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GNDU QUESTION PAPERS 2021
Bachelor of Commerce (B.Com) 2nd Semester
BUSINESS ECONOMICS
Time Allowed: 3 Hours Maximum Marks: 50
Note: There are Eight quesons of equal marks. Candidates are required to aempt any
Four quesons.
1. Discuss in detail the concept of demand and price elascity of demand.
2. Explain Law of Equi-Marginal Ulity.
3. Explain Law of Returns to Scale.
4 Explain the relaonship between Average Revenue and Total Revenue with example.
5. Explain the Price and Output determinaon of rm under Perfect Compeon.
6. Write a detailed note on Monopoly.
7. What are the dierent problems in measurement of Naonal Income in
underdeveloped countries ? Explain.
8. Explain the Keynes Psychological Law of Consumpon.
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GNDU ANSWER PAPERS 2021
Bachelor of Commerce (B.Com) 2nd Semester
BUSINESS ECONOMICS
Time Allowed: 3 Hours Maximum Marks: 50
Note: There are Eight quesons of equal marks. Candidates are required to aempt any
Four quesons.
1. Discuss in detail the concept of demand and price elascity of demand.
Ans: 1. Concept of Demand
Imagine you go to a market to buy mangoes . You dont just want mangoesyou also
have money and are ready to buy them at a certain price. This is what economists call
demand.
Demand means the quantity of a product that consumers are willing and able to buy
at different prices during a given period of time.
So, demand has three important elements:
Desire to buy
Ability to pay
Willingness to spend
If even one of these is missing, it is not demand.
Law of Demand
The law of demand is very simple and logical:
When price increases, demand decreases. When price decreases, demand increases.
Why does this happen?
When prices are high, people buy less
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When prices are low, people buy more
For example:
If petrol price rises people reduce usage
If mobile phones become cheaper more people buy
Demand Curve (Diagram)
To understand this visually, economists use a demand curve:
-10-8-6-4-22468105101520-4.04, 14.04
This downward-sloping line shows:
Price on the vertical axis (Y-axis)
Quantity on the horizontal axis (X-axis)
As price decreases, quantity demanded increases
Thats why the curve slopes downward from left to right
Types of Demand
1. Individual Demand Demand of one person
2. Market Demand Total demand of all consumers
3. Direct Demand Goods used directly (food, clothes)
4. Derived Demand Demand for factors of production (labour, machines)
2. Price Elasticity of Demand (PED)
Now lets move to the second concept.
Imagine:
If the price of tea increases slightly, you still buy it
But if the price of a car increases a lot, you may cancel the plan
This difference in reaction is called elasticity.
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Definition
Price Elasticity of Demand measures how much the quantity demanded changes when
the price changes.
In simple words:
It tells us how sensitive consumers are to price changes
Formula
Where:
= Elasticity of demand
%Qd = Percentage change in quantity demanded
%P = Percentage change in price
Types of Price Elasticity of Demand
Lets understand this with real-life examples:
1. Perfectly Elastic Demand (Ed = )
A very small price increase demand becomes zero
Consumers are extremely sensitive
Example:
Products with many substitutes (like online services)
2. Perfectly Inelastic Demand (Ed = 0)
Price changes demand remains the same
Example:
Life-saving medicines
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Even if price increases, people still buy.
3. Relatively Elastic Demand (Ed > 1)
Demand changes more than price
Example:
Luxury goods (cars, TVs)
If price increases demand drops sharply
4. Relatively Inelastic Demand (Ed < 1)
Demand changes less than price
Example:
Necessities (salt, food grains)
Even if price rises, people still need them.
5. Unitary Elastic Demand (Ed = 1)
Demand changes exactly in proportion to price
Factors Affecting Elasticity
Why are some goods elastic and others not? Lets see:
1. Nature of Goods
Necessities Inelastic
Luxuries Elastic
2. Availability of Substitutes
More substitutes More elastic
Example: Tea vs Coffee
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3. Income Level
Higher income Less sensitivity to price
4. Time Period
Short run Inelastic
Long run Elastic
5. Habit-forming Goods
Cigarettes, alcohol Inelastic
Practical Importance of Elasticity
Elasticity is not just theoryit is very useful:
1. For Business Firms
Helps in price setting
Maximizes profit
2. For Government
Helps in taxation policy
Taxes are higher on inelastic goods
3. For Consumers
Helps in making smart decisions
Simple Summary
Lets quickly revise:
Demand:
Quantity people are willing and able to buy
Inversely related to price
Represented by a downward-sloping curve
Price Elasticity of Demand:
Measures responsiveness of demand to price change
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Can be elastic, inelastic, or unitary
Final Understanding
Think of demand as how much people want to buy at different prices
And elasticity as how strongly people react when prices change.
If people react a lot Elastic
If people hardly react Inelastic
2. Explain Law of Equi-Marginal Ulity.
Ans: The Big Idea: Law of Equi-Marginal Utility
The law of equi-marginal utility is also called the Law of Substitution or the Law of
Maximum Satisfaction. It explains how a rational consumer allocates their limited income
among different goods to maximize satisfaction (utility).
In simple terms:
A consumer gets maximum satisfaction when the marginal utility per rupee spent on each
good is equal.
Breaking Down the Terms
Utility: The satisfaction or happiness you get from consuming a good or service.
Marginal Utility (MU): The extra satisfaction you get from consuming one more unit
of a good.
Equi-Marginal: Equal marginal utility per rupee across all goods.
So, the law says: distribute your money in such a way that the last rupee spent on each good
gives you the same level of satisfaction.
Everyday Example
Imagine you have 100 to spend on two things: ice cream and pizza.
The first slice of pizza gives you a lot of satisfaction (say 50 units).
The second slice gives less (say 40 units).
The first ice cream gives 45 units, the second gives 35 units.
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Now, if you spend all 100 on pizza, your satisfaction will decline with each slice. But if you
balance between pizza and ice cream, you can maximize overall happiness.
The trick is to spend money so that the marginal utility per rupee is equal for both pizza and
ice cream.
Step 1: The Rule in Formula Form
Where:
= marginal utility of good X
= price of good X
This means: the ratio of marginal utility to price must be equal across all goods.
Step 2: Storytelling Approach
Lets imagine Ramesh, a college student with 500 pocket money. He loves three things:
books, movies, and snacks.
Books give him knowledge and joy.
Movies give him entertainment.
Snacks satisfy his hunger.
If he spends all 500 on movies, hell enjoy the first few but get bored later. If he spends all
on snacks, hell feel sick. If he spends all on books, hell miss out on fun.
So, Ramesh wisely divides his money: some on books, some on movies, some on snacks. He
keeps adjusting until the satisfaction per rupee is equal across all three. Thats the law of
equi-marginal utility in action.
Diagram to Visualize
Consumers Money Allocated to Goods
Books MU/P
Movies MU/P
Snacks MU/P
Condition: MU/P (Books) = MU/P (Movies) = MU/P (Snacks)
This balance point is where maximum satisfaction is achieved.
Step 3: Why Is This Important?
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Consumer Behavior: Explains how people make choices with limited income.
Business Strategy: Helps firms understand demand patterns.
Policy Making: Guides governments in welfare economics (how subsidies affect
consumption).
Step 4: Assumptions of the Law
1. Consumers are rational.
2. Utility can be measured in cardinal numbers (like 10 units, 20 units).
3. Income is limited.
4. Prices of goods are given.
5. Marginal utility of money remains constant.
Step 5: Limitations
In reality, utility is subjective and hard to measure.
People dont always act rationally.
Marginal utility of money may change with spending.
But despite these limitations, the law gives a powerful framework to understand consumer
choice.
Final Narrative
So, the Law of Equi-Marginal Utility is really about balance. Its like jugglingyou dont put
all your effort into one ball, you spread it so the performance looks smooth. In economics,
consumers juggle their money across goods to maximize happiness.
The law teaches us that satisfaction doesnt come from spending everything on one thing,
but from wisely distributing resources. Its a principle of rational choice and economic
efficiency.
3. Explain Law of Returns to Scale.
Ans: Law of Returns to Scale
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Introduction (Lets Understand with a Simple Idea)
Imagine you are running a small factory. You have workers (labour), machines (capital), and
raw materials. Now, suppose you increase all inputs togethermore workers, more
machines, more materials.
The big question is:
Will your production increase in the same proportion, more than that, or less than that?
This is exactly what the Law of Returns to Scale explains.
What is the Law of Returns to Scale?
The Law of Returns to Scale studies what happens to output when all factors of production
are increased simultaneously in the same proportion.
In simple words:
If you double all inputs, what happens to output?
Three Types of Returns to Scale
There are three possible outcomes:
1. Increasing Returns to Scale (IRS)
When output increases more than proportionately compared to inputs.
Example:
Inputs doubled Output becomes more than double
Real-life understanding:
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Suppose you open a bigger factory:
Machines work more efficiently
Workers specialize in tasks
Costs per unit decrease
This happens due to efficiency and better organization
Why does it happen?
Division of labour
Better technology
Economies of scale
2. Constant Returns to Scale (CRS)
When output increases in the same proportion as inputs.
Example:
Inputs doubled Output also doubles
Real-life understanding:
You expand your factory, but everything grows at the same pace:
No extra efficiency
No inefficiency either
This is a balanced situation
3. Decreasing Returns to Scale (DRS)
When output increases less than proportionately compared to inputs.
Example:
Inputs doubled Output increases but less than double
Real-life understanding:
Your factory becomes too big:
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Hard to manage
Communication problems
Workers become less efficient
This happens due to management difficulties and inefficiencies
Diagram Explanation (Easy Understanding)
Look at the diagram above (Returns to Scale graph):
The horizontal axis (X-axis) shows inputs (Labour + Capital)
The vertical axis (Y-axis) shows output
Curve Behavior:
Steep curve Increasing returns (output rises faster)
Straight/linear curve Constant returns
Flat curve Decreasing returns (output rises slowly)
Simple Formula Understanding
Economists often express this as:
If inputs increase by k times:
Output > k Increasing Returns
Output = k Constant Returns
Output < k Decreasing Returns
Real-Life Example (Very Easy Story)
Lets take a bakery example :
Step 1: Small Bakery
2 workers 100 breads
Step 2: Medium Bakery
4 workers 250 breads
Output increased more than double Increasing Returns
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Step 3: Bigger Bakery
8 workers 400 breads
Output doubled Constant Returns
Step 4: Very Large Bakery
16 workers 600 breads
Output less than double Decreasing Returns
Difference from Law of Variable Proportions
Many students confuse this with another concept.
Feature
Returns to Scale
Variable Proportions
Inputs
All inputs change
Only one input changes
Time
Long run
Short run
Focus
Scale of production
Efficiency of one factor
Why is this Law Important?
This concept helps businesses and economists to:
Decide optimal size of production
Understand efficiency levels
Plan expansion strategies
Avoid over-expansion problems
Key Points to Remember
It is a long-run concept
All inputs change together
Three stages:
o Increasing
o Constant
o Decreasing
Helps in business decision-making
Conclusion (In Simple Words)
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The Law of Returns to Scale tells us how output behaves when a business grows in size.
At first, growth brings more efficiency (Increasing Returns)
Then comes a balanced stage (Constant Returns)
Finally, too much growth leads to problems (Decreasing Returns)
So, the key idea is:
Bigger is not always betterthere is always an optimal level of production.
4 Explain the relaonship between Average Revenue and Total Revenue with example.
Ans: The Big Idea: AR and TR
Revenue is simply the money a firm earns from selling goods or services. There are two key
measures:
Total Revenue (TR): The total money earned from selling a certain quantity of goods.
Average Revenue (AR): The revenue earned per unit of output.
In simple terms:
TR is like the total bill at a restaurant.
AR is like the average cost per dish on that bill.
Relationship Between AR and TR
1. AR is derived from TR. Since AR = TR Q, AR depends directly on TR.
2. When AR is constant, TR increases proportionally. Example: If each pen costs 10,
then selling 1 pen = 10 TR, 2 pens = 20 TR, 3 pens = 30 TR. AR stays 10.
3. When AR falls, TR may still rise but at a decreasing rate. Example: If you lower the
price to sell more units, AR decreases, but TR may increase up to a point.
4. TR reaches maximum when AR and Marginal Revenue (MR) interact. Beyond that,
lowering AR further reduces TR.
Everyday Example
Imagine you run a lemonade stall:
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Price per glass = 20.
If you sell 1 glass:
o TR = 20 1 = 20
o AR = 20 1 = 20
If you sell 5 glasses:
o TR = 20 5 = 100
o AR = 100 5 = 20
Here, AR = Price = 20, and TR grows steadily with quantity.
But suppose you reduce price to attract more customers:
Price per glass = 15.
Sell 10 glasses:
o TR = 15 10 = 150
o AR = 150 10 = 15
Notice: AR fell, but TR increased because more units were sold.
Step 1: Graphical Relationship
Economists often show this with curves:
AR Curve: Usually downward sloping (because to sell more, firms often reduce
price).
TR Curve: Starts from zero, rises, reaches a maximum, then may decline if AR falls
too much.
Diagram to Visualize
Step 2: Why Is This Important?
For Firms: Helps decide pricing strategy.
For Economists: Shows consumer behavior and demand elasticity.
For Students: Builds foundation for understanding marginal revenue, profit
maximization, and monopoly pricing.
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Step 3: Key Insights
1. AR is essentially the price per unit. In perfect competition, AR = Price = Demand.
2. TR is the sum of all ARs across units. If AR falls slowly, TR can still rise.
3. TR peaks when MR = 0. Beyond that, lowering price reduces overall revenue.
Final Narrative
So, the relationship between Average Revenue and Total Revenue is like the relationship
between the average score of a cricket team and the total runs scored. The total runs (TR)
depend on how many players contribute, while the average (AR) tells us how much each
player contributes on average.
In economics, AR tells us the revenue per unit, while TR tells us the overall revenue. Firms
must balance the twosometimes lowering AR (price) increases TR (total earnings), but
only up to a point. Beyond that, both can decline.
Understanding this relationship is crucial for pricing, production, and profit strategies. Its
not just mathits the story of how businesses juggle price and quantity to maximize
earnings.
5. Explain the Price and Output determinaon of rm under Perfect Compeon.
Ans: Price and Output Determination under Perfect Competition (Simple Explanation)
To understand this concept, imagine a very large vegetable market where many farmers are
selling the exact same tomatoes. No seller can influence the price because buyers can easily
switch to another seller. This is what economists call Perfect Competition.
What is Perfect Competition?
Perfect competition is a market situation where:
There are many buyers and sellers
All firms sell identical products
Firms are price takers (they cannot decide price)
There is free entry and exit in the market
Buyers and sellers have perfect knowledge
Example: Agricultural markets like wheat, rice, vegetables.
Price Determination (Who Decides the Price?)
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In perfect competition, price is not decided by a single firm.
Instead, it is determined by market demand and market supply.
Key Idea:
The industry (whole market) decides the price.
Each firm accepts that price.
So, if the market price of tomatoes is 20/kg, every farmer must sell at 20/kg. If someone
tries to sell at 25, no one will buy from them.
Demand Curve of a Firm
For an individual firm:
Demand curve is perfectly elastic (horizontal line)
This means the firm can sell any quantity at the given price
Why? Because there are many sellers offering the same product.
Revenue Concepts
For a firm under perfect competition:
Price = Average Revenue (AR) = Marginal Revenue (MR)
This is very important.
Output Determination (How Much to Produce?)
Now comes the main question:
How does a firm decide how much to produce?
The answer lies in profit maximization.
Profit Maximization Rule
A firm will produce that level of output where:
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Marginal Cost (MC) = Marginal Revenue (MR)
Lets visualize this:
Why MC = MR?
MR (Marginal Revenue) Extra revenue from selling one more unit
MC (Marginal Cost) Extra cost of producing one more unit
Cases:
1. If MR > MC
Profit increases Produce more
2. If MR < MC
Loss increases Reduce production
3. If MR = MC
Profit is maximum Optimal output
Diagram Explanation (Conceptual)
Imagine a graph:
X-axis Output (Quantity)
Y-axis Cost and Revenue
Curves:
MR = AR = Price Horizontal line
MC curve U-shaped
The point where MC curve cuts MR curve from below is the equilibrium point.
At this point:
Output is fixed
Profit is maximized
Short Run vs Long Run
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Short Run:
Firms may earn:
o Supernormal profit
o Normal profit
o Loss
Even if losses occur, firms may continue temporarily.
Long Run:
Only normal profit exists
Why?
o New firms enter when profit is high
o Firms exit when losses occur
This adjusts supply and stabilizes price
Example to Understand Easily
Suppose:
Market price = 50 per unit
A firm checks its costs
Output
MC ()
Decision
1
30
Produce more
2
40
Produce more
3
50
Stop here (MC = MR)
4
60
Dont produce
So, output = 3 units is the best choice.
Key Features Summary
Firm is a price taker
Demand curve is perfectly elastic
MR = AR = Price
Profit is maximized when:
MC = MR
In long run:
Only normal profit
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Final Conclusion
In perfect competition, the firm has no control over priceit simply accepts what the
market gives. Its main decision is how much to produce, and that is determined by
comparing cost and revenue.
6. Write a detailed note on Monopoly.
Ans: What is Monopoly?
A monopoly is a market structure where a single seller controls the entire supply of a
product or service, and there are no close substitutes available. Because of this, the
monopolist has significant power to influence prices and output.
Think of it like this: imagine theres only one water supplier in your town. You cant get
water from anywhere else. That supplier is a monopolistthey control the market.
Features of Monopoly
Lets break down the key characteristics:
1. Single Seller
o Only one firm supplies the product.
o Example: A local electricity board in many regions.
2. No Close Substitutes
o Consumers cant easily switch to another product.
o Example: Railways in Indiatheres no close substitute for long-distance train
travel in many areas.
3. Price Maker
o The monopolist decides the price, since they control supply.
o Consumers are price takers.
4. Barriers to Entry
o Other firms cant enter the market easily due to patents, high costs, or
government regulations.
o Example: Pharmaceutical companies with patents.
5. Control Over Supply
o The monopolist controls how much is produced and sold.
6. Downward Sloping Demand Curve
o To sell more, the monopolist must lower the price.
o This is different from perfect competition, where firms face a horizontal
demand curve.
Revenue in Monopoly
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In monopoly, the relationship between Average Revenue (AR), Marginal Revenue (MR),
and Total Revenue (TR) is crucial:
AR = Price (since AR is revenue per unit).
TR = Price Quantity.
MR < AR because to sell more units, the monopolist must reduce price.
Example
Imagine a monopolist selling bottled water:
At 10 per bottle, they sell 100 bottles TR = 1,000.
To sell 120 bottles, they reduce price to 9 TR = 1,080.
Notice: TR increased, but MR (extra revenue from selling 20 more bottles) is less
than AR.
This shows how monopolists balance price and quantity.
Diagram to Visualize
Code
Price \
\
\
\
\
Quantity
Demand Curve (AR)
MR curve lies below AR curve
TR curve rises, peaks, then falls
Advantages of Monopoly
Economies of Scale: Large-scale production can reduce costs.
Innovation: Monopolists with patents may invest in research.
Stable Prices: Since one firm controls supply, prices may be more stable.
Disadvantages of Monopoly
Higher Prices: Lack of competition often means consumers pay more.
Lower Output: Monopolists restrict supply to maximize profit.
Consumer Exploitation: Limited choices for consumers.
Inefficiency: Without competition, firms may become complacent.
Real-Life Examples
Indian Railways: A government monopoly in rail transport.
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Microsoft (1990s): Accused of monopoly in operating systems.
Local Electricity Boards: Often monopolies in their regions.
Types of Monopoly
1. Natural Monopoly: Arises due to high fixed costs (e.g., utilities).
2. Legal Monopoly: Protected by patents or laws.
3. Technological Monopoly: Based on unique technology.
4. Government Monopoly: Run by the state (e.g., postal services).
Final Narrative
So, monopoly is a market structure where one seller dominates. Its powerful because it
controls supply, sets prices, and faces no competition. While monopolies can bring benefits
like economies of scale and innovation, they often lead to higher prices and less choice for
consumers.
Understanding monopoly helps us see why governments regulate marketsto prevent
abuse of power and protect consumers. Its not just theoryits the story of how markets
balance freedom, power, and fairness.
7. What are the dierent problems in measurement of Naonal Income in
underdeveloped countries ? Explain.
Ans: Problems in Measurement of National Income in Underdeveloped Countries
Measuring National Income (the total value of goods and services produced in a country)
may sound simple, but in reality, it is quite complexespecially in underdeveloped or
developing countries like India, Nepal, Bangladesh, etc.
In developed countries, most economic activities are recorded properly through banks, tax
systems, and official reports. But in underdeveloped countries, a large part of the economy
operates informally, which creates many difficulties in measurement.
Basic Idea of National Income
Before understanding the problems, think of National Income like this:
Imagine you are trying to calculate the total earnings of a village in one year.
You need to count:
Income from farming
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Income from shops
Salaries of workers
Services like teaching, tailoring, etc.
But what if many people dont keep records? Or they dont even know their exact income?
Thats exactly the problem faced in underdeveloped countries.
Simple Diagram of the Problem
NATIONAL INCOME MEASUREMENT
Organized Unorganized Hidden Economy
Sector Sector (Black Money)
Easy to count Difficult to Almost impossible
measure to track
Main Problems in Measuring National Income
1. Large Non-Monetized Sector
In many rural areas, people do not use money for transactions.
Example:
A farmer grows wheat and consumes it at home.
He may exchange goods with neighbors (barter system).
Problem:
Since no money is involved, it becomes very difficult to assign value to such activities.
2. Lack of Proper Records
In underdeveloped countries, many people:
Do not maintain accounts
Do not keep written records
Small shopkeepers, farmers, and laborers often rely on memory.
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Problem:
Without proper data, economists cannot accurately calculate income.
3. Dominance of Agriculture
A large part of the population depends on agriculture.
Issues in agriculture:
Production depends on weather
Crops may fail
Output varies every year
Problem:
This makes National Income unstable and difficult to measure accurately.
4. Unorganized Sector
A big portion of economic activity happens in the informal sector.
Example:
Street vendors
Daily wage workers
Small repair shops
Problem:
These sectors are not registered, so their income is not officially recorded.
5. Black Money (Hidden Economy)
Some people do not report their income to avoid taxes.
Example:
Illegal businesses
Unreported earnings
Problem:
This black money is never included in National Income, leading to underestimation.
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6. Difficulty in Valuing Household Services
Many services are provided within families without payment.
Example:
A mother cooking food
Taking care of children
Cleaning the house
Problem:
These services have value but are not counted in National Income.
7. Illiteracy and Lack of Awareness
Many people:
Do not understand economic surveys
Cannot provide correct information
Problem:
Data collected may be inaccurate or incomplete.
8. Multiple Occupations
People often do more than one job.
Example:
A farmer who also works as a laborer
A shopkeeper who also farms
Problem:
It becomes difficult to calculate total income without double counting.
9. Poor Statistical Infrastructure
Underdeveloped countries often lack:
Advanced data collection systems
Skilled statisticians
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Problem:
Surveys may be outdated, incomplete, or unreliable.
10. Difficulty in Valuing Non-Market Goods
Some goods are produced but never sold in the market.
Example:
Milk produced and consumed at home
Vegetables grown for personal use
Problem:
Assigning a market value to such goods is difficult.
Summary Diagram
PROBLEMS IN MEASURING NATIONAL INCOME
Non-monetized sector
Lack of records
Agriculture dependence
Unorganized sector
Black money
Household services
Illiteracy
Multiple occupations
Weak statistical system
Non-market goods
Conclusion (Easy to Remember)
In simple words:
Measuring National Income in underdeveloped countries is like trying to count money in
a place where:
Many people dont use money
Many dont keep records
Some hide their income
And some activities are not even counted
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So, the final National Income figure is often not fully accurate.
Final Line for Exam
You can write this:
The measurement of National Income in underdeveloped countries is difficult due to the
presence of a large non-monetized sector, lack of reliable data, dominance of agriculture,
unorganized sector, black money, and weak statistical systems, which together lead to
underestimation and inaccuracy.
8. Explain the Keynes Psychological Law of Consumpon.
Ans: The Big Idea: Keynes Psychological Law of Consumption
John Maynard Keynes, one of the most influential economists of the 20th century, observed
something very human about how people spend money. He noticed that when peoples
income increases, their consumption also increasesbut not by the same proportion.
In simple words:
As income rises, people spend more, but they also save a part of that extra income.
Consumption increases, but not as much as income.
The Law Explained
Keynes called this the Psychological Law of Consumption because it reflects human
psychologyour natural tendency to save a portion of additional income rather than spend
it all.
The law has three main points:
1. Consumption increases with income. When people earn more, they buy more goods
and services.
2. But consumption doesnt increase as much as income. If your income doubles, your
spending wont doubleyoull save some.
3. Therefore, savings also increase with income. Higher income higher consumption
+ higher savings.
Everyday Example
Imagine you earn 10,000 per month. You spend 9,000 and save 1,000.
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Now your income rises to 20,000. Do you spend 18,000 and save 2,000? Not exactly. You
might spend 15,000 and save 5,000.
So, consumption increased (from 9,000 to 15,000), but not as much as income (which
doubled). Savings increased too.
This is Keynes law in action.
Step 1: Why Is This Important?
Keynes used this law to explain why economies sometimes face underemployment or
recessions. If people dont spend all their extra income, demand doesnt rise as fast as
production capacity. This can lead to unsold goods and unemployment.
Thats why Keynes emphasized government spending to boost demand when private
consumption slows down.
Diagram to Visualize
Income Consumption (but less than income)
Savings
Graphically:
Consumption curve rises with income but at a slower rate.
Savings curve also rises with income.
Step 2: Assumptions of the Law
Keynes made some assumptions:
1. Short-run analysis: The law applies in the short run.
2. Normal conditions: No extraordinary changes in habits.
3. Closed economy: No foreign trade considered.
4. Stable prices: Inflation not considered in this law.
Step 3: Implications
1. Savings grow with income. Richer households save more.
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2. Consumption function: Keynes introduced the concept of the consumption function,
showing the relationship between income and consumption.
3. Multiplier effect: Since people save part of their income, government spending can
multiply economic activity by filling the gap in demand.
Real-Life Connection
Think about your own life:
When you got your first pocket money, you probably spent most of it.
As you grew older and earned more, you started saving for bigger goalseducation,
travel, or emergencies.
This natural tendency to save more as income rises is exactly what Keynes described.
Final Narrative
So, Keynes Psychological Law of Consumption is really about human nature. We love to
spend when we earn more, but we also become cautious and save a portion of that extra
income. This balance between spending and saving shapes the entire economy.
Keynes used this insight to argue that economies dont automatically reach full
employment. Because people save part of their income, demand may lag behind
production. Thats why government interventionthrough spending and investmentis
sometimes necessary to keep the economy healthy.
This paper has been carefully prepared for educaonal purposes. If you noce any
mistakes or have suggesons, feel free to share your feedback.
