumption. The general utility maximization is based on the notion that the
consumers might be regulated or restricted from achieving the absolute maximum level
of utility. The major restriction would be the amount of income available in comparison
to the price paid. Constrained utility maximization generally does reach the peak of the
total utility curve.
While the idea of utility maximization as an unrestricted quest of utility is very
essential in the consumer demand theory and the study of economics, our everyday life
is directed by the idea of constrained utility maximization.
2.5 DEMAND CURVE AND FACTORS SHIFTING IT

When the demand curve changes its position (retaining its slope though not necessarily),
the change is known as a shift in the demand curve. For example, suppose that the
original demand curve for commodity X is given as D1 in Fig. 2.5. As shown in the figure,
at price OP2, the consumer would buy OQ1 units of X, other factors remaining constant.
But, if any of the other factors (e.g., consumer’s income or price of the substitutes)
changes, it will change the consumer’s ability and willingness to buy commodity X. For
Check Your Progress example, if consumer’s disposable income increases due to decrease in income tax, he
4. List any two would be able to buy OQ2 units of X instead of OQ1. This is true for the whole range of
assumptions of the prices of X; consumers would be able to buy more at all other prices. This will cause an
law of diminishing
marginal utility. upward shift in demand curve from D1 to D2. Similarly, decrease in disposable income
5. When does a of the consumer due to, say, rise in taxes may cause a downward shift in the demand
consumer attain curve from D2 to D1.
equilibrium?
6. What is the central
theme of the
consumption
theory?
Self-Instructional
40 Material

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ECONOMIC THEORY

RAJIV GANDHI UNIVERSITY

2. Prof. J C Soni Member

3. Dr. P K Acharya Member

4. Ms. Moyir Riba Member

5. Dr. Ashan Riddi Member Secretary

Copyright  Reserved, 2016

Vikas® is the registered trademark of Vikas® Publishing House Pvt. Ltd.

Unit I: Basic Economic Issues Unit 1: Basic Economic Issues

Unit II: Demand Analysis Unit 2: Demand Analysis

Unit III: Supply Analysis Unit 3: Supply Analysis

UNIT 1 BASIC ECONOMIC ISSUES 3-30

UNIT 2 DEMAND ANALYSIS 31-59

UNIT 4 PRICE AND MARKET STRUCTURE 109-171

UNIT 5 NATIONAL INCOME AND ITS CLASSICAL DETERMINATION 173-218

UNIT 6 KEYNESIAN MODEL AND MACRO-POLICIES 219-246

UNIT 1 BASIC ECONOMIC ISSUES

1.1 UNIT OBJECTIVES

1.2 ECONOMY AND ITS BASIC PROBLEMS:

Fig. 1.1 The Production Possibilities Frontier

1.4 MICRO AND MACRO ECONOMICS

1.6 KEY TERMS

1.7 ANSWERS TO ‘CHECK YOUR PROGRESS’

1.8 QUESTIONS AND EXERCISES

1.9 FURTHER READING

UNIT 2 DEMAND ANALYSIS

2.1 UNIT OBJECTIVES

2.2 BASIS OF DEMAND: UTILITY AND INCOME

2.3 DIMINISHING MARGINAL UTILITY

Fig. 2.1 Diminishing Marginal Utility

Fig. 2.2 Budget Line and Budget Space

Fig. 2.3 Shift in the Budge Space

Since, by implication, MUx/MUy = MRSx, y, the necessary condition of equilibrium

This is a necessary but not a sufficient condition of consumer’s equilibrium.

Fig. 2.4 Equilibrium of the Consumer

2.5 DEMAND CURVE AND FACTORS SHIFTING IT

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