Module 3: Market Structure - Detailed

Summarized Notes
1. Perfect Competition
• Definition: A market structure with many buyers and sellers trading identical
(homogeneous) products at a uniform price, with no restrictions on entry or exit.
• Key Features:
◦ Large Number of Buyers and Sellers: No single buyer or seller can
influence market price; each is insignificant.
◦ Homogeneous Products: Products are identical in quality, appearance, and
features, making them perfect substitutes. This ensures uniform pricing.
◦ Freedom of Entry and Exit: No legal or economic barriers to entering or
leaving the market, leading to normal profits in the long run.
◦ Perfect Knowledge: Buyers and sellers have complete information about
prices, quality, and market conditions.
◦ Perfect Mobility: Goods and factors of production (labor, capital) move
freely between regions and industries.
◦ No Transport Costs: Ensures uniform pricing across the market.
• Price and Output Determination:
◦ Price is determined by the intersection of market demand and supply curves
(equilibrium point E).
◦ Firms are price takers, accepting the market price (OP) and selling any
quantity at this price.
◦ Firm’s demand curve is perfectly elastic (horizontal line at OP), as they can
sell any quantity without affecting price.
◦ Average Revenue (AR) = Marginal Revenue (MR), and both coincide with
the demand curve.
◦ Equilibrium occurs where Marginal Cost (MC) equals MR, determining
output.
• Advantages:
◦ Competitive pressure keeps prices low, benefiting consumers.
◦ Resources are allocated efficiently due to competition.
◦ Standardized products eliminate the need for advertising, reducing costs.
◦ Prevents wealth concentration, as no single firm dominates.
• Examples: Agricultural markets (e.g., wheat, rice) approximate perfect competition.
2. Monopoly
• Definition: A market with a single seller controlling the entire supply of a product
with no close substitutes and significant barriers to entry.
• Key Features:
◦ Single Seller: The firm is the industry, controlling production and distribution
(e.g., Indian Railways).
◦ No Close Substitutes: The product has no alternatives that satisfy the same
need.
 ◦ Barriers to Entry: Legal restrictions, exclusive resource ownership,
proprietary technology, or economies of scale prevent new firms from
entering.
◦ Price Maker: The monopolist sets prices without competition, unlike price
takers in perfect competition.
◦ Price Discrimination: Charging different prices to different buyers (e.g.,
higher fees for richer patients) to maximize profits.
• Price and Output Determination:
◦ Equilibrium at MC = MR, where MC intersects MR from below (point E).
◦ Output (OQ) yields a price (AR) higher than average cost (AC), generating
supernormal profits (profit per unit = AR - AC).
◦ Total profit is represented by the rectangle PABC (Price - AC × Output).
◦ Government taxes may reduce profits; losses are rare, and a loss-making
monopolist may shut down.
◦ Normal profit or loss scenarios are shown in diagrams (AR = AC for normal
profit; AC > AR for loss).
• Advantages:
◦ Economies of Scale: Large-scale production lowers costs, potentially
benefiting consumers if prices are regulated.
◦ Full capacity utilization minimizes resource wastage.
◦ Absolute price-setting power maximizes profits.
◦ Fewer product varieties reduce production costs (e.g., fewer car models).
• Regulation of Monopoly:
◦ Antitrust Laws: Prevent mergers and break up monopolies (e.g., India’s
MRTP Act).
◦ Price Regulation: Government sets price ceilings (e.g., for utilities like water,
electricity).
◦ Public Ownership: Government takes over the monopoly to prioritize public
welfare.
• Related Concepts:
◦ Bilateral Monopoly: One seller and one buyer, both monopolists, negotiating
terms.
◦ Dumping: Selling at lower prices internationally to clear stock or gain market
share.
3. Monopolistic Competition
• Definition: A market with many sellers offering differentiated products that are close
substitutes, competing through product differentiation.
• Key Features:
◦ Large Number of Buyers and Sellers: Fewer sellers than perfect competition
but still many, each with limited market influence.
◦ Product Differentiation: Products vary in color, shape, quality, or packaging,
giving firms some monopoly power (e.g., different toothpaste brands).
◦ High Selling Costs: Firms invest heavily in advertising and promotions to
highlight product differences.
◦ Freedom of Entry and Exit: No barriers, ensuring normal profits in the long
run as new firms enter or loss-making firms exit.
◦ Imperfect Knowledge: Buyers and sellers lack complete information about
prices, quality, or costs.
 • Price and Output Determination:
◦ Equilibrium at MC = MR, with MC rising at the equilibrium point (E).
◦ Short Run: Firms may earn supernormal profits (AR > AC) or incur losses
(AC > AR). Profit per unit is AR - AC; total profit is rectangle PABC.
◦ Long Run: Entry of new firms reduces demand (AR curve shifts down),
leading to normal profits (AR = AC, curves tangent).
◦ Losses minimized at MC = MR; exiting firms increase demand for remaining
firms, shifting AR upward to normal profit.
• Examples: Soft drinks, bath soaps, toothpaste, where brands compete through
differentiation.
• Advantages:
◦ Variety of products caters to diverse consumer preferences.
◦ Competition drives innovation in product features.
• Disadvantages:
◦ High selling costs increase prices.
◦ Excess capacity due to differentiation reduces efficiency.
4. Oligopoly
• Definition: A market with a few firms producing similar or differentiated products,
characterized by interdependence and strategic behavior.
• Key Features:
◦ Few Sellers: Limited number of firms, each significant enough to affect the
market.
◦ Interdependence: One firm’s actions (e.g., price cut) prompt reactions from
others, creating strategic competition.
◦ No Barriers to Entry: Firms can enter or exit, though high initial costs or
brand loyalty may deter entry.
◦ Product Types: Homogeneous (perfect oligopoly, e.g., steel) or differentiated
(imperfect oligopoly, e.g., cars).
◦ High Selling Costs: Heavy spending on advertising and promotions to capture
market share.
◦ Price Leadership: One dominant firm sets prices, followed by others (e.g., in
telecom).
• Price and Output Determination (Kinked Demand Curve):
◦ Developed by Paul Sweezy (1939) to explain price rigidity in oligopolies.
◦ Assumptions:
▪ If a firm raises prices, competitors don’t follow, leading to significant
demand loss (elastic upper demand curve).
▪ If a firm lowers prices, competitors match, limiting demand gain
(inelastic lower demand curve).
◦ Kinked Demand Curve: A kink at the current price (point K), with elastic
demand above and inelastic below.
◦ MR Discontinuity: A gap in the Marginal Revenue curve (between points S
and R) stabilizes price and output.
◦ Equilibrium output (OQ) remains unchanged even if costs rise (MC shifts
from mc1 to mc2), as long as MC intersects MR within the gap.
• Collusion and Cartel:
◦ Cartel: Formal agreement among firms to fix prices or output (e.g., OPEC).
Highly organized and legal in some contexts.
 ◦ Collusion: Informal, secretive agreement to limit competition and raise prices.
Less structured and often illegal.
◦ Both increase monopoly power and profits but differ in formality and
transparency.
• Non-Price Competition:
◦ Firms avoid price wars and compete through:
▪ Product Differentiation: Unique features (e.g., packaging, quality).
▪ Promotion/Advertising: Branding, loyalty programs, or persuasive
ads.
◦ Examples:
▪ Loyalty Cards: Reward repeat customers (e.g., airline miles,
supermarket points).
▪ Subsidized Delivery: Free shipping (e.g., Amazon) to attract online
shoppers.
▪ After-Sales Service: Enhances reputation and customer retention.
▪ Advertising/Branding: Builds brand loyalty, creating entry barriers.
▪ Good Reviews: Encourages positive online feedback to boost sales.
▪ Coupons/Free Gifts: Attracts customers without lowering base prices.
◦ Increases selling costs, raising average production costs but boosting market
share.
• Examples: Car manufacturing, telecom, petroleum (OPEC).
5. Product Pricing Strategies
• Cost Plus (Markup) Pricing:
◦ Price = Average Cost (AC) + Markup (m, typically 10%).
◦ Simple and convenient; used when competition is low.
◦ Limitation: Ignores demand and competition, unsuitable for dynamic
markets.
• Target Return Pricing:
◦ Similar to cost plus, but markup is calculated based on a desired rate of return.
◦ Considers consumer purchasing power, market risks, and firm experience.
◦ More rational than arbitrary markup setting.
• Penetration Pricing:
◦ Sets a low price to enter a competitive market and gain market share (e.g.,
Reliance in mobile phones).
◦ Short-term strategy; success depends on high price elasticity of demand.
◦ Attracts price-sensitive customers but risks low profits initially.
• Predatory Pricing:
◦ Dominant firm sets prices below cost to drive competitors out or deter new
entrants.
◦ Expects future monopoly profits to offset current losses.
◦ Anti-competitive: Harms consumers long-term and may violate competition
laws.
• Going Rate Pricing:
◦ Firm adopts the prevailing market price set by a dominant firm or industry
norm.
◦ Used for close substitutes with high cross-elasticity (e.g., bottled water).
◦ Avoids price wars and suits mature, generic products.
• Price Skimming:
 ◦ High price at product launch to target high-income, status-conscious buyers.
◦ Price reduced during maturity to attract broader, price-sensitive customers.
◦ Maximizes early profits and captures different market segments over time.
• Administered Pricing:
◦ Monopolist Context: Monopolist sets prices freely as a price maker.
◦ Indian Context: Government fixes prices for essential goods (e.g., cooking
gas) to serve social interests, overriding market forces.
6. Additional Concepts
• Bilateral Monopoly: One seller (monopolist) and one buyer (monopsonist) negotiate
terms, both reliant on each other.
• Duopoly: A market with only two sellers, a special case of oligopoly (e.g., Boeing
and Airbus in large aircraft).
• Price Discrimination: Charging different prices for the same product to different
buyers (e.g., lower electricity rates for domestic use vs. commercial).
• Dumping: Selling at lower prices in international markets to clear excess stock,
increase market share, or undercut competitors.
Comparison of Market Structures
Perfect Monopolistic
Feature Monopoly Oligopoly
Competition Competition
Number of
Many One Many Few
Sellers
Product Unique, no Homogeneous or
Homogeneous Differentiated
Type substitutes Differentiated
Entry
None High None None/Low
Barriers
Selling Costs None None High High
Demand Perfectly
Less elastic More elastic Indeterminate (kinked)
Curve elastic
Price
Price taker Price maker Limited control Interdependent
Control

Module 4: Macroeconomic Concepts -

Detailed Summarized Notes
1. Circular Flow of Income
• Definition: A model illustrating the interdependence and flows (real and monetary)
between economic sectors.
• Types of Flows:
◦ Real Flows: Factors of production (land, labor) from households to firms;
 goods and services from firms to households.
◦ Money Flows: Factor payments (wages, rent) from firms to households;
consumption expenditure from households to firms.
• Two-Sector Model (Households and Firms):
◦ Households provide factor services to firms, receiving factor payments (rent,
wages, interest, profit).
◦ Households spend income on goods/services from firms, completing the cycle.
◦ Diagram: Factor market (upper part) shows factor services and payments;
commodity market (lower part) shows goods/services and expenditure.
◦ Equation: Factor payments = Household income = Consumption expenditure.
• Three-Sector Model: Adds government sector, which receives taxes, makes transfer
payments, and spends on goods/services.
• Four-Sector Model: Includes households, firms, government, and foreign sector.
◦ Households: Provide factors to firms, government, and foreign sector; receive
factor payments, transfer payments; spend on goods, taxes, imports.
◦ Firms: Receive revenue from households, government, foreign sector; pay for
factors, taxes, imports; receive subsidies.
◦ Government: Collects taxes, sells goods/services; spends on factor payments,
transfers, subsidies.
◦ Foreign Sector: Earns from exports; spends on imports and factor payments
to households.
• Significance:
◦ Highlights inter-sectoral interdependence.
◦ Facilitates national income estimation.
2. Stock and Flow Concepts
• Stock: A quantity measured at a specific point in time (no time dimension).
◦ Examples: Capital, money quantity, wealth.
◦ Static concept.
• Flow: A quantity measured over a period (has time dimension).
◦ Examples: Income, expenditure, production, consumption.
◦ Dynamic concept.
• Relationship:
◦ Stock influences flow (e.g., larger capital stock increases output flow).
◦ Flow influences stock (e.g., monthly money supply increases money stock).
• Comparison:
◦ Stock: Point-in-time, no time dimension, static.
◦ Flow: Period-based, time dimension (hour, day, year), dynamic.
3. Final and Intermediate Goods
• Final Goods:
◦ Goods used for direct consumption or investment, requiring no further
processing.
◦ Examples: Shoes, tractors.
◦ Included in national and domestic income.
◦ Crossed production boundary.
• Intermediate Goods:
◦ Goods used in producing other goods/services (producer goods).
 ◦ Examples: Wood for chairs.
◦ Not included in national/domestic income.
◦ Within production boundary.
• Significance: Only final goods are counted in national income to avoid double-
counting.
4. Three Sectors of the Economy
• Primary Sector: Agriculture, fishing, mining, quarrying.
• Secondary Sector: Manufacturing, transforming raw materials into goods.
• Tertiary Sector: Services like transport, communication, banking, education, health.
5. National Income
• Definition: Total money value of all final goods and services produced in a country in
a year.
◦ Reflects the nation’s economic status (Shapiro: sum of wages, rent, interest,
profit).
• Significance:
◦ Economic Welfare: Higher per capita income indicates better living
standards.
◦ Economic Structure: Shows sector contributions (e.g., agriculture, industry).
◦ Economic Policy: Guides planning and policy formulation.
◦ Grants-in-Aid: Helps allocate funds in federal systems.
◦ Underdeveloped Countries: Analyzes sectoral backwardness.
Measurement Methods

1 Product (Value Added) Method:

◦ Calculates value of final goods/services produced.
◦ Steps:
▪ Classify production units into primary, secondary, tertiary sectors.
▪ Estimate Gross Value Added (GVA) by each unit/sector: GVA =
Gross Value of Output (GVO) - Intermediate Consumption.
▪ Sum GVA to get GDP at Market Price (GDPMP).
▪ Add Net Factor Income from Abroad (NFIA) to get GNPMP.
▪ Subtract depreciation to get NNPMP.
▪ Subtract Net Indirect Tax (NIT = Indirect Tax - Subsidies) to get
NNPFC (National Income).
◦ Formulae:
▪ GDPMP = Σ GVA
▪ GNPMP = GDPMP + NFIA
▪ NNPMP = GNPMP - Depreciation
▪ NNPFC = NNPMP - NIT
2 Income Method:
◦ Sums incomes of all factors of production.
◦ Steps:
▪ Classify production units into sectors.
 ▪ Classify factor incomes: Compensation of Employees (wages,
salaries), Operating Surplus (rent, interest, profit), Mixed Income (self-
employed).
▪ Estimate factor incomes per sector, summing to get NDPFC (Domestic
Factor Income).
▪ Add NFIA to get NNPFC (National Income).
◦ Formulae:
▪ NDPFC = Compensation of Employees + Operating Surplus + Mixed
Income
▪ NNPFC = NDPFC + NFIA
3 Expenditure Method:
◦ Sums expenditure on final goods/services.
◦ Steps:
▪ Identify components: Private Consumption (C), Government
Consumption (G), Investment (I), Net Exports (X - M).
▪ Estimate total expenditure: GDPMP = C + I + G + (X - M).
▪ Add NFIA to get GNPMP.
▪ Subtract depreciation for NNPMP, then NIT for NNPFC.
◦ Formulae:
▪ GDPMP = C + I + G + (X - M)
▪ GNPMP = GDPMP + NFIA
▪ NNPMP = GNPMP - Depreciation
▪ NNPFC = NNPMP - NIT
National Income Concepts

• Gross Domestic Product (GDP): Total value of final goods/services produced

domestically.
◦ GDPMP = GDPFC + NIT
◦ GDPFC = GDPMP - NIT
• Gross National Product (GNP): GDP + NFIA.
◦ GNPMP = GNPFC + NIT
• Net National Product (NNP): GNP - Depreciation.
• NNP at Factor Cost (NNPFC): National Income; total factor earnings (wages, rent,
interest, profit) + NFIA.
• Personal Income (PI): Total household income from all sources before direct taxes.
• Disposable Personal Income (DPI): PI - Direct Taxes.
• Per Capita Income (PCI): National Income / Population.
Difficulties in Measurement

• Inadequate statistical data in developing countries.

• Illiteracy among farmers, leading to poor record-keeping.
• Lack of occupational specialization; multiple income sources.
• Production for self-consumption, hard to value.
• Non-monetized sector (barter transactions).
 • Issues like black money and price changes.
Numerical Examples

1 Example 1 (Value Added, Expenditure, Income Methods):

◦ Data (Rs. Crores): GVOMP = 8000, Intermediate Consumption = 2000,
Private Consumption = 3000, Investment = 2000, Govt. Expenditure = 700,
Exports = 600, Imports = 300, Depreciation = 1000, NFIA = -500, Indirect
Tax = 800, Subsidies = 300, Wages = 2000, Rent = 500, Interest = 500, Profit
= 1500.
◦ Value Added Method:
▪ GDPMP = GVOMP - Intermediate = 8000 - 2000 = 6000
▪ NDPMP = GDPMP - Depreciation = 6000 - 1000 = 5000
▪ NNPMP = NDPMP + NFIA = 5000 + (-500) = 4500
▪ NNPFC = NNPMP - NIT (800 - 300) = 4500 - 500 = 4000
▪ National Income = Rs. 4000 Crores
◦ Expenditure Method:
▪ GDPMP = C + I + G + (X - M) = 3000 + 2000 + 700 + (600 - 300) =
6000
▪ Follow same steps as above: National Income = Rs. 4000 Crores
◦ Income Method:
▪ NDPFC = Wages + Rent + Interest + Profit = 2000 + 500 + 500 + 1500
= 4500
▪ NNPFC = NDPFC + NFIA = 4500 + (-500) = 4000
▪ National Income = Rs. 4000 Crores
2 Example 2 (Bicycle Company):
◦ Data: 100 bicycles sold at Rs. 2500 each, Tax = Rs. 300/unit, Foreign Profit =
Rs. 500/unit, Depreciation = Rs. 20,000.
◦ GDPMP: Price × Quantity = 2500 × 100 = Rs. 2,50,000
◦ National Income:
▪ NNPFC = GDPMP - Depreciation + NFIA - NIT
▪ NFIA = -500 × 100 = -50,000 (profit outflow)
▪ NIT = 300 × 100 = 30,000
▪ NNPFC = 2,50,000 - 20,000 + (-50,000) - 30,000 = Rs. 1,50,000

6. Inflation
• Definition: Persistent rise in general price level; too much money chasing too few
goods (Coulborn); falling money value (Crowther).
• Types:
◦ Creeping: <3% p.a., mild, good for growth.
◦ Walking: 3-10% p.a., warning signal.
◦ Running: 10-20% p.a., requires strong measures.
◦ Hyper/Galloping: >20-100% p.a., runaway inflation.
◦ Stagflation: Stagnation + inflation (inflationary recession).
◦ Reflation: Deliberate price increase to stimulate economy during depression.
◦ Deflation: Continuous price decline, linked to depression/unemployment.
• Features:
◦ Uninterrupted price increase.
◦ Monetary phenomenon (excess money supply).
◦ Economic phenomenon (interaction of forces).
◦ Can be demand-pull or cost-push.
◦ Essence: Excess demand relative to supply.
• Theories:
◦ Demand-Pull Inflation:
▪ Aggregate demand exceeds supply at current prices.
▪ Keynesian Diagram: AD shifts up (AD to AD1), price rises (P to P1),
output increases to full employment (YF). Beyond YF, AS is inelastic,
so only prices rise.
◦ Cost-Push Inflation:
▪ Rising production costs (wages, profits, raw materials) reduce supply.
▪ Diagram: AS shifts left (AS1 to AS2), price rises (P to P1), output
falls (YF to Y).
▪ Causes: Wage-push (union power), profit-push (business monopoly),
material-push (supply shocks).
• Causes:
◦ Demand-Side:
▪ Increased money supply (more cash, higher spending).
▪ Higher disposable income (per capita income rise, tax cuts).
▪ Government expenditure (expansionary fiscal policy).
▪ Deficit financing (printing money).
▪ Population growth (more buyers).
◦ Supply-Side:
▪ Scarcity of factors (labor, capital, raw materials).
▪ Wage increases (higher production costs).
▪ Increased exports (less domestic stock).
▪ Natural calamities (reduced production).
▪ Trade union strikes, wars, industrial disputes (lower supply).
• Effects:
◦ Production/Investment:
▪ Misallocation of resources (shift to non-essential goods).
▪ Reduced production (cost uncertainty).
▪ Hoarding creates artificial scarcity.
▪ Encourages speculation over production.
▪ Lower savings (reduced purchasing power).
▪ Discourages foreign capital (high costs).
◦ Income/Wealth Distribution:
▪ Debtors gain, creditors lose (lower money value).
▪ Wage earners lose (wages lag prices).
▪ Businessmen gain (higher profits).
▪ Share investors gain, bondholders lose (fixed returns).
▪ Government faces higher expenditure.
◦ Non-Economic:
▪ Social: Widens rich-poor gap, creates tension.
▪ Moral: Promotes black marketing, adulteration.
▪ Political: Corrupts politicians, weakens discipline.
 • Control Measures:
◦ Monetary Policy (Central Bank):
▪ Increase Bank Rate: Raises commercial bank interest rates, reduces
borrowing, lowers money supply.
▪ Open Market Operations: Selling government securities reduces
bank cash, limits credit.
▪ Cash Reserve Ratio (CRR): Higher CRR reduces bank lending
capacity.
▪ Statutory Liquidity Ratio (SLR): Higher SLR limits credit creation,
ensures bank solvency.
◦ Fiscal Policy (Government):
▪ Reduce Public Expenditure: Cuts demand for goods/services.
▪ Increase Taxes: Reduces disposable income, lowers spending.
▪ Public Borrowing: Absorbs excess purchasing power.
▪ Control Deficit Financing: Minimizes money printing.
◦ Direct Measures:
▪ Increase Supply: Import essentials, ban exports, boost production.
▪ Price Control: Fix maximum prices for essentials.
▪ Rationing: Limit quantities of scarce goods.
▪ Wage Control: Prevents cost-push inflation.
7. Business Financing
• Sources:
◦ Internal Self-Finance: Savings from households, businesses (depreciation,
retained earnings), government.
◦ Equity, Debentures, Bonds: Equity (shares) for ownership; debentures/bonds
for fixed-interest loans.
◦ Public Deposits: Short-term debt for working capital, but unreliable.
◦ Bank Loans: Short-term loans, overdrafts, or debenture purchases.
◦ Indigenous Bankers: High-interest loans, mainly for small industries.
◦ Development Finance Institutions: E.g., IDBI, IFCI, provide large-scale
industrial finance.
• Shares vs. Bonds:
◦ Shares: Ownership stake, high risk, variable dividends, no maturity.
◦ Bonds: Loan to company, low risk, fixed interest, repaid at maturity.
◦ Comparison:
▪ Shares: Issued by companies, uncertain returns, depend on share price.
▪ Bonds: Issued by government/companies, certain returns, full
repayment.
8. Money and Capital Markets
• Money Market:
◦ Short-term credit market for liquid assets (treasury bills, bills of exchange).
◦ Functions:
▪ Finances trade (bills of exchange).
▪ Supports industry (working capital).
▪ Enables profitable investment of excess reserves.
▪ Ensures financial mobility.
 ▪ Promotes economic growth.
• Capital Market:
◦ Long-term funds market for stocks, bonds, debentures.
◦ Functions:
▪ Allocates savings to productive investments.
▪ Encourages saving and investment.
▪ Promotes economic growth via resource allocation.
▪ Acts as economic barometer (share price movements).
◦ Sub-Markets:
▪ Primary (New Issue) Market: New securities issued.
▪ Secondary (Stock Exchange) Market: Trading existing securities.
◦ Primary vs. Secondary:
▪ Primary: New issues, no fixed organization, one-time sale, company-
to-investor.
▪ Secondary: Existing securities, organized exchanges, continuous
trading, investor-to-investor.
9. Stock Market
• Definition: Organized marketplace for trading stocks, shares, securities (secondary
market).
• Functions:
◦ Ensures liquidity (easy conversion to cash).
◦ Provides continuous market for long-term funds.
◦ Ensures safe dealings (regulated by Securities Contract Act, 1956).
◦ Supplies long-term funds (transferable securities).
◦ Promotes investment via capital formation.
◦ Directs capital to profitable companies (price reflects profitability).
◦ Reflects business cycles (booms/depressions).
• Problems in India:
◦ Lack of integration among exchanges, causing price fluctuations.
◦ Investor interests ignored, favoring brokers.
◦ Weak management structure.
◦ Non-uniform settlement systems.
◦ Discretionary margins on speculative transactions.
• Transactions:
◦ Stages:
▪ Place order with broker (fixed price, limit, discretionary, immediate/
cancel).
▪ Execute order in relevant exchange section.
▪ Report deal via contract note (details price, commission, settlement
date).
▪ Settle transaction (ready delivery: 1-7 days; forward delivery: fixed
future date).
◦ Speculative Transactions:
▪ Spot: Same-day delivery/payment.
▪ Ready: Delivery/payment within 1-7 days.
▪ Forward: Settlement on fixed days (15th/30th).
• Demat and Trading Accounts:
 ◦ Demat Account: Holds securities electronically, eliminating physical
certificates.
◦ Trading Account: Facilitates buying/selling securities via a broker.
• SENSEX and NIFTY:
◦ SENSEX: Index of 30 major stocks on Bombay Stock Exchange (BSE).
◦ NIFTY: Index of 50 stocks on National Stock Exchange (NSE).
◦ Both reflect market performance and economic trends.
10. Monetary Policy Tools
• Repo Rate: Rate at which RBI lends short-term funds to banks against securities.
◦ Increase in repo rate raises borrowing costs, controls inflation.
• Reverse Repo Rate: Rate at which RBI borrows from banks.
◦ Lower than repo rate, controls money supply.
• Bank Rate: Rate for long-term loans without securities (vs. repo’s short-term).
• Comparison:
◦ Repo: Banks borrow from RBI, higher rate, inflation control.
◦ Reverse Repo: RBI borrows from banks, lower rate, money supply control.

Module 5: International Trade - Detailed

Summarized Notes
1. Introduction to International Trade
• Definition: Exchange of goods and services between countries (Penguin Dictionary,
Anatol Murad).
◦ Internal Trade: Within a country’s regions.
◦ International Trade: Across national borders.
• Distinction from Domestic Trade:
◦ Involves different currencies, trade policies, and regulations.
◦ Affected by international relations and global economic conditions.
◦ Requires customs procedures and trade barriers.
2. Basis of International Trade
• International Specialization: Countries produce goods where they have resource
advantages (e.g., natural resources, labor).
• Non-Availability of Specific Factors: Countries lack certain resources, necessitating
imports (e.g., oil for non-oil-producing nations).
• Difference in Costs: Variations in production costs across countries drive trade.
• Comparative Cost Difference: A country produces goods where its cost advantage is
greatest, even if it can produce all goods cheaper than others.
 • Product Differentiation: Importing varieties of goods (e.g., India imports cloth
despite producing it) to meet diverse consumer preferences.
3. Advantages of International Trade
1 Optimal Use of Resources: Countries focus on goods suited to their resources,
minimizing waste.
2 Availability of Goods: Access to diverse global products.
3 Large-Scale Production: Exports expand markets, enabling economies of scale and
cost reductions.
4 Price Stability: Global availability prevents sharp price fluctuations.
5 New Industries: Importing technology/machinery fosters industrial growth.
6 Increased Efficiency: International competition drives quality improvements and cost
efficiency.
7 Employment Opportunities: Trade expansion creates jobs domestically and abroad.
8 International Cooperation: Promotes cultural exchange, ideas, and cordial relations
among nations.
4. Disadvantages of International Trade
1 Threat to Domestic Industries: Foreign competition can harm infant or less
competitive industries.
2 Economic Dependence: Underdeveloped nations rely on developed ones, risking
exploitation.
3 Resource Depletion: Excessive exports can exhaust natural resources.
4 Endangers Independence: Over-reliance on trade may impair economic sovereignty.
5 Harmful Goods: Imports of substandard or harmful products can affect public health.
5. Commercial/Foreign Trade Policy
• Free Trade: No restrictions on goods/services exchange; non-discriminatory
(Bhagawati: no tariffs, quotas, or subsidies).
• Protection: Policies to shield domestic industries via tariffs, subsidies, or restrictions.
Case for Free Trade

1 Maximizes Output: Specialization in comparative advantage increases global

production.
2 Optimal Resource Use: Imports offset factor shortages, reducing waste.
3 Higher Factor Incomes: Factors move to higher-paying regions, increasing wages,
rent, etc.
4 Optimized Consumption: Access to cheaper, diverse goods enhances consumer
welfare.
5 Prevents Monopolies: Global competition curbs exploitative monopolies.
6 Develops Transport/Communication: Expands global infrastructure for trade.
7 Educative Effects: Competition drives innovation and productivity (Haberler).
8 Economic Growth: Underdeveloped nations import capital goods, boosting
development.
9 Promotes Cooperation: Interdependence fosters international harmony.
Case Against Free Trade

1 One-Sided Development: Over-specialization neglects other industries.

 2 Curtails Social Welfare: Harmful/substandard goods may enter markets.
3 Economic Dependence: Backward nations rely on imports, risking exploitation.
4 Harmful Imports: Unrestricted imports of dangerous goods.
5 Exploitation of Poor Countries: Advanced nations’ superior technology harms
poorer nations’ industries.
6 Infant Industry Protection: Backward nations need trade barriers to nurture new
industries.
Protection

• Definition: Policies (e.g., tariffs, subsidies) to shield domestic industries from foreign
competition (Harry G. Johnson).
• Methods: Customs duties (tariffs), bounties, or subsidies for domestic producers.
Arguments for Protection

1 Revenue Generation: Import duties provide government revenue.

2 Saves Jobs: Tariffs reduce imports, boosting demand for domestic goods and
employment.
3 Limits Harmful/Luxury Goods: Restricts imports that affect public health or morals.
4 Safeguards National Security: Ensures self-sufficiency in critical goods during
emergencies.
5 Conserves Resources: Prevents over-exploitation of natural resources via export
controls.
6 Keeps Money at Home: Buying domestic goods retains wealth domestically.
7 Balance of Trade: Tariffs correct trade deficits, improving balance of payments.
8 Anti-Dumping: High tariffs counter foreign dumping to protect local markets.
Arguments Against Protection

1 Lazy Producers: Lack of competition reduces innovation and efficiency.

2 Monopolies: Domestic producers may form exploitative monopolies.
3 Corruption: Protected industries may bribe officials for benefits.
4 Reduces Foreign Trade: High tariffs lower imports, reducing exports in retaliation.
5 Ignores Comparative Costs: Encourages production of less efficient goods, violating
comparative advantage.
6. Trade Barriers
• Definition: Government policies restricting free flow of goods.
• Types:
◦ Tariff Barriers: Taxes on imports/exports.
◦ Non-Tariff Barriers: Non-tax restrictions (e.g., quotas, licenses).
Tariff Barriers

• By Origin/Destination:
◦ Export Duties: Taxes on goods leaving the country.
◦ Import Duties: Taxes on goods entering the country.
◦ Transit Duties: Taxes on goods passing through a country.
• By Quantification:
◦ Specific Duties: Fixed amount per unit.
◦ Ad-Valorem Duties: Percentage of commodity value.
◦ Compound Duties: Combination of specific and ad-valorem.
 • By Purpose:
◦ Revenue Tariff: Low rates to generate government revenue.
◦ Protective Tariff: High rates to shield domestic industries.
◦ Countervailing/Anti-Dumping Tariffs: Counter subsidized or dumped
foreign goods.
Effects of Tariffs

1 Protective: Higher import costs boost demand for domestic goods.

2 Revenue: Generates government income unless imports stop.
3 Income/Employment: Increased domestic production creates jobs.
4 Balance of Payments: Reduced imports improve trade balance.
5 Consumption: Higher prices reduce purchasing power.
6 Competitive: Less competition may lead to inefficiencies.
Non-Tariff Barriers

1 Quotas: Quantitative limits on imports/exports for a period.

2 Licenses: Permits for importing specific goods.
3 Embargoes: Bans on trade with specific countries for political/economic reasons.
4 Voluntary Export Restraints: Exporting countries limit exports to others.
5 Sanctions: Administrative/customs measures to restrict trade.
7. Balance of Payments (BOP)
• Definition: Record of a nation’s economic transactions with the world over a period
(usually annual).
• Purpose: Informs governments about international currency positions for policy
formulation.
• Features:
◦ Records all transactions (visible and invisible).
◦ Uses double-entry bookkeeping (credits = debits).
◦ Equilibrium: Receipts = Payments; Surplus: Receipts > Payments; Deficit:
Payments > Receipts.
◦ Total credits and debits always balance.
Balance of Trade (BOT) vs. BOP

• BOT: Only visible goods (exports/imports); can show surplus or deficit.

• BOP: Includes visible and invisible items; always balanced.
• Scope: BOT is part of BOP’s current account; BOP includes current and capital
accounts.
Components of BOP

1 Current Account:
◦ Merchandise (Visible): Exports (credits), imports (debits).
◦ Invisibles: Services (e.g., transport, insurance), tourism, interest/dividends.
2 Capital Account:
◦ Short/long-term capital flows (e.g., investments, loans).
◦ Surplus: Credits > Debits; Deficit: Debits > Credits.
3 Unilateral Transfers:
◦ One-way transfers (e.g., remittances, aid, gifts, charitable contributions).
 ◦ Part of current account.
4 Official Reserve Account:
◦ Government-held foreign currency/securities.
◦ Increases with trade surplus, decreases with deficit.
◦ Used to stabilize exchange rates.
BOP Disequilibrium (Deficit)

• Definition: Demand for foreign exchange exceeds supply.

• Causes:
◦ Economic:
▪ Development: High imports for capital goods increase deficits.
▪ Cyclical: Booms increase imports, creating deficits.
▪ Secular: High demand/prices in developed nations boost imports.
◦ Political: Instability causes capital outflows.
◦ Social: Changing tastes/fashions affect imports/exports.
Correction of BOP Deficit

1 Automatic Correction:
◦ Exchange rate adjusts (domestic currency devalues), boosting exports,
reducing imports.
2 Deliberate Measures:
◦ Monetary:
▪ Contraction: Reduces money supply, lowering demand/prices, cutting
imports.
▪ Devaluation: Lowers currency value, making exports cheaper, imports
costlier.
▪ Exchange Control: Government controls foreign exchange to limit
imports.
◦ Trade:
▪ Export Promotion: Subsidies, duty abolition, export-oriented
facilities.
▪ Import Control: Higher duties, quotas, licensing.
◦ Miscellaneous: Attract foreign investment, promote tourism.
Devaluation

• Definition: Deliberate reduction in domestic currency value.

• Effects:
◦ Exports become cheaper, imports costlier.
◦ Example: $1 = ₹10 pre-devaluation; $1 = ₹20 post-devaluation.
▪ Exports: Foreigners pay less for Indian goods.
▪ Imports: Indians pay more for foreign goods.
• Limitations:
◦ Ineffective if other countries devalue simultaneously.
◦ Requires elastic demand for exports/imports.
◦ Signals economic weakness.
8. Theories of International Trade
1. Absolute Advantage Theory (Adam Smith)

• Concept: Countries specialize in goods where they have an absolute cost advantage.
• Example: Country A is more efficient in good X, Country B in good Y; they trade for
mutual benefit.
• Limitation: Narrow scope; doesn’t address cases with no absolute advantage.
2. Comparative Advantage Theory (David Ricardo)

• Concept: A country specializes in goods where its relative cost disadvantage is least,
even without absolute advantage.
• Assumptions:
◦ Two countries, two commodities.
◦ No trade barriers or transport costs.
◦ Labor as sole cost; homogeneous, mobile within country.
◦ Perfect competition, full employment.
• Example:
◦ England: 100 labor units (cloth), 120 (wine); 1 wine = 1.2 cloth.
◦ Portugal: 90 (cloth), 80 (wine); 1 wine = 0.88 cloth.
◦ Portugal specializes in wine (greater advantage), England in cloth.
◦ Trade benefits both if exchange ratio is between 0.88–1.2 cloth per wine.
• Criticisms:
◦ Labor not sole cost.
◦ Exchange ratios vary with demand/supply.
◦ Unrealistic assumptions (full employment, free trade).
◦ Large/small country dynamics limit specialization.
3. Heckscher-Ohlin Theorem (Factor Endowment Theory)

• Concept: Countries export goods using abundant/cheap factors and import goods
using scarce/expensive factors.
• Assumptions:
◦ Perfect competition, full employment.
◦ Factors mobile within, immobile between countries.
◦ No transport costs, same technology.
• Explanation: Comparative advantage stems from factor endowments (e.g., labor-
abundant countries export labor-intensive goods).
• Example:
◦ Country A: 50 labor, 40 capital (ratio 0.8).
◦ Country B: 16 labor, 20 capital (ratio 1.25).
◦ Country B is capital-abundant (higher capital-labor ratio), exports capital-
intensive goods.
• Factor Price Equalization (Heckscher-Ohlin-Samuelson):
◦ Trade increases demand for abundant factors, raising their prices.
◦ Reduces demand for scarce factors, lowering their prices.
◦ Substitutes for factor mobility, equalizing prices globally.
• Merits:
◦ Explains comparative cost differences via factor endowments.
◦ Highlights relative factor prices’ role in trade.
◦ Shows trade’s impact on product/factor prices.
• Effects:
 ◦ Equalizes factor prices across countries.
◦ Equalizes commodity prices via trade flows.
9. Effects of International Trade (Heckscher-Ohlin)
1 Factor Price Equalization: Specialization aligns factor prices globally.
2 Commodity Price Equalization: Goods flow from abundant to scarce regions,
balancing prices.
10. India’s Adverse BOP and Correction Measures
• Causes:
◦ High imports of capital goods for development.
◦ Oil imports due to limited domestic production.
◦ Rising consumer goods imports with growing incomes.
◦ Political instability affecting capital inflows.
◦ Global price fluctuations impacting trade balance.
• Measures:
◦ Export Promotion: Incentives, SEZs, duty exemptions.
◦ Import Controls: Higher tariffs, quotas on non-essentials.
◦ Devaluation: Periodic rupee adjustments to boost exports.
◦ Exchange Controls: RBI manages foreign exchange reserves.
◦ Foreign Investment: Policies to attract FDI.
◦ Tourism Promotion: Campaigns to earn foreign exchange.