IMPORTANT TERMS IN BUDGET THAT EVERYONE MUST KNOW

Do you get confused or stressed when you listen about the budget on business news channels or read about it in the newspapers? Do technical terms such as current account deficit, GDP, fiscal deficit,government expenditure, corporate tax, STT(securities transaction tax), abatement, etc sound intimidating to you? Listed below is a comprehensive picture of some of these technical terms.

Union Budget
The Union Budget is the annual report of India. It is an exhaustive display of the government of India’s finances. The Finance Minister puts down a report that contains Government of India’s revenue and expenditure for one fiscal year. The fiscal year runs from April 01 to March 31. It comprises the revenue budget and the capital budget. It also contains estimates for the next fiscal year.

Abatement 
Abatement is reduction of or exemption from taxes granted by a government for a specified period, usually to encourage certain activities such as investment in capital equipment. A tax incentive is a form of tax abatement.

Direct taxes
These are the taxes that are levied on the income of individuals or organisations. Income tax, corporate tax, inheritance tax are some instances of direct taxation. Income tax is the tax levied on individual income from various sources like salaries, investments, interest etc. Corporate tax is the tax paid by companies or firms on the incomes they earn.

Indirect taxes
Indirect taxes are those paid by consumers when they buy goods and services. These include excise and customs duties. Customs duty is the charge levied when goods are imported into the country, and is paid by the importer or exporter. Excise duty is a levy paid by the manufacturer on items manufactured within the country. Usually, these charges are passed on to the consumer.

Revenues & expenditure
The government’s budget comprises largely about revenues and expenditure. Government revenue is the income a government receives, while government expenditure is the money it spends. Spending or expenditure is further divided into plan and non-plan. 

Revenue receipt & expenditure 
All revenues or receipts include taxes, while expenditure consists of salaries, subsidies and interest payments. These revenue receipts and expenditure—which generally do not lead to sale or creation of assets—come under the revenue account. 

Capital receipt & expenditure 
Capital receipt is the amount received from the sale of assets, shares and debentures. Capital account includes all receipts from liquidating (for instance selling shares in a public sector company), assets and spending to create assets (for example lending to receive interest). 

Revenue budget 
The government has to prepare a revenue budget which outlines in detail revenue receipts & revenue expenditure. The revenue budget consists of revenue receipts of the government (revenues from tax and other sources), and its expenditure. 

Capital budget
The government also prepares capital budget which includes capital receipts and payments.

Capital receipts
Capital receipts are government loans raised from the public, government borrowings from the Reserve Bank and treasury bills, loans received from foreign bodies and governments, divestment of equity holding in public sector enterprises, securities against small savings, state provident funds, and special deposits.

Capital payments
Capital payments are capital expenditure on acquisition of assets like land, buildings, machinery, and equipment. Investments in shares, loans and advances granted by the central government to state and union territory governments, government companies, corporations and other parties.

Gross tax revenue 
The total tax received by the government from which it has to pay the states their share as mandated by the relevant finance commission. The balance is available to the Union government. 

Non-tax revenue 
The main receipts under the non-tax revenue are interest on loans given by the government, and dividends and profits received from PSUs. The government also earns from various services, including public services, it provides. Of this, only the Railways is a separate department, though all its receipts and expenditure are routed through the Consolidated Fund of India. 

Capital receipts
These include recoveries of loans and advances. 

Gross budgetary support 
Gross Budgetary Support is the government’s support to five-year plans, which includes state plans. The five-year plans are divided into five annual plans. The funding of the plan is split almost evenly between government support (from the budget) and internal and extra-budgetary resources of state-owned enterprises.

Plan expenditure
There are two components of expenditure—plan and non-plan. Planned expenditure is essentially the budget support to the annual plans. This is typically considered developmental spending (on health, education, infrastructure and social goals). Like all budget heads, it is also split into revenue and capital components. 

Non-plan expenditure 
This is in the nature of consumption expenditure, broadly corresponding to revenue expenditure: interest payments, subsidies, salaries, defence & pensions. Its ‘capital’ component is small, the largest chunk being defence.

Central plan outlay
It is the division of financial resources among the various sectors in the economy and the ministries of the government.

Finance Bill
The government proposals for the levy of new taxes, changes in the present tax structure or continuance of the current tax structure beyond the period approved by Parliament, are laid down before Parliament in this Bill. The Parliament approves the Finance Bill for a period of one year at a time, which becomes the Finance Act.

Public debt 
Public debt or public borrowing is considered to be an important source of income to the government. If revenue collected through taxes & other sources is not adequate to cover government expenditure government may resort to borrowing. Such borrowings become necessary more in times of financial crises & emergencies like war, droughts, etc. Public debt may be raised internally or externally. Internal debt refers to public debt floated within the country; while external debt refers loans floated outside the country.

Fiscal policy
Fiscal policy is a change in government spending or taxing designed to influence economic activity. These changes are designed to control the level of aggregate demand in the economy. Governments usually bring about changes in taxation, volume of spending, and size of the budget deficit or surplus to affect public expenditure.

Fiscal deficit
The fiscal deficit is the gap between expenditure and revenue receipt. Generally the government spends more than what it earns through various sources. This shortfall, which is met with borrowed funds, is called fiscal deficit.

Revenue deficit 
It is the excess of revenue expenditure over revenue receipts. All expenditure on revenue account should ideally be met from receipts on revenue account; the revenue deficit should be zero. In such a situation, the government borrowing will not be for consumption but for creation of assets. 

Effective revenue deficit 
This is an even tighter number than the revenue deficit. It is revenue deficit less grants for creation of capital assets. 

Primary deficit 
It is the fiscal deficit less interest payments made by the government on its earlier borrowings. 

Gross domestic product
Gross domestic product (GDP) is the market value of all officially recognized final goods and services produced within a country in a given period of time. It includes all of private and public consumption, government outlays, investments and exports less imports that occur within a defined territory.

Fiscal deficit
It is the gap between expenditure and revenue receipt. Fiscal deficit is essentially the difference between what the government spends and what it earns. It is expressed as a percentage of GDP.

FRBM ACT
The Fiscal Responsibility and Budget Management Act was enacted in 2003 and required the elimination of revenue deficit and reduction of fiscal deficit to 3% of GDP. The financial crisis and the subsequent slowdown had forced the government to abandon the path of fiscal consolidation for a while. A new fiscal consolidation road map is likely to be announced this year. 

Ways and means advances 
A system whereby the Reserve Bank of India (the country's central bank) extends loans to the central and state governments to offset temporary cash flow problems they may have. Ways and means advances may be issued without collateral (normal WMAs) or they may be guaranteed by Indian government bonds (special WMAs). 

Current account deficit 
The CAD is the difference between a country’s total imports of goods, services and transfers and its total export of goods, services and transfers. In common terms, it means that India is a net debtor to the rest of the world.

Securities transaction tax 
STT is levied on every purchase or sale of securities that are listed on the Indian stock exchanges. This would include shares, derivatives or equity-oriented mutual funds units. The rate of tax that is deducted is determined by the central government, and it varies with different types of transactions and securities. STT is deducted at source by the broker or AMC, at the time of the transaction itself, the net result is that it pushes up the cost of the transaction done.

RICARDIAN THEORY OF RENT

Definition:

The theory of economic rent was first propounded by the English Classical Economist David Ricardo (1773 -1823). David Ricardo in his book. "Principles of Political Economy and Taxation", defined rent as that:

"Portion of the produce of the earth which is paid to a landlord on account of the original and indestructible powers of the soil, Ricardo in his theory of rent has emphasized that rent is a reward for the services of land which is fixed in supply. Secondly, it arises due to original qualities of land which are indestructible". (The original indestructible powers of the soil include natural soil, fertility, mineral deposits, climatic conditions etc., etc.).

Assumptions:

(i) Rent Under Extensive Cultivation.

(ii) Rent Under Intensive Cultivation.

Explanation and Example of Ricardian Theory of Rent:

Rent Under Extensive Cultivation:

According to Ricardo:

"All the units of land are not of the same grade. They differ in fertility and location. The application of the same amount of labor, capital and other cooperating resources give rise to difference in productivity. This difference in productivity or the surplus which arises on the superior units of land over the inferior units is an economic rent".

The Ricardian theory of rent is explained by taking an example:

Schedule:

Grades of Land	Yield in Quintals per Acre	Price per Quintal ($)	Total Return ($)
A	50	50	2500
B	35	60	2100
C	20	70	1400
D	15	80	1200

In the above schedule, we assume that there are four grades of land A, B, C and D in an uninhabited country. A grade land is more fertile than B grade land. B grade land is superior to C grade and so is C grade to D grade land.

Following Ricardo let us assume, a batch of settlers migrate to this island. They begin cultivating A grade land which yield 50 quintals of wheat per acre. Let us suppose now that the population of that country increases and A grade land is not sufficient to meet the food requirements of the growing population. The inhabitants of that country shall then have to bring under cultivation B grade land. With the identical amounts of labor and capital. B grade land yields 35 quintals of wheat per acre. A surplus of 15 quintal of wheat {50 - 35 = 15) which arises with the same outlay on A grade land is an economic rent. B grade land being a marginal land gives no rent. When owing to the pressure of growing population and a rise in demand for food, C grade land is brought under cultivation, it yields only 20 quintals of wheat with the identical amount of labor and capital. With the cultivation of C grade land, the economic rent of A grade land is now raised to 30 quintals per acre: (50 - 20 = 30) and that of B grade land 15 quintals of wheat per acre. C grade land is a no rent land as it is cultivated at the margin.

If the expenses of production on A grade of land yielding 50 quintals of wheat are $2500 and the market price of total yield on A grade land is also $2500, then A grade land only will be brought under cultivation. A grade land here is the marginal land. If the price of agricultural produce increases ($60 per quintal) and the expenses of producing wheat on B grade land are equal to the market price of the produce i.e.. $2100, then B grade of land which was hitherto neglected would be brought under cultivation. B grade land then becomes the marginal land. Similarly, D grade land will be the marginal land when it compensates the cultivator by giving a yield of $1200, and enjoys no surplus over cost. Marginal land is thus not fixed. It varies with the changes in the price of agricultural produce. If population increase still further and the demand for food increases, then D grade land will be brought under plough. The surplus or economic rent of A grade land will go up to 35 quintals (50 - 15 = 35), of B grade 20 quintals, of C grade 5 quintals. D grade land being the marginal land yields no rent.

Rent Under Intensive Cultivation:

The theory of rent which has been discussed above applies to Intensive margin of cultivation. The surplus or economic rent also arises to the land cultivated intensively. This occurs due to the operation of the famous law of diminishing returns.

When the land is cultivated intensively, the application of additional doses of labor and capital brings in less and less of yield. The dose whose cost just equates the value of marginal return is regarded marginal or no rent dose. The rent arises on all the infra-marginal doses.

For example, the application of first unit of labor and capital to a plot of land yields 25 quintals of wheat, the 2nd dose gives 15 quintals of wheat and with third it drops down to 10 quintals only, the farmer applies only 3 doses of labor and capital as the total outlay on the third does equals its return. The rent when measured from the third or marginal dose is 15 quintal       (25 - 10 = 15) on first dose and 5 quintal on second dose (15 -10 = 5). The third dose is a no rent dose.

Criticism on Ricardian Theory of Rent:

(i) No Original and Indestructible Power: Ricardo is of the opinion that rent is paid due to the original and indestructible powers of the soil. It is pointed out that there are no powers of the soil which are indestructible. As we go on cultivating a piece of land time and again, its fertility gradually diminishes. To this criticism, it is replied that there are properties of the soil, such as climate situation, sunshine, humidity, soil composition, etc., which are infect original and indestructible.

(ii) Wrong Assumption of 'No Rent Land': Ricardo assumes the existence of no-rent land. A land which just meets the cost of cultivation. The modern economists are of the opinion that if a plot of land can be put to several uses, then it does yield rent.

(iii) Rent Enters Into Price: According to Ricardo, rent does not enter into price. The modern economists are of the opinion that it does eater into price.

(iv) Wrong Assumption of Perfect Competition: Ricardo is of the opinion that perfect competition prevails between the landlord and the tenant, but in the actual world, it is imperfect competition which is the order of the day.

(v) All Lands are Equally Fertile: Ricardo assumes that rent arises due to difference in the fertility of the soil. But the modern economists assert that if all lands are equally fertile, even then the rent will arise. The rent can arise: (a) if the produce is not sufficient to meet the requirements of the people, and (b) due the operation of the law of diminishing returns.

(vi) Historically Wrong: Carey and Roscher have criticized the orders of cultivation assumed by Ricardo. They are of the opinion that it is not necessary that A grade land will be cultivated first, even if it lies far away from the city. To this it is replied by Walker that when Ricardo uses the words 'best land' he means by it the land which is superior both in fertility and in situation.

(vii) Neglect of Scarcity Principle: It is pointed out by the modem economists that the concept of rent can be easily explained with the help of the scarcity principle and so there is no need to have a separate theory of rent.

INTERNATIONAL TRADE

International trade is the exchange of goods, services and capital across national borders. It is a multi-trillion dollar activity, central to the GDP of many countries, and it is the only way for people in many countries to acquire resources they require. Absent trade, consumers and suppliers are forced to either develop substitute goods or devote a large percentage of their income to acquiring products where demand is inelastic and domestic supply is inadequate.

Two of the key concepts in the economics of international trade are specialization and comparative advantage.

It seems readily apparent that countries can benefit from trade if each country does something better than the other (i.e. can produce goods or services at a lower cost). What if one company is more efficient in every good? This situation is called absolute advantage.

Even in situations of absolute advantage, though, there can be benefits to trade. As long as a country is not equally superior in producing all goods, there will be different relative costs for producing various goods. This is where comparative advantage comes in; so long as the two countries have different relative efficiencies, the two countries can benefit from trade – the country with absolute advantage will still benefit by directing its resources to those goods where it is most productive and trading for the others.

Specialization refers to this process; countries (as well as individual businesses) can maximize their welfare by specializing in the production of those goods where they are most efficient and enjoy the largest advantages over rivals. 

A country's balance of payments basically tracks the financial flows between trading partners. The balance of payments includes the payments made for imports and exports, as well as financial transfers. Exports create a positive entry, while imports are a negative. That said, a balance of payments must always balance out at zero – a trade deficit (more imports than exports) must be balanced with foreign investments, declines in reserves, or increased debt; likewise, a trade surplus will be balanced out with financial outflows or increased reserves.

Within a nation's balance of payment is the current account. The current account is made up primary of a company's trade balance (exports minus imports), as well as net interest and dividends, and net transfer payments (like foreign aid).

Impediments to Trade

While free trade is generally thought of as a positive, countries will periodically put up barriers to trade. Tariffs are taxes on imports that make imported goods more expensive and less competitive relative to domestically-produced goods. While national governments used to obtain a significant percentage of their receipts from tariffs (in the days before income taxes were common), tariffs today are more commonly used to protect domestic industries and/or to punish other countries for perceived wrongdoing (typically subsidizing local industries to the detriment of the importing country's industries).

Subsidies are transfer payments given by governments to domestic suppliers of goods or services. The motivation to provide subsidies is to increase production and/or lower prices for a country's consumers and/or to make domestically-produced goods more competitive with imports.

Quotas are limits on the amount of a good that can be imported in a given period. Quotas serve a similar purpose to tariffs in that the increase the price of imported goods, but quotas can be even more severe as no additional goods are available once the quota level is reached.

Cost-Push Inflation Versus Demand-Pull Inflation

Do you remember how much less you paid for things even two years ago? This increase in the general price level of goods and services in an economy is inflation, measured by the Consumer Price Index and the Producer Price Index.  But there are different types of inflation, depending on its cause. Here we examine cost-push inflation and demand-pull inflation. 

Factors of Inflation 

Inflation is defined as the rate (%) at which the general price level of goods and services is rising, causing purchasing power to fall. This is different from a rise and fall in the price of a particular good or service. Individual prices rise and fall all the time in a market economy, reflecting consumer choices or preferences and changing costs. So if the cost of one item, say a particular model car, increases because demand for it is high, this is not considered inflation. Inflation occurs when most prices are rising by some degree across the whole economy. This is caused by four possible factors, each of which is related to basic economic principles of changes in supply and demand:

1. Increase in the money supply.
2. Decrease in the demand for money.
3. Decrease in the aggregate supply of goods and services.
4. Increase in the aggregate demand for goods and services.

In this look at what inflation is and how it works, we will ignore the effects of money supply on inflation and concentrate specifically on the effects of aggregate supply and demand: cost-push and demand-pull inflation. 

Cost-Push Inflation 

Aggregate supply is the total volume of goods and services produced by an economy at a given price level. When there is a decrease in the aggregate supply of goods and services stemming from an increase in the cost of production, we have cost-push inflation. Cost-push inflation basically means that prices have been "pushed up" by increases in costs of any of the four factors of production (labor, capital, land or entrepreneurship) when companies are already running at full production capacity. With higher production costs and productivity maximized, companies cannot maintain profit margins by producing the same amounts of goods and services. As a result, the increased costs are passed on to consumers, causing a rise in the general price level (inflation). 

Production Costs 

To understand better their effect on inflation, let's take a look into how and why production costs can change. A company may need to increases wages if laborers demand higher salaries (due to increasing prices and thus cost of living) or if labor becomes more specialized. If the cost of labor, a factor of production, increases, the company has to allocate more resources to pay for the creation of its goods or services. To continue to maintain (or increase) profit margins, the company passes the increased costs of production on to the consumer, making retail prices higher. Along with increasing sales, increasing prices is a way for companies to constantly increase their bottom lines and essentially grow. Another factor that can cause increases in production costs is a rise in the price of raw materials. This could occur because of scarcity of raw materials, an increase in the cost of labor and/or an increase in the cost of importing raw materials and labor (if the they are overseas), which is caused by a depreciation in their home currency. The government may also increase taxes to cover higher fuel and energy costs, forcing companies to allocate more resources to paying taxes. 

Putting It Together 

To visualize how cost-push inflation works, we can use a simple price-quantity graph showing what happens to shifts in aggregate supply. The graph below shows the level of output that can be achieved at each price level. As production costs increase, aggregate supply decreases from AS1 to AS2 (given production is at full capacity), causing an increase in the price level from P1 to P2. The rationale behind this increase is that, for companies to maintain (or increase) profit margins, they will need to raise the retail price paid by consumers, thereby causing inflation. 

Demand-Pull Inflation 

Demand-pull inflation occurs when there is an increase in aggregate demand, categorized by the four sections of the macroeconomy: households, businesses, governments and foreign buyers. When these four sectors concurrently want to purchase more output than the economy can produce, they compete to purchase limited amounts of goods and services. Buyers in essence "bid prices up", again, causing inflation. This excessive demand, also referred to as "too much money chasing too few goods", usually occurs in an expanding economy. 

Factors Pulling Prices Up 

The increase in aggregate demand that causes demand-pull inflation can be the result of various economic dynamics. For example, an increase in government purchases can increase aggregate demand, thus pulling up prices. Another factor can be the depreciation of local exchange rates, which raises the price of imports and, for foreigners, reduces the price of exports. As a result, the purchasing of imports decreases while the buying of exports by foreigners increases, thereby raising the overall level of aggregate demand (we are assuming aggregate supply cannot keep up with aggregate demand as a result of full employment in the economy). Rapid overseas growth can also ignite an increase in demand as more exports are consumed by foreigners. Finally, if government reduces taxes, households are left with more disposable income in their pockets. This in turn leads to increased consumer spending, thus increasing aggregate demand and eventually causing demand-pull inflation. The results of reduced taxes can lead also to growing consumer confidence in the local economy, which further increases aggregate demand. 

Putting It Together 

Demand-pull inflation is a product of an increase in aggregate demand that is faster than the corresponding increase in aggregate supply. When aggregate demand increases without a change in aggregate supply, the ‘quantity supplied' will increase (given production is not at full capacity). Looking again at the price-quantity graph, we can see the relationship between aggregate supply and demand. If aggregate demand increases from AD1 to AD2, in the short run, this will not change (shift) aggregate supply, but cause a change in the quantity supplied as represented by a movement along the AS curve. The rationale behind this lack of shift in aggregate supply is that aggregate demand tends to react faster to changes in economic conditions than aggregate supply. 

As companies increase production due to increased demand, the cost to produce each additional output increases, as represented by the change from P1 to P2. The rationale behind this change is that companies would need to pay workers more money (e.g. overtime) and/or invest in additional equipment to keep up with demand, thereby increasing the cost of production. Just like cost-push inflation, demand-pull inflation can occur as companies, to maintain profit levels, pass on the higher cost of production to consumers' prices. 

Conclusion 

Inflation is not simply a matter of rising prices. There are endemic and perhaps diverse reasons at the root of inflation. Cost-push inflation is a result of decreased aggregate supply as well as increased costs of production, itself a result of different factors. The increase in aggregate supply causing demand-pull inflation can be the result of many factors, including increases in government spending and depreciation of the local exchange rate. If an economy identifies what type of inflation is occurring (cost-push or demand-pull), then the economy may be better able to rectify (if necessary) rising prices and the loss of purchasing power. 

COUSTESY: INVESTOPEDIA 

MARKET STRUCTURE BASICS FOR BEGINNERS

Economists assume that there are a number of different buyers and sellers in the marketplace. This means that we have competition in the market, which allows price to change in response to changes in supply and demand. Furthermore, for almost every product there are substitutes, so if one product becomes too expensive, a buyer can choose a cheaper substitute instead. In a market with many buyers and sellers, both the consumer and the supplier have equal ability to influence price. 

In some industries, there are no substitutes and there is no competition. In a market that has only one or few suppliers of a good or service, the producer(s) can control price, meaning that a consumer does not have choice, cannot maximize his or her total utility and has have very little influence over the price of goods. 

A monopoly is a market structure in which there is only one producer/seller for a product. In other words, the single business is the industry. Entry into such a market is restricted due to high costs or other impediments, which may be economic, social or political. For instance, a government can create a monopoly over an industry that it wants to control, such as electricity. Another reason for the barriers against entry into a monopolistic industry is that oftentimes, one entity has the exclusive rights to a natural resource. For example, in Saudi Arabia the government has sole control over the oil industry. A monopoly may also form when a company has a copyright or patent that prevents others from entering the market. Pfizer, for instance, had a patent on Viagra. 

In an oligopoly, there are only a few firms that make up an industry. This select group of firms has control over the price and, like a monopoly, an oligopoly has high barriers to entry. The products that the oligopolistic firms produce are often nearly identical and, therefore, the companies, which are competing for market share, are interdependent as a result of market forces. Assume, for example, that an economy needs only 100 widgets. Company X produces 50 widgets and its competitor, Company Y, produces the other 50. The prices of the two brands will be interdependent and, therefore, similar. So, if Company X starts selling the widgets at a lower price, it will get a greater market share, thereby forcing Company Y to lower its prices as well. 

There are two extreme forms of market structure: monopoly and, its opposite, perfect competition. Perfect competition is characterized by many buyers and sellers, many products that are similar in nature and, as a result, many substitutes. Perfect competition means there are few, if any, barriers to entry for new companies, and prices are determined by supply and demand. Thus, producers in a perfectly competitive market are subject to the prices determined by the market and do not have any leverage. For example, in a perfectly competitive market, should a single firm decide to increase its selling price of a good, the consumers can just turn to the nearest competitor for a better price, causing any firm that increases its prices to lose market share and profits. 

UTILITY BASICS FOR BEGINNERS

We have already seen that the focus of economics is to understand the problem of scarcity: the problem of fulfilling the unlimited wants of humankind with limited and/or scarce resources. Because of scarcity, economies need to allocate their resources efficiently. Underlying the laws of demand and supply is the concept of utility, which represents the advantage or fulfillment a person receives from consuming a good or service. Utility, then, explains how individuals and economies aim to gain optimal satisfaction in dealing with scarcity. 

Utility is an abstract concept rather than a concrete, observable quantity. The units to which we assign an "amount" of utility, therefore, are arbitrary, representing a relative value. Total utility is the aggregate sum of satisfaction or benefit that an individual gains from consuming a given amount of goods or services in an economy. The amount of a person's total utility corresponds to the person's level of consumption. Usually, the more the person consumes, the larger his or her total utility will be.Marginal utility is the additional satisfaction, or amount of utility, gained from each extra unit of consumption. 

Although total utility usually increases as more of a good is consumed, marginal utility usually decreases with each additional increase in the consumption of a good. This decrease demonstrates the law of diminishing marginal utility. Because there is a certain threshold of satisfaction, the consumer will no longer receive the same pleasure from consumption once that threshold is crossed. In other words, total utility will increase at a slower pace as an individual increases the quantity consumed. 

Take, for example, a chocolate bar. Let's say that after eating one chocolate bar your sweet tooth has been satisfied. Your marginal utility (and total utility) after eating one chocolate bar will be quite high. But if you eat more chocolate bars, the pleasure of each additional chocolate bar will be less than the pleasure you received from eating the one before - probably because you are starting to feel full or you have had too many sweets for one day. 

This table shows that total utility will increase at a much slower rate as marginal utility diminishes with each additional bar. Notice how the first chocolate bar gives a total utility of 70 but the next three chocolate bars together increase total utility by only 18 additional units. 

The law of diminishing marginal utility helps economists understand the law of demand and the negative sloping demand curve. The less of something you have, the more satisfaction you gain from each additional unit you consume; the marginal utility you gain from that product is therefore higher, giving you a higher willingness to pay more for it. Prices are lower at a higher quantity demanded because your additional satisfaction diminishes as you demand more. 

In order to determine what a consumer's utility and total utility are, economists turn to consumer demand theory, which studies consumer behavior and satisfaction. Economists assume the consumer is rational and will thus maximize his or her total utility by purchasing a combination of different products rather than more of one particular product. Thus, instead of spending all of your money on three chocolate bars, which has a total utility of 85, you should instead purchase the one chocolate bar, which has a utility of 70, and perhaps a glass of milk, which has a utility of 50. This combination will give you a maximized total utility of 120 but at the same cost as the three chocolate bars. 

ELASTICITY BASICS FOR BEGINNERS

The degree to which a demand or supply curve reacts to a change in price is the curve's elasticity. Elasticity varies among products because some products may be more essential to the consumer. Products that are necessities are more insensitive to price changes because consumers would continue buying these products despite price increases. Conversely, a price increase of a good or service that is considered less of a necessity will deter more consumers because the opportunity cost of buying the product will become too high.

A good or service is considered to be highly elastic if a slight change in price leads to a sharp change in the quantity demanded or supplied. Usually these kinds of products are readily available in the market and a person may not necessarily need them in his or her daily life. On the other hand, an inelastic good or service is one in which changes in price witness only modest changes in the quantity demanded or supplied, if any at all. These goods tend to be things that are more of a necessity to the consumer in his or her daily life.

To determine the elasticity of the supply or demand curves, we can use this simple equation:

Elasticity = (% change in quantity / % change in price)

If elasticity is greater than or equal to one, the curve is considered to be elastic. If it is less than one, the curve is said to be inelastic.

As we mentioned previously, the demand curve is a negative slope, and if there is a large decrease in the quantity demanded with a small increase in price, the demand curve looks flatter, or more horizontal. This flatter curve means that the good or service in question is elastic.

Meanwhile, inelastic demand is represented with a much more upright curve as quantity changes little with a large movement in price.

Elasticity of supply works similarly. If a change in price results in a big change in the amount supplied, the supply curve appears flatter and is considered elastic. Elasticity in this case would be greater than or equal to one.

On the other hand, if a big change in price only results in a minor change in the quantity supplied, the supply curve is steeper and its elasticity would be less than one.

A. Factors Affecting Demand Elasticity 

There are three main factors that influence a demand's price elasticity:

1. The availability of substitutes - This is probably the most important factor influencing the elasticity of a good or service. In general, the more substitutes, the more elastic the demand will be. For example, if the price of a cup of coffee went up by $0.25, consumers could replace their morning caffeine with a cup of tea. This means that coffee is an elastic good because a raise in price will cause a large decrease in demand as consumers start buying more tea instead of coffee.

However, if the price of caffeine were to go up as a whole, we would probably see little change in the consumption of coffee or tea because there are few substitutes for caffeine. Most people are not willing to give up their morning cup of caffeine no matter what the price. We would say, therefore, that caffeine is an inelastic product because of its lack of substitutes. Thus, while a product within an industry is elastic due to the availability of substitutes, the industry itself tends to be inelastic. Usually, unique goods such as diamonds are inelastic because they have few if any substitutes.

2. Amount of income available to spend on the good - This factor affecting demand elasticity refers to the total a person can spend on a particular good or service. Thus, if the price of a can of Coke goes up from $0.50 to $1 and income stays the same, the income that is available to spend on coke, which is $2, is now enough for only two rather than four cans of Coke. In other words, the consumer is forced to reduce his or her demand of Coke. Thus if there is an increase in price and no change in the amount of income available to spend on the good, there will be an elastic reaction in demand; demand will be sensitive to a change in price if there is no change in income.

3. Time - The third influential factor is time. If the price of cigarettes goes up $2 per pack, a smoker with very few available substitutes will most likely continue buying his or her daily cigarettes. This means that tobacco is inelastic because the change in price will not have a significant influence on the quantity demanded. However, if that smoker finds that he or she cannot afford to spend the extra $2 per day and begins to kick the habit over a period of time, the price elasticity of cigarettes for that consumer becomes elastic in the long run.

B. Income Elasticity of Demand 

In the second factor outlined above, we saw that if price increases while income stays the same, demand will decrease. It follows, then, that if there is an increase in income, demand tends to increase as well. The degree to which an increase in income will cause an increase in demand is called income elasticity of demand, which can be expressed in the following equation:

If EDy is greater than one, demand for the item is considered to have a high income elasticity. If however EDy is less than one, demand is considered to be income inelastic. Luxury items usually have higher income elasticity because when people have a higher income, they don't have to forfeit as much to buy these luxury items. Let's look at an example of a luxury good: air travel.

Bob has just received a $10,000 increase in his salary, giving him a total of $80,000 per annum. With this higher purchasing power, he decides that he can now afford air travel twice a year instead of his previous once a year. With the following equation we can calculate income demand elasticity:

Income elasticity of demand for Bob's air travel is seven - highly elastic.

With some goods and services, we may actually notice a decrease in demand as income increases. These are considered goods and services of inferior quality that will be dropped by a consumer who receives a salary increase. An example may be the increase in the demand of DVDs as opposed to video cassettes, which are generally considered to be of lower quality. Products for which the demand decreases as income increases have an income elasticity of less than zero. Products that witness no change in demand despite a change in income usually have an income elasticity of zero - these goods and services are considered necessities.

DEMAND AND SUPPLY BASICS

Supply and demand is perhaps one of the most fundamental concepts of economics and it is the backbone of a market economy. Demand refers to how much (quantity) of a product or service is desired by buyers. The quantity demanded is the amount of a product people are willing to buy at a certain price; the relationship between price and quantity demanded is known as the demand relationship. Supply represents how much the market can offer. The quantity supplied refers to the amount of a certain good producers are willing to supply when receiving a certain price. The correlation between price and how much of a good or service is supplied to the market is known as the supply relationship. Price, therefore, is a reflection of supply and demand.

The relationship between demand and supply underlie the forces behind the allocation of resources. In market economy theories, demand and supply theory will allocate resources in the most efficient way possible. How? Let us take a closer look at the law of demand and the law of supply.

A. The Law of Demand
The law of demand states that, if all other factors remain equal, the higher the price of a good, the less people will demand that good. In other words, the higher the price, the lower the quantity demanded. The amount of a good that buyers purchase at a higher price is less because as the price of a good goes up, so does the opportunity cost of buying that good. As a result, people will naturally avoid buying a product that will force them to forgo the consumption of something else they value more. The chart below shows that the curve is a downward slope.

A, B and C are points on the demand curve. Each point on the curve reflects a direct correlation between quantity demanded (Q) and price (P). So, at point A, the quantity demanded will be Q1 and the price will be P1, and so on. The demand relationship curve illustrates the negative relationship between price and quantity demanded. The higher the price of a good the lower the quantity demanded (A), and the lower the price, the more the good will be in demand (C).

B. The Law of Supply 
Like the law of demand, the law of supply demonstrates the quantities that will be sold at a certain price. But unlike the law of demand, the supply relationship shows an upward slope. This means that the higher the price, the higher the quantity supplied. Producers supply more at a higher price because selling a higher quantity at a higher price increases revenue.

A, B and C are points on the supply curve. Each point on the curve reflects a direct correlation between quantity supplied (Q) and price (P). At point B, the quantity supplied will be Q2 and the price will be P2, and so on. (To learn how economic factors are used in currency trading, read Forex Walkthrough: Economics.)

Time and Supply
Unlike the demand relationship, however, the supply relationship is a factor of time. Time is important to supply because suppliers must, but cannot always, react quickly to a change in demand or price. So it is important to try and determine whether a price change that is caused by demand will be temporary or permanent.

Let's say there's a sudden increase in the demand and price for umbrellas in an unexpected rainy season; suppliers may simply accommodate demand by using their production equipment more intensively. If, however, there is a climate change, and the population will need umbrellas year-round, the change in demand and price will be expected to be long term; suppliers will have to change their equipment and production facilities in order to meet the long-term levels of demand.

C. Supply and Demand Relationship 
Now that we know the laws of supply and demand, let's turn to an example to show how supply and demand affect price.

Imagine that a special edition CD of your favorite band is released for $20. Because the record company's previous analysis showed that consumers will not demand CDs at a price higher than $20, only ten CDs were released because the opportunity cost is too high for suppliers to produce more. If, however, the ten CDs are demanded by 20 people, the price will subsequently rise because, according to the demand relationship, as demand increases, so does the price. Consequently, the rise in price should prompt more CDs to be supplied as the supply relationship shows that the higher the price, the higher the quantity supplied.

If, however, there are 30 CDs produced and demand is still at 20, the price will not be pushed up because the supply more than accommodates demand. In fact after the 20 consumers have been satisfied with their CD purchases, the price of the leftover CDs may drop as CD producers attempt to sell the remaining ten CDs. The lower price will then make the CD more available to people who had previously decided that the opportunity cost of buying the CD at $20 was too high.

D. Equilibrium
When supply and demand are equal (i.e. when the supply function and demand function intersect) the economy is said to be at equilibrium. At this point, the allocation of goods is at its most efficient because the amount of goods being supplied is exactly the same as the amount of goods being demanded. Thus, everyone (individuals, firms, or countries) is satisfied with the current economic condition. At the given price, suppliers are selling all the goods that they have produced and consumers are getting all the goods that they are demanding.

As you can see on the chart, equilibrium occurs at the intersection of the demand and supply curve, which indicates no allocative inefficiency. At this point, the price of the goods will be P* and the quantity will be Q*. These figures are referred to as equilibrium price and quantity.

In the real market place equilibrium can only ever be reached in theory, so the prices of goods and services are constantly changing in relation to fluctuations in demand and supply.

E. Disequilibrium 

Disequilibrium occurs whenever the price or quantity is not equal to P* or Q*.

1. Excess Supply
If the price is set too high, excess supply will be created within the economy and there will be allocative inefficiency.

At price P1 the quantity of goods that the producers wish to supply is indicated by Q2. At P1, however, the quantity that the consumers want to consume is at Q1, a quantity much less than Q2. Because Q2 is greater than Q1, too much is being produced and too little is being consumed. The suppliers are trying to produce more goods, which they hope to sell to increase profits, but those consuming the goods will find the product less attractive and purchase less because the price is too high.

2. Excess Demand
Excess demand is created when price is set below the equilibrium price. Because the price is so low, too many consumers want the good while producers are not making enough of it.

In this situation, at price P1, the quantity of goods demanded by consumers at this price is Q2. Conversely, the quantity of goods that producers are willing to produce at this price is Q1. Thus, there are too few goods being produced to satisfy the wants (demand) of the consumers. However, as consumers have to compete with one other to buy the good at this price, the demand will push the price up, making suppliers want to supply more and bringing the price closer to its equilibrium.





F. Shifts vs. Movement 
For economics, the "movements" and "shifts" in relation to the supply and demand curves represent very different market phenomena:

1. Movements
A movement refers to a change along a curve. On the demand curve, a movement denotes a change in both price and quantity demanded from one point to another on the curve. The movement implies that the demand relationship remains consistent. Therefore, a movement along the demand curve will occur when the price of the good changes and the quantity demanded changes in accordance to the original demand relationship. In other words, a movement occurs when a change in the quantity demanded is caused only by a change in price, and vice versa.

Like a movement along the demand curve, a movement along the supply curve means that the supply relationship remains consistent. Therefore, a movement along the supply curve will occur when the price of the good changes and the quantity supplied changes in accordance to the original supply relationship. In other words, a movement occurs when a change in quantity supplied is caused only by a change in price, and vice versa.

2. Shifts
A shift in a demand or supply curve occurs when a good's quantity demanded or supplied changes even though price remains the same. For instance, if the price for a bottle of beer was $2 and the quantity of beer demanded increased from Q1 to Q2, then there would be a shift in the demand for beer. Shifts in the demand curve imply that the original demand relationship has changed, meaning that quantity demand is affected by a factor other than price. A shift in the demand relationship would occur if, for instance, beer suddenly became the only type of alcohol available for consumption.


Conversely, if the price for a bottle of beer was $2 and the quantity supplied decreased from Q1 to Q2, then there would be a shift in the supply of beer. Like a shift in the demand curve, a shift in the supply curve implies that the original supply curve has changed, meaning that the quantity supplied is effected by a factor other than price. A shift in the supply curve would occur if, for instance, a natural disaster caused a mass shortage of hops; beer manufacturers would be forced to supply less beer for the same price.