May 20, 2014
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Elasticity of Demand
1st year POE - Principles of Economics Notes
Elasticity of Demand
Meaning
There is a close connection between the quantity of a commodity
purchased and its price. Changes in price are bound to affect the
purchasers. The law of demand only indicates the direction of change in
the quantity demanded as a result of change in prices. It does not tell
the amount or the extant by which the demand will change in response
to changes in prices. The concept which measures the responsiveness of
quantities demanded to price changes is the elasticity of demand.
The term elasticity expresses the degree of correlation between demand
and price. It is a result at which the quantity demanded varies with
change in price. It may be defined as “ The degree of responses (in the
form of variations in the quantity demanded) to changes in price.
To be more exact we can say that “the elasticity of demand is a measure
of the relative change in amount purchased n response to a relative
change in price n a given demand curve.”
Kinds
There are various kinds of elasticity of demand viz:
1. Price elasticity
2. Income elasticity
3. Cross elasticity
4. Substitution elasticity
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Elasticity of Demand 1st year POE - Principles of Economics Notes Elasticity of Demand Meaning There is a close connection between the qu...
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Law of Demand
1st year POE - Principles of Economics Notes
Law of Demand
* Introduction of Law of Demand
* Demand Schedule
* Demand Curve
* Elasticity of Demand
* Measurement of Elasticity
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Introduction of Law of Demand
Demand depends on price. Demand is always at a price. At different
prices different quantitities will be purchased. The law of demand
states:
"Demand varies inversely with price not necessarily proportionally, it means that when price falls demand rises and vice versa.
It can also be stated in these words:
"A rise in the price of a commodity or service is followed by a
reduction in demand and a fall in price is followed by increase in
demand if conditions of demand remain constant."
It can also be written in the words of S.T. Thomas as:
"At any given time the demand for the commodity or service at the
prevailing price is greater than it would be at a higher price and less
than it would be at higher price and less than it would be at lower
price."
There are several factors that cause change in demand e.g. changes in weather, fashion, taste, change in population etc.
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Demand Schedule
Demand schedule is simply a statement in the form of a table given
against each price the quantity of the commodity that will be demanded
for a given period of time.
The individual demand schedule is not of very great importance. It
shows only the demands of an individual. Putting down against price the
total quantity of commodity, which will be disposed off in the market,
can prepare the market demand schedule.
Demand Curve
Demand curve is a geometrical presentation of the demand schedule.
Demand schedule is a table and demand curve is based on this table. Thus
one represents the other. The above schedule can be stated in terms of
demand curve as:
Changes in Demand
According to the law of demand the demand for a product increases due
to change in its price. But there are certain other reasons that
influence the demand. Some of them are as follows:
1. Changes in the Taste and Fashion
The changes in the taste and fashion influence the demand to a great
extant. Actually a human being psychologically want continuous change in
his life style so that he get maximum satisfaction .To achieve his
state of satisfaction he do not consider whatever the price of commodity
he has to pay. Even if the price is high and the commodity is in high
fashion or matches exactly his taste he will ultimately go for
purchasing it.
2. Change in climatic conditions
The climatic conditions tend to increase or decrease the demand for a
product. In winter there a great demand for warm clothing and in summer
there a demand for electric fans and cold rinks and the marketers do
not usually charge , less prices in these seasons in order to sell
their products.
3. Change in Population
A change in the composition of the population will also affect demand.
Influx of new people will create a demand for the good; they are in
the habit of consuming. If the population of a country is rising, the
over all demands of the people increase even at the same high price.
4. Change in the Amount of Money
Inflation also has a significant bearing on the demands of the people.
When there is inflation it causes a great deal in demand, which leads
to an increase in prices. Similarly if the amount of money is decreased
the demand goes down even if there is no change in its price.
5. Change in Methods of Production
Changes in techniques and in the use of factors will affect the demand
pattern of those factors as in the case of capital equipment and
labour or chemicals.
6. Changes in the Price of the Substitutes
If the prices of the substitutes are varied their demand will directly
be affected. If the price of any commodity whose substitute is also
available in the market is decreased its demand will be increased
whereas the demand for its substitute despite of unaltered price will
fall down.
7. Changes in the Wealth Distribution
The distribution of wealth also affects the demand for a product. If
the wealth is distributed evenly the goods demanded by people the have
acquired more wealth will increase and demand of the people who have
lost wealth will decrease.
8. Anticipated Political or Price Change
Some time norms and general speculation about tax changes war etc or
of future shortages or abundance causes the present pattern of demand to
change.
9. Changes in Conditions of Trade
The conditions of trade are closely related with the demand of the
product. Demand for every thing is greater in a boom though the prices
are rising. Opposite is the case when there is depression.
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Measurment of Elasticity
The practical purposes, it is not enough to know whether the demand is
elastic or inelastic. It is more useful to find out to what extent it is
so. For that purpose it is essential to measure elasticity.
Three methods are generally used for measurement of elasticity, which are explained below:
1. Total Outlay Method
In this method, we compare the total outlay of the purchases (or total
revenue from the point of view of the seller) before and after the
variations in the price. It may be expressed as:
Unity: It is unity, when even though the price has changed, the total amount spent or total revenue remains the same.
Greater than Unity
When with the fall in the price the total amount spent or total revenue
increases on the total amount spent (total revenue) decreases when the
price rise it is said to be greater than unity .
Less than Unity
Elasticity between two prices is considered to be less than unity when
the total amount spent (total revenue) decreases with the rise n the
price and decreases with a fall in the price.
Though this method is dimple it suffers from a serious drawback. It
simply classifies the price elasticity in three categories and does not
assist in measuring it in numerical terms.
2. Proportional Method
In this method we compare the percentage change in price with the
percentage change in demand. The elasticity is the ratio of the
percentage change in the quantity demanded to the percentage change in
the price charged. Its formula is:
Elasticity of Demand = Propotionate Change in amount Demanded / Propotionate Change in Price
3. Geometrical Method
We can better understand with the help of the figure:
In the figure DD’ is the demanded curve which is a straight line. Here
the demand is represented by the fraction distance from D’ to a point on
the curve divided by the distance from the other to that point. Thus
elasticity of demand on the points P1, P2 and P3 is.
If the curve is not a straight line the above formula can be used by
drawing a tangent at a point where the elasticity is to be measured
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Theories of Population
1st year POE - Principles of Economics Notes
Theories of Population
* Malthusian Theory of Population
* Propositions of The Theory
* Economics of Scale
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Malthusian Theory of Population
The Malthusian theory of population was first propounded in 1798 by a
British economist Robert Malthusian. . In his own words the theory can
be stated as,
“By nature human food increases in a slow arithmetical ratio: man
himself increases in a quick ratio unless wants and vice stop him”
Malthus based his theory on the biological fact that every living
organism tends to multiply to an unimaginable extant while on the other
hand production of food increases with less than proportionate change.
It is subject to law of diminishing returns. According to Malthus
population tends to outstrip food supply.
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Propositions of The Theory
The theory propounded by Malthus can be reduced to the following four propositions:
1. Food is necessary for the life of a man and therefore
exercises a strong check on population. In other words, the size of
population is determined by the availability of food.
2. Human population increases faster than food production which tends to out turn the increase in food production.
3. Population always increases when the means of subsistence increase unless prevented by some powerful checks.
4. There are two types of checks that can keep population on
a level with the means of subsistence. They are preventive and
positive checks.
Explanation
The explanation of the propositions is:
Means of subsistence
According to the first proposition, the population of a country is
limited by means of subsistence i.e. the population is determined by the
availability of food. The greater the food production, the greater
would be the population and vice versa.
Growth or Population Outruns Food Production
According to Malthus, there is no limit to the fertility of man. Man
multiplies itself at an enormous rate. But the power of land to produce
food is limited. It means that the production of land increases at a
lesser rate as compared to production of man. Thus, the continued growth
of the population would result in a decrease in output per worker and a
decline in the amount of food available per person.
Population Increases When the Means Increase
According to third preposition as the food supply in a country
increases, the member of children per family also increases. It,
therefore, would result in an increased demand for food and their food
per person will diminish. Thus, according to Malthus, the standard of
living of the people cannot rise permanently.
Checks
According to Malthus, contain positive and preventive checks can
control the population. Preventive checks are those that are applied by
man and includes measures for bring down the birth rate. The positive
checks on the other hand exercise their influence on the growth of
population by increasing death rates. They are applied by nature.
Epidemics, wars and famines are some examples of positive checks.
Optimum Or Modern Theory Of Population
According to the theory, given a certain amount of resources, the
state of technical know-how and a certain stock of capital, a country
must have a certain size of population at which the real income (goods
and services) per capital is the highest. This size of population is
called optimum population. In other words, optimum population refers to a
size of population at which the real income per capital is the
maximum. If population exceeds the optimum size, it is said to be over
populated. Such a condition develops in a country. When it’s available
resources are fully exhausted and there exists no chance of their
further exploitation. It is necessary at this stage that the country
must practice preventive checks and to escape from the misery of
positive checks.
According to this theory, there are three phases population in a country viz.
(a) Under Population
A condition at which real per capital income rises with a rise in the size of population.
(b) Optimum Population
A situation at which real income per capital is the highest.
(C) Over Population
From under and optimum population, a country moves, unless preventive
checks are applied, to the level of over population, at which the real
income per capital diminishes.
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Economics of Scale
Professor Marshall his divided the economics arising from an increase
in the scale of production of any kind of goods in the broad classes.
External Economics
The outcomes of the general development of an industry either in a
particular locality or a country are called external economics of scale.
These economics do not depend upon the organizing capacity of
particular business man, rather they are available to all the
businessman alike. They depend on external condition and independent of
any individual business or establishment and of it’s resource. Some
examples are
- Benefits of low freight rates
- Benefits of banking facilities
- Benefits of power development
Internal Economics
The outcomes of the expansion of a particular firm cutting down the
production costs and securing increasing returns is called Internal
Economics for that firm are not shared by other firms and only a
particular business man or firm enjoys the benefits. There can be many
casual economics for a firm when it expands itself. Some of them may be:
- Benefit of expert services
- Benefit of construction
- Benefit of use of latest machinery
- Benefit of use of division of labour.
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Laws of Returns
1st year POE - Principles of Economics Notes
Laws of Returns
* Law of Diminishing Returns
* Law of Increasing Returns
* Law of Constant Returns
* Why does Law of Diminishing Returns apply to Agriculture?
* Does it apply only to Agriculture?
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Law of Increasing Returns
Introduction
In order to increase the production, a producer has to increase the
proportion of its fraction of production. However, the returns due to
variations in the factors are not fixed. In some cases, return due to
each successive unit is increased. This tendency is known as Law of
Increasing Returns.
Explanation
This law is mostly found to be operating in manufacturing industries.
This law was first propounded by Prof. Marshall, in his words, the law
states that:
“An increase of labour and capital leads generally to improved
organization, which increases the efficiency of the work of labour and
capital.”
According to this law whenever a new dose of labour and capital is
applied it yields increasing returns. Also the cost of production
diminishes.
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Law of Diminishing Returns
Introduction
In some cases the return due to each successive additional unit, the
production goes on diminishing. It is known as Diminishing Returns and
is further explained by the Law of Diminishing Returns.
Explanation
This law is one of the most fundamental law of Economics. Usually it is
related with agriculture and was also first enumerated by a Scottish
Farmer.
Usually an increase in any of the factor of production results in an
increase in production but this change is a proportionate change. It
means that if the quantity of land and labour is doubled, although there
will be an increase in the production but it will not be doubled. And
that is what Law of Diminishing Returns states. In the words of
Marshall:
“An increase in the capital and labour applies in the cultivation of
land causes in general a less than propotionate change or increase in
the amount of production raised. Unless it happens to coincide with an
improvement in the art of agriculture.
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Law of Constant Returns
Introduction
Similarly, in some of the cases, the increase in the productive unit
keeps the production constant. This tendency is known as law of Constant
Returns.
Explanation
When an increase or decrease in the output of an industry makes not
alteration in the cost of production per unit, the law of constant
returns is said to operate. In other words when fresh doses of
productive resources results in an equal return, it is called constant
returns.
The law of constant returns operates in those industries where the cost
of raw material and manufacturing cost are half and half. In other words
the law operates where man and nature dominate equally. It is also said
that a point where the opposite tendencies of diminishing returns and
increasing returns are in equilibrium is the Constant Returns.
Examples
Possible examples of industries where the law applies are cane growing
and sugar making, Iron-ore mining and steel making, cane growing and
iron ore are subject to law of diminishing turns whereas sugar making
and steel making to law of increasing turns. In these industries the
advantage of increasing returns are neutralized by increasing cost of
raw materials.
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Why does Law of Diminishing Returns apply to Agriculture?
The law of diminishing returns specially applies to agriculture and
other extractive industries. One thing that is common to all these
industries is the supremacy of nature. It is therefore often remarked
that the part that nature plays in production corresponds to diminishing
returns and the part which man plays confirms to the law of increasing
returns. The reason is that, nature where it is supreme is subject to
diminishing returns, while industry where man is supreme, is subject to
increasing return. Besides the supremacy of nature, there are several
other reasons why agriculture is subject to the law of diminishing
returns.The agricultural operations are spread out over a wide area, and
supervision cannot be very effective. Scope for the use of specialized
machinery is also very limited. Therefore economics of large scale
production cannot be reaped
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Does it apply only to Agriculture?
It is wrong to say that the law only applies to agriculture as
agriculture is always subject to diminishing and manufacturing to
increasing returns. The application of the law is universal. It applies
to industries also. If the industry is expanded too much and becomes
unwisely supervision will become tax and the cost will go up. The law of
diminishing returns thus sets in. The only difference is that in
agriculture it sets in earlier and in industry much later.
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Importance of Elasticity of Demand
1st year POE - Principles of Economics Notes
Importance of Elasticity of Demand
* Importance
* Price Determines the Demand
* Monopoly
* Market Price
Importance
The concept of elasticity is not just an abstract idea its practical importance is very great.
(1) Importance For Government
The concept of elasticity of demand helps the finance minister of the
monopolist. When it imposes a tax. When a tax is imposed the price
tends to rise. But if the demand is very elastic it will considerably
fall when the price has risen and thus the government will not be able
to earn expected revenue. Thus this concept of elasticity of demand
helps the government to impose the tax on a commodity whose demand lass
elastic and hence earn valuable revenue.
(2) Importance for Businessmen
The businessmen also take cue from the nature of demand while fixing
his price. IF the demand is inelastic he knows that the people must buy
such commodities. Thus he will be able to change a higher price and big
profits.
(3) Importance for Monopolist
The concept of elasticity of demand is of special importance to the
monopolist. He is in a position to control the price and fix high price
when demand is inelastic and low price when it is elastic will bring
him the maximum profit.
(4) Application in Case of Joint Products
In case of joint products seperate costs are not ascertainable. Hence
the producer will mostly be guided by the nature of demand while fixing
the price.
(5) Determinitation of Wages
The concept of elasticity of demand influences the determination of
wages of a particular type of labour. If the demand of particular type
of labour is inelastic trade union can easily get their wages raised. On
the other hand of the demand for labour is relatively elastic trade
union trade unions may not be successful in raising wages.
(6) Importance for International Trade
The concept of elasticity of demand is used in calculating the terms
of trade. Whenever a country fees an adverse balance of payment the
government considers the elasticity of demand for the countries export
and imports before devaluing its currency.
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Price Determines the Demand
The demand for the commodity is related to price. IT is always at a price. Prof. Beaham defines as under:
“The demand for anything at a given price is the amount of it which will be brought per unit of time at that price.”
Demand varies with price. It varies inversely with price. If the price
rises the demand contracts and if the price falls the demand extends.
This responsiveness depends on many factors the effective demand for
necessaries generally do not change with price. In other words the
effective demand for necessaries is inelastic. The may rise or fall but
the effective demand for necessaries remain practically the same. The
effective demand for comforts is elastic. In other words variation in
for comforts is in perpotion to a change in price.
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Monopoly
Monopoly is that market from in which the single producer controls the
whole supply of a single commodity that has no close substitutes.
Two points must be noted in regard to the definition. First there must
be an individual owner it seller if. There will be monopoly. That
single producer may be individual owner or group of partners or a joint
stock company or any other combination of producers of the state. Hence
there must be a sole producer or seller in the market if it is to be
called monopoly.
Secondly, the commodity produced by the producer must have no close
substitutes. Competing if he is to be called a monopolist this ensures
that there must no rival of the monopolist. By the absence of closer
substitutes we mean that there are no other firms producing similar
products or product varying only slightly from that of the monopolist.
The above two conditions ensure that the monopolist can set the price
of his product and can pursue an independent price policy.
“POWER TO INFLUENCE PRICE IS THE VERY ESSENCE OF MONOPOLY.”
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Market Price
Market price is the actual price that prevails in the market at any
particular time. It never remains constant. It changes from day to day
and even from moment to moment. It can change at any time at any moment.
Determination of Market Price
Market price is determined by the relative forces of demand and
supply. The demand depends upon the satisfaction, which a consumer
drives from the consumption of the commodity. Supply on the other hand
depends upon the cost of production of the commodity. The consumer tries
to achieve more and more satisfaction least possible expenditure. He
does not pay more than the marginal utility of the commodity to him the
seller on the other hand tries to maximize his profit by changing as
much as he can. He will never accept the price which is less than the
marginal cost of production of the commodity and thus marginal utility
and marginal cost pf production are the two limits the maximum and the
minimum and price is determined between these two limits, so we can say
that,
“The price is determined at point where the amounts demanded and offered for sale are equal.”
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National Income
1st year POE - Principles of Economics Notes
National Income
* Definition of National Income
* Concepts of National Income
* Methods of Calculating National Income
* Difficulties Faced while Calculating National Income
* Importance of National Income Computation in Modern Economic Analysis
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Definition of National Income
The term national income has been differently defined by different
authors. A very simple definition of national income can be given as :
"The National Income for any period consists of the money value of the
goods and services becoming available for consumption during the
period."
National income in the words of Pigou is:
"That part of objective income of the community including income derived from abroad which can be measured in money."
It is the aggregate factor of income i.e. earnings of labour and
property which arises from the current production of goods and services
by the nation's economy.
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Concepts of National Income
The various concepts of national income are given below:
1. Gross National Product (G.N.P)
Gross national product is defined as
“ The total market value of all final goods and services produced in a year”
Two things are important with respect to this definition:
Firstly, it measures the market value of amount output. Therefore it is a monetary measure.
Secondly, for calculating national product accurately all goods and services produced during a year must be counted only once.
G.N.P generally includes the following.
(i) Agricultural Product
In agricultural product wheat, rice, cotton, tobacco, jute all types of vegetables pulses, fruits etc are included.
(ii) Industrial Product
By industrial products we mean all types of machineries, means of
transportation, furniture, electronic items and other electric
equipments.
(iii) Mineral Product
It includes coal, iron, petroleum, natural gas, salts and other materials like gold silver etc.
Since, G.N.P deals in market prices these market prices may be obtained by adding up:
1. What private person spends on consumption?
2. What businessman spends on replacement, renewal or making new investment?
3. What the rest of the world spends on the out put of national economy.
4. What the government spends on the purchase of goods and services.
Equalization of G.N.P can be written as:
G.N.P = CONSUMER GOODS + CAPITAL GOODS + DEPRECIATION + INDIRECT TAXES
2. Net National Product (N.N.P)
During a year the production of gross nation al product some capital
goods are consumed i.e. the plants, machinery, and other equipments are
brought in use. The se capital goods due to utilization in the
production expire its value, commodity known as depreciation allowances
are deducted from the gross national product (G.N.P) we get the net
national product (N.N.P). Its equation can be given as:
N.N.P = G.N.P – DEPRECIATION
Thus the definition of the N.N.P can be properly written as, “The
market value of final goods and services after deducting the
depreciation charges is called net national product.
3. Personal Income (P.I)
The some of all incomes actually received by all individuals or
households during a given financial year is called personal income.
Personal income is different from national income for the simple reason
that some incomes such as social security contribution cooperate income
taxes and distributed profits which are included in national income
are not actually received by the house holds. The equation of personal
income thus can be written as:
PERSONAL INCOME (P.I)= NATIONAL INCOME – SOCIAL SECURITY CONTRIBUTION - COOPERATE INCOME TAX – UNDISTRIBUTED PROFITS
4. Disposable Income (D.I)
After payment of personal taxes like income tax, property tax etc.
What party of personal income is left for others consumption is called
disposable personal income. Its equation is:
DISPOSIBALE INCOME = PERSONAL INCOME - PERSONAL TAXES
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Methods of Calculating National Income
To calculate national income the following three methods are generally used:
1. Net output Method or Production Method
For calculating national income under this method the net output or
the production of various commodities is estimated and evaluated at the
market prices. For this purpose we take two steps,
Firstly we estimate the monetary value of the commodities that are
produced internally .The production or output of different sections of
the economy i.e. agricultural, manufacturing, trade, commerce,
transport etc is analyzed after deducting the depreciation charges.
Secondly; we consider the foreign business transactions that were
performed during the financial year. In this regards in this regard we
only consider the difference between exports and imports.
These two aggregate are then summoned up to get the gross domestic
product which in turn is deducted from the total revenue earned to
arrive at national income. In very simple words the contribution, which
each enterprise makes to total output, is equal to its total revenue
minus what is paid out to other enterprises and the depreciation of
equipment used in the process of production. The production method is
the most direct method for calculating national income. It s equation
can be written as:
NATIONAL INCOME = G.N.P – COST OF CAPITAL – DEPRECIATION – INDIRECT TAXES
2. Income Method
Under this method the various factors of production are classified in a
few broad categories. The incomes of various and sectors are obtained
from there financial statements. Under this method the national income
is also estimated by summing up the income that arrives to the factors
of production provided by the national residents. Thus the rate at which
the national income is distributed among the various factors of
production is estimated. This method of calculating national income is
quite complex. Usually the undeveloped countries where most of the
people are not directly covered by direct taxation. Equation wise the
method can represent national income as:
NATIONAL INCOMER = RENTAL INCOME + WAGES + INTEREST + PROFIT
3. Expenditure or outlay Method
This method gives national income by adding up all public and private
expenditures made on goods and services during a year. It is obtained
by:
- Personal consumption expenditure of goods and services.
- Gross domestic private investment.
- Government purchase of goods and services.
- Net Foreign investment.
It must however be recognized that it is the final expenditure only which must be counted and not the immediate expenditure.
______________________________________________________________________________
Difficulties Faced while Calculating National Income
Some of the problems or the difficulties that are usually faced while calculating national income are as follows.
1. Problem of Definition
One of the greatest difficulties while calculating national income is
that what should be included and what excluded with respect to the
goods and services produced. As a general rule only those goods and
services which are bought and sold i.e. enter into exchange must be only
considered. For example the service of parents towards their children
is not a part of national income on the ground that there is no
investment of there market value. But allowances are made for some
non-exchangeable goods and services e.g. the national product include
the estimated value of food consume on farms. This creates a problem.
2. Calculation of Depreciation
Another problem is the calculation of depreciation. The main reason
behind it is that both the amount and the composition of jour capital
change from time to time. There are no standard or concept rules of
depreciation that can be applied. Since depreciation is an estimate so
correct deduction can be made until and unless these accurate
depreciation estimates are not deducted from the estimate of net
national product the net national income is bound to wrong.
3. Treatment of the Government
Government expenditures:
1. Defiance and administration expenditure.
2. Social welfare expenditure.
3. Payment of interest on national debts
4. Miscellaneous development expenditure.
The real problem that is faced relates to which of the above should be included in the national income.
4. Income from Foreign Firms
One of the major problem relates to the fact that weather the income
arising from the activities of the foreign firms operating in a country
should be included in the countries national income or not .With the
growing trend of doing business globally has increased this problem to a
great extant. However the I.M.F has given the viewpoint that the
production and income of these foreign forms should go to the owning
country while there profit must be credited to the parent concern.
5. Danger of Double Counting
Proper care is required for calculating national income so that double
counting may not take place. This problem usually arises in those
countries where proper documentation or statistics are not available.
6. Value of Inventories
Since it is not easy to calculate the value of raw materials, semi
finished and finished goods in the custody of producers there fore it
creates problems.
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Importance of National Income Computation in Modern Economic Analysis
The computation of national income is one of the very important
statistics for a country. IT has several important uses and therefore
there is a great need for there regular preparation. The following are
some of the important uses of national income statistics:
Level of Economic Welfare
The national income estimate reveals the overall performance of the
country during a given financial year. With the help of this statistics
the per capita income i.e. the income earned by every individual is
calculated. It is obtained by dividing the total national income by the
total population. With this we come to the level of economic welfare in
terms of its standard of living.
Rate of Economic Growth
With the help of national income statistics we can know weather the
economy is growing or declining. In simple words it helps us to know the
conditions of a country economy. If the national income is growing over
a period of year it means that the economy is growing and if the
national income has reduced as compares to the previous it reveals that
the economy is detraining. Similarly the growing per capita income shows
an increasing standard o living of the people which is a positive sign
of a nations growth and vice versa.
Distribution of Wealth
One of the most important objectives that is achieved after calculating
national income is to check its distribution among different categories
of income such as wages, profits, rents and interest. It helps to
understand that how well the income is distributed among the various
factors of the economy and their distribution among the people as well.
Ease in Planning
Since the national income estimates also contain the figures of saving,
consumption and investment in the economy so it proves to be a valuable
guide to economic policy relating to planning and active government
intervention in the economy. The estimates are used as a data for future
planning also.
Formation of Budget
Budget is an effective tool for planning and control. It is prepared in
the light of the information regarding consumption, saving, and
investment which are all provided by the national income estimates.
Further we can asses and evaluate the achievements or otherwise of the
development targets laid down in the plans from the changes in national
income and its various components.
Conclusion
Thus we may conclude that national income statistics chart the movement
of a country from depression to prosperity its rate of economic growth
and its standard of living in comparison with rest of the world.
National Income 1st year POE - Principles of Economics Notes National Income * Definition of National Income * Concepts of Nationa...
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Rent
1st year POE - Principles of Economics Notes
Rent
* Definition of Rent
* Recardian Theory of Rent
* Quasi Rent
* Modern Theory of Rent
Definition of Rent
In ordinary sense the term rent refers to the hiring charges paid to the
owner of an asset for using his right of ownership for a specific
period of time. In economics the term rent is called economic rent. It
is defined as
“That part of the payment by the tenant, who is made only for the use of land i.e. free gift of nature”.
In economics rent is mainly related to agriculture and is mainly distinguished as economic and contact rent.
Economic Rent and Contact Rent
Some times the agriculturist tenant makes the payment which consist on
capital made by the landlord such as drainages, wells etc. This part of
the payment, which consists of the interest on capital made by the
landlord, is called contact rent. Where as the part of the payment which
is made for the use of land only is called economic rent.
Rent and Transfer Earnings
The concept of the rent is also explained by the help of transfer
earnings. The amount which factor can earn in its next best paid
alternative use called transfer earning. In this sense if the factor is
earning above its transfer earnings, the surplus or excess earnings is
called economic rent.
_______________________________________________________________________________
Recardian Theory of Rent
The British economist Devid Recardo propounded the theory of rent a century ago.
Assumptions
The Recardian theory of rent is based on the following assumptions.
1. Rent is paid to the landlord for the use of original and the indestructible power of land.
2. Rent is a differential return due to the differences in the
fertility of land as well as their locations. The more fertile land the
higher will be its rent and vice versa.
3. The Recardian theory depends on the historical order of cultivation
i.e. the more fertile land is cultivated first and such rent does not
pay rent in the beginning but as but as other grades of land come under
cultivation it begins to pay the rent.
4. The land on which the cost of production is equal to the amount it produces is a no rent land or marginal land.
Theory
The Recardian theory of rent can be stated as
“Rent is that portion of the produce of earth which is paid to the
land lord for the use of original and indestructible power of soil”.
Economic rent according to Recardo is the true surplus left after the
expenses of cultivation as represented by payment to labour, capital
and enterprise.
Criticism
Recardian theory of rent has been criticized on the following grounds.
1. Recardo’s statement that the properties of soil are
indestructible is wrong. The fertility of land often gets exhausted
when it is continuously used. However it can be increased by using
artificial manures but such fertility is considered to be temporary.
2. Statement of the theory that the superior land is
cultivated first is not always true. Actually in general the order of
cultivation is not the same as the theory says since a cultivates that
land first which is near to him.
3. Recardo assumes that the no rent land exists in a country
is also not applicable everywhere. This concept of no rent land is
merely imaginary and theoretical.
_____________________________________________________________________________
Quasi Rent
The concept of Quasi rent was first introduced by Marshal according to
him, quasi rent is a surplus earned by investments of production other
then land. It is the income derived from appliances and machines,
which are the product of human effort. Quasi rent stands for whole of
the income, which some agents of production yield when demand for them
is suddenly increased. It is earned during a period that their supply
cannot be increased in response to increase in demand for them. Hence it
is a short period concept. It has also been defined as the excess of
total revenue earned in the short run over and above the total variable
costs.
QUASI RENT = TOTAL REVENUE – TOTAL VERIABLE COST
The concept of quasi rent can be understood with the help of an
example. At the time of independence of Pakistan, the demand for houses
increased due to sudden increase in population but the supply could not
be increased due to the scarcity of building material. The abnormal
increase in the return on capital invested in capital (building) is
quasi rent.
____________________________________________________________________________
Modern Theory of Rent
This theory is also known as demand and supply theory of land. It is based on the following assumptions:
1. There is always perfect competition among various cultivations.
2. The fertility of different lands is same.
3. The land is used for a particular job.
Explanation of the Theory
The theory explains the concept of rent in terms of demand and supply.
According to the theory rent is payment for the use of land. Demand
for the use of land is actually the demand for that product which is
produced on it. Demand for the land will increase with increase in
demand for that particular product. Since th supply of land is fixed
i.e. the supply cannot increase or decrease therefore the rise or fall
of rent will be entirely governed by it’s demand. Thus on the side of
demand rent of land is determined by its productivity not total
productivity, but marginal productivity. And for supply, the supply of
land in general is absolutely inelastic, as such in supply is
independent of what it earns. From the following figure it is clear that
the supply of land is fixed SS, while as demand is increasing from DD
to D’D’ and to D’’ to D’’, the rent is also increasing from RR to R’R’
and to R’’R’’.
_________________________________________________________________________
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Market
1st year POE - Principles of Economics Notes
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Market
In ordinary language market means a place where things are bought and
sold, but in Economics the market does not mean a particular place or
bazar, it only means a commodity and a group of buyers and sellers of
the same. Thus we speak of cotton market or share market etc. Same are
willing to buy and others are willing to sell. The buyers and sellers
can with one another by verbal, by letter, telephone, internet etc but
place does not matter.
Classification of Market
Categories of market are:
1. Perfect market
2. Imperfect market
Again categories are classified into:
Market on the Basis of Time
On the basis of time market could be classified into the following kinds:
1. Day–to-Day Market
This type of market is concerned with goods that are perishable like
milk, fish, vegetable, fruits etc. The price in this market is
determined by the demand of the market. If the demand expands the period
is short that the supply can’t be increased immediately at all,
therefore the price will increase similarly if demand decrease the time
is so short that the surplus supply can’t be stored due to the
perishability of the goods, obviously the price will decrease.
2. Short Period Market
It is the market when time allows supply to adjust with the demand of
the market to the extent of available size of the firm or producing
units. For example: If market demand is so goods per day and particular
firm of the same goods could produce max: 100 units by using its full
production capacity .If demand increases from 50 to 75 units the firm
can supply utilising the unused capacity, but if demand becomes 120 it
can’t be satisfied by existing production capacity because total size
of firm is 100 units per day.
3. Long Period Market
When the period is so long that the supply can adjust with the demand
of the market by changing the size of the firm. If the demand of the
market increases immediately the prices will also increase. This
increase of price will expand the margin of profits of the producers
therefore the firm can increase the production through employing more
labor, more machines , raw material etc. By increasing supply reduces
the increased prices and they come again on the previous point.
Similarly if demand falls the price also decrease and producers curtail
their production due to decrease in margin of profits. As consequence
of curtail in production the depressed price goes up again on the
previous point.
Market on the Basis of Location
Markets can be classified on the basis of location.
1. Local Market
If the goods are sold and purchased in a limited area is called local
market. For example: If the goods produced in Karachi are sold in
Landhi or Malir, it will be the example of local market. Local market
generally is concerned with the perishable good like milk, fish, bricks
etc.
2. National Market
This is the kind of the market which covers the whole of the country.
For example: the textiles of Karachi are sold in all the four provinces
of Pakistan. Similarly sports goods produced in Sialkot are supplied
in whole the country.
3. International Market
When the goods produced locally are sold in all the countries of the
world is called International market. For example: the cars produced in
Japan are sold in whole of the world. The buyers and sellers from all
over the world compete with one another therefore prices are influenced
by the world environment.
Market on the Basis of Nature of Goods
1. General Market
Market is said to be general where not a specific but general goods are
sold and purchased. For example: if cloth, pots, shoes, vegetable,
fruit are sold at a time it will be called general market.
2. Specialised Market
In this market special or specific goods are brought to sale in this
kind of the market. For example: grains are sold in grain market
similarly fruits are sold and purchased in fruit market. These markets
provide facility to the buyers that they could purchase goods of their
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Wages
1st year POE - Principles of Economics Notes
Wages
* Wages and Its Forms
* Factors Determining Real Wages
* Relative Wages
* Causes of Differences
_____________________________________________________________
Wages
In very simple words, the remuneration that is made for the service of
the labour is called wages. Wage payment is essentially the price paid
for the particular commodity viz labour. Berham defines wages as:
"Sum of money paid under contract by an employer to a worker for the service rendered."
______________________________________________________________
Forms of Wages
Broadly speaking, wages are categorized as:
1. Nominal Wages
Nominal or money wages are the wages paid or received by the labour in
terms of money . Money is the principle factor in normal or money
wages. The wages are calculated in terms of money in this regard.
2. Real Wages
Real wages refer to the income of a worker in terms of real benefits. E.g. bonuses, holidays, transport.
In other words, the value of additional income is called real wages. It
is the real wages that enable us to clear that the worker really
earns.
____________________________________________________________
Factors Determining Real Wages
Some of the factors that determine real wages are as follows
1. Purchasing Power of Money
The purchasing power of money has great influence on the real wages.
The value of money keeps on changing constantly which varies inversely
with the price level. This purchasing power of money influences the
calculation how much the worker a worker earns since all the monitory
calculation depends on the value of money. The places where the prices
are high the real wage will be low and vice versa.
2. Subsidiary Wages
The worker earning other than regular wages have higher real wages. In
order to find the real earnings of a worker, we should not only
consider his salary but also the extra earning that he may be able to
make. A worker may work part time and in such case his real wage will be
higher as compared to the worker working only on regular wages.
3. Working Hours and Holidays
Real wages to a great extant depend upon the working hours and
holidays. Obviously a worker working for more time and enjoying less
holidays will have higher real wages. His income will always be higher
and so will be his real wages.
4. Future Prospects
Future prospects means opportunities for the future. A businessman
viewing a good prospect for his business in the future will pay higher
real wages to his workers so that they can work more willingly to make
best use of the opportunities of the future. However a business not
having very bright prospect may even offer higher wages.
5. Nature of Work
The occupation which require great amount of skills and whose nature
is quite dangerous offers high wages to the labours. The work requiring
more physical and mental capabilities should offer high money and
benefits to the labours.
6. Expenses
In order to calculate the real wages the expenses must also be
considered. The workers incurs certain expenditures which must be
deducted in order to get the final figures.
________________________________________________________________________________
Relative Wages
The concept of relative wages explains the comparison between money
and real wages. It explains that only the wages of labourers of
different occupations employment or grades are different from each
other. It tells that why some men working at the same place and at same
level in different organizations receive different wages.
_______________________________________________________________________________
Causes of Differences
1. Differences in Efficiency of Labour
The labour to a great extant depends on its efficiency. This efficiency
may include education, necessary skills to perform a job condition of
work etc. As a general rule, the higher will be the wages and lower
efficiency, lower will be the wages. It implies that more efficient
workers are likely to earn higher wages as compared to inefficient once.
2. Training
Training is one of the important offers for the employees. Most of the
organizations after recruiting labour provide them proper training
necessary for their jobs. In this way skilled persons get a chance to
groom themselves during which they receive very minimum remuneration.
But as soon as they get trained they are offered respectable jobs and
are absorbed easily at high wages.
3. Regularity of Work
Regularity of work has an important impact on the wages of the worker.
Actually there are two categories of businesses viz: Seasonal i.e. for
limited period of time and Non Seasonal i.e. for whole or unlimited
period of time. Generally the labour workings in seasonal factories are
often paid higher wages as compared to those working in non-seasonal
ones. The simple reason behind it is that the organizations working
seasonally hire the service of the labour for the limited period of time
and thus pay them handsomely.
4. Degree of Trust and Responsibility
One of the major reasons of difference in the wages is the degree of
trust and responsibility. As a normal course the men working at
positions of high responsibility are usually highly paid. This is so
because their jobs require high degree of skill; sense of responsibility
and good decision-making abilities and this is what they are paid for.
5. Hours of Work
The working hours are also important in determinants of wages. The
workers working for more time are paid more wages as compared to the
workers working for less period of time even in the same organizations.
This is why the working hours are classified as part-time or full time
jobs.
6. Extra Benefits
A very interesting fact about wages is that the workers enjoying more
fringe benefits are often paid low wages. Usually the wages are high in
those occupations or business where such benefits are not offered. For
example in a factory a worker may be earning RS 1,800 but he may be
getting medical allowance, housing allowance, old age pension, bonuses
etc
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Barter System
1st year POE - Principles of Economics Notes
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Barter System
* Introduction
* Defects of Barter System
* How Money Removed The Difficulties of Barter
Introduction
Barter economy means the exchange of commodities. It consists if a
bargain of commodity with the other with out the help of another of
exchange, such as money. Therefore we can say that buying goods against
goods is called barter system.
The barter system can easily be understood with the help of the
following example. Suppose Mr. A is a farmer and produces wheat in his
fields. When the crop is ready A finds that he can stock as much wheat
as his family need for the whole year and still he will have a surplus
which he can use for exchange purpose. Now he has to get his plough
repaired through a carpenter. After availing the services of the
carpenter, Mr. A makes him the payment in the form of wheat in exchange
of his services. Again Mr. A wants to purchase cloth and goes to
merchant’s shop. Here he exchanges the desired quantity of cloth with
surplus wheat. Thus the process will keep on continuing and the needs
and wants will be satisfied by making use of any commodity as the
medium of exchange.
______________________________________________________________________________
Difficulties of Barter System
Following are some of the difficulties of the barter system.
1. Double Coincidence of Wants
Barter requires a double coincidence of wants. If a person for
insistence has wheat and wants to exchange it with cotton, he has to
find a person possessing cotton and requiring wheat. It was possible
only when the people lived in small areas and their wants were too
limited.
2. Lack of Common Measures
There was no fixed measure in which two things could be exchanged. It
means every one did not derive complete satisfaction out of his deal.
The ratios of exchange were fixed accordingly to the necessities and
demands of the parties. One party had to suffer under these conditions
were each transaction is an isolated transaction.
3. Lack of Divisibility
Another great disadvantage of barter system was the lack of
divisibility. Suppose a man possess horse and requires wheat and cotton
in exchange but both of these commodities may not be obtained from one
man. One person may have wheat another has rice in surplus and both of
them want to exchange their commodities with the horse. Now the horse
cannot be divided and fence the transaction may not be completed.
4. Lack of Store of Value
Under the barter system wealth consisted of non-durable goods, which
are quickly perished or detoriated with the passage of time. There value
may not be stored for long period. Hence no body could think of
storing something to provide against future.
5. Inconvenient Media of Exchange
Commodities like little wheat or other things alike cannot be easily
transported and thus have little value. Therefore under barter system
the mediums of exchange were really inconvenient.
_____________________________________________________________________________
How Money Removed The Difficulties of Barter
With the help of money it has now become possible to over come the inconveniences of barter system.
1. Standard of Value
Under the system of exchange i.e. sales and purchase the value of each
commodity is expressed in terms of standard of value such as gold or
silver.
2. No need of Double Coincidence
Under monitory economy there is no such need of such two persons whose surplus suits with each other wants.
3. Sub-Division of Articles is Not Necessary
Money has solved the difficult of sub-divisibility of some of the
commodities with out any loss. Under this system if any one needs urgent
cash and has some valuable he can simply sell it in the market and get
the desired money.
4. Store of Value
Money has provided man an opportunity to save money in the form of
liquid cash that helps him to preserve his assets for a longer period of
time and avoid any unseen stringencies.
5. Large-scale Production
Large scale of production is possible by the use of money, which was not possible under barter economy.
Summing Up
Thus money or sale and purchase system has removed all the difficulties of barter economy.
________________________________________________________________________________
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Money
1st year POE - Principles of Economics Notes
http://karachiboardnotes.blogspot.com/
Money
* Definition
* Functions of Money
* Types of Money
* Value of Money
* Quantity Theory of Money
* Importance of Money
* Dangers of Money
* Gresham's Law
* Bi Metallism
________________________________________________________________________________
Definition
Money is some thing, which has general acceptability in the settlement
of debt, or in transfer of ownership of goods and services in a country.
The value of exchange of every thing in a country is expressed in terms
of money.
Mr. Robertson defines money in the following words
“Money is a commodity which is widely accepted in payment of goods or in discharge of other kinds of business obligation”.
An English economist Mr. Hawtrey observes that
“Money is one of those concepts which are definable primarily by the use or the purpose which they serve”.
In the words of Goh Cole,
“Money is purchasing power some thing that buys things”
According to Ely,
“Any thing that passes freely from hand to hand as a medium of exchange and is generally received in final discharge of debts”.
One of the simplest definitions of money is given by Mr. Walker who says that
“Money is what money does”.
In the light of the above definitions, it can be said that
“Any thing that is generally accepted as a means of exchange and at the same time acts as a measures and a store of value”.
_________________________________________________________________________
Functions of Money
Money is said to perform the following functions
1. It serves as a medium of exchange.
2. It is used as a store of value.
3. It acts as an instrument of deferred payment.
4. It is a measure of value.
These are further discussed below
1. Medium of Exchange
The most general function of money is that it serves as a medium of
exchange. The ownership in goods and services is exchanged through it.
Money is accepted in exchange of goods and services and property rights
simply because in its turn money can be exchanged for them at such
places and times the possessor wishes. It means any thing can be brought
and sold through it. Money acquires the capacity of serving as a
medium of exchange also because of legal sanctions behind it and as
such it is generally accepted in the settlements of debts or any
financial transaction.
2. Measure of value
Money is used as a measure of value in the sense that the value of
every thing is demanded in terms of money. As a measure of value money
not only facilitates business transactions but is also useful
transacting the sale and purchase if immovable properties buying at
distant places. Money as a measure of value is also helpful in asserting
the financial worth or stability of a business unit or an industrial
concern which is possible from the study of their balance sheets
containing the value of their assets and liabilities in terms of money.
In simple words we can say that function of money as a measure of value
helps us almost in every aspect of our daily life.
3. Store of Value
Another function of money is that it serves as a store of value. We
can keep our assets in liquid form so that they can be used any time we
feel of doing so. A unique feature of our daily life is that the flow
of income does not correspond with the expenditure. The income in the
majority of cases does not come to us with the same intervals as we have
to make payments and consequently their adjustment would have been
difficult but money, serving as a store of value makes a happy
adjustment possible between the flow of income and expenditure
intervals. Due to its value payments for the future can be made.
4. Instrument of Deferred Payment
Money also acts as an instrument of differed payment, which means that
transactions requiring deferred payment are made possible through it.
It so happens because the value of money having legal sanction behind,
is more stable in comparison to other goods the value of which are
liable to great fluctuation under the influence of their demand and
supply position. The value of money being stable the parties in
transaction are assured of getting the same value even after some time
if the payments are made in terms of money. It means that money serving
as an instrument of deferred payment facilitates credit transactions.
Similarly for the same it encourages lending and borrowing which
stimulate saving and investment and ultimately accelerates the economic
growth of a country.
5. Transfer of Value
Money has simplified the process of transfer of value from one place
to another with out losing its worth. Money is readily accepted by all
without any difficulty. It is even possible to transfer a billion of
rupees from one place to another.
_____________________________________________________________________________
Types of Money
Generally the classification of money is based on the material that is
being used for the purpose. According to the material used, the money
can be classified as:
1. Metallic Money
The currency in use or to be used when is made of some metal; it is
known as metallic money. The metallic money usually consist of coins
made up of gold, silver, copper, bronze etc. a characteristic of these
coins is that they are properly shaped and stamped by the central
issuing authority to prevent any misuse. In today’s modern age of
business the coins are Marley used and issued. The metallic money is
further classified as:
Classification of Metallic Money
Full Bodied Coin
Full bodied coin is the one, the face value of which is equal to the
quantity of metal used in it. In this case the face value of the coins
is equal to its intrinsic value.
Token Coins
A token coin or money is the one whose face value is higher than the
value of the metal contained in it. It is usually as a subsidiary unit
or coin. In token coin the face value is higher than the intrinsic
value.
2. Paper Money
Paper currency refers to the currency notes issued or used in a
country. These notes are made up of special kind of paper. Paper
currency also includes notes (promissory) and cheques but they circulate
as money only in the countries where they are used freely for settling
business transactions such as U.S.A and U.K.
In early times when notes were introduced they were backed by an
exactly equal amount in gold or silver kept by the issuing authority.
Paper money is not wholly backed by some precious metal now. only a
proportionate reserves are maintained and a good deal of the paper money
rests on people’s of people’s confidence in the word of issuing
authority generally the government or the central bank. Such a currency
is also called fiduciary issue.
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Classification of Paper Money
Paper money may be of following types
(i) Representative Paper Money
When the paper money is backed by an exactly equal amount of in gold
or silver kept in reserve by the issuing authority it is known as
representative money. Such notes could be exchanged for coins when
needed and did nothing more then to represent coins.
(ii) Convertible Paper Money
The currency notes which can be exchanged for full bodied or standard
coins is called convertible money. Its value is backed by a
proportionate reserve of some precious metal and the confidence in the
word of eh issuing authority. It is also called fiduciary money.
(iii) Inconvertible Paper Money
The currency notes that cannot be converted in full-bodied coins. The
issuing authority gives no promise for its conversion. It can also be
called fiat money.
Advantages of Paper Money
Following are some advantages of the paper money
1. Economical
Currency notes are cheapest media of exchange. Paper money practically
costs nothing to the government. It does not need to spend anything on
the purchase of gold for minting coins. Certain other expenditure or
losses associated with metallic coins are also avoided.
2. Convenient
Paper money is the most convenient mean of money. A large amount can
be carried conveniently in the pocket with out any body knowing about
it. It possessed in very large measure the quality of portability, which
a money material should have.
3. Homogenous
Among the coins there are good and bad coins. But currency notes are
all exactly similar. It is therefore the substitute medium of exchange.
4. Stability
The value of money can be kept stable by properly regulating its
issue. Managed proper currency method is therefore adopted by many
countries.
5. Cheap Remittance
Money in the form of currency notes can be cheaply remitted from one place to another in an insured cover.
6. Elasticity
Paper money is absolutely elastic. Its quantity can be increased or
decreased at the will of the currency authority. Thus paper money can
better meet the requirements of trade and industry.
7. Advantages to the Banks
Paper money is of great advantage to the banks. They can keep their
cash reserves against liabilities in this form, for currency notes are
full legal tender.
Disadvantages of Paper Money
Its disadvantages are as follows
1. No Value Outside the Country
Paper money is of no value outside the country where it is issued.
Gold and silver coins were accepted even by foreigners as they had no
intrinsic value.
2. Risk of Damage
There is always a possibility of damage to the paper. Fire may burn it, water may tear it etc.
3. Danger of Over Issue
A serious drawback in paper currency is the ease with which it can be
issued. There is always a danger of its over issue when the government
is in financial difficulties. Once this course is adapted the momentum
leads to further notes printing until it losses all the value. This over
issue of notes is called over inflation.
4. Price Increase
Some times especially when the money loses its value there is always
an increase in the price of goods. As a result, labours and other people
with fixed income suffer greatly. The whole public feels the pinch.
5. Effect on Business
During the days of monetary stringencies in a monetary economy, the
business activities are affected very badly. The indirect result of
price increase, shortage of currency etc, result in a fall of exports
and a rise in imports. It leads to the export of gold from the country,
which is not a desirable thing. Its balance of payments gets
unfavourable.
3. Bank or Credit Money
Bank money consist of demand deposit, which is drawn by cheques. A
deposit is like any other medium of exchange and being payable, on
demand, serves as a standard of value or unit of an account as it is
convertible into standard of value i.e. money or crash at fixed terms.
In the words of J.M. Keynes.
"Bank money is simply an acknowledgment of a private debt
expressed in the money of account which is used by passing from one hand
to another as an alternative of money to settle transactions."
_____________________________________________________________________________
Value of Money
The value of money refers to the purchasing power of one unit of money
in terms of goods and services. It indicates the quantity of goods and
services that can be had in exchange of one unit of money. If the
value of money is studied in relation to the home market, it is called
internal value as against external value, which gives the value of money
in terms of foreign currency.
Value of Money and Price Level
The price level of a country refers to the value of goods and services
in terms of money. It means that value of money is expressed in terms
of money. As for example, one unit of money supposes fetches 3 seers of
wheat and value of 3 seers of wheat is one unit of money. Suppose the
value of money rises and its one unit now fetches 5 seers of wheat. It
means that the value of wheat has come down and now 5 seers of wheat
will fetch one unit of money, which previously only did 3 seers.
From the above example it is evident that value of money is followed by
the fall in price level and vice versa. In other words rise in price
level makes the value of money fall and the same quantity of money can
be had with more units of money. The above fact can also be interpreted
as an increase in the quantity of money brings a corresponding fall in
the value of money and the fluctuations in the value of money occurs
due to a change in the quantity of money. This relationship between
value of money and its quantity is explained by quantity theory of
money.
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Quantity Theory of Money
Theory
The quantity of money states that other things remaining the same, the
value of money falls in proportion to increase in the quantity of money
in circulation. It mans that in the case, when the quantity of money
increases by 25%, the value of money falls by 25%. Thus the quantity of
money and its value of money are inversely related.
Explanation
The value of money like any other commodity is determined by its demand
and supply. Thus the quantity theory of money can be explained under
these two heads.
1. As Regards Demand of Money
Demand of money according to Fisher is the derived demand i.e. not for
direct consumption. Money being a medium of exchange is demanded for the
purchasing of goods and services. Demand for money therefore depends
upon the demand for goods and services.
2. As Regards Supply of Money
According to Fisher supply of money is represented by the total
expenditure made by the people calculated during a given period of time.
The total expenditure made by the people is calculated by multiplying
the total quantity of legal tender money by its velocity plus the bank
money (cheque, drafts etc) multiplied by its velocity. Velocity of money
means the number of hands that one unit of money changes during a given
period of time. For example a RS 100 note changes 10 hands in a year,
its velocity will therefore be 10. It means that total payment made by
this note will be .
RS. 100 * 10 = RS. 1000
According to Fisher, supply of money is determined by the following equation.
MV + M‘V’
M represents the actual money and M’ the bank money where as V and V’ represent their respective velocities.
Demand for money is represented by price multiplied by turnover i.e.
total quantity of goods and services sold and therefore demand is
determined as:
Demand of money = P x T
Where P is the price and T is the turnover.
Since the value of money is determined at a point where its demand is
equal to supply and accordingly Fisher gives the following equation of
exchange:
PT = M‘V’ + MV
Or
P = (M‘V’ + MV)/T
According to the above definition / equation, the price level is determined by dividing the total supply of money by turnover.
Criticism
The quantity theory of money is theoretically convincing but practically it is consider as a misleading one.
1. The very assumption in the theory that other things remaining same
are incorrect. Fisher assumed money as independent variable where as
credit (M’) is a function of business activity i.e. the turnover. It
means the turnover increases, the supply of bank or credit also
increases and consequently money is not an independent variable.
2. Velocity of money and bank money has been assumed is assumed in this
theory to be constant where as they are not so because they depend upon
business activity which is never constant.
3. The theory fails to explain as to why during depression the increase
in supply of money does not bring a corresponding increase in the price
level.
4. According to quantity theory high price is the effect of increase in
supply of money which is not always true. Scarcity of goods caused by a
fall in production or increase in production with respect to an increase
in population also raises the price level.
5. It is argued that Fisher’s equation is only valid in a static
economy. The economy becomes static beyond full employment level because
the physical production does not increase in such a situation. the
extra money if introduced in such a stage of economy is not absorbed by
increased quantity of output and consequently the price level is
directly affected. This shows that Fisher equation in a dynamic economy
is of no use.
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Importance of Money
In order to have a comprehensive idea of the importance of money, we can classify it as.
1. Importance to individuals in their daily life.
2. Importance to an economy.
1. Importance to Individuals in their Daily Life
Importance to individuals in their daily life is well established under the following heads
i. Removal of Double Coincidence
Money has removed the problems of double coincidence of wants. An
individual because of money is in position to exercise his choice and
can purchase or consume a commodity according to their liking.
ii. Convenience in Buying and Selling
Money being a measure of value, an individual can sell his goods for
money and purchase the goods he needs through it. The sale and purchase
of goods is not confined to with in the borders of a country only, but
are also conducted abroad.
iii. Ease in Planning
Money has given an opportunity to an individual to plan his
consumption in a way that he gets the maximum satisfaction out of his
limited income. Because of money price of every thing is known to him on
the basis of which he can ascertain that what he can afford and what
he cannot.
iv. An Option for Saving
Money being a store of value helps the individual to make provision
for rainy days. During the period of his earning, he may have some
thing, which he can use in his old age when his earning has reduced.
v. Recovery Options
Money also helps an individual to cover the gap between income and
expenditure intervals, which is done either by withdrawing the past
saving or by borrowing. Saving and borrowing have become common and a
part of our economic activities.
vi. Possibilities of Specialization
Money has made possible the regional specialization of production on
the basis of the most favorable condition principle, which has given
birth to international division of labour have reduced the cost,
improved the quality and increased the verities of products. Individuals
are in a position to consume superior goods at a cheaper price.
vii. Transfer of Value
Money being a measure of value helps the individuals to transfer the
value of their fixed assets from one places to another in the country or
out side the country. In other words even the immoveable assets have
become mobile.
viii. A Source of Income
Because of lending and borrowing practices facilitated by money, the
individuals saving become a source of income. The individuals make
savings, invest them in productive activities and receive a regular
income, which increases their welfare by improving their standard of
living.
2. Importance to Economy
The economy of a country is however, benefited by money in more than one-way:
i. Enhancing Exchange Facility
Money enhances the exchange facility and extends the market for goods
and services produced in the economy. The extension of market creates
demand for goods and services and consequently the resources are fully
exploited to increase the output so that the inc4reased demand may be
adequately met.
ii. Economies of scale
Money oriented demand provides economics of scale. The economy in such
a situation produces goods at a cheaper cost because of the reason
that input and output ratio rises.
iii. Increased Opportunities of Employment
Increased volume of production increases the level of employment and
income level follows suit. Raised income level stimulates saving and
investment and consequently the investment rate in the economy rises.
iv. Facilitate International Trade
Through money international trade is facilitated, which makes the
resources of an economy more mobile and such resources are exploited to
the maximum extent.
v. Introduction of Lending and Borrowing
Because of money lending and borrowing have become a common practice
among the nations of the world. The surplus resources o fan economy
moves to another economy, which is deficient in such resources. Flow of
resources helps an undeveloped to venture into her development plan.
Lending and borrowing practices developed through money, exchange saving
and stimulate investment n the economy. As a result the economic
growth is accelerated.
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Dangers of Money
Money has proved dangers in several ways
1. Economic Instability
Some economists of the view that money is responsible for economic
instability. When there was no money, saving was not divorced from
investment. Those who saved also invested. But in a monetised economy,
saving is done by certain people and investment by some other people.
Hence, it does not follow that saving and investment should be equal.
When savings in a community exceeds investments, then national income
output and employment decrease and the economy is engulfed in
depression.
2. Danger of Over-Issue
The main danger of money lies in its liability of being aver issued.
The over issue of money may result in inflation. Excessive rise in
prices hits hard the consuming public. It endangers speculation and
inhibits productive enterprises. It adversely effect distribution of
income and wealth in the community so that the gulf between the rich and
poor widens.
3. Economic Inequalities
Money has proved to be a very continent tool for amassing wealth and
exploitation of the poor by the rich. The misery and degradation has
gone to a great extant after the existence of money.
4. Moral Depravity
Money has weakened the moral fiber of the man. The social evil like
corruption has proved to be a soul-killing weapon. As said by an eminent
German economist Von Mises
“Money is regarded as the cause of theft and murder”.
Money is itself is not bad, but its possession or debt facilitates corruption and crime.
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Gresham's Law
Concept
Gresham’s law can be stated, as
“Bad money tends to drive good money out of circulation when both of them are full legal tender”.
Thus when two kinds of money good and bad circulate together, other
things remaining constant, bad money will remain in circulation and
good money will go out of circulation.
Classification of Good and Bad Money
Good and bad money may be classified as:
1. Good money is full valued coins of standard wealth
and fineness while bad money is the one, which is debased or worn out.
2. Good money may be superior money of higher substance
while bad money will be inferior money of less intrinsic value.
Explanation
In the light of the first classification the law may be stated as:
“Whenever legal tender coins of the same face value but of different
weight or degree of fineness are in continuous circulation, the light
weight or bad coins tend to drive out the full weight fine coins out of
circulation”.
Marshal states the law in the light of second classification as:
“ Money which is inferior in respect to exchange or substance value,
commonly shows greater tendency in circulation than those which are
superior in this respect”.
Application
The law is applicable in three cases:
Under Mono – Metallism
When coins of same metal but of varying weight or fineness or both
circulate together at the same face value, it will be the human tendency
to keep a brand new coin and give out the depreciated one. Thus the
old and worn out coins will tend to drive newly minted full weight fine
coins out of circulation.
Under Bi – Metallism
When gold and silver coins are freely circulated as legal tender, then
the over valued coin will drive the under value coin out of the game.
Under Paper Currency
When paper money and metallic money circulate together as standard,
however paper money being inferior tends to drive metallic money out of
circulation.
The reasons for this are:
- Good money is exported to earn profits.
- Good money is hoarded for later adjustments.
- Good coins are melted and sold as bullion.
Exceptions
The law does not operate when:
- There is a shortage of currency.
- When there is strong public opinion against bad money.
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Bi Metallism
Definition
Bimetallism is a system of currency under which the price of the
monitory unit is regulated with reference to any two metals (generally
gold and silver). Both the metals act as a medium of exchange and the
standard of value. The two metals remain in circulation side by side.
The ratio between their values is fixed and maintained by the currency
issuing authority.
Essential Features
The essential features of bimetallism are:
1. Standard coins of two metals, generally gold and silver remain in circulation side by side.
2. Coins of each of the metals remain unlimited legal tender.
3. Generally free coinage of both metals is considered as legal and
allowed. But some times free coinage of only one metal is allowed. If
it is so then the system is called limping standard.
4. There is a fixed legal ratio of exchange between the two metals e.g.
if an American silver coin has 16 g. of silver for every gram of gold
in gold coins, the ratio of exchange between the two would be 16:1. Any
payment that would be made it would be made keeping in view the ratio
between them.
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