TABLE OF CONTENTS

THEORY OF CONSUMER BEHAVIOUR 5

Who is a Consumer (Basic Assumptions) 5

Cardinal Utility Analysis 5

Fundamental Assumptions behind Cardinal Approach 5

Meaning of Utility 6

Law of Diminishing Marginal Utility 6

Some Important Definitions and Formulae 6

Relationship between Total Utility and Marginal Utility 7

Consumer’s Equilibrium 7

Ordinal Approach (Indifference Curve Analysis) 8

Indifference Curve 9

Indifference Map 9

Budget Line 10

Changes in Budget Line 10

Consumer’s Equilibrium 12

WELFARE ECONOMICS 13

Pareto Efficiency 13

Keldor Hicks Principle (Compensation Principle) 13

FORMS OF MARKET 15

Perfect Competition 15
 Individual and Market Curves 16

Profit Maximisation 17

Entry of New Firm or Long-Term Equilibrium and Breakeven Point 18

Shutdown Point 19

Monopoly 20

Price Discrimination 20

Profit Maximisation 20

Oligopoly 22

Strategies 22

Demand Curve 22

Sticky Price 23

Revenue and Sales Maximisation 23

Other Forms of Market 24

Duopoly 24

Monopolistic Competition 24

Monopsony 24

Bilateral Monopoly 25

GAME THEORY 26

Types of Games 26

Simultaneous Move Game (One Stage Game) 26

Sequential Move Game (Multiple Stage Game) 26

 Dominant Strategy 26

Nash Equilibrium 27

Zero Sum Game 27

Credible Threats 28

EFFICIENCY 28

Productive Efficiency 28

Allocative Efficiency 28

Market Failure 29

EXTERNALITIES 29

Types of Externalities 29

Abatement for Externalities 29

Remedies to Externalities 30

Private Sector Solutions 30

Public Sector Solutions 30

Tragedy of Commons 31

Coase Theorem 31

Limitations of Bargaining 31

MACROECONOMICS 32

Tools of Macroeconomics Policy 32

Fiscal Policy 32

Monetary Policy 33
 Gross Domestic Product (GDP) 33

Formula 33

Components of GDP 33

Types of GDP 33

Other Key Indicators 34

Gross National Product (GNP) 34

Net National Product (NNP) 35

National Income (NI) 35

GREEN REVOLUTION 35

Main Objectives of Green Revolution 36

New Techniques 36

Achievements 37

Weaknesses 37

Impacts 38

Economic Impacts 38

Social Impact 38

Political Impact 38

Demographic Impact 39

Ecological Impact 39

FIVE YEAR PLANS 39

Redundancy of Planning Commission 41

 NITI Ayog 42

THEORY OF CONSUMER BEHAVIOUR

The aim of this module is to make you understand how does a consumer maximise their
satisfaction from consumption of goods and services. As the resources are limited in relation
to unlimited wants of a consumer, they have to follow some basic principles or laws in order
to attain the highest satisfaction level. The two main approaches we will use to analyse
consumer’s behaviour are:

1. Cardinal Utility Approach (Marshall’s utility analysis)

2. Ordinal Utility Approach (Indifference curve analysis)

WHO IS A CONSUMER (BASIC ASSUMPTIONS)

A consumer is the main decision-maker of consumption pattern. A consumer is one who buys
goods and services for satisfaction of wants. They take decisions with regard to the kind of
goods to be purchased in order to satisfy his wants. The main objective is to get maximum
satisfaction from spending his income on various goods and services.

CARDINAL UTILITY ANALYSIS

People consume different goods and services in order to maximise the satisfaction level.
However, to do this, it is necessary to determine quantum of satisfaction obtained from a
particular commodity. Cardinal utility approach is based on the foundation of determining
this quantum of satisfaction derived from consumption or, in other words, ascribing a
numerical value to ‘utility’.

Fundamental Assumptions behind Cardinal Approach

1. Utility is measurable. It is possible for consumers to ascribe a numerical value to the

quantum of satisfaction derived from consumption.
2. Utility if a function of quantity. Utility from consumption will keep on changing
depending on your quantity of the consumption.
 3. Marginal Utility of Money (MUm) remains constant. Every additional rupee (or any
currency) gives same satisfaction.

Meaning of Utility

Utility refers to want satisfying power of a commodity. It is the satisfaction, actual or

expected, derived from the consumption of a commodity. In the words of Prof. Hobson,
"Utility is the ability of a good to satisfy a want". In short, when a commodity is capable of
satisfying human wants, we can conclude that the commodity has utility.

Law of Diminishing Marginal Utility

Law of diminishing marginal utility states that as we consume more and more units of a
commodity, the utility derived from each successive unit goes on decreasing. Suppose your
parent has just come from work and you offer them a glass of juice. The first glass of juice
will give him great satisfaction. The satisfaction with the second glass of juice will be
relatively lesser. With further consumption, a stage will come, when they would not need any
more glass of juice, i.e. when the marginal utility drops to zero. After that point, if he is
forced to consume even one more glass of juice, it will lead to disutility. Such a decrease in
satisfaction with consumption of successive units occurs due to 'Law of diminishing marginal
utility'.

Some Important Definitions and Formulae

1. Total Utility: Total utility refers to the total satisfaction obtained from the
consumption of all possible units of a commodity. It measures the total satisfaction
obtained from consumption of all the units of that good. For example, if the 1" ice-
cream gives you a satisfaction of 20 utils and 2nd one gives 16 utils, then TU from 2
ice-creams is 20+ 16-36 utils. If the 3rd ice-cream generates satisfaction of 10 utils,
then TU from 3 ice-creams will be 20+16+10= 46 utils.

TU can be calculated as TU = ƩU

2. Marginal Utility: Marginal utility is the additional utility derived from the
consumption of one more unit of the given commodity. As per given example, when
 3rd ice-cream is consumed, TU increases from 36 utils to 46 utils. The additional 10
utils from the 3rd ice-cream is the MU.

MU = Δ Total Utility / Δ Total Quantity consumed

3. Average Utility: Satisfaction gained from per unit consumption of commodity. In the
given example, if total utility after consumption of three units of ice-cream is 46 units,
average utility is 46/3 = 15.33.
AU = Total Utility / Total Quantity Consumed

Relationship between Total Utility and Marginal Utility

1. TU increases with an increase in consumption of a commodity, as long as MU is positive

(till point N). In this phase, TU increases but in a diminishing rate, as MU from each
successive unit of consumption tends to keep falling due to law of diminishing marginal
utility.
2. When TU reaches its maximum (point M), MU becomes zero. This is known as point of
satiety. TU curve stops rising at this stage.
3. When consumption is increased beyond the point of satiety, TU starts falling as MU
becomes negative.

Consumer’s Equilibrium

Consumer's Equilibrium refers to the situation when a consumer is having maximum

satisfaction with limited income and has no tendency to change his way of existing
expenditure. To determine the equilibrium point, consumer compares the price (or cost) of
the given commodity with its utility (satisfaction or benefit). Being a rational consumer, they
will be at equilibrium when marginal utility is equal to price paid for the commodity.
Marginal utility is expressed in utils and price is expressed in terms of money.

Consumer in consumption of single commodity (say, x) will be at equilibrium when Marginal

Utility (MUx) is equal to Price (Px) paid for the commodity; i.e., MUx = Px. If MUx > Px, then
consumer is not at equilibrium and he goes on buying because benefit is greater than cost. As
he buys more, MU falls because of operation of the law of diminishing marginal utility.
When MU becomes equal to price, consumer gets the maximum benefits and is in
equilibrium.

Units Price Marginal Utility Remark

1 10 20

MU > P ; Will
2 10 16 consumer another
unit

3 10 14

4 10 10 Equilibrium

5 10 4

MU < P ; will
6 10 0 decrease
consumption

7 10 -4

Similarly, when MUx, < Px, then also consumer is not at equilibrium as he will have to reduce
consumption of commodity x to raise his total satisfaction till MU becomes equal to price.

ORDINAL APPROACH (INDIFFERENCE CURVE ANALYSIS)

Modern economists disregarded the concept of 'cardinal measure of utility'. They were of the
opinion that utility is a psychological phenomenon and it is next to impossible to measure the
utility in absolute terms. According to them, a consumer can rank various combinations of
goods and services in order of his preference. For example, if a consumer consumes two
goods, Apples and Bananas, then he can indicate:

1. Whether he prefers apple over banana; or

2. Whether he prefers banana over apple; or
3. Whether he is indifferent between apples and bananas, i.e. both are equally preferable
and both of them give him same level of satisfaction.

Indifference Curve

When a consumer consumes various goods and services, then there are some combinations,
which give them exactly the same total satisfaction. The graphical representation of such
combinations is termed as indifference curve. Indifference curve refers to the graphical
representation of various alternative combinations of bundles of two goods among which the
consumer is indifferent. Alternately, indifference curve is a locus of points that show such
combinations of two commodities which give the consumer same satisfaction.

Indifference Map

Indifference Map refers to the family of indifference curves that represent consumer
preferences over all the bundles of the two goods. An indifference curve represents all the
combinations, which provide same level of satisfaction. However, every higher or lower level
of satisfaction can be shown on different indifference curves. It means, infinite number of
indifference curves can be drawn.
IC1, represents the lowest satisfaction, IC 2, shows satisfaction more than that of IC 1, and the
highest level of satisfaction is depicted by indifference curve IC 3, However, each indifference
curve shows the same level of satisfaction individually. It must be noted that higher
indifference curves represent higher levels of satisfaction.

Budget Line

Budget line is a graphical representation of all possible combinations of two goods which can
be purchased with given income and prices, such that the cost of each of these combinations
is equal to the money income of the consumer. Alternately, Budget Line is locus of different
combinations of the two goods which the consumer consumes and which cost exactly his
income.

Algebraic Expression of Budget Line is M = (P a x Qa) + (Pb x Qb) where: M is Money

Income, Q is Quantity and P is Price.

The slope of a budget line is the amount of one commodity that the market requires an
individual to give up to obtain one additional unit of another commodity without any change
in the amount of money spent.

Changes in Budget Line

Budget line is drawn with the assumptions of constant income of consumer and constant
prices of the commodities. A new budget line would have to be drawn if either (a) Income of
the consumer changes, or (b) Price of the commodity changes (Substitution Effect)
1. Income Effect: If there is any change in the income, assuming no change in prices of
apples and bananas, then the budget line will shift. When income increases, the
consumer will be able to buy more bundles of goods, which were previously not
possible. It will shift the budget line to the right from AB to A'B'. The new budget line
A'B' will be parallel to the original budget line AB.

2. Substitution Effect: When price of one commodity changes, while the price of other
commodity remains constant and there is no change in income of consumer, the slope
of budget line changes.

3. Total Effect: The total effect of a price change on the total change in the quantity
demanded as the consumer moves from one equilibrium to another.

TE = Δ Total Price/Δ Total Quantity

Consumer’s Equilibrium

The point of maximum satisfaction is achieved by studying indifference map and budget line
together. On an indifference map, higher indifference curve represents a higher level of
satisfaction than any lower indifference curve. So, a consumer always tries to remain at the
highest possible indifference curve, subject to his budget constraint.

IC1, IC2, and IC3, are the three indifference curves and AB is the budget line. With the
constraint of budget line, the highest indifference curve, which a consumer can reach, is IC 2.
The budget line is tangent to indifference curve IC 2, at point 'E'. This is the point of consumer
equilibrium, where the consumer purchases OM quantity of commodity 'X' and ON quantity
of commodity 'Y'.

All other points on the budget line to the left or right of point 'E' will lie on lower indifference
curves and thus indicate a lower level of satisfaction. As budget line can be tangent to one
and only one indifference curve, consumer maximizes his satisfaction at point E, when both
the conditions of consumer's equilibrium are satisfied.
 WELFARE ECONOMICS

PARETO EFFICIENCY

Pareto efficiency, or Pareto optimality, is an economic state where resources cannot be

reallocated to make one individual better off without making at least one individual worse
off. Pareto efficiency implies that resources are allocated in the most economically efficient
manner. An economy is said to be in a Pareto optimum state when no economic changes can
make one individual better off without making at least one other individual worse off.

A Pareto improvement is an improvement to a system when a change in allocation of goods

harms no one and benefits at least one person. This better off situation is called Pareto
Superior.

Pareto efficiency can be graphically depicted to more easily demonstrate the production
possibility frontier. The production possibility frontier is all of the possible combinations of
resources that yield market efficiency. Combinations that do not reside on the production
possibility frontier are inefficient because additional resources can be allocated.

KELDOR HICKS PRINCIPLE (COMPENSATION PRINCIPLE)

A Kaldor–Hicks improvement, is an economic re-allocation of resources among people that

captures some of the intuitive appeal of a Pareto improvement, but has less stringent criteria
and is hence applicable to more circumstances. Unlike a Pareto Improvement, a Keldor-Hicks
improvement can have people getting worse off, if, the consequential improvement exceeds
the loss of those who are made worse off.
 A re-allocation is a Kaldor–Hicks improvement if those that are made better off could
hypothetically compensate those that are made worse off and still have some benefit to
themselves, improving the overall satisfaction in society. The compensation does not actually
have to occur and thus, a Kaldor–Hicks improvement can in reality leave people worse off.

A situation is said to be Kaldor–Hicks efficient, or equivalently is said to satisfy the Kaldor–

Hicks criterion, if no potential Kaldor–Hicks improvement from that situation exists.

For example, a voluntary transaction between factory and buyers that creates pollution would
be a Kaldor–Hicks improvement if the buyers and sellers are still willing to carry out the
transaction even if they have to fully compensate the victims of the pollution. Kaldor–Hicks
does not require compensation actually be paid, merely that the possibility for compensation
exists, and thus need not leave each at least as well off.
 FORMS OF MARKET

Market refers to the whole region where buyers and sellers of a commodity are in contact
with each other to effect purchase and sale of the commodity. In economics, market has no
reference to a specific place. It is not necessary for buyers and sellers to assemble at a
particular place for sale or purchase of goods. The only condition is that they should be in
contact with each other through any means of communication, like internet, telephones,
letters, etc. In this module, we will study different forms of free market and how the actors
act in such markets. Before we proceed, let us reiterate certain assumptions behind a free
market:

1. There are no external controlling factors such as government intervention etc. The
prices are set through forces of market (supply and demand) only.
2. A firm will always look to maximise their profit.

PERFECT COMPETITION

A perfect competition is a market situation where:

1. There is a large number of buyers and sellers resulting in each buyer and seller having
no control and say over prices.
2. There is freedom of entry and exit in market. There are a large number of sellers
because there are no artificial or natural barriers to entry or exist in such an industry
where there is perfect competition. People can easily join or leave the market.
3. All sellers deal in homogenous products. There is no qualitative difference between
the products from different sellers. This gives the buyers unlimited options to choose
from where to buy.
4. Both buyers and sellers have perfect knowledge about the products being dealt with in
this market.

All this results in firms being a price taker. Price taker means that an individual firm has no
option but to sell at a price determined by the industry. Under perfect competition, an
individual firm cannot influence the price on its own as its share in total market supply is
negligible. Therefore, a firm plays no role in price determination. Price is determined at the
point where market demand curve intersects market supply curve.
Competition is entirely impersonal (not directed against any particular individual or group).

Individual and Market Curves

The first graph represents the market demand curve which intersects with supply curve
setting the equilibrium price or known as market price at point P. At this price determined by
forces of market, individual firms can theoretically sell any quantity of output as shown in
second graph.

The second graph representing individual demand or firm’s demand curve also shows that
demand is perfectly elastic, that is to say the while the firm can sell theoretically unlimited
output at the price determined by market, if it chooses to raise the price slightly, they will not
be able to sell any output because the buyers will simply go to other sellers who are selling at
market prices since there are multiple sellers selling homogenous output.
Profit Maximisation

In a perfect competition, since price determined by market remains same at every unit sold,
the market price is also the marginal revenue (MR). In a perfect competition, the firm cannot
control the prices, or MR (since firm is a price taker) and it cannot control its costs.
Therefore, the only thing firm can decide to maximise its profit is the output or quantity it
will sell.

A rational firm, in perfect competition will maximise profits when it produces (or sell) at that
level where Marginal Cost (MC) = Price (MR). As shown in the graph above, the point where
your MR curve intersects with MC, the quantity denoted by the corresponding point on X
axis to that intersection is where the rational firm will maximise its profit. This is because for
all units after this point, MC > MR, and thus the firm will incur a loss.

In the given graph, the lower rectangle (name it using points such as OABC) represents the
costs incurred by firm (since it is at the corresponding point on Average Total Cost curve for
our desired output) in producing the output while the upper rectangle (Total Revenue – Total
Cost) represents the profits it made by selling the output at market price.
Entry of New Firm or Long-Term Equilibrium and Breakeven Point

Any market with profit will attract many sellers because there are no barriers to entry in a
perfect competition. As sellers will increase, so will the supply. An increase in supply will
result in a rightward shift in supply curve as demonstrated in the right graph which shows a
shift from S1 to S*. This rightward shift in supply curve results in fall in market price from P 1
to P2.

This fall in price will result in MR Curve falling and intersecting with MC curve right where
MC Curve also intersects with ATC Curve as shown in first graph. This point where MC, MR
and ATC Curve intersect is called Zero-Economic Profit or Breakeven Point. Breakeven
Point represents the price and production level at which firms make absolutely no economic
profit. At this point, revenue that a firm generates is just enough to cover its costs and
obligations.

A firm will keep operating if it is operating between breakeven point and shutdown point
because at least it is able to recoup its variable costs in its operations (MR Curve lies above
AVC Curve).
Shutdown Point

Shutdown Point represents price and Level of operation where company experiences no
benefit of continuing its operation and decides to shut down. The Market price is such that
revenue is just equal to variable costs. Below the shutdown point, firm will minimize its cost
by shutting down.

In this given graph, the market prices at point P1 are such that the MR curve lies below the
ATC curve and intersects with MC Curve and AVC curve. At all prices below this level,
firms lose money with every unit produced and sold and therefore have no incentive to
continue and decide to shut down.
 MONOPOLY

Monopoly is a situation where only single seller operates in a market. The reason why there
is only one seller because of legal barriers like patent (Xerox Machine, COVAXIN),
government license (Railways, Defence) or illegal barriers like cartelisation (cement industry,
tyre industry) to entry. There is often no close substitute to the product under a monopoly,
giving buyers no alternatives, and seller enjoys a lot of power in setting prices, only restricted
by law of demand (quantity sold decreases with an increase in price).

Price Discrimination

Price discrimination in a monopoly is a practice of charging different prices for the same
product. Monopolies usually have more control over suppliers than regular sellers, which
means they can significantly influence the suppliers' selling prices. Monopolists can also set
higher prices to increase profit when the supply is low. Monopolists use this strategy to sell
the same products at different prices to different consumers.

Personal price discrimination may refer to price discrimination based on the individual
characteristics of customers. This type of price discrimination depends on the consumers'
income level and willingness to pay for the product. For example, Mama sells mattress for a
higher price to incoming first years than he does to fifth year students.

Profit Maximisation
For a monopoly, marginal revenue decreases as it sells additional units of output (because of
Law of Demand). The marginal cost curve is upward-sloping. The profit-maximizing choice
for the monopoly will be to produce at the quantity where marginal revenue is equal to
marginal cost: that is, MR = MC. If the monopoly produces a lower quantity, then MR > MC
at those levels of output, and the firm can make higher profits by expanding output. If the
firm produces at a greater quantity, then MC > MR, and the firm can make higher profits by
reducing its quantity of output.

Thus, a profit-maximizing monopoly should follow the rule of producing up to the quantity
where marginal revenue is equal to marginal cost—that is, MR = MC. This quantity is easy to
identify graphically, where MR and MC intersect.
 OLIGOPOLY

Oligopoly refers to a situation where few sellers dominate the market. The reason behind few
sellers is high barriers to entry such as requirement of a lot of capital to enter the industry.
Since only few firms operate in the market, all of them enjoy a significant share of market,
and power to dictate behaviour in the market. The few firms in the market are interdependent
on each other as well because each of them has significant market share.

Strategies

A firm in oligopoly can chose from a variety of strategy for competing with its rival firms in
the market such as:

1. Ignorance – Firms can ignore the price changes implemented by other firms.
2. Interdependence – Your firm’s strategy is dependent on strategy adopted by rival
firms. For example, if your rival firms chose to offer a discount, so do you.
3. Price Leadership – Price leadership occurs when a leading firm in a given industry is
able to exert enough influence in the sector that it can effectively determine the price
of goods or services for the entire market. This type of firm is sometimes referred to
as the price leader. For Example, Airlines industry.
4. Cartelisation – When firms decide to work together and collaborate their behaviour
such as price levels and output instead of competing against each other. Such
cartelisation is easy in oligopoly market because it is easier to coordinate with lesser
players in market.

Demand Curve
In an oligopolistic market, the kinked demand curve hypothesis states that the firm faces a
demand curve with a kink at the prevailing price level. The curve is more elastic above the
kink and less elastic below it. This means that a small increase from prevailing price results
in a significant decline in output sold while a significant decline from prevailing prices only
results in a slight increase in output sold. This is because of the presumption that price
increase will not be followed by other firms in market while a fall in price will be mimicked
by all competitors. This is why firms within an oligopoly market structure prefer non-price
competition. This demand curve also demonstrates policy of sticky price in an oligopoly.

Sticky Price

Price stickiness refers to the tendency of prices to be resistant to change, especially in

response to changes in demand or cost conditions. In an oligopoly, firms may be hesitant to
change their prices for fear of triggering a price war or losing market share to their rivals. As
a result, prices may be slow to adjust to changes in demand or cost conditions, leading to
price stickiness. The kinked demand curve model is often used to explain price stickiness in
an oligopoly.

Revenue and Sales Maximisation

Although the traditional theory of the firm assumes that all firms aim to maximise their
profits, in reality firms may have a range of objectives. Sometimes a firm might have an
objective to maximise their revenue instead of profits. Revenue is the total amount of income
generated by the sale of goods while profit, is the amount of income that remains after
accounting for all expenses. Similarly, sometimes, a firm might want to maximise their sales
(volume of commodities sold) as opposed to revenue or profits.
Therefore, when the primary objective of a firm is to maximise revenue, the firm will
produce/sell at the output level where MR=0 at point Q 1 in the graph above (as opposed to
where MR=MC as is case in profit maximisation). This is because at all levels before this
point, there is some positive revenue to be generated.

On the other hand, when a firm wants to maximise its sales by volume under cost constraints,
it will produce/sell at Q2 point because at that level, AR = AC The firm might be able to sell
more than this, but the diagram shows that on all units of output beyond OQ 2, AC is greater
than AR and, therefore, a loss would be incurred. So, OQ 2 maximise sales volume without a
loss being incurred.

OTHER FORMS OF MARKET

Duopoly

It is a situation where only two players in a market dominate the industry. They together
control all, or nearly all the output and sales in the market and therefore have high individual
market share. There are strong barriers to entry preventing others from entering such as high
capital demands. Because there are only two players, such a market is prone to collusion, at
which point the market becomes a virtual monopoly. An example of Duopoly is airplanes
(Boeing & Airbus), Payment Processing (Visa & Mastercard), Soft Drinks (Pepsi & Coca
Cola).

Monopolistic Competition

In such a market, there are many sellers, but all of them deal in a homogenous commodity.
Which means while the commodities dealt are similar, they are not perfect substitute to each
other and there is a qualitative difference between the goods sold by different sellers. There
are relatively low barriers to entry, and therefore no single seller dominates the market. For
example, restaurant business, hair salon industry etc.

Monopsony

It is a situation where there are multiple sellers but only a single buyer in a market giving the
buyer significant power with respect to dictating prices and quantity. The single buyer alone
controls the entire demand and therefore giving very low bargaining power to seller. An
example would be Labour market in industrial towns like Jamshedpur, or Government buying
agricultural produce at fixed prices of MSP (if we assume private sector is not an option).

BILATERAL MONOPOLY

A bilateral monopoly is a market situation in which there is both a monopoly on the selling
side and a monopsony on the buying side. Eg: coal mine and power station
 GAME THEORY

Game refers to situation where number of individuals or actors have to make decisions and
the resulting outcome is not only dependent on your decision but decision of everyone else as
well. Therefore, each actor cares not only about their own choice, but also choices of others.
Some examples of games are Rock-Paper-Scissors, Poker, but game theory is also applicable
to situations like military planning, business strategies etc.

In business decisions, a firm is operating in a market of many players has to figure out the
best course of actions, firm needs to anticipate decisions of other actors and then make the
choice. In economic terms, we say that the firm’s choice must be guided by a strategy.

TYPES OF GAMES

Simultaneous Move Game (One Stage Game)

This is a game where all players move at the same time, therefore, each participant makes all
their choices before observing any choice by other participants. An Example would be Rock-
Paper-Scissors.

Sequential Move Game (Multiple Stage Game)

Players take turns for making a choice and moving. Therefore, at least one participant gets to
observe the choice made by other participant before making their own decision. Examples
would be chess, tic-tac-toe.

DOMINANT STRATEGY

In a game, a player is always trying to anticipate the choice of other actors in order to make
the best choice for themselves. However, a dominant strategy refers to a situation where one
choice or course of action results is best payoff for the actor regardless of how other actors
make their choice.
Harold

Mike

Mike
In the game given above if we have to find dominant strategy for our player (Mike, we will
assume that the other actor (Harold) makes the first choice (Deny). Under that assumption we
look for what choice has the best outcome for our actor. It is squeal.

After that, we assume that Harold makes the other choice (Squeal). Then we look for best
choice for our actor under that assumption, which again is squeal. Therefore, Squeal is
dominant strategy for our player in this game because it results in best possible payoff for our
player regardless of how other player choses.

Some games where the best course of action for our player under each assumption is different
do not have a dominant strategy because in such a situation, our player has to anticipate the
choice by other player.

NASH EQUILIBRIUM

It refers to a situation where each player adopts the dominant strategy for themselves
(favourable for them) and do not deviate from it despite correctly anticipating the strategy of
other player. In the game between Harold and Mike, the dominant strategy of both the actors
is to squeal, therefore Nash equilibrium would be achieved at the outcome denoted by the
bottom left cell where both the players squeal. This is because despite knowing other actor’s
dominant strategy is to squeal, there is no incentive for the other player to change their choice
based on this knowledge.

ZERO SUM GAME

Zero-sum game is a situation in which one person’s gain is equivalent to another’s loss, so
the net change in benefit is zero. Zero-sum games are found in many contexts. Poker and
gambling are popular examples of zero-sum games since the sum of the amounts won by
some players equals the combined losses of the others.

Prisoner’s dilemma (the example of Mike and Harold) is a non-zero-sum game or a positive
sum game since there are outcomes possible where both of them win or both of lose
collectively.
 CREDIBLE THREATS

If an actor announces that a choice by other actor will result in a response by the first actor
that will be detrimental to second actor is called a threat. For example, A announces that B’s
behaviour will lead to a response from A that will harm B.

EFFICIENCY

A state of efficiency is achieved where all factors of production are fully employed, say
labour is producing at maximum capacity, the plant is working at maximum capacity etc.
There is no wastage. However, mere full employment of resources is not enough to prevent
any wastage. Sometimes, even when all the resources are employed, there may be a state of
inefficiency when firms do not use least cost method to produce the commodity.

PRODUCTIVE EFFICIENCY

Productive firms seek to maximize their profits by bringing in the most revenue while
minimizing costs. Productive efficiency is a situation where firms seek the best combination
of inputs to lower their costs of production. It is when firm are producing its output at the
lowest possible cost. By doing so, they operate efficiently; when all firms in the economy do
so, it is known as productive efficiency.]

ALLOCATIVE EFFICIENCY

Allocative efficiency means that economic resources are distributed in a way that produces
the highest consumer satisfaction relative to the cost of inputs. When economic resources are
allocated across different firms and industries in a way that produces the right quantities of
final consumer goods in a manner that maximises consumer satisfaction, this is called
allocative efficiency.

If the level of output of some product is such that marginal cost to producers exceeds
marginal value of consumers, too much of that product is being produced, because the cost to
society of the last unit produced exceeds the benefits of consuming it.

On the flip side, if the level of output of some good is such that the marginal cost to firm is
less than the marginal value to consumer, too little of that good is being produced, because
the cost to society of producing the next unit is less than the benefits that would be gained
from consuming it.

MARKET FAILURE

Market failure refers to inefficient allocation of resources in the free market that occurs when
individuals acting in rational self-interest generate less-than-optimal economic outcomes. An
example of such situation is poverty, recession etc. Causes of market failure are externalities
(CFC Production poking holes in ozone layer), Information Asymmetry (2008 Sub-Prime
Mortgage Crisis) etc.

EXTERNALITIES

An Action creates an externality it affects someone with whom the decision maker has not
engaged with in a market transaction. It results in inefficient allocation of resources. An
externality defies the logic of free markets. Free markets are based on the fact that when
every actor in a free-market acts in individual self-interest, it results in most efficient
allocation of resources for entire market. However, an externality results when in pursuit of
individual self-interest results in third party harms to people who have not consented to such
harm, resulting in inefficiencies and market failure.

TYPES OF EXTERNALITIES

1. Positive Externality – A decision that has third party benefits is called positive externality
for example, investment in education doesn’t only benefit people receiving the education
but also reduces crime and poverty rate in society making society better off. A person
carefully tending to its garden increases value of surrounding houses in the
neighbourhood as well.
2. Negative Externality – A decision that has third party harms is called negative externality
for example, a contract between chemical factory and buyer to produce and sell chemicals
results in water pollution which harms the society. A person smoking in public also
causes passive smoking harms to people around him.

ABATEMENT FOR EXTERNALITIES

While abatement of externalities such as pollution would seem intuitive and moral course of
action to most, but from an economics POV, abatement only makes sense if the increase in
collective benefit of society by removing the externality (say pollution) exceeds the cost it
would have to incur for abatement. It is only in such cases that abatement is perceived to be
efficient. If the abatement costs exceed the increment in benefit, then economists say
abatement is inefficient.

Therefore, in order to determine if abatement is efficient or not, compare the increment in

benefit to society without the externality as compared to with it, and see is the abatement
costs are less than this benefit or not. If it is less than the increment in benefit, abatement is
said to be efficient.

REMEDIES TO EXTERNALITIES

Private Sector Solutions

Whenever the allocation of resources is inefficient, it is always possible to arrange mutually

beneficial trades. Private parties therefore have strong incentives to identify inefficiencies and
negotiate solutions by implementing mutually beneficial trades.

Outcome of any negotiation depends on how property rights are allocated. The party which
has the appropriate property right is in stronger position to bargain and get a favourable deal
while the other party which seeks an accommodation has to make an offer incentivising the
right holder to give up its right.

For example, if farmer has right to clean water, it is on factory that’s polluting the river to
make an offer to farmer saying I will pay you an amount to allow me to pollute. Similarly, if
factory has right to pollute, farmer will have to make an offer incentivising the factory to not
exercise its right to pollute.

Public Sector Solutions

When private negotiations fail to remedy the market failures associated with externalities,
appropriate government policies can potentially improve economic efficiency. Various public
policies are designed to address externalities such as:

1. Build & Operate a Market – Where a common resource is used by everyone to an

extent the resource becomes unpleasant to use for example extremely crowded public
parks, or airspace for mobile signals, government can intervene and build a market
 out of these resources, charging the users for its use reducing the people who can have
access to such resources.
2. Quality Control – Government can come up with regulations and standards penalising
activities that do not meet that standard. For example, to deal with problem of
pollution, government has come up with regulations for factories on how to treat
waste before disposing and any deviation from such regulations is penalised.
3. Taxes, Fees & Subsidies – government can change the incentives for private sectors
that result in inefficient allocation of resources by imposing heavy taxes and fees to
disincentivise a behaviour and give subsidies to incentivise another behaviour. For
example, government charges heavy taxes on cigarettes to disincentivise smoking
while it gives subsidies on production of electronic vehicles to promote eco-friendly
transportation.

TRAGEDY OF COMMONS

The tragedy of the commons refers to a situation in which individuals with access to a public
resource (also called a common) act in their own interest and, in doing so, ultimately deplete
the resource. This theory explains individuals’ tendency to make decisions based on their
personal needs, regardless of the negative impact it may have on others.

COASE THEOREM

If bargaining is frictionless, regardless of how property rights are allocated, private parties
will reach an agreement to efficiently remedy the externality and restore economic efficiency.

Limitations of Bargaining

1. Costs of Bargaining – Negotiations and bargaining often have high costs, both
monetary and other resources like time etc., associated with it. Therefore, bargaining
for every externality might not always be economic efficient course of action.
2. Vague Property Rights – In real life, property rights are not defined very strictly.
While we have right to clean water and air, factories also are given some exemptions
within reasonable limit to pollute, therefore most of the times, its unclear where the
property right lies.
3. Information Asymmetry – In most cases, the private parties do not have complete
information of prospective gains, loses and costs to the other parties and thus cannot
reach an economically efficient agreement.
4. Enforcement difficulties – It is highly difficult to get an agreement enforced. Even if
an agreement is reached but one party violates it, it would take a lot of time, effort and
resources on the other party to get it enforced.
 MACROECONOMICS

This branch of economics focuses on economy as a whole and deals with problems of
economy such as employment, interest, income, inflation etc. It deals with the structure,
performance, behaviour, and decision-making of the whole, or aggregate, economy.

TOOLS OF MACROECONOMICS POLICY

Two main instruments by which government can influence economy

Fiscal Policy

Fiscal policy refers to the use of government spending and tax policies to influence economic
conditions. Government does this through two ways, by increasing or decreasing its
expenditure or taxes.

1. Government expenditure – there are two types of expenditure, either its spending
through salaries, infrastructure etc, which puts money in hands of private individuals
or its through transfers such as allowances etc which puts money in hands of
disadvantaged individuals (senior citizens, girl child). Both of these are directly
related to disposable income for individuals in an economy and effect consumption
and investment.
2. Taxes – this represents income of government. An increase in taxation results in
firstly a decrease in disposable income and secondly, an increase in prices.

Government can increase or decrease its expenditure and taxes according to its objectives.
Monetary Policy

Monetary policy controls the supply of money and credit through interest rates etc in a
market. This is done by policy makers in central bank. Easy availability of credit or cheaper
credit (lower interest rates charged by banks) results in increase in investments while increase
in money supply results in inflation.

GROSS DOMESTIC PRODUCT (GDP)

A country’s Gross Domestic Product is the total monetary value of all final economic goods
and services produced during a given period in local currency. GDP is the broadest measure
of economic activity in a country. In addition to indicating a country’s economic health, the
GDP also indicates its living standard. In other words, as the GDP increases, so does the
living standard of the people in that particular country. GDP provides key guidance to
policymakers, investors, and businesses when making strategic decisions, despite its
limitations.

Formula

GDP (Y) = C + I + G + NX

where C is consumption; I is Investment; G is Government Purchases and NX is Net Exports

(Exports – Imports)

Components of GDP

1. Consumption (C) – Consumption spending by households on goods and services for

example food, automobiles, hair saloon etc.
2. Investment (I) – Spending on capital equipment, assets such as houses or shares etc.
3. Government Purchases (G) – Money spent by government either through salaries or
through investment in infrastructure etc.
4. Net Exports (NX) - It is spending on domestically produced goods by foreigners
(exports) minus spending on foreign goods by domestic residents (imports)

Types of GDP
Since GDP is taken at prevailing price levels, and price levels keep on changing due to many
reasons such as inflation, when comparing GDP of two years, we cannot just compare the
total monetary value, we need to adjust it for price changes to make a fair comparison.

1. Nominal GDP – It is when GDP is taken at prevailing price levels.

2. Real GDP – it is when nominal GDP of a year is adjusted for inflation when
comparing it with another year by taking a base year for purpose of standardisation.
Real GDP uses constant base-year prices to place a value on the economy’s
production of goods and services. Since, real GDP is not affected by changes in
prices, changes in real GDP reflect only changes in the amounts being produced.

Nominal GDP is converted into Real GDP by dividing the Nominal GDP with what we call is
a GDP Deflator. GDP deflator, also known as the implicit price deflator, is used to measure
inflation. It is used to determine the levels of prices of the new domestically produced final
goods and services in a country in a year.

GDP Deflator = Nominal GDP

_______________ x 100

Real GDP

If you have to convert a Nominal GDP into Real GDP, then divide the Nominal GDP of that
year by

Prevailing Prices in actual year

______________________

Price in base year

OTHER KEY INDICATORS

In order to understand other key indicators besides GDP, it is important that you understand
the difference between domestic and national. Domestic refers to goods and services
produced on territory of India (includes production by foreigners in India) and national refers
to goods and services produced by national of India (includes production by Indian nationals
on foreign soil).

Gross refers to total value of goods and services produced while net refers to total value of
goods and services less the other expenses. Keep both these differences in mind from now on
to understand why we add or subtract certain things in each new indicator
Gross National Product (GNP)

GNP = GDP + Factor Payments from Abroad – Factor Payments to Abroad

Factor income from abroad is the factor income earned by normal residents of our country
who are temporarily residing abroad or are working outside our domestic territory. It is added
to GDP to find GNP.

Factor Income to abroad is the factor income earned by normal residents of other country
who are temporarily residing in our domestic territory. It is subtracted from GDP to find
GNP.

Net National Product (NNP)

NNP = GNP – Depreciation

Depreciation is loss in values of capital assets every year due to wear and tear. It is subtracted
from GNP to reach NNP.

National Income (NI)

NI = NNP – Indirect Taxes

Indirect taxes goes in pocket of government and not nationals of the country, therefore it is
not part of national income and has to be deducted.

GREEN REVOLUTION

For centuries agriculture in India has been characterized by subsistence farming, primitive
techniques, and low yields. Most of the land was devoted to foodgrain production, yet deficits
could not be eradicated and, in many areas, starvation and famines were frequent. As a result
of excessive pressure of population on farms, unemployment was chronic, and millions of
people moved to industrial areas and plantations.

In 1960’s, however, the introduction of high-yielding variety of seeds facilitated a significant

breakthrough in foodgrain production, and Indian agriculture was on the threshold of a great
change. This latest development earned the popular name “Green Revolution”. During this
period, agriculture in India was converted into a modern industrial system by the adoption of
technology, such as the use of high yielding variety (HYV) seeds, mechanised farm tools,
irrigation facilities, pesticides, and fertilizers. Mainly led by agricultural scientist M. S.
Swaminathan in India, this period leveraged agricultural research and technology to increase
agricultural productivity.

MAIN OBJECTIVES OF GREEN REVOLUTION

1. Self-Dependency in food security – A farmer is able to produce enough to provide for

its family and country is able to produce enough to provide for everyone without
relying on imports which were often of lower quality.
2. Expansion of Agro-Based industry – Being primarily an agrarian economy, green
revolution sought to maximise the contribution of agriculture to our economy by
creating industries around it (sugar industry, paper industry etc.)
3. Increase in Yield – Per hectare output had to be maximised in order to expand our
agricultural sector. This was done using variety of scientific methods such as
irrigation techniques, use of fertilizers and most importantly, use of High Yield
Variety (HYC) seeds etc.

NEW TECHNIQUES

The Green Revolution in India was a period of rapid agricultural growth from the mid-1960s
to the mid-1970s. It was characterized by the introduction of new technologies, such as:

1. HYV seeds: Seeds that have been bred to produce high yields of crops. They are
typically more responsive to fertilizers and pesticides than traditional varieties of
seeds and are drought resistant.
2. Fertilizers: Substances that are added to soil to improve its fertility and increase crop
yields. They typically contain nitrogen, phosphorus, and potassium, which are
essential nutrients for plant growth. They helped to increase food production
significantly. The most commonly used fertilizers were nitrogen, phosphorus, and
potassium.
3. Pesticides: Chemicals that are used to kill pests, such as insects, weeds, and fungi.
They helped to protect crops from pests and diseases. The most commonly used
pesticides were insecticides, herbicides, and fungicides.
4. Irrigation: Process of supplying water to crops. It is essential for agriculture in many
parts of India, where rainfall is limited. It helped to increase crop yields in areas with
 low rainfall. The most common irrigation methods used were canals, wells, and
tubewells.

ACHIEVEMENTS

1. Boost to production of cereals – Cereals such as wheat, maize, rice etc were now
being produced in abundant quantities resulting in increase in per capita intake of
cereals providing healthy and nutritious diet to Indian population
2. Increase in Commercial crops – Increase in commercial crops such as cotton, coffee,
sugarcane etc resulted in creation of industries around these crops resulting in huge
boost for Indian economy and also increasing India’s exports.
3. Change in Crop Pattern – An increase in disposable income and output by agricultural
industry resulted in a shift from lower quality grains to cereals to pulses increasing
nutrition around the country.
4. Boost to employment – Since agricultural was being industrialised, it could now
employ more people and reduce unemployment. We had different tasks like irrigation,
fertilising, sprinkling pesticides, weeding etc.
5. Strengthening forward and backward linkages - New technology and modernization
of agriculture have strengthened the linkages between agriculture and industry.

WEAKNESSES

1. Dependence on Monsoon – Indian Agriculture still remains highly dependent on

timings of monsoon and artificial irrigation is not adopted widely across entire India,
leaving us at behest of nature.
2. Increased inequality – The Green Revolution benefited large farmers more than small
farmers. This is because large farmers were more likely to have access to the
resources needed to implement the new technologies, such as land, water, and credit.
As a result, the gap between rich and poor farmers widened.
3. Growth of Capitalist Farming – Industrialisation of Agricultural resulted in its focus
being shifted from small farmers to large players. The policies and reforms started
becoming tailored to such industrial players, thus ignoring the small farmers.
 4. Labor displacement: The Green Revolution led to the mechanization of agriculture,
which displaced many agricultural labourers. This was especially true in Punjab and
Haryana, where the Green Revolution was most successful.
5. Socio-economic relations: The Green Revolution led to the emergence of a new class
of wealthy farmers, while many small farmers and agricultural labourers were
impoverished. This has led to social and economic tensions in rural India.

IMPACTS

Economic Impacts

There are some major impacts either related to the structure of the economy or the working of
the economy.

1. There is more demand for loans and banking services for farmers. A lot more credit is
being given out for farming efforts than for other types of activities. This might help
people learn skills that save time and effort, but in the long run, it has made rural
unemployment worse.
2. The number of banks in rural areas should grow. Another important result of more
lending is that it makes the weak parts of the economy even weaker. This happens
because credit facilities like credit unions, credit banks, and so on are run by the
wealthy. Increasing the flow of credit has helped the wealthy, but it has hurt farmers
who aren't as well off.

Social Impact

Green Revolution has changed the way the village is connected to the rest of society
structurally. There is a difference between villages and other units like cities in how much
they rely on outside assistance. Villages generally tend to be more independent. However,
when HYVT is used, these units become more dependent on external inputs.

This has a number of secondary effects, such as: i) the village's cultural identity is slowly
lost; ii) people in rural areas become more aware of social problems because they are exposed
to outsiders; and iii) more money will be needed for growth.
Because people are more aware of the differences, these factors will indirectly lead to more
people moving to cities. This can sometimes lead to social unrest because people become
more aware of differences.

Political Impact

1. Loss of Hierarchy – It has had a big political effect on the towns, which have lost their
usual hierarchal structure because they can't meet their own needs anymore and are
dependent on external inputs.
2. Introduction of Trade Unions – The second result is that trade unions have come to the
farm sector. Trade union leaders are moving into this area to help because of the job and
pay uncertainty in farms. Farmworkers should be able to count on their jobs and make
steady pay.
3. Political Influence – Since there is organised political action in the farming sector, a new
class of farmers with more business connections and influence in politics is coming
into the India. The power in politics is slowly shifting towards farmland, and you can see
this trend in our politics like what we saw during the 2021 farmers' protest

Demographic Impact

Farmers like large families to work in their fields because of the increased labour
requirements per unit area. In the long run, increase in family size causes further
fragmentation of land due to property division. If this trend continues the number of marginal
farms will increase and this slowly induces people to go away to urban areas, causing
migration-generated population explosions.

Ecological Impact

Increased fertilizer application is causing increased fertilizer runoff from the fields. This is
likely to affect the fish production. Fish cannot grow fast in water containing nitrates and
sulphates.

The HYV crop is denser than the conventional varieties. This factor, along with the high
humidity, causes fast multiplication of pests and pathogens. This induces the increased
application of pesticides, which are mainly nonbiodegradable. These nonbiodegradable
insecticides accumulate in the human body through the food chain. Cattle usually consume
straw from fields causing increased pesticide residues in urban milk supply sources.

FIVE YEARS PLANS

The term economic planning is used to describe the long-term plans of the government of
India to develop and coordinate the economy with efficient utilization of resources.
Economic planning in India started after independence in the year 1950 when it was deemed
necessary for economic growth and development of the nation. Long term objectives of Five
Years Plans in India are:

1. High Growth rate to improve the living standard of the residents of India.
2. Economic stability for prosperity.
3. Self-reliant economy.
4. Social justice and reducing the inequalities.
5. Modernization of the economy.

The idea of economic planning for five years was taken from the Soviet Union under the
socialist influence of first Prime Minister Pt. Jawahar Lal Nehru. The first eight five-year
plans in India emphasised on growing the public sector with huge investments in heavy and
basic industries, but since the launch of Ninth five year plan in 1997, attention has shifted
towards making government a growth facilitator.

Plan Objective Performance

1st Five Year Plan (1951-56) Agricultural development This plan was successful and
at the end of this plan, five
IITs were set up in the
country.

2nd Five Year Plan (1956-61) Industrial development Plan Failed

It was criticized by experts

and India faced a payment
 crisis in the next year 1957

3rd Five Year Plan (1961-66) Self Sustaining Economy The plan was a flop due to
and balance industry and wars (Indo-china & India-
agriculture. Pak) and drought.

4th Five Year Plan (1969-74) Growth with stability and Plan failed
progressive achievement of
self-reliance.

5th Five Year Plan (1974-78) Growth with Social Justice Cut short due to Janata
Party’s ascent to power in
1977 but overall the plan
was success.

6th Five Year Plan (1980-85) Economic liberalization by Plan was a success.
eradicating poverty and
achieving technological
self-reliance.

7th Five Year Plan (1985-90) Accelerating food grain Plan was a success
production, increasing
employment opportunities.
Focus on ‘food, work &
productivity’

8th Five Year Plan (1992-97) Development of human Plan was Succesful, highest
resources i.e. employment, ever growth rate achieved
education, and public (6.8 percent). Panchayati
health Raj and Nagar Palika
 institutions were given
constitutional status so that
plan benefits could percolate
to the grassroots.

9th Five Year Plan (1997- Main focus of this plan was Plan failed, The East
2002) “Growth with Social Asian financial crisis took
Justice and Equality”. place in 1997. Kargil War in
1999. 9/11 in 2001.

10th Five Year Plan (2002-07) Attain 8 per cent GDP The period saw the global
growth per year. economy grow. India also
benefited. NREGA and
Reduction of poverty rate
National Rural Health
by 5 per cent points by
Mission were begun during
2007
this plan. But we fell just
short of our ambitious 8%
target with economy
growing at 7.8 per cent.

11th Five Year Plan (2007-12) Rapid and More Inclusive Plan Failed, global economy
growth went into a great recession
with the subprime mortgage
crisis of US.

12th Five Year Plan (2012-17) Faster, More Inclusive and Plan was not pursued after
Sustainable Growth change in government in
2014. It failed to meet its
target

REDUNDANCY OF PLANNING COMMISSION

The 65 years-old Planning Commission had become a redundant organization. It was relevant
in a command economy structure, but not any longer with liberalised and globalised
economy. India is a diversified country and its states are in various phases of economic
development along with their own strengths and weaknesses. In this context, a ‘one size fits
all’ approach to economic planning is obsolete. It cannot make India competitive in today’s
global economy.

NITI AYOG

NITI Aayog or the National Institution for Transforming India is a policy think tank of the
Indian government which provides inputs regarding the different programmes and policies of
the government. NITI Aayog gives relevant advice to the centre and state governments as
well as to the Union territories.

This institution was formed in the year 2015 through a resolution of the Union cabinet and is
chaired by the Prime Minister of India and the Chief Ministers of all states and Union
territories along with the legislatures and Lt. Governors of other Union Territories.

The NITI Aayog plays an important role in designing the strategies for the long-term policies
and programmes put forth by the government of India. This institution replaced the planning
commission which was instituted in 1950. By taking this step, the government of India aimed
at providing a common platform for all the states to get together and act in national interest
while also serving the needs of the people in a much better way. NITI Aayog has been a
revolutionary institution which fosters cooperative federalism.