Sunday, 27 March 2016

Money - Meaning and Definition | Four functions of money

The importance of money
Money plays an important role in economics. It acts as a medium of exchange for goods and as the unit and store of value for execution of transactions. Without money, it would have been much difficult to procure your goods and services. In the ancient barter system, one has to search for the person who can exchange his goods with those of the goods required by him. So, both parties to the barter system should have the product desired by each other and/ or the need and interest for the same products. But, in the modern money economy, we need not search for the person who likes your product and exchanges it with the product needed by you. You can sell your product directly in the market and get money in return. Then you can buy with that money whatever is required by you. It becomes very easier for you to make any kind of transaction with money. You can buy goods or services at your own time, make payments of bills, keep it in banks for future uses, transfer it to any part of the world and utilise it there. So, this is the benefit and importance of money in your life.

What is money? Meaning and definition of money
Money is a medium of exchange that is generally acceptable to people as a unit of exchange and as a store of value. Generally, the currency notes and coins are considered as money by public. It is a kind of instrument having the purchasing power and capable of being stored for future uses.

The great economist Geoffrey Crowther, who was the editor of a newspaper "The Economist" during the 1930s and 1940s and later became the Managing Director and Chairman of Economist Newspaper Ltd., defined money in his book "An Outline of Money" as follows:

"Anything that is generally acceptable as a means of exchange and which at the same acts as a measure and store of value".

So, money is anything that is legally and socially acceptable for buying and selling things or for making payments of goods and services utilised or in repayment of debts.

Four functions of money in economy
Money performs four major functions -
1) Money is the medium of exchange.
2) Money is a unit of account and measure of value.
3) Money functions as a store of value.
4) Money is a standard of deferred payments.

Of the above four functions, a medium of exchange and measure of value are regarded as primary functions of money. The functions of a store of value and standard of deferred payment are regarded as secondary functions of money as they are derived from the primary functions.

A) Primary functions of money:

1) Medium of exchange
Money is a medium of exchange in the sense that it is used to used to exchange for goods and services. The buyer buys goods and services and pays money for it. The seller sells goods whereas the service provider provides his services and in both cases, they receive money from the receiver of goods or services. Thus, money is an important medium of their transactions.

For example, you buy a chocolate and pay money for it. The seller of chocolate is receiving money in exchange of his chocolate. Similarly, you get the service of a barber to shave your beard and in exchange of it, you are paying the money. Thus, money serves as an important medium of exchange in all transactions.

2) Measure of value or unit of account
Money acts as a unit of account or measure of value. You value any goods or services in terms of money value. You are fixing monetary value per one unit of good or service. So, any goods or services that we buy or sell are quoted by its value per one unit in terms of money.

For example, a chocolate is quoted as of $5 value, a bread is quoted as of $10 value, a computer is quoted as of $10,000 value, so on. Similarly, one shave is quoted at $5 value, one haircut at $10 value, one car wash at $20 value like that. When you give the value per unit of good or service it becomes very easy to identify those goods and services and compare them with other similar products or services offered by different seller or providers.

B) Secondary functions of money:

1) Store of value
Money can be stored and used subsequently without losing its value for a certain period. Money can be used only when you need to buy or procure something. Till then, you can keep your money in your purse or wallet or you can keep it in your bank account. So money is stored for your future needs. With that, you can buy anything like rice, bread, chocolate, wheat flour, car, computer, so on. Thus, you are storing the purchasing power of money for a certain period, until you actually need the goods or services. So, you are much relaxed as you know that you can purchase anything with the stored value of money. This is one wonderful function performed by money.

This function of money comes from the primary functions of money acting as a unit of account and as a medium of exchange. It is because of those two functions, that you are capable of storing money. It is because of the fact that money is generally accepted as a medium of exchange, that you are keeping it in store. It is because of the fact that it is a unit of transaction, that you are procuring different denominations of money and using them for your purchases.

2) Standard of deferred payments
Money functions as a standard for deferred payments. When someone borrows money from you and agrees to return it after a certain period, he will pay back it in the form of money on that stipulated date along with interest if any charged by you for lending him the money instead of using it for other useful purposes by you. Millions of transactions are taking place now, which are not paid immediately.

Payments get deferred till a certain period of time or till the happening of a certain event or till the actual goods or services reach you. So, till such period, the payment gets postponed or deferred and nobody worries as money will not lose its value even if paid later under normal circumstances. You are able to defer the payment because of the standard value of money and its general acceptability. This function of money has given rise to the various financial institutions and lending businesses and thereby advanced the economic development also.

Wednesday, 2 March 2016

Definition and explanation of producer equilibrium in economics under different approaches

Just like the consumers indulge in maximising their satisfaction and utility levels by reaching towards consumer equilibrium, the producers also try to reach out to an equilibrium point of maximisation of their profits that is known as "producer equilibrium".

What is producer's equilibrium?
Producer's equilibrium is that point in the scale of production, at which point, the level of production of any particular commodity gives the maximum profit to the producer of that commodity. So, the total cost of production of that commodity will be much lesser than the total revenue obtained through sale of that commodity at that level. It is the maximum possible profit that any producer can obtain at that equilibrium point.

In other words, producer equilibrium refers either to the level of profit maximisation or otherwise, to the level of cost minimisation. Cost minimisation also results in profit maximisation.

Definition of producer equilibrium in economics

  • Producer's equilibrium can be defined as a state of economic condition that leads to achievement of that level of output after reaching which, no further maximisation of profit is possible.
  • It is that stage where there is no further inclination towards expansion or contraction of the output.
  • It is that point where there is maximum profitability and / or minimal loss.

Two approaches towards producer equilibrium

There are two approaches for reaching out to producer's equilibrium:
1) the TR - TC approach and
2) the MR = MC approach.

There can be two types of markets for studying producer equilibrium

a) Perfect competition market where prices remain constant and
b) Imperfect competition market where prices are either raising or falling constantly.
We need to study the equilibrium under both these conditions of the markets.

Now, let us study producer's equilibrium under all these different conditions, one by one.

I) Total Revenue - Total Cost (TR - TC) approach

Under TR - TC approach, the producer tries to attain equilibrium point by maximising his profits to the utmost possible level. So, this implies that the TR-TC approach should satisfy two conditions.

  • The difference between Total Revenue and Total Cost has been maximised.
  • Any further effort to increase output after that point will result in a fall of the total profit.

Let me explain this under both circumstances of perfect competition and Imperfect competition.

i) The producer equilibrium under perfect competition (When prices remain constant)
When prices are constant in perfect competition, producer goes on increasing output or sales and is able to enjoy maximum profit till a certain point after which, he may not be able to produce more without adding extra machinery or extra expenses and capital. So, addition of capital and machinery may result in increased costs of the product. Or, otherwise, he may not be able to sell more unless he decreases the price, which also may result in decrease of profits.

Let us study it through a table as below.

Price per unit       Output (units)      Total Revenue     Total Cost     Profit

      6                        1                          6                      5                  1
      6                        2                        12                     10                 2
      6                        4                        24                     19                 5
      6                        6                        36                     28                 8
      6                        7                        42                     34                 8
      6                        8                        48                     41                 7

From the above illustration, we can see that producer equilibrium has been achieved at the output level of 7 units, at which point you are able to maintain the maximum profit of 8 dollars by producing maximum output of 7 units. When you tried to increase the output by another unit, the profit decreased to 7 dollars.

The same thing can be illustrated in the form of a graph also.

ii) Now, watch producer equilibrium under imperfect competition (when prices are falling upon increased output )
There is no control over prices, and each producer has his own price fixation norms and sells products accordingly. But, after a certain level of output, he gets forced to lower the prices as he has got excess stocks of output. The below example illustrates this position.

Price per unit       Output (units)      Total Revenue     Total Cost      Profit
       8                       2                          16                    10                   6
       7                       3                          21                    14                   7
       6                       5                          30                    21                   9              
       5                       6                          30                    23                   7

The producer equilibrium in the above example is attained at output level of 5 units. After that level, additional output of another unit resulted in fall of total profit.

II) Marginal Revenue = Marginal Cost Approach (MR = MC approach)

According to this approach, producer equilibrium is attained where the marginal revenue of additional output equals its marginal cost.

This approach should satisfy the following two conditions or assumptions:
1) MC = MR
2) Marginal cost becomes higher than Marginal Revenue if one more addition to output takes place after reaching the output level of MR = MC

Let us study this approach also under both the perfect and imperfect competition conditions of the market.

i) Producer equilibrium under perfect competition (when price is constant)
When price is constant, each unit of output is sold at the same price. So, the average price (AR) of any particular unit is same for each and every unit. The marginal revenue (MR) will be same as the AR and the marginal revenue (MR) also will be same as AR for each unit. So, you will enjoy the producer equilibrium until there is any rise in MC or fall in MR.

Let me illustrate this with a table as below.

Price (Rs.)    No.of units         TR            TC              MR            MC          Profit (TR-TC)
6                    1                     6                8                6                 8                -2
6                    2                    12              15                6                 7                -3
6                    3                    18              20                6                 5                -2
6                    4                    24              24                6                 4                 0
6                    5                    30              28                6                 4                 2
6                    6                    36              34                6                 6                 2
6                    7                    42              41                6                 7                 1

From the above, we can see that the producer was incurring losses initially and he went on increasing his output to nullify the losses and make profits. When he produced 4 units, there were no losses. At the level of 5 units production and 6 units production, he was able to make profits of 2 points. At the level of 6 units production, the MR is equal to MC. When he tried to increase output by one more unit, the profit decreased again. So, the producer equilibrium output is 6 units in this case.

ii) Producer equilibrium under imperfect competition (when price falls with increase in output)
When there is no perfect competition among sellers, the producers and sellers try to maximise their profits, by indulging in unhealthy practices. They take advantage of some monopolistic circumstances and charge very high prices to gain maximum profits. This is workable until certain stage. But when the quantity produced becomes too much with alternative identical products coming into the market, demand gets distributed among identical products and naturally each brand of product loses its demand in the long run. The effect will be fall in prices of products. So, too much increase in production will result in fall of prices. In such circumstances, the producer has to decide upon his maximum level of production based on producer equilibrium. He will try to match Marginal Cost with Marginal Revenue in deciding his level of production.

Let us consider an example to arrive at this producer equilibrium under changing prices of market.

Qty. produced   Price per unit           Total              Total       MR      MC      Profit 
                                                     Revenue           Cost                             (TR-TC)
           1                    8                        8                   6           8        6            2
           2                    7                       14                 11           6        5            3
           3                    6                       18                 15           4        4            3
           4                    5                       20                 18           2        3            2

In the above illustration, it is noticed that MR and MC are both equal to one another at the level of 3 units production. After that level, when production is increased to 4 units, the profit began decreasing as MC is higher than MR at that point. So, producer equilibrium level of output is 3 units in this case.   

From the above study of producer equilibrium, we are able to notice two salient features.
1) Under perfect competition (where prices remain constant), Price = MR = MC, ie. the product price, marginal revenue and marginal cost equal to one another at the equilibrium point.
2) Under imperfect competition (where prices fall with every increase in supply or production), Price is always greater than MC or MR as equilibrium is attained at a point of MC=MR and marginal revenue will be always decreasing with additions of supply.