Principles of Economics

Transcription

1

2 Principles of Economics

3 Principles of Economics D N DWIVEDI Professor in Economics Maharaja Agrasen Institute of Management Studies, Delhi Former Reader, Ramjas College University of Delhi VI KASPUBLI SHI NGHOUSEPVTLTD

4 VIKAS PUBLISHING HOUSE PVT LTD 576, Masjid Road, Jangpura, New Delhi Phones: , Fax: First Floor, N.S. Bhawan, 4th Cross, 4th Main, Gandhi Nagar, Bangalore Phone: Damodhar Centre, New No. 62, Old No. 59, Nelson Manickam Road, Aminjikarai, Chennai Phone: , , Palm Avenue, Kolkata Phone: F-20, Nand Dham Industrial Estate, Marol, Andheri (East), Mumbai Phone: , Distributors: UBS PUBLISHERS DISTRIBUTORS PVT LTD 5, Ansari Road, New Delhi Ph , Fax: , Internet: 10, First Main Road, Gandhi Nagar, Bangalore Ph , M P Nagar, Zone-1, Bhopal Ph , , Nelson Manickam Road, Aminjikarai, Chennai Ph /7940, Convent Road, Ernakulam Ph , NVK Towers, 2nd Floor, Adjacent to old Hyderabad Stock Exchange, Himayat Nagar, Hyderabad Ph /1-B, Chowringhee Lane, Kolkata Ph , st Floor, Halwasiya Court Annexe, 11-MG Marg, Hazratganj, Lucknow Ph nd Floor, Apeejay Chambers, 5 Wallace Street, Fort, Mumbai Ph A, Rajendra Nagar, Patna Ph , Budhwar Peth, 2nd Floor, Appa Balwant Chowk, Pune Second Edition ISBN: Copyright Author, 1985, 2005 No part of this publication which is material protected by this copyright notice may be reproduced or transmitted or utilized or stored in any form or by any means now known or hereinafter invented, electronic, digital or mechanical, including photocopying, scanning, recording or by any information storage or retrieval system, without prior written permission from the publisher. Information contained in this book has been published by VIKAS Publishing House Pvt. Ltd. and has been obtained by its authors from sources believed to be reliable and are correct to the best of their knowledge. However, the publisher and its authors shall in no event be liable for any errors, omissions or damages arising out of use of this information and specifically disclaim any implied warranties or merchantability or fitness for any particular use. Printed at Gajendra Printing Press, Delhi

5 Preface to the Second Edition Although basic principles of economics remain the same as delineated in the first edition of this book, the need for bringing out its second edition was felt for three reasons. First, Principles of Economics is being reintroduced in the economics syllabi of various universities. The way these syllabi were designed it created an impression that there are two kinds of economics microeconomics and macroeconomics with some specialized branches. The system seems to be returning to the earlier form of first giving students a comprehensive view of the basic principles and then initiate them to its two major branches with increasing emphasis on macroeconomics and international economics. This new trend has enhanced the relevance and usefulness of this book. Secondly, there is a greater emphasis on using quantitative method of elaboration and exposition of economic theories in recent years while the use of high-level mathematics is being underplayed. So, there was a need for introducing simple quantitative methods in the presentation of theories. Thirdly, the application of economic concepts and theories to real life problems is of late also being emphasised and this is also finding entry into management, medical and engineering courses. So application content has been brought into focus in this second edition. The primary objective of writing this test has been to provide a comprehensive text on the basic principles of economics for undergraduate and postgraduate students in a compact volume. This book will also be of immense use to students preparing for competitive examinations, like IAS, IES, CA, MBA and BBA degree and diploma courses, economics paper in engineering and medical courses. In nutshell, it is an all-purpose book for the students of economics. The students of the latter categories who begin with virtually no economics background often find it difficult to comprehend the complex theories of economics. For them this book is a boon. It begins with simple introduction to economics as a social science, then moves on to basic economic problems of individuals, firms and the society focusing on the problem of scarcity and choice making finally discussing the higher levels of economic theories. Parts II to VI deal with microeconomic theories. Graphical illustrations and simple algebraic formulations have been used, wherever necessary, for clear exposition of economic theories. Review questions and exercises are given at the end of each chapter to help students assess their own understanding of economics. Thus, substantial changes have been made for this edition and the subject matter has been reorganized. While most chapters are rewritten, expanded and updated, some new have been added. The new chapters are listed below. Chapter 1. Introduction to Economics: (An abridgement and updated version of earlier Ch. 1, 2 and 3). Chapter 2. The Economy and Its Basic Problems: Scarcity and Choice. Chapter 3. The Laws of Demand and Supply and Market Equilibrium: (Constitutes a new part Part II: Fundamentals of the Market Economy). Chapter 6. Failures of the Market Economy and the Role of the Government. Chapter 21. Factor Market: Factor Demand and Supply. Chapter 22. Theory of Wage Determination (A revised version of earlier Ch. 24).

6 vi Chapter 23. Rent, Quasi Rent and Economic Rent (A rewritten version of earlier Ch. 26). Chapter 26. Product Exhaust Theorem. Chapter 29. Introduction to Macroeconomics Chapter 30. The Circular Flow Model of the Economy. Chapter 39. Inflation: Meaning, Measure and Effects Chapter 40. Theories of Inflation and Control Measures Most other chapters are rewritten with additional topics as listed below: Meaning and Measurability of Utility; Consumer Equilibrium: The General Case; Derivation of Demand Curve has been added (Ch. 7) The Corner Solution: The Extreme Choice; The Composite Goods Case; Goods, Bads and Neuters (Ch. 8) Meaning of Production; Some Basic Concepts (Ch. 11) Economies of Scale: Why LAC Decreases; Cost Functions and Cost Curves (Ch. 14) Preface to the Second Edition Game Theory Approach to Oligopoly (Ch. 19) Some Early Thoughts of Interest Theory; Classical Theories of Interest (Ch. 24) Partial Vs. General Equilibrium, Walrasian General Equilibrium Model; The Process of Automatic Adjustment (Ch. 27) Cardinal Utility Approach: Social Welfare is the Sum of Individual Utility; Pareto Approach: Social Welfare as Social Optimum; The New Welfare Economics: Compensation Criteria for Welfare Judgement; The Bergson Criterion: The Social Welfare Function (Ch. 28) Shift in Aggregate Demand Function and the Multiplier (Ch. 32) Meaning of Economic Growth; Factors in Economic Growth (Ch. 37) The book is thus being presented with significant qualitative improvement and with most comprehensive coverage. I am extremely grateful to Shri Piyush Chawla, Director Publishing and Marketing of Vikas Publishing House for giving me an opportunity to revise the book. Comments and suggestions will be gratefully acknowledged. D N Dwivedi

7 Preface to the First Edition The aim of this book is to provide a standard and comprehensive text on a wide range of principles of economics. It is addressed to the undergraduate and post-graduate students of Indian universities and to the candidates for IES and IAS examinations. It would meet the requirement of also those who want to possess a textbook in economics for general reference. Writing a textbook, in economics these days is somewhat similar to producing a commodity with product differentiation. The salient features of this book that distinguish it from other similar books may be briefly mentioned here. Unlike most advanced texts, this book provides a nonmathematical treatment of economic concepts and theories. But, unlike many other texts that rely solely on verbal and imprecise description, this book uses the modern tools of economic analysis in the exposition of the subject-matter. It presents the complex economic theories in a clear and precise manner with the help of self-explanatory diagrams and simple algebra. Besides, an attempt has been made throughout to equip the reader with classical and modern tools of economic analysis and their relative merits. In view of the fact that many students from other disciplines take to economics at a fairly advanced stage, the discussion on each topic begins at an elementary level and proceeds by stages towards the higher levels. Also, a list of standard texts and important papers is given at the end of each chapter to facilitate advanced study of the subject. In preparing this book, I have heavily drawn from the writings of the reputed economists. My debt in this regard is incalculable. I am indebted to my friend and colleague Mr. R. R. Suresh for going through several chapters of the book and making valuable suggestions. I gratefully acknowledge the help I have received from Mr Ramesh Bhatt and Mr Chandra Shekhar Sharma, both of Sriram College of Commerce (Delhi), in writing the chapters on linear programming and profit theory, respectively. I owe also to my wife and son who were deprived of their due share in my time during the preparation of this book. The comments and suggestions to improve the book shall be gratefully acknowledged. D N Dwivedi

8 Contents Preface to the Second Edition Preface to the First Edition Part I INTRODUCTION v vii 1. Introduction to Economics 1 What is Economics?; The Scope of Economics; Is Economics a Positive or a Normative Science; Methodology of Economics: What Economists Do and How; How Reliable are the Economic Laws; Why Economic Laws; Review Questions and 2. The Economy and Its Basic Problems: Scarcity and Choices 16 The Economy and its Working; Kinds of Economic Systems; Production Possibilities of an Economy; The Basic Problems of an Economy; How Market Mechanism Solves the Basic Problems; How Efficient is the Market System; Reasons for the Failures of the Market System; The Government and the Economy; Review Questions and Part II FUNDAMENTALS OF MARKET ECONOMY 3. The Laws of Demand and Supply and Market Equilibrium 37 Introduction; The Law of Demand: Price-Demand Relationship; The Law of Supply; The Supply Function; Equilibrium of Demand and Supply: Determination of Equilibrium Price; Review Questions and 4. Elasticities of Demand and Supply 55 Price Elasticity of Demand; Determinants of Price Elasticity of Demand; Price Elasticities and Marginal Revenue; Price Elasticity and Consumption Expenditure; Cross-Elasticity of Demand; Income Elasticity of Demand; The Elasticity of Price Expectations; The Uses of Elasticity; Price Elasticity of Supply; Review Questions and 5. Market Equilibrium and Disequilibrium 71 Introduction; Meaning and Uses of Equilibrium; Kinds of Equilibria; Partial and General Equilibrium; Short-term and Long-term Equilibrium; Unique and Multiple Equilibrium; Review Questions and 6. Failure of the Market Economy and Role of the Government 86 Introduction; Imperfect Market Information and Market Failure; Growth of Monopolies and Market Failure; Market Failure in Case of Public Goods; Public Provision of Public Goods; Externalities and Government Intervention; Review Questions and Part III THEORY OF CONSUMER DEMAND 7. Theory of Consumer Demand: Cardinal Utility Approach 97 Introduction; Cardinal Utility Theory; The Law of Diminishing Marginal Utility; Consumer s Equilibrium, Derivation of Demand Curve; Drawbacks of Cardinal Approach; Review Questions and 8. Theory of Consumer Demand: Ordinal Utility Approach 106 Introduction; The Meaning and Nature of Indifference Curve; The Diminishing Marginal Rate of Substitution; Properties of Indifference Curves; The Budget Constraint and The Budget Line; Consumer s Equilibrium; Effects of Change in Consumer s Income; Effects of Price Change; Income and Substitution Effects on Inferior Goods; Complementarity and Substitutability; The Corner Solution: The Extreme Choice; The Composite Goods Case; Goods, Bads and Neuters; Derivation of Individual Demand Curve;

9 x Comparison of Cardinal and Ordinal Utility Approaches; Critique of Indifference Curve Approach; Applications of Indifference Curve Analysis; Review Questions and 9. Recent Developments in Consumption Theory 146 Introduction; Samuelson s Revealed Preference Theory; Neumann-Morgenstern Utility Theory; Friedman-Savage Hypothesis; Hicks Revised Demand Theory; Review Questions and 10. Consumer s Surplus 161 Introduction; The Marshallian Consumer s Surplus; Hicksian Method of Measuring Consumer s Surplus; Some Uses of the Consumer s Surplus Concept; Review Questions and Part IV THEORY OF PRODUCTION AND ANALYSIS OF COST 11. Theory of Production-I: Production with One Variable Input 171 Introduction; Meaning of Production; Some Concepts; Production Function; The Laws of Production; Review Questions and 12. Theory of Production-II: Production with Two Variable Inputs 179 Introduction; Isoquant Curves; Marginal Rate of Technical Substitution; Properties of Isoquant Curves; Isoquant Map and Economic Region; Other Forms of Isoquants; Elasticity of Substitution; Laws of Returns to Scale: Long Run Analysis of Production; Review Questions and 13. Optimum Combination of Inputs 194 Introduction; Budgetary Constraints and Isocosts; Optimising Combination of Inputs; Choice of Optimal Expansion Path; Change in Input Prices and Input Combination; Review Questions and 14. Theory of Production Cost 200 Cost Concepts; Short-Run Cost-Output Relations; Long-run Cost-Output Relations; Economies of Scale: Why LAC Decreases; Diseconomies of Scales: Why LAC Increases; Cost Functions and Cost Curves; Review Questions and Contents Part V THEORY OF FIRM: PRICE AND OUTPUT DETERMINATION 15. Objective of Business Firms and Market Structure 219 Introduction; Objectives of Business Firms; Profit Maximization; Alternative Objectives of Business Firms; The Market Structure; Review Questions and 16. Price and Output Determination Under Perfect Competition 233 A Prelude to the Theory of Firm; The Features of Perfect Competition; Perfect Vs. Pure Competition; Equilibrium of the Firm; Derivation of Supply Curve of the Firm; Derivation of Supply Curve of the Industry; Price and Output Determination Under Perfect Competition; Price and Output Determination in the Long Run; Longrun Supply Curve of a Competitive Industry; Review Questions and 17. Price and Output Determination Under Monopoly 247 Introduction; Monopoly: Definition and Sources; Demand and Revenue Curves Under Monopoly; Cost and Supply Curves Under Monopoly; Profit Maximisation Under Monopoly; Why Absence of Supply Curve Under Monopoly; Monopoly Vs. Perfect Competition: Comparison of Long-run Price and Output; Equilibrium of the Multiplant Monopoly; Price Discrimination by Monopoly; Measures of Monopoly Power; Review Questions and 18. Price and Output Under Monopolistic Competition 268 Introduction; The Nature of Monopolistic Competition; Foundations of the Monopolistic Competition Model; Price and Output Determination Under Monopolistic Competition; Analysis of Selling Cost and Firm s Equilibrium; Critical Appraisal of Chamberlin s Theory of Monopolistic Competition; Review Questions and 19. Price and Output Determination Under Oligopoly 278 Oligopoly: Meaning and Characteristics; Duopoly Models; Oligopoly Models; The Game Theory Approach to Oligopoly; Review Questions and 20. Some Topics in Pricing Theory 302 Introduction; Full-Cost Pricing; Limit Pricing:

10 Contents Bain s Model; Baumol s Theory of Sales Maximisation; Review Questions and Part VI THEORY OF FACTOR PRICING 21. The Factor Market: Factor Demand and Supply 311 Introduction; Marginal Productivity Theory of Factor Pricing: An Overview; Marginal Productivity and Factor Demand; The Factor Supply: An Overview; Derivation of Individual Labour Supply Curve; Derivation of Market Labour Supply Curve; Review Questions and 22. Theory of Wage Determination 322 Introduction; Wage Determination Under Perfect Competition in Product and Labour Markets; Monopoly in Commodity Market and Perfect Competition in Labour Market; Wage Determination Under Monopoly in Product and Monopsony in Labour Market; Perfect Competition in Commodity Market and Monopoly in Labour Market (Labour Union); Wage Determination Under Bilateral Monopoly: Collective Bargaining; Review Questions and 23. Rent, Quasi-Rent and Economic Rent 336 Introduction; Ricardian Theory of Rent; Quasi- Rent: The Short-Term Rent on Fixed Factors; Factor Price, Transfer Earning and Economic Rent; Review Questions and 24. Theories of Interest 342 Introduction; Some Early Thoughts on Interest Theory; Classical Theories of Interest; The Loanable Fund Theory of Interest; Review Questions and 25. Theories of Profit 349 The Meaning of Pure Profit; Theories of Profit; Does Profit Enter the Cost of Production?; Review Questions and 26. Product Exhaustion Theorems 358 Introduction; The Adding-up Controversy; Relative Factor Shares and Income Distribution; Review Questions and Part VII GENERAL EQUILIBRIUM AND WELFARE ECONOMICS 27. The General Equilibrium 367 Partial Vs. General Equilibrium; General Equilibrium Approach; The Walrasian Approach to General Equilibrium; Existence, Uniqueness and Stability of General Equilibrium; Evaluation of General Equilibrium Approach; Review Questions and 28. Welfare Economics 378 Introduction; Definition of Welfare Economics; Nature of Welfare Economics; The Concept and Measurement of Social Welfare; Classical Welfare Economics: Smith s Welfare Criteria; Neo-Classical Welfare Economics: Pigou s Welfare Economics; Pareto s Welfare Economics; Externalities and Pareto Optimality; The New Welfare Economics: Compensation Criteria for Welfare Judgement; The Bergson Criterion: The Social Welfare Function; Arrow Theorem of Democratic Group Decision; Grand Utility Possibility Frontier and Welfare Maximisation; The Theory of Second Best; Review Questions and Part VIII MACROECONOMICS 29. Introduction to Macroeconomics 406 What is Macroeconomics?; Major Macroeconomic Issues; Macroeconomics in Perspective; Review Questions and 30. The Circular Flow Model of The Economy 415 Introduction; Circular Flows in a Simple Economy Model; Circular Flows of Goods and Money in a Three-Sector Economy; Circular Flows in a Four- Sector Model: A Model with Foreign Sector; Review Questions and 31. National Income: Concept and Measurement 421 Some Basic Concepts; Measures of National Income; Methods of Measuring National Income; Choice of Methods; Measurement of National Income in India; Growth and Composition of India s National Income; Review Questions and 32. Theory of National Income Determination 430 The Keynesian Theory of National Income Determination; Determination of National Income: Two-Sector Model; The Consumption Function; Derivation of Saving Function; A formal Model of a National Income Determination; Shift in Aggregate Demand Function and the Multiplier; Shift in Aggregate Demand Function and the Multiplier; Review Questions and xi

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