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Production Possibility Curve

A-X-Z-B, extended both ways to meet the axes, is the PPC Curve

A full-employment economy must always, in producing one commodity, be giving up something of another. Satisfaction is the law of life in a full-employment economy. The Production Possibility Curve (PPC) depicts society's menu of choices. It is also called the country's Production Possibility Frontier.

Let us explain the concept with the help of the adjoining diagram.

Any point inside the PPC is a point of less than full employment. If we move from X to Z, we sacrifice XY of food and get YZ of clothing. Thus a full-employment economy must sacrifice some amount of one commodity to get some amount of another commodity. The opposite thing will happen if we move from Z to Y. We will sacrifice YZ of clothing to get XY of food. Thus a Production Possibility Curve shows the options open to a society. It shows the maximum possible combined output of two commodities.

If we are at a point, which is inside the Production Possibility Curve, then it implies less than full-employment. At this point we can increase the production of both the commodities and eventually move to a full-employment point on the PPC. After attaining full-employment we can choose any point on the Production Possibility Curve, like A, B, X, Z etc.

Opportunity Cost: As the economy decides to produce more of one commodity at full-employment level, it will have to give up some units of some other commodity. At full-employment no factor of production remains unutilized. The opportunity cost of a product at full-employment level is the alternative, which must be given up to produce that product. In the above diagram when we move from point X to Z, we have to give up XY of food to get YZ of clothing. Therefore, XY of food is the opportunity cost of YZ quantity of clothing.  As we further increase the production of cotton, the opportunity cost increases. This is because first of all we will plant cotton in those areas, which are not very suitable for food grain cultivation. If we go on increasing cotton production, more efficient food grain-producing lands will have to be brought under cotton production. Thus the opportunity cost also increases.

But a Production Possibility Curve does not include all options. It does not include options under less than full-employment.
We can select any point on the PPC if we manage the economy well and maintain a high level of employment. Otherwise, if we mismanage the economy, we will end up inside the curve, say at point I.
But we cannot be at a point, which is outside the PPC, (say at point Q) with our present land, labour, capital and technology.

Outward shift of the Production Possibility Curve.
With passage of time it may be possible for us to attain the point translated above. This will be possible when our economy grows and the productive capacity increases.
Reasons for growth:
1. Technological improvement - better and more economical ways of producing goods
2. Increase in capital
3. Increase in labour force
Growth of the economy will be slower if more of the current resources are used for the production of consumption goods to satisfy current wants.
Conversely, growth of the economy will be faster if more resources are directed towards production of capital goods to take care of future needs.  

World Economy - 2014

 

The prices of food items have increased manifold during the last three years. In 2008 the prices of wheat and rice had doubled. Rising price of food items affect the poor and the lower middle class the most, because they spend a major portion of their income on purchase of food items. But apparently there is no shortage of food items. Better storage facilities of food grains are required, mainly in the developing countries to preserve what has been produced. Wastage cannot be afforded. Developing nations, with borrowings and investments from developed nations, have moved forward a bit. But they also have not been able to divert the fruits of development in the right direction. Rising Oil prices have affected the balance of payments.

Low interest rates, deficit budgets, and government borrowings have dampened the growth of the world economy. As a result of moderate growth, unemployment has cropped up. Accumulation of wealth and liquidity in the hands of a few has affected the economies adversely. Developing nations have tried to control inflation by keeping the interest rate high. High interest rate discourages investment and growth of gross domestic product. In spite of their best efforts to keep the economy away from the pressure of inflationary price rise, through monetary and fiscal policies, effective demand has not gone down as desired. Without proper investment decisions, employment has been affected adversely.

A huge capital resource is remaining sunk in fixed assets. Conversion into liquid assets is not so easy. Markets, on one side, are getting flooded with consumer durables. Over-emphasis on opportunities in some areas has resulted in an unbalanced growth of the world economy. Some areas have progressed, while some have fallen back. Governments need to put a judicious check on expenditure, subsidies and benefits to mellow down the price rise. But that again gives rise to unemployment. It has to be ensured that subsidies and benefits reach those sections of the population for which it is meant.

Per unit cost of energy is increasing. This adds to the production cost. So the price rise is not only because of high effective demand. It is also a case of cost-push inflation. Need to find alternative sources of energy are necessary. A suitable alternative for coal needs to be found out. The energy resource needs to be used more effectively and judiciously. Nuclear energy is not appearing to be a very safe long-term option. Those who are at the helm of managing the energy resources have to handle the situation with more caution and care, keeping in mind long-term effects of their decisions and actions.

It is required to boost the economies with fresh investments, but the moment that is done, prices will rise further. More areas have to be brought under food grain cultivation to increase food production. New technologies have to be implemented to get more yields from the same land. Importing food grains puts pressure on the economy, as it is always costlier. Transportation cost also adds to the cost. Local yields have to be raised. Cutting down the cost is an absolute necessity.

Attention should be shifted to less saturated areas where small and medium scale industries can and need to be developed. Capital resources should be diverted to areas and sectors where it is needed the most. This will increase the output. More supply of goods and services will then bring down the price level. This will create fresh employment as well, which will gear up the economies with a more equitable distribution of income. A change in consumption pattern and lifestyle is required. Collective well-being should get a big priority. Too much of optimism, with respect to revenue earning, is required to be curtailed. Speculative activities, based on the rising price level, should be controlled, keeping in mind that ultimately it will be a self-defeating policy. Governments need to chalk out their fiscal and monetary policies very judiciously. Distribution system needs to be smooth enough to bring parity in price level. Governments will have to manage their debts, if any, efficiently.

Most of the economies need to swing back to a near non-inflationary situation. A total evaluation and overhauling of the world economic structure needs to be done with sufficient co-operation among countries.

World Economy - more discussion

Certain areas of the economic world are showing a high growth rate. Demand for goods and services, outstripping supply, is creating an inflationary situation. Too fast an economic growth is not a very good thing to strive for. That which grows fast also dies out fast. Many economic areas are showing a retarded growth rate. We must never forget that resources are limited in supply, energy resources being the most important of these. A very judicious use of such resources is absolutely necessary, keeping in mind a balanced and equitable growth rate while formulating plans and policies. Changing our lifestyles may bring some long-term beneficial effects.

Too much of capital is remaining sunk in assets that have gone unproductive. This has given rise to a scarcity of capital underneath. Too much optimism is responsible for this. Who does not want to grow and prosper? The faster the demand for a thing grows, the faster it dies also. Once it dies, the capital sunk in the production of those goods lose their economic value.

Excessive competition of goods and services is responsible for this. Excessive consumption and consequent demand gives rise to over-optimism among producers and investors. But optimism in an area is dying out very soon. Its place is taken over by some other. Rapid change in lifestyle is a key factor that is responsible for this.

Judicious management of fiscal and monetary policies is of utmost importance. Fiscal measures, backed up by a sound direct tax management policy, a smooth system of distribution of goods and services, prudent energy management policies, long-term environment control measures and their utilization, and above all, a high level of mutual understanding among nations is necessary for the upliftment and smooth functioning of world economy as a whole. Collective well-being is very important.

Monetary measures can bring short-term positive results but that does not last long. Fiscal measures are of prime importance.

Some oil markets are tending to come under stressful conditions. However, nothing can be taken up in isolation. All are interconnected.

Countries are incurring debts, rapid growth is threatening the pool of future resources, both natural and man-made, rapidly changing consumption pattern is putting producers in a difficult spot, business houses, driven by over-optimism, are unknowingly trying to outgrow themselves.

Social, political and economic situations have to be taken up and assessed in totality. One affects the other. A widespread socio-economic-political transformation is necessary to bring back the world economy to a smooth track.

World Economy - The Dual Challenge

The world economy faces dual challenges over the next few years to assure financing of the huge payment imbalances arising from the major oil price increases that have taken place and to promote fundamental adjustment to the changing world energy situation, which is at the heart of global economic difficulties. Rising cost of food items are also putting national economies under severe pressure. Whether a coordinated effort on the part of various nations succeeds in restoring a strong and stable global economy has a critical and direct bearing on the economic well-being of the world. The health of the world economy directly affects markets for the production of farm and factory products and the employment situation of the world. Nations are learning fast that in collective well-being lies the essence of personal well-being. Everybody's stake in a healthy world economy is growing stronger and stronger. 

International investment has become very important both at home and abroad. Exchange of capital outlay among nations is important, as through it production centres can be located at desired places and production can be carried on in the most economical way. Thereby exchange of technology also can be promoted, which again contributes to bring down the overall global cost of production. Labour may be less costly somewhere. Proximity to market reduces the transportation cost. Everybody then will be able to get things at a low cost.

Political and economic unrest in certain areas are putting a serious pressure on the well-being of the world economy. The political turmoil is the Middle East has contributed to uncertainty about future oil supplies at a time when the world economy is already facing a difficult situation since the 2008 recession, effects of which are still lingering. During the past 30-35 years widespread fluctuations in oil prices, which always remain very sensitive to changes, economic or non-economic, have given the world economy several jolts. Increase in oil prices during the past two years, a climbing inflation, balance of payments deficit, and lowering of income from foreign investments continue to disturb the major economies of the world. The changing face of the world economic environment is likely to make it not only more difficult for nations to obtain the much-needed financing, but more difficult also for them to make the economic adjustments required by changing external circumstances. Oil-importing nations are facing a deteriorating position in their current accounts.

As growth rates slow down, unemployment rises and trade deficits widen, many countries keep on feeling the pressure to keep their internal economy in fine tune. A coordinated and cooperative international response to the problems of the world economy, both political and economic, is needed to assure an effective solution, and maintain the essential economic framework. Oil price increase imposes serious hardship on the poorest nations, whose development plans need to be altered to accommodate increased payments for oil. Some individual countries are facing serious financial difficulties.

Over the next few years the world faces a dual task of assuring not only that growth in gross domestic product is achieved keeping the price level within a controllable limit, but also that basic economic adjustments are initiated and carried through to restore a sustainable basis for future world economic growth and development.

Finding out alternative sources of energy is what is needed the most, as a time will come when world fossil fuel reserves will start their steep downward swing. We have to keep in mind that world consumption of energy keeps on increasing. Nuclear energy is being considered hazardous and unsafe by many because of the disasters that have taken place. Harnessing solar energy, wind and water energy, using hydrogen as fuel to produce energy, or inventing some other synthetic fuel are the major options open. Some innovative technology needs to be developed which will be cost-effective or economically viable as well as clean and pollution-fee.

Protecting the world environment is also a serious challenge for everyone. Even way back in 1981 it was a known fact that energy use at such a large scale, mainly fossil fuel, even if otherwise feasible, could raise the average surface temperature of the earth with potentially catastrophic global effects. That has started happening and now we need to put a check on fossil fuel consumption to minimize emission of greenhouse gases. Burning of fossil fuels has contributed to the increase in carbon dioxide in the atmosphere. Global warming, a recent warming of the Earth's surface and lower atmosphere, is believed to be the result of a strengthening of the greenhouse effect mostly due to human-produced increases in atmospheric greenhouse gases. We still rely heavily on fossil fuel.

The Kyoto Protocol(adopted on December 11, 1997, and entered into force on February 16, 2005), aimed at fighting global warming, is an international environmental treaty with the goal of achieving the stabilization of greenhouse gas concentrations in the atmosphere at a level that would protect the climate system. The objective of the Kyoto climate change conference was to establish a legally binding international agreement, whereby all the participating nations commit themselves to tackling the issue of global warming and greenhouse gas emissions. The target agreed upon was an average reduction of 5.2% from 1990 levels by the year 2012.

The Copenhagen Accord (December 18, 2009) recognized the scientific issue for keeping temperature rise to no more than 2 degree C but did not contain commitments to emissions reduction to achieve that goal. The agreement was a vital first step and accepted that there was a lot more work to be done to get assurances so that it would become a legally binding treaty. It endorsed the continuation of the Kyoto Protocol, but was not legally binding and did not commit countries to agree to a binding successor to the Kyoto Protocol, whose present round ended in 2012.

The 2012 United Nations Climate Change Conference took place during November-December 2012, at the Qatar National Convention Centre in Doha. The conference reached an agreement to extend the life of the Kyoto Protocol, which had been due to expire at the end of 2012, until 2020, and to make a more concrete and real successor to the Kyoto Protocol,  set to be developed by 2015 and implemented by 2020. For the first time the concept of "loss and damage" has been incorporated,  an agreement in principle, which says that richer nations could be financially responsible to other nations for their failure to reduce carbon emissions.

In the actual field, nothing much has changed during the past 30 years. Now some clean, pollution-free source of energy, which will fulfill our long-term energy requirements, is needed to keep the earth and its atmosphere cool. The energy base of industrial civilization has to include some new energy source. The chances of success in creating a new energy base are reasonably good. Only the length of time available and the scale of resources devoted to the task will help determine the outcome.

An Economic Overview

The prices of food items have increased manifold during the last three years. In 2008 the prices of wheat and rice had doubled. Rising price of food items affect the poor and the lower middle class the most, because they spend a major portion of their income on purchase of food items. But apparently there is no shortage of food items. Better storage facilities of food grains are required, mainly in the developing countries to preserve what has been produced. Wastage cannot be afforded. Developing nations, with borrowings and investments from developed nations, have moved forward a bit. But they also have not been able to divert the fruits of development in the right direction. Rising Oil prices have affected the balance of payments.

Low interest rates, deficit budgets, and government borrowings have dampened the growth of the world economy. As a result of moderate growth, unemployment has cropped up. Accumulation of wealth and liquidity in the hands of a few has affected the economies adversely. Developing nations have tried to control inflation by keeping the interest rate high. High interest rate discourages investment and growth of gross domestic product. In spite of their best efforts to keep the economy away from the pressure of inflationary price rise, through monetary and fiscal policies, effective demand has not gone down as desired. Without proper investment decisions, employment has been affected adversely.

A huge capital resource is remaining sunk in fixed assets. Conversion into liquid assets is not so easy. Markets, on one side, are getting flooded with consumer durables. Over-emphasis on opportunities in some areas has resulted in an unbalanced growth of the world economy. Some areas have progressed, while some have fallen back. Governments need to put a judicious check on expenditure, subsidies and benefits to mellow down the price rise. But that again gives rise to unemployment. It has to be ensured that subsidies and benefits reach those sections of the population for which it is meant.

Per unit cost of energy is increasing. This adds to the production cost. So the price rise is not only because of high effective demand. It is also a case of cost-push inflation. Need to find alternative sources of energy are necessary. A suitable alternative for coal needs to be found out. The energy resource needs to be used more effectively and judiciously. Nuclear energy is not appearing to be a very safe long-term option. Those who are at the helm of managing the energy resources have to handle the situation with more caution and care, keeping in mind long-term effects of their decisions and actions.

It is required to boost the economies with fresh investments, but the moment that is done, prices will rise further.
More areas have to be brought under food grain cultivation to increase food production. New technologies have to be implemented to get more yields from the same land. Importing food grains puts pressure on the economy, as it is always costlier. Transportation cost also adds to the cost. Local yields have to be raised. Cutting down the cost is an absolute necessity.

Attention should be shifted to less saturated areas where small and medium scale industries can and need to be developed. Capital resources should be diverted to areas and sectors where it is needed the most. This will increase the output. More supply of goods and services will then bring down the price level. This will create fresh employment as well, which will gear up the economies with a more equitable distribution of income. A change in consumption pattern and lifestyle is required. Collective well-being should get a big priority. Too much of optimism, with respect to revenue earning, is required to be curtailed. Speculative activities, based on the rising price level, should be controlled, keeping in mind that ultimately it will be a self-defeating policy. Governments need to chalk out their fiscal and monetary policies very judiciously. Distribution system needs to be smooth enough to bring parity in price level. Governments will have to manage their debts, if any, efficiently.

Most of the economies need to swing back to a near non-inflationary situation. A total evaluation and overhauling of the world economic structure needs to be done with sufficient co-operation among countries. 

Classical Theory of the rate of Interest

It is also known as the Supply-Demand Theory of the rate of Interest, or the Savings-Investment Theory.

Higher the rate of interest, higher will be the supply of savings. But the investors will invest less because interest is the cost of acquisition of an asset.

Investment is the demand for loanable funds, and savings is the supply of loanable funds.
According to the classical theory, which is the real theory of the rate of interest, the equilibrium rate of interest is determined by the interaction of the demand-for-investment curve and supply-of-savings curve. Although for the economy as a whole, savings is equal to investment, savers and investors are two different groups of people. Savings is mainly undertaken by the household sector, and investment is undertaken by private business firms. From the savers' point of view the rate of interest is the return on an asset or simply the return on money. From the investors' point of view, the rate of interest is a cost factor. It is the cost of borrowing money in order to acquire an asset. These two reasons adequately explain why savings is directly related to the rate of interest, and investment is inversely related to the rate of interest. Higher the rate of interest, higher will be the savings and lower the investment, and vice versa.

In the diagram the downward sloping demand-for-investment curve intersects the upward sloping supply-of-savings curve at point E. At the point E savings is equal to investment, and the resultant rate of interest is r, which is called the equilibrium rate of interest.
Criticism: The classical theory of the rate of interest focuses its attention on the real variables, namely savings and investment, and ignores the monetary factors, namely demand for money and supply of money and certain other things. It is to remedy this deficiency, J.M. Keynes developed the most important theory regarding the determination of the rate of interest, namely The Liquidity Preference Theory of the rate of Interest. In the Liquidity Preference Theory all motives for holding money, namely transactions motive (a classical concept), precautionary motive (again a classical concept) and speculatory motive (basically a Keynesian concept) have been considered. The whole Liquidity Preference Theory is based on speculatory motive for holding money.
 

World Economy - 2012 onwards

The world economy is currently undergoing a radical change, possibly for the better. The traditional ways of trade, industry and commerce are changing. Privatization is taking place in certain key sectors. Governments are trying to concentrate on more important areas like defence, disaster management, social and cultural uplifting etc. However, the changes themselves are not taking place very fast. These are undergoing at a moderate pace.

Art and culture are getting industrialized. The world is undergoing a thorough cultural change, and when art and culture changes, everything else changes.  Now we have the notion that a poet or a dramatist is not only born, he can be groomed up into also; he can be made.

Technological changes are also taking place at a fast pace, though certain technological advancements are being assumed to bring some potential adverse effects on life and living.

The small artisans who were catering the local, or at the most the regional market are finding markets at far off places. Transport and communication has improved dramatically. Tele-communication is still advancing by leaps and bounds making the world a very closely-knit network. It has now become very easy to showcase ones' products at distant markets.

The small industries, which were, until the turn of this century, operating at a very small scale with moderate profit margins are attracting big investors. The small scale manufacturers are getting orders, which are thousand times bigger than what is was previously. Big players are entering into micro cottage industry sectors, which never had dreamt of entering the international market.

The basic and heavy industries are operating at a low ebb. There is comparatively less demand for steel and chemicals. Automobile industry will sooner or later get saturated. So unless new sectors are boosted up creating more income for the moderate and relatively weaker sections, the basic and heavy industries will continue to suffer. Real estate business will fail to get revived. But a real estate boom will no longer possibly be looked upon with great optimism by the experts. 

The whole money multiplier cycle needs to be energized with potentially prospective endeavours so that the whole economy gets charged up.

Investors are on the look out for new, prospective sectors, which promises a steady and secured flow of income.

Energy charges are rising fast. Need for renewable, cheaper sources of energy are necessary. Unless energy is made cheap, it is difficult to control cost-push inflation in a situation where demand-pull inflation is already having its daily share everywhere. Changes in lifestyle for less consumption, general awareness about the pollution of nature and its drastic changes, conservation of natural resources and more dependence on nature by curtailing artificial means of comforts and luxuries are needed the most. A mass realization about balancing the world economy with its natural resources will surely go a long way to remove the problems the world is facing currently and will ensure a much better tomorrow.

Monopoly Market Situation

In a monopoly market situation the industry comprises of only one firm. There is no close substitute for the product produced by the monopolist. The demand for the monopoly product is the same as the industry demand.  This demand has finite price elasticity. Fresh entry of producers cannot take place. There is no pronounced supply curve for the industry. However, a single firm monopoly is a rare situation. More prevalent is the monopolistic competition, where elements of both perfect competition and monopoly are present.

A monopolistic market situation is characterized by the following features:

1. The product produced by the monopolist has no close substitutes.

2. There is only one seller in the industry. Hence there is no distinction between the monopolistic firm and the industry.

3. In a monopoly market the producing firm is the price-maker. This means the firm can sell more at a lower price, or sell less at a higher price.

4. The monopolist may also be guided by the motive of profit maximization.

In a monopoly market the profit maximizing condition is fulfilled in terms of marginal revenue (MR) and marginal cost (MC). If MR > MC, production will increase. If MR < MC, production will decrease. Thus the equilibrium condition for the monopoly firm is reached where MR = MC. Also the slope of the MR curve must be less than that of the MC curve.

In the adjoining diagram we measure quantity along the horizontal (X) axis, and price, revenue and costs along the vertical (Y) axis. Average revenue curve is the demand curve for the firm's product. At point E, MC = MR. The shaded area IFGH measures the profit. Equilibrium price is OH and equilibrium quantity is OQ. The MC curve passes through the minimum point of the AC curve. At E, where MC intersects MR, equilibrium position of maximum profit is found. Any shift from E will result into loss of profit. Under monopoly or imperfect conditions, the firm will have to reduce the price in order to sell more. That is why marginal revenue is less than average revenue (MR < AR) and the MR curve lies below the AR curve. The gap between these two curves measures the degree of monopoly or imperfect competition.

Destabilized economy and corrective measures

Fiscal Policy

When the economy does not function properly under the influence of unemployment, depression or inflation, the government tries to make certain changes in its expenditure policy to bring in the desired changes, and to eliminate the forces that are destabilizing the economy.

There are two basic measures that a government can undertake to stabilize the economy.

1. Government Expenditure

Increase in government expenditure acts as an investment. It gets added to the private investment that is prevailing in the economy. Thus, more government expenditure generates more employment and income, and takes the economy to a new equilibrium position.

2. Taxation

Government Expenditure expands the economy, whereas taxation contracts the economy. More taxation reduces the disposable income of individuals. This reduces their capacity to spend on consumer goods. A rise in taxes lowers the demand curve of the economy. This reduces income and employment. This is necessary during periods of inflation, when prices are moving upwards.

A reduction in taxes will give more income in the hands of consumers. Demand will increase, and new investment and income will be generated. This is necessary during periods of depression. Cut in taxes helps the economy to recover from a depressed state.

Monetary policy is aimed to control the supply of money in an economy. The central bank, which acts as the agent for the government, determines and controls the money supply according to the need of the economy.
Monetary policy is a tool or a process through which a government, central bank, or monetary authority of a country controls
(a) the supply of money,
(b) availability of money, and
(c) cost of money or rate of interest to attain certain sets of objectives to promote the growth and stability of the economy.

Cash reserve Ratio (CRR) is the amount of money or funds that the banks have to keep with the central monetary authority, mainly the central bank of the country.  If the central bank decides to increase the CRR, commercial banks are left with lesser money in hand.  The central banking authority uses the CRR to pull out excess money from the economy or put in more money into the economy.

Commercial banks are always required to maintain with the central monetary authority an average cash balance, the amount of which shall not be less than a certain percentage (say 4-5%) of their total demand and time Liabilities.

Repo(ssession) rate or discount rate is the rate at which the central bank of a country lends money to commercial banks. It is an instrument of monetary policy. Whenever banks have any shortage of funds they can borrow from the central bank. A reduction in the repo(ssession) rate helps banks to get money at a cheaper rate and vice versa. 

Reverse Repo(ssession) rate is the rate is at which the central monetary authority of a country borrows money from commercial banks, or the rate at which the central monetary authority pays to commercial banks for keeping surplus funds with it (above CRR-determined amount).

An increase in reverse repo. rate can prompt banks to deposit more funds with the central bank to earn higher returns on idle cash. It is also a tool, which can be used by the central bank to pull out excess money from the banking system or the country's economy as a whole.
Repo(ssession) rate, reverse repo(ssession) rate and Cash Reserve Ratio are all determined by the central monetary authority of a country.
 
When the growth rate of an economy slows down abnormally, it is an indication there is possible dearth of liquid capital. Along with this there may be a great decrease in optimism among investors. This affects the supply side of the economy due to lower and lower rates of production of goods and services. As a resultant effect inflation sets in. Too much money starts chasing too few goods causing a spiraling price rise. Dearth or scarcity of capital may be caused by sinking of capital in assets, which are absolutely non-performing, like gold and silver, or are non-performing in relation to the current economic scenario. Less optimism increases the dampening effect. An acute imbalance of excess government expenditure over government income, including foreign trade (balance of payments) deficits (imports exceeding exports) destabilizes the economy further and pushes it towards possible stagflation, which is stagnation (abnormally slow growth rate) and inflation (price rise) combined.

But the peculiar aspect of this whole depressing economic affair might have been initially caused by an excess demand for goods and services created in one or more sectors of the economy, causing excess income in the hands of people working in those sectors. This excess income, mainly due to over-caution, gets invested and consequently sunk in relatively secured non-performing assets, causing a drain out of effective, production-oriented capital from the economy.

Under such circumstances, an effective combination of monetary (short term measure) and fiscal policy (long term measure) has to be adopted by the government to gear up the economic growth rate and bring down the rate of price rise.

Employment

Say's Law: The classical economists try to explain the economic theories on the assumption of full-employment. Full-employment means a situation in the economy where the people are willing to work and able to work.

They admitted that there could be 4% to 5% unemployment in the economy. When all the labourers are more or less employed, other factors of production will also be employed. In other words, at the time of full-employment there will be no idle resources in the country.

The classical economists developed the concept of full-employment on the basis of Say's Law. According to Mr. J. B. Say "supply creates its own demand". Whatever amount of goods is produced in the country will automatically be demanded in the country. This is because due to the increase in production, employment will increase. This will increase the income of the suppliers of factors of production. Thus, with the increase in income, demand will also increase. Hence it will be profitable for the businessmen to employ more labourers. As a result of this, all the labourers will be fully employed or occupied.

Thus Say's Law plays an important role in classical economic theories.

Keynes' Theory: Mr. J. M. Keynes did not accept the concept of full-employment. So he tried to develop a new concept of employment. According to him, employment in the economy depends on many factors. Of these factors, the most important factor is the Marginal Efficiency of Capital.

According to Mr. Keynes, employment depends on expenditure. When the expenditure is more, the effective demand will be more. This will increase the price, profit, investment, production and employment. But expenditure depends on the income. When the income is more, expenditure will be more. But the income is the sum of 1) consumption, 2) investment and 3) government expenditure.

1) Consumption: In order to satisfy the economic wants, man uses goods and services. Thus consumption depends on two factors, income and propensity to consume. Propensity to consume shows the relationship between change in income and change in consumption. When people consume more with an increase in income, propensity to consume will be more. But propensity to consume is influenced by many other factors. Some of the factors are as follows:

a) Distribution of income in the society: According to Mr. Keynes, the psychology of the people is that when people have less income, propensity to consume will be more.

b) When the desire to imitate others is more, the propensity to consume will be more.

c) If the government levies more taxes on expenditure, propensity to consume will be less.

d) If the people are economical, propensity to consume will be less.

e) If the propensity to save is more, propensity to consume will be less.

The propensity to save is again influenced by other factors, such as

i) the opportunity to save
ii) the power to save
iii) social position
iv) social guarantee
v) rate of interest, etc.

2) Investment: Investment in the economy is primarily determined by two factors

a) Marginal Efficiency of Capital
b) Rate of Interest

a) Marginal Efficiency of Capital: It shows the relationship between change in marginal investment and expected return out of that investment. When the expectation of return is more, marginal efficiency of capital will be more and vice versa.

This marginal efficiency of capital again is determined by many other factors.

i) Population: If the rate of growth of population is quite fast, effective demand will be more in the economy. Hence marginal efficiency of capital will be more.

ii) Innovation: If businessmen succeed to introduce new techniques and new machines, cost of production will be low, and so marginal efficiency of capital will be more.

iii) Taxes: If the government levies more taxes on production, cost will increase, and so marginal efficiency of capital will be less.

iv) Stock of goods: If the existing stock of finished goods is more, marginal efficiency of capital will be less.

v) Existing rate of investment: If the rate is more, marginal efficiency of capital will be more.

b) Rate of Interest: According to Mr. Keynes, rate of interest is determined by the demand for and supply of money. The demand for money depends on the desire of the people to hold money. There are basically three motives for which people want to hold money. These three motives are

i) Transactions Motive: People earn their income at the end of a certain period of time. So to meet the daily transactions during that period of time, people hold money.

ii) Precautionary Motive: In order to safeguard against the future uncertainties, people want to hold money.

iii) Speculative motive: In order to earn more money from the use of money, people want to hold money. According to Mr. Keynes, People want to hold money to buy bonds. When people expect to get more return from the purchase of bonds, they invest the money in the purchase of bonds.

3) Government Expenditure: The government can spend money either on consumption or on investment. When government spends money on consumption by giving unemployment allowances or social security, the purchasing power of the people increases. This leads to rise in demand, price, profit, investment, production and employment. Again, when the government spends money on investment, production and employment increases.

Conclusion: According to Mr. Keynes, there are many factors on which employment depends. Of these factors, consumption is not very active in the determination of employment, because in the long run consumption remains more or less constant. Government expenditure does not depend on the economic policy of the country. It generally depends on the political policy of the government. So it is outside the scope of economics. The rate of interest also remains constant. Hence it is the marginal efficiency of capital, which goes on fluctuating, actually determines employment.

Software System Development Process

Software Systems development requires an organized, step by step approach. The steps should be natural and have well-defined results. The completion of each step should provide a check-point where it can be determined whether the next step can be carried out or not.

The Conception Phase starts as someone, the user or anyone else, recognizes a problem or an opportunity, which has a data processing solution. The systems analyst and the user meet to develop information, mainly description of the problem or opportunity, goals, benefits and project scope.

The Initial information of the Conception Phase are generally recorded in a document called Project Request Form, whatever be its format. In the Conception Phase face to face discussion with the user is the best way to collect the true and exact facts.

Since users mostly can't explain their problems properly, the systems analyst must have interviewing skills. He should know what questions to ask. Thus Conception and Initiation are the preliminary phases involving a lot of queries, and interviewing those people who will be using the system. As stated earlier, one has to know what questions to ask to bring out the exact requirements. Users are not always very clever in expressing what they actually need.

Goals to be achieved and benefits to be derived from the software system must be well defined and documented. It will show whether the solution is adequate or not. A systems analyst should have a reasonably good understanding of the user's business and particularly the functional area for which the system is to be developed.

Sources from which information have been derived should be properly listed.

Benefits should be quantified in terms of money and should be listed in a sequence such that the first one is the easiest one to quantify.

A rough estimate of the project development cost is necessary against which the money values of the benefits are to be compared.

All the departments & sections as well as personnel that will be affected by the software system are recorded to determine the size of the project.

'User' is the manager, lowest in the organization, to whom all affected areas report.

Analysis and design are the two most vital phases, which can ensure a long life of the software.

Analysis part is all about understanding and ascertaining what the system is supposed to do.

In involves preparation of the Context Analysis Diagram,
Data Flow diagram, top level as well as lower level ones,
identifying external entities involved with the system, like the departments affected by the system or outside people,
processes that are required to convert raw data into processed data,
which then becomes usable, meaningful information for the user,
blowing up the processes to identify the sub-processes existing within the major (top level) processes, and identifying the data structures that are required to be updated by the various processes.
converting processed data into meaningful, understandable data, properly formatted and printed or shown on the screen,

Design part is supposed to take care of how the system should perform all that has been ascertained in the Analysis part. It involves preparing structure charts, module specifications, logic involved, checks and validations that need to be incorporated, taking care of interfaces with other systems, and exporting or importing data to or from other systems.

Building a software is a costly affair. A company cannot build it from the scratch every year, though upgradations are always done according to the changes that take place in course of time. So a long life of the software is very essential. Another very vital thing is the changeability of the software system,.... how far and how long it can undergo changes. The more flexible it is, the longer will be its life. So its development cost will automatically be spread over a long period,....seven to ten years... thereby lowering the yearly charge. Changeability totally depends on the Design part..... how the individual modules of the software are related to one another, and how far the modules are independent. The more independent a module is, the less will be chances of other modules getting affected by a change made in one particular module. More the changes a system can take, the more will be its life and the more beneficial it will be for the company using the software.

Another very vital thing is designing the database structure, and individual data file structure. There are rules and principles to do that. This also affects the changeability of the system. A poor database structure will make the system too rigid, ....life span will not be more than four years. It has to be scrapped after that period.

Then comes the Construction Phase when the actual programming work, building up the data files and the database, syntax and logical testing etc. are done. Interactions with the user are necessary, as and when required.

At the end comes the System Testing part when tests like Stress Testing, Volume testing, Data Validation Check Testing etc. are done.

This completes an overview of the system development process.

Economic Functions of the Government

The functions that a modern government should perform basically hover around securing freedom from want and better working conditions. The functions that a modern government is expected to perform can be categorized under the following eight heads.

1. Securing Full Employment

In any modern day economy unemployment is a serious problem. One who is unemployed has to depend upon others to satisfy his basic economic wants. He cannot afford to raise his standard of living, which always remains low. This way he remains frustrated also. Unemployment in a large scale leads to social and other kinds of disorders. A country facing large scale unemployment thus wastes a lot of its human resource, which is the most valuable of all economic resources.

There may also be under-employment and disguised unemployment. These are also equally bad as unemployment. Unemployment leads to low income, low effective demand, and low level of national income.
The government should take up more public works and make fresh investments in areas like building of roads, bridges, dams etc. This will create employment for many. Also the government can induce private investors to invest in new areas by lowering the cost of investment, primarily interest rate, and by providing better infrastructural facilities.


2. Improvement of the Standard of living

Everybody wants better food, better clothes, better housing and the like. All economic policies of the government should be directed towards the fulfillment of these wants. Endeavours by the government to create fresh income for the people will ensure improvement in the standard of living. Increasing the per capita income seems to be the objective here.

In less developed countries development of the agricultural sector is of great importance as a large number of workers engaged here have primarily a low level of income. Development of the industrial sector, transport, commerce, foreign trade also helps to improve the overall standard of living of a country.

Ensuring a sustainable level of investment seems to be the goal with scope for future growth. This will go a long way in fulfilling the desires of the people.

3. Reduction of Inequalities in Income and Wealth

Uneven distribution of income and wealth can be seen in almost every country in varying degrees. When wealth and income gets concentrated in the hands of a few, it becomes a very harmful thing for every economy and society.

Redistribution of income and wealth is absolutely necessary from time to time, and its duty lies with the government. The government can do this by revising the tax system, thereby collecting more taxes from the rich and giving tax relief to the poor. Excess tax collected from the rich can be spent by the government to provide free education, free medical facilities, low cost housing etc. to the poor. Ensuring minimum level of wages, giving foods at a subsidized price are some other measures through which the inequality can be eliminated to some extent. However, in a free economy some level of inequality will always be there.

4. Keeping the Value of Money Stable

A stable price level is always necessary for the well being of the people of a country as well as for its economy. Rising price level reduces the real income in the hands of people. They can buy less things with their income. Income does not increase at par with rises in price level. So rising level of prices affects the living standards of middle class and the poor.

When prices fall, producers start producing less to curtail the supply with an expectation that it will bring the price level up again.

Through adoption of various fiscal and monetary measures a government can keep the price level steady to a great extent, though some fluctuations will always be here. Fiscal and monetary measures help to keep the value of money stable.

5. A Stable Currency and Banking System

Money is the central element of every economy. In order for the economy to function healthily a good, stable currency system is necessary. This is connected with the banking system of a country, which handles the major portion of the currency. A government should ensure a sound banking and currency system so that the economy can function smoothly.

6. Controlling Monopolistic Practices

Monopoly is harmful for the society as well as the economy. Consumers get exploited by it as they have to pay higher prices charged by the monopolists. Monopolists can control affairs unfairly by paying lower wages to workers and thereby increasing their profit. This promotes income inequality. So it is the duty of the government to curb the growth of monopoly.

7. Better Terms and Conditions

As labourers are poor, they cannot bargain with their employers. So they somehow have to accept the terms and conditions of work laid down by the employer. Such terms and conditions may at times be unfavourble for the labourers. Here the government must step in and make laws in order to protect the interests of the labourers. There should be laws to govern the pay, the working conditions as well as the welfare and other benefits of the workers.

8. Social Security

Financial insecurity is in itself a very serious thing that affects everyone. When there is sickness, accident, death or unemployment, the poor finds it very difficult to tackle the situation. They do not have savings to fall back upon. In such situations it is the duty of the government to come to the help of the poor.

A fund is created where the worker, employer and the government contributes. When some worker falls sick, meets with an accident etc. he is provided with a certain amount out of that fund to tackle the situation. Old age benefits, pensions to widows, orphans, maternity benefits, unemployment benefits etc. can also be provided out of this fund. Thus social security eliminates certain insecurities of the poorer sections of the society. In case of social security contributions made by the government is of prime importance as contributions made by the workers and employers are highly inadequate. Governments of developing countries have fewer funds to contribute in this regard.

Shut Down Conditions of a Firm - Short Run and Long Run

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Short Run Decision

In the short run, a profit-maximizing firm will:

increase production if marginal revenue is greater than marginal cost
decrease production if marginal revenue is less than marginal cost

The shutdown rule is that in the short run a firm should continue to operate if price is greater than average variable costs. In the short run a firm must earn sufficient revenue to cover its variable costs. When a firm shuts down operation, it does not incur any variable cost. However, the firm still has to bear its fixed costs. Because fixed cost must be paid irrespective of whether a firm operates or not, fixed costs should not be considered in deciding whether to produce or shutdown.

Total variable cost/Quantity = Average variable cost (AVC)
Total Fixed cost/Quantity = Average Fixed cost (AFC)
Average variable cost (AVC) + Average Fixed cost (AFC) = Average total cost or Average cost (ATC/AC)

1. When P > AVC, the firm is covering all variable cost plus there is additional revenue or contribution, which can be applied to fixed costs. The size of the fixed costs is not relevant in this regard as it is already spent.
a) P < AC - part of fixed cost remains uncovered. The firm will continue production.
b) P = AC - The firm is at break even earning only normal profit. It is at minimum average cost. The firm will continue production.
c) P > AC - the firm is making economic profit. The firm will continue production.
2. P = AVC - Whole fixed cost remains uncovered, but covering the whole variable cost. The firm will continue production.

3. P < AVC - The firm cannot cover even the variable expenses. This is a shut down point. The shut down point is at the minimum of the average variable cost curve.

When a firm decides to shut down, it is really a temporary suspension of production. The firm is not going out of the industry. It may again resume production if situation becomes favourable. Hence shutting down is a short-run affair. A firm that has decided to shut down operations cannot avoid its fixed costs.

Long Run Decision

Leaving the industry is a decision that can only be taken in the long run. When a firm exits, it basically winds up all its operations. The capital resources thus get free for use in another venture. In the long run, so long as the price is greater than or equal to average variable cost, the firm should not wind up its operations. If marginal revenue is equal to marginal cost, the firm should operate. If price is less than average variable cost and total revenue is less than total cost, it is advisable for the firm to leave the industry.

Also read: Perfect Competition - Short Run Equilibrium
Perfect Competition - Long Run Equilibrium

Perfect Competition - Long Run Equilibrium

Before reading this, read: Perfect Competition - Short Run Equilibrium

The long run is a period of time in which the quantities of all inputs are variable. The distinction between short run and long run varies from one industry to another. The plant capacity, which is considered as fixed in the short run, can also be considered as variable in the long run. It is assumed that in the long run all firms have made necessary long-term adjustments. The short run is a period of time in which the quantity of at least one input is fixed and the quantities of the other inputs can be varied.

In the long run it is impossible for a perfectly competitive firm to hold on to its short run economic or supernormal profit. The firm, in the long run, earns just enough profit to cover its economic (opportunity) costs.

As there is supernormal profit in the short run, new firms enter the industry. On the other hand, less efficient firms may be forced to move out of the industry. As new firms enter into the industry, they increase the supply of the product in the market. Competition among all the firms brings down the price of the product. More and more new firms, offering products at lower prices, bring down the market price of the product further.

The market price of the product, and with it the demand, will thus keep coming down until all the firms earn only normal profits. All of the economic or supernormal profit gets wiped out or disappears. Only in perfect competition P = AR = MR. Firms thus have no eagerness to enter or exit the industry. As short run economic profit disappears, there is no incentive for other firms to enter the industry. As the firms do not incur economic loss or earn below-normal profit, there is no urge for the firms to leave the industry.

As there is only 'normal profit', revenue is equal to cost, or average revenue (AR) is equal to average cost (AC). Equilibrium occurs where the AR curve (demand curve) is tangent to the AC curve at the only possible point of tangency, the minimum point. At the equilibrium point D, the equilibrium condition P=AC=AR=MC=MR is satisfied.

Equilibrium output OB is the profit-maximizing output as MC=MR. Equilibrium price is OA. Rectangle OADB represents the total cost, which is equal to total cost.

The firm's long run supply curve is the long run marginal cost curve above the minimum long run average cost curve (AC curve).

Remember that marginal cost rises less sharply in the long run, making the long run marginal cost curve flatter than what it is in the short run.

Also read: Shut down Conditions of a firm

Perfect Competition - Short Run Equilibrium

In the model of price and output determination under perfectly competitive market conditions, price is determined by the impersonal market forces of supply and demand, and not by individual actions of buyers and sellers. The individual firm in such a market may be said to be a price-taker. Perfect competition is used by economists not so much as an attainable goal, but as a pure state against which all other markets can be measured.

For a market to be perfectly competitive, the following necessary conditions must, in general, prevail.

1. There must be many firms acting independently. Each firm is small enough relative to the size of the market, so that a single firm's decision to either stop production entirely or to produce to full capacity will not have any perceptible effect on market supply to cause a change in market price.

2. Entry and exit from the market are free and frictionless for both the firms and consumers.

3. The products offered for sale are homogeneous and divisible into small units.

5. Buyers and sellers have perfect knowledge about the market conditions.

6. Price is determined by the impersonal market forces of supply and demand, and not by individual actions of buyers and sellers. The individual firm in such a market may be said to be a price-taker.

7. There is perfect knowledge among consumers about the price at which goods are being sold in the market. Sellers thus cannot manipulate the commodity price and thereby exploit the consumer.

8. There is perfect mobility of goods and factors of production among firms. Uniformity in factor prices is prevalent in the market.

If these necessary conditions prevail, the firm can lose its entire market if it sets its price above the market price. It can also expect no gain by lowering price, since it can sell all it wishes to produce at the market price. The competitive firm has no price discretion. Market price will not be affected by the independent action of a single firm. No firm is able to influence market price.

The objective of each firm is to maximize profit. Profit is the difference between revenue and cost of production. Marginal cost (MC) is the cost incurred to produce an additional unit of the product. If the per unit price of a commodity is greater than the marginal cost, the firm will be interested in producing more of the commodity. On the other hand if price falls below marginal cost, the firm will curtail its production.

Equilibrium condition will prevail at a point where profit is maximized. This happens where price is equal to marginal cost (P = MC). Also at the point of equilibrium, the marginal cost curve must be upward sloping.

Average Revenue (AR) = Total Revenue/No. of units sold.

Since the price is set by impersonal forces of supply and demand and every individual firm is a price taker, the average revenue (AR) curve is a straight line, parallel to the X-axis. Price always remains the same and is equal to AR. Marginal revenue (MR) is the price at which an additional unit may be sold. Since this can be done only at the current market price, marginal revenue is equal to average revenue (MR=AR) and the marginal revenue curve is the same as the average revenue curve (MR curve = AR curve). This is the demand curve for the firm. It is perfectly elastic as it is parallel to the X-axis.

The short run is a period of time in which the quantity of at least one input is fixed and the quantities of the other inputs can be varied. In the short run an increase in the variable input results in an increase in the marginal productivity of the variable input. When first few quantities of a variable input are added to a fixed input, marginal returns from the variable input flow in an increasing rate.

As marginal returns flow in an increasing rate and average fixed cost starts declining, the marginal cost per unit starts falling and the marginal cost curve shows a downward slope. After some time, as more and more of the variable input is combined with the fixed input, the marginal productivity of the variable input eventually starts declining.

So with diminishing returns, the marginal cost per unit starts increasing and the marginal cost curve starts showing an upward trend. This explains the U-shape of the marginal cost curve.

Short Run Equilibrium of a perfectly competitive firm

In the short run total fixed cost remains unchanged. So any change in total cost is caused by changes in the total variable cost in the short run. Marginal cost is the cause of change in total cost or total variable cost. Marginal cost is defined as additional variable cost incurred due to an additional change in output.
Similarly the average cost curve also takes an U-shape like the marginal cost curve. As production increases, both marginal cost curve and the average cost curve rises due to the Law of Diminishing Marginal Productivity. As the MC curve lies below the AC curve, while rising it cuts the AC curve at its minimum point. A perfectly competitive firm's supply curve is the portion of its marginal cost curve that lies above the minimum of the average (variable) cost curve.

In the short run, the demand curve, namely the average revenue curve, and the supply curve, namely the marginal cost curve, intersects at two places, E' and E. The profit maximizing P = MC is satisfied at both the points. If the firm continues to produce even after E', it will still be able to increase its revenue as marginal revenue or price will continue to be greater than marginal cost till the point E. So the firm continues production up to point E. Thus E is the point of profit maximization. E' is the point of loss minimization since until E' the marginal cost curve lies above the marginal revenue curve. E is the profit-maximizing point where the MC (supply) curve cuts the MR (demand) curve from below. Equilibrium output is OB and equilibrium price is OC. Rectangle OCEB shows the total revenue and rectangle OADB shows the total cost. Profit is shown by the rectangle ACED, which is basically 'economic profit'.

A few points

1. Price = Marginal cost (P=MC) shows the economic efficiency of the firm.
2. Marginal cost=Marginal revenue (MC=MR) is the standard condition for profit maximization. This gives the highest economic profit to the firm.
3. Price=Average revenue=Marginal revenue (P=AR=MR) shows that
a) a perfectly competitive firm has no market control
b) price is determined by the combined forces of demand and supply. The firm can sell any or all of its production at this going market price.
c) the firm is a price-taker.
d) the firm faces a perfectly elastic demand curve equal to market price.

Also read: Perfect Competition - Long Run Equilibrium
Shut down Conditions of a firm

Opportunity Cost, Normal Profit, Economic Profit and Accounting Profit

Opportunity Cost:

Supply of economic resources is limited. Scarcity is fundamental to the study of economics. If certain resources are used somewhere, it can no longer be used anywhere else. When such limited resources are used to satisfy certain wants or needs, it means many alternative uses of those resources automatically get overlooked. All those alternatives that get overlooked can be evaluated in terms of returns or satisfaction that could have been derived out of them, had the resources in question been put into use in each of such alternatives, or had each of such alternatives been pursued. The highest valued return or satisfaction thus foregone in the pursuit of one activity is called the Opportunity cost. This is because of the mutually exclusive nature of the use of such economic resources. Doing one thing means foregoing many others. Economic wants are unlimited but resources are limited. Thus opportunity cost is the highest valued foregone or sacrificed return from an alternative use.

Put in another way, Opportunity cost is the benefits or returns a firm could have received by taking an alternative course of action.

An opportunity cost can be either explicit, usually involving a monetary payment, or implicit, which does not involve a monetary transaction. Opportunity cost is also known as economic cost. In economics, cost primarily means economic cost. It is different from the term 'cost' used by accountants, which is more financial by nature. However, all economic costs are not accounting costs and vice versa.

Opportunity cost does not consider all alternatives foregone. It is concerned only with the foregone alternative use that would have fetched the highest return or satisfaction. When a particular activity is pursued, it is assumed that it is the most beneficial and economic use of the resources that are being used to pursue that activity.

Normal Profit:

Normal profit is the opportunity cost of using entrepreneurial abilities in the production of a commodity, or the profit that could be received by entrepreneurship in another business venture. Entrepreneurship used in the production of a certain commodity can as well be used in the production of another commodity. But both cannot be done together. Profit that could have been earned from the venture that is foregone is the opportunity cost of the venture that is undertaken. This is termed as the normal profit. Normal profit represents the total opportunity costs (both explicit and implicit) of a venture to an entrepreneur.

Use of every resource has an opportunity cost. Like the opportunity cost of all other resources, normal profit (foregone profit) is deducted from revenue to determine the economic profit. It is however, never included as an accounting cost when accounting profit is calculated.

Thus, normal profit is the profit that could be earned in another activity elsewhere. It is the profit that could be earned in an alternative venture.

Normal profit is different from accounting profit because opportunity cost is taken into consideration.

Normal profit is the minimum level of profit needed for a firm to remain competitive in the market.

Normal Profit + economic profit = accounting profit (current activity profit)

Or, Current activity profit (accounting profit) - normal profit = economic profit

If economic profit is greater that zero, Then the current activity is better; it is giving more earning.

If economic profit is less than zero, (though accounting profit from current activity is positive), switching entrepreneurship to the other activity is advisable. That would generate more earning.

Normal profit is not deducted from revenue to calculate accounting profit. The foregone profit is the opportunity cost of entrepreneurship and is deducted from revenue to calculate economic profit.

Economic Profit:

Economic profit is the difference between the total opportunity cost of production and the total revenue received by a firm. Economic profit is what remains after all opportunity costs associated with production, including normal profit (entrepreneurial opportunity cost) is deducted from the revenue generated by the production. Opportunity costs are the alternative returns foregone by using the chosen inputs.

Economic profit acts as an indicator when the focus is turned towards efficiency. In a perfect world, no firm receives economic profit. Firms receive economic profit only when price exceeds opportunity cost of production (including entrepreneurial opportunity cost).

Economic profit = Total revenue - total (opportunity) cost (including normal profit).

A firm can stay in business without economic profit or supernormal profit or above-normal profit. It can continue producing goods and services so long as it is able to pay all opportunity costs. One critical opportunity cost is normal profit. Because accounting profit is generally the combination of normal profit and economic profit, zero economic profit does not mean zero accounting profit. A firm can continue by earning normal profit only.

Total revenue - Opportunity cost of all resources associated with production (including opportunity cost of entrepreneurship)
= Economic profit

Total Revenue - $100 million
Total Cost - $60 million
Entrepreneurial opportunity cost or normal profit (Profit that can be earned from alternative venture) - $30 million

Current activity profit (accounting profit) = $(100 - 60) million = $40 million

Current activity profit (accounting profit) - normal profit = economic profit
That is, $(40 - 30) million = $10 million (economic profit)

In another way,

Total revenue - Opportunity cost of all resources associated with production (including opportunity cost of entrepreneurship)

= Economic profit

That is, ${100 - (60+30)} million = $10 million (economic profit)

Accounting Profit:

Accounting profit is the difference between total revenue earned and the explicit accounting costs incurred to earn the revenue.

Accounting profit differs from economic profit because there is a difference between accounting cost and economic cost. Some accounting costs are not economic costs, and vice versa.

In reality, opportunity costs of all other resources associated with production tends to be equal to explicit accounting cost incurred to earn the revenue.

Automatic Stabilizer and Discretionary Fiscal and Monetary Policy

In a stable economy relative prices and outputs must be free to vary with changes made in technology, tastes and preferences of consumers and suppliers of factors of production, namely land, labour and capital.

An automatic stabilizer is any feature of the economic system, which automatically tends to reduce the strength of recessions or inflations without any policy changes being made. Automatic adjustments in expenditures or revenues take place to bring about economic stability without deliberate government intervention.

This can be shown in the following diagram.

Taxes act in such a way that the economy is automatically stabilized. At full-employment National Income NP1, tax revenues are just adequate to cover government expenditure (E). Now if business activity falls and the economy swings down into a recession to NP2, tax collections fall as income falls, and the budget automatically moves towards a deficit. CD measures the amount of deficit at NP2. As tax collections fall, more disposable income is left in the hands of the public. Thus the downward trend is checked as demand increases, and the budget deficit is wiped off.

The tax system also acts as a restraint to upward swing. As National Income rises from NP1 to NP3, tax collections rise and this produces a budget surplus. As a result the disposable income in the hands of public is reduced. This reduces the demand and subsequently inflation. Thus the upward momentum is slowed down.

The degree of automatic stabilization depends on the tax rates. Higher the tax rates, higher will be the degree of stabilization.

Automatic stabilizers are there on the government expenditure side also. During recession unemployment, insurance, compensation and welfare expenditures automatically rise. This maintains the sufficient level of disposable income and checks recession and downward swing by increasing the aggregate demand. The opposite thing happens in case of inflation and budget surplus.

Discretionary Fiscal Policy

Automatic stabilizers can never fully stabilize the economy. So government action is necessary to make the economy stable.

The principal weapons of discretionary fiscal policy are

a) Varying public works and other expenditure programmes
b) Varying transfer expenditure programmes (welfare, subsidy, social security etc.)
c) Varying rates of tax cyclically

Discretionary variations in transfer expenditure programmes and tax rates may have greater short-run stabilizing effects.

Monetary Policy and Fiscal Policy

An important function of the modern government is the attempt to prevent chronic unemployment and stagnant growth and to wipe off the effects of demand inflation or deflation.

Monetary Policy: It is the policy of the Central Bank, which aims at changing the quantity of money or credit conditions. There are various ways like open market operations, change in discount rate etc. The main aim is to ensure that the monetary conditions are consistent with the achievement of the goods of high employment and stable prices.

Fiscal Policy: The government has the ability and responsibility to manage the aggregate demand to ensure a continued prosperity or sustained growth without unemployment and inflation. Fiscal policy is the tool by which the government can affect the aggregate demand. Fiscal policy means change in government expenditure or tax rates.

During depression the government initiates work on public investment projects for the unemployed. These investments are primarily aimed to create work for the people. But the effect of public works on the economy is felt after a certain time. There is a time lag between the launching of the project and generation of production and employment.

Therefore during a mild recession economists rely more on monetary policy than on public works programme (fiscal policy). However, fiscal measures are not to be dispensed with. They should be carried on for their own sake and over long periods of time.

Transfer expenditure programmes (welfare, subsidy, social security etc.) may also be undertaken to stabilize the economy. The government can stop giving some veteran's bonus in inflationary times to bring down the disposable income and aggregate demand and disburse them during periods of depression.

Variation of tax rates: If the economists think that the recession will be brief, a temporary tax cut may prevent income and demand from falling, or a tax rise may be used to eliminate extra demand and inflationary gap.

However there is a need for coordination between fiscal policy and monetary policy. It will not be proper on the part of a government to adopt a restrictive monetary policy when the demand is increasing as a result of an expansionary fiscal policy. An optimum mix of the two must be chosen by the government. In short, fiscal policies, along with stabilizing monetary policies, can provide a favourable and stable economic environment, giving the people a maximum opportunity for achievement.

Automatic Stabilizer Versus Discretionary Fiscal and Monetary Policy

While automatic stabilizers reduce the severity of economic fluctuations, they do not eliminate them. The objective of Discretionary Policy is to reduce the fluctuation even more. So a government should stress on two things.

1) The automatic stabilizers are the first line of defense, but are not sufficient to maintain full stability.

2) Reliance on them in preference to discretionary programme raises some philosophical and ethical questions.

In short, a built-in stabilizer acts to reduce part of any fluctuation in the economy, but does not wipe out 100 per cent of the disturbance. It leaves the rest of the disturbance as a task for fiscal and monetary discretion.

Also read: Role of Fiscal Policy and Monetary Policy

Theory of Consumption - Revealed Preference Analysis

Introduction: In 1960 Mr. Samuelson introduced the Revealed Preference Analysis to explain the behaviour of the consumer. The fundamental difference between the Utility Analysis, Indifference Curve Analysis and Revealed Preference Analysis is that when the first two are based on the psychology of the consumer, the revealed Preference is based on the actual behaviour of the consumer.

Assumptions: In order to explain the behaviour of the consumer with the help of Revealed preference Analysis, Mr. Samuelson made the following assumptions.

1. Utility cannot be measured.

2. The consumer always prefers more of a good to less, until his income is exhausted.

3. It is based on the Principle of Strong Ordering. This means that if the consumer is given many commodities, he can place them in order of his preference.

4. It is based on the Principle of Consistency, and the consumer acts consistently. 'Consistency in choice' means that if the consumer chooses the commodity combination P in preference to all other combinations, then he will never subsequently choose any combination from the rejected ones in a situation in which P is also available. This is the key to this approach.

5. The choice made by the consumer will reveal the preference of the consumer for the commodity. If he chooses P over Q, then this choice reveals his preference for P.

6. The consumer's preference pattern maintains transitivity. If the consumer prefers P over Q, and Q over R, Then he definitely prefers P over R.

The substitution effect is always non-positive. It can never result into a reduction in the purchase of the commodity whose price has fallen.

In order to find out the consumer's equilibrium position with the Revealed Preference Analysis, we make the following assumptions.

1. The consumer has a fixed amount of income.
2. There are only two commodities available in the market, namely A and B.

On the basis of these assumptions we can now draw the following diagram and find out the consumer's equilibrium position.

Let us assume that the price line or budget line is XY. It represents all combinations of commodities A and B available to the consumer. The consumer can choose any of the combinations of commodities A and B, lying within, or on border of the shaded triangle OXY.
We now assume that out of all the combinations available to him, the consumer chooses to consume Oa of commodity A and Ob of commodity B. This combination is represented by the point P. Thus the consumer has chosen the combination P in preference to all other combinations lying within the triangle OXY. So in future he will never choose any combination from triangle OXY in a situation where P is also available.

Now there is a fall in the price of commodity B. The price of commodity A and the income of the consumer remains constant. Given the same income, the consumer can still consume OX of commodity A by spending all his income on commodity A. Also as the price of commodity B has fallen, he can consume OZ of commodity B instead of Ob, by spending all his income on commodity B. Therefore, XZ is the new budget line.

A fall in the price of a commodity is equivalent to an increase in real income. This income effect needs to be eliminated. This is done by moving the new budget line XZ towards the origin O, keeping it parallel to its original position, until it passes through point P. So the new budget line is X'Z', where the consumer is able to purchase his original combinations of commodities A and B at P, but at the new set of prices. (new price for commodity B only; price of commodity A has not changed). The consumer can now choose any point on X'Z'.

Considering the segment X'P: All points on segment X'P were available to the consumer before the fall in the price of commodity B. All these points were within the triangle OXY and rejected by him originally in favour of the combination at point P. So, in the new situation, where P is still available, he will definitely choose P rather than a combination previously rejected. This is because the consumer moves according to the Principle of Consistency.

Considering the segment PZ': The segment PZ' represents combinations of commodities which were not previously available to the consumer. It would therefore be quite consistent for the consumer to choose some combination along the PZ' part of the new budget line. This could mean consuming more of commodity B, whose price has fallen.

This implies that the consumer either consumes same quantity of commodity B as before by remaining at point P, or more of the commodity B by choosing a point on the segment PZ'. The consumer selects the point Q. If we now restore the income effect and return to the changed budget line XZ, the consumer will move to R on the changed budget line XZ, as a result of both income effect and substitution effect, where bc (the price effect) = bs (the substitution effect) + sc (the income effect).

Conclusion: The substitution effect can never lead the consumer to buy less of a commodity whose price has fallen.

Unless the income effect is negative and of sufficient magnitude to neutralize the substitution effect, under the assumption of consistency in choice, the demand curve of a consumer for any product will slope downward to the right.

Criticism: Some economists have said that this analysis is based on the assumption of Strong Ordering. But according to the critics if the consumer is given many commodities it will not be possible for him to follow the Principle of Strong Ordering. In the case of many commodities there may be a stage where the consumer will be indifferent.

Though there are some defects in this analysis, the advocates of this analysis regard this as superior to the other two because it is based on the actual behaviour of the consumer. So according to them this is more scientific because it is based on the actual behaviour of the consumer.

General Equilibrium Theory - Overview

Micro-economics is the study of the behaviour of isolated economic entities as individual consumers, firms or industries. It deals with the division of the total output among individuals, industries, products, and firms and the allocation of resources among competing users. It looks at the whole thing with a singular point of view.

Contrarily, macro-economics is the study of the behaviour of the economy as a whole, as measured by the aggregate value of such variables like the aggregate volume of output of an economy (GNP), the extent to which its resources are employed, the size of the national income, the price level (i.e. whether there is inflation, deflation or price stability), and the level of employment. It is concerned with the overall dimension of economic life. It looks at the size, shape and functioning of the whole economic system.

General equilibrium theory actually forms a bridge between these two branches of economic theory and uses the tools of micro-economics to analyze the behaviour of the entire economy.
In common with macro-economics, general equilibrium theory is concerned with inter-relationships that exist among the markets for goods and services in the economy.
In common with micro-economics, the analysis in general equilibrium theory is carried out in terms of individual decision-makers and commodities, rather than in terms of aggregates.
The fundamental questions that general equilibrium theory attempts to answer are the same as those posed in macro-economic theory. Given different economic environments, what goods will the economy produce, how will these be produced, and who will obtain them? But, whereas macro-economics provides answers in terms of aggregates, general equilibrium theory provides answers in terms of the individual consumers, producers and commodities making up these aggregates.

Micro-economics may be regarded as a simple form of general equilibrium theory in which the decision makers in the economy are the consumers, the producers and the government. The consumer has to make decisions with respect to the allocation of his income between consumption and saving, the amount of labour he is to supply, and the form in which he will hold his wealth (money or security). The producer, in his turn, has to take decisions on the number of units of labour to hire to produce a particular commodity, which may be used either as a consumption or as a capital item. The producer has also to determine how much units to set aside for production in future. The resulting interaction among these consumption, wealth-holding, and production decisions determine such variables as the price of a commodity, the interest rate, the number of units of labour and capital employed, the number of units of output, their distribution cost etc. within a framework of government policies, namely fiscal and monetary.

Macro-economics provides simple and straightforward answer to such questions like which goods will be produced and how, and also who will acquire them. General equilibrium theory has a much more ambitious goal - that of analyzing the operations of the economy, explicitly taking into account of such things as the diversity of consumption and capital goods, and the varying tastes and preferences and wealth and income positions of consumers, as well as the differences in technological possibilities available to production firms. To quote J. K. Galbraith: "There is also the world of farmers, repairmen, retailer, small manufacturer, plumber, television repairmen, service station operator, medical practitioner, artist, actress, photographer..... In economics, as in anatomy, the whole is much more than the sum of the parts." The analytical framework of general equilibrium analysis is that of micro-economics.

The essential theme of general equilibrium analysis is that all markets are interrelated (commodity market, labour market, money market, capital market, stock market etc). It deals with interconnected markets and emphasizes the inter-relationship of prices and output of various goods and factors of production. Consumers spend their incomes on all commodities, and the demand for each commodity depends upon all prices. If the goods A and B are gross substitutes, an increase in the price of A will induce consumers as a whole to substitute B for A. The opposite would be the case if A and B were compliments. Likewise pairs of inputs may also be defined as substitutes and compliments. Furthermore, production and consumption are not independent. Consumers earn their incomes from the sale of labour, services, and other productive factors to producers. Similarly they spend their incomes on goods and services produced by the firms. Thus business firms earn their income from the expenditure made by consumers. As a consequence, equilibrium from all commodity markets and factor (land, labour and capital) markets must be determined simultaneously in order to secure a consistent set of prices.

The general equilibrium theory uses utility and production function of consumers and producers, prices of all factors of production and commodities, and quantities purchased by each consumer and producer. Consumers and producers behave in a manner to maximize their utility and profit correspondingly, and there exists a set of equilibrium prices, with which all the markets will be cleared. Existence of a competitive economy is assumed, and the general equilibrium analysis is done with a relative price concept in view. Absolute prices are nor relevant.

General equilibrium theory deals with the fundamentals of supply and demand within an economy where there are a group of markets. It considers all markets in totality. Its objective is to prove that all input and output prices are at equilibrium. It was initially done by Leon Walras, a French economist in the year 1870. The concept was revised by Gustav Cassel in 1932. It is popularly known as the Walras-Cassel Model.