CVSRTA-Land_and_Building (5) PDF Study Material

STUDY MATERIAL FOR THE EXAMINATION IN THE DISCIPLINE OF LAND AND BUILDING PREPARED BY: CENTRE FOR VALUATION STUDIES, RESEARCH AND TRAINING ASSOCIATION...

STUDY MATERIAL FOR THE EXAMINATION IN THE DISCIPLINE OF LAND AND BUILDING PREPARED BY: CENTRE FOR VALUATION STUDIES, RESEARCH AND TRAINING ASSOCIATION (CVSRTA) CVSRTA - 1 CVSRTA - 2 CVSRTA - 3  Centre for Valuation Studies, Research and Training Association, India (CVSRTA) Regd. Office: 8/1, Meghal Service Industrial Estate, First Floor, Devidayal Road, Near Johnson & Johnson, Mulund (West), Mumbai – 400 080. Tel. No.: (022) 25682817 Registered under Society’s Registration Act, 1860, Admn. Office: ‘AMI’, Plot No.3, Rainbow Park – ‘A’, Vidyanagar Road, Maharashtra State, Mumbai Karamsad – 388 325 District Anand, Gujarat. under no. 816/2010, G.B.B.S.D. Tel. No.: (02692) 222 018 dated 30/03/2010 Email: [email protected] http://www.valuationstudies.in Chairman Secretary Treasurer Kirit P. Budhbhatti Nelson J. Macwan Sundeep H. Bikhchandani BE. (E), FCVSRTA BE(C),M. Val.(RE&PM),LLB(Gen) BE(M), M.Val.(RE&PM), MIE (C), FIS, FIV FCVSRTA, MIS, FIV, MIE MRICS FCVSRTA,FIV Mobile: +91 98211 41333 Mobile: +91 99982 16236 Mobile: +91 98202 35744 Centre for Valuation Studies, Research and Training Association (CVSRTA) considers itself privileged to prepare the study material for the examinations in the disciplines of Land and Building as well as Plant and Machinery conducted by the Insolvency and Bankruptcy Board of India (IBBI) which will be beneficial to professionals in India. CVSRTA is thankful to IBBI for giving an opportunity to prepare the material. Kirit P. Budhbhatti Chairman - CVSRTA CVSRTA - 4 First Edition February, 2019 IMPORTANT NOTICE The views and interpretations contained within the book are entirely those of the author. Whoever adopts any of the views or interpretations contained within this book does so entirely at his or her own risk and the author shall not be responsible for any consequences resulting from adoption of such views or interpretations or any content of the book. Centre for Valuation Studies, Research and Training Association C/o, Sundeep H.B. & Co, 8, Meghal Service Industrial Estate, Devidayal Road, Near Johnson & Johnson Mulund (West), Mumbai – 400 080, India. Phone: +91 (0) 22 25682817 E-mail: [email protected] All rights are reserved. No part of this publication may be reproduced, stored in retrieval system or transmitted in any form known or unknown or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior permission of the publisher in writing. To err is human. Improvement is a continuous process. Therefore, any mistake, error or discrepancy noted may be brought to the notice of author/publisher, which shall be taken care of in the further editions. CVSRTA - 5  LAND AND BUILDING SUBJECTS PRESCRIBED  PRINCIPLES OF ECONOMICS (7)  ** BOOK KEEPING AND ACCOUNTANCY (322) **  LAW – GENERAL(439)**  INTRODUCTION TO STATISTICS (757) **  ENVIRONMENTAL ISSUES IN VALUATION (856)**  PROFESSIONAL ETHICS AND STANDARDS (933) **  PRINCIPLES OF INSURANCE AND LOSS ASSESSMENT (939)**  LAW- REAL ESTATE (1007)  VALUATION OF REAL ESTATE (1279)  REPORT WRITING (1834)  CASE STUDIES (1854) NOTE: ** This indicates the subjects common to both the disciplines Land & Building and Plant & Machinery and the study material for these subjects will be found along with the study material of Plant & Machinery. CVSRTA considers itself lucky to do pioneering work in introducing the valuation courses in the disciplines of real estate and plant & machinery in India under full time as well as distance learning and developing the course material since 1994 by the outstanding valuers from length and breadth of India. This study material also the result of the efforts by the experts. CVSRTA - 6  PRINCIPLES OF ECONOMICS Author - Mr. Sunny Thomas M.A., LLB, BPH, LLM, Ph.D., NET Subject Editor - Dr. Wahida Thomas M.A., M.phil, MBA, Ph.D., NET Language Editor - Mr. Sunny Thomas M.A., LLB, BPH, LLM, Ph.D., NET CVSRTA - 7  ACKNOWLEDGEMENT Centre for Valuation Studies, Research & Training Association (CVSRTA) is thankful to the author of this subject Mr. Sunny Thomas for preparing the study material, editing the same and also surrendering his right in favor of CVSRTA to get copyright in favor of CVSRTA. CVSRTA is also thankful to Dr. Wahida Thomas for rendering the service as subject editor. Kirit P. Budhbhatti Chairman, CVSRTA 1 CVSRTA - 8  INDEX Sr. No. Unit No. Content Page No. 1 I Definitions and Connotations 3-25 2 II Consumption 26-48 3 III Demand and Supply 49-86 4 IV Production 87-97 5 V Pricing of Product 98-131 6 VI Pricing of Factors (Distribution) 132-182 7 VII National Income 183-214 8 VIII Theory of Money 215-232 9 IX Saving, Investment and Banking 233-298 10 X Parallel Economy 299-314 2 CVSRTA - 9  UNIT – I DEFINITIONS AND CONNOTATIONS 1.1 INTRODUCTION Economics can be divided into three parts, namely, descriptive economics, economic theory, and applied economics. In descriptive economics one collects together all the relevant facts about a particular phenomenon. While economic theory or analysis gives a simplified version of the way in which an economic system functions. Applied economics takes the framework of analysis provided by economic theory. There are three broad assumptions namely assumptions regarding behaviour of individual. Economists are concerned with people as consumers and as businessmen. When economists discuss the actions of consumers, they assume that they behave rationally. It means that they try to maximize their satisfaction with minimum possible expenditure. In the same manner, economic theories assume that the businessmen try to maximize their profits. It is their economic rationality. The second group of assumptions is about the physical structure of the world i.e. natural conditions. They always remain to be given. It is these conditions give rise to economic problem because resources are limited in relation to their demand. Therefore, goods and services are scarce in supply. The scarcity of resources leads to economic system and economic problem. What is worse is that the scarce resources have alternative uses. This makes all the more difficult for human being to solve economic problems. The third group of assumptions relates to social and economic institutions. Under this group of assumptions, comes political stability. Without which neither consumers nor producers attain their goals. For economic prosperity, political stability is a must. Applied economists are often concerned with ‘test’ theory studying statistical and other evidence to discover if it appears to support particular economic theory. Hence, economics is concerned with a study of one of the aspects of human beings. It enquires into how a human being gets his income to satisfy his unlimited wants with limited means. It deals with day-to-day activities of human being relating to his efforts of maximizing his satisfaction. Therefore scope of economics centers around wants – efforts – satisfaction. 3 CVSRTA - 10  Economic problem begins with human wants and ends with satisfaction of those wants. Economics is concerned with every human being poor as well as rich. In nutshell it could be deduced that science of economics enquires into how a consumer attains his income and spends it in order to achieve maximum satisfaction with minimum efforts or expenses. 1.2 DEFINITION OF ECONOMICS A good number of definitions of economics have been numerated but we shall be dealing with three main definitions given by Adam Smith who is considered to be the father of economics, Dr. Alfred Marshall and Prof. L. Robbins. Adam Smith called economics as “Science of Wealth”. He emphasized wealth because in days of Adam Smith monarchy was in existence. The kings were interested in amassing wealth for their military operations. Hence, Adam Smith emphasized wealth. He paid attention exclusively to wealth. He totally neglected role played by man. Wealth has no significance if there is no man to make use of it. Wealth attains importance if it is considered in relation to man because wealth is not be all and end all of human life. It is simply a means to end and the end being the maximum welfare of the society. According to Dr. Alfred Marshall “Economic is a study of man’s actions in the ordinary business of life; it enquires how he gets his income and how he uses it – Thus it is on one side a study of wealth and on the other, and more important side a part of the study of man.” Dr. Marshall in his definition of economics makes it clear that in economics how human being earns his living by earning income and spending it for maximization of his welfare. Marshall shifted emphasis from wealth to man. Production of wealth and using it for his welfare is stressed by Marshall. Thus Marshall’s definition covers consumption, production, exchange and distribution. Marshall pays more attention to material welfare of man which is obtained by using economic resources rationally. Thus, Marshall accords secondary position to wealth. Economics concerns with ordinary men and women who are motivated by maximum advantages that is welfare. He holds that it is a social science which studies individual behaviour also. It is therefore economics ignores non-material aspects. 4 CVSRTA - 11  However, Marshall’s definition is criticized by Prof. Lionel Robbins on the following grounds: 1. It is classificatory. 2. It is concerned with material welfare alone narrowing the scope of economics. 3. Marshall’s definition totally neglects the non-material services. 4. No clear-cut distinction is made between ordinary business of life and extraordinary life. Wealth and welfare cannot go together. Wealth like poison does not increase the welfare. Non-material things like love and affection also raises the human welfare, which Marshall totally neglected. Moreover concept of welfare is subjective. It varies from person to person, time to time and place to place. The term welfare may land us in the domain of ethics. Prof. Lionel Robbin held that economics is neutral between wants. Economics is not concerned with the causes of material welfare as such. It is for this reason Robbins held that Marshall’s definition is narrow, classificatory and unscientific. 1.2.1 LIONEL ROBBIN’S DEFINITION “Economics is a science that studies human behaviour as a relationship between ends and scarce means which have alternative uses.” The following are the four pillars of Robbin’s definition: 1. Economic is a science that studies economic aspect of man’s life. From the social point of view, it is a normative science but from individual point of view, it is positive science. 2. Wants unlimited Human wants are unlimited. It is not possible to satisfy them all because means are limited. If one want is satisfied another crops up. Man is such an animal that he is never satisfied. He tries for variety and plenty. This applies to his all wants. Besides his basic wants, he wants to have a number of things such as comforts and luxuries. Since human wants are countless, as a rational being he or she has to be selective ones. He chooses to satisfy most urgent wants first postponing the satisfaction of less urgent wants. Hence, human wants are be all and end of all of economic activities. 5 CVSRTA - 12  3. Limited means Though wants are unlimited, means to satisfy them are limited. Moreover they have alternative uses. That is why economic problem arises, because all goods are not free goods. That is why goods are paid to obtain them. Scarcity of resources gives rise to economic problem because these resources have alternative uses either for this or that. But one must know that it is not the absolute scarcity. It is in light of demand for it, is to be considered. For example rotten egg may be scarce in supply but since nobody demands it, it is plentiful in supply. Hence scarcity be considered in relation to demand only. 4. Alternative uses of resources Means or resources are not only limited but they have alternative uses also. It means that they can be put to number of uses. Had they possessed fixed and specified use, economic problems would not have arisen. But multiplicity of uses of scarce means makes things all the more difficult. Hence, scale of preference of uses is to be made. Most urgent wants are to be satisfied first. In case of less urgent wants, satisfaction is postponed. This means that a rational choice is to be made between wants. Hence multiplicity of wants, scarcity of means and their alternative uses give rise to economic problem. Thus, L. Robbins held that economics tells us how a man makes use of his scarce resources having alternative uses for the satisfaction of his countless ends. Hence it involves choice making it all the more difficult that is why economics is called as a science of choice. 1.2.2 Superiority of Robbin’s Definitions Prof. L. Robbins definition of economic preferred to all other definitions. It is called as scarcity definition. It is considered to be scientific definition because it is independent of any classification. Secondly, all types of wants social as well as individual fall within the domain of economics. Thirdly, it has a widened the scope. Marshall had restricted it only to wealth and activities related to the material welfare of man. Fourthly, Robbins held that economics is only science and not arts. Lastly it is also held that economics is neutral between wants. It does not consider moral – immoral consideration. It is for the consumer to make rational choice between wants. This makes economics is a positive science. 6 CVSRTA - 13  Limitations Robbins definition though it is widely accepted and more scientific yet it is considered to be colourless, impersonal and neutral between wants. However, from the social point of view, economics cannot keep aside its normative appearance. The job of economics is also to advocate and condemn. It also appears that L. Robbins has reduced economics only to valuation theory. Economics not only touches upon resource allocation or price determination but also study how the national income and employment are determined. Thirdly, Robbins definition does not cover theory of economic growth or development which has become an important branch of economics. The theory of economic growth deals with growth of economy but according to Robbins resources are given. He only discusses their allocation. Further more, Robbins definition does not deal with problem of plenty and also of unemployment. According to Robbins economics studies only the problem of scarcity. It also lacks human touch. L. Robbins made economics more abstract and complex making it more difficult. Hence it goes away from its utility for the common man because it must be concrete and realistic study. 1.2.3 Modern Views Of late economic thinking has gone a long way. Lionel Robbins held that economics is concerned with multiplicity of wants and scarcity of resources having alternative uses. But in modern times, it is held that economics is much more than merely a theory of value and allocation of resources. It was Lord J.M. Keynes who brought about a change in economic thinking by advocating government participation in economic development of the country. Now economics is looked upon as the study of the administration of limited resources and of the determinant of employment and income. Thus, besides, theory of value, it studies how the levels of income and employment are determined. It means that modern economics studies the causes of economic fluctuations in order to achieve economic stability. In other words economics studies the factors affecting the size, distribution and stability of country’s national income. Second half of the twentieth century, saw growth theories occupying important place in the study of economics particularly with reference to poor countries. Therefore, one can conclude that a satisfactory definition of economics is one which includes in it theory of income, employment and growth in addition to theory of value or resource allocation. 7 CVSRTA - 14  1.3 Scope of Economics Scope of economics as stated earlier is wants, efforts and satisfaction. Economics begins with human wants and ends with satisfaction of those wants. Man undertakes efforts to satisfy his innumerable wants. It studies only one aspect of man’s life. All activities of man are centred around the satisfaction of his wants. Economics is concerned with satisfaction of wants. It is a social science and therefore tries to find out solutions to social problems like unemployment of natural resources, raising national income through planned economic development. Acceleration of economic growth has become main thrust of economic development in these days. Economic is a science. Science is defined as a systematized body of knowledge. Economics, too, has its rules, regulations and laws in which it binds itself. Now, the question is whether economics is a positive or normative science. Positive science is one which deals with the facts as they are while normative science is one which deals with the facts as they should be or ought to be. Positive economics attempts to describe and analyze the existing situation rather than suggesting how to change it. But many times economists do often make normative statements. Instead of explaining how the economy actually operates, they suggest, how it should operate. Especially, where problems of the economy are concerned, economists abandon the objectivity of positive economics and make normative statements. It is in this context, that we suggest what the government’s economic policy ought to be. How government should act to raise the level of employment etc. Physics, chemistry, geology and biology are the positive sciences as they deal with the facts as they are while social sciences like economics, psychology, sociology, political science etc. deal with the facts as they should be. Thus, economics is both positive as well as normative science. While dealing with individual economic problems, it is a positive science and while dealing with social problem it becomes normative science. The study of economics incorporates it in its scope, consumption, production, exchange and distribution of natural resources. It concerns with economic growth leading to raising national income and its equitable distribution along with balanced economic development. Now-a-days economics’ scope is widened so much that maximization of economic welfare has become the main goal of the economic activities. The knowledge of economics has gone so far that it reached a stage when its facts have been collected and carefully analyzed and laws or general principles explaining to facts have been laid down. This makes economics a positive science. 8 CVSRTA - 15  It is also considered an Art because it lays down and formulates to guide people who want to achieve a certain aim. The aim may be removal of poverty or raising production of goods and services in the country. Economics does help us in solving many day-to-day practical problems. It is not mere a theory. It has great practical use. Therefore, one can conclude that economics is both a science and an art also. 1.4 Micro-Economics British Economist named Adam Smith is the founder of micro-economics which deals with individual behaviour such as markets, firms and households. According to Smith, economic benefit comes from the self-interested actions of individuals. K.E. Boulding holds, “Micro-economics is the study of particular firms, households, prices, wages, incomes, industries and commodities, etc.”. In micro-economic, we study how the various cells of economics organism namely individual consumers and producers reach their equilibrium positions. In other words, in micro-economics, we make microscopic study of the entire economy. However, it must be noted that the micro-economics does not study the economy in its entirety, instead under this branch of economics, we study equilibria of thousands of units of the economy. Prof. Lerner rightly observes, “Micro-economics consists of looking at the economy through a microscope as it were to see how millions of cells in the body of economics viz. individuals or the firms as producers play their part in the working of the whole economic organization. 9 CVSRTA - 16  Micro Economics ProductPricing Factor Pricing Economic Welfare Rent Wages Interest Profit Theory of Theory of demand supply The scope of micro-economics includes in it production, consumption and distribution or any other activity tends to be carried out with the highest efficiency so as to maximize social welfare. It also studies every constituents of the circular flow of income. In other words micro-economics is the application of partial equilibrium analysis to economic problems. Micro-analysis are useful for price determination and allocation of resources, determination of economic policies, international trade, linear programming and optimum utilization of resources. Limitations of micro-economics – it does not throw any light on the collective activity. The analysis is based on unrealistic assumptions which may result into doubtful conclusions. 10 CVSRTA - 17  1.5 Macro-Economics It deals with aggregates. It is concerned with total demand, supply, output, income and so on. Hence macro-economics is a study of aggregates and averages. It is the study of economic system as a whole. It directly concerns with relations among large aggregate such as national income, general price level, total output, consumption, employment, savings, investment, demand and supply. These relations indicate the behaviour of economic system as a whole. J.M. Keynes holds that macro-economics concerns itself with those aggregates which relate to the whole economy. Prof. Paul Samuelson rightly remarks, “There is really no opposition between micro and macro economics. Both are absolutely vital; and you are only half educated if you understand one while being ignorant of the other.” The scope of macro-economics is very wide and it assumed added importance since the publication of J.M. Keynes, General Theory of Employment, Interest and Money in 1936. It is considered to be policy making economics. The study of macro-economics includes, the theory of income, employment, general price level, theory of factor pricing, economic growth and inflation and deflation. Macro-Economics The theory of The theory of Theory of The Theory Income and General Price Factor Pricing Economic Growth Employment Level and Inflation 11 CVSRTA - 18  Importance of Macro-Economics 1. The study of macro-economics enables the government to frame the correct and effective economic policy. 2. It proves to be more helpful in economic planning. 3. It helps developing micro-economic theories. 4. It also enables one to have international comparison. 5. Lastly it is absolutely essential to have knowledge of macro-economics to make correct decisions. Limitations Use of macro-economics analysis complicates the process of the study of prices, savings, investment, factor pricing etc. Secondly all aggregates are not identical and therefore macro-study will become rather difficult. Thirdly, statistical data and techniques are the soul of the study of macro-variables. Therefore, if reliable data is not available decisions based on such data proved to be wrong. In the fourth place, it cannot be said that only one variable is affected from the changes leaving all other variables unaffected. According to Prof. K.E. Boulding, “Micro-economics follows the method of slicing whereas macro-economics uses the method of humping.” 1.6 Connotations If we probe a little deeper, however, we find that economics is really not so much about money as about some things which are implied in the use of money. Three of these – exchange, scarcity, and choice are of special importance. Let us take them in turn. 12 CVSRTA - 19  1.6.1 Exchange Money implies exchange. It is in fact the medium of exchange. In a primitive community, where exchanges are rare, we can dispense with money and resort to direct barter. Money is unnecessary so long as we are at the stage of trying to satisfy all our wants by our own efforts, growing our own wheat, milling our own flour, baking our own bread, and only now and again exchanging, say, wheat for a ploughshare or a calf for a millstone. But immediately we begin to specialize, and cease to produce goods for our own use, money becomes indispensable if exchanges are to take place smoothly. Exchange becomes triangular – we convert goods into money and money into other goods, instead of simply bartering goods for goods. If exchanges did not take place in this apparently circuitous way, no one who specialized in making bricks or bowler hats would relish a morning’s shopping. The grocer might have no use for bricks, and match-sellers would hesitate to accept the hundredth part of a bowler hat. A walletful of money goes so much further than other walletfuls! Nowadays, therefore, exchange rarely takes the form of direct barter. Instead, we do business with money. We buy what we want with money, sell for money, fix prices in terms of money, are paid our wages, salaries, or dividends in money, save money, and measure our wealth in money. But the problems which present themselves to us in terms of money are exactly similar to the problems raised by direct barter. There is a surface difference between money-exchange and barter-exchange, but no difference in principle. Economics, therefore, does not limit itself only to money-problems but studies exchange-problems of all kinds. It is, in fact, about exchange rather than about money, for exchange underlies the use of money. Exchange Implies Interdependence When one exchange, we have stopped being self-sufficing and have become dependent in those from whom we buy and to whom we sell. Our fortunes are linked with theirs. If they are poor or unemployed then we are likely to be in danger of poverty and unemployment ourselves. Famine and flood in one part of the world can create scarcity and distress thousands of miles away by cutting off supplies of foodstuffs and raw materials. We are all within the circle of exchange. Yet this interdependence rarely occurs to us : it is so easy to overlook the implications of exchange. 13 CVSRTA - 20  Consider, for example, some everyday event like the purchase of a packet of cigarettes. I take from my pocket a small piece of metal – probably Mexican silver alloyed with Canadian nickel – and offer it to a total stranger who accepts it with alacrity. In exchange, I receive a cardboard packet whose contents are the product of workers from all over the globe – Norwegian lumbermen, Turkish peasants, Malayan tin-miners, American inventors. I draw also on the services of British workers scattered over the country. The packing of the cigarettes has been done in Bristol; the cellophane wrapper and silver paper come from London; the paper round the cigarettes from Swindon; the stiffener, or cigarette card, from Glasgow. But about all these workers, through whose efforts I am able to smoke my cigarettes, I am amazingly ignorant. I do not trouble to inquiry whether they include cannibals, racketeers, Jew-baiters; whether they are mean, grasping, or dissolute; or whether their daily earnings are less than 1d or over £100. Their creed, their way of living, their income, the colour of their skin, do not interest me. I can drive my bargain with them without even knowing that they exist. The cash-nexus that binds us is the loosest of bonds. It leaves me free to pursue my own interest, undeterred by any sense of moral obligation to other workers as fellow-citizens. They satisfy my wants and earn the means of satisfying theirs. And that, to most of us, might seem to be the end of the matter. But not to the economist. It is precisely these exchange-bargains which he sets out to investigate. Why, he asks, do people exchange at all? What advantages does society reap from leaving people free to satisfy their wants by exchange? When exchange is fair and when unfair? Is it in the social interest that exchanges dictated by mutual self- interest should be left unregulated by the State? Or, if regulation is desirable, on what principles should the State intervene? 1.6.2 Scarcity The use of money implies scarcity. Money itself must be scarce or it will cease to be used. If the supply of money is increased without limit it will soon lose value and in the end no one will accept it. Whatever passes as money, therefore, must necessarily be scarce. So also – and this is the important point – must be the things that money will buy. We only exchange one scarce thing for another. We do not pay for air and earth and water unless somehow they are stinted just as the supply of money is stinted. 14 CVSRTA - 21  The fact of scarcity makes it necessary for us to economise, i.e., to make the most of what we have. We have constantly to be counting the cost, weighing up alternatives, and going without one thing so as to be able to buy more of another. Nominally it is money that we economise, for what we have to decide is whether to spend money on this or on that. What we are really doing, however, is to economise the things that money will buy. We try to buy, with our limited income, the collection of goods and services which gives us most satisfaction. We are faced with the fact that these goods and services are scarce, and we have to accommodate this scarcity as best we can to our wants and needs. Similarly, in earning money we have to husband our scarce time and energy in order to obtain as large a return as possible (in money or in amenities and personal satisfaction) for our efforts. On some men, of course, the pressure of scarcity and want bears harder than on others. On the millionaire, for example, the pressure is negligible; he can almost always neglect considerations of cost. But for others the necessity of making ends meet enforces constant self-denial. 1.6.3 The Economic Problem What is true of each of us is true also of society as a whole. There is an economic problem of making the social income go as far as possible. The goods produced and services rendered in any country in the course, say, of a year, are limited in amount and insufficient to maintain a standard of more than moderate comfort if equally distributed amongst the inhabitants of the country. The goods and services at the disposal of the country in other words, are scarce in relation to the demand for them. There are very few things that can be provided free of charge, even in a rich country. We can make as much use as we like of public libraries and parks and roads. But we cannot help ourselves to books and motor-cars, much less to food and clothing. The more of one thing is offered to us, the less can we have of other things. We cannot have more of all simultaneously. If A is free, B will be all the dearer. The provision of free motor-cars, - for example, would lead to an expansion of the automobile industry and the transference to it of engineers, materials, and machinery from a host of other industries. Motor-cars would be more abundant; but other things would be scarcer. Only if we set a very high value on motor-cars (like the value which we set on good roads, or schooling, or health services) will we be prepared to face the cost of offering them free. 15 CVSRTA - 22  This balance between value and cost is forced on us wherever we are faced with a shortage of supplies relatively to our wants. The things which we value highly and which cost little to produce will be provided first and in large quantities. What costs a great deal and is of comparatively little value will not be produced at all. We have to decide what commodities, and how much of each, to produce; and our decision will rest upon our estimates of cost and value. The decision is one that must be taken in every society, whether it be Russia or the United States, Italy or Malaysia. The way in which the decision is taken, and the kind of people who take it, are, of course, very different in different countries. The responsibility may rest with a bureaucracy or with the mass of “consumers.” One country may have a State Planning Commission; another may rely on the laws of supply and demand. Whatever the economic system, the decision is one that cannot be avoided. There is an economic problem which has to be solved by dictatorships and democracies, “planned” and “unplanned” societies alike. Want and scarcity are universal, and so, too, is the problem of a accommodating the one to the other. In some countries the problem may be solved more satisfactorily than in others. But there is no question of one social system bringing plenty and another condemning us to scarcity. Man’s wants are insatiable, and there would continue to be scarcity under any social system. If, for example, we all had twice as large an income as at present – an advance which could not be brought about immediately by any conceivable change in our social system – the annual income of the average British worker would still be under £600, and from this sum a large slice would be taken in taxation, and a further slice would have to be put aside as savings. Such an income would probably fall short of the aspirations of most people and could be reached only by exertions which would be decidedly irksome. The conflict between scarcity and want would continue to be felt. Scarcity, like exchange, raises problems for the economist. He tries to formulate the principles on which our limited productive resources can be used to the fullest advantage. He studies how unemployment, for example – an obvious waste of labour power – can be reduced or eliminated; how the community’s savings can be made to find their way into productive investments, how the land can be cultivated in the best interests of society. He studies; too, on what principles we should allocate resources between different industries so as to produce a maximum of all commodities in the right proportion of each; and how the output of commodities should be distributed between those who help to make them. 16 CVSRTA - 23  These are problems which cannot be confined within the narrow bounds of pure economics. They extend into politics, ethics, and even religion. But we can get a better view of them from the heights of economic theory than from any other standpoint. Since this better view will still be coloured by our personal convictions, it will not of itself remove differences in outlook. But it will give us a wider perspective and open our eyes to the more remote implications of our problems. 1.6.4 Choice The use of money also implies choice. We have to choose between the many claims on our purse when we spend money, and between the many uses to which we might put our time and energy in earning it. We cannot spend the same evening in the cinema and in the theatre. We must choose one form of entertainment or the other. We may have to choose, also, between spending an extra shilling or so on a seat and spending the same shilling later on cigarettes. Our choice, of course, is not always made rationally. That is, we do not always weigh up carefully the possible ways in which we might spend our money. We are much more lighthearted and irrational in buying sweets, for example, than we are in renting a house. We buy, very, often, impulsively or through habit or force of example. Or we may buy because our “sales resistance” has crumpled at the sounding of some advertiser’s trumpet. It is irrational to pay more than is necessary for a thing; and yet hardly a day passes but we buy goods without asking their price, or cannot be bothered to look for cheaper brands. We do not take the trouble to find out where prices are lowest; or we take excessive trouble to save a trifling sum, like the wealthy man who walks to save a penny fare. We do not budget for so much on clothes, so much on amusements, so much on food, so much on our savings account, and so on, but spend haphazard so long as the money lasts. Or at least that is what large numbers of us do. Perhaps, however, the careful housewife – and the tradition amongst economists are to think of housewives, as the persons who hold the purse-strings – is more rational in her buying. The economic woman may be less of an abstraction than the economic man! 17 CVSRTA - 24  The way in which we make a choice is of great importance to the economist. For he cannot tell how much weight to place on the preferences expressed in the spending and earning of money until he knows how far these preferences are rational (i.e., based on full knowledge and formed after reflection). If for instance, people persist in buying an expensive brand of cigarette it is important to know whether they buy it out of a liking for that particular brand or because they are ignorant of cheaper brands with the same flavour or because of snob-appeal in the advertisements. Until the psychology of cigarette-smokers is explained to us, we cannot say whether the production and the sale of these high-priced cigarettes involve a social waste. If smokers are rational there may still be a waste (for instance the price may be kept high by a monopoly). But if they are irrational, there is certainly a waste; they are paying more than they would if they were in possession of all the facts. In economics we begin by assuming that choice is rational. The so-called “economic man” is simply one who is completely “rational” in satisfying his wants, and pays no regard to the interests of others. It is, of course, an abstraction from the facts to assume that men are self-interested and rational. But to make this kind of abstraction is the only satisfactory procedure open to us. If we assume that people are self- interested and rational, we can predict how they will behave given a certain monetary inducement, and we can work out an analysis of action and reaction. For instance, if similar goods are on sale at different prices, or similar jobs advertised at different rates of pay, we know that men will, other things being equal, purchase the cheaper goods, and apply for the better-paid job. If we could not make such generalizations, if men were quite irrational, then we should never “get anywhere” in economics. So we begin by assuming that choice is deliberate and rational, without, however, overlooking the part played by impulse, custom, and inertia. Later, we may study the psychology of choice more closely; analyzing what shapes our expectations and desires, and sifting what is basic in our wants from what is superficial or conventional. But to begin with, we ignore these difficulties, take people’s desires for granted, and assume that choice is rational. 18 CVSRTA - 25  In the economic system as we know it, choice rests largely with the individual. His preferences go to determine what is to be produced and what is not. Every penny spent on A is a vote in favour of the production of A; every refusal to buy B is a vote against the production of B. It is the free choice of individual consumers between the goods, competing on the market that determines what industries can carry on at a profit. The industries that cannot show a profit are not carried on at all. Those that show excessive profits attract competition and expand until people’s wants – as indicated by the price which they are prepared to pay – are more adequately met. That is, if competition is possible and effective. But if some commodity is monopolized, consumers may be powerless to get what they want (and will pay for) in the proper quantity. They show their readiness to cast votes for more of the commodity by offering high prices for it. But the election is disregarded. No one is willing to stand against the monopolist. So he is able to preserve an excessive scarcity by keeping people out of his line of business. He makes things scarcer than people want them to be and earns high profits by doing so. Thus a country like ours does not deliberately decide what industries fit best with its advantages and needs and on what scale they should be carried on. The decisions that might otherwise rest with a central planning authority take shape instead in the market. One industry expands and another contracts as consumers alter their preferences and purchases. The scarce productive resources of the community are not always rationed between the different industries by some Planning Commission. They flow into the channels lubricated by the expenditure consumers. But is it desirable that the individual should retain so much freedom of choice? What if consumers are irrational or incapable of judging between competing goods? Would it be better to appoint a State Planning Commission with power to decide what kind of goods should be produced and what kind of jobs workers should be encouraged to take up? Should each man’s daily rations be assigned to him as the average man’s daily work is at present? With whom should choice rest, and through what agencies is it best exercised? Here is another batch of problems for the economist. 19 CVSRTA - 26  Now it is clear that scarcity is more fundamental than exchange. It is, in fact, as a result of our efforts to deal with scarcity (i.e. to economise) that exchange arises. We try to ration our limited means among the innumerable wants that compete for satisfaction and find that we can make our limited means go farther by striking bargains with our neighbours. We give what we have in relative abundance – muscle or brain, professional knowledge or organizing ability – for what is comparatively scarce, what we could not do, or could not afford to do, ourselves. We sell our time and energies and spend our earnings on what others have laboured to produce. In doing so, we are offering goods or services in which our talents show to greatest advantage (or least disadvantage) for the goods or services which others are specially fitted to produce. We are supplementing our deficiencies – our imperfect versatility, for instance – our of the proficiencies of others. Not only are we able to draw on the skill of others – skill which we may not possess at all – but we are also able to give our whole energises to a single task – one to which, either through practice or natural bent, we are far more fitted than those who engage in it only intermittently. By exchanging, we are making our efforts go further towards meting our wants. We are reducing the pressure of scarcity and achieving economy. 1.7 SOCIETY’S TECHNOLOGICAL POSSIBILITIES Each economy has a stock of limited resources – labour, technical knowledge, factories and tools, land, energy. In deciding what and how things be produced, the economy is in reality deciding how to allocate its resources among the thousands of different possible commodities and services. How much land will go into growing wheat? Or into housing the population? How many factories will produce computers? How many will make pizzas? How many children will grow up to play professional sports or to be professional economists or to program computers? Faced with the undeniable fact that goods are scarce relative to wants, an economy must decide how to cope with limited resources. It must choose among different potential bundles of goods (the what), select from different techniques of production (the how), and decide in the end who will consume the goods (the for whom). 20 CVSRTA - 27  1.7.1 Inputs and Outputs The answer these thee questions, every society must make choices about the economy’s inputs and outputs. Inputs are commodities or services that are used to produce goods and services. An economy uses its existing technology to combine inputs to produce outputs. Outputs are the various useful goods or services that result from the production process and are either consumed or employed in further production. Consider the “production” of pizza. We say that the eggs, flour, heat, pizza oven, and chef’s skilled labour are the inputs. The tasty pizza is the output. In education, the inputs are the time of the faculty, the laboratories and classrooms, the textbooks, and so on, while the outputs are educated and informed citizens. Another term for inputs is factors of production. These can be classified into three broad categories: land, labour, and capital.  Land – or, more generally, natural resources – represents the gift of nature to our productive processes. It consists of the land used for farming or for underpinning houses, factories, and roads; the energy resources that fuel our cars and heat our homes; and the non-energy resources like copper and iron ore and sand. In today’s congested world, we must broaden the scope of natural resources to include our environmental resources, such as clean air and drinkable water.  Labour – consists of the human time spent in production – working in automobile factories, tilling the land, teaching school, or baking pizzas. Thousands of occupation and tasks, at all skill levels, are performed by labour. It is at once the most familiar and the most crucial input for an advanced industrial economy.  Capital resources form the durable goods of an economy, produced in order to produce yet other goods. Capital goods include machines, roads, computers, hammers, trucks, steel mills, automobiles, washing machines, and buildings. As we will later see, the accumulation of specialized capital goods is essential to the task of economic development. 21 CVSRTA - 28  Restating the three economic problems in terms of inputs and outputs, a society must decide – (1) what outputs to produce, and in what quantity; (2) how to produce them – that is, by what techniques inputs should be combined to produce the desired outputs; and (3) for whom the outputs should be produced and distributed. 1.8 The Production-Possibility Frontier Societies cannot have everything they want. They are limited by the resources and the technology available to them. Take defense spending as an example. Figure 1 : The Production Possibilities in a Graph This figure displays the alternative combinations of production pairs from Table 1. Alternative Production Possibilities Butter Guns Possibilities (millions of pounds) (Thousands) A 0 15 B 1 14 C 2 12 D 3 9 E 4 5 F 5 0 Table 1 : Limitation of Scarce Resources Implies the Guns-Butter Tradeoff 22 CVSRTA - 29  Scarce inputs and technology imply that the production of guns and butter is limited. As we go from A to B … to F, we are transferring labour, machines, and land from the gun industry to butter and can thereby increase butter production. Countries are always being forced to decide how much of their limited resources go to their military and how much goes into other activities (such as new factories or education). Some countries, like Japan allocate about 1% of their national output to their military. The United States spends 5% of its national output on defense, while a fortress economy like North Korea spends up to 20% of its national output on the military. The more output that goes for defense, the less there is available for consumption and investment. Let us dramatize this choice by considering an economy which produces only to economic goods, guns and butter. The guns, of course, represent military spending, and the butter stands for civilian spending. Suppose that our economy decides to throw all its energy into producing the civilian good, butter. There is a maximum amount of butter that can be produced per year. The maximal amount of butter depends on the quantity and quality of the economy’s resources and the productive efficiency with which they are used. Suppose 5 million pounds of butter is the maximum amount that can be produced with the existing technology and resources. At the other extreme, imagine that all resources are instead devoted to the production of guns. Again, because of resource limitations, the economy can produce only a limited quantity of guns. For this example, assume that the economy can produce 15,000 guns of a certain kind if no buster is produced. There are two extreme possibilities. In between are many others. If we are willing to give up some butter, we can have some guns. If we are willing to give up still more butter, we can have still more guns. A schedule of possibilities is given in Table 1. Combination F shows the extreme where all butter and no guns are produced, while A depicts the opposite extreme where all resources go into guns. In between – at E, D, C, and B – increasing amounts of butter are given up in return for more guns. How, you might well ask, can a nation turn butter into guns? Butter is transformed into guns not physically but by the alchemy of diverting the economy’s resources from one use to the other. 23 CVSRTA - 30  We can represent our economy’s production possibilities more vividly in the diagram shown in Figure 1. This diagram measures butter along the horizontal axis and guns along the vertical one. We plot point F in Figure 1 from the data in Table 1 by counting over 5 butter units to the right on the horizontal axis and going up 0 gun units on the vertical axis; similarly, E is obtained by going 4 butter units to the right and going up 5 gun units; and finally, we get A by going over 0 butter units and up 15 gun units. If we fill in all intermediate positions with new rust-colored points representing all the different combinations of guns and butter, we have the continuous rust curve shown as the production-possibility frontier, or PPF, in Figure 2. The production-possibility frontier (or PPF) shows the maximum amounts of production that can be obtained by an economy, given its technological knowledge and quantity of inputs available. The PPF represents the menu of goods and services available to society. Putting the PPF to Work The PPF in Figure 2 was drawn for guns and butter, but the same analysis applies to any choice of goods. Thus, the more resources the government uses to build public goods like highways, the less will be left to produce private goods like houses; the more we choose to consume of food, the less we can consume of clothing; the more society decides to consume today, the less can be its production of capital goods to turn out more consumption goods in the future. Figure 2 : A Smooth Curve Connects the Plotted Points of the Numerical Production Possibilities This frontier shows the schedule along which society can choose to substitute guns for butter. It assumes a given state of technology and a given quantity of inputs. Points outside the frontier (such as point I) are infeasible or unattainable. Any point inside the curve, such as U, indicates that the economy has not attained productive efficiency, as occurs when unemployment is high during severe business cycles. 24 CVSRTA - 31  1.9 Exercise : 1. How would you define Economics? How it is related to human wants? 2. How would you differentiate between Micro-economics and Macro- economics? 3. What do you understand by Production Possibility Frontier? Explain with diagram. 4. Explain the role of exchange, scarcity and choice as issues in economics. *** 25 CVSRTA - 32  UNIT – II CONSUMPTION 2.1 INDIFFERENCE CURVES ANALYSIS The technique of indifference curves was first used by Prof. Edgeworth, but he used it only to show the possibilities of exchange between the two persons. A decade later Prof. Irvin Fisher of America tried to develop a theory of consumer’s equilibrium based on ICs analysis but he did not go beyond substitutes and complementary goods. It is so because they believed in cardinal measurement of utility. Then Prof. Pareto developed his theory of demand based on ordinal measurement of utility. But credit goes to Prof. J.R. Hicks and Dr. R.G.D. Allen of Great Britain of introducing ICs technique in demand analysis. Prof. J.R. Hicks published a book named ‘Value and Capital (1939) in which he made use of ICs techniques. This technique is developed to mark an improvement over utility approach. It is based on new assumptions. After having criticized Marshall, J.R. Hicks stated ICs approach based on ordinal measurement of utility. Since, utility is psychic and cannot be measured in cardinal numbers such as 1, 2, 3, 4 etc., Prof. J.R. Hicks and Dr. R.G.D. Allen made use of ordinal numbers like 1 st, 2nd, 3rd, 4th etc. to measure the level of satisfaction since utility is subjective and state of mind. 2.2 What is an IC? The indifference curve is a conceptual curve at which every point represent the combination of goods at x-axis and y-axis, which would place a consumer at a point of indifference as to which combination to choose. Every combination at each point of the curve gives him the equal satisfaction. That is why he is indifferent to any particular choice and the curve is called indifference curve. An IC is defined as one which joins all those combinations of two goods such as ‘x’ and ‘y’ goods which yield same level of satisfaction to the consumer or which occupy the same position in the consumer’s scale of preference. In other words, it is a curve which joins all those combinations of two goods yielding same level or equal level of satisfaction to the consumer. The curve which represents all those points on it which yield equal level of satisfaction is called IC because the consumer is indifferent between the combinations of two goods since they yield him the same level of satisfaction. 26 CVSRTA - 33  The Figure given below depicts the ICs curve yielding equal level of satisfaction from combinations of ‘x’ and ‘y’ goods. The combinations of ‘x’ and ‘y’ goods A, B, and C lie on IC, yielding the equal level of satisfaction to the consumer. Though they yield same level of satisfaction the quantity of ‘x’ and ‘y’ goods differ at each combinations. As the consumer moves from A to C combination, he consumes more of ‘x’ and less and less of ‘y’. Similarly, when he moves from C to A combination he prefers ‘y’ to ‘x’. It all depends upon his tastes and preferences as to which good is to be consumed more or less. 2.3 Assumptions of ICs Analysis ICs approach is based on following assumptions: 1. Like Marshallian approach the ICs approach also takes the assumption of rationality. Rationality implies that the consumer possesses all the relevant information to make his rational decision of maximization of satisfaction. 2. Ordinal measurement of utility is the second important assumption of ICs. Since utility cannot be measured in objective cardinal numbers like 1, 2, 3, 4.. 5 etc. because it is psychic, it is to be measured in ordinal numbers such as 1 st, 2nd, 3rd, 4th, etc. 27 CVSRTA - 34  3. Assumption of continuity - This assumption falls under the domain of geometry, yet it forms core of ICs analysis. Continuity implies the consumer is capable of ordering or ranking all the possible combinations of two goods in accordance with satisfaction they yield to him. He can move from low level of satisfaction to a high level of satisfaction provided his money income permits him to do so. 4. Assumptions of transitivity - It implies that if the consumer prefers ‘A’ combination of two goods to B and B to C it means he prefers A to C. Similarly if he is indifferent between A and B. B and C, it means that he is indifferent between A and C. In other words under this approach, the consumer’s preference is valid for every successive pairs in the curve. 5. The ICs approach is based on weak ordering form of preference hypothesis. Thus, the weak ordering form of hypothesis recognizes the relation of preference as well as indifference. Strong ordering believes in only one relationship and that is preference. 2.4 The Scale of Preference The rational consumer always makes his purchases in the light of his scale of preferences. It refers to valuation of goods and services independent of their market prices. In short it involves choices of buying goods and services. Each consumer develops his own scale of preference independent of others. It differs from person to person based on everybody’s level of income and tastes and preferences. 2.5 IC’s Map An IC’s map is an important tool of this approach. It represents complete description of the consumer’s tastes and preferences. As long as consumer’s tastes and preferences remain constant, IC’s map also remain constant. It refers to a set of ICs or a family of ICs representing different levels of satisfaction. Each IC represents different level of satisfaction. A higher IC represents a higher level of satisfaction and a lower IC represents a lower level of satisfaction, but how much higher or lower is not indicated because ICs approach is based on ordinal measurement of utility. The scale of preference of the ICs analysis replaces the utility schedules of Marshall’s approach. The following ICs map is drawn based on hypothetical tastes and preferences. 28 CVSRTA - 35  ICs No.1, 2, 3 and 4 represent different levels of satisfaction. Hence combination ‘A’ represents the lowest level of satisfaction while ‘D’ represents the highest level of satisfaction. 2.6 Price Line or Budget Line Price line represents the money income of the consumer given the prices of goods and services. Prices of goods and money income are the two constraints of the price line. If the money income changes (rise or fall), prices remaining constant price line shifts upward or downward as the case may be. If the prices change, money income remaining constant, price line still changes. Price line is also called as the budget line because it provides various opportunities to the consumer costing the same money expenditure. Assumptions of Budget Line 1. Prices of goods and services are given and remain constant through out. 2. The consumer tries to maximize his satisfaction with given money income and set of prices of ‘x’ and ‘y’ goods. 3. He has limited income which he spends on ‘x’ and ‘y’. 4. Tastes and preferences of the consumer remain constant. 5. Goods are divisible and their units are homogeneous. Given the above assumptions, the consumer has to choose that combination of ‘x’ and ‘y’ goods which will lie on the given price line. Any combinations lying on the same price line, will cost the consumer the same money expenditure though quantity of ‘x’ and ‘y’ goods is different at different combinations. 29 CVSRTA - 36  The consumer cannot choose any combination beyond AB price line because his limited money income does not permit him to do so nor he would choose any combinations inside the  AOB because in that case he may not be spending his entire money income. Therefore, he would choose that combination which would lie only on price line AB. In the graph, it is shown the consumer chooses B combination which gives him maximum satisfaction with the given money income. He does not choose either A or C combinations because in that case he may not be spending his entire income. At the same time combination R is beyond reach of the consumer. ‘d’ combination does not allow him to spend his entire income. Hence, it is out of question. That is why he chooses B combination which gives him maximum satisfaction and permits him to spend his entire income on ‘x’ and ‘y’ goods. The price line shifts if prices of goods change or money income changes prices remaining constant. The following three diagrams depicts the position of the price line. 30 CVSRTA - 37  The slope of the price line is measured and always equal to price ratio of both the goods. AO Px The slope of price line AB =  OB Py 2.7 Consumer’s Equilibrium A consumer is said to be in equilibrium when he is buying such a combination of two goods as leaves him with no tendency to rearrange his purchases. In other words, he would choose that combination which would give him the maximum satisfaction with the given money income and prices of goods and services. 31 CVSRTA - 38  Assumptions 1. The consumer has his IC map exhibiting his scale of preference 2. The consumer has limited money income which he spends on ‘x’ and ‘y’ goods. 3. The consumer is rational. It means that he knows market conditions. He tries to maximize his satisfaction. 4. Goods are divisible and their units are identical. 5. Prices of goods are given and they remain constant. Conditions for Equilibrium 1. The consumer would attain his equilibrium at a point where price line is tangent to the highest possible IC. In other words, the slope of the price line and IC curve must be the same at the point of equilibrium. The slope of the price line Px is represented by the ratio of prices of goods i.e. while slope of the IC is Py represented by MRSxy. Px Px Thus at the point of equilibrium = = MRSxy or MRSxy = Py Py 2. The second condition is that IC curve must be convex at the point of equilibrium, then only satisfaction of the consumer would be maximum. This is depicted in the following diagram: 32 CVSRTA - 39  Marginal Rate of Substitution (MRSxy) MRS between two goods is an important tool of ICs analysis. It refers to the rate at which one good is substituted for another at margin without altering the level of satisfaction. Thus, MRSxy represents the amount of ‘y’ good which the consumer has to give up for the gain of one more unit of ‘x’ good so that his level of satisfaction remains the same. The MRS between two goods always falls as the quantity of one good is increased. The consumer is in equilibrium at ‘E’ point where IC2 is tangent to the price line AB. The consumer buys ON quantity of ‘y’ good and OM quantity of ‘x’ good maximizes his satisfaction. At ‘E’ point both conditions of equilibrium are fulfilled i.e. MRSxy = Px and also MRSxy is declining or IC2 is convex to the origin. That is why the Py consumer is in equilibrium at ‘E’ combination. He is not in equilibrium at ‘R’ point Px Px because it is here MRSxy > and in case of ‘S’ combination MRSxy <. Py Py Combinations ‘R’ and ‘S’ place him on lower IC. Therefore, the consumer is permanently in equilibrium at ‘E’ point where both the conditions of equilibrium are fulfilled. Px The equality between MRSxy = is essential condition for equilibrium but not Py sufficient condition. The sufficient condition is that at the point of equilibrium MRSxy must be falling or IC must be convex to the origin. Then only the consumer would be maximizing his satisfaction. 33 CVSRTA - 40  2.8 Income Effect The consumer may become better off or worse off because of a change in his money income. Prices of goods and services remaining constant. His satisfaction will either increase or decrease based on larger or smaller size of money income at his disposal. The result of this type is called as income effect. In other words, it refers to a change in his level of satisfaction on account of a change in his money income. Under income effect consumer is allowed to become either better off or worse off as the case may be. If the income increases he will buy more of both the goods and thus will become better off. In the same manner his income may fall, as result of which he would buy less of both the goods, which would reduce his level of satisfaction making him worse off prices remaining constant. When he becomes better off, he will reach on higher IC and when he becomes worse off he will be placed on lower IC. Income effect can be negative also if the commodity is interior. Even after increase in income he may buy less quantity of the commodity, which is inferior. However it is difficult to name certain goods to be inferior. What is inferior to one person may not be inferior to other person. Therefore, taste and preferences along with size of money income label certain goods as inferior one. Assumption of Income Effect 1. Money income alone changes; rise or fall. 2. Prices of goods and services remain constant throughout. 3. Consumer is rational and tries to maximize his satisfaction. 4. Tastes and preferences remain constant. 5. The consumer has no control on market conditions. 34 CVSRTA - 41  In the light of the above assumptions let us examine the income effect in case of normal good with a diagram below: I.C.C. = Income Consumption Curve Income effect is to be studied with the help of ICs’ map and price line. ICs number one to four represents consumer’s ICs map highlighting his tastes and preferences whereas price lines AB, CD, EF and GH present different levels of money income. As the money income of the consumer increases, he moves from IC1 to IC4 consuming more of both the goods and becoming better off. And when his money income falls from GH to AB price line he is shunted to lower and lower ICs, thus making him worse off as he buys less and less of both the goods. The consumer attains equilibrium at E, E 1, E2 and E3 tangency points on AB, CD, EF, GH price lines as his money income goes on increasing. He becomes better and better off. When his money income falls he becomes worse off when he becomes better off, he is placed on higher ICs and in case of worse he is placed on lower ICs. Thus under income effect the consumer is allowed to become either better off or worse off. 35 CVSRTA - 42  2.9 Income Consumption Curve (I.C.C.) Since, the price line represents the money income of the consumer or in other words, his purchasing power, the price line in its each point represents the affordability of the limited purchasing power within which the means of income. The combination of goods at E point will give him the maximum satisfaction because, it is at this point it will touch the indifference curve. The other points of which are beyond his reach with his limited income. The combination pf ‘X’ and ‘Y’ goods at point E will be his obvious choice because it satisfies both his affordability as well as preference. Similar points of intersection can be considered at the successive price line. A line which is drawn through all the equilibrium points such as E, E 1, E2 and E3 is called as income consumption curve. It shows how the consumer’s purchases react to change in money income when prices remain constant. If the prices were different the ICC would take different shape and position. It is also defined as the locus of equilibrium points at different levels of consumer’s money income. It traces out income effect on the quantity of goods purchased. I.C.C. can be positive or negative. It is positive when an increase in money income is accompanied by increase in consumption of goods and services and negative when an increase in money income is accompanied by reduction in consumption of goods. If I.C.C. slopes backwards towards ’y’ axis, then ‘x’ good is inferior good and if it slopes towards ‘x’ axis, ‘y’ good is inferior. In case of normal goods it slopes upwards. The following diagram depicts the shapes of I.C.C. 36 CVSRTA - 43  One thing must be noted that IC approach does not tell which goods are inferior. It merely describe the phenomenon. 2.10 Substitution Effect While explaining income effect, we held that prices remain constant but it is not a realistic assumption. Prices always change and therefore consumer’s real income undergoes changes. It may rise or fall. When prices rise, real income of the consumer falls, money income remaining constant. Likewise when prices fall, real income of the consumer rises. But under substitution effect we shall be analyzing the effect of fall in price of one of the goods, real income of the consumer keeping it constant. In other words when prices rise or fall, the consumer’s money income is also changed in such a way that he is neither better off nor worse off than before so he will find it worth his while to buy more of that good which has become relatively cheaper. He will substitute relatively cheaper good for relatively costlier good. The result of this type is known as a substitution effect. In substitution effect, the consumer’s real income remains the same but he rearranges his purchases in such a way that he is neither better off nor worse off than before as a result of change in price of one of the goods. The following diagram illustrates the phenomenon. 37 CVSRTA - 44  In the above figure, AB is the original price line. IC is tangent at ‘P’ point so the consumer is in equilibrium at ‘P’ point where both the conditions of equilibrium are fulfilled. The consumer consumes ON quantity of ‘y’ good and O M quantity of ‘x’ good. Now we suppose the price of ‘x’ falls and ‘y’ remains constant. That is why AB, new price line is drawn to show fall in price of ‘x’ good. Now ‘x’ has become relatively cheaper and ‘y’ good relatively costlier. If his money income kept intact, he will become better off. But under substitution effect consumer is not allowed to become better off. Therefore, his money income is cut in such a way that his real income remains the same. So that he is neither better off nor worse off. To show cut in money income, a new price line C D is drawn parallel to A B, price line to keep his real income intact. Now he will choose that combination which will lie on C D price line. Since ‘x’ has become relatively cheaper he will buy more of ‘x’ good and less of ‘y’ good. In other words, he will substitute relatively cheaper good for relatively costlier good by rearranging his purchases in accordance with change in prices. Thus, he substitutes M M’ quantity of ‘x’ good for N N’ quantity of ‘y’ good and attains his new equilibrium at Q point on C D price line and on the same IC curve. He moves from ‘P’ equilibrium to ‘Q’ equilibrium in favour of ‘x’ good. 38 CVSRTA - 45  The amount by which his money income is changed so that he is neither better off nor worse off than before is called as the compensating variation in income. In other words, it is a change in money income of the consumer which is just sufficient to compensate him for a change in the price of ‘x’ good. Hicks Allen substitution effect takes place on the same IC whereas Slusky’s substitution effect takes place on a different IC. Substitution effect is always positive. It is positive because general tendency of the people is that to buy that good more which is relatively cheaper and that good less which is relatively costlier. 2.11 Price Effect Price effect studies the effect of a change in real income of the consumer on his purchases. A change in real income may be either an increase or a decrease in the real income of the consumer due to fall or rise in prices of goods. Therefore, under price effect the consumer is allowed to become either better off or worse off as the case may be. Assumptions 1. Money income remains constant 2. Prices rise or fall; as result of which real income of the consumer rises or falls 3. The consumer spends his entire money income 4. The consumer is rational 5. Price of ‘x’ falls and price of ‘y’ remain When price of ‘x’ falls, real income of the consumer rises. This means that with the same money income he can buy more of both the goods and becomes better off. An increase in real income produces two effect simultaneously viz. income effect and substitution effect. Thus the price effect is the combination of income effect and substitution effect. Under price effect, the consumer is allowed to become either better off or worse off as the case may be. We suppose price of ‘x’ falls and price of ‘y’ remains constant. Therefore ‘x’ becomes relatively cheaper in terms of ‘y’ and ‘y’ costlier in terms of ‘x’. Since substitution effect is always positive, the consumer will buy more and more of ‘x’ good as price continues to fall. Price lines AB, AB1, AB2, AB3 show fall in price of ‘x’ good. Therefore, the consumer becomes better and better off and reaches higher and higher ICs. The following diagram illustrates the phenomenon. 39 CVSRTA - 46  The curve which passes through all the equilibrium points such as E, E 1 and E2 is called as price consumption curve. If traces out the price effect on the purchase of the consumer. It shows how changes in price of ‘x’ good will affect the consumer’s purchases of ‘x’, price of ‘y’, tastes and preferences and money income remaining constant. It is locus of equilibrium points at different levels of prices or real income. The P.C.C. may shift backward towards ‘y’ axis if ‘x’ good becomes inferior or it may slope downward towards ‘x’ axis if ‘y’ good is inferior and it may slope upward if both the goods are normal goods. 40 CVSRTA - 47  2.12 Breaking up Price Effect Price effect is combination of income effect and substitution effect. Substitution effect is always positive but nothing can be said about income effect. It can be negative also. Therefore, it is necessary to decompose price effect into income effect and substitution effect. When price of ‘x’ falls, the consumer’s real income increase, money income remains constant. Therefore, the consumer either buys more quantity of both the goods or relatively cheaper good and will become better off. When he becomes better off I.C.C. curve takes him on a higher IC. This shows income effect is positive. Now, he buys more of both the goods. He reaches second IC. His movement from IC to IC2 is due to positive income effect. However, he won’t be at ‘R’ point in Px equilibrium permanently as MRSxy > at ‘R’ equilibrium. Moreover, substitution Py effect is stronger than income effect. Therefore, he substitutes some units of ‘x’ good for some units of ‘y’ good. It is done because ‘x’ has become relatively cheaper and ‘y’ relatively constlier as a result of fall in price of ‘x’ good. It is a general tendency of the consumer to buy that commodity more which is relatively cheaper. That is why he slides down along the IC2 towards right. Now he moves from ‘R’ equilibrium to ‘Q’ equilibrium point on IC2. the movement from ‘R’ to ‘Q’ is due to positive substitution effect. Thus, price effect is made of income effect and substitution effect. Price = Income effect + Substitution effect 41 CVSRTA - 48  This phenomenon is illustrated in the following diagram: Price effect = I.E. + S.E. MM2 = M M1 + M’ M2 42 CVSRTA - 49  2.13 Giffen’s Good In case of Giffen’s good negative income effect is so large that it outweighs completely positive substitution effect as a result of which consumer buys less than before. The following diagram depicts the phenomenon. P E = Strong negative I.E. + P.S.E. = – L M + L M’ = – M’ M 43 CVSRTA - 50  2.14 Derivation of Demand Curve from the P.C.C. The P.C.C. of the indifference curve approach does not directly relate price with quantity demanded. It does not explicitly express price in money terms. It is so because in the IC analysis price is not explicitly shown on ‘y’ axis. On the other hand Marshall’s demand curve explicitly relates price with quantity demanded. Thus, the demand curve showing the relationship between quantity demanded of a good at its various alternative prices can be derived from the P.C.C. of the indifference curves approach. Instead of price of a good being measured in terms of money, it is measured in terms of a good. For example we measure price of ‘x’ good in terms of ‘y’ good and price of ‘y’ in terms of ‘x’ good. Thus the P.C.C. also expresses the same relationship i.e. inverse between price and quantity demanded in case of normal good and direct in case of inferior and Giffen’s goods. The following diagram depicts the derivation of demand curve from the P.C.C. Assumptions 1. The consumer possesses Rs.120/- as his money income 2. Price lines AB, AB1, AB2, AB3 are different alternative price lines representing Rs.15/-, Rs.12/-, Rs.10/- and Rs.8/- per unit. 44 CVSRTA - 51  The above graph shows that the P.C.C. curve of the IC analysis is the same as Marshall’s demand curve. Normally demand curve slopes downward from left to right due to positive income effect. Both the positive effect extend demand for the good. Limitations of ICs Analysis 1. Unrealistic assumptions 2. Combination of two goods may lead to absurdity like shoes and shirts. 3. In case of more than two goods, IC analysis cannot be put to use. 4. The assumption of continuity is also not true. 5. No provision for uncertainty. 6. The approach is highly introspective rather than behaviouristic. 7. Prof. Robertson calls the IC approach as old wine in new bottle! 2.15 CONSUMER SURPLUS 2.15.1 Law of diminishing utility: The concept of consumer surplus is based on theory of diminishing utility. The law of diminishing utility means that total utility increases at the decreasing rate after a point is reached in the consumption level. As we consume glasses of water when we are thirsty, the total utility from consuming second or the third glass of water may reflect in increase in total utility at an increasing rate. But after point, we are less inclined to take more water. The fourth glass of water may, therefore, add o our total utility only at decreased rate. That is what we call the marginal utility is less as we consume fourth one. The fifth glass of water correspondingly may yield a still less marginal utility. If we project the rate of decreasing utility in a geometrical curve, it represents the law of diminishing utility. The idea of consumer’s surplus was developed by French engineer economist A.J. Dupuit in 1844. But it was improved and popularized by English economist Dr. Alfred Marshall in 1879 in his book named “Pure theory of Domestic Values”. 45 CVSRTA - 52  2.15.2 Meaning and Definition of Consumer’s Surplus We buy goods and services because they give us utility. But at the same time we lose some utility in terms of money. Payment of prices means parting with money in exchange of goods and services. This causes disutility to the consumer. In the beginning utility gained is higher than the utility lost. Since the consumer being rational goes on buying units of the commodity as long as utility gained is higher than utility lost. In terms money paid. Utility goes on falling, as more units of the same commodity are consumed but utility of units of money remains constant. Thus a point will reach when utility gained is equal to utility lost in terms of price. At this point, the consumer stops purchasing additional units of that commodity. Beyond this point utility lost is greater than utility gained. In other words, a rational consumer buys the commodity only if he expects a surplus of utility and this surplus is called consumer’s surplus. It is defined as the difference between the satisfaction gained and satisfaction lost. The satisfaction that the consumer obtains from the consumption of a commodity is measured by the price he would pay for it rather than go without it. While satisfaction he loses in procuring that commodity is measured in terms of price he actually pays for it. According to Dr. Alfred Marshall, “the excess of the price which he would be willing to pay rather than go without the thing over that which he actually does pay, is the economic measure of this surplus satisfaction. It may be called consumer’s surplus.” In other words, it can be called as the difference between the expected price for a commodity in terms of price and the actual price that the consumer pay for it rather than go without it. 2.15.3 Measurement of Consumer’s Surplus It is derived from the demand curve or the marginal utility curve. The following diagram and table illustrate the concept. Let us suppose that our consumer has only five rupees to spend on apples. Price of apple is hundred paise per unit which remains constant. As the consumer goes on buying units of apple his utility gained is much more than the utility lost. At the 5th unit of apple, utility lost (100) becomes equals to utility gained (100 units). It is at this point he would stop buying further as beyound 5 th unit, the utility lost would be greater than utility gained. 46 CVSRTA - 53  The following table explains the whole thing. Units of Apple No. Price in Paise Consumer’s Surplus 1 150 100 50 2 130 100 30 3 120 100 20 4 112 100 12 5 100 100 0 Total - 5 Units - 612 - 500 = 112 Consumer’s surplus The surplus derived by him from five units of apple is 112. The total utility derived is 612 units and utility lost in buying five units is 500. Thus, total consumer’s surplus is 612 - 500 = 112 units. C.S. = Total utility gained - Total utility lost = 612 - 500 = 112 units But one must keep in mind the consumer’s surplus derived from different commodities is different. Some commodities yield higher surplus than others. For instance, salt, match box, newspapers etc. People enjoy greater surplus on these commodities than luxury goods. The concept of individual consumer’s surplus can very well be applied to the society as a whole. 47 CVSRTA - 54  Price is measured along ‘ox’ axis which is hundred paise per unit that remains constant and quantity demanded along ‘ox’ axis. Demand curve DD is based on MU schedule. The price of apples assumed to be fixed and remains constant for all units. Therefore, the consumer loses 100 x 5 = 500 units whereas he gains 150 + 130 + 120 + 112 + 100 = 612 units. Hence consumer’s surplus = Total satisfaction (u) - Total satisfaction scarified (DO) in buying apples  612 – 500 = 112 units c.s. Assumptions 1. The fixed relationship between utility and satisfaction, but utility is different from satisfaction. 2. MU of money remains constant through out the process of exchange. No comparison is made in the absence of this assumption and it becomes difficult to measure the consumer’s surplus. 3. The concept of consumer’s surplus is based on cardinal measurement of utility which is not true. 4. DD schedule and MU schedule are assumed to be the same but they are not. 5. The concept ignores the differences in incomes, fashions, tastes and preferences between consumers. Importance 1. The concept is made use of public finance in the matter of taxation. Taxes are imposed on those commodities on which people enjoy very high consumer’s surplus. 2. It helps producers to decide upon pricing policies. 3. It is also helpful to international trade. 4. International comparison of economic welfare can also be possible through consumer is surplus. Limitations 1. It is based on certain assumptions which are not tenable in actual life. Therefore, it is said that the concept is based on unrealistic assumptions. 2. Cardinal measurement of utility is not possible. Utility is psychic and hence cannot be quantified. 3. Marginal utility of money cannot remain constant. 4. It is also said utility is not independent. It is inter-dependent. 5. Differences in income, tastes and preferences cannot be ignored. 6. There is no definite relationship between utility and satisfaction as visualized by Marshall. 48 CVSRTA - 55  UNIT III DEMAND AND SUPPLY 3.1 DEMAND In economics, demand has a distinct meaning. Supposing, you desire to have a car, but you do not have enough money to buy it. Then desire will remain just a wishful thinki