Professional Documents
Culture Documents
1.2. Introduction
1.3. Nature and scope of and its relationship with other disciplines
1.5.1. Marginalism
1.6. Summary
Module 2:
2.1. Objectives
2.2. Introduction
2.18. Summary
3.2. Introduction
3.6. Isoquants
3.23. Summary
4.3.1. Monopoly
4.7. Summary
5.2 Introduction
6.2 Introduction
6.7. Inflation
6.12. Summary
1.1 OBJECTIVES
The primary purpose of this chapter is to define and explain the scope of economics and
the methodology economists use in solving problems. A unique feature of this chapter is
that it explains the economic way of thinking and shows the student how to apply the
tools of economic thinking to everyday decisions. Graphs are used consistently in this
module, so the student will need a good knowledge of how a graph is constructed and
how to interpret its lines. It would be best to follow the examples in the appendix so that
the student has both the text and class notes to review. Stress that the concept of scarcity
is a key element in all economic analysis and a link to the rest of the course.
Key Terms
Scarcity, resources, land, labor, capital, opportunity costs, marginalism, risk and
uncertainty, discounting time perspective
1.2 INTRODUCTION
Economics is essentially the study of logic, tools and techniques of making optimum use
of the available resources to achieve the ends. Economics thus provides analytical tools
and techniques that managers need to achieve the goals of the organization they manage.
Therefore, a working knowledge of economics, not necessarily a formal degree, is essential
for mangers. Managers are essentially practicing economists.
In performing his functions, a manager has to take a number of decisions in conformity
with the goals of the firm. Many business decisions are taken under the condition of
uncertainty and risk. Uncertainty and risk arise mainly due to uncertain behavior of the
market forces, changing business environment, emergence of complexity of the modern
business world and social and political, external influence on the domestic market and
9
social and political changes in the country. The complexity of the modern business world
adds complexity to business decision-making. However, the degree of uncertainty and
risk can be greatly reduced if market conditions are predicted with a high degree of reality.
The prediction of the future course of business environment alone is not sufficient. It is
important equally to take appropriate business decisions and to formulate a business
strategy in conformity with the goals of the firm.
NOTES
1.3. NATURE AND SCOPE OF AND ITS RELATIONSHIP WITH
OTHER DISCIPLINES
Taking appropriate business decisions requires a clear understanding of the technical and
environmental conditions under which business decisions are taken. Application of economic
theories to explain and analyze the technical conditions and the business environment
contributes a good deal to the rational decision-making process. Economic theories have,
therefore, gained a wide range of application in the analysis of practical problems of
business. With the growing complexity of business environment, the usefulness of
economic theory as a tool of analysis and its contribution to the process of decision-
making has been widely recognized.
Baumol has pointed out three main contributions of economic theory to business economics.
First, one of the most important things which the economic (theories) can contribute to
the management science is building analytical models, which help to recognize the
structure of managerial problems, eliminate the minor details, which might obstruct decision-
making and help to concentrate on the main issue. Secondly, economic theory contributes
to the business analysis a set of analytical methods which may not be applied directly to
specific business problems, but they do enhance the analytical capabilities of the business
analyst. Thirdly, economic theories offer clarity to the various concepts used in business
analysis, which enables the managers to avoid conceptual pitfalls.
Scope of
The problems in business decision-making and forward planning can be grouped into four
categories as follows:
z Inventory and Queuing Problems: Inventory problems involve decisions about holding
of optimal levels of stocks of raw materials and finished goods over a period. These
decisions have to be taken by considering demand and supply conditions. Queuing
problems involve decisions about installation of additional machines or not hiring
labor, against the cost of such machines or labor.
z Pricing Problems: Fixing prices for the products of the firm are important decision-
making problems. Pricing problems involve decisions regarding various methods of
pricing to be followed.
(ME) seeks solutions to these problems. So, there is a wide spectrum of topics that
fall under ME and they are as follows:
10
1. Profit Analysis. 2. Cost Analysis
3. Production Possibility Chart 4. Pricing theory and policies
5. Demand Analysis 6. Market penetration studies
7. Economic Forecasting 8. Sales Forecasting
9. Marginal analysis 10. Break-even analysis
NOTES
11. Competitive market studies 12. Anti-Trust issues
13. Plant location studies 14. Mergers and Acquisitions
15. Labor cost studies 16. Inventory problem
17. Investment analysis 18. Capital Budgeting
19. Cost of Capital 20. Government regulations
Out of the above lists, there are some major areas, which are very much important for
management, they are as follows:
z Demand analysis and forecasting,
z Production and cost,
z Competition,
z Pricing and output, and
z Investment and capital budgeting.
1.6. SUMMARY
The can be viewed as an application of that part of microeconomics that focuses on such
topics as risk, demand, production, cost, pricing and market structure.
12
Understanding these principles will help to develop a rational decision-making perspective
and will sharpen the analytical framework that the managers must bring to bear on managerial
decisions.
(c) Emergence of complexity of the modern business world and social and
political, external influence on the domestic market and social and political
changes in the country,
1.2. Economics is a science of choice when faced with unlimited ends and scarce
resources having alternative uses. Comment.
1.3. uses the theories of economics and the methodologies of the decision sciences
for managerial decision-making. Elaborate.
Further Readings
z Hirschey, Economics for Managers, Cengage Learning
z Baumol, Microeconomics: Principles & Policies, 9th editions, Cengage Learning
z Froeb, : A Problem Solving Approach, Cengage Learning z Mankiw,
Economics: Principles and Applications, Cengage Learning
z Gupta, G.S. 2006, , 2nd Edition,Tata McGraw Hill
z Peterson, H.C and Lewis, W.C. 2005, , 4th Edition, Prentice
Hall of India
z R Ferguson, R., Ferguson, G.J and Rothschild,R.1993 Business Economics
Macmillan.
z Varshney, R.Land Maheshwari, 1994 Manageriaql; Economics, S Chand and Co.
z Chandra, P.2006, Project: Preparation Appraisal Selection Implementation and
Review, 6th Edition, Tata McGraw Hill.
14
UNIT 2 Consumer Behavior
STRUCTURE
2.1. Objectives
NOTES
2.2. Introduction
2.3. Demand Function
2.4. Determinants of demand
2.5. Law of Demand
2.6. Exceptions to the Law of Demand
2.7. Shift of Demand v/s Expansion or Contraction of Demand
2.8. Demand Elasticity
2.9. Types of Elasticity
2.10. Methods of measuring elasticity and its significance
2.11. Demand Forecasting
2.12. Supply Function
2.13. Factors affecting Supply
2.14. Elasticity of Supply
2.15. Budget Constraint
2.16. Indifference Curves Analysis
2.17. Consumer Equilibrium and Consumer Surplus
2.18. Summary
2.19. Check Your Progress
2.20. Questions and Exercises
2.21. Further Readings
2.1. OBJECTIVES
The objective of this chapter is to define and analysis of . The chapter also focuses on
the Demand Function, Determinant of Demand, Law of Demand and Exceptions,
Elasticities of Demand and their Measurements, Demand Forecasting Methods,
Supply Function, Elasticities of Supply, Indifference Curve Analysis, Consumer
Equilibrium and Consumer Surplus. Graphs are used consistently in this chapter for
understanding the subject matter easily.
Key Terms
Demand, Demand Function, Determinant of Demand, Law of Demand, Elasticity, Demand
Forecasting Methods, Supply, Supply Function, Indifference Curve, Consumer Equilibrium
and Consumer Surplus.
2.2. INTRODUCTION
The amount of good that a consumer is willing to buy and able to purchase over a period
of time, at a certain price is known as the quantity demanded of that good. The quantity
desired to be purchased may be different from the quantity of good actually bought by the
consumer. Quantity demanded is a flow concept, so the relevant time dimension has to
be mentioned which will indicate the quantity demanded per unit of time.
15
2.3. DEMAND FUNCTION
Demand is a relationship between the price and the quantity demanded, other things
remaining the same. If X1 denotes the quantity demanded and P1 its price per unit of the
good, then other things remaining constant, the demand function is;
NOTES X1 = f (P1 ),
Which shows that quantity demanded depends on the price. This means that any change
in price will result in a corresponding change in the quantity demanded.
16
there consumption of meat and buy more of bread, which was still the cheapest food. This
implied that quantity demand of bread (an inferior good) increased with the increase in its
price. Sir Robert Giffin, an economist, was the first to give an explanation to this situation.
Hence such goods which display direct price demand relationship are called Giffin Goods.
These goods are considered inferior by the consumer, but they occupy a significant place
in the individuals consumption basket. It so happens that people in this case, with the
rise of price of this good (say rice), are forced to reduce their purchase of other expensive NOTES
goods (say, chicken) and increase the purchase of that good (rice) in larger quantity to
supplement the reduction in luxury food item (chicken). These goods categorically are
those on which major portion of consumers income is spent, hence they are termed as
inferior.
Snob Appeal: opposite to Giffen Goods, there are certain goods which have snob value,
for which the consumer measures the satisfaction derived from there commodities not by
their utility value, but by their social status. The consumer of this particular commodity
wants to show it off to others, and as a result they buy less of it at lower prices and more
at higher prices. Thus in this case, price and quantity move in the same direction.
Diamond or antique works of art, latest model of mobile phones, sports cars, and designer
clothes are example of such goods. Higher is the price of diamond, higher is the snob
value attached to it and higher is its demand. These goods are sometimes also known as
Vevlen Goods after the economist Thorstein Vevlen.
17
When price of a good remain the same but any one of the other determinants changed
then we will get a new demand curve. So, when demand increases without any change in
price of that good, the demand curve will shift to the right and with a reduction in demand,
the demand curve will shift to the left.
NOTES
18
Price elasticity of demand (ep)
ep = percentage change in quantity demanded resulting from one percent change in the
price of the good, other things remaining constant.
Unitary Elastic % Q = % P Ep = 1.
Perfectly Elastic % P = 0 Ep = .
Perfectly Inelastic % Q = 0 Ep = 0.
19
positive for normal goods. A commodity is considered to be a luxury if its income elasticity
is greater than unity. A commodity is considered to be a necessity if its income elasticity
is less than unity.
The main determinants of income elasticity are:
1. The nature of the need that the commodity covers: the percentage of income spent on
NOTES food declines as income increases.
2. The initial level of income of a country: for example, a TV set is a luxury in an
underdeveloped and poor country, while it is a necessity in a country with high per-
capita income.
3. The time period: consumption patterns adjust with a time lag to changes in income.
1. Survey Methods.
Survey methods are generally used where the purpose is to make short-run forecast of
demand. Under the survey methods there are two types of survey: I) Consumer Survey
Methods Direct Interviews, and ii) Opinion Poll Methods
20
i) Consumer Survey Methods Direct Interviews
The customer survey method of demand forecasting involves of the potential consumers.
It may be in the form of:
a) Complete enumeration,
b) Sample survey,
c) End-use method. NOTES
a) Complete enumeration method
By this method, almost all potential users of the product are contacted and are asked
about their plan of purchasing the product in question. The quantities indicated by the
consumers are added together to obtain the probable demand for the product. The main
limitation of this method is that it can be used successfully only in case of those products
whose consumers are concentrated in a certain region or locality.
b) Sample survey
In this method, only a few potential consumers and users selected from the relevant
market through a sampling method are surveyed. Method of survey may be direct interview
or mailed questionnaire to the sample-consumers. This method is generally used to estimate
short-term demand from business firm, government department and agencies and also by
the households who plan their future purchases.
c) End-use method
This method of demand forecasting has a considerable theoretical and practical value,
especially in forecasting demand for inputs. This method requires building up a schedule
of probable aggregate future demand for inputs by consuming industries and various other
sectors. This method has two exclusive advantages. First, it is possible to work out the
future demand for an industrial product in considerable details by types and size. Second,
in forecasting demand by this method, it is possible to trace and pinpoint at any time in
future as to where and why the actual consumption has deviated from the estimated
demand.
21
c) Market studies and experiments
It is an alternative method of collecting necessary information regarding demand is to
carry out market studies and experiments on consumers behavior under actual, though
controlled, market conditions. This method is known in common parlance as market
experiment method.
NOTES 2. Statistical Methods
This method is utilizes historical (time-series) and data for estimating long-term demand.
This method is considered superior techniques of demand forecasting for the following
reasons:
z In this method, the elements of subjectivity are minimum.
z Method of estimation is scientific.
z Estimates are relatively more reliable.
z It involves smaller cost.
Statistical methods of demand projection include the following techniques;
1. Trend Projection Methods.
2. Barometric Methods.
3. Econometric Method.
22
= [Qs/Qs] / [P/P] = [Qs/P] *
[P/Qs] Where,
Qs = Original quantity supplied, P = Original price,
Qs = Change in quantity supplied,
P = Change in price.
NOTES
2.15. BUDGET CONSTRAINT
The consumer has a given income which sets limits to his maximizing behaviour. Income
acts as a constraint in the attempt for maximizing utility. The income constraint, in the
case of two commodities, may be as:
Y = PX QX+ PYQY
The income constraint graphically present by the budget line, whose equation is derived
as,
1 PX
QY- Y- QX-
PY PY
Assigning successive values of Q X, we may find the corresponding values of QY. Thus, if QX
= 0, the consumer can buy Y/ PY units of good y. Similarly, if QY = 0, the consumer can buy
Y/ PX units of good x.
24
At the point of tangency the slopes of the budget line and of the indifference curve are
equal:
MUx Px
=
MU y Py
Thus the first-order condition is denoted graphically by the point of tangency of the two
relevant curves. The second-order condition is implied by the convex shape of the indifference NOTES
curve. The consumer maximizes his utility by buying Xe and Ye amount of the two
commodities.
The concept of consumer surplus was first introduced by Marshal. Consumer surplus is
the difference between the price consumers are willing to pay and what they actually pay.
The amount that the consumer is willing to pay for the first unit of good he buys is termed
as consumers marginal value. The marginal value decreases as more and more units are
bought. A consumer who maximizes marginal value will buy to that extent where marginal
value equals price. A graphically presentation of consumer surplus is given below.
AB is the demand curve of a consumer. The consumer is willing to pay a price of q 1p 1 for
q1 units of goods. For q2 units of goods he will be willing to pay q2p2. And for Q, he will be
willing to pay QN and so on. Now, suppose that the market price is OP, which the consumer
can decide about the quantity of good he would like to demand. With the demand curve
AB, he will demand OQ. Here, the consumer actually pays OP per unit of the good, but he
was willing to pay more than OP for any unit to the left of Q. For the quantity q1, the
consumer is willing to pay q1p1, but he actually pays q1r1. Hence, the consumer surplus is
(q1p1 - q1r1) = r1p1. In the same way for q2, the consumer surplus is r2p2 and for Q, it is zero. If
the quantities are finally divisible, the total amount that the consumer is willing to pay is
the area OANQ, whereas what he actually pays is the area OPNQ and the consumers
surplus is the area APN.
2.18. SUMMARY
Demand refers to the number of units of a good or service that consumers are willing and
able to buy at each price during a specified interval of time. Changes in demand can be
caused by changes in tastes and preferences, income and prices of other goods and
services also. Marginal revenue is the change in total revenue per unit change in demand.
25
Total revenue is increasing when marginal revenue is positive. Marginal revenue is zero at
the maximum point of total revenue and total revenue is declining when marginal revenue
is negative. Elasticity measures the responsiveness of demand to various factors. Price
elasticity of demand is defined as the percentage change in quantity demanded per 1
percent change in price.
NOTES
CHECK YOUR PROGRESS
1. Which of the following statements is true?
(a) When the supply increases, both the price and the quantity will increase,
(b) When the supply increases, the supply curve shifts towards the left,
(c) A shift in the supply curve towards the right results in a fall in the price,
(d) A decrease in the quantity supplied results in shifting of the supply curve
towards the left.
(a) An increase in tax will affect the customers more than the producers if the
supply schedule is inelastic,
(b) An increase in tax will affect the customers more than the producers if the
demand schedule is inelastic,
(d) An increase in tax will affect the customers less than the producers if the
demand schedule is inelastic.
4. When the income elasticity of demand for a good is negative, the good is
5. If both income and substitution-effects are strong, this region of the demand
curve must be
26
6. The law of demand is always applicable to marginal buyers and is usually applicable
to intra-marginal buyers. Comment.
7. Distinguished between substitutes and complements with examples. How does this
distinction of goods help in business decision making?
8. If price of milk increases, what do you think will happen to the demand for cornflakes?
9. What are the factors that cause the demand curve to shift? NOTES
10. If the demand is fixed but supply of a product increases, what happens to equilibrium
price and quantity?
11. If the market demand curve is given by Q d = 15 8P and the market supply curve Qs
= 2P, find the equilibrium price and quantity graphically and mathematically.
12. Why is it said that the market equilibrium is a highly unstable one?
13. Given the following demand and supply functions, find the equilibrium price and quantity
in the market: Demand Qd = 100 P and Supply P = 10 + 2Qs.
14. Differentiate between the following on the basis of elasticity of demand.
i) Superior Goods and Inferior Goods.
ii) Complements and substitutes.
Fundamental Questions
1. What is demand?
2. What are determinants of demand?
3. What are the different elasticities of demand?
4. What are the different measures of demand forecasting?
5. What is supply?
6. How do we measure supply elasticity?
7. How do you apply indifference curve analysis in analysis?
8. What is consumer surplus?
Skill Development
i) In the context of demand analysis, review the air-fare season wise of Indigo Airlines
and Kingfisher Airline.
ii) Choose a branded cosmetic product (Shampoo, Hair Dye, Talcum Power etc.), col-
lect monthly price-demand (sales) / advertising expenditure sales revenue data on
an average over a period of six months and measure the point and arc price and
promotional elasticity of demand.
Further Readings
z Hirschey, Economics for Managers, Cengage Learning
z Baumol, Microeconomics: Principles & Policies, 9th editions, Cengage Learning
z Froeb, : A Problem Solving Approach, Cengage Learning z Mankiw,
Economics: Principles and Applications, Cengage Learning
z Gupta, G.S. 2006, , 2nd Edition,Tata McGraw Hill
z Peterson, H.C and Lewis, W.C. 2005, , 4th Edition, Prentice
Hall of India
z R Ferguson, R., Ferguson, G.J and
Rothschild,R.1993 Business Economics Macmillan.
27
z Varshney,R.Land Maheshwari, 1994 Manageriaql; Economics, S Chand and Co.
z Koutsoyiannis,A. Modern Economics, Third Edition.
z Chandra, P.2006, Project: Preparation Appraisal Selection Implementation and Re-
view, 6th Edition, Tata McGraw Hill.
z Goldfield,S.M and Chandler,L.V. The Economics of Money and Banking.
NOTES
28
Cost And Production Analysis
UNIT 3 COST AND PRODUCTION
ANALYSIS
STRUCTURE NOTES
3.1. Objectives
3.2. Introduction
3.3. Production Functions
3.4. Law of Variable Proportion or Law of Diminishing Returns to Factors.
3.5. Difference between Returns to a Factor and Returns to Scale
3.6. Isoquants
3.7. Isocost Line or Equal Cost Line
3.8. Marginal Rate of Technical Substitution
3.9. Choices of Input Combination (Optimal Input combination)
3.10. Theory of Cost
3.11. Cost Functions
3.12. Various types of Costs
3.13. Relationship between AC and MC
3.14. Long and Short Run Cost Curves
3.15. Cost and Output Relationship (Cost Function)
3.16. Short Run and Long Run
3.17. Economies / Dis-economies of Scale
3.18. The Theory of firm (Profit Maximization Model)
3.19. Break-even and Shut-down Point
3.20. Managerial Theories of the Firm
3.21. Baumols Model
3.22. Marris Model.
3.23. Summary
3.24. Check Your Progress
3.25. Questions and Exercises
3.26. Further Readings
3.1. OBJECTIVES
The objective of this chapter is to define and application of the production and cost. The
chapter also focuses on the Production Function, Total Product, Average Product, Marginal
Product; Law of Variable Proportion or Law of Diminishing Returns to Factors, Returns to
a Factor and Returns to Scale, Isocost and Isoquant, Marginal Rate of Technical Substitution
(MRTS), Model of Profit Maximization, Sales Revenue Maximisation Model by Baumol,
Managerial Utility Models, Growth Maximisation Models, Total Cost (TC), Total Fixed
Cost (TFC), Total Variable Cost (TVC), Average Fixed Cost (AFC), Average Variable Cost
(AVC), Average Total Cost (ATC) and Marginal Cost (MC), Long and Short Run Cost
Curves, Cost and Output Relationship, Economies / Dis-economies of Scale, Break-even
and Shut-down Point, Baumols Model and Marris Model. Graphs are used consistently
for understanding the subject matter easily.
29
Key Terms
Production, Production Function, Total Product, Average Product, Marginal Product, Law
of Diminishing Returns to Factors, Returns to a Factor, Returns to Scale, Isocost, Isoquant,
Marginal Rate of Technical Substitution (MRTS), Total Cost (TC), Total Fixed Cost (TFC),
Total Variable Cost (TVC), Average Fixed Cost (AFC), Average Variable Cost (AVC), Average
Total Cost (ATC), Marginal Cost (MC), Long and Short Run Cost Curves, Cost and Output
NOTES Relationship, Economies / Dis-economies of Scale, Break-even and Shut-down Point.
3.2. INTRODUCTION
Production is basically an activity of transformation which transfers inputs into outputs.
Firms use land, labour, seeds and small amount of capital as inputs to produce output
like corn. Similarly, a flour mill uses inputs like wheat, labour, capital for machinery,
factory building to produce output like wheat flour. So, an input is the goods or services
which produce an output. The firm generally uses many inputs to produce an output.
Output of any firm may be the inputs of other firms, e.g., steel is an output of the steel
producer, but this steel is also an input of automobile or rail coach manufacturing or
refrigeration manufacturing or air-condition manufacturing industries. The transforming
process of inputs into output can be three types: i) change in form (output should be new
form compared to inputs, for example cloth as output and thread as input) ii) change in
space (transportation) and iii) change in time (storage). The transformation process or
production increases the consumer usability of goods and services.
31
If instead labour is fixed in the short run, the total product of the capital function can be
similarly expressed as:
TPK = f (L0, K) .(v)
NOTES
Average Product (AP) is total product per unit of variable input; therefore it can be expressed
as:
APL = TP/L..(vi)
If instead labour is fixed in the short run, average product of the capital function(APK )can
be similarly expressed as:
APK = TP / K..(vii)
Marginal Product (MP) is defined as addition in total output per unit change in variable
input. Thus marginal product of labour (MP L) would be:
MPL = TP / L ....(viii)
Production Function with Two Variable Inputs: Most simplistic form of production
function with two variable inputs, labour (L) and capital (K), and a single output, Q, is as
follows;
Q = f (L, K) .(ix)
This production function is constructed based on the assumption that the state of the
technology is given and output can be increased by increasing inputs. When the state of
technology changes, the production function itself changes. Further, it is assumed that
the inputs are utilized in the best possible way, i.e., optimum utilization of inputs. The
best utilization of any particular input combination is a technical, not an economic problem.
Selection of best input combination for the production of a particular output level depends
upon the input and output prices and is subject of economic analysis.
32
The law is also known as diminishing returns to factors. It states that as more and more Cost And Production Analysis
one factor of production is employed, other factor remaining the same, its marginal
productivity will diminishing after some time. For example, if we increase labour input and
capital input remaining the same, then the marginal productivity of labour first increased,
reaches maximum and then decreases. The law of diminishing returns to factors is
depending on three assumptions.
i) It is assumed that the state of technology is given. NOTES
ii) It is assumed that one factor of production must always be kept constant at certain
level.
iii) This law is not applicable when two inputs are used in a fixed proportion and the law
is applicable only to varying ratios between the two inputs.
33
In the second stage, the total product increases but less than proportionate to increase in
labour. In this stage, marginal product of labour falls and this stage is called as diminishing
returns to variable factors. Here, MPL > 0 and MPL < APL.
The stage three is a technically inefficient stage of production and a rational producer will
never produce in this stage. Here, MPL < 0 and total product is decreasing.
NOTES The law of returns to scale refers to the long run analysis of production. It refers to the
effects of scale relationships which implies that in the long run output can be increased by
changing all factors by the same proportion, or by different proportions. If the production
function is Q0 = f (K, L) and we increase all the factors of production by the same proportion
p. So, the new production function is Q* = f (p.K, p.L).
If Q* increases in the same proportion as the factors of production, p, then we can say
there are Constant Returns to Scale (CRS).
If Q* increases less than proportionately with an increase in the factors of production, p,
then we can say there are Decreasing Returns to Scale (DRS).
If Q* increases more than proportionately with an increase in the factors of production, p,
then we can say there are Increasing Returns to Scale (IRS).
3.6. ISOQUANTS
An isoquant is the firms counterpart of the consumers indifference curve. It is a curve
representing the various combinations of two inputs that produce the same amount of
output. It is also known as iso-product curve or equal product curve or production indifferent
curve. It is the collection of inputs in the form of factors of production labour (L) and
capital (K), which yield the same output. For a definite level of output, i.e., for Q 0, say
1000 units of output or for Q1, say 2000 units of output, the equation of production function
is
Q0 = f (L, K) or Q1 = f (L 1, K1)
34
Cost And Production Analysis
NOTES
The locus of all the combinations of L and K which satisfy the above equation forms an isoquant.
Since the production function is continuous, an indefinite number of input combinations will lie
on each and every isoquant. The two factors of production are substitutable and can employ
more of one input and less of another input to get the same level of output. A higher level of
output is represented by a higher isoquant. If we assume that that the marginal productivities of
both the factors of production are positive and decreasing as more of them are used, the
isoquant will be downward sloping and convex to the origin.
Types of Isoquant: Isoquants are various shapes depending on the degree or elasticity of
substitutability of inputs. These are as follows;
i) Linear Isoquant: This type assume perfect substitutability between factors of pro-
duction, i.e., a given output can be produced by using only capital or only labor or by
a large number of combinations of capital or labor.
35
ii) Input-Output Isoquant: It assume strict complementary or zero substitutability
between the factors of production, we get input-output isoquant.
NOTES
iii) Kinked Isoquant: This assume limited substitutability of capital and labor. Since
there are only a few processes available for producing any commodity, substitutabil-
ity of factors is possible only at kinks. This form is also called activity analysis
isoquant or linear programming isoquant.
iv) Smooth Convex Isoquant: This form assumes continuous substitutability of capital
and labor only over a certain range, beyond which factors can not be substituted for
each other. Such an isoquant appears as a smooth curve convex to the origin.
36
NOTES
An isoquant is a curve showing all combinations of inputs that can be used to produce a
given output. The characteristics of isoquant are as follows.
Isoquants are Downward Sloping: Technological efficiency connotes that an isoquant
must slope downwards from left to right, which implies that using more of one input to
produce the same level of output must imply using less of the other input. Thus if more of
labour is used in the production process, then less of capital must be used to produce the
same level of output. Slope of the isoquant is equal to: K/L, ratio of capital and labour.
37
NOTES
NOTES
In the above figure, if the firm spend entire amount of money i.e., C0 in hiring lanour, the
firm will get OB units of labour which is equal to C0 / w. On the other hand, if the firm
spends the entire money in purchasing capital, the firm will get OA units of K which is
equal to C0 / r. By joining the two points A and B we get the isocost line C0 . With the given
cost C0 the firm can purchase any combination of labour and / or capital on the line AB.
Consider the isoquant Q1 of above figure, MRTSLK would measure the downward vertical
distance (representing the amount of capital that the producer is willing to sacrifice) per
39
unit of the horizontal distance (representing additional units of labour).In other words,
MRTS is expressed as the ratio between rates of change in L and K, down the isoquant.
Thus: MRTS LK =
'.
'L
MRTS of labour for capital is equal to the slope of the isoquants, it is also equal to the
NOTES ratio of the marginal product of one input to the marginal product of other input. Since
output along an isoquant is constant, if 'K units of labour are substituted for 'K units of
capital, then the increase in output due to increase in , i.e (x ) should match with the
decrease in output due to decrease in i.e., (-x MPK). In other words:
'L x MPL = -'Kx MPK
Or,
MPL / MPK = 'K- / 'L
'.
A change in the level of output can be expressed as change in total output (Q) equals to
'L the sum of change in labour input ('L) times MP of labour and change in capital input
('K) times MP of capital.
In other words:
'Q = MPL x + MPK x 'K
However, along a given isoquant, output remains unchanged, ie. 'Q = 0.
Hence we have
So, the marginal rate of technical substitution between two inputs is equal to the ratio of
the marginal physical products of the inputs.
40
the highest possible point that can be attained by a firm while increasing its output at a Cost And Production Analysis
given cost constraint that can be attained by a firm while increasing its output at a given
cost constraint of Co. The movement from E to E2 and further to E4 is not desirable by the
firm as by moving to these points the firm decreases its level of output and shift to lower
isoquants. The geometric interpretation of the objective of the firm to maximize output
subject to the cost constraint, is that the firm tries to attain the highest possible isoquant
with the given cost constraint. This happens only when the isoquant is tangent to the NOTES
isocost line.
The necessary condition for the maximization of output given the factor prices is that the
isoquant line must be tangent to one of the isoquants. This means that the slope of the
particular isoquant must be equal to the slope of the isocost line. We know that the slope
of the isoquant is given by the ratio of the marginal productivities, i.e.-(MP L/MPK) also
known as the MRTSL, K and the slope of the isocost line is given as the ratio of the factor
prices, i.e.- w/r. So at the point of tangency we have
MPL/MPK = w/r,
i.e., the ratio of the marginal products is equal to the ratio of the factor prices. The above
condition can also be written in the form:
fL / fK = w / r,
Where, fL is marginal productivity of labour and fK is the marginal productivity of capital.
Rearranging the above equation,
we have
fL / w = fK / r.
Now, fL / w is the amount of output that can be obtained by spending one unit of money in
purchasing the factor labor. Similarly, f K / r is the amount of output that can be attained by
spending one unit of money in purchasing the factor capital.
When these two expressions are equal it means that the firm gets the same amount of
output by spending one unit of money either in labor or in capital. In any case, if the
equality does not hold, e.g; when fL / w > fK / r the firm will get more output in spending one
unit of money on labor than that on capital. Reallocation of the factors of production
continues in this way until a point is reached where total output cannot be increased
further by such reallocation of expenditure between labor and capital. At such a point total
output is maximum.
41
So, in a nutshell, the necessary condition of output maximization can be mathematically
represented as
MPL / w = MPK / r
An underlying assumption to the fulfillment of the above condition is the isoquants must
be convex to the origin. However, if the isoquants are concave to the origin, the tangency
NOTES solution will give us the lowest possible output level. This is because, in the case of
concave isoquants the marginal productivity of the factors of production are negative. So,
obviously, the highest attainable point on a concave isoquant will rise to the lowest possible
output level.
Minimization of cost for a given level of output: Least Cost Conditions:
In the above part, we have seen how output can be maximized for a given cost constraint.
Here we will discuss how the firm minimizes its cost of production for a particular level of
output. The conditions of equilibrium of the firm are formally the same as in the previous
section.
As the level of output is fixed, we will be having only one isoquant and different levels of
cost combinations. For equilibrium, there must be tangency of the given isoquant and the
lowest possible isocost line, the shape of the isoquant being convex to the origin. However,
the problem is conceptually different in the case of cost minimization. The entrepreneur,
in this case wants to produce a given level of output (e.g., a bridge, a building, or q tons of
a particular commodity Q) with the minimum possible cost outlay. In this case we will
have a single isoquant denoted by Q o which represents the desired level of output, but we
have a set of isocost lines denoted by AB, CD and GH in the above figure.
Lines closer to the origin will show a lower total cost outlay and vice-versa. The isocost
lines are parallel because they are drawn on the assumption of constant prices of the
factors of production. The level of output Q o can be produced by different combinations of
the two factors of production. The locus of all such combinations is an isoquant for the
output level Qo. The problem of the firm is to select a point on the isoquant which is least
costly. The firm can produce at any point such as, E 2, E 1, E, E 3, E 4, etc. If we proceed
from the points E2 or E4 towards the point E we see that the level of cost at E is much less
then the points like E 1, E 2, E 3, or E 4. Here E is the point which corresponds to the lowest
possible isoquant line. When we move from E2 to E1 we substitute labor for capital. Such
a substitution is possible since total cost is reduced as a result of the substitution.
Similarly, as we move from the point E4 to point E3 we substitute capital for labor. Once
42
the point E is reached further substitution is no more possible, as any deviation from this Cost And Production Analysis
point implies an increase in the cost of production. Hence at point E, the cost of production
the output level Qo is the minimum.
Points below the point E are desirable because they show lower cost, but are not attainable
for the output level Qo . Points above the E, shows higher costs. Hence the point E is the
least cost point for the output level Qo. The least cost combination is fulfilled when the
given isoquant Qo is tangent to the lowest possible isocost line AB, i.e; the slope of the
NOTES
isoquant is equal to the slope of the isocost line, i.e; the ratio of the marginal productivities
must be equal to the ratio of the factor prices. This is given as follows:
MPL/MPK = w / r,
which is the same necessary condition, that we had deduced for output maximization
given the cost constraint.
43
T = technology
Pf = prices of factors
K = fixed factor(s)
Graphically, costs are shown on two-dimensional diagrams. Such curves imply that cost
is a function of output, C = f (X), ceteris paribus. The clause ceteris paribus implies that
NOTES all other factors which determine costs are constant. If these factors do change, their
effect on costs is shown graphically by a shift of the cost curve. This is the reason why
determinants of costs, other than output, are called shift factors. Mathematically there is
no difference between the various determinants of costs. The distinction between
movements along the cost curve (when output changes) and shifts of the curve (when the
other determinants change) is convenient only pedagogically, because it allows the use of
two-dimensional diagrams. But it can be misleading when studying the determinants of
costs. It is important to remember that if the cost curve shifts, this does not imply that the
cost function is indeterminate.
44
Total Fixed Cost (TFC) Cost And Production Analysis
Total fixed cost corresponds to fixed inputs in the short run production function. It is
obtained by summing up the product of quantities of the fixed factors multiplied by their
respective unit prices. TFC remains the same at all levels of output in the short run.
Suppose a small furniture shop proprietor starts his business by hiring a shop at a monthly
rent of Rs. 1,000 borrowing Rs. 50,000 from a bank at an interest rate of 10% and buys
capital equipment worth Rs. 2,000. Then his monthly total cost is estimated to be:
NOTES
Rs. 1,000 + Rs. 2,000 + Rs.500 = Rs. 3,500
(Rent) (Equipment cost) (Monthly interest on th loan)
NOTES Suppose the total cost of producing 4 chairs (i.e. n = 4) is Rs. 10,000 while that for 3
chairs (i.e. n 1 is Rs. 8,000. Marginal cost of producing the 4th chair, therefore, works out
as under:
MC4 = TC4 TC3 = Rs. 10,000 Rs. 8,000 = Rs. 2,000.
Marginal cost is the cost of producing an extra unit of output. In other words, marginal
cost may be defined as the change in total cost associated with a one unit change in
output. It is also an extra unit cost or incremental cost, as it measures the amount by
which total cost increases when output is expanded by one unit. It can also be calculated
by dividing the change in total cost by the one unit change in output.
Symbolically, thus, MC = 'TC / '1Q where, ' denote change in output assumed to
change by 1 unit only.
Therefore, output change is denoted by '
1.
It must be remembered that marginal cost is the cost of producing an additional unit of
output and not of average product. It indicates the change in total cost of producing an
additional unit.
46
In the following figure, the MC curve crosses the AC curve at point P. At this point, for OQ Cost And Production Analysis
level of output the average cost of PQ which is minimum.
NOTES
It should be noted that no such relationship can ever be traced between the MC curve and
the AFC curve simply because by definition, the MC curve is independent. Further, the
area underlying the MC curve is equal to the total variable cost of the given output. In fact,
the point on each average cost curve measures the average cost but the area underlying
them denote total costs as under:
z Total, area underlying the AFC curve measures the total fixed cost.
z The area underlying the AVC curve measures the total variable cost.
z The area underlying the MC curve measures the total variable cost.
z The area underlying the ATC curve measures the total cost.
Finally, the MC curve is important because it is the cost concept relevant to rational
decision making. It has greater significance in determining the equilibrium of the firm. In
fact, the increasing MC due to diminishing returns sets a limit to the expansion of a firm
during the period. Further, it is the MC curve which acts on the supply curve of the firm.
From the above discussion of cost behavior we may conclude that short run average cost
curves (AVS, ATC and MC curves) are U shaped, except then AFC curve, which is an
asymptotic and downward sloping curve.
47
In the long run, a firm will use the level of capital (or other inputs that are fixed in the short
run) that can produce a given level of output at the lowest possible average cost.
Consequently, the LRAC curve is the envelope of the short run average total cost (SR
ATC) curves, where each SR ATC curve is defined by a specific quantity of capital (or other
fixed input).
NOTES
In the short run, because at least one factor of production is fixed, output can be
increased only by adding more variable factors. Hence we consider both fixed and
variable costs. Fixed costs are business expenses that do not vary directly with the level
of output i.e. they are treated as independent of the level of production.
Examples of fixed costs include the rental costs of buildings; the costs of leasing or
purchasing capital equipment such as plant and machinery; the annual business rate
charged by local authorities; the costs of full-time contracted salaried staff; the costs of
meeting interest payments on loans; the depreciation of fixed capital (due solely to age)
and also the costs of business insurance.
In short, the internal economies and diseconomies have their significance in determining
the shape of the LAC curve of a firm. However, the shift in the LAC curve may be attributed
to the external economies and diseconomies. External economies reflect in reducing the
overall cost function of the firm. Thus, a downward shift in the LAC may be caused by
external economies as shown in following Figure.
In above figure, ABCD is the LAC curve. Its AB portion the downward slope is subject
to the internal economies. Its BC portion the horizontal slope is due to the balance
between economies and diseconomies. Its CD portion the upward slope is subject to
internal diseconomies.
In following figure, the original LAC 1 curve shifts downward as LAC2 on account of external
economies.
50
Cost And Production Analysis
NOTES
Similarly, an upward shift in the LAC curve may be attributed to the external diseconomies,
as shown in following figure.
In above figure, the original LAC 1 curve shifts up as LAC2 owning to the external
diseconomies.
51
(a) Firm is a unit which transforms valued inputs into outputs of a higher value, given the
state of technology.
(b) The firm strives towards the achievement of its goal- usually profit maximization.
(c) The market conditions (like competition, monopoly, etc.) for a firm to operate are
given.
NOTES (d) While choosing between alternatives, the firm prefers the alternative which helps it to
consistently achieve profit maximization.
(e) The primary concern of the theory of firm is to analyze changes in the price and
quantity of inputs and outputs.
Taking these as central points, the theory of firm has been carried to varying degrees of
elaboration and refinement. Before taking it up in detail, let us note the basic assumptions
on which this theory rests.
Assumptions of the Model:
1. The firm has a single goal , viz., to maximize profit( Motivational assumption)
2. The firm acts rationally to pursue its goal. Rationality implies perfect knowledge of all
relevant variables at the time of decision-making.
3. The firm is a single ownership one, i.e; run by its owner, called the entrepreneur.
The Model: The term profit maximization is usually taken to mean the generation of
largest absolute amount of profits over the time period being analyzed. This then leads us
to defining the term time period. Economists have suggested two broad time period: the
short-run and long-run; consequently, there is short-run and long-run profit maximization.
The short run is defined as a period where adjustments to changed conditions are only
partial, e.g.; if defined for the product for a firm increases, in the short run it can meet the
increased demand through changes in man-hours and intensive use of existing machinery,
but it cannot increase its production capacity. On the other hand, long-run is a period
where adjustment to changed circumstances is complete. For example, the above
mentioned firm can meet the increased demand in the long-run by making changes in its
production capacity or by setting up an additional plant, besides changes in man-hours
and intensive use of its existing machinery. Thus, in the short-run there are certain
constraints (physical or financial) on expansion. As time passes, these constraints can
gradually be overcome. And, when all the constraints are overcome, the long-run is reached.
No calendar time can be specified for short-run or long-run. It depends upon the nature of
production. For example, a furniture workshop can increase its capacity and make complete
adjustments within a matter of months, while a firm manufacturing automobile may take
years to do so. The long-run will, therefore, be a matter of months in case of furniture
workshop and a matter of years for an automobile firm.
Relationship between Short-run and Long-run Profit Maximization: We know that
the long-run consists of a number of short-run periods. But, it implies that if the firm
maximizes profit in the short-run, it must be found to maximize in the long-run also. It
depends upon the two following conditions;
1. Assumption of independence of periods. Is each short-run period considered in isola-
tion, in the sense that a short-run period has no effect which link this period to the
next period?
2. Assumption of period-linkages- Each short-run period is linked to the next short-run
period.
Under the assumption of independence of periods, the short-run and long-run profit
maximization is consistent. On the other hand, with the assumption of period-linkages,
52
the profit maximization in the two periods may conflict. For example, a firm which dominates Cost And Production Analysis
the market may decide to restrict supplies in order to change higher price to maximize
profits. This would, in the long-run, attract rival firms into the industry, thus forcing a
reduction in the price and profits of the dominant firm. Had the firm not attended to maximize
profits in the short-run the rival would not possible have been attracted to the industry,
thus allowing the dominant firm to achieve long-run profit maximization. Here the short-run
profit maximization policy results in the defeat of long-run profit maximization. Several NOTES
instances may be cited where a conflict between the profit maximization in the two periods
may exist, like:
(a) Higher profits in the short-run may in the long-run induce workers to demand higher
wages.
(b) Maximization of profits in the short-run may give an impression of being exploitative,
thus inviting legal or government intervention which would affect long run profits ad-
versely.
(c A firm trying to build up its reputation by charging low prices and supplying quality
products in the short run would be able to make long run profits.
It may however be noted that the assumptions of independence of period are not found
tenable in practice. On the other hand the period linkage are considerably affected by the
condition of uncertainty since the dependence of one period on the other involves future
reactions, there remains an element of uncertainty. The extent of uncertainty increases
the further we go into the future. This perhaps is the reason why firm prefer short run profit
maximization to the long run. There is however a major problem if the firms prefer long run
rather than short run profit maximization. In such cases almost any decision can be
defended on the basis that it aims at long run profit maximization, e.g. extravagancy in
the reception facilities may be defended on the grounds of improving firms public image
which would contribute to long run profits.
Determination of profit maximizing output and price
The approach of the traditional economic theory is that the firm compares the cost and
revenue implication of different output levels and fix up the output level that maximizes the
absolute difference between the two. Let TR and TC be the total revenue and total cost at
a given level of output X .then profit () at that level of output would be,
=TR-TC
For to attain the maximum value, the firm shall produce that level of output where the
following two marginal conditions are satisfied:
53
which implies that the slope of MR curve is less than the slope of MC curve.
An output level (X) which satisfies both the above conditions would be the profit-maximizing
level of output.
NOTES
Since profit () is the difference between total revenue (TR) and total cost (TC), the profit-
maximizing output will occur when the gap between TR and TC is maximum. In Fig. 3.1,
TR and TC curves represent the total cost and total revenue for different output levels. The
gap between TR and TC is maximum at output Oq* where the slopes of the two curves are
equal. Since slopes of total cost and total revenue curves are marginal cost (MC) and
marginal revenue (MR) respectively, it implies that profit is maximized at that output level
where MR=MC.
Limitations: The traditional theory suggests a number of reasons as to why do a firm
want to maximize profits. All these reasons essentially fall into the following categories:
1. Traditional economic theory assumes that the firm is owner-managed, and therefore
maximizing profit would imply maximizing the income of the owner. Owner would like
to have adequate return for his activity as an entrepreneur. Maximizing-profits for a
given amount of effort will, therefore, be quite a rational behavior for him.
2. The very survival of the firm depends upon the entrepreneurs ability to maximize
profits in the long run. The goal of profit maximization is, in fact, forced upon him by
the impact of the competing firms. By maximizing profits the firm can accumulate
financial assets which allow it to grow faster than those firms which pursue goals
other than profit maximization share of the latter gradually shrinks and such firms
eventually get eliminated. In case of monopoly situation, where there are no rivals to
force him to maximize profits, he would like to pursue this goal to achieve the maxi-
mum return for his efforts.
3. Firm may pursue goals other than profit-maximization, but they can achieve these
subsidiary goals much easier if they aim for profit-maximization.
These justifications of profit-maximization have been subjected to severe criticism and
certain alternative goals have been suggested by economists. Some of the main points of
criticism are the following:
1. In the context of real business situation the assumption of profit-maximization is of
doubtful validity. There is no reason to believe that all businessmen pursue the same
goal. They may aim at sales maximization, expansion of market share, etc.
54
2. The assumption of traditional theory that firms are owner-managed is not valid in the Cost And Production Analysis
modern business world where firm is a complex organization run by salaried manag-
ers whose interests may, and often do, differ from those of the shareholders who want
maximum profits.
3. In the absence of usually incomplete information all the business decisions may not
be optimal. This lack of information may be of two types: a) Since business decisions
always, directly or indirectly, relate to the future, and since future is always uncertain, NOTES
the businessmans decisions may not always be what he wants them to be. b) Fur-
ther, the lack of information also results from the failure or inability of the firm to
collect the adequate information and to use the information it already possesses.
Former results due to expensiveness of collection of information, and the latter due to
the difference in what the business firm collects and what it actually needs.
4. The modern business firm divides itself into separate departments, each having a
considerable degree of autonomy in its operations. Under these conditions it is not
possible for those at the top of the firm to ensure that decisions taken in particular
departments or functions fit in with the overall policy of the firm and whether these
decisions lead to the overall optima for the whole firm. It will be more appropriate to
say that given the organization of the modern firm and its problems, firms are often
too complex for any individual or group to be able to see them as a whole.
5. One cannot say that in non-competitive situations the firms that do not maximize
profits will be driven out of business; and that, under such a situation a profit-earning
firm need not quickly adjust to changes in the economic environment. It is also not
true that these adjustments will be done in the direction which economic theory has
predicted. For example, if there is a large group of firms, demand for whose products
remains at a very high level for a long period of time, any firm in this group, however
inefficient, will be able to survive. It has been found that where profits are easy to
come the keen quest for profits will be abandoned in many cases. Such a situation
was there in advanced countries during the long period of inflation and full employ-
ment after World War II. Further, the firms might enter into open or tacit agreement to
avoid some kinds of competition, especially price competition. These agreement are
found quite often in markets like those for automobiles, aircrafts, detergents and
chemicals. Thus, while the assumption of profit maximization has served economics
well for many years, it is clear that it needs supplementing by other assumptions.
6. It has been observed in the modern business world that the emerging dominant mar-
ket structure is oligopoly, where a few large firms dominate the market. The small
firms often have to follow these large firms in fixing the price. Under such circum-
stances how can these small firms (which are generally in majority) are expected to
pursue the goal of profit-maximizations?
7. Lack of predictive power of managers, and they generally being risk-averse, results in
firms settling with less-than-maximum profit as their goal. Firms are prevented to
maximize profits also because they generally suffer from lack of proper intra-firm
communication.
Literature criticizing profit-maximization hypothesis is extensive and much of it is of
considerable economic and philosophical subtlety. However, the attack on profit-maximizing
hypothesis is threefold:
a) Firms cannot have profit maximization as their goal as they lack the necessary infor-
mation and ability to do so.
b) Even if the firms could, they do not want to pursue profit-maximizations. There are
multiplicity of goals a modern firm pursues and profit-maximizations may be only one
of them; and,
55
c) Firms do not maximize profits but face some bind of minimum profit constraint. The
management has discretion in setting goals subject to minimum profit constraint.
56
analysis, but here we would explain graphical method only. Total revenue and total cost Cost And Production Analysis
measured in the vertical axis and output is measured in the horizontal axis. Here, total
cost (TC) is total fixed cost (TFC) plus total variable cost (TVC); i.e., TC = TFC +TVC.
Total revenue (TR) is 45o line, which starts from origin, where output (Q) is zero and TR is
also zero. In the following figure, at point E, the total revenue is equal to total cost, i.e.,
TR=TC, that means no loss no profit case. In this case, the total output is OQe units. So,
the breakeven point is E and Breakeven amount of output is OQe units. NOTES
The fixed cost is that cost which is occurs irrespective of output, which means the firm
has to bear this TFC even when the production is stopped. To get normal profit or zero
profit, the firm has to cover TC (TFC + TVC). But if the firm is not able to cover this TC then
also the firm will continue to produce up to the level where the loss amount is equal to
TFC. Because, the firm is identical in both the cases, i.e., if stopped production then the
maximum amount of loss is TFC or if they produce then also they can bear the same
amount of loss (equal to TFC). So, in the following figure, the shut-down point is S and
shut-down output is OQs.
58
TC Cost And Production Analysis
NOTES
Implications of Baumols Model: If both the profit maximiser and a constrained sales
maximiser face the same demand curve, the later will charge a lower price to sell the
extra output (Q3 Q1 ). A sales maximiser will spend more on advertisement than does a
profit-maximiser firm. Baumol assumes that advertisement does not affect the products
price but it does lead to increased output sold. It is also assumed that advertisement will
always lead to a rise in TR; MR will never become negative. This is shown in the following
figure. Since, advertisement will always increase TC; the management will increase
advertisement until prevented by the profit constraint (0 ).
59
3.22. MARRIS MODEL
Marris tried to improve upon Baumols model. He offered a variation of Baumols model
that stressed the maximization of growth subject to the security of managements position.
Marris hypothesis is that executive actions are limited by the need for management to
protect itself from dismissal or takeover raids in the event of failure. Like Williamson,
NOTES Marris approach is also based on the fact that ownership and control of the firm is in the
hands of two different sets of people. He, like Williamson, also suggested that manager
have a utility function in which salary, status, power, prestige and security are important
variables. Owners of the firm (i.e.; shareholders) are, however, more concerned about
profits, market share, output etc. In other words, goals of the managers and shareholders
differ from each other. The utility function of managers (Um) and that of the owners (Uo)
may, therefore, be defined as:
Um = f (salaries, power, status, job security)
And, Uo = f (profits, market share, output, capital, public esteem).
In contrast to Williamson, Robin Marris believes that most of the variables entering into
the utility function of managers and owners are strongly correlated with a single variable:
the size of the firm. He, therefore, postulates that the managers would be mainly concerned
about the rate of the growth of size. However, various measures of size exist, like capital,
output, revenue, and market share. Marris defines size in terms of corporate capital,
which is measured as the sum total of the book value of assets, inventory and short-term
assets including cash revenue. Further, it may be noted that managers aim to maximize
rate of growth of size rather than absolute size, as the managers generally wish to stay in
the concern and grow rather than move from a smaller size firm to a bigger size firm.
Moreover, maximizing the rate of growth of size also satisfies the owners, while absolute
size may not. Thus, the attraction of the growth rate of size stems from the fact that not
only it has a positive effect upon the prospects of promotion of the managers, but it also
keeps the shareholders satisfied.
Marris recognizes that the drive for the rate of growth of size is not, however, without
constraints. He lists mainly two constraints to the achievement of maximization of the
rate of growth:
(a) Marris adopts Penroses thesis of the existence of a sure limit on the rate of manage-
rial expansion. In other words, the capacity of the managerial team in fact determines
the upper limits to the growth of the firm. There is a high possibility that management
would lose control over a rapidly growing firm. There is a limit to output increase by
hiring new managers due to their lack of experience. And the time-lag involved in their
acquiring the specific corporate culture and developing coordination with the existing
managerial team. The ability of manager to find and successfully launch new prod-
ucts to take the place of old ones is also subject to a limit. Similarly, the research and
development department cannot be expected to produce expanding flow of products
continuously. All these factors are strong enough to set a limit to the rate of growth of
size of the firm.
(b) The second constraint on the rate of the growth stems from the voluntary slowing
down process by the management itself. This slowing down process comes from the
desire of the management for job-security. The management which holds high the
consideration of job security would grow in such a way that it remains safe on the
financial side. For example, in case management aims to achieve growth at any cost,
it should not hesitate to borrow large sum of money from the capital market for invest-
ment purpose. But increased rate of borrowing may give out an impression of follow-
60
ing a less prudent financial policy, thus inviting take-over bid by another firm. This Cost And Production Analysis
would definitely be real danger to the job-secure motivation of the managers. Obvi-
ously, there is definite disutility of risk and the managers would like to seek the job
security through the adoption of a cautious and prudent financial policy which would
consist of: non-involvement in risky investments; financing growth mainly from the
profit levels being generated by the present set of products. The ratio of external to
internal finance is not allowed to grow significantly. NOTES
To judge the prudent of a financial policy, Marris proposes the concept of financial constraint
(a) which is mainly determined by the risk attitude of the top management. A risk-loving
management would prefer a high value of a, while a risk-averting management would
prefer a low value of a. Marris defines a as the weighted average of the following three
security ratios:
Liquidity Ratio (a1) = Liquid Assets/Total Assets;
Leverage Ratio (a2) = Value of Debts/Total Assets;
Profit-Retention Ratio (a 3) = Retained Profits/Total Profits.
Low liquidity ratio implies the possibility of insolvency of the firm. High liquidity, of course
increases the security, but a too high liquidity ratio has an adverse impact on rate of
growth. To ensure security the management has, therefore to choose a level of a1 which is
neither too high nor too low. The leverage ratio relates to the extent of reliance on borrowing
for expansion purposes. A high and growing leverage ratio would invite takeover bids and
increase the rate of failure, while a too low leverage ratio would retard growth. Retained
profits are perhaps the most important financial source for the growth of capital. But, a
high level of retained profits is perhaps the most important financial source for the growth
of the capital. But a high level of retained profits cannot keep the shareholders happy and
a too high a3 would mean that management is taking a risk of displeasing the shareholders.
As is obvious from the discussion above, value of the financial constraint (a) would increase
if either a2 or a3 are increased or a1 is reduced. That is, liquidity ratio and profit-retention
ratio are positively related. Marris further postulates that there is a negative relationship
between job-security and the financial constraint: job security of managers is reduced if a
is increased and job security increases if a is reduced. Thus, financial security constraint
determines the level of job security and therefore limits the rate of growth of the capital
supply and thereby the rate of growth of size of firm.
Model: Merris argues that the managers would aim to have a balanced growth, in the
sense that growth in demand (stemming mainly from new products) would be matched by
growth in capital (making available the investible funds for launching and producing these
products). That is, the managers would want to maximize balance growth rate (g), which
is equal to the growth rate of demand for the product (gd) and growth rate of capital supply
(gc):
Max. g = gd= gc
By this process the managers achieve maximization of their own utility as well as that of
the shareholders. In case the management wants to expand too rapidly (by undertaking
highly risky projects, resorting to heavy borrowing for expansion, etc.), it runs the risk of
job security. On the other hand, if it wants to expand too slowly (due to lack of initiative
in finding new market and products, keeping excessive reserves by high profit-retention
ratio but shying away from new investment projects), it would be considered as an inefficient
management, again impairing job-security.
The first step to achieve balanced growth rate would be to identify the factors that go in to
determining gd and gc. According to Marris, these determinants can be expressed in
terms of two variables:
61
1. Diversification rate(d);
2. Average profit margin (m).
Both these variables can be however determined only after the management has decided
about its financial policy, a. The diversification rate can be chosen either by changes in
style of the existing products or by expanding the range of products. Given the price of the
NOTES product and the production cost, the average profit margin would be affected by the levels
of advertising and R&D. Higher the expenditure on advertisement (A) as well as R&D,
lower would be average profit margin (m). Thus, the Marris firm has three policy variables:
a, d and m.
Marris also points out that there can be a conflict between managers objective of
maximizing growth and stockholders objective of maximizing profits. Therefore, if the
growth maximizing solution does not generate sufficient profits, growth rate will have to be
reduced to increase dividend to meet shareholders expectations.
In brief in Marris model the management, whose actions are limited by the motivation to
protect itself from dismissal or take over bids, takes to the following course:
1. The management must walk on a knife-edge between debt/assets ratio high enough
to stimulate growth but not low enough to suggest financial imprudence.
2. The management must also maintain a low liquidity ratio, i.e; liquid asset/total as-
sets. But this ratio must not be so low that it endangers paying all obligations on
time.
3. The management must try to keep a high retention ratio, viz., retained earnings/total
profits. But this ratio should not be so high that shareholders are not paid satisfactory
dividend.
3.23. SUMMARY
The theory of cost is a fundamental concern of . The best measure of resource cost is the
value of that resource in its highest-valued alternative use. The cost of a long-lived asset
during the production period is the difference in the value of that asset between the
beginning and end of the period. The cost function relates cost to specify rates of
output. The basis for the cost function is the production function and the price of the
inputs. In the short run, the rate of one input is fixed. The cost associated with that
input is called fixed cost. In the long run, all costs are variable. The long-run average cost
curve is the envelope of a series of short run average cost curves. The long run cost
functions are used for planning the optimal scale of plant size.
62
3. When average product is highest Cost And Production Analysis
(a) Long run total cost curve, (b) Long run average total cost curve,
(c) Long run marginal cost curve, (d) Long run average variable cost curve
Fundamental Questions
1. What is production?
2. What are factors of production?
3. What are the difference between short run and long run?
63
4. What are the inputs and outputs?
5. What is cost?
6. How do we define total, average and marginal product of labour?
7. What is Marginal Rate of Technical Substitution (MRTS)?
8. What is Law of Variable Proportion?
NOTES
9. What are economies of scale?
10. What are the basic features of profit maximization model?
11. Why long run average cost curve is the envelope of short run average cost curves?
12. Why marginal cost curve passes through the minimum point of average cost curve?
Further Readings
z Hirschey, Economics for Managers, Cengage Learning
z Baumol, Microeconomics: Principles & Policies, 9th editions, Cengage Learning
z Froeb, : A Problem Solving Approach, Cengage Learning z Mankiw,
Economics: Principles and Applications, Cengage Learning
z Gupta, G.S. 2006, , 2nd Edition,Tata McGraw Hill
z Peterson, H.C and Lewis, W.C. 2005, , 4th Edition, Prentice
Hall of India
z R Ferguson, R., Ferguson, G.J and
Rothschild,R.1993 Business Economics Macmillan.
z Varshney,R.Land Maheshwari, 1994 Manageriaql; Economics, S Chand and Co.
z Koutsoyiannis,A. Modern Economics, Third Edition.
z Chandra, P.2006, Project: Preparation Appraisal Selection Implementation and Re-
view, 6th Edition, Tata McGraw Hill.
z Goldfield,S.M and Chandler,L.V. The Economics of Money and Banking.
64
Market Structure Analysis
UNIT 4 MARKET STRUCTURE
ANALYSIS
STRUCTURE NOTES
4.1. Objectives
4.2. Introduction: - Perfect Competition
4.2.1. Assumptions of perfect competition:
4.2.2. Short Run Equilibrium
4.2.3. Long Run Equilibrium
4.3. Monopoly: Price Discrimination
4.3.1. Monopoly
4.3.2. Price and Quantity Determination in Short Run
4.3.2.1. Supernormal Profit
4.3.2.2. Normal Profit
4.3.2.3. Subnormal Profit or Loss
4.3.3. Price and Quantity Determination in Long Run
4.3.4. Price Discrimination
4.4. Monopolistic Competition
4.5. Oligopoly-Mutual Interdependence
4.5.1. Non-collusive Oligopoly
4.5.2. Sweezys Model of Kinked Demand Curve
4.5.3. Collusive Oligopoly
4.5.4. Price Leadership
4.6. Prisoners Dilemma
4.7. Summary
4.8. Check Your Progress
4.9. Questions and Exercises
4.10. Further Readings
4.1. OBJECTIVES
The objective of this chapter is to define and application of market structure. The chapter
also focuses on the Perfect Competition, Assumptions of perfect competiton, Short Run
and Long Run Equilibrium, Monopoly, Price Discrimination, Price and Quantity Dtermination
in short Run, Supernormal Profit, Normal Profit, Subnormal Profit or Loss, Price and
Quantity Determination in Long Run, Price Discrimination, Monopolistic Competition,
Oligopoly, Mutual Interdependence, Non-collusive Oligopoly, Sweezys Model of Kinked
Demand Curve, Collusive Oloigopoly, Price Leadershuip, Prisoners Dilemma. Graphs are
used consistently for understanding the subject matter easily.
Key Terms
Perfect Competition, Assumptions, Short Run and Long Run Equilibrium, Monopoly, Price
Discrimination, Price and Quantity Determination in Short Run, Supernormal Profit, Normal
65
Profit, Subnormal Profit or Loss, Price and Quantity Determination in Long Run, Price
Discrimination, Monopolistic Competition, Oligopoly, Mutual Interdependenc, Non-Collusive
Oligoply, Sweezys Model of Kinked Demand Curve, Collusive Oligopoly, Price Leadership,
Prisoners Dilemma.
Product homogeneity:
The industry is defined as a group of firms producing a homogenous product. The technical
characteristics of the product as well as the services associated with its sale and delivery
are identical. There is no way in which a buyer could differentiate among the products of
different firms. If the products were differentiated the firm would have some discretion in
setting its price. This is ruled out ex hypothesis in perfect competition. The assumption of
large number of sellers and of product homogeneity imply that the individual firm in pure
competition is a price taker, its demand card is infinitely elastic, indicating that the firm
can sell any amount of output at the prevailing market price. The demand card of the
individual firm is also its average revenue and its marginal revenue carves.
66
Free entry and free exit of the firm: Market Structure Analysis
There is no barrier to entry or exit from the industry. Entry or exit may take time but the
firms have freedom of movement in and out of the industry.
Profit maximization:
The only goal of all firms is profit maximization. NOTES
No government regulation:
There is no government intervention in the market. Here the firm is a price-taker and have
and infinitely elastic demand curve.
The market structure in which the above assumptions are fulfilled is called pure competition,
which is different from perfect competition. Perfect competition requires two more
assumptions.
Perfect knowledge:
It is assumed that all sellers and buyers have complete knowledge of the conditions of
market. This knowledge refers not only to the prevailing conditions in the current period
but in all future periods as well. Information is free and costless. In this market situation
uncertainty about future developments in the market is ruled out.
67
NOTES
Normal profit: In the short run, it is not possible to earn supernormal profit by all the
firms, some of them may also earn normal profits, which means revenue is equal to cost.
Like pervious case, the equilibrium of the firm is shown as E in the figure, the output that
maximizes is OQ*. The total revenue earn by the firm is the rectangular area OP* EQ*,
which is also the total cost of producing the equilibrium output OQ*. Therefore, in this
case, the firm makes normal profit which means no profits. This is possible because the
average cost curve is tangent to the average revenue line.
Loss or Subnormal profit: Here also the equilibrium point E determines the equilibrium
level of output OQ* and price OP*. The total revenue is given by rectangular area OP* EQ*
and total cost is the rectangular OABQ*, which is more than the total revenue by the
amount is equivalent to the rectangular area P*ABE. This extra amount of cost incurred
by the firm is called loss or profit, which occurs in the short run because the average cost
is more than the market price.
68
Market Structure Analysis
NOTES
69
4.3. MONOPOLY PRICE DISCRIMINATION
4.3.1. Monopoly:
Monopoly is a market in which a single seller sells a product or service which has no
NOTES substitute. Economists distinguished between pure monopoly and monopoly. Pure
monopoly is that market situation in which there is absolutely no substitute of the product,
and the entire market is under control of a single firm. A monopoly exist if there is no close
substitute to the product and also when there is a single producer and seller of the
product, like Indian Railways, but it has a very remote substitute in the market, like Buss
services, Flights etc.
The features of monopoly are Single Seller, Single Product, No Difference between Firm
and Industry, Independent Decision Making of the Firm and Restricted Entry.
The monopolist can not set both the price and quantity at its own will. A monopolist firm is
able to independently determine an optimal combination of price and quantity, and has a
normal demand curve with a negative slope. The reason behind the negative slope is that
although a monopoly firm is in total control of the market price, but it can sell more only
when it reduces the price of its product. Here both the MR and AR curves are downward
sloping. The reason is that, a monopoly firm faces a normal demand curve which is highly
inelastic, therefore AR curve would be downward sloping and the MR curve would lie below
the AR curve. This is because of fact that the monopolist has to lower the price of all units
of products for selling an additional unit.
72
Third-degree price discrimination is the most common form of price discrimination. It Market Structure Analysis
involves separating consumers or markets in terms of their price elasticity of demand.
This segmentation can be based on several factors. Often third degree price discrimination
occurs in the markets that are geographically separated. Let us consider an example. It
is often seen that books of US publication are sold in other countries at a lower price
compared to US evidently; buyers in other countries have greater elasticity of demand
than do US buyers. At the same time, cost of collecting and shipping books make it NOTES
unprofitable for other firms to buy in foreign countries and resell in the United States.
Discrimination can also be based on the nature of use. Telephone customers are classified
as either residential or business customers. The monthly charge for a phone located in a
business usually is somewhat higher than for a telephone used in a home.
Finally, markets can be segmented based on personal characteristics of consumers. Age
is a common basis for price discrimination. For example, most movie theatres charge for
adults, though the cost of providing service to the two groups in the same.
Equilibrium
A firm in this market has limited control over the prices of their products. Generally, the
consumers prefer the products of specific sellers and are ready to pay more, but within
specific limit, to satisfy their preferences. The condition for the equilibrium of a firm is that
it maximizes profit and the group or industry will be in equilibrium when each firm within
73
the group is in equilibrium earning normal profits and there is no tendency to enter into or
exit from the group.
NOTES
Let us first consider the equilibrium of a single firm. A single firm may be regarded as a
monopolist. Its equilibrium condition can, therefore, be determined by the same way as in
case of a monopolist. Its AR (same as the demand curve) curve is downward sloping and
the MR curve lies below the AR curve. The firm will be in equilibrium where MR=MC to
maximize profits. At the equilibrium point, the firm may be earning normal profits or more
than normal profits or less than normal profits as it happens in the case of a monopolist.
In the above figure, let AR1 and MR1 be the AR and the MR curves of the first firm and
MC1 be the MC curve of the firm. The equilibrium level of output is OQ1 and the equilibrium
price level is OP1. The firm maximizes total profits. But under group equilibrium, the
equality of MR and MC is not the sufficient condition for profit maximization though it is
the necessary condition. Industry equilibrium is possible only when each firm is earning
only normal profits, that is, the point where AR=AC for each firm. This is so because, if the
existing firms earn more than normal profits, new firms will enter into the industry. This will
reduce the volume of abnormal profits of the existing firms. Entry will continue until all the
firms earn only normal profits. The situation of the group equilibrium can be analyzed with
the help of the figure given below.
74
In the above figure the firm is in equilibrium at point E where the AR curve is tangent to the Market Structure Analysis
LAC curve and the output level of OQ1 . It can be proved that at the output level where AR
is tangent to AC. MR must be equal to MC. We know that,
MR = AR + Q. dAR/dQ and MC = AC + Q. dAC/dQ, where, Q is the level of output. Now,
when the level of output is the same, if AR = AC and it is such that dAR/dQ = dAC/dQ i.e.
AR is tangent to AC, MR will be equal to MC. Note that each firm will be in equilibrium at
a point on the AC curve which is to the left of its minimum point, F. if the firm operates
NOTES
under perfect competition, equilibrium will be achieved at the lowest point of the AC curve,
where the level of output is OQ2 and the price is OP2. The long run equilibrium point under
monopolistic competition (E) must be at the falling portion of the AC curve because here
AR is falling and such an AR curve can be tangent to the AC curve only at the latters
downward sloping portion.
This property of equilibrium under monopolistic competition is known as the excess capacity
theorem. This means that under monopolistic competition excess capacity remains in
each firm in the sense that more output can be produced at a lower cost. Suppose that
the number of firms is reduced but the output level of each firm is increased so that the
total output of the industry remains the same. In this case, each firm will produce the
output at a lower cost and hence total cost of obtaining the same level of output by
eliminating some firm will be lower. Thus excess capacity remains under monopolistic
competition and this capacity can be utilized by eliminating some firms form the industry.
For social standpoint, monopolistic competition is inferior to perfect competition. Under
perfect competition, capacity is fully utilized. Production takes place at the minimum
point of the average cost curve. But this condition is not fulfilled under monopolistic
competition.
76
fall in the price. The kinked demand curve is, therefore based on the assumption that a Market Structure Analysis
rise in price by one seller will not be followed by a rise in the price of the other sellers,
while a fall in the price of one seller will be followed by the corresponding fall in the price
by others. A kinked demand curve is shown in the following figure.
NOTES
Suppose that we have drawn two demand curves dd and DD. The demand curve dd is
drawn on the assumption that when one seller changes his price, the other sellers do not
change their prices and keep their prices unaffected. The demand curve DD is drawn on
the assumptions that when one seller changes his price, the other sellers also change
their price is the same direction. The demand curves dd and DD intersect at the point P.
In the kinked demand curve analysis it is assumed that the rise in price will be unmatched
while a fall in the price will be matched. Hence the demand curve is dPD which has a kink
at the point P. Let us consider a situation where price is reduced from OP1 to OP2. If the
other sellers also reduce the price, the quantity sold by this seller will increase by QR.
But if the sellers do not reduce prices the quantity sold will increase by QS. Similarly,
when the price is increased form OP1 to OP3 the quantity demanded will be reduced by
PQ (if other sellers do not increase their prices) and the quantity demanded will be
reduced by PR if other sellers also increase their prices. Since it is assumed that price
decrease by a firm will be matched by a price reduction by rivals but an increase in the
price is not matched by the rivals, the relevant demand curve has a higher price elasticity
than the lower part. The position of the curve is determined by the location of OP1, the
price at which the oligopolist now happens to be selling his product. The price OP1 is the
datum and it is not determined in the model.
Consider now the implication of a kink in the demand curve faced by the seller in the
market. If the demand curve is kinked, the corresponding MR curve will be discontinuous.
This is seen in the following figure. In this figure dA portion of the MR curve corresponds to
the dP portion of the demand curve, while the BC portion of the MR curve corresponds to
the PD portion of the demand curve. The length of the discontinuity is equal to AB. The
point P on the demand curve has two elasticities of demand. If we think that P is a point
on DD we get another elasticity of demand.
77
NOTES
The greater the difference between the two elasticities of demand, the greater will be the
length of the discontinuity. This is so because, we know from the relation between the
MR, price and the absolute value of the demand elasticity (e) that MR = price [1-1/e].now
at that point P, both the demand curves DD and dd have the same output level. The MR
will therefore be different because of the differences in the elasticities are equal at point P,
the discontinuous range will disappears.
Suppose now that the MC curve of the firm passes through the discontinuous range of the
MR curve, in this case, we cannot say that MR equals MC at the equilibrium point.
Equality of MR and MC is not possible. All that we can say is that MR cannot be less than
MC. In this situation the price and quantity remain the same at the kink point. Even if the
MC curve shifts but passes through the discontinuous range B, the price-quantity
combination remains constant.
The price-quantity combination given by the point of the kink remains more or less stable
in the oligopoly market. The price rise or the price fall is not profitable for a single seller
because of the asymmetrical behavior of the sellers for a price rise or a price fall. The
equilibrium of the firm is defined by the point of the kink because for any output level less
than OM, MC is below MR, while for any output level greater than OM, MC is greater than
MR. thus total profit is maximized at the kink through the profit maximizing condition
(MR=MC) is not fulfilled at the kink point.
The discontinuity of A and B of the MR curve implies that there is a range within which
costs may change without affecting the equilibrium price and output of the firm. This level
of price and output is compatible with a wide range of costs. Thus the kink can explain
why the price and output will not change despite changes in cost within the range AB.
If the demand curve is kinked, a shift in the market demand upwards or downwards, will
affect the volume of output but not the level of price, so long as the MC curve passes
through the discontinuous range of MR curve. In this case the demand curve shifts but the
kink point lies on the horizontal straight line. As the market expands, the firm will not raise
its price, although output will increase.
In conclusion it can, therefore, be said that the kinked demand analysis as a method of
price-output determinations not analytically sound. But it can be accepted as a reasonable
explanation for the rigidity of price and output in the oligopolistic markets.
78
4.5.3. Collusive Oligopoly Market Structure Analysis
Dominant Firm
Often an oligopoly market is dominated by few firms, among which one may be the
largest player. There can be numerous such examples, Google among search engines,
Intel in the micro chips market, Nokia in mobile phones and IBM in the PC segment.
Specific to Indian context, we can look at Bajaj Auto in the two wheeler market, Maruti in
cars and Godrej in steel furniture. The highlight of this situation is that other companies
acknowledge the leadership of this largest firm for price determination. The basis of such
dominance is that a firm may emerge as a leader in terms of either market share, or
presence in all market segments, or just being the pioneer in the particular product category.
Normally the leader is very large in size and earns economies of scale; it produces
optimum output at which it is able to maximize returns. This dominant firm may be either
a benevolent firm or an exploitative firm.
A benevolent leader is one which allows other firms to exist by fixing a price at which
small firms may also sell. This price is higher than marginal cost of the overall market so
that firms operating at higher cost of production may also survive. There are two major
reasons behind the creation of a benevolent firm: (i) it lets others exist so that it does not
have to face allegations of monopoly creation; (ii) it earns sufficient margin at this price
and still retains market leadership. However, there is one limitation of this aspect and that
is, the success of this type of leadership exists on the assumption that others will follow
the leader. However, there may be a possibility that another rival takes advantage of the
benevolence of the dominant firms leadership. Therefore in some cases the dominant firm
acts exploitative, i.e., it fixes a price at which small inefficient players may not survive and
thus it gains large share of the market.
79
Barometric Firm
Some markets may be such that no single player is so large to emerge as a leader, but
there may be a firm which has a better understanding of the markets. This firm acts like a
barometer for the market; it has better industry intelligence and can preempt and interpret
its external environment in an effective manner. For example if the Indian Rupee is
NOTES appreciating against US Dollar, how will it affect the market of a particular good, say
television? A barometric firm would be able to see the link of this phenomenon with its
impact on cost of production, on the demand for the product or on the general price index.
If the appreciation of Rupee is likely to increase the cost of production, then the barometric
firm will initiate a price rise with the declaration that due to rise in cost the price is being
increased. Since all the firms in the industry are facing this threat in the same manner,
they will also follow the barometric firm and will dissuade from price war.
80
By your understanding of game theory and Nash equilibrium you can easily infer that both Market Structure Analysis
the prisoners will confess and thus would serve five years imprisonment. This is because
each of the prisoners knows that both the dominant strategy of the opponent is to confess,
hence each will confess, while his accomplice keeps his strategy intact. This dominant
strategies equilibrium is a special case of Nash equilibrium.
Similarly if either A or B adopts maxmin or max-min strategy, the outcome in both the
cases would be the same.
NOTES
4.7. SUMMARY
Market structures can be characterized on the basis of four characteristics; i) number and
size of distribution of sellers, ii) number and size distribution of buyers, iii) product
differentiation and iv) ease of entry and exit. The model of perfect competition assumes a
large number of small buyers and sellers, undifferentiated products, and ease of entry and
exit. The profit maximization output for the perfectly competitive firm occurs where price
equals to marginal cost. The monopolist is a single seller of a differentiated product. Entry
into the market is difficult or prohibited. As a single seller, the monopolist has power over
price. Chamberlins model for monopolistic competition assumes ease of entry and exit
and a large number of small sellers. It differs from perfect competition by viewing sellers
as providing products that are slightly differentiated. Thus, firms have some control over
price. Oligopolistic market structures have many buyers but only few sellers dominate the
market. The product may be differentiated or undifferentiated. Entry into this industry is
somehow difficult.
81
Questions and Exercises
1. What are the assumptions required for perfect competition model?
2. Write down the differences between pure competition and perfect competition.
3. Explain the short run equilibrium of the firm in the perfectly competitive market.
Further Readings
z Hirschey, Economics for Managers, Cengage Learning
z Baumol, Microeconomics: Principles & Policies, 9th editions, Cengage Learning
z Froeb, : A Problem Solving Approach, Cengage Learning z Mankiw,
Economics: Principles and Applications, Cengage Learning
z Gupta, G.S. 2006, , 2nd Edition,Tata McGraw Hill
z Peterson, H.C and Lewis, W.C. 2005, , 4th Edition, Prentice
Hall of India
z R Ferguson, R., Ferguson, G.J and
Rothschild,R.1993 Business Economics Macmillan.
z Varshney,R.Land Maheshwari, 1994 Manageriaql; Economics, S Chand and Co.
z Koutsoyiannis,A. Modern Economics, Third Edition.
z Chandra, P.2006, Project: Preparation Appraisal Selection Implementation and Re-
view, 6th Edition, Tata McGraw Hill.
z Goldfield,S.M and Chandler,L.V. The Economics of Money and Banking.
82
Capital Budgeting and Risk and
UNIT 5 CAPITAL BUDGETING AND Uncertainty Analysis
5.1 OBJECTIVES
The primary objective of this chapter is to define and explain the Investment Analysis, i.e.,
Project valuation and Capital Budgeting Techniques. The chapter also covers the Risk
and Investment Analysis part, which includes Decision Tree Analysis and Concept of
Behavioral Economics. A unique feature of this chapter is that it explains the very important
concept of economics, i.e., Behavioral Economics. In most of the cases, explanations
are incorporated with mathematical examples.
5.2 INTRODUCTION
Any type investment is risky and investment decision is also difficult to make. It depends
on availability of money and information of the economy, industry and company and the
share prices ruling and expectations of the market and also of the companies. For making
such decision the common investors may have to depend more upon a study of fundamentals
rather than technical, although technical is also important. Otherwise they will burn their
fingers as happened in 1992 following the Harshad Mehta Scam and in 2001 following
Ketan Parekh Scam. For this purpose, a study of companys performance, past record
and expected future performance are to be looked into. It is necessary for a common
investor to study the balance sheet and annual report of the company or analyze the
quarterly or half yearly results of the company and decide on whether to buy that companys
share or not. This is called fundamental investment analysis.
Payback technique
The payback measures the length of time it takes a company to recover in cash its initial
investment. This concept can also be explained as the length of time it takes the project
to generate cash equal to the investment and pay the company back. It is calculated by
dividing the capital investment by the net annual cash flow. If the net annual cash flow is
not expected to be the same, the average of the net annual cash flows may be used.
For the Cottage Gang, the cash payback period is three years. It was calculated by
Capital investment
Cash Payback Period =
Average annual net cash flow
dividing the $150,000 capital investment by the $50,000 net annual cash flow ($250,000
inflows - $200,000 outflows)
84
The shorter the payback period, the sooner the company recovers its cash investment. Capital Budgeting and Risk and
Uncertainty Analysis
Whether a cash payback period is good or poor depends on the companys criteria for
evaluating projects. Some companies have specific guidelines for number of years, such
$150,000
= 3.0 years
$50,000
NOTES
as two years, while others simply require the payback period to be less than the assets
useful life.
When net annual cash flows are different, the cumulative net annual cash flows are used
to determine the payback period. If the Turtles Co. has a project with a cost of $150,000,
and net annual cash inflows for the first seven years of the project are: $30,000 in year
one, $50,000 in year two, $55,000 in year three, $60,000 in year four, $60,000 in year five,
$60,000 in year six, and $40,000 in year seven, then its cash payback period would be
3.25 years. See the example that follows.
The cash payback period is easy to calculate but is actually not the only criteria for
choosing capital projects. This method ignores differences in the timing of cash flows
during the project and differences in the length of the project. The cash flows of two
projects may be the same in total but the timing of the cash flows could be very different.
For example, assume project LJM had cash flows of $3,000, $4,000, $7,000, $1,500, and
$1,500 and project MEM had cash flows of $6,000, $5,000, $3,000, $2,000, and $1,000.
Both projects cost $14,000 and have a payback of 3.0 years, but the cash flows are very
different. Similarly, two projects may have the same payback period while one project
lasts five years beyond the payback period and the second one lasts only one year.
Present Value of 1
Period 2% 4% 5% 6% 8% 10% 12% 14% 16% 18% 20% 22%
1 0.980 0.961 0.952 0.943 0.925 0.909 0.892 0.877 0.862 0.847 0.833 0.819
4 5 4 4 9 1 9 2 1 5 3 7
2 0.961 0.924 0.907 0.890 0.857 0.826 0.797 0.769 0.743 0.718 0.694 0.671
2 6 0 0 3 4 2 5 2 2 4 9
3 0.942 0.889 0.863 0.839 0.793 0.751 0.711 0.675 0.640 0.608 0.578 0.550
3 0 8 6 8 3 8 0 7 6 7 7
4 0.9238 0.8548 0.8227 0.7921 0.7350 0.6830 0.6355 0.5921 0.5523 0.5158 0.4823 0.451
8 8 7 1 0 0 5 1 3 8 3 4
5 0.905 0.821 0.783 0.747 0.680 0.620 0.567 0.519 0.476 0.437 0.401 0.370
7 9 5 3 6 9 4 4 1 1 9 0
6 0.888 0.790 0.746 0.705 0.630 0.564 0.506 0.455 0.410 0.370 0.334 0.303
0 3 2 0 2 5 6 5 4 4 9 3
7 0.870 0.759 0.710 0.665 0.583 0.513 0.452 0.399 0.353 0.313 0.279 0.248
6 9 7 1 5 2 3 6 8 9 1 6
8 0.853 0.730 0.676 0.627 0.540 0.466 0.403 0.350 0.305 0.266 0.232 0.203
5 7 8 4 3 5 9 6 0 0 6 8
9 0.836 0.702 0.644 0.591 0.500 0.4241 0.360 0.307 0.263 0.225 0.193 0.167
8 6 6 9 2 1 6 5 0 5 8 0
10 0.820 0.675 0.613 0.558 0.463 0.385 0.322 0.269 0.226 0.191 0.161 0.136
3 6 9 4 2 5 0 7 7 1 5 9
11 0.804 0.649 0.584 0.526 0.428 0.350 0.287 0.236 0.195 0.161 0.134 0.112
3 6 7 8 9 5 5 6 4 9 6 2
12 0.788 0.624 0.556 0.497 0.397 0.318 0.256 0.207 0.168 0.137 0.112 0.092
5 6 8 0 1 6 7 6 5 2 2 0
86
Capital Budgeting and Risk and
13 0.773 0.600 0.530 0.468 0.367 0.289 0.229 0.182 0.145 0.116 0.093 0.075
Uncertainty Analysis
0 6 3 8 7 7 2 1 2 3 5 4
14 0.757 0.577 0.505 0.442 0.340 0.263 0.204 0.159 0.125 0.098 0.077 0.061
9 5 1 3 5 3 6 7 2 5 9 8
15 0.743 0.555 0.481 0.417 0.315 0.239 0.182 0.140 0.107 0.083 0.064 0.050 NOTES
0 3 0 3 2 4 7 1 9 5 9 7
16 0.728 0.533 0.458 0.393 0.291 0.217 0.163 0.122 0.093 0.070 0.054 0.041
4 9 1 6 9 6 1 9 0 8 1 5
17 0.714 0.513 0.436 0.371 0.270 0.197 0.145 0.107 0.080 0.060 0.045 0.034
2 4 3 4 3 8 6 8 2 0 1 0
18 0.700 0.493 0.415 0.350 0.250 0.179 0.130 0.094 0.069 0.050 0.037 0.027
2 6 5 3 2 9 0 6 1 8 6 9
19 0.686 0.474 0.395 0.330 0.231 0.163 0.116 0.082 0.059 0.043 0.031 0.022
4 6 7 5 7 5 1 9 6 1 3 9
20 0.673 0.456 0.376 0.311 0.214 0.148 0.103 0.072 0.051 0.036 0.026 0.018
0 4 9 8 5 6 7 8 4 5 1 7
When net cash flows are not all the same, a separate present value calculation must be
made for each periods cash flow. A financial calculator or a spreadsheet can be used to
87
calculate the present value. Assume the same project information for the Cottage Gangs
investment except for net cash flows, which are summarized with their present value
calculations below
Period Estimated Annual Net Cash Flow (1) 12% Discount Factor (2) Present Value (1) (2)
The difference between the NPV under the equal cash flows example ($50,000 per year
for seven years or $350,000) and the unequal cash flows ($350,000 spread unevenly over
seven years) is the timing of the cash flows.
Most companies required rate of return is their cost of capital. Cost of capital is the rate
at which the company could obtain capital (funds) from its creditors and investors. If there
is risk involved when cash flows are estimated into the future, some companies add a risk
factor to their cost of capital to compensate for uncertainty in the project and, therefore, in
the cash flows.
Most companies have more project proposals than they do funds available for projects.
They also have projects requiring different amounts of capital and with different NPVs. In
comparing projects for possible authorization, companies use a profitability index. The
index divides the present value of the cash flows by the required investment. For the
88
Cottage Gang, the profitability index of the project with equal cash flows is 1.54, and the Capital Budgeting and Risk and
Uncertainty Analysis
profitability index for the project with unequal cash flows is 1.56.
Present Value of Cash Flows
Profitability Index =
Required Investment
Equal Cash Flows = $ 230,452 / $ 150,000 = 1.54, and
NOTES
Unequal Cash Flows = $ 233,195 / $ 150,000 = 1.56
Internal rate of return
The internal rate of return also uses the present value concepts. The internal rate of return
(IRR) determines the interest yield of the proposed capital project at which the net present
value equals zero, which is where the present value of the net cash inflows equals the
investment. If the IRR is greater than the companys required rate of return, the project
may be accepted. To determine the internal rate of return requires two steps. First, the
internal rate of return factor is calculated by dividing the proposed capital investment
amount by the net annual cash inflow. Then, the factor is found in the Present Value of an
Annuity of 1 table using the service life of the project for the number of periods. The
discount rate of the factor is the closest to is the internal rate of return. A project for
Knightsbridge, Inc., has equal net cash inflows of $50,000 over its seven-year life and a
project cost of $200,000. By dividing the cash flows into the project investment cost, the
factor of 4.00 ($200,000 $50,000) is found. The 4.00 is looked up in the Present Value of
an Annuity of 1 table on the seven-period line (it has a seven-year life), and the internal
rate of return of 16% is determined.
89
NOTES
NOTES
The annual rate of return should not be used alone in making capital budgeting decisions,
as its results may be misleading. It uses accrual basis of accounting and not actual cash
flows or time value of money.
Figure 1
5.6 SUMMARY
Investment is very risky decision, so it needs priory analysis before finalizing. It depends
on availability of money and information of the economy, industry and company and the
share prices ruling and expectations of the market and also of the companies. For making
investment decision the investors are depend more on a study of fundamentals rather
than technical. It is necessary for a common investor to study the balance sheet and
annual report of the company or analyze the quarterly or half yearly results of the company
and decide on whether to buy that companys share or not. This is called fundamental
investment analysis. Capital budgeting is the process of spending capital on long-term
projects and on other projects requiring significant investments of capital. Capital is usually
limited in its availability. So, capital budgeting is individually evaluated using both quantitative
analysis and qualitative information. Most of the capital budgeting analysis uses cash
inflows and cash outflows rather than net income calculated using the accrual basis.
Decision Trees analysis is also useful tools for choosing best one among available several
courses of actions. This makes them particularly useful for choosing between different
strategies, projects or investment opportunities, particularly when your resources are
limited.
(c) Cash inflows and cash outflows, (d) None of the above
(c) Capital (funds) from its employees, (d) All the above.
93
3. Decision Trees are useful tools for helping you to choose between several courses
of
(a) Decisions that are made in practice; combines psychology and mathematical,
(b) Decisions that are made unpracticed; combines psychology and economics,
(d) The decisions that are made in practice; combines psychology and
economics.
Further Readings
z Hirschey, Economics for Managers, Cengage Learning
z Baumol, Microeconomics: Principles & Policies, 9th editions, Cengage Learning
z Froeb, : A Problem Solving Approach, Cengage Learning z Mankiw,
Economics: Principles and Applications, Cengage Learning
z Gupta, G.S. 2006, , 2nd Edition,Tata McGraw Hill
z Peterson, H.C and Lewis, W.C. 2005, , 4th Edition, Prentice
Hall of India
z R Ferguson, R., Ferguson, G.J and
Rothschild,R.1993 Business Economics Macmillan.
z Varshney,R.Land Maheshwari, 1994 Manageriaql; Economics, S Chand and Co.
z Chandra, P.2006, Project: Preparation Appraisal Selection Implementation and Re-
view, 6th Edition, Tata McGraw Hill.
94
Macro-economics Analysis
UNIT 6 MACRO-ECONOMICS
ANALYSIS
STRUCTURE NOTES
6.1. Objectives
6.2 Introduction
6.3. Basic Concept Circular Flow of Income and Money
6.4. National Income and Keynesian Model
6.5. Saving and Consumption Function
6.6. Investment Multiplier
6.7. Inflation
6.8. Monetary and Fiscal Policies
6.9. International Economics Fixed and Flexible Exchange Rates
6.10. Spot and forward Exchange Rates
6.11. Current and Capital Account Convertibility a case study of India.
6.12. Summary
6.13. Check Your Progress
6.14. Questions and Exercises
6.15. Further Readings
6.1. OBJECTIVES
The purpose of this chapter is to enable the student to follow the development of
macroeconomic analysis and to finalize them with a number of basic concepts. Here, we
highlight the main concept of macroeconomic variables, i.e., National Income and Keynesian
Model, Saving and Consumption Function, Investment Multiplier, Inflation, Monetary and
Fiscal Policies, International Economics Fixed and Flexible Exchange Rates, Spot and
forward Exchange Rates and Foreign Exchange Rates.
6.2 INTRODUCTION
Microeconomics is the study of human behavior and choices as they relate to relatively
small units, such as an individual, a firm, an industry, or a single market. Macroeconomics
is the study of human behavior and choices as they relate to an entire economy. Economic
analysis attempts to explain why problems arise in the economy and how these problems
can be dealt with. It is, therefore, indispensable for formulating and conducting economic
policy. However, before studying macroeconomic theory and policy, one must know the
macroeconomic goals of the economy. There is no point in formulating a policy without
definite objectives. Macroeconomic policy operates within a framework of goals and
constraints. The most important goals of economic policy are;
i. Full employment full utilization of human and non-human resources
ii. High living standards
iii. Price Stability
iv. Reduction of economic inequality and removal of poverty
95
v. Rapid economic growth
vi. External balance vs overall balance in economic relations with the rest of the world.
96
goods such as machine tools, furnaces, railway wagons, factory buildings, etc. augment Macro-economics Analysis
the productive capacity of the economy. Intermediate goods such as steel and cement
are not desired in themselves but only as inputs in producing other goods. The ultimate
aim of all economic activity is to make available goods and services for consumption now
and for augmenting productive capacity so that consumption in future can be maintained
or increased. Gross National Product (GNP) and Gross Domestic Product (GDP) and
other variants are measures of aggregate production of all goods and services which NOTES
either afford consumption now or add to productive capacity.
Aggregate Consumption
This is the aggregate of all expenditures on current consumption of goods and services
i.e. those which are consumed during the period. Living standards are usually correlated
to per capita consumption of goods and services. This is obtained by dividing aggregate
consumption by population. Current consumption is normally the proximate goal of
economic activity. At low levels of income almost all of it has to be spent on current
consumption food, clothing, rent, fuel, education, etc. As income levels rise it is possible
to set aside some income for saving. The relationship between aggregate consumption
expenditures and aggregate income of household sector is known as the consumption
function, that is C = C(Y). Consumption expenditure may be related to either national
income or disposable income. It is one of the most important relationships in
macroeconomics.
Income (Y)
Rs. 1000
A closed economy exists when there is no international trade. We shall also assume that
in this particular closed economy there is no government spending or taxation. Here,
households have two alternative uses of the income they can consume it or they can
save it. Savings are (S). AD aggregate demand consists of consumption (C) and savings
(S). Savings are lost to Y and will reduce the level of Y. However, some (if not all) of S will
be used to finance investment (I). I is the creation of real capital goods such as machinery
NOTES
and factories, and adds to Y. If S = I, then Y is in equilibrium.
In this economy
Y = AD
Therefore, Y=C+I
In equilibrium S = I
However, if S is greater than I, AD and Y will fall. If I is greater than S, AD and Y will rise.
3. The circular flow of income in an open economy:
An open economy is one in which international trade exists. Assume also that there is
government spending and taxation.
Thus, households need not consume all of their income. Some may be saved (S), spent
on imports (M), or taxed (T). So the savings (S) and imports (M) and taxes imposed (T)
are known as withdrawals (W) or Leakages from the actual flow. An increase in withdrawals
(W) will reduce the level of output and income (Y).
However, Y will be added to investment (I), government spending (G) and money spent by
foreigners on exports (X). These are known as injections (J).
In an open economy the size of Y is determined by the size of AD, which is determined by
C + I + G + X.
99
Income (Y)
Rs. 1000
NOTES
101
Relationship among eight variants of national product
The distinction between national product at market prices and national product at factor
cost, based on whether or not net indirect taxes have been included and there is also a
distinction between gross or net national product according to which whether investment
is inclusive of capital consumption or not. Further, a distinction has been drawn between
domestic and national product, according to whether we are measuring net factor income
NOTES from abroad or whether we are measuring what is produced within the domestic economy.
This implies that there are eight combinations of national product aggregates as shown
below.
Gross Domestic Product (GDP) at Market Price (MP)
at Factor Cost (FC)
Gross National Product (GNP) at Market Price (MP)
at Factor Cost (FC)
Net Domestic Product (NDP) at Market Price (MP)
at Factor Cost (FC)
Net National Product (NNP) at Market Price(MP)
at Factor Cost (FC)
The way that these national product aggregates are related to each other be understood
from the figure given below.
We can sum up the differences between gross and net marketing prices and factor cost
and national and domestic concepts in the following way:
Gross = Net + Depreciation
Market Prices = factor cost + [indirect taxes subsidies]
102
National = Domestic + Net factor income from abroad. Macro-economics Analysis
There are some national product aggregates that are more frequently met with and we
have several ways to ordering them. One of these is as follow:
Gross domestic product at market price + net factor income from abroad
equals
Gross national product at market price net indirect taxes (indirect taxes- Subsidies) NOTES
equals
Gross national product at factor cost capital consumption (depreciation)
equals
Net national product at factor cost, which is popularly known as national Income
103
Changes in prices and the real GNP
NOTES
The above table illustrates how real GNP is measured and why it is important to adjust for
price changes. Between 1987-88 and 1991-92, nominal GNP increased 83.09%. However,
a large portion of this increase in nominal GNP reflected higher prices rather than a larger
rate of output. The GNP deflector in 1991-92 was 147.08 compared 100 in 1987-88.
Prices rose by 47.08% between 1987-88 and 1991-92. Determining the real GNP for
1991-92 in terms of 1987-88 prices,
Real GNP (1991-92) =Nominal GNP (1991-92) x [GNP deflator (1987-88)] /
[GNP deflator (1991-92)].
Because prices were rising, the letter ratio is less than one. In terms of 1987-88 prices,
the GNP in 1991-92 was Rs. 3, 63,785 crore, only 24.49% more than in 1987-88. So,
although money GNP expanded by 83.09%, real GNP increased by only 24.49%.
A change in nominal GNP tell us nothing about what is happening to rate of real production
unless we also know what is happening to prices. Money income could double while
production actually declines, if prices more than double. On the other hand, money income
could remain constant while real GNP increases, if prices fall during a time period. Data
on money GNP and price changes are both essential for a meaningful duration a time
period. Data on money GNP and price changes are both essential for a meaningful
comparison of real income between two time periods. So we look at real rather than
nominal GNP as basic measure for comparing output in different years.
The measurement of national income: output, expenditure and income methods of
measurement
There are three methods of calculating national income, and they are all conceptually
equivalent to each other. These are: the output method, the income method and the
expenditure method. These three measures give rise to several different ways of describing
the various macro-aggregates employed in compiling the national accounts and these are
described and illustrated in tables.
1. The output method: The output method is followed either by valuing all final good
and services produced during a year or by aggregating the value imparted to the intermediate
products at each stage of production by the industries and productive enterprises in the
economy. The sum of these values added gives the gross domestic product at factor cost
which after a similar adjustment to include net factor income from abroad gives gross
national product at factor cost.
This approach is used to estimate gross and value added in the primary sector- Ex.
Agriculture, and allied activities, forestry and logging, fishing, registered manufacturing,
etc.-of the Indian Economy.
104
The output (value added) method Macro-economics Analysis
2. The Expenditure method: The expenditure method aggregates all money spent by
private citizens, firms and the government within the year, to obtain total domestic
expenditure at market prices. This includes consumer spending and investment i.e. total
domestic spending. It aggregates only the value of final purchases and excludes all
expenditures on intermediate goods. However, since final expenditure at market price
includes both the effects of taxes and subsidies and our expenditures on imports while
excluding the value of our exports, all these transactions have to be taken into account
before we obtain gross national product by this method.
For instance, in case of private consumption expenditure, quantities of goods and services
entering private consumptions are estimated by deducting from quantities produced,
quantities used up in intermediate uses, purchased by government, etc. Similarly several
items of machinery and equipment are identical and market values of their output are
together to estimate capital in from of machinery and equipment.
Consumers expenditure(C) 70
Plus Government current expenditures on goods and services (G) 20
Plus Gross domestic fixed capital formation (I) 20
Plus Value of physical increase in stocks and work in progress (I) 10
105
3. The Income Method: The income approach to measuring national income does not
simply aggregate all incomes. It aggregates only those of those residents of the nation,
corporate and individual, that obtain income directly from the current production of goods
and services. It aggregates money payments made to the different factors of production
i.e. factors income and excludes all incomes which cannot be concerned as payment for
current services to production (i.e. Transfer incomes and which therefore do not enter
NOTES national income). What is factor payment for the producers is factor income for factor
owners. It includes wages and salaries (W), rent (R), interest (I) and profits (P). The last
includes the profits of companies and surpluses of public corporations. Thus, the total of
all factor income gives total domestic income which once adjusted stock appreciation
gives gross domestic product at factor cost. If we then add on net factor income from
abroad we have obtained one measure of gross national income or more properly known
as gross national product.
According to above table, conceptually whatever may be the method followed for the
measurement of national income, with appropriate adjustments all three methods will give
the same result. Hence, the three methods give rise to estimates of GNP which once
adjusted to take account of capital consumption (depreciation) provides the measurement
of national income by different methods, the consistency and accuracy of the national
income estimates can be cross checked.
Other measures of national output
There are five alternative measures of national product and income:
1. Gross national product
2. Net National income
3. National income
4. Personal income
5. Disposable income
The bar chart given below explains the relationship among five alternative measures of
national product. The alternatives range from GNP, which is the broadest measures of
output, to disposable income, which indicates the funds available to households for either
personal consumption or saving.
106
Five alternative measures of income Macro-economics Analysis
NOTES
GNPs measured through expenditure method is the sum of consumption (C), Gross
Private Domestic Investment (I), Government Purchases (G), and Net Export (E-M). Exports
include factor income received from abroad and factor income paid abroad is included in
imports. Therefore, net exports include net factor income from abroad (NFIA). By deducting
depreciation from abroad net indirect taxes from NNP MP, we get NNPFC, widely known as
National Income.
Through income method, national income can also be calculated by summing up payments
to all factors production: Land, Labor, Capital and Entrepreneurship. Factor payments to
land are rents, to labor wages, to capital interest payments and to entrepreneurship
profits. Therefore national income computed through income method is equally to sum of
rents, wages, interests and profits. Total profits can be either from incorporated business
or unincorporated business. Profits of incorporated are corporate profits and profits of
unincorporated business (like self-employment, small scale industries, etc.) are proprietors
income.
Personal income is the total income received by individuals that is available for
consumptions, saving and payment of personal taxes. When we subtract income that is
earned but not directly received from and add income that is received but not earned
during the current period to national income we get personal income. Thus, corporate
profits (Profit before Taxes) which are equal to corporate profit taxes plus retained earnings
plus dividends and social insurance taxes are deducted and transfer payments, net interest
and dividends are added to national income to get personal income.
Disposable income is the income available to individuals after personal taxes i.e. Disposable
income = personal income minus personal taxes. It can be either spent on consumption
or saved.
Difficulties in measuring the national income in India
There are some conceptual and statistical problems in measuring national product. Some
items are excluded from the national income accounting, even though they would be
properly classified as current production of goods and services. Sometimes production
leads to harmful side effects which are not taken into consideration. A brief discussion of
some of these limitations of national products is given below.
1. Non-market production
The national product fails to account house hold production because such production
107
does not involve a market transaction. As a result the house hold services of millions of
people are exactly from the national income accounts. e.g. house work done by house-
wives is not included but the same work done by paid servant is.
2. Imputed values
Some self supplied goods and services are given as imputed values for their inclusion in
NOTES national income accounts, for examples, owner-occupied houses and the value for food
consumed by the farmers themselves. Sometimes this may results in overestimation or
underestimation of national income.
3. The underground economy
There are many transactions that go unreported because they involve either illegal activities
or taxes evasion. Most of these underground activities produce goods and services that
are valued by the purchasers. However, these activities are unreported and not included in
national income accounts. They do not figure in our product estimate.
4. Side-effects and economic bads
National income accounts make no adjustment for harmful side effects that sometime
arise from several productive activities and the events of nature. If they do not involve
market transactions, economic bads are not deducted from national product. When
private rights are not defined properly, air and water pollution are sometimes side effects
of the process of economic activity and reduce our future production possibilities. Similarly
the growing defense and the greater outputs of military equipment might increase the
national product but the moot point is whether the country has become better off or not.
Since national accounts ignore these negative aspects of growth and development, it
tends to over state a real national output.
5. Leisure and human cost
According to Simon Kuznets, the failure to fully include leisure and human costs is one of
the grave oddities of national income accounting. National income accounts exclude
leisure, a commodity that is valuable to everybody. Similarly national product also fails to
take into account human cost of employment in terms of the physical and mental strains
associated with many jobs. On an average, jobs today are relatively less strenuous and
less exhausting than they were some forty years ago, but they have become perhaps
more monotonous. These limitations reduce the significance of national product
comparisons in the long run.
3. Double counting
There is a possibility that some output may be counted twice. Thereby the measure of
national product is exaggerated. We must exclude the value of inputs if they have already
been accounted for. Because, the distinction between intermediate product and final product
is vital in connection with the welfare significance of the national product measure.
To calculate real national income or national income at constant prices for year X:
100(base year price index)
National income at market prices x
Price index of year X
National income must be related to the size of population. When national income is
divided by the total population, this gives per capita national income.
The uses of national income statistics
National income statistics have four main uses:
1) As an instrument of economic planning and review.
2) As a means of indicating changes in a countrys standard of living.
108
3) As a means of comparing the economic performance of different countries. Macro-economics Analysis
109
z Low quality of labor;
z Low level of productivity;
z Lack of consistency in managing the economy and policy; and
z Fragile Balance of payments (BOP) situation
4) As a means of comparing the economic performance of different countries
NOTES
National income statistic gives a guide to the standard of living in two different countries.
However, there again some difficulties:
z The statistic may be calculated differently.
z To avoid the effect of inflation and population size, the statistics are best presented as
real national per capita.
z The distribution aspect of national income does not fit into the statistics.
z There is the problem of the exchange rate between the currencies of two countries.
z The size and composition of unrecorded transactions may differ between the tow
countries.
z The two countries may have different cultures and climates, therefore commodities
required in one country are not in demand in other.
z National income statistics tell us nothing about the number of doctors per head of
population, the availability of leisure activities, the climate rate or the number of people
physically or mentally ill.
110
Macro-economics Analysis
The intercept a on the consumption axis gives the consumption when the level of income
is Zero. The slope of the consumption function is equal to b. It indicates the marginal
propensity to consume (MPC). The marginal propensity to consume is the increase in
consumption per unit increase in income.
In a two sector economy, income is either spent or saved; there are no other uses to NOTES
which it can be put. It follows that any theory that explains consumption is equivalently
explaining the behavior of saving.
Let us derive the savings function from the consumption function. Income can be spent
or saved. Thus,
Y= C + S
This gives us
S=Y-C
Making use of consumption function, we get
S = Y C = Y a bY = -a + (1 b) Y
From the above savings function, it can be seen that when consumption increases linearly
with income, so do savings. (1 b) gives the marginal propensity to save (MPS), which
gives the increase in savings per unit increase in income. The sum of MPC and MPS has
to be equal to one. For instance, if MPC = 0.8, than MPS = 0.2.
Planned Investment (I), Government Purchases (G) and Net Exports (NX)
We have now specified one component of aggregate demand, the consumption demand.
For the time being, assume that the other components of aggregate demand I, G and NX
are constant and independent of the level of income. Let the constant levels of investment,
government purchases and net exports be indicated by
Now that we have all the components of aggregate demand defined, let us derive the
equation of demand in terms of income.
AD = C + I + G +NX
= a + bY + + G + NX
=(a + + G + NX )
=+bY
Where = a + + G + NX and is a constant.
111
NOTES
In the figure, we have both the consumption function and the aggregate function. Here AD
line is parallel to the consumption line because the other components of aggregate demand
are assumed to be constant. Part of aggregate demand is independent of the level of
income, or autonomous and the other part bY is dependent on income and output.
Equilibrium Income: The next step is to use the aggregate demand function, AD, to
determine the equilibrium level of income and output. Equilibrium level of income is that
level of income for which aggregate demand equals output. The 45 line serves as a
reference line that translates any horizontal distance into equal vertical distance.
Thus, anywhere on the 45 line, the level of aggregate demand is equal to the level of
output. The level of income at which aggregate demand line cuts the 45 line is the
equilibrium income. In figure, at Y, aggregate demand is equal to income and thus is the
equilibrium income and output. At any income level below Y, firms find that demand exceeds
output and their inventories are declining. In order to make up for the decline in inventories,
firm increases production. For the levels above Y, firm find inventories piling up (I > 0) and
therefore cut production. As the arrows shows, this process leads to output level Y, at
which current production equals planned aggregate spending and unintended inventory
changes are equal to zero. Let us derive the formula for equilibrium output. At equilibrium,
output is equal to aggregate demand.
112
Macro-economics Analysis
NOTES
113
NOTES
114
It should be noted that equilibrium output is not the same as full employment output and Macro-economics Analysis
thus the two need not be equal.
Equilibrium output depends on the slope and the position of the AD curve. If the total
autonomous expenditure () or the marginal propensity to consume (b) or both are less
than what is required to achieve an equilibrium level that is equal to full employment
output, we would have a situation of unemployment (of labor and other factors of production).
What can government do to raise the equilibrium output to the level of full employment
NOTES
output? Obviously, by raising autonomous government expenditure. But by how much?
From figure it is seen that the gap in equilibrium output and full employment output is.
This should be the increase in income as a result of an increase in government expenditure.
115
= a+ b (Y-T) + I + G
= [a- bT + I + G] / (1-b)
With this the budget of government is balanced in the sense that tax revenue (T) is
equivalent government expenditure.
[{- b/ (1-b)} x T]
= [(1-b)/ (1-b)] x G
=G
6.7. INFLATION
Inflation is an increase in general level of price in an economy that is sustained over a
period of time. The emphasis is on the general price level which is sustained over a period.
Therefore increase in price level is not called inflation. Inflation is measure for the basket
of goods and services. Within the basket, prices of some of the goods and services may
rise and prices of some of the goods and services may fall. When the overall price of the
defined basket increases it is called inflation.
116
Macro-economics Analysis
NOTES
Depending on the rate at which the prices rise, inflation is classified into three categories:
creeping inflation, galloping inflation and hyperinflation. When the increase in prices is
small it is called creeping inflation. When inflation reaches double- or triple- digits, it is
called galloping inflation. When price rise is very large and accelerating, it is called
hyperinflation.
Measuring inflation
Inflation is rate at which change in the price level in current year is P1 and in the previous
year P0. The inflation for current year is [(P 1-P 0) / P0] x 100. For example, the price level
in India for the year 1996-97 is 314.6 and for the year 1997-98 is 329.8. The rate of inflation
for the year 1997-98 is [(329.8-314.6)/314.6]x 100 = 4.8%.
Monetary policy
These are two main macroeconomic policy tools the government uses to keep the economic
growth at a reasonable rate, with low inflation. Fiscal policy has its initial impact in the
goods market, and monetary policy has its initial impact mainly in the assets market.
But, because the goods and the assets markets are closely interconnected, both monetary
and fiscal policies have effects on both the level of output and interest rates. The monetary
policy of any country refers to the regulatory policy, whereby the monetary authority
maintains its control over the supply of money for the realization of general economic
objectives, such as stability of employment and prices, economic growth and balance of
payments. This involves manipulation of the supply of money, the level and structure of
117
interest rate and other conditions affecting the availability of credit. In the context of
developing countries like India, monetary policy acquires a still wider role and it has to be
designed to meet the particular requirements of the economy. This involves not merely the
restriction of credit expansion to curb inflation, but also the provision of adequate funds to
meet the legitimate requirements of industry and trade and curbing the use of credit for
unproductive and speculative purposes. In India, the three major objectives of economic
NOTES policy are growth, social justice and price stability. So, price stability is perhaps one that
can be pursued most effectively by the monetary authority of the country. Therefore,
monetary policy is required to facilitate the fulfillment of the basic objectives of planning
and is also required to play the difficult role of a countervailing force. The monetary policy
of any economy operates through three important instruments, i.e., the regulation of
money supply, control over aggregate credit and the interest rate policy.
Salient features of monetary policy
Let us now see a bit more closely how monetary policy works.
The initial equilibrium at point E is on the initial LM schedule that corresponds to a real
money supply. Suppose now that the nominal quantity of money is increased, for example
by open market operations. Given a constant price level, when real quantity of money
increases due to nominal quantity of money increases. As a result of the increase in the
real quantity of money, the LCM schedule shifts to LM1.
For the new schedule LM1, the equilibrium will be at point E1 with a lower rate of interest
and a higher level of income.
Let us see a bit more closely how with an expansion in real money supply the economy
moves from the original equilibrium at E to a new equilibrium at E1. At economy moves
from the original equilibrium point, E, the increase in money creates an excess supply of
money. The public tries to adjust to the excess supply of money by buying financial
assets. As a result of the increase in demand, the price of financial assets rises, and thus
the yield decline. The adjustment process in the assets markets is much more rapid than
that in the goods market and, therefore, we move immediately to point E1 when the money
supply increases. At E1, however, there is an excess demand for goods. The decline in
118
the interest rate, given the initial income level and thus causes Y0 , raises aggregate Macro-economics Analysis
demand inventories to run down. In response, the output expands and we start moving up
the LM1 schedule. As output expands, the interest rate rises (after the immediate decline
in interest rate when money supply is increased) because increase in output raises the
demand for money and the increase in demand for money has to be checked by higher
interest rates.
NOTES
The Transmission Mechanism
The mechanism by which the changes in monetary policy affect aggregate demand is
called transmission mechanism. Two stages in transmission mechanism are important.
First is that an increase in real money supply causes portfolio disequilibrium at the prevailing
interest rate and level of income, i.e. people are holding more money than they wants.
They try to get rid of the excess money they are holding by financial assets. This action
of theirs pushes up the price of financial assets. This action of theirs pushes up the price
of financial assets and thus causes the interest rate to fall.
The second stage of the transmission process occurs when the change in interest rate
affects aggregate demand. The fall in interest rates induces an increase in investment
expenditure, and also possibly consumption expenditure, thereby increasing the aggregate
demand and ultimately the income.
Fiscal policy
An increase in Government Spending:
Let us examine how an increase in government spending affects the interest rate and the
level of income. When government spending increases, at unchanged interest rates, the
level of aggregate demand increases. To meet the increased demand for goods, outputs
must rise as shown by a shift in the IS schedule in the figure
If the economy is initially at point E, an increase in government spending would shift the
economy to point E11 if the interest rate remained constant. At E11 , the goods market is in
equilibrium but the money market is no longer in equilibrium. Because of the increase in
income, the quantity of money demanded goes up, which in turn pushes up the interest
rate. With interest rate rising, firms planned investment spending declines and the
aggregate demand begins to fall from the high level it reaches immediately on increase in
119
the government spending. The economy finally reaches its new equilibrium at point E1
where both the goods market and the money market are in equilibrium. As compared to
point E, at point E1 the level of income is higher and so is the interest rate. Thus, an
increase in government spending results in an increase in the level of income and an
increase in the interest rate.
121
Chinese Yuan 8.2765 0.120824
Danish Krone 5.653 0.176897
Euro 0.759821 1.3161
Hong Kong Dollar 7.7955 0.128279
NOTES Indian Rupees 43.68 0.02289380
Japanese Yen 103.42 0.00966931
Malaysian Ringgit 3.8 0.263158
Mexican Peso 11.217 0.0891504
New Zealand Dollar 1.42816 .700202
Norwegian Kroner 6.2278 0.16057
Singapore Dollar 1.6363 0.611135
South African Rand 5.955 0.167926
South Korean Won 1045 0.000956938
Sri lanka Rupees 98.1 0.0101937
Swedish Krona 6.8616 0.145739
Swiss Franc 1.1758 0.850485
Taiwan Dollar 31.98 0.0312695
Thai Baht 39 0.025641
Venezuelan Bolivar 1915.2 .000522139
The dollar is likely to appreciate against the pound. Imagine the spot exchange rate is
pound 1=$1.50 when market opens. As the day progresses, dealers demand more dollars
and fewer pounds. By the end of the day, the spot exchange rate might be pound 1=$1.48.
Each pound now buys few dollars than at the start of the day. The dollar has appreciated
and the pound has depreciated.
122
some specific date in the future. Exchange rates governing such future transactions are Macro-economics Analysis
referred to as foreign exchange rates. For most major currencies, foreign exchange rates
are quoted for 30 days, 90 days and 180 days into the future
In some cases, it is possible to get forward exchange rate for several years into the future.
Returning to our computer importer example, let us assume the 30 day forward exchange
rate for converting dollars into yen is $1=yen 110. The importer enters into 30 days forward
exchange rate transaction with a foreign exchange dealer at this rate and is guaranteed
NOTES
that she will have to pay no more than $1,818 for each computer. This guarantees her a
profit of $182 per computer. She also insures herself against the possibility that the
unanticipated change in the dollar/yen exchange rate will turn a profitable deal into an
unprofitable one.
In this example, the spot exchange rate and forward exchange rate differ. Such differences
are normal; they reflect the expectation of the foreign exchange market about future
currency movements. In our example, the fact that $1 bought more yen with a spot
exchange than with a 30 day forward exchange indicates foreign exchange dealers expected
the dollar to depreciate against the yen in the next 30 days. When this occurs, we say
dollar is selling at a discount on the 30 day forward market. Of course, the opposite can
also occur. If the 30 day forward exchange rate were $1 = yen 130, for example, $1 would
buy more yen with a forward exchange than with a spot exchange. In such a case, we say
the dollars selling at a premium on 30 day forward market. This reflects the foreign exchange
dealers expectation that the dollar will appreciate against the yen over the next 30 days.
In sum, when a firm enters into a foreign exchange contract, it is taking out insurance
against the possibility that future exchange rate movements will make a transaction
unprofitable by the time that transaction has been executed. Although many firms routinely
enter into forward exchange contracts to hedge their foreign exchange risk, there are
some spectacular examples of what happens when firms dont take out this insurance.
124
brought in only after certain preconditions were satisfied. These included low inflation, Macro-economics Analysis
financial sector reforms, a flexible exchange rate policy and a stringent fiscal policy.
However, the report was not accepted due to Asian Crisis.
The five-member committee has recommended a three-year time frame for complete
convertibility by 1999-2000. The highlights of the report including the preconditions to be
achieved for the full float of money are as follows:-
NOTES
Pre-Conditions Set By Tarapore Committee:
z Gross fiscal deficit to GDP ratio has to come down from a budgeted 4.5 per cent in
1997-98 to 3.5% in 1999-2000.
z A consolidated sinking fund has to be set up to meet governments debt repayment
needs; to be financed by increased in RBIs profit transfer to the govt. and disinvest-
ment proceeds.
z Inflation rate should remain between an average 3-5 per cent for the 3-year period
1997-2000
z Gross NPAs of the public sector banking system needs to be brought down from the
present 13.7% to 5% by 2000. At the same time, average effective CRR needs to be
brought down from the current 9.3% to 3%.
z RBI should have a Monitoring Exchange Rate Band of plus minus 5% around a neu-
tral Real Effective Exchange Rate. RBI should be transparent about the changes in
REER.
z External sector policies should be designed to increase current receipts to GDP ratio
and bring down the debt servicing ratio from 25% to 20%.
z Four indicators should be used for evaluating adequacy of foreign exchange reserves
to safeguard against any contingency. Plus, a minimum net foreign asset to currency
ratio of 40 per cent should be prescribed by law in the RBI Act. Phased liberalisation
of capital controls.
The Committees recommendations for a phased liberalization of controls on capital outflows
over the three year period which have been set out in detail in a tabular form in Chapter 4
of the Report, inter alia, include:-
(i) Indian Joint Venture/Wholly Owned Subsidiaries (JVs/WOSs) should be allowed to
invest up to US $ 50 million in ventures abroad at the level of the Authorised Dealers
(ADs) in phase 1 with transparent and comprehensive guidelines set out by the RBI.
The existing requirement of repatriation of the amount of investment by way of divi-
dend etc., within a period of 5 years may be removed. Furthermore, JVs/WOs could
be allowed to be set up by any party and not be restricted to only exporters/exchange
earners.
(ii) Exporters/exchange earners may be allowed 100 per cent retention of earnings in
Exchange Earners Foreign Currency (EEFC) accounts with complete flexibility in
operation of these accounts including cheque writing facility in Phase I.
(iii) Individual residents may be allowed to invest in assets in financial market abroad up
to $ 25,000 in Phase I with progressive increase to US $ 50,000 in Phase II and US$
100,000 in Phase III. Similar limits may be allowed for non-residents out of their non-
repatriable assets in India.
(iv) SEBI registered Indian investors may be allowed to set funds for investments abroad
subject to overall limits of $ 500 million in Phase I, $ 1 billion in Phase II and $ 2 billion
in Phase III.
(v) Banks may be allowed much more liberal limits in regard to borrowings from abroad
125
and deployment of funds outside India. Borrowings (short and long term) may be
subject to an overall limit of 50 per cent of unimpaired Tier 1 capital in Phase 1, 75 per
cent in Phase II and 100 per cent in Phase III with a sub-limit for short term borrowing.
In case of deployment of funds abroad, the requirement of section 25 of Banking
Regulation Act and the prudential norms for open position and gap limits would apply.
(vi) Foreign direct and portfolio investment and disinvestment should be governed by
NOTES comprehensive and transparent guidelines, and prior RBI approval at various stages
may be dispensed with subject to reporting by ADs. All non-residents may be treated
on part purposes of such investments.
(vii) In order to develop and enable the integration of forex, money and securities market,
all participants on the spot market should be permitted to operate in the forward
markets; FIIs, non-residents and non-resident banks may be allowed forward cover to
the extent of their assets in India; all India Financial Institutions (FIs) fulfilling requisite
criteria should be allowed to become full-fledged ADs; currency futures may be intro-
duced with screen based trading and efficient settlement system; participation in
money markets may be widened, market segmentation removed and interest rates
deregulated; the RBI should withdraw from the primary market in Government securi-
ties; the role of primary and satellite dealers should be increased; fiscal incentives
should be provided for individuals investing in Government securities; the Government
should set up its own office of public debt.
(viii) There is a strong case for liberalising the overall policy regime on gold; Banks and FIs
fulfilling well defined criteria may be allowed to participate in gold markets in India and
abroad and deal in gold products.
The assumption of the committee was that these pre-conditions would take care of possible
problems created by unseen flight of capital. Given a sound fiscal and financial set-up, the
flight of capital was unlikely to be large, particularly in the short run, as capital would be
invested and not all of it would be in a liquid form.
Present Status:
The process of opening up the Indian economy has proceeded in steady steps.
z First, the exchange rate regime was allowed to be determined by market forces as
against the fixed exchange rate linked to a basket of currencies.
126
z Second, this was followed by the convertibility of the Indian rupee for current account Macro-economics Analysis
transactions with India accepting the obligations under Article VIII of the IMF in Au-
gust 1994.
z Third, capital account convertibility has proceeded at a steady pace. RBI views capi-
tal account convertibility as a process rather than as an event.
z Fourth, the distinct improvement in the external sector has enabled a progressive NOTES
liberalisation of the exchange and payments regime in India. Reflecting the changed
approach to foreign exchange restrictions, the restrictive Foreign Exchange Regula-
tion Act (FERA), 1973 has been replaced by the Foreign Exchange Management Act,
1999.
Thus, at present in India we have restricted capital account convertibility. Indian entities
(i.e. individuals, companies or otherwise) are allowed to invest or acquire assets outside
India or a foreign entity remit funds for investment or acquisition of assets with specified
cap on such investments and for specific purpose. A full convertibility will allow free
movement of funds in and out of India without any restrictions on purpose and amount.
Thus, after full convertibility is allowed, residents in India will be able to transfer money
abroad and receive from other entities across the world. However, government will certainly
make rules and regulations to ensure these do not lead to money laundering or funding for
illegal activities.
Prime Minister Manmohan Singh on 18th March 2006 said that the countrys economic
position internally and externally had become far more comfortable and it was worth
looking into greater capital account convertibility. In a speech at the Reserve Bank of India
(RBI) in the countrys financial hub Mumbai, Prime Minister Manmohan Singh said he
would ask the Finance Minister and RBI to come out with a roadmap to greater convertibility
based on current realities. PM also said Given the changes that have taken place over
the last two decades, there is merit in moving towards fuller capital account convertibility
within a transparent framework, Singh said.
RBI in its circular issued in March, 2006 has laid down that economic reforms in India
have accelerated growth, enhanced stability and strengthened both external and financial
sectors. Our trade as well as financial sector is already considerably integrated with the
global economy. Indias cautious approach towards opening of the capital account and
viewing capital account liberalisation as a process contingent upon certain preconditions
has stood India in good stead.
Given the changes that have taken place over the last two decades, however, there is
merit in moving towards fuller capital account convertibility within a transparent framework.
There is, thus, a need to revisit the subject and come out with a roadmap towards fuller
Capital Account Convertibility based on current realities. In consultation with the Government
of India, the Reserve Bank of India has appointed a committee to set out the framework for
fuller Capital Account Convertibility.
The Committee consists of the following:
i. Shri S.S Tarapore Chairman
ii. Dr. Surjit S. Bhalla Member
iii. Shri M.G Bhide Member
iv. Dr. R.H. Patil Member
v. Shri A.V Rajwade Member
vi. Dr. Ajit Ranade Member
127
The terms of reference of the Committee will be:
i. To review the experience of various measures of capital account liberalisation in India,
ii. To examine implications of fuller capital account convertibility on monetary and ex-
change rate management, financial markets and financial system,
iii. To study the implications of dollarisation in India of domestic assets and liabilities
NOTES and internationalisation of the Indian rupee,
iv. To provide a comprehensive medium-term operational framework, with sequencing
and timing, for fuller capital account convertibility taking into account the above impli-
cations and progress in revenue and fiscal deficit of both centre and states,
v. To survey regulatory framework in countries which have advanced towards fuller capi-
tal account convertibility?
vi. To suggest appropriate policy measures and prudential safe- guards to ensure mon-
etary and financial stability, and
vii. To make such other recommendations as the Committee may deem relevant to the
subject.
Factors Which Are Critical / Of Concern In Adopting Capital Account Convertibility:
There are number of issues which are of concern for adopting capital account convertibility.
z The impact of allowing unlimited access to short-term external commercial borrowing
for meeting working capital and other domestic requirements is manifold. In respect
of short-term external commercial borrowings, there is already a strong international
consensus that emerging markets should keep such borrowings relatively small in
relation to their total external debt or reserves. Many of the financial crises in the
1990s occurred because the short-term debt was excessive. When times were good,
such debt was easily accessible. The position, however, changed dramatically in
times of external pressure. All creditors who could redeem the debt did so within a
very short period, causing extreme domestic financial vulnerability. The occurrence of
such a possibility has to be avoided, and we would do well to continue with our policy
of keeping access to short-term debt limited as a conscious policy at all times good
and bad.
z Providing unrestricted freedom to domestic residents to convert their domestic bank
deposits and idle assets (such as, real estate), in response to market developments
or exchange rate expectations. The day-to-day movement in exchange rates is deter-
mined by flows of funds, i.e. by demand and supply of spot or forward transactions
in the market. Now, suppose the exchange rate is depreciating unduly sharply (for
whatever reasons) and is expected to continue to do so for the near future. Now,
further suppose that domestic residents, therefore, that they should convert a part or
whole of their stock of domestic assets from domestic currency to foreign currency.
This will be financially desirable as the domestic value of their converted assets is
expected to increase because of anticipated depreciation. And, if a large number of
residents so decide simultaneously within a short period of time, as they may, this
expectation would become self-fulfilling. A severe external crisis is then unavoidable.
z Although at present our reserves are high and exchange rate movements are, by and
large, orderly. However, there can be events like Kargil war or Pokhran Test, which
creates external uncertainty, Domestic stock of bank deposits in rupees in India is
presently close to US $ 290 billion, nearly three and a half times our total reserves. At
the time of Kargil or Pokhran or the oil crises, the multiple of domestic deposits over
reserves was in fact several times higher than now. One can imagine what would have
had happened to our external situation, if within a very short period, domestic resi-
128
dents decided to rush to their neighborhood banks and convert a significant part of Macro-economics Analysis
these deposits into sterling, euro or dollar. No emerging market exchange rate sys-
tem can cope with this kind of contingency. This may be an unlikely possibility today,
but it must be factored in while deciding on a long term policy of free convertibility of
stock of domestic assets. Incidentally, this kind of eventuality is less likely to occur
in respect of industrial countries with international currencies such as Euro or Dollar,
which are held by banks, corporates, and other entities as part of their long-term NOTES
global asset portfolio (as distinguished from emerging market currencies in which
banks and other intermediaries normally take a daily long or short position for pur-
poses of currency trade).
Impact of Capital Account Convertibility
After full convertibility is adopted by India, it will lead to acceptance of Indian Rupee
currency all over the world.
In case of two convertible currencies, Forward Exchange Rates reflect interest rate
differentials between these two currencies. Thus, we can say that the Forward Exchange
Rate for the higher interest rate currency would depreciate so as to neutralize the interest
rate difference. However, sometimes there can be opportunities when forward rates do
not fully neutralize interest rate differentials. In such situations, arbitrageurs get into the
act and forward exchange rates quickly adjust to eliminate the possibility of risk-less
profits.
Capital account convertibility is likely to bring depth and large volumes in long-term INR
currency swap markets. Thus for a better market determination of INR exchange rates,
the INR should be convertible.
Bimal Jalan: Exchange rate management - an emerging consensus?
Address by Dr Bimal Jalan, Governor of the Reserve Bank of India, at the 14th National
Assembly of the Forex Association of India, Mumbai, 14 August 2003.
I am very happy to be here with you on the occasion of the 14th National Assembly. This
annual gathering of our Forex specialists is a very special occasion for everyone interested
in the evolution of forex market in India - not only the dealers and market participants, but
also the RBI, Government and outside experts interested in appropriate macro-economic
management for higher growth and the greater good of our people. It provides all of us with
an opportunity to review recent developments in forex markets against the background of
global developments in a fast changing world economic scenario and modify our own
policy and approach. I am, therefore, delighted to be with you once again.
As you know, RBI is in regular touch, formally and informally, with your association to
review market developments. My senior colleagues and I have also benefited from your
advice and, as you are aware, a large number of measures have now been put in place to
liberalise our regulations in respect of foreign exchange transactions. With your permission,
today, on this special occasion, I would like to deal briefly with some of the longer term
policy issues in respect of exchange rate and reserves management. Several of these
issues have also been debated in various international fora. In the context of upsurge in
our reserves in recent years and the appreciating trend in the external value of the rupee,
there has also been considerable domestic discussion of these issues.
You will recall that the last time I had addressed your Association was in December 2000
- nearly 2 years ago - on the occasion of the 21st Asia Pacific Forex Congress. That
meeting was taking place against the background of the Asian crisis in 1997-98. The
Asian region had just come out of the forex crisis of a very destabilising kind. I had used
that occasion to review the on-going debate on management of the external sector,
129
particularly the appropriate exchange rate systems, the appropriate intervention policy,
and the foreign exchange reserve policy. Soon after the Asian crisis, these subjects had
figured very prominently in the discussions on International Financial Architecture in various
fora, such as IMF, the World bank, G20, Financial Stability Forum and the Bank for
International Settlements.
At that time, while reviewing the state of the debate, I had mentioned that a worldwide
NOTES consensus on several issues was still evolving. Today, while .consensus. may be too
strong a word, I believe that there is a fair degree of convergence in the dominant international
opinion among experts and various specialised institutions on many of these issues. Let
me summarise some of the main conclusions which have emerged in the last 2 or 3 years
on the management of the external sector. Once again, I should emphasise that, given
widely different economies of the world that we are talking about, there is no global
consensus as such or unity of views. However, at present, as I see it, there is certainly a
dominant. view of what is right and appropriate, which is increasingly commanding
international acceptance.
Thus, on the question of the appropriate exchange rate regime, a fixed exchange rate
regime (even with a Currency Board) is clearly out of favour. The Brazilian and Argentinian
crisis, after the Asian crisis, came as a rude shock. Even strong Currency Board type
arrangements of a fixed peg vis--vis dollar were found to be unviable. You will recall that,
soon after the Asian crisis, the widely accepted theoretical position was that a country
had the choice of either giving up monetary independence and setting up a Currency
Board or giving up the stable currency objective and letting the exchange rate float freely
so that monetary policy could then be directed to the objectives of inflation control. There
is a shift in this paradigm. The possibility of having a viable fixed rate mechanism has
been generally discarded, and the dominant view now is that, for most countries floating
or flexible rates are the only sustainable way of having a less crisis-prone exchange rate
regime.
In regard to the desirable degree of flexibility in exchange rates, opinions and practices
vary. But a completely .free. float, without intervention, is clearly out of favour except
perhaps in respect of a few global or reserve currencies. And, in respect of these currencies
also (say, Euro and Dollar), concerns are expressed at the highest levels if the movement
is sharp in either direction - recently, for example, when Euro was strengthening at a fast
pace. Studies by the IMF and several experts also show that by far, the most common
exchange rate regime adopted by countries, including industrial countries, is not 2 BIS
Review 36/2003 a free float. Most of the countries have adopted intermediate regimes of
various types, such as, managed floats with no pre-announced path, and independent
floats with foreign exchange intervention moderating the rate of change and preventing
undue fluctuations. By and large, barring a few, countries have .managed. floats and
Central Banks intervene periodically. This has also been true of industrial countries. In the
past, the U.S., the EU and the U.K. have also intervened at one time or another. Thus,
irrespective of the pure theoretical position in favour of a free float, the external value of the
currency continues to be a matter of concern to most countries, and most central banks.
The reason why intervention by most central banks in forex markets has become necessary
from time to time is primarily because of two reasons. A fundamental change that has
taken place in recent years is the importance of capital flows in determining exchange
rate movements as against trade deficits and economic growth, which were important in
the earlier days. The latter do matter, but only over a period of time. Capital flows, on the
other hand, have become the primary determinants of exchange rate movements on a
day-to-day basis. Secondly, unlike trade flows, capital flows in gross.
130
terms which affect exchange rate can be several times higher than .net. flows on any day. Macro-economics Analysis
These are also much more sensitive to what everybody else is saying or doing than is the
case with foreign trade or economic growth. Therefore, herding becomes unavoidable. I
am sure you will agree that all dealers prefer to be wrong with everyone else rather than
being wrong alone!
A related issue, which is a corollary of the prevalent intermediate regimes in respect of
exchange rates, concerns the need, if any, for foreign exchange reserves. In a regime of
NOTES
free float, it could be argued that there was really no need for reserves. If demand for
foreign exchange is higher than supply, exchange rates will depreciate and equilibrate
demand and supply over time. If supply exceeded demand, exchange rates will appreciate
and sooner or later, the two will equalise at some price. However, today in the light of
volatility induced by capital flows and the self-fulfilling expectations that this can generate,
there is now a growing consensus that emerging market countries should, as a matter of
policy, maintain .adequate. reserves. How adequacy is to be defined is also becoming
clearer. Earlier, the rule used to be defined in terms of number of months of imports. Now,
increasingly it is felt that reserves should at least be sufficient to cover likely variations in
capital flows or the liquidity-at-risk. (However, there is as yet no consensus on the upper
limit for reserves. Even after an adequate level is reached, reserves may continue to
increase if capital inflows are strong and central banks decide to intervene in order to
moderate the degree of appreciation.)
To sum up, it seems that the debate on appropriate policies relating to forex markets has
now converged around some generally accepted views. Among these, as I mentioned are:
(a) exchange rates should be flexible and not fixed or pegged; (b) countries should be able
to intervene or manage exchange rates - to at least some degree - if movements are
believed to be destablising in the short run; and (c) reserves should at least be sufficient
to take care of fluctuations in capital flows and liquidity at risk.
Let me now briefly deal with some issues of practical importance in the management of
forex markets in India, which have figured prominently in the media and expert commentary.
I will first take up 2 or 3 matters which are rather straight-forward and on which our policy
stance is also equally unambiguous. and clear-cut. Then I will move to, and conclude
with, a discussion of the appropriate exchange rate policy for India in the current situation.
A frequently discussed question is about Capital Account Convertibility (CAS), i.e. when
is India going to move to full CAC? As you are aware, we have already liberalized and
deregulated a whole host of capital account transactions. It is probably fair to say that for
most transactions which are required for business or personal convenience, the rupee is,
for all practical purposes, convertible. In cases, where specific permission is required for
transactions above a high monetary ceiling, this permission is also generally forthcoming.
It is also the declared policy of the Government and the RBI to continue with this process
of liberalization. In this sense, Capital Account Convertibility continues to be a desirable
objective for all investment and business related transactions and India should be able to
achieve this objective in not too distant a future.
There are, however, two areas where we would need to be extremely cautious - one is
unlimited access to short-term external commercial borrowing for meeting working capital
and other domestic requirements. The other area concerns the question of providing
unrestricted freedom to domestic residents to convert their domestic bank deposits and
idle assets (such as, real estate), in response to market developments or exchange rate
expectations.
In respect of short-term external commercial borrowings, there is already a strong
international consensus that emerging markets should keep such borrowings relatively
131
small in relation to their total BIS Review 36/2003 3 external debt or reserves. Many of the
financial crises in the 1990s occurred because the short-term debt was excessive. When
times were good, such debt was easily accessible. The position, however, changed
dramatically in times of external pressure. All creditors who could redeem the debt did so
within a very short period, causing extreme domestic financial vulnerability. The occurrence
of such a possibility has to be avoided, and we would do well to continue with our policy
NOTES of keeping access to short-term debt limited as a conscious policy at all times - good and
bad.
So far as the free convertibility of domestic assets by residents is concerned, the issues
are somewhat more fundamental. It has to do with the differential impact of .stock. and
.flows. in determining external vulnerability. The day-to-day movement in exchange rates
is determined by .flows. of funds, i.e. by demand and supply of spot or forward transactions
in the market. Now, suppose the exchange rate is depreciating unduly sharply (for whatever
reasons) and is expected to continue to do so for the near future. Now, further suppose
that domestic residents, therefore, decide - perfectly rationally and reasonably - that they
should convert a part or whole of their stock of domestic assets from domestic currency
to foreign currency. This will be financially desirable as the domestic value of their converted
assets is expected to increase because of anticipated depreciation. And, if a large number
of residents so decide simultaneously within a short period of time, as they may, this
expectation would become self-fulfilling. A severe external crisis is then unavoidable.
Consider India.s case, for example. Today, our reserves are high and exchange rate
movements are, by and large, orderly. Now, suppose there is an event which creates
external uncertainty, as for example, what actually happened at the time of the Kargil or
the imposition of sanctions after Pokhran, or the oil crises earlier. Domestic stock of bank
deposits in rupees in India is presently close to US$ 290 billion, nearly three and a half
times our total reserves. At the time of Kargil or Pokhran or the oil crises, the multiple of
domestic deposits over reserves was in fact several times higher than now.
One can imagine what would have had happened to our external situation, if within a very
short period, domestic residents decided to rush to their neighbourhood banks and convert
a significant part of these deposits into sterling, euro or dollar.
No emerging market exchange rate system can cope with this kind of contingency. This
may be an unlikely possibility today, but it must be factored in while deciding on a long
term policy of free convertibility of .stock. of domestic assets. Incidentally, this kind of
eventuality is less likely to occur in respect of industrial countries with international
currencies such as Euro or Dollar, which are held by banks, corporates, and other entities
as part of their long-term global asset portfolio (as distinguished from emerging market
currencies in which banks and other intermediaries normally take a daily long or short
position for purposes of currency trade).
Another issue, which has figured prominently in the current debate, relates to foreign
exchange reserves. As is well known, India.s foreign exchange reserves have increased
substantially in the past few years and are now among one of the largest in the world. The
fact that most of the constituents of India.s balance of payments are showing positive
trends - on the current as well as capital accounts - is a reflection of the increasing
competitiveness of the Indian economy and strong confidence of the international community
in India.s growth potential. For the first time after our Independence 56 years ago, the
fragility of the balance of payments is no longer a concern of policy makers. This is a
highly positive development and regarded as such by the country at large.
Nevertheless, there are two concerns that have been expressed by expert commentators
- one is about the .cost. of additional reserves, and second concerns the impact of .arbitrage.
132
in inducing higher inflows. So far as the cost of additional reserves is concerned, it needs Macro-economics Analysis
to be borne in mind that the bulk of additions to reserves in the recent period is on account
of non-debt creating inflows. India.s total external debt, including NRI (Non-Resident Indian)
deposits, has increased relatively slowly as compared with the increase in reserves,
particularly in the last couple of years. In fact, India pre-paid more than $ 3 billion of
external debt earlier this year. It may also be mentioned that rates of interest paid on NRI
deposits and multilateral loans in foreign currency are in line with or lower than prevailing NOTES
international interest rates.
On NRI rupee deposits, interest rates in the last couple of years have been in line with
interest rates on deposits by residents, and are currently even lower than domestic interest
rates. So far as other non-debt creating inflows (i.e., foreign direct investment, portfolio
investment or remittances) are concerned, such inflows by their very nature are commercial
in nature and enjoy the same returns and risks, including exchange rate risk, as any other
form of domestic investment or remittance by residents. The cost to the country of such
flows is the same whether they are added to reserves or are matched by equivalent foreign
currency outflow on account of higher imports or investments abroad by 4 BIS Review 36/
2003 residents. On the whole, under present conditions, it seems that the .cost. of additional
reserves is really a non-issue from a broader macro-economic point of view.
Indian interest rates have come down substantially in the last three or four years. They
are, however, still higher than those prevailing in the U.S., Europe, U.K. or Japan. This
provides an arbitrage opportunity to holder of liquid assets abroad, who may take advantage
of higher domestic interest rates in India leading to a possible short-term upsurge in
capital flows. However, there are several considerations, which indicate that .arbitrage.
per se is unlikely to have been a primary factor in influencing remittances or investment
decisions by NRIs or foreign entities in the recent period. Among these are:
The minimum period of deposits by NRIs in Indian rupees is now one year, and the
interest rate on such deposits is subject to a ceiling rate of 2.5 per cent over Libor. This is
broadly in line with one-year forward premium on the dollar in the Indian market (interest
rates on dollar deposits by NRIs are actually below Libor).
Outside of NRI deposits, investments by Foreign Institutional Investors (FIIs) in debt funds
is subject to an overall cap of only $ 1 billion in the aggregate. In other words, the possibility
of arbitrage by FIIs in respect of pure debt funds is limited to this low figure of $ 1 billion
(excluding investments in a mix of equity and debt funds).
Interest rates and yields on liquid securities are highly variable abroad as well as in India,
and the differential between the two rates can change very sharply within a short time
depending on market expectations. It is interesting to note that the yield on 10 year
Treasury bills in the U.S. had risen to about 4.4 per cent as compared with 5.6 per cent on
Government bonds of similar maturity in India at the end of July 2003. Taking into account
the forward premia on dollars and yield fluctuations, except for brief period, there is likely
to be little incentive to send large amounts of capital to India merely to take advantage of
the interest differential.
On the whole, it is likely that external flows into India have been motivated by factors other
than pure arbitrage. Figures on sources of reserve accretion available upto the end of last
year (2002-03) confirm this view. It is also pertinent to note that domestic interest rates
among industrial countries also vary considerably. For example, in Japan, they are close
to zero. In the U.K., they are above 4 per cent, and in the U.S. about 1.5 per cent. There
is no evidence that capital has been moving out of U.S. to U.K. or Europe merely on
account of interest differential. Within a certain low range, capital flows are likely to be
more influenced by outlook for growth and inflation than pure arbitrage even among industrial
countries with full CAC.
133
Another point which has been forcefully put forward by several experts in the context of
rising reserves, is that India should use its reserves for increasing investment for further
development of the country rather than keep them as liquid assets. It is argued that it is
paradoxical for a developing country to have a current and capital account surplus, and
thereby add to its reserves, rather than use foreign savings to enhance the rate of investment
in the economy.
NOTES In principle, this point is valid. There is no doubt that in our present situation, maximum
support has to be given to increasing the level of investment, particularly in the infrastructure
sector. It is for this reason that RBI in the recent period has been following a soft interest
rate policy in an environment of low inflation. However, at the same time, it must be
emphasized that there is very little that RBI, (or, for that matter, Government) can directly
do to use additional reserves for investment. The equivalent rupee resources have already
been released by the RBI to recipients of foreign exchange, and equivalent rupee
liquidity has already been created. The decision on whether to invest, consume or deposit
these additional rupee resources lies with recipients, and not with the RBI. By all means,
let us urge them to invest, but there is not much of a case for pointing a finger at
additional reserves as a cause. of lower than desirable level of investment activity in the
economy.
Let me now come to my last point, which is of considerable present-day interest in India
in the context of high and rising reserves, easy liquidity, low interest rates and the weakening
dollar, i.e., what should be the correct or right policy stance for the management of exchange
rate in India in the present environment? In RBI.s periodic credit policy statements, as
well as other public statements, RBI has highlighted the main pillars of its strategy for the
management of the exchange rate. These are: RBI does not have a fixed .target. for the
exchange rate which it tries to defend or pursue over time; RBI is prepared to intervene in
the market to dampen excessive volatility as and when necessary; RBI.s purchases or
sales of foreign currency are undertaken through a number of banks and are generally BIS
Review 36/2003 5 discreete and smooth; and market operations and exchange rate
movement should, in principle, be transaction-oriented rather than purely speculative in
nature.
It is perhaps fair to say that the actual results of the exchange rate policy followed by the
RBI, since the Asian crisis in particular, have been highly positive so far. In addition to
sharp increase in reserves and generally .orderly. movements in exchange rates with
lower volatility, the confidence level of domestic and foreign investors in the Indian external
sector policies is strong. India.s policies have also been described by the IMF as being
comparable to the global best practices. in a recent study of 20 select industrial and
developing countries. Interestingly, a leading global news agency, in an international journal,
has recently described India.s currency model as being .ideal. for Asia. India is now one
of the very few developing countries which has set up its own clearing house for dollar-
rupee transaction with the concurrence of the Federal Reserve System, New York.
In the last few months, however, when the dollar has been depreciating against major
currencies, and rupee has been appreciating against the dollar (albeit slowly), a number
of suggestions have been made by experts and others calling for a shift in RBI.s exchange
rate policies. There are, in the main, three alternative approaches that have been suggested
for consideration:
One view advanced by several distinguished economists, including Prof. Kenneth Rogoff
of IMF during his recent visit to India, is that rupee should be allowed to appreciate freely
in line with market trends. According to this view, there is no strong case for RBI.s further
intervention as reserves are already very high. RBI.s purchases create substantial additional
domestic liquidity, which may be destabilising in the long run. There is also no evidence,
134
in their opinion, that unconstrained appreciation or volatility would affect growth prospects Macro-economics Analysis
or lead to any other macro-economic problem.
An exactly opposite view, which, among others, has been recently articulated by an
important all-India industry association, is that RBI should intervene more aggressively in
the market to further reduce the degree of appreciation. The main argument in favour of
this view is that India must maintain its global .competitiveness., particularly in relation to
China which has a fixed exchange rate with the dollar and whose currency has been
NOTES
depreciating along with it.
A third view, which has been recently put forward by a leading economic journal, among
others, is that RBI should pursue what it has referred to as a policy of calculated volatility.
It has been argued that the present policy of controlled volatility has provided virtually risk-
less gain to market participants since the rupee has been expected to appreciate
substantially and continuously over the past few months. According to this view, in order
to prevent excessive capital inflows during this period, RBI should have allowed the
exchange rate to overshoot. quickly the targeted exchange rate of, say, Rs. 46.20 (or any
other number) to, say, Rs. 45.50. Thereafter, it should have allowed the rupee to depreciate
slowly, but not necessarily smoothly, to the above targeted number over a period of next
few months. In essence, this proposal is akin to a policy of (announced or unannounced)
fixed exchange rate within a wider band.
The RBI welcomes the current debate. Reserves, at present, are certainly at a level which
is more than enough to meet any foreseeable contingency. It is also clear that, in the
present period, capital inflows and remittances have been strong, requiring continuous
domestic liquidity management. In principle, therefore, it would be nice if an alternative
viable exchange rate management system could be put in place which would avoid
excessive build-up of reserves and domestic liquidity and, at the same time, maintain
India.s external competitiveness with low inflation and low interest rates.
In theory, each of the above alternative approaches has some merit. However, it is not
entirely clear that they can be put into practice without causing substantial instability or
uncertainty and possible emergence of macro-economic problems which are worse than
what they are trying to solve. An implicit assumption in two of the above alternatives is
that there is a level at which, after initial fast appreciation, the exchange rate will either
stabilise or turn around. A further implicit assumption is that the level (whatever it is) is
either already known or will become known to the market as it is approached.
RBI.s past experience does not suggest that these assumptions are valid. It would be
recalled that there have been periods when rupee exchange rates have been relatively
more volatile and movements have been sharper. However, during periods of sharper
appreciation, instead of inflows declining and demand for foreign currency rising, it was
noticed that actual market behaviour was the 6 BIS Review 36/2003 opposite. The opposite
was true during periods of sharp depreciation. Exchange rate expectations had their own
momentum and were often self-fulfilling. There must, of course, be a level where these
expectations will reverse. However, if that level, because of momentum. trading in imperfect
and thin markets happens to be significantly out of line with fundamentals., considerable
instability and substantial overvaluation (or under valuation) may result Such an outcome
may do more harm than good to continued confidence in a countrys exchange rate system.
The third suggestion to hold the rates at current levels, and not to allow it to appreciate
any further, even if inflows are strong, is also likely to be unsustainable over any length of
time. It virtually amounts to adopting a fixed or a near-fixed exchange rate system with a
floor. Past experience suggests that this system can work well, as it did in East Asia prior
to the crisis, when the economy is doing well and inflows are strong, but it comes under
extreme pressure when there are unfavourable domestic or external developments.
135
Abandonment of a system of .fixed. exchange rates (or a system with a known floor) then
becomes unavoidable. Such a change, when it occurs under pressure, can result in
considerable instability which is likely to be spread over a fairly long period. At the end of
this process, the country then has no option but to revert to a more flexible exchange rate
system.
It is by no means a mere coincidence that all countries affected by external crises in the
NOTES 1990s had a fixed or near-fixed exchange rate systems. China at present is an exception
to the rule in view of its persistent trade surpluses over a long period combined with very
high levels of foreign direct investment. It is not certain how long into the future this
situation will prevail. In any case, China.s special characteristics are difficult to replicate
in other emerging markets with lower volume of trade and foreign investment.
The desirability of maintaining the-overall competitiveness of an economy can hardly be
questioned. However, the long-run competitiveness of an economy needs to be measured
in relation to a multiple currency basket, and in relation to major trading partners over a
reasonably long period of time.
Exchange rate fluctuations among major currencies are now an everyday fact of life, and
it is important for all entities with foreign exchange exposures to resort to .hedging. with
appropriate risk management of assets and liabilities.
On balance, the benefits of the suggested alternatives to the present system are not very
clear. The present system is by no means an ideal one. However, like the old cliche about
virtues of democracy, it is probably better in the long run than all the available alternatives.
In view of behavioural and market complexities in this area, as well as multiple economic
policy objectives, solutions which seem ex-ante. optimal may turn out to be disastrous ex
-post - after the event - as happened in Argentina recently and East Asia and Mexico
some years ago.
Nevertheless, as I said a while ago, RBI welcomes the present debate. As a contribution
to this debate, I have tried to deal with some relevant issues, and indicate our present
views on them. These views are, of course, subject to change in the light of domestic and
international experience and further academic insights.
We look forward to your deliberations and hope to benefit from them.
136
Exchange Rate Management : Dilemmas, Inaugural Address by
Dr. Y.V. Reddy, Deputy Governor, Reserve Bank of India
Inaugural Address by Dr. Y.V. Reddy, Deputy Governor, Reserve Bank of India at XIth
National Assembly Forex Association of India at Hotel Cidade De Goa, Goa, on August
15, 1997
Exchange Rate Management : Dilemmas NOTES
Mr Chairman and friends,
I am thankful to the organisers of the XI th National Assembly of the Forex Association of
India for giving me an opportunity to share with you the dilemmas that we face in foreign
exchange management. The fifty years since independence have seen significant changes
in our exchange rate regime. The exchange rate policy has evolved from the rupee being
pegged to the pound sterling until 1975, pegged to an undisclosed currency basket until
1992 and after a years experience with dual exchange rate system to a market-related
system by March 1993. This has helped to bring about flexibility in exchange rate
management. A couple of years ago, my predecessor, distinguished Dr. S. S. Tarapore,
addressed this Assembly on some of the burning issues of foreign exchange markets.
Last year, my colleague, Mrs. Usha Thorat gave an authentic and analytical account of
the recent developments in forex markets and on the role of authorised dealers (ADs) in
forex markets. Today, I will address the dilemmas that we, as policy makers face, in the
conduct of exchange rate policy.
International Parity
2. I will briefly as a backdrop, revisit the four parity conditions, that you are familiar with.
First, the Purchasing Power Parity (PPP) which links the spot exchange rate and inflation.
Secondly, the International Fisher Relation which links interest rates and inflation. Thirdly,
the Foreign Exchange Expectations which link forward exchange rates and expected
future spot exchange rates. Fourthly, the Interest Rate Parity, which links spot exchange
rates, forward exchange rates and interest rates. The four parity relations could be combined
in several ways to throw light on the four critical variables that are often used in exchange
rate management policies, viz., the interest rate differential, the inflation differential, the
forward discount/premium, and the exchange rate movement. The theories built around
the parity relations help us to understand the foreign exchange markets better, but, they
rarely give us ready made solutions to the problems that arise in day-to-day, say, minute-
to-minute operations in the exchange markets.
3. What could be the explanation for such a phenomenon? In the real world, expectations
cannot be easily subjected to definitive formulae; goods cannot be transferred across
countries simultaneously; shipping and other transactions costs can turn out to be much
different from the initial conditions; trade and other restrictions often exist, distorting prices.
Even in the most efficient markets, ideal conditions do not exist, and forward premia as
a result, have not been able to predict future spot rates accurately. The actual exchange
rates are usually overvalued or undervalued in terms of the purchasing power parity. Under
Indian conditions, however, there are some additional questions. For instance, which is
the correct risk-free interest rate to be compared while calculating interest rate differentials?
Should we consider the 91-Day T-Bill rate or some other short-term rate? The theoretical
forward premia could vary depending on the interest rate chosen. In the quest for answers
to some questions, dilemmas do arise.
Current Context
5. The elements of continuity, contextual response and change would be present in the
conduct of any policy, including the exchange rate policy. In this address, I would be
focusing on the contextual response. After all, exchange rate policy will form part of the
overall macroeconomic policy and will, therefore, have to be subservient to overall
macroeconomic targets. The conduct of exchange rate policy during 1996-97 was primarily
guided by market conditions resulting from the contraction in the current account deficit
and resurgence of capital inflows. Foreign exchange reserves (including gold) scaled a
peak of US$ 26.4 billion by end-March 1997, without sacrificing exchange rate stability. In
regard to 1997-98, the exchange rate policy needs to be seen in the context of the
Monetary Policy Statement of April 15, 1997. The Statement indicates, given the real
GDP growth for 1997-98 of 6.0 - 7.0 per cent, the expansion in M3 would be sought to be
maintained in the range of 15.0 - 15.5 per cent to keep the inflation rate at around 6.0 per
cent. Monetary policy would, in other words, continue to be directed towards maintaining
a stable financial environment in relation to price, interest rate and exchange rate.
6. Against these broad parameters, we have to look at the variables that have a bearing on
contemporary exchange rate management. Some of the crucial variables at this juncture
apart from price stability and money supply which are always dominant are, in my view,
the revenue and expenditure position of the Government, the oil pool deficit, the buoyancy
in industrial activity, the progress in infrastructure sector, and the developments in trade
and capital flows. Besides, leads and lags operate, affecting the market. Moreover, major
players in the market influence exchange rate movements and thereby the perceptions
about policy. Let me illustrate this point with reference to the oil pool deficit. IOC has, in
the recent past, increasingly resorted to foreign currency borrowing rather than domestic
borrowing to finance the deficit, presumably in view of the lower cost and the perceived
stability of the rupee. To the extent IOC resorts to additional overseas borrowing for oil
purchases, the demand in the forex market is depressed leading to pressure on the rupee
to appreciate even further. There would be an exactly opposite effect, when IOC starts
reducing the exposure to short term borrowing, simultaneously making the cash payment
for current purchases, with implications for exchange rate management.
138
was 61.02 per cent in August 1993 and 65.78 per cent in August 1995, i.e. an appreciation
of 7.8 per cent. In August 1995, the volatility in the exchange rate of the rupee started and
in the following months, the rupee depreciated and corrected for real appreciation by
January 1996 when the REER was 59.32. For most of 1996, the REER remained stable.
However, with the sharp appreciation of the US dollar vis-a-vis other major currencies
since the last quarter of 1996, the rupee also appreciated in real terms. In August 1996,
the trade based REER (1985=100) was 62.26 which rose to 65.41 in April 1997, i.e. an
NOTES
appreciation of around five per cent. Over January 1996, the appreciation in April 1997 was
10.3 per cent. There is a considerable discussion as to whether the rupee is overvalued or
not. As per the REER, it would certainly appear so, irrespective of the base chosen. The
overvaluation has got exacerbated with the sharp appreciation of the US $ against other
major currencies, viz., the DM and the Yen. The relative cheapening of imports may not
have resulted in increasing imports and larger current account deficits. This is because
imports are relatively less responsive to exchange rate changes and are more sensitive to
the level of economic activity. There could be a potential larger current account deficit as
industrial activity rebounds - even at the present exchange rates and if oil demand picks
up, a correction cannot be ruled out.
The optimal size of the external current account deficit, of course, depends upon the
degree of openness of the economy. In the Indian context, the ratio of current receipts to
GDP of 15 per cent, as at present, could sustain a current account deficit of the order of
two per cent of GDP and would still enable a decline in the debt service ratio from the
present level of 25 per cent. A current account deficit of two per cent of GDP in conjunction
with the domestic saving rate of 25- 26 per cent could ensure an investment rate of around
28 per cent which, even with ICOR of around 4.0 should be able to sustain a real GDP
growth of seven per cent per annum. Since 1991-92, however, the current account deficit
has averaged around only one per cent of GDP.
Thus, enlargement of current account deficit beyond the present level is sustainable.
Volatility
8. The Reserve Bank has been intervening in both the spot and forward markets to prevent
undue fluctuations. In the context of large capital flows (inflows as well as outflows) within
a short period, it may not be possible to prevent movements in the exchange rate away
from the fundamentals. Hence, the management of rate fluctuations becomes passive,
i.e., one of preventing undue appreciation in the context of large inflows and providing
supply of dollars in the market to prevent sharp depreciation. But, the correction, if any,
has to be gradual and not sudden.
Level of Reserves
9. Adequacy of reserves is, as I mentioned, an important consideration. The level of
foreign exchange reserves rose to US$ 29.8 billion by August 1, 1997, equivalent to seven
months of imports. In the context of the changing interface with the external sector and
the importance of the capital account, we have to evaluate reserve adequacy in terms of
both conventional indicators and non-conventional norms. The present level of foreign
exchange reserves is equivalent of about 30 months of debt service payments and 5.7
months of payments for import and debt service taken together. In the context of mobile
capital flows, it may be useful to assess the level of reserves in terms of the volume of
short-term debt which can be covered by reserves.
At the end of March 1997, the ratio of short-term debt to the level of reserves amounted to
a little over 25 per cent, compared to about 100 per cent for Indonesia, 50 per cent for
Argentina, and 25 per cent for Malaysia. In fact, the level of reserves exceeds the total
139
stock of short-term debt and portfolio flows which, taken together, constitute little less
than 75 per cent of the level of reserves.
The present level of external reserves is a source of comfort as it provides a measure of
insulation against unforeseen external shocks or shocks created by domestic supply
shortages.
NOTES Besides, it helps to meet the precautionary motive and satisfy the need for liquidity, which
in itself instills confidence in the Indian economy among international investors and financial
markets.
Such confidence has also a bearing on the extent and of course cost of external borrowings.
As the economy becomes more open, external shocks need a cushion which reserves
alone can provide. The volatility of some of the capital flows needs to be kept in mind. It is
true that reserves are not required to meet the transaction motive which is to be taken
care of by changes that will naturally occur in the market determined exchange rates.
But, in a period of transition, when structural shifts can release strong excess demand or
throw up temporary bottlenecks, reserves smoothen the process of change and mitigate
pains of adjustment. So, some addition to reserves, in my view, would give additional
comfort.
Forex Markets
10. Developing exchange markets is another important consideration in exchange rate
management. Recently, several measures were initiated to further integrate the Indian
forex market with the global financial system. Banks were permitted to fix their own
position limits and Aggregate Gap Limits (AGLs) in January 1996. Banks were permitted
in October 1996 to provide foreign currency denominated loans to their customers out of
the pool of FCNR - B deposits.
In order to achieve greater integration between domestic and overseas money markets,
authorised dealers (ADs) were permitted in April 1997 to borrow from their overseas offices/
correspondents as well as to invest funds in overseas money market instruments up to
US $ 10 million. With a view to imparting flexibility to corporates and improving liquidity in
the forward markets for periods beyond six months, ADs were also permitted to book
forward cover for exporters and importers on the basis of a declaration of exposure supported
by past performance and business projection provided the total forward contracts
outstanding at any point of time did not exceed the average export/import turnover of the
last two years. ADs were also allowed to arrange forex-rupee swaps between corporates
and run a swap-book within their open positions/gap limits without prior approval of the
Reserve Bank.
Now, as per the decision taken last week, FIIs are allowed to cover as a first step, their
debt exposures in the forward market.
In order to further facilitate integration between domestic and overseas markets, banks
with adequate capital strength may be encouraged to have higher limits for investments in
overseas markets. This will help in developing further the forward markets.
140
banking system had fueled intense foreign currency speculation, as the market participants
felt that the natural course of the currency was to depreciate. Given the huge short-term
borrowings, the fund managers started exiting the economy with the first sign of trouble,
leading to a de facto devaluation of the Thai baht. An important point to be noted here is
that the currency crises in these countries was managed quite efficiently with the help of
reserves which most of these countries had, to defend their currencies. Thailand, as also
other East Asian economies, despite a large current account deficit, are high saving NOTES
economies with good underlying growth rate and strong competitiveness.
Capital Inflows
13. Capital inflows constitute a major factor affecting the value of the rupee now. With the
resurgence in capital inflows, the net surplus on the capital account more than doubled to
about US $ 11,600 million during 1996-97 thereby exceeding the previous peak of US $
9,695 million touched in 1993-94. Reflecting these developments, surplus conditions
prevailed in the foreign exchange market throughout the year. In general, the policy response
has taken the form of partial sterilised intervention through open market operations,
liberalisation of capital outflows, raising of reserve requirements and deepening of the
foreign exchange market by routing increased volumes of transactions through the market.
To prevent appreciation of the rupee, and to protect international competitiveness, the
Reserve Bank made substantial purchases of US dollars in the market. During 1997, the
141
RBI intervened in the spot and forward markets, both in the outright and swap segments.
Outright spot and forward purchases of US dollars during 1996- 97 amounted to $ 7.9
billion and $ 0.9 billion, respectively. Swap purchases amounted to $ 2.4 billion. While
spot sale of US dollars was marginal, forward and swap sales amounted to $ 0.3 billion
and $ 3.1 billion, respectively. Thus, net purchases of US dollars during 1996-97 amounted
to $ 7.8 billion.
NOTES The influx of capital continues during 1997-98. The Reserve Bank has accumulated US $
3.9 billion of foreign currency assets until August 8, during the current financial year. Total
spot and forward purchases and swap sales of US dollars up to end-July 1997, totalled $
4.3 billion, $ 1.1 billion and 0.9 billion, respectively. Thus, net purchases of US dollars by
the Reserve Bank of India up to end July, during the financial year 1997-98 amounted to
about $ 4.6 billion.
The optimal policy response to capital inflows is very much a function of the anticipated
persistence of capital inflows. The design of policy depends upon the expectation whether
the inflow of capital is temporary or is expected to continue. A temporary increase in
inflow and perceived as such by the public, which may lead to a temporary real appreciation
of the exchange rate, is unlikely to have major effects. Problems, however, arise if the
inflow is temporary, but the public expects the inflow to continue. But, in real life, nobody
knows with confidence, what is temporary, how temporary it is, and what the public
perception is, and indeed how temporary the public perception is! So, let me straightaway
go into the instruments.
Internationally, a number of instruments have been used to sterilise capital inflows, the
chief among them being the sale of government bonds through open market operations.
This policy is useful temporarily and if used for long, leads to renewed inflows. We, in the
Reserve Bank, are however, well equipped with physical stock of government securities.
We have been active in the repo market in recent months to manage temporary liquidity
conditions. The idea is to realise a fine balance in order to achieve the objectives of
sterilisation without putting pressure on yields.
Discount policy, which implies restricting the access of banks to central bank credit or
raising the cost of refinance has also been used by countries to sterilise capital inflows.
This instrument cannot, however, be used in the current context when there is plenty of
liquidity in the money market and there is no borrowing from the central bank. However,
this instrument may go against the long-term objectives of monetary and credit policy.
Varying the reserve requirements is yet another policy tool. Mobilising Government deposits
has served as a variation to absorption of reserves in some countries. Variable deposit
requirements in the nature of interest free deposits with the central bank is another form of
discouraging capital inflows. This measure, while it reduces the need for costly sterilisation
through sale of bonds, may result in misallocation of resources and reduce the facility to
borrowers to take advantage of lower international interest rates. We have used the CRR
successfully in the past, to stem inflows. After the imposition of CRR on incremental NRI
deposits, there has been some deceleration in the growth of foreign currency deposits
during the current financial year.
Entering into foreign currency swaps (spot sell - forward buy) is another way of sterilising
capital inflows. The foreign currency purchased by banks may be used to finance domestic
activities or for investment abroad. Our experience shows that the market is fairly thin and
in such a market, the use of foreign currency swaps for sterilisation only adds volatility to
the forward market unless there is a constant swap window.
Central banks can employ outright forward exchange transaction, i.e., buy outright forward
instead of spot. This will have the desired effect on the spot rate, only if it is not countered
142
by very large spot inflows from participants like FIIs and forward supplies by exporters
who wish to take advantage of the increase in premium.
Taxing on capital inflows is yet another form of dissuading flows. For foreign investors, it
effectively lowers the rate of return on local assets. This instrument also carries the
disadvantage of raising the cost of capital. This option was considered at one time, but
deferred considering its disadvantages.
NOTES
Conclusion
14. I have explained the dilemmas, mainly to show that we are committed to the stated
objectives, and assert that we are equipped to handle the problems - equipped with requisite
will and skill. However, some believe that we are cautious - whether in allowing the rupee
to appreciate or inducing adequate depreciation. Perhaps, some explanation would be in
order.
First, we are going through a process of economic reform. In a democratic federal set up
going through such economic reform, we require a general mandate on essential
complementary policies.
Second, we are vulnerable to supply shocks, especially food stock and oil prices.
Third, the East Asian Countries support each other. The G-10 countries coordinate with
each other. The Latin American countries are generally supported by North America. We
are not members of any blocks. We have gone through the truama of balance of payments
crisis in early 1990s and we cannot ignore the threat to economic sovereignty if we take
undue risks.
Fourth, and most important, price stability is critical to the economy as a whole, to both
the poor and exporters. In fact, as our Governor, Reserve Bank of India, Dr. C. Rangarajan,
mentioned in his address at the Annual Presentation Ceremony of the Engineering Export
Promotion Council earlier this month, containment of domestic price increase has the
same beneficial effect as the depreciation of the nominal exchange rate. If the nominal
exchange rate is stabilised at a certain level by letting the foreign exchange assets of the
central bank to increase, it may have an adverse effect on he exporters through price
increase arising from more than the desired increase in money supply. There can therefore,
be no rigid formula governing exchange rate determination. Monetary authorities need
continually to perform a balancing act between ensuring an exchange rate which will be
supportive of exports and the need to contain monetary expansion within reasonable
limits.
During the current financial year up to August 1, deposits have grown rapidly by 4.1 per
cent (3.7 per cent in the corresponding period last year). M3 has grown by 4.4 per cent up
to July 18 (3.7 per cent last year). The year-on-year growth in M3 is 16.7 per cent. The
positive features during the current year are that interest rates have come down, both in
the short and long end, and so has the inflation rate. The area of concern relates to money
supply. Any further measures in terms of exchange rate should consider the money supply
effect so that the gains already made on interest rate and inflation fronts are not eroded.
This is the critical aspect of the current exchange rate management stance.
Finally, the extent, the pace and the manner of correction of the exchange rate will have to
be taken in conjunction with money supply, since price stability continues to be the
dominant objective of monetary policy. We, in the Reserve Bank, seek your assistance,
advice, cooperation and understanding. For my part, I am happy to announce that,
henceforth the Reserve Bank will make available weekly data relating to its intervention in
the forex market.
Thank you.
143
6.12. SUMMARY
Macroeconomics takes as given distribution of output, employment and total spending, is
what microeconomics seeks to explain. Thus, macroeconomic theory has a foundation in
microeconomic theory. There is interdependence between the two. In practice, analysis
of economy is not done separately in two watertight compartments. When macroeconomics
NOTES variables are analyzed, one must allow for changes in microeconomic variables that
influence the macroeconomic variables and vice versa. Macroeconomic policy operates
within a framework of goals and constraints. The most important and crucial goals of
economic policy are as follows. Full employment, i.e., full utilization of human and non-
human resources; High living standards; Price Stability; Reduction of economic inequality
and removal of poverty; Rapid economic growth and External balance vs overall balance in
economic relations with the rest of the world.
5. If the interest rate is below the equilibrium interest rate, then the quantity
of money exceeds the quantity of money, and there is
a of money.
6. If the interest rate falls, the opportunity cost of holding money and
the quantity demanded of money .
144
Macro-economics Analysis
7. A general definition of the transmission mechanism is: the routes or channels
that ripple effects created in the
a. market for goods and the services travel to affect the money market.
b. money market travel to affect the market for goods and services.
c. labor market travel to affect the market for goods and services. NOTES
d. market for goods and services travel to affect the labor market.
e. none of the above
8. Which best describes the Keynesian transmission mechanism when the money
supply rises?
a. The interest rate rises; this in turn cuts back investment spending, which in
turn raises total expenditures and shifts the AD curve rightward.
b. The interest rate falls; this in turn stimulates investment spending, which in
turn raises total expenditures and shifts the AD curve leftward.
c. The interest rate falls; this in turn stimulates investment spending, which in
turn raises total expenditures and shifts the AD curve rightward.
d. The interest rate falls; this in turn stimulates investment spending, which in
turn lowers total expenditures and shifts the AD curve leftward.
12. Which scenario best explains the Keynesian transmission mechanism when the
money supply rises while the money market is in a liquidity trap?
a. The interest rate and investment are not affected; there is no shift in the AD
curve.
b. The interest rate falls, investment rises, total expenditures rise, and the AD
curve shifts rightward.
145
c. The interest rate falls, investment falls instead of rising, and the AD curve
ends up shifting leftward.
d. The interest rate falls, but investment does not respond; there is no change
in total expenditures and no shift in the AD curve.
14. Which scenario best explains the Keynesian transmission mechanism when the
investment demand curve is vertical?
a. The interest rate falls, investment falls even more, the AD curve shifts
rightward, but total expenditures do not change.
b. The interest rate falls, investment rises, total expenditures rise, and the AD
curve shifts rightward.
c. The interest rate falls, investment falls instead of rising, and the AD curve
ends up shifting leftward.
d. The interest rate falls, but investment does not respond; there is no change
in total expenditures and no shift in the AD curve.
a. assumption that the money supply curve is vertical as a result of the Feds
control.
b. problem that occurs when interest rates reach such high levels that no
individuals want to hold their wealth in the form of money.
d. possibility that interest rates drop so low that people willingly hold all the
additions to the money supply, rather than use it to buy bonds.
16. Suppose the money market is in the liquidity trap and the Fed increases the
supply of money. We expect that
a. people will end up willingly holding more money.
b. the excess money holdings will flow into the loanable funds market and
there will be a decrease in interest rates.
c. interest rates will increase, since the demand curve for money is upward
sloping in this case.
d. eventually, via the transmission mechanism, Real GDP will increase.
17. What do Keynesians mean when they say that you cant push on a string?
a. An increase in the supply of goods does not really create its own demand.
b. If the government reduces taxes in an attempt to increase household
consumption, it will not always work.
146
Macro-economics Analysis
c. An increase in the money supply will not always stimulate the economy.
d. If the government wants to get something done, the best way is not to force
the issue, but to offer incentives.
e. If the government puts too much expansionary pressure on the economy, it
will probably overheat.
NOTES
18. If market interest rates increase, the prices of existing bonds will
a. decrease. b. not change.
c. increase.
d. decrease if Real GDP decreases and increase if Real GDP increases.
19. An individual buys a bond for $1,000 and sells it one year later for $1,080. What
is the interest rate return that this individual has received?
20. Suppose that one year ago you purchased a $100 bond with an interest payment
of $10 per year and, at the time, the interest rate was 10 percent. One year later
the interest rate has increased to 10.5 percent, and you still hold the bond. Your
bond is now worth
a. more than it was before. b. less than it was before.
c. the same as it was before, that is, $100.
d. More information is necessary to answer the question.
21. Suppose the money market is in the liquidity trap and the Fed increases the
supply of money. Individuals would rather hold than
because they expect that bond prices can go no .
a. bond prices are so low that they have nowhere to go but up; given this, now
is a good time to be holding bonds.
b. bond prices are so high that they have nowhere to go but down; given this, it
is better not to be holding bonds.
c. bond prices will soon rise so it is better to get out of bonds now.
NOTES e. b and c
148
Macro-economics Analysis
30. Keynesians are more likely to propose
a. contractionary monetary policy to eliminate an inflationary gap than
expansionary monetary policy to eliminate a recessionary gap.
b. contractionary monetary policy to eliminate a recessionary gap than
contractionary monetary policy to eliminate an inflationary gap.
c. expansionary monetary policy to eliminate a recessionary gap than
NOTES
contractionary monetary policy to eliminate an inflationary gap.
d. none of the above; instead, Keynesians are as likely to propose expansionary
monetary policy to eliminate a recessionary gap as they are to propose
contractionary monetary policy to eliminate an inflationary gap.
149