Objectives

The objectives of this chapter is to study price- output decisions under non-collusive oligopoly. While going through this chapter, you will study about various models of non-collusive oligopoly and analystical difficulties in oligopoly market.

We will discuss under this
1) Chamberlin's Model
2) Kinkd Models of Oligopoly
3) Stackelberg's Duopoly Model





Chamberlin's Model

Chamberlin questioned the illogical assumption in all the three classical models of oligopoly discussed above, namely, that the producers do not learn from their experience even when their assumption regarding the behaviour- reaction of the rival producers is falsified again and again. These models imply that the oligopolists are so short-sighted that they are unable to recognise their mutual dependence. Chamberlin does away with this unrealistic assumption and instead assumes that oligopolists are sure to recognise their mutual dependence either intuitively or as a result of experience.

Thus the distinguishing feature of Chamberlin's model of oligopoly is that it is securely based on the assumption that the duopolists or the oligopolists, as the case may be recognise their mutual dependence. Therefore, in his model, the oligopolist does not assume that his rivals will continue to stick to their output or price or both regardless of what he does to his own output or price or both. Instead, he perceives that any move by him to gain advantage at the expense of his rivals will be retaliated. If any individual oligopolist thinks of lowering his price he can easily see that the number of firms in the “industry” or “group” being very small particularly in the case of duopoly, the adverse effect of his price-cutting on the sales of his rivals will be significant. Therefore, he will foresee that his rivals will not stick to their current price and output but will strike back by lowering their prices.


On account of this perception he can easily see that his own sales, as the result of price-cutting, will increase not along the elastic sales curve dd' of Fig. I above but along the inelastic sales curve DD' of this Fig. 1. Such a result of a price cut by any of the oligopolists is not likely to increase his profits. Hence, the oligopolists recognising their mutual dependence, will avoid any engagement in a price war one another.

The same recognition of mutual dependence which prevents the oligopolists from indulging in price cutting competition will induce them to fix their price at the level which would have prevailed under monopoly. Of course, this is based on the heroic assumption that the cost curves of the oligopolists are identical and such that, when added together, will become identical with the cost curves of single monopolists. The equilibrium output of the “industry”or the “group”, in that case, will be the same as the equilibrium monopoly output under a single monopolists and this total output will be equally shared by all the oligopolists. It may be thought that the solution of equilibrium problem under oligopoly as suggested by Chamberlin and explained above points towards “collusion” among the oligopolists. But Chamberlin argues that the monopoly arrangement among the oligopolists that results in his model is not the result of any collusion among them. It rather results from the oligopolist's intuition or business sense or their experience gained through some earlier price war.

However, regardless of the contention of Chamberlin his model is not a model of a purely non-collusive oligopoly. There may not be in his model an open agreement among the oligopolists on the monopoly arrangement, but there is a tacit agreement all the same.

We have already pointed out the basic weakness of the classical models, namely, that they implicitly assume that oligopolists do not learn from their experience. That they are permanently short-sighted and therefore fail to recognise their mutual dependence. Chamberlin's model does not suffer from this failing but his model is not a model of a genuine not-collusive oligopoly. But there is another more fundamental weakness which not only Chamberlin's model but also a number of other models share with the classical models.
All these models are based on the assumption of perfect knowledge and they rule out uncertainty. As soon as we introduce uncertainty into a model of oligopoly, the analysis of equilibrium under oligopoly becomes even more complicated.
This has led some mathematical economists like Von Neumann and Morgenstern to suggest that laws governing the behaviour of oligopolists resemble not to the laws of physics, from which the technique of equilibrium analysis has been borrowed by the economists, but the laws governing the outcome of games and wars which involve strategies and counter-strategies.
Kinky Models of Oligopoly

The kinky models of oligopoly are described so because they postulate the demand curve or average-revenue curve facing an oligopolist as a curve which has a kink in it at the current level of price as shown in Fig. 4 below. OP is the current price, the demand curve (AR curve) facing the oligopolist is DD' which has a kink at k corresponding to the current price P. Its
companion marginal-revenue curve is MR curve which too has rather two kinks in it at A and B. The solid vertical regiment AB over it is described as
the discontinuity gap which is due to the sudden change in the elasticity of the demand curve from just above

the kink at K to just below it. The portion above it is rather elastic while the portion below it is inelastic. In fact, you can derive this type of kinked demand curve from our Fig. 1 above. The point where, in that figure. DD' and dd' intersect, can be taken as the point indicating the current price. You take the portion of dd' curve (elastic curve) above this point and combine it with the portion of DD curve (inelastic curve) below this point and thus you will get an obtuse-angled kinked demand curve like the DKD curve in our Fig. 4 above.

Note that the kinks A and B in the marginal-revenue curve MR as well as the discontinuity gap AB are exactly below the kink K, that is, if you extend the discontinuity gap AB. vertically upwards, it will pass through K. This model
stipulates that the cost conditions of the oligopolist are such that his marginal cost curve MC cuts the marginal-revenue curve in its discontinuity gap marginal revenue is the profit-maximising output and OP is the profit-maximising price. The oligopolist in this model does not experiment with price-output changes. It is because he is assumed to expect a retaliation by his rivals, if he reduces his price and consequently his sales are expected to increase along the less elastic portion of his demand (sales or average-revenue) curve.

Therefore he will not expect to increase his profits by a cut in his price. He will not experiment with an increase in his price either, precisely because int this case he does not expect his rivals to follow him suit. If our oligopolist raises his price, it does not harm his rivals but, on the contrary, is beneficial for them. Hence they are not expected to match any increase in price that out oligopolist may effect. And, the portion of out oligopolist's demand curve above the kink being highly elastic, any increase in his price will reduce his sales
proportionately much more and thus reducing his total revenue too. Hence he will not increase his price. Thus the tendency would be to stick to the current price and output. This explains the rigidity or stickiness of prices under oligopoly. It can be seen from Fig. 4 above that even when the costs of the monopolist increase or decrease and in consequence of which his marginal cost curve shifts up or down, the equilibrium price and output of the oligopolist will not change, provided the shifted MC curve continues to cut the MR curve in its discontinuity gap.

Paul Sweezy has suggested that the obtuse-angled demand curve as postulated in the model of Fig. 4 above is peculiar to periods of depression when there develop buyer's markets because then in most of the industries demand lags behind supply, in such a situation any cut in price by any one of the oligopolists is sure to be retaliated with similar cuts by the other firms also, while any increase in price by one will not be followed by others.


But, argues Sweezy, during periods of boom and prosperity there develop seller's markets as then demand moves ahead of supply. Therefore
producers do not find any difficulty in selling. In this condition a cut in price by one will not be followed by others. This means that the demand curve below the current price will be elastic. On the other hand, an increase in price by any one will be followed by others which means that the portion of demand curve above the kink will be inelastic. This behavioural assumption read to boom period will give a reflex-angled kinked demand curve like the one in Fig. 5 this type of demand curve can also be derived form Fig. 1 by continuing the
portion of inelastic demand (sales) curve DD' above the point of intersection between DD' and dd' with the lower portion of the elastic of dd.' curve.

In this case also the equilibrium price will be OP and equilibrium output PC which will tend to be rigid so long as the marginal cost curve continues to cut the marginal revenue curve in the discontinuity gap.

It is sometime observed that kinky models of oligopoly explain the rigidity of prices under oligopoly but they do not explain how equilibrium price is determined under oligopoly. This observation is not quite correct because as we
have seen above the kinky models are consistent with the conventional profit- maximising principle of price determination, it is, though a different matter, if the current price is made to be determined by some other principle such as the
“cost-plus” or “mark up” or full-cost principle and then kinky models are relied on to explain the rigidity of prices. We shall consider the full-cost principle of Hall and Hitch in the lesson on the Marginalist Controversy.


Stackelberg's Duopoly Model

The profit of each duopolist is generally, taken as a function of the output levels of both, i.e.

π1=h1(q1,q2) and
π2=h2(q1,q2)


The Cournot solution is obtained by maximising π1 with respect to q1 assuming and keeping q2
as constant. Similarly, π2 is calculated with respect to q2,where q1is assumed to be constant. This means each firm might make certain assumptions about its rival's response. To the extent the firms make erroneous assumptions about each other's response will not be called an
improvement over the Cournot's model of duopoly.
An attempt regarding the variation in the sets of assumptions is contained in the analysis of leadership and followership given by Heinrich Von
Stackelberg, a German economist. A follower obeys his reaction function and sets his output level that maximise profit given the quantity decision of his rival to whom he regards his leader. But a leader is supposed to obey his reaction function. He assumed that his rival acts as a follower, and maximises his profits, given his rival's reaction function. Each duopolist determines his
maximum profit from both leadership and followership and tries to play the role which yields the still larger maximum. In such a situation four outcomes are possible : (1) I (duopolist) desires to be a leader, and II a follower; (2) II desires to be a leader and I a follower; (3) Both desire to be leaders; or (4) both desire to be followers.
Stackelberg tried to make an improvement, though implicit, in Cournot's model. He assumes that one duopolist is enough sophisticated to recognise
that his rivals acts on the Cournot's assumption. It enables the sophisticated duopolist to determine the reaction curve of his rival and incorporate it in his own strategy for maximum profit. It can be shown with the help of a diagram. The isoprofit curves and the reaction functions of the duopolists have been shown in figure 6. Suppose there are two firms A and B. If firm A is sophisticated oligopolist it will assume that firm B will act according to its own reaction curve. This presumption would allow firm A to select its own
production level which provides it the maximum profit. In the fig. 6 this has been shown by point a which is on the lowest possible isoprofit curve of A.
This indicates the maximum profit A can earn given B's reaction curve. Here firm A acting as a monopolist will produce XA and firm B will react by
producing XB on the basis of its own reaction curve. The oligopolist who acts on Cournot's assumption becomes followers and the sophisticated one becomes the leader. The follower becomes worse off in comparison to
Cournot's equilibrium. It is because with this level of output he faces an isoprofit curve which is relatively, at a longer distance from his axis.
Suppose, if B is the sophisticated leader, it would like to produce X-B which is indicated by point b on A's reaction curve and which provides the
maximum possible profit to B in the face of its isoquant map and A's reaction curve. In this case firm B, being leader would earn higher profit than A, as compared with Cournot's equilibrium solution.


But, there can be a situation where both firms are sophisticated. In this situation both will try to act as leaders and the situation is termed as
stackelberg's disequilibrium. Due to the actions of the both either there would be a price war until one of the firms accepts its defeat and starts acting as a follower or there can be collusion between the two firms. In this case, the collusion point would be on (or nearer to) the Edgeworth contract curve where both the firms obtain higher profits. It implies that naive behaviour does not pay and the firms should realize their interdependence. If firms do not take into consideration the actions and reactions of each other, both will be worse off, due to the price war. Thus, it is by realising the other's reactions each firm can earn a higher lever of profit for itself. But, when the model is assessed critically, it is said that in a Cournot- type market situation the sophisticated duopolist bluffs the rival one, by producing level of output higher than the one that would be produced under the Cournot equilibrium. And also if the naive rival, sticks to his Cournot behavioural reaction style and being misled, produces less than what he would
have produced under the Cournot equilibrium.

Under this article we will discuss-
1) Cournot's Model,
2) Bertrand's model
3) Edgeworth's Model,


Introduction

We have studied price and output determination under three market forms, namely, perfect competition, monopoly and monopolistic competition.However, in the real world economices we find that many of the market or industries are oligopolistic. Oligopoly is an important form of imperfect competition. Oligopoly is said to prevail when there are few firms or sellers in the market producing or selling a product. Oligopoly is also ofter referred as "compeition among the few:. The simplest case of oligopoly is duopoly when there are only two producers or sellers of a product.

Oligopoly and Duopoly Defined

Among the various forms of market organisation that we come across in the real world, oligopoly is one of the most important market forms. By now, that is, in view of what you have already learnt about the various market forms, you may will be aware that perfect or pure competition as a market form is largely a mere conceptual construct and, therefore, this type of market form in its pure variety exists only in text-books. In real life there are few markets which can be said to near this market form. Monopoly is another pure market form which forms the opposite pole to perfect competition. Monopoly, though not as rare as perfect competition in real world, is not quite common either the real world market forms are monopolistic competition and oligopoly of the two,
it is oligopoly which is a peculiar feature of modern large scale industry.

But, what is oligopoly ? Well, we can define oligopoly as a market form in which there are only few freely competing firms in a given “industry” or “group” producing either standardised (homogenous) product or differentiated products such that an individual firm controls a substantial part of the total supply of the product or products. In view of it, any price-output decision taken by an individual firm has significant impact on the aggregate supply and the market price. When the
product is standardised, that is, homogenous, the oligopoly is said to be pure oligopoly. If the product is differentiated, it is said to be differentiated oligopoly. Duopoly is a special case of oligopoly when the number of firms in a
given “group” or “industry” is so small as two only. If in such a market form the product is standardised, the duopoly is said to be pure duopoly. On the other hand, if the product is differentiated, the Duopoly is said to be differentiated duopoly.


Analytical Difficulties

It is generally acknowledged that there are great difficulties in analysing the price-output determination under oligopoly. These difficulties arise from the peculiar structure of the market under oligopoly. As we observed above, the number of firms in an oligopolistic market is small that any change in the price and output effected by any one of the firms has a significant impact on the total condition in the “industry”. On account of it any change in the price and output of one firm is bound to provoke a counter-change by the rival firm in their own prices and output which may, in turn, provide a feature change in the price-output policy of the first firm. Such a chain reaction may go on till some sort of market equilibrium is attained. This shows that there is a great degree of inter-dependence of the firm's price-output policies under oligopoly, which suggest a seues of moves and counter-moves through determination under oligopoly a very intricate problem. It is important in this context to understand the structural difference between oligopoly, on the one hand, and other market firms like perfect competition and monopoly , on the other hand. Under perfect competition as well as monopoly and even under monopolistic competition an individual firm can disregard the behavioural reaction of the rival firms to its own price-output policy. But it can not do so under oligopoly. An individual firm in a perfectly competitive market can afford to disregard the behavioural reaction of the rival firms because it produces only an insignificant part of the total supply of the given commodity, on account of which achange in the output of a single individual firm does not change the total supply significantly and thus it has no influence on the price. The market structure of perfect competition is such that any individual firm can sell as must as it likes at the giving price. This is the meaning of the individual firm's demand or sale curve being
horizontal under perfect competition. So the rival firms are not expected to react and will not react to any price-output policy move made by any individual firm.

The monopolist also has hardly any need to bother about such a reaction because by the very definition of monopoly there is no rival facing a monopolist.Monopoly is as you know, a market form in which there is one and only one firm in a given industry producing a commodity which has no close substitute.

Under monopolistic competition, too, the individual firm will not normally bother about the rival firms reaction to its own policy moves. This is because the number of firms being very large under monpolistic competition, the adverse affect of any policy move by any one firm on the sales of the rival firms would be widely distributed. On account of it each of the rival firm will feel insignificant impact of it which will normally be ignored by it. Hence this is no reaction.

The structural conditions of oligopoly are different. The number of firms being very small under oligopoly, any move made by one of the firms is bound to be met with a counter—move by the rival firms. This makes the price-output decision under oligopoly a tricky one. An oligopolist has to make some assumption with regard to the probable behaviour reaction of the rival firm to his policy move before making the final decision. This behavioural assumption is crucial to the solution of the equilibrium problem under oligopoly. Different assumption in this regard lead to different solution. It is due to this that equilibrium output and price are said to be indeterminate under oligopoly. This is also the reason why there is a wilderingly large number of models of oligopoly.

It is only the position of sales curve of any oligopoly firm that is indeterminate, its slope which is broadly indicative of its elasticity is also indeterminate.This again depends on the nature of the behaviour reaction of rival firms to any price output more made by any one of them. Once again
taking the case of duopoly with only two firms, A and B, whether the sale curve facing an oligopolist firm, say, A will be elastic or inelastic depends on
A's assumption with regard to the behaviour reaction of the rival firm B to its price-output moves. For example, if A's assumption that whatever it does to its own output and price, B will stick to its own output and price, then the sales
curve of A will be rather elastic as shown by the curve dd' in the following Fig1. On the other hand, if any price-output move by A is limited or retaliated by B, then the sales curve of A will be rather inelastic like the curve DD' in Fig. 1.


Having explained the analytical difficulties with regard to equilibrium and price-output determination under oligopoly, we may now consider some important models of non-collusive oligopoly. Generally, we speak of two types of oligopoly on the basis of the organisational relationship between the firms belonging to a given oligopoly market, when firms belonging to a given oligopoly have a tactic or open agreement of some sort in order to eliminate mutual competition, the oligopoly is said to be collusive oligopoly. But, if the firm do not have any agreement on output and price, tactic or open, and rather compete freely with one another, the oligopoly is said to be non-collusive oligopoly.

Cournot's Model

Cournot's model is a model of non-collusive duopoly which can be easily extended to cover cases of oligopoly with more than two firms. August Cournot, an early nineteenth century, French economist, was probably the first economist who analysed the problem of equilibrium under duopoly. This model is based on the following explicit or implicit assumptions :

1. There are only two producers producing a homogeneous commodity. Incidently, the commodity assumed is mineral water whose production cost per unit is constant, though zero, it being a free gift of nature.

2. The two producers are assumed to have identical constant costs which, in his example if mineral water, are zero.

3. Both the Producers are assumed to be know with certainly the total demand curve for the commodity.

4. The demand curve is assumed to be negatively sloping straight line.

5. Absence of collusion and therefore presence of free competition between the two producers is assumed.

6. It is assumed that the objective of each producer is to maximize his individual profit. And, the most crucial assumption relates to the expected behaviour reaction of each producer.

7. Each producer assumes that whatever he may do to his own output, the rival producer will stick to the output that he is currently producing.

On the basis of the above assumption Cournot's analysis leads to the conclusion that under non-collusive duopoly the equilibrium output of the duopolistic “group” would be two thirds of the competitive equilibrium output which would be equally shared by the two producers that is, the equilibrium
output of each one of them would be one-third of the competitive output. How this result follows logically from the above assumptions, is explained below : Let us name of two producers as A and B, and let the total demand curve for their homogeneous commodity (mineral water) be represented by the straight line QR in Fig. 2 below. Since the cost per unit (average cost) is assumed to be
constant and zero (mineral water being a free gift of nature), the marginal cost will equal the average cost and will also be constant at zero. This means that the average cost-cum-marginal cost curve will coincide with the horizontal axis OX. Since both producers are assumed to have identical costs, the horizontal axis OX represents the average cost-cum-marginal cost curve of each one of them. Let us assume that producer A enters the market first. He is then, the lone producer and seller of the commodity, the total demand for which is represented by the straight the QR in our Fig. 2 above. A will behave like a monopolist and produce OM quantity at which his marginal cost equals his marginal revenue. When he is the sole producer and seller, the demand curve facing him is QR which is also his average revenue curve. QM is its companion marginal revenue curve which meets the marginal cost curve (i.e. the horizontal axis) at point M, i.e. condition of profit maximization. Hence he will produce OM output which is one-half of OR, and charge OP price.
Now let B enter the market. He observes that one-half of market is already occupied by A. He assumes that whatever be his own output A will stick to the output OM which he is already producing. So he considers that only the remaining one-half of the market represented by the portion MR of the demand curve QR is open to him. He will behave like, a monopolist in this part of the market, producing one-half of MR, that is, MM, output (1 =1/4 of competitive output OR) which maximises his profit. Now the total output is OM1..... and consequently the price is brought down to OP1.This affects the profits of A adversely. So he makes a counter-move on the assumption that B will stick to MM1 (= 1/4 OR) output. So he believes that now only 3/4 of the market is open to him where in he can monopolistically, producing 3/8 of the competitive output OR.


Thus we find that the Cournot's model of non-collusive duopoly, the equilibrium total output is 2/3 of the equilibrium competitive output which is equally shared by the two producers. This output is greater than the equilibrium monopoly output and hence the price under duopoly will be, according to this model less than the monopoly price. As we remarked earlier, Cournot's model of duopoly can be extended to cover oligopoly cases with any number of firms. The general formula for this is that the equilibrium total output under oligopoly is n/n+1 of the competitive,output which is equally shared by all the firms, n in the above formula represents the number of firms. If there are three producers, for example, all other assumptions remaining the same, the equilibrium total output according to Cournot's model, would be 3/4th of the competitive output which will be equally shared by all the three producers, each producing 1/4th of the competitive output.

Bertrand's Model

Cournot's model was presented in 1838. About half a century later another french economist, Goseph Bertrand, presented an alternative model of duopoly by changing the crucial behavioural assumption of Cournot's model. Cournot had assumed that each producer expects his rival or rivals to stick to the output that he or they are currently producing regardless of what the
former does to his own output. This behavioural assumption of Cournot is replaced by Bertrand with the alternative behavioural assumption which states that each producer expects his rival to stick to the price which he is currently charging regardless of what the former does to his own price. Bertrand retains all other assumptions of Cournot's model.We assume that it is producer A who enters the market first. Being the sole producer, the whole market is open to him. But he would supply only such an output and charge such a price which would maximise his profit. So he will, obviously, settle for monopoly output and monopoly price. In terms of the diagram of Fig. 2, he will supply OM output and Charge OP price. Now B enters the market.

Assuming that whatever the price he may charge. A will continue to charge Op price, he fixes p1 price which is a little lower than OP which is being charged by A. Now the commodity being homogenous and competition free all the customers will switch over to B and the new customers will also buy from him. It is obvious that in such a situation A will not take things lying down. He is sure to retaliate by reducing the price even lower than that of B which will now take away all thecustomers of B to A. A too is assuming that B will stick to his price. Thus there will start what is known as a price war or cut-throat price competition between the two.

In the short period the price can fall even below the average cost of production.But no businessman will remain in a particular business in the long period, he is unable to recover his costs inclusive of his normal profit. This means that the price was between the duopolists (oligopolists) will go on till in the long period an equilibrium is attained. In this state of long-period equilibrium the price will equal the long-period average cost. In the case of the mineral water example of Cournot's model, the equilibrium Price will be zero as mineral water being a free gift of nature
has zero cost. And, the equilibrium output of the “industry” will be the same as under perfect competition. In term of the diagram of Fig. 2 above, the total equilibrium output will be OR, that is, the same as the competitive output and the equilibrium price also be the same as under perfect competition, that is, zero in this example. The total output and sales will be equally shared by all the producers who make up the given oligopolistic “industry”

Edgeworth's Model

The third classical model of duopoly (oligopoly) was formulated by the British economist, Edgeworth. In his model, there is no stable equilibrium : instead, there on perpetual oscillations of prices.The above rather interesting result in Edgeworth's model is also the result of a changed assumption. His assumptions are the same as those of Bertrand including the behavioural assumption of Betrand which stipulates that each producer assumes that whatever he may do to his own price, the rival producer will stick to the price which is currently charging. If Edgeworth adopts all the assumptions contained in Bertrand's model, then how is it that his result is different from that of Bertrand's model? The answer to this question lies in all
additional assumptions made in Edgeworth's model. He assumes that the combined output capacity of the two procucers is less than the competitive output. The detailed process of the price-output decisions making in Edgeworth's
model which rules out a stable equilibrium and instead points towards perpetual price oscillations is explained here under with the help of fig. 3.

The example taken in this model is also that of zero-cost mineral water. The output of producer A is measured in Fig. 3 along OX and that of B along
OX1.This horizontal axis X1OX also represents the zero-cost line. The output capacity of A is OA and that of B is OB so that the combined output capacity of the two producers is AB which is less than the competitive output D1D2.DD1 is the demand curve facing A while DD2 is the demand curve facing B both of which are identical.
Supposing A enters the market first, he being the sole producer will behave monopolistically producing 1/2 of OD1(= PC) and charging price P which will maximise his profit. Now B enters the market and assuming that A will continue to charge price P puts in the market the whole of his capacity output (P1D = OB) and fixes a price lower than what A is charging, say at p1as shown in Fig. 3 above. Thus we will encroach on A's market as shown by P1D. Now A will retaliate by bringing into the market the whole of his capacity output and fixing a price lower than P1charged by B on the assumption that whatever he may do to his price, B will stick to his price P1 So A fixes the price, say, P2 and selling his capacity output P2E (= OA) encroaches on B's market. B will retaliate by a similar counter-move, lowering the prices still further. Thus there will be a price-war between the two producers as in Bertrand's model. Sooner or later one of the producers will have lowered the price to such a level at which the demand in his own pat of the market equals his capacity output. In terms of Fig. 3, this comes about when B lowers the price to the level P3 at which the demand in his our own part of the market is P3 F which equals his capacity output OB. Now there is no question of B encroaching of A's market. Now A seeing that B has done his worst to the price while his part of the market remains unencroached on by B1,will once again behave monopolistically assuming that B will stick to the price P3. So, once again, he fixes price P and producers and sells PC output. This attracts B to raise his price, though to a level lower than P. Thus there will start another round of price-cutting competition dragging the price once again to p3 and then again pulling it up to P. Thus there are perpetual price oscillations without any stable equilibrium.

The modern theory of public debt or the new orthodoxy as Buchanan puts it, is an offshoot of the economics of depression or the Keynesian
economics. The economic anamoly created by the great depression of the 1930s, led to the development of the new theory of public debt. The modern theory states that a huge public debt is a national asset rather than a liability and continuous deficit spending is essential to the economic prosperity of the nation. A.H. Hansen, the exponent of modern fiscal theory, declares that
public debt is an essential means of increasing employment and has become an instrument of economic policy today.

The modern theory of public debt is concerned with macro-economic variables and not with individual utilities, economists treat the whole economy as one unit. They are mainly concerned with internal debt as they regard external debt as a definite burden since repayment of principal and interestto foreign countries are entailed, such repayment involves a transfer of real goods and services from the debtor to the creditor country in the payment of interest and principal amount. Until a few years ago, the modern version of public debt remained unchallenged.

The Keynesian economics has also discarded the notion of debt burden on basis of income creating potentialities. Debt creation brings into the
exchequer unutilised resources and the productive employment of these resources leads to an increase in the national income. Tax payments, necessary for servicing the debt are met out of the increased income and therefore it is not burden on the economy. Prof. J.M. Buchanan in his book Principles of Public Debt declared that the 'New Orthodoxy' has produced three main
propositions which are as follows :
1. The creation of public debt does not involve any transfer of the primary real burden to future generations.
2. The analogy between individual or private debt and public debt is fallacious in all essential respects.
3. There is a sharp and important distinction between an internal and an external public debt.

After Keynesian era there were some economists who also accepted the central idea of the new orthodox that the burden of public debt rests on the generation living at the time of debt creation. However, their emphasis was on the transfer of secondary burden to the individuals of the future generation. As D Mc. Wright stated, that "an internally held public debt imposes no economic
burden on society, is not entirely true. The burden has been enormously exaggerated but it would be foolish to deny that it does not exist.'' However,
they also suggested that proper methods of taxation can reduce this burden to some extent, but they never attacked their (New Orthodox's) central ideas.

Buchanan's Thesis : Revolt against the 'No Burden Hypothesis'

The dissent from the 'no burden' thesis has arisen with the publication of J.M. Buchanan's Principles of Public Debt in 1958. Professor Buchanan holds that the financing of a project by the government by means of borrowing does shift a burden
to the future generations. According to him the concept of burden should be interpreted in terms of the individual attitudes towards their economic well-being rather than in terms of changes in private sector outputs and real income because
of the inheritance by the later generations of a larger or smaller amount of capital instrument. Buchanan argues that during the period in which the project is financed and borrowing takes place, no burden of any kind is created : individuals who give loans to the government voluntarily exchange liquid funds for less liquid government bonds instead of using the funds of acquiring consumption or investment goods since this is done voluntarily by the individuals concerned, they do not feel themselves worse off. When, however, the bonds are repaid in the future, funds are
taken from the taxpayers to change bonds into cash of the bond holders; as a result, the taxpayers feel themselves to be worse off, but the bond holders are not better off since they have now merely changed bonds for cash. In other words, as
the bond holders are not worse off by changing cash into bonds so also they cannot be better off later by the changing of bonds into cash. But in the later periods the taxpayer's future generations are worse off-since tax is a compulsory payment. As
a result, the society as a whole becomes worse off during the future. It is in this sense that the burden is shifted to the future generations.

Bowen, Dawis, Kopf Thesis : Bowen, Dawis and Kopf (B.D.K.) consider a society with a changing composition over time and define in terms of the
life-time consumption of different generations of taxpayers. They demonstrated that even if a project is financed wholly by a reduction in consumption by generation I, a burden is nevertheless shifted to the future generations. Thus suppose, a country producing only timber, in year 1900, quantum of 100 tons of timber is consumed by the government for meeting, say, war needs and the "project" is "financed" wholly by a reduction of 100 tons of timber consumption
by generation I. Supposing that the life span of each generation is 44 years and assuming that the reduction in the consumption of timber made by each generation at the time of its appearance is met by a corresponding increase in its consumption before it passes away, the pattern of timber consumption by three generations will be as follows :
It should be noted from the above illustration that though the government consumption of timber has been financed wholly by a reduction in the
consumption of timber by generation I still the Consumption of every generation is deferred by 44 years : and this will continue until the debt floated by the government for consuming the timber initially is matched. The deferred consumption, according to BDK, is a burden even though the whole of the initial consumption of timber by the government is matched by a corresponding decrease in the private consumption.

Modigliani's Burden Thesis :

Prof. Modigliani's analysis of the burden of public debt is different from that of his predecessor. He is of the opinion that pubic debt is a burden on the future Generation because of the loss of partial capital formation and the consequent reduction of the potential future income. The community's income need not fall simply because of the fall in
the private capital formation. If government's capital formation increases through borrowing methods and the borrowed funds are utilised productively, the income of the nation is bound to rise. Therefore, the important problem is whether
the borrowed funds are employed productively and contribute to economic development. Modigliani himself accepts that through productive capital formation, the burden that falls on the future generation might be fully or partly off set.

Musgrave's Thesis of Inter-Generation Equity :

R.A. Musgrave explains the same problems that has been examined by 'BDK', but his assumption
regarding the reactions of the tax payers and the lenders are fundamentally different. Musgrave feels that the burden of debt financed expenditure shifts via reduction in private investment. He constructs a case in which, regardless of the reduction of generation I, loan finance, always divides the cost among generations whereas tax finance can never do so. In the sense, loan financing does shift (equitably) the burden to the generations to come. Musgrave is concerned with a long-lived government facility the cost of which is to be distributed equitably amongst those who make use of it.

Suppose that the project has a life of three periods and each generation has a life span of three periods. As period I opens, generation I already in its last period, is on the scene : as also Generation II, with one more period to go and generation III in its initial periods. In the second period, there exists
generation II in its last period as also generation III and IV. In the third period, there will be generation III, IV and V respectively in their third, second
and first periods. The problem is how to take from the generations in question their "due" shares of the cost of the project, namely, the following :
The 'due' share being proportional to the period or periods for which the services of the facility are enjoyed by each generation. Musgrave's solution
requires generation I to pay 1/9th of the cost in form of taxation and so on. As to financing the project in its year of construction, 6/9th must be covered by loan; but no part of the loan can be demanded from generation V, since it is already in its last period, and thus could never be repaid. Generation I is vanishing at the end of the first period so 6/9 is financed by loans from generations II and III, who are repaid before they vanish. Thus everybody gets his moneyback, except to the extent that he is required to pay tax, and tax is distributed over time in accordance with the degree of service use. From the above explanation it is clear that there had been taxation and the total cost of the period had been taken from them. GI, GII, GIII in Ist period, no cost would have been transferred to subsequent generations.


Domer assumed initially that the burden of the debt or the average tax rate covering interest charges to income, or the ratio of the debt to income multiplied by interest rate paid on bonds proceeding with simple mathematical relations, he arrived at the formula for debt as under :

Tax rate = L/n, i

where L = fraction of national income borrowed

i = interest paid on bonds and

n = relative annual rate of growth of income.

From the above analysis it is clear that the tax rate, given constant rate of interest, depends usually on the ratio of money income on the debt. From this analysis, it is very clear that for the first time, a systematic attempt has been made to link up the burden of a country's debt with growth of its national income.

Secondary Burden of Public Debt : New economists analysed the secondary burden of public debt in terms of the effects on incentive to save, work and invest on account of the tax friction caused by existence of a large public debt.

1. Pigou Effect or Wealth Effect : The existence of a large public debt implies large holding of wealth by people in the form of government securities.
Due to this, the incentive to save will be adversely affected, because already sufficient amount is held by them. However, it is difficult to measure that to what extent the incentive to save is affected by the existence of a large public
debt.

2. Kaldor Effect : The existence of a large public debt also has adverse consequence on incentive to work, invest and accumulate. However, in practice, it is difficult to establish how far this has affected the incentive to work, invest and accumulation. However, there are some economists who are of the opinion that there
are several advantages and disadvantages of the offset of the existence of a large public debt. A.H. Hanson thinks that a large public debt provides a
certain amount of security in times of depression. It acts as a built-in-stabilizer and that is kind of National Insurance. A.P. Lerner also tried to show that without the creation of debt, usually public
expenditure is impossible and that only alternative to debt is depression or widespread poverty. He also emphasized that even in the absence of a large public debt, tax friction may take place for other reasons. Less public debt means more private debt, the servicing of which will have the same inflationary effect and to meet this inflationary threat, an increase in the tax on income and wealth becomes inevitable. Some timesthis tax rate may be much greater than what would be required to service the public debt. The only way to prevent these evils, he says, is to maintain a state of depression in which people are too poor to accumulate wealth. Further he is of the opinion that when unemployment is fought by deficit spending and as such the amount of public
debt increases, the so-called burden of the debt should be weighed against the burden of unemployment which would be there if deficit spending programme had not been undertaken. And if this is done, the burden of the debt may appear to be much smaller and even nil or negative.


Does Borrowing Shift Burden of Government Activities to Future Generations

A long debated question which has given rise to a great deal of controversy in recent years is whether the system of financing a project by means of public debt shifts the burden to the future generations. One traditional argument is
this : If taxes are used to finance a project, persons pay for the project now; if funds are raised by borrowing the present generation escapes the cost and the burden is shifted to the future generation which pays the interest and the
principal. Hence the public debt shifts the burden to the future generation. The 'No Burden Thesis' is once again established. Lerner in an observation also warns that it is not quite right to say that public debt does not matter at all. R.N. Bhargava also emphasized this 'No burden analysis' in the context of internal debt. If posterity inherits the burden of paying interest and principal of the debt, it also inherits a corresponding and equivalent right to receive this interest and principal.
Thus its liability to pay is matched by an equivalent right to receive that payment and in the case of external debt, the posterity will have to use a part of its current resources for servicing the debt, that is, a part of total output of goods and services
produced within the country will have to be used for servicing the external debt.

However, these depend upon the purposes for which the debt is incurred. If the debt was obtained for development purposes the posterity benefits from this expenditure. In the absence of foreign loans, this expenditure would not have been incurred and national income and output would have been adversely affected. If foreign loans were incurred to fight against war then the lack of foreign loans might have meant defeat
and slavery. Thus posterity would benefit from the independence of the country that it inherits. Similarly, if foreign loans were incurred for the useful consumption purpose, there would be improved health and efficiency of the people and against the burden of servicing foreign debt we have to balance the advantage posterity inherits from a more efficient and healthy working 'force'.


Principles of Debt Management

Debt Management means the formulation and implementation of a debt policy regarding the forms of public debt to be issued, terms on which new bonds are to be sold, the pattern of maturities of the debt, ownership pattern of debt and methods of redemption of public debt. Hence the management of public debt is concerned with the decision regarding floatation, refunding and
retirement of debt as to gain the greatest economic advantages or to create the least economic disadvantages. The objectives of debt management are to manage public debt in a way that meets the governments gross funding needs
at the lowest possible long-term cost, with due regard to the underlying risks. Debt management is guided by the following principles :

(i) Management must be capable of generating the necessary funds from the lending market without undue coercion and that at the lowest feasible interest cost. This principle suggests that debt should be managed in such a manner that necessary funds are available from the lending market. Besides, it is also needed that these funds are procured at the minimum interest cost.

(ii) Public debt should be managed in such a way that the needs of the investors are satisfied. An efficient debt management policy not only keeps the interest rates on government bonds low but should also devise the pattern of interest rates on government obligations which conform to the preference pattern of the investors.

(iii) Refunding and flotation of debt should be managed in such a way that the economic stability is not disturbed.

(iv) Public debt policy must be co-ordinated with fiscal and monetary policy.

(v) Public debt policy should maintain a suitable structure of maturity.

(vi) There are two important issues relating to management of foreign debt. These are (a) the extent of government regulation of foreign debt and (b) the appropriate composition of debt.

I. Introduction

Public debt, both internal and external, as a means of financing economic development assumes a significant role in modern times. In recent years,
Government's expenditure has been increasing faster than its ability to raise resources. It is so because now its activities are not so restricted as only to maintain law and order and protect the country against external aggression there have expanded intensively as well as extensively. Therefore, when expenditure exceeds revenue, these is a deficit in the budget of the government.
This deficit can be bridged either by raising revenue from taxation or by borrowing from the public or by depreciating the value of money in the hands of the people.

So far as taxation is concerned, both in developed and the developing countries, there are certain limits beyond which taxation cannot be raised without adverse effects on the levels of investment and production and consequently on the rate of economic growth.
Therefore, the most appropriate method, preferred by all the countries alike in mobilising their financial resources is the method of debt finance.


Meaning :-

Public debt is not fundamentally different from taxation. It may be defined as a kind of deferred tax through which public enjoys the advantages of the public expenditure much before it is met out of the current revenue. It refers to those obligations of the state as a borrower and private investor of capital where state promises to pay the lender the amount borrowed with interest after a given period of time. It excludes inter-state borrowing within the
country, unpaid salaries of public officials and pensions to be paid on retirement.

There have been different views regarding public debt. In the opinion of Hume and Adam Smith, debt was a cause in leading a nation towards disaster. A Government should normally meet all of its expenditure out of its current revenue and if really necessary, then only under certain exceptional circumstances, a government could be justified in raising some resources through loans.

Now-a-days public debt is regarded as income of the state. It is also a method through which the government may finance public services without
reducing the real wealth of individuals. It is comparatively a recent development.

The classical views on public debt:-

Public debt was favoured by the economists in the eighteenth century because they had great faith in the role of the state in the economic activities
and their favourable attitude towards public debt was a part of the Mercantilist doctrine. But in the laissez faire state of the nineteenth century and the early part of the twentieth century, public debt was condemned by the early classical economists mainly because of their lack of faith in the role of state in economic activities. Besides, Public spending was considered by them to be wasteful and unproductive. J.B. Say said, "There is this ground distinction between an individual borrower and a government borrowing that, in general, the later borrows capital for the purpose of barren consumption and expenditure." Obviously, in this
socio-political climate public finance had very little to do. Huge revenue were un-necessary for the conduct of minimum government functions-the policy of minimum spendings implied to policy of minimum taxation.

Subsequent thinkers like Malthus, Mills, Sidgwick and Cairnnes had some liberal views about the consequences of debt. But they were not whole
heartedly in favour of debt creation. The opposition to public debt was on the ground that public expenditure is wasteful and unproductive.


The classical theory of public debt came to be formulated in the last decades of the nineteenth century. H.C. Adams and C.F. Bastable who may
be taken to be the best representatives of the classical theory of public debt, refuted the idea that the burden of public debt cannot be shifted on the future generation.

Forms of Public Debt

Public debt may take various forms. Loans may be classified according to whether they are voluntary or compulsory, or according to use for which
they are intended, according to duration, or according to origin.

(1) Voluntary and Compulsory : In the case of voluntary loans, people are free to purchase government bonds if they choose to do so and there is no compulsion to lend money to the government. Normally, public debt is voluntary but during emergencies, the government compels the public to subscribe to forced loans. When emergencies such as war, famine, etc. arise,
government enforces borrowing through legal compulsion because voluntary loans fail to extract the required amount of funds for the purpose. A compulsory loan is also known as "refundable taxation" because on the one hand like a loan, government promises to repay the sum with little or no interest to the contributors and on the other hand, like taxation, it is a compulsory contribution to the government.

(2) Productive and Unproductive : Sometimes public debt is classified into productive and unproductive debt. Productive debt is that which is incurred for the purpose of constructing capital assets that yield a revenue to the government, for example expenditure on railways, irrigation, etc. The income thus yielded can be used to repay the debt and therefore, debt borrowed for such purposes is called a productive debt. On the other hand, public debt incurred to cover budgetary deficits on revenue account or for purposes which
do not yield any direct income to the government including capital expenditure that is not productive, such as construction of hospitals, school buildings or expenditure on poor relief, etc. is called unproductive debt.
But now-a-days The government never spends its revenue in a way which is unproductive from the social welfare point of view.

3) Redeemable and Irredeemable : On the basis of maturity pattern of a debt, public debt may be classified as redeemable and irredeemable. The
former is repayable at some definite future date. After the maturity period, the government pays the amount to the lenders. It is also known as a terminable loan. In the case of irredeemable debt, the principal is not repayable on any definite date, but the government may repay it at its will. However, interest on both types of debt is payable at the stipulated rate at stated intervals.

(4) Funded and Unfunded : The classification is based primarily on the duration of the debt. The public debt of the government, which is repayable
or redeemable usually after more than a year, is known as funded debt. Unfunded debt, on the other hand, is that public debt of a government which is repayable within year. The unfunded debts are commonly used for temporary purpose. They permit the government to secure funds at low rate of interest. Such securities are mostly purchased by banks and other financial institutions. They generally accelerate the rate of inflation in the economy.

(5) Internal and External : This is a classification according to the place or location of the loan. When public loan is subscribed entirely by the people of the country and the repayment is done in home currency, it is called internal debt. External debt is that debt which is borrowed by the foreign country (from individuals institutions or government). The repayment of external debt is usually done in foreign currency. Sometimes it may also be repayable in home currency.

Significance of Public Debt

The case for borrowing can be examined from two angles, the first relatesto the use of borrowing as a method of financing as compared to taxation and
the second relates to the choice of borrowing in preference to the other non-
tax sources, namely, the creation of money.

1. Taxes versus Loans

Most economists agree that, for its normal budgetary requirement a government should raise funds through taxes, because if it does not tax now, it will have to tax in the future. Meanwhile, a growing debt will shake people's confidence in its financial stability. Besides it, a public debt is usually subscribed out of savings, while a tax is likely to be met, partly or wholly, by reducing expenditure. Thus, in general, taxes reduce private expenditure while loans do not. If a government finances its entire expenditure through loans, there may be continuous under-saving and excess of expenditure by the people. This may lead to an artificial boom in which a low volume of savings available for investment will check production. Thus boom will get out of control and the State may be forced to tax to restore a balance between
savings and spendings. Therefore, it is desirable to meet expenditure of a normal recurring type through taxes.

The tax method reduces future income less than the loan method because under the tax method people generally reduce their expenditure. Taxation, relatively speaking, implies the shifting of income from the present to thefuture. On the other hand, borrowing implies the shifting of incomes from the future to the present. It may be desirable to alter the income streams to achieve stability over time. If present incomes are more because of a boom, then future incomes may fall when the boom is over. In such a case, the state
may use the tax method which will reduce present income. Thus, loans or taxes could be used as a counter-cyclical device to reduce the intensity of
economic fluctuations.

2)Choice between Borrowing and the Creation of Money

If new taxes are not supposed to be imposed, the government can raise funds through borrowing or creation of money. The latter method has two advantages; it has no contractionary effects, whatsoever and it does not give rise to interest charges or problems arising out of servicing and retirement of debt. Therefore, in periods of depression, in which non- tax methods are used
in order to lessen contradictory effect of the rising of funds, the case for creation of money is particularly strong. Borrowing is objectionable because it does exercise some contractionary effect, although such effect is much less
than in the case of taxation.

In full-employment periods, borrowing is always preferable to money creation, in depression periods, however, there is a stronger case for money creation and the use of borrowing will necessitate a large deficit to obtain a
given degree of recovery. If society accepts money creation as acceptable and there were no danger of irresponsible use of it, the case for it would be strong. Under the existing attitude, its advantages are weakened by the possibility of general loss in public confidence and subsequent misuse of the policy. Because of psychological factors, the central bank's borrowing form of money creation
is preferable to the printing of additional paper money.


Burden of Public Debt

The term burden of public debt is ambiguous. A distinction is generally made between financial or primary burden and real or secondary burden.
When a loan is obtained by the government the level of taxation in the economy has to be increased in order to meet the interest charges so long as the debt continues to exist. The income of the people is transferred to the government to the extent of the increase in the tax level. The consequent loss in the income of the people may be called the financial burden of the public debt.
The higher level of taxation caused by the rising public debt may have some repercussions on the economy in the form of adverse effects on the
capacity and willingness to save. These effects may be called the real burden or secondary burden of the public debt.


Effects of Public Debt

(i) Public Debt and Consumption: The existence of public debt has an important effect on consumption. Those who hold government bonds
representing the latters obligation to pay consider these bonds as personal wealth. This wealth would not have arisen if the government had financed its expenditure through taxation. The net result is that the possession of government bonds will induce them to speed not only their current
income but also in excess of their current income since they hold wealth.

(ii) Public debt and Liquidity: public debt is represented by bonds which are highly negotiable. Those who have bonds have highly negotiable and highly liquid form of assets.

(iii) Public Debt and Production: Public debt is generally favourable to promote production, income and employment. But the fear created by plausible higher does of taxation or even capital levy in future to repay the public debt may
discourage the investors.

(iv) Public Debt and Distribution of Income:Public debt is said to promote inequality in the distribution of income. It is held that a large amount of public debt increases inequality of income distribution in favour of the bond holders.
Since bond holders are generally rich, this leads to move inequality in distribution in income.

Introduction

The balance of payments of a country is a systematic record of all its economic transactions with the outside world in a given year. It is a statistical record of the character and dimensions of the country's economic relationships with the rest of the world. According to Bo Sodersten, "The balance of payments is merely a way of listing receipts and payments in international transactions for a country."B. J. Cohen says, "It showsthe country's trading position, changes in its net position as foreign lender or borrower, and changes in its official reserve holding."

Objectives of the lesson

In this lesson we will study the structure of balance of payments account and different policies, exchange rate and determination of equilibrium exchange rate.

Structure of Balance of Payments Accounts

The balance of payments account of a country is constructed on the principle of double-entry book-keeping. Each transaction is entered on the credit and debit side of the balance sheet. But balance of payments accounting differs from business  accounting in one respect. In business accounting, debits (-) are shown on the left side and credits ('+) on the right side of the balance sheet. But in balance of payments accounting, the practice is to show credits on the left side and debits on the right side of the balance sheet.

When a payment is received from a foreign country, it is a credit transaction while payment to a foreign country is a debit transaction. The principal items shown on the credit side (+) are exports of goods and services, unrequited (or transfer) receipts in the form of gifts, grants, etc. from foreigners, borrowings from abroad,
investments by foreigners in the country and official sale of reserve assets including gold to foreign countries and international agencies. The principal items on the debit side (-) include imports of goods and services, transfer (or unrequited) payments to foreigners as gifts, grants, etc., lending to foreign countries, investments by residents to foreign countries and official purchase of reserve assets or gold from foreign countries and international agencies.

These credit and debit items are shown vertically in the balance of payments account of a country according to the principle of double-entry book-keeping. Horizontally they are divided into three categories: the current account, the capital
account and the official settlements account or the official reserve assets The balance of payments account of a country is constructed in Table 1:

1. Current Account. The current account of a country consists of all transactions relating to trade in goods and services and unilateral (or unrequited) transfers. Service transactions include costs of travel and transportation, insurance,
income and payments of foreign investments etc. Transfer payments relate to gifts,foreign aid, pensions, private remittances, charitable donations etc. received from foreign individuals and governments to foreigners.

In the current account, merchandise exports and imports are the most important items. Exports are shown as a positive item and are calculated f.o.b. (free on board) which means that costs of transportation, insurance, etc. are excluded. On
the other side, imports are shown as a negative item and are calculated c.i.f. which means that costs, insurance and freight are included. The difference between exports and imports of a country is its balance of visible trade or merchandise trade or simply balance of trade. If visible exports exceed visible imports, the balance of trade is favourable. In the opposite case when imports exceed exports, it is unfavourable.

2. Capital Account. The capital account of a country consists of its transactions in financial assets in the form of short-term and long-term lendings and borrowings, and private and official investments. In other words, the capital account shows international flow of loans and investments, and represents a change in the country's foreign assets and liabilities. Long-term capital transactions relate to international capital movements with maturity of one year or more and include direct investments like building of a foreign plant, portfolio investment like the purchase of foreign bonds and stocks, and international loans. On the other hand, short-term international capital transactions are for a period ranging between three months and less than one
year.

There are two types of transactions in the capital account—private and government. Private transactions include all types of investment: direct, portfolio and short-term. Government transactions consist of loans to and from foreign official agencies.


3. The Official Settlements Account.

The official settlements account or official
reserve assets account is, in fact, a part of the capital account. But the U.K. and U.S. balance of payment accounts show it as a separate account. "The official settlements account measures the change in nation's liquidity and non-liquid liabilities to foreign official holders and the change in a nation's official reserve assets during the year.
The official reserve assets of a country include its gold stock, holdings of its convertible foreign currencies and SDRs and its net position in the IMF." It shows transactions in a country's net official reserve assets.

Errors and Omissions.

Errors and omissions is a balancing item so that total credits and debits of the three accounts must be equal in accordance with the principles of double entry book-keeping so that the balance of payments of a country always balances in the accounting sense.

Equilibrium in Balance of Payments

Balance of payments always balances means that the algebraic sum of the net credit and debit balances of current account, capital account and official settlements account must equal zero. Balance of payments is written as:

B = Rf-Pf

Where
B represents balance of payments, R receipts from foreigners, P payments made to foreigners.
When B = Rf – Pf = 0, the balance of payments is in equilibrium.
When R- P > 0, it implies receipts from foreigners exceed payments made to foreigners
and there is surplus in the balance of payments.

On the other hand, when Rf- Pf < 0 or Rf < P there is deficit in the balance of payments as the payments made to foreigners exceed receipts from foreigners. If net foreign lending and investment abroad are taken, a flexible exchange rate creates an excess of exports over imports. The domestic currency depreciates in terms of other currencies. The exports become cheaper relatively to imports. It can be shown in equation form:

X+B=M+I

Where X represents exports, M imports, I. foreign investment, B foreign borrowing

or X-M = If-B

or (X-M)-I,-B) = Q

The equation shows the balance of payments in equilibrium. Any positive balance in its current account is exactly offset by negative balance on its capital account and vice versa. In the accounting sense, the balance of payments always balances. This can be shown with the help of the following equation : C + S + T = C +
I + G + (X-M)

or Y- C + I + G + (X-M) [ Y = C + S +T]
where C represents consumption exepnditure, S domestic saving, T tax receipts, / investment expenditures, G government expenditures, X exports of goods and services, and M imports of goods and services. In the above equation
C + S + T + GNI or national income (K) and
C + I+G=A, where A is called 'absorption'.
 In the accounting sense, total domestic expenditures (C + I + G) must equal current income (C + S + T) that is A = Y. Moreover, domestic saving (Sd) must equal domestic investment (Id). Similarly, an export surplus on current account (X > M) must be offset by an excess of domestic savings over investment (Sd > Id). Thus, the balance of payments always balances in the accounting sense, according to the basic principle of accounting. In the accounting system, the inflow and outflow of a transaction are recorded on the credit and debit sides respectively. Therefore, credit and debit sides always balance. If there is a deficit in the current account, it is offset
by a matching surplus in the capital account by borrowings from abroad or/and withdrawing out of its gold and foreign exchange reserves, and vice versa. Thus, the balance of payments always balances in this sense also.

Disequilibrium in Balance of Payments

A disequilibrium in the BOP of a country may be either a deficit or a surplus. A deficit or surplus in BOP of a country appears when its autonomous receipts (credits) do not match its autonomous payments (debits). If autonomous credit receipts exceed autonomous debit payments, there is a surplus in the BOP and the disequilibrium is said to be favourable. On the other hand, if autonomous debit payments exceed autonomous credit receipts, there is a deficit in the BOP and the disequilibrium is said to be unfavourable or adverse.

Causes of Disequilibrium

There are many factors that may lead to a BOP deficit or surplus:

1. Temporary Changes: There may be a temporary disequilibrium caused by random variations in trade, seasonal fluctuations, the effects of weather on agricultural production etc. Deficits or surpluses arising from such temporary causese are expected to correct themselves within a short time.

2. Fundamental Disequilibrium: Fundamental disequilibrium refers to a persistent and long-run BOP disequilibrium of a country. It is a chronic BOP deficit,caused by such dynamic factors as changes in consumer tastes within the country or abroad which reduce the country's exports and increase its imports, continuous fall in the country's foreign exchange reserves due to supply inelasticities of exports and excessive demand for foreign goods and services, excessive capital outflows due to massive imports of capital goods, raw materials, essential consumer goods, technology and external indebtedness, low competitive strength in world markets which adversely affects exports and inflationary pressures within the economy which make exports dearer.

3. Structural Changes: Structural changes bring about disequilibrium in BOP over the long-run. They may result from the following factors: (a) Technological changes in methods of production of products in domestic industries or in the industries of other countries. They lead to changes in costs, prices and quality of products, (b) Import restrictions of all kinds bring about disequilibrium in BOP. (c) Deficit in BOP also arises when a country suffers from deficiency of resources which it is required to import from other countries. (d) Disequilibrium in BOP may also be caused by changes in the supply direction of long-term capital flows. More and regular flow of long-term capital may lead to BOP surplus, while an irregular and short supply of capital brings BOP deficit.

4. Changes in Exchange Rates: Changes in foreign exchange rate in the form of over-valuation or under-valuation of foreign currency lead to BOP disequilibrium. When the value of currency is higher in relation to other currencies, it is said to be overvalued. Opposite is the case of an undervalued currency. Over-valuation of the domestic currency makes foreign goods cheaper and exports dearer in foreign countries. As a result, the country imports more and exports less of goods. There is also outflow of capital. This leads to unfavourable BOP. On the contrary,
under-valuation of the currency makes BOP favourable for the country by encouraging exports and inflow of capital and reducing imports.

5. Cyclical Fluctuations: Cyclical fluctuations in business activity also lead to BOP disequilibrium. When there is depression in a country, volumes of both exports and imports fall drastically in relation to other countries. But the fall in exports may be more than that of imports due to decline in domestic production. Therefore, there is an adverse BOP situation. On the other hand, when there is boom in a country in relation to other countries, both exports and imports may increase. But there can be either a surplus or deficit in BOP situation depending upon whether the country
exports more than imports or imports more than exports. In both the cases, there will be disequilibrium in BOP.

6. Changes in National Income: Another cause is the change in the country's national income. If the national income of a country increases, it will lead to an increase in imports thereby creating a deficit in its balance of payments, other things remaining the same. If the country is already at full employment level, an increase in income will lead to inflationary rise in prices which may increase its imports and, thus, bring disequilibrium in the balance of payments.

7. Price Changes. Inflation or deflation is another cause of disequilibrium in the balance of payments. If there is inflation in the country, prices of exports increase. As a result, exports fall. At the same time, the demand for imports increase. Thus, increase in export prices leading to decline in exports and rise in imports results in adverse balance of payments.

Measures to Correct Deficit in Balance of Payments

When there is a deficit in the balance of payments of a country, adjustment is brought about automatically through price and income changes or by adopting certain policy measures like export promotion, monetary and fiscal policies devaluation and direct controls.

1. Devaluation or Expenditure-Switching Policy

Devaluation raises the domestic price of imports and reduces the foreign price of exports of a country devaluing its currency in relation to the currency of another country. Devaluation is referred to as expenditure switching policy because it switches expenditure from imported to domestic goods and services. When a country devalues its currency, the price of foreign currency increases which makes imports dearer and exports cheaper. This causes expenditures to be switched from foreign to domestic goods.

2. Direct Controls

To correct disequilibrium in the balance of payments, government also adopts direct controls which aim at limiting the volume of imports. The government restricts the import of undesirable or unimportant items by levying heavy import duties, fixation of quotas etc. At the same time, it may allow imports of essential goods duty free or at
lower import duties, or fix liberal import quotas for them. For instance, the government may allow free entry of capital goods, but impose heavy import duties on luxuries. Import quotas are also fixed and the importers are required to take licenses from the authorities in order to import certain essential commodities in fixed quantities. In these ways, imports are reduced in order to correct an adverse balance of payments.

3. Adjustment through Capital Movements

A country can use capital import to correct a deficit in its balance of payments. A deficit can be financed by capital inflows. When capital is perfectly mobile within countries, a small rise in the domestic rate of interest brings a large inflow of capital. The balance of payments is said to be in equilibrium, when the domestic interest rate equals the world rate. If the domestic interest rate is higher than the world rate, there will be capital inflows and the balance of payments deficit is corrected.

4. Adjustment through Income Changes

Given the foreign exchange rate and prices in a country, an increase in the value of exports, causes an increase in the incomes of all persons associated with theexport industries. These, in turn, create demand for goods and services within the country. This will raise the incomes of persons engaged in the latter industries and services. This process will continue and the national income increases by value of the multiplier.

5. Stimulation of Exports and Import Substitutes

A deficit in the balance of payments can also be corrected by encouraging exports. Exports can be encouraged by producing quality products, by reducing exports through increased production and productivity and by better marketing. They
can also be increased by a policy of import substitution. It means that the country produces those goods which it imports. In the beginning, imports are reduced but in the long-run exports of such goods start. An increase in exports causes the national income to rise by many times through the operation of the foreign trade multiplier.

Foreign Exchange Rate

The foreign exchange rate or exchange rate is the rate at which one currency is exchanged for another. It is the price of one currency in terms of another currency. It is customary to define the exchange rate as the price of one unit of the foreign currency in terms of the domestic currency. The exchange rate between the dollar and the pound refers to the number of dollars required to purchase a pound. Thus, the exchange rate between the dollar and the pound from the US viewpoint is expressed as $ 2.50 = £ 1.

The Britishers would express it as the number of pounds required to get one dollar, and the above exchange rate would be shown as £0.40 = $ I. Theexchange rate of $ 2.50 = £ 1 or £ 0.40 = $ 1 will be maintained in the world foreign exchange market by arbitrage. Arbitrage refers to the purchase of a foreign currency in a market where its price is low and to sell it in some other market where its price is high. The effect of arbitrage is to remove differences in the foreign exchange rate of currencies so that there is a single exchange rate in the world foreignexchange market. If the exchange rate is $ 2.48 in the London exchange market and $ 2.50 in the New York exchange market, foreign exchange speculators, known as arbitrageurs, will buy pounds in London and sell them in New York, thereby making a profit of 2 cents on each pound. As a result, the price of pounds in terms of dollars rises in the London market and falls in the New York market. Ultimately, it will equal in both the markets and arbitrage comes to an end. If the exchange rate between the dollar and the pound rises to $ 2,60 = £ 1 through time, the dollar is said to depreciate with respect to the pound, because now more dollars are needed to buy one pound. When the rate of exchange between the dollar and the pound falls to $ 2.40 = £ 1, the value of the dollar is said to appreciate because now less dollars are required to purchase one pound. If the value of the first currency depreciates that of the other appreciates, and vice versa. Thus, a depreciation of the dollar against the pound is the same thing as the appreciation of the pound against the dollar and vice versa.

Determination of Equilibrium Exchange Rate

The exchange rate in a free market is determined by the demand for and the supply of foreign exchange. The equilibrium exchange rate is the rate at which the demand for foreign exchange equals to supply of foreign exchange. In other words, it is the rate which clears the market for foreign exchange. There are two ways of determining the equilibrium exchange rate. The rate of exchange between dollars and pounds can be determined either by the demand and supply of dollars with the price of dollars in pounds, or by the demand and supply of pounds with the price of pounds in dollars. Whatever method is adopted, it yields the same result. The analysis that follows is based on the dollar price in terms of pounds.

The demand for foreign exchange is a derived demand from pounds. It arises from import of British goods and services into the US and from capital movements from the US to Britain. In fact, the demand for pounds implies a supply of dollars. When the US businessmen buy British goods and services and make capital transfers to Britain, they create demand for British pounds in exchange for US dollars because they cannot make payments to Britain in their currency, the US dollars.

The demand curve for pounds DD. is downward sloping from left to right in Figure 1. It implies that the lower the exchange rate on pounds, the larger will be the quantity of pounds demanded in the foreign exchange (US) market, and vice versa. This is because a lower exchange rate on pounds make British exports of goods and services cheaper in terms of dollars. The opposite happens if the exchange rate on pound is higher. It will make British goods and services dearer in terms of dollars, and the demand for pounds will fall in the foreign exchange (US) market. But the shape of the demand curve for foreign exchange will depend on the elasticity of demand for imports. If a country imports necessities and raw materials,
we may expect the elasticity of demand for imports to be low and the quantity imported to be insensitive to price changes. If, on the other hand, the country imported luxury goods and goods for which suitable substitutes exist, demand elasticities for imports might be high. If the country has many well-developed import competing industries, the elasticity of demand for imports most certainly is high. In the short-run, elasticity of demand for imports may not be very high. In the long-run, however, it is much more probable that the production pattern will alter according to price changes and the demand for imports, therefore, will be more elastic.

The supply of foreign exchange in our case is the supply of pounds. It arises from the US exports of goods and services and from capital movements from the US to Britain. Pounds are offered in exchange for dollars because British holders of pounds wish to make payments in dollars. Thus, the supply of foreign exchange reflects the quantities of pounds that would be supplied in the foreign exchange market at various
dollar prices of pounds.

The supply curve for pounds SS is an upward sloping curve as shown in Fig. 58.1. It is a positive function of the exchange rate on pounds. As the exchange rate on pounds increases, the greater is the quantity of pounds supplied in the foreign exchange market. This is because with increase in the dollar price of pounds (lower pounds price of dollars), US goods, services and capital funds become better bargains to holders of pounds. Therefore, the holders of pounds will offer larger quantities of pounds with the increase in the exchange rate.

But the shape of supply curve of foreign exchange will be determined by the elasticity of the supply curve. As the value of the country's own currency increases, imports become relatively cheaper, and more is imported. As more is imported, more of the home currency is supplied in the foreign exchange market, provided elasticity is greater than unity. When imports become relatively cheap, new goods will start to be imported and domestic import-competing industry will be gradually eliminated by import.

Equilibrium Exchange Rate

Given the demand and supply curves of foreign exchange, the equilibrium exchange rate is determined where DD, the demand curve for pounds intersects SS, the supply curve of pounds. They cut each other at point E in Figure 1. The equilibrium rate is OR and OQ of foreign exchange is demanded and supplied. At OR exchange rate the US demand for pounds equals the British supply of pounds and the foreign exchange market is cleared. At any higher rate than this, the supply of pounds would be larger than the demand for pounds so that some people who wish to convert pounds into dollars will be unable to do so. The price of pounds will fall, less pounds will be supplied and more will be demanded. Ultimately, the equilibrium rate of exchange will be re-established. In Fig. when the exchange rate increases to OR2, the supply of pounds is more than the demand for pounds. With the fall in the price of pounds, the equilibrium exchange rate OR2 is again established at point E. On the contrary, at an exchange rate lower than this, say OR1 the demand for pounds is greater than the supply of pounds. Some people who want pounds will not be able to get them. The price of pounds will rise which will reduce the demand and increase the supply of pounds so that the equilibrium exchange rate OR is re-established at point E where the two curves DD and SS intersect.


Thus, under flexible exchange rates equilibriumrate of exchange will prevail which will clear the market and keep the balance of payments in equilibrium.

The Balance of Payments Theory

According to this theory, under free exchange rates the exchange rate of the currency of a country depends upon its balance of payments. A favourable balance of payments raises the exchange rate, while an unfavourable balance of payments reduces the exchange rate. Thus, the theory implies that the exchange rate is
determined by the demand for the supply of foreign exchange.

The demand for foreign exchange arises from the debit side of the balance of payments. It is equal to the value of payments made to the foreign country for goods and services purchased from it plus loans and investments made abroad. The supply of foreign exchange arises from the credit side of the balance of payments. It equals all payments made by the foreign country to our country for goods and services purchased from us plus loans disbursed and investments made in this country. The balance of payments balances if debits and credits are equal. If debits exceed credits, the balance of payments is unfavourable. On the contrary, if credits exceed debits it is
favourable. When the balance of payments is unfavourable, it means that the demand for foreign currency is more than its supply. This causes the external value of the domestic currency to fall in relation to the foreign currency. Consequently, the
exchange rate falls. On the other hand, in case the balance of payments is favourable, the demand for foreign currency is less than its supply at a given exchange rate. This causes the external value of the domestic currency to rise in relation to the foreign currency. Consequently, the exchange rate rises.

When the exchange rate falls below the equilibrium exchange rate in a situation of adverse balance of payments, exports increase and the adverse balance of payments is eliminated, and the equilibrium exchange rate is re-established. On the other hand, when under a favourable balance of payment situation, the exchange rate rises above the equilibrium exchange rate, exports decline, the favourable balance ofpayments disappears and the equilibrium exchange rate is re-established. Thus, at any point of time, the rate of exchange is determined by the demand for and the supply of foreign exchange as represented by the debit and credit side of the balance of payments. "Any change in the conditions of demand or of supply reflects itself in a change in the exchange rate, and at the ruling rate the balance of payments balances from day to day or from moment to moment.

The determination of exchange rate under the balance of payments theory is illustrated in Fig. 8.3 DD is the demand curve for foreign currency. It slopesdownward to the left because when the rate of exchange rises, the demand for foreign currency falls, and vice versa. SS is the supply curve of foreign exchange which slopes upwards from left to right. This is because when the exchange rate falls, the amount of foreign currency offered for sale will be less, and vice versa. The two curves intersect at E where OR equilibrium exchange rate is determined. E is also the point where the balance of payments is in equilibrium. Any exchange rate above or below OR will mean disequilibrium in the balance of payments. Suppose the exchange rate rises to OR1. The demand for foreign exchange R1A is less than its supply R1B. It means that there is a favourable balance of payments. When the exchange rate is more than the equilibrium rate, exports decline and imports increase.

Consequently, the demand for foreign exchange will rise and the supply will fall. Ultimately, the equilibrium exchange rate OR will be restored where demand and supply of foreign exchange equals at point E. In the opposite case, when the exchange rate falls below the equilibrium rate to OR2, the demand for foreign exchange is greater than its supply. It implies an unfavourable balance of payments. But fall in the exchange rate leads to increase in exports and decline in imports. As a result, the demand for foreign currency starts falling and the supply starts rising till the equilibrium exchange rate OR is re-established with the equality of demand and supply of foreign exchange at point E.

Criticism of the Theory

The balance of payments theory has been criticised by economists on the following counts:

1. Balance of Payments Independent of Exchange Rate: The main defect of the theory is that the balance of payments is independent of the exchange rate. In other words, the theory states that the balance of payments determines the exchange rate. This is not wholly true because it is changes in the exchange rate that bring about equilibrium in the balance of payments.

2. Neglects the Role of Price Level : The theory neglects the role of the price level in influencing the balance of payments of a country and hence its exchange rate. But the fact is that price changes do affect the balance of payments and the exchange rates between countries.

3. No Free Trade and Perfect Competition: The theory is based on assumptions of free trade and perfect competition . This is unrealistic because free trade is not practised these days. Governments impose a number of restrictions to reduce imports and adopt measures to encourage exports. This is how they try to correct disequilibrium in the balance of payments.

4. Truism: The theory presupposes that there is an equilibrium exchange rate where balance of payments balances. This is a truism. But the equilibrium exchange rate may not be one of balance of payments equilibrium. In fact, exchange rates between countries continue to prevail under conditions of surplus or deficit in the
balance of payments and there is no tendency for the balance of payments to be in equilibrium over the long-run.

5. Demand for Imported Raw Materials not Inelastic: The theory has been criticised for the assumption that the demand for imported raw materials is inelastic. There is no raw material in the world the demand for which is perfectly inelastic.

Conclusion

The above analysis is based on the assumption of fixed exchange rates. Thus, a deficit (or surplus) in the balance of payments is possible under a system of fixed exchange rates. But under freely floating exchange rates, there can in principle be no deficit (or surplus) in the balance of payments. The country can prevent a deficit (or surplus) by depreciating (or appreciating) its currency. Further, balance of payments always balances in an ex-post accounting sense, according to the basic principle of accounting.