Induced and Autonomous Investment

Investment is an important determinant of the Aggregate demand and thereby of the level of income, output and employement.Investment is taken in the sense of real investment.

Investment refers to that part of the aggregate output which takes the form of new plants, new capital equipments and machinery, new structures (factories, office building, residential houses etc.) and addition to business inventories (stock of goods).

Private and Public Investment

Private Investment:

It refers to expenditure by private investors on the purchase of such goods which add to their stock of capital.

Investment implies increase in the stock of capital, also called Capital Formation.

Rate of interest is the principal determinants of private investment.

Higher rate of interest generally implies lower investment expenditure.

Investment in private sector is motivated solely by profit motive.

Public Investment:

Investment undertaken by the government is known as public investment.

The government often invest in projects like road, dams, schools, colleges, housing etc.

Public investment is largely motivated by public welfare.

Saving Function (2)

As we have already understood various components of savings, now here we will understand the saving function graphically. 

Tabular explanation of Consumption function

Y(Rs)	C (Rs)	S ( Y- C)
0 20 40 60 80 100 120	30 35 40 45 50 55 60	-30 -15 0 15 30 45 60

The above table shows:

Like consumption, saving is an increasing function of the level of income, i.e. the amount of saving increases with an increase in the level of income.

Saving Function

Saving is the excess of income over consumption during an accounting year. Algebraically, saving (S) is defined as: 

S = Y – C, where Y is income and C is consumption 

Since income is either spent or saved, there is a close relationship between consumption and saving,
i.e. the part of income which is not consumed is saved and the part of income which is not saved is used in the form of consumption expenditure.

Like consumption, saving is an increasing function of the level of income, i.e. 

the amount of saving increases with an increase in the level of income.

Thus, S = f (Y)

Propensity to save

Propensity to save is the ratio between S and Y. 

It shows the level of S with respect to a given level of Y. 

Like propensity to consume, propensity to save also has two aspects:

1) Average propensity to save

2) Marginal propensity to save

Tabular explanation of Consumption function

Consumption function depends on income. It is directly related to the level of income. It increases as income increases. However, there is always some minimum level of C (consumption) irrespective of level of Y. Also, increase in C tends to lag behind the increase in Y. Because, after certain level of Y is reached, people start saving a part of Y. As shown below:

Y(Rs)	C (Rs)
0 20 40 60 80 100 120	30 35 40 45 50 55 60

The above table shows:

1) 30 is the minimum level of C even when Y = 0. Survival requires that C be at least 30 even with zero income. The level of consumption at zero level of income is called autonomous consumption.

Consumption Function

The amount of money spent by the people on the purchase of goods and services in order to satisfy their wants directly is called consumption expenditure. 

Consumption function or propensity to consume shows the relationship between total desired consumption spending by the households and the factors that determine it. The factors that can affect consumption of a person are income, rate of interest, wealth, liquid assets, future expectation about income, consumer credit, distribution of income, etc.

However among all the factors mentioned above Income is considered to be a major factor of propensity to consume.

Keynesian theory of consumption function, therefore, shows the functional relationship between the desired consumption expenditure and income.

Propensity to consume has two aspect:

1) Average propensity to consume

2) Marginal propensity to consume

Aggregate Demand and its components

In macroeconomics, AD (aggregate demand) refers to demand for all goods and services in the economy during a period of time (generally, one year).

AD is measured in terms of expenditure on all the goods and services in the economy during a period of time.

Simple Keynesian model of income determination states that an economy’s total income in the short – run is determined by desired aggregate demand or aggregate spending of the people. The more is the desired demand of the people, more amount of goods and services that firms can sell. The more goods and services firms can sell, the more output they will like to produce and more workers they will employ.

Components of AD

Aggregate demand is the total amount of goods and services demanded in the economy. It refers to the desired intended or planned demand or spending by the people, i.e. the total amount of goods and services they would like to purchase.

Short run equilibrium of the firm perfect competition

The short-run equilibrium of the firm can be illustrated by combining the short-run cost curve with 
the demand curve (AR curve) faced by the firm.Since the firm is price- taker, it has to decide 
the amount of output it should produce at the given price so as to maximise its profits.
Thus, the firm is output adjuster under perfect competition.
In order to determine the profit maximising output, the firmhas to meet two conditions :

1) Short run marginal cost curve = Marginal revenue, and SMC curve cuts the MR curve from below.

Since in perfect competition MR = AR = price (p), it follows that SMC = P.

This is the profit maximisation rule.
2) Perfect competition firms may be earning super-normal profits, incurring losses or 
just earning normal profits.Whether a firm makes abnormal profits or normal profits or losses 
depends on its cost and revenue conditions.Three equilibrium conditions can be seen.

a) AR > SAC, it means the firm is earning abnormal or supernormal profits.

As shown by the graph above, as short run average cost is below the P = AR = MR 
line at equilibrium, the firm earns super – normal  or pure profits as shown by the shaded area.

As the firm is covering all its cost thereby earning abnormal profits.

b) AR < SAC (but > AVC), then the firm is incurring losses

If the AR (P) > AVC, then he is covering entire variable costs and part of fixed costs as well. 

Here, losses in production would be less than losses in case of shut down, and the firm will definitely produce.

As shown by the below graph:

As explained above, SAC lies above the price ( P= AR= MR), the firm is incurring losses shown by the shaded area. Since price exceeds AVC, the firm continues to produce in the short run (since loss is of fixed factors only so continue production) 

c) AR = SAC, it means firm is making only normal profits.

As shown by the graph above, SAC is tangent to P = AR = MR line, the firm covers 
only its SAC,which includes normal profits. The firm, therefore earns normal profits 
(no profit no loss situation)

Short run supply curve of the firm in perfect competition

In a state of perfect competition, price is given to a firm.

Implying that, AR is constant for different levels of firm’s output.

Constant AR implies that AR=MR, 

so that the equilibrium condition that MR=MC can also be stated as P=MC.

At a given Price (P) a firm strikes its equilibrium when P=MC and MC is rising. Supply curve of the 
firm shows that various quantities of a commodity a firm is willing to supply at different prices.

The quantity which a firm is willing to supply at a particular price is determined by the equality 
of SMC and MR (=AR=P). By finding out equilibrium output at different prices and by joining 
different equilibrium points we an derive the short-run supply curve of the firm as shown by the 
below graph:

1) At P_o price (P_o = AR_o = MR_o), SMC curve cuts MR_o from below at E_o, giving  E_o as 
the equilibrium point and OQ_o as the equilibrium quantity. 
At P_o price, firm is able to cover only variable cost since P=AVC.
The firm will not operate below this point and stop production since P <  AVC (firm is unable to 
cover variable as well as fixed cost). 
Eo is known as shut-down point because the firm would not like to operate below this.

OQ_o is the minimum supply of the firm in the short run.

2) If the price rises to P₁, equilibrium point shifts to E₁, where SMC = MR, and AR = SAC, and the 

equilibrium quantity increases to Q₁.

Point E₁, where SMC curve cuts the minimum point of SAC, is known as ‘break-even point’ 

because the firm is able to cover all costs at OP₁ price.

Firm is just covering all its cost i.e. AR = AC.

At P₁ price the firm will supply OQ₁ quantity.

3) At P₂ and P₃ prices, equilibrium is at E₂ and E₃ respectively, and the amount supplied is OQ₂ and 

OQ₃ respectively. While producing OQ₂ and OQ₃ quantities of output, the firm is earning super 

normal profits since AR > SAC.

4) By joining E_o, E₁, E₂ and E₃, we get the firm’s short run supply curve.

The part of short run MC curve which lies above the minimum point of AVC curve is the 

supply curve of the firm in the short run.

Supply curve of the firm in the short run is always upward sloping. 

Break even point and shut down point

Break-even point

Break even is said to occur when:

TR = TC

Or, TR / Q = TC / Q

Or, P = AC

A firm is just covering all its costs

break even point

Break – even occurs at point Q. Here AR (price) = AC= or TR = TC. The firm is just making normal profits.

AC = LQ = OP

A firm is just covering its costs as price (=OP) happens to be equal to AC (average cost) = LQ

It is a situation of  no - profit no - loss situation.

Marginal revenue and Marginal cost approach

The second method of showing equilibrium of the firm is in terms of marginal revenue and marginal cost curves.

There are three condition that must be satisfied for the profits to be maximum.

Rule 1 :

In the short run, a firm should produce 

if and only if P or AR > AVC  OR TR > TVC

1) A firm has to incur fixed cost even if there is no production, firm sometimes continues to produce even when it is facing losses.

If a firm decides to shut down and produce nothing, the losses would be equal to its fixed cost.

2) A profit earning firm will never lose more than its fixed cost, if the revenue is so low that the firm is unable cover its variable cost, to avoid this cost a firm can stop (cease) production, but if the firm still has the capital to resume production later, 

so this is a situation of Shut down ( a firm produce no output to minimise its lose).

Producer Equilibrium

Producer’s Equilibrium refers to a situation of ‘profit maximization’.

A producer strikes his equilibrium at that level of output where profit is maximized.

Any other output will yield lower profit.

Profit is calculated as the difference between TR (Total revenue) and TC (Total cost)

Profit = TR – TC

Profit maximization rules are also the rules of equilibrium of a firm.

These rules of a firm are common to all the firms operating under different market structure.

There are two ways of explaining how a firm reaches its equilibrium level of maximizing profits:

1) Total revenue and Total cost approach

2) Marginal revenue and Marginal cost approach

Market Structure Oligopoly

It is a form of the market in which there are a few big sellers of a commodity and a large number of buyers. Each seller has a significant share of the market.

There is a high degree of interdependence among the sellers regarding their price and output policy.

When the number of sellers of a product is two to ten, it is a situation of oligopoly market.

For example goods like automobolies, electronic products and many of the consumer products like baby foods, vegetables oils, soft drinks, etc.

There are only a few auto-producer in the Indian market. Maruti, Tata, Fiat, Ford and GM are well known brand names.

Features of Oligopoly

1) Few Firms :

A few firms, but large in size, dominate the market for a commodity.

Each firm commands a significant share of the market, it can impact market price of  the product.

Market Structure Monopolistic Competition

Both Monopoly and Perfect Competition market structure are rarely found in actual practice.

In the real world it is imperfect competition which dominates the market structure.

The main form of imperfect competition is Monopolistic Competition.

It is a form of market in which there are many sellers of the product, but the product of each seller is somewhat different from that of the other.

Thus, there are many sellers, selling a differentiated product.

For example: firms producing different brands of toothpastes like Colgate, Pepsodent, close –up etc.

Monopolistic Competition combines the features of monopoly and perfect competition.

Trademark gives monopoly power to the firms also since many firms are producing a commodity (like toothpaste) there is a competition in the market.

In view of the blending  of monopoly and competitive elements, this type of market has a Partial Control over price of their product.

It is only through product differentiation that a monopolistic competitive firm enjoys partial control over price.

Difference in design, colour or even packing of the product attracts buyers to buy a particular product even at a relatively higher price.

But full control over price is ruled out because

a) there are competitors in the market, and

b) there is a large number of close substitutes

Market Structure Monopoly

The term monopoly is derived from two greek words, ‘monos’ means single and ‘polus’ means a seller.
Thus, monopoly is a market structure in which there exists only a single seller of a product who is the sole producer of the product which has no close substitutes.

For example, Railways in India are a monoply industry of the government of India.

Since there is only one producer of a product in the market, the distinction between ‘firm’ and industry disappears.

Also electricity in India are a monoply industry of the government of India.

Features of Monopoly

1) One seller and large number of seller :

Under monopoly, there is a single producer of a commodity.

He may be alone, or there may be a group of parteners or a joint stock company or state.

However, there is a large number of buyers of the product.

Since there is only one seller, any change in the amount of output produced by the monopolist would have significant influence over the market price.

As the number of buyers are large, so no buyer can influence the price of the product under monopoly.

Market Structure Perfect Competition

Perfect competition is a market structure in which there are large number of producers (firms) producing a homogeneous product  that no individiual firm can influence the price of the commodity.

In this type of market price is detemined by the industry, i.e. by all the firms taken together, by the forces of demand and supply, a single firm cannot affect the price of the commodity.

Features of perfect competition

A perfectly competitive market structure shows the following features.

1) Large number of buyers and sellers :

A perfectly competitive market is dominated by a large number of buyers as well as sellers.

It means that there is no such buyer or seller in the market whose purchase or sale is so large as to impact the total sale or purchase in the market.

Each buyer/seller has only a fractional share in the market demand/market supply.

Since price is determined by the forces of market demand and market supply, no individiual buyer or seller has any control on it. 

Each buyer/seller has to accept the price as it is in the market.

Therefore, it is said that a firm under perfect competition is a price taker not a price maker.

Behaviour of Revenue Monopoly

A firm under monopoly is required to reduce the price if it wants to sell more.

A monopolist by definition is price taker.

Being a single seller of the product in the market, he can fix whatever price he wishes to.

But he can sell more only if he lowers the price of his product.

Thus, there is a negative relationship between price of the product and demand for the product in a monopoly market.

Thus firms demand curve or AR curve (price line) slopes downwards.

Tabular Relationship between TR, AR and MR under Monopoly

Units of output (Q)	Price / AR  ( P)	TR	MR (TRn- TRn-1)
1 2 3 4 5 6 7	20 18 16 14 12 10 8	20 36 48 56 60 60 56	20 16 12 8 4 0 -4

Behaviour of Revenue

We distinguish between two types of market situation in this situation

1) Perfectly competitive market

2) Imperfectly competitive market

The behaviour of Toal revenue, Average revenue and Marginal revenue will be different in the two types of market.

Relationship between TR, AR and MR under Perfect Competition

A firm under perfect competition is able to sell additional units of output at the ruling price. It is not required to reduce the price to sell more.

Reason:

As perfect competition is a market structure where there are large number of firms, so increase or decrease in production by any one firm do not affect in total supply in the whole market and also on price.

The collective force of demand and supply determines price in perfect competition which prevails in the market.

So each firm sells at the prevailing price (so do not reduce the price to sell more).

So firms are price taker and their demand curve is perfectly elastic.

Tabular Relationship between TR, AR and MR under Perfect Competition

Units of output (Q)	Price  ( P)	AR (TR / Q)		TR (P x Q)	MR (TRn- TRn-1)
1 2 3 4 5	10 10 10 10 10	10 10 10 10 10	10 20 30 40 50		10 – 0 = 10 20 – 10 = 10 30 – 20 = 10 40 – 30 = 10 50 – 40 = 10