Micro Economics Meaning Nature And Scope

Economics is the study of those activities of human beings, which are

concerned, with the satisfaction of unlimited wants by using the limited resources.
Micro means the millionth part. The term micro has been taken from the Greek
word mikros meaning small. Under microeconomics we study the individual units
like a consumer, a firm, an industry, price determination of a particular commodity
etc. In short the microeconomics deals with the study of the economic problems of a
single unit like a firm or small economic units or resource owners. The main
objective of microeconomics is to study the principles, policies and the problems
relating to the optimum allocation of resources. From the theoretical point of view it
tells us the functioning of a free enterprise economy. It explains us how through the
market mechanism goods and services produced in the economy are distributed.

Nature and scope of Micro Economics

In the nature of economics we may consider whether it is a science or an art.
Science not only means the collection of facts but it also means that the facts are
arranged in such a manner that they speak for themselves. It means that some laws
are discovered through these facts. Thus science is a systematic body of knowledge
concerning the relationship between causes and effects of a particular phenomenon.

Characteristics of a science
1 First of all the facts are observed. E.g. when price rise the demand contracts.
2 The facts in this step are properly classified. Like if price falls how much the
demand has fallen.
3 After the compilation of facts and having knowledge about the magnitude of
a problem a law is framed keeping onto consideration the cause and effect of
a fact. E.g. Law of demand
4 The final feature of science is by applying the scientific laws to real life. It is
verified whether they are valid or not.

Thus from the above discussion it could be concluded that economics is a

science. But some economists believe that it is not an exact science.

Whether it’s a social science or a natural science

Arguments in favour of social science
1. Economics is a systematic study. It is the study of the interrelated activities
like production consumption and exchange of wealth.
2. Laws of economics show a cause and effect relationship between them
3. Laws of economics are based on real experiences of life.

Arguments against economics as a natural law

1 The laws of economics are not the exact laws. Like law of economics does not
operate if there is a change in the income of the person or a change in price of
substitute goods.
2 Economics laws are far from universal applicability. These laws cannot be
applied in all situations and at all the times.
3 The laws of economics cannot be verified in the laboratories. In the
exceptional cases even the information or the results obtained through the
application can prove to be futile.
Thus economics is not a natural science. It is a social science.

Economics As A Positive Or A Normative Science

Positive science is that science which studies an accurate and true description of
events as they happen. Thus it deals with what, how and why. Normative science is
suggestive in nature. Normative science tells us what ought to be.

Economics as a positive science

1 Positive science is logical whereas normative science is emotional. Therefore

it is more exacts it is based on the logic.
2 If economics studies only the realities of the real world then the chances of the
disagreement are less, as the case would be if it studies both.
3 The economists cannot make the rational judgments if they try to analyze both
what is and what ought to be.

Economics as a normative science

1. Economics would offer more meaningful conclusions if it gives suggestions too
long with the facts.
2. Economics will be more useful if it is fruit bearing too along with the light
bearing. Most of the people study economics for the fruits and not for the light
merely.
3 if the economist synchronizes the analysis of economic problems with concrete
economic policies he would save time. Else it would be difficult if one person
finds the solutions and the other tries to justify those solutions.

Thus the argument can be put to an end only by saying that it is both the positive as
well as a normative science

Arguments in favour of economics as an art

Many economists like Marshall, Pigou etc. believe that economics is an art also
besides being a science
Economics as an art

1. Economics offer a solution to the problems of human beings. It tells us how

we can make the judicious use of our resources.
2. It is through the art that we can verify the economic laws. For example the law
of demand
3. The doubts can be removed by dividing the economics into science as well as
an art.

Arguments against art

1 Science and art are different. If economics is science it cannot be art and
if it is an art it cannot be a science.
2 Economic problems are influenced by social and political nature.
Therefore economics cannot be considered from the economic point of
view only.
UTILITY
It’s the want satisfying power of a commodity.
1. Utility is subjective. It depends upon the human wants.
2. Utility keeps on changing with time and place.
3. It need not be always useful.
4. Utility has nothing to do with the morality.
Measurement of utility
It can be measured both in terms of money as well as in terms of units. If two
persons pay different sum of money for the same amount of commodity then it is
the measurement in terms of money.
Marshall, Jevons and Menger etc have tried to measure it in terms of cardinal
numbers. Pareto, Allen, Hicks etc. measured it in ordinal an term that is Indifference
curve approach.
Utility has three concepts:
1. Initial utility
2. Marginal utility
3. Total utility

Marginal utility can further be divided into Positive Marginal Utility or Zero
Marginal Utility or Negative Marginal Utility

Quantity Total utility Marginal utility

0 0 -
1 8 8
2 14 6
3 18 4
4 20 2
5 20 0
6 18 -2

Opportunity costs
Opportunity costs may be defined as the expected returns from the second best use
of the resources which are foregone due to the scarcity of resources. E.g. if with a
sum of Rs. 1 lakhs one can purchase two machines. One yields a profit of Rs.20000
and the other a profit of Rs. 10000. Now the buyer will forego the use which is less
productive. It can also be termed as economic rent
(Rs. 20000 – Rs 10000 = Rs. 10000)
Explicit and Implicit costs
Marginal and Incremental costs
It is the change in Total costs due to the production of one more or one less unit of a
factor of production.

MC = TCn – TCn-1
Incremental costs refer to the total additional costs associated with the decisions
to expand output or to add a new variety of product etc. In the long run when firms
expand their production they hire more of men, machinery and equipments. These
expenditures are included in the incremental costs. These costs also arise due to
change in the product lines, addition or introduction of a new product, replacement
of worn out plant and machinery, replacement of old techniques of production with
a new one etc.
Sunk costs are those costs, which cannot be increased or decreased by varying
the rate of output. Example once it is decided to make incremental investment
expenditure and the funds are allocated, all the preceding costs are considered to be
the sunk costs as these costs cannot be recovered when there is a change in the
market decisions.
EQUILIBRIUM
Equilibrium is a state of balance. In fact sometimes the modern economics is
also called as an equilibrium analysis. When the forces act in the opposite
direction is in the state of rest they are called as to be in the equilibrium.
Equilibrium can be a stable equilibrium, unstable equilibrium or a neutral
equilibrium.

1) Stable equilibrium is that equilibrium in which the object concerned after

having been disturbed reverts back to the original state.
2) In an unstable equilibrium a slight disturbance further evokes disturbance.
3) In the neutral equilibrium the disturbing forces neither bring it back nor they
can take it away from the equilibrium position.

Short term or the long-term equilibrium

In the short run demand plays an important role in the determination of price
and in the long run both demand and supply plays an important role.
Partial and general equilibrium
Partial equilibrium excludes certain variable and studies a few selected items
at a time. This method takes into consideration the impact of one or two variables
and keeps all others constant. E.g. demand and supply depends upon many
variables but for the sake of simplicity we study only a few aspects.

In case of general equilibrium analysis

An analysis that treats various individual units and markets as interrelated and
attempts to trace the consequence of an economic event is called the general
equilibrium. In the process of making the decisions the consumers as well as the
firms affect the prices of the commodities. The changes in the prices serve as
signals to various consumers and firms that affect their decisions accordingly. In
this way the changes in the prices will go on bringing the changes in the
quantities supplied and demanded until equilibrium in all the markets is not
achieved simultaneously.
Static and dynamic approaches
The word static generally means a position of rest but in economics it means a
state in which there is a continuous, regular, certain and constant movement
without any change. According to Clark there is an absence of the following five
types of changes 1) size of population 2) supply of capital 3) methods of
production 4) forms of business organization and 5) the wants of the people.
Harrod is of the view that static analysis is concerned with the lack of
investment in the economy. In static economics we do not study about the
sequences, lags etc. its like ordinary demand and supply theory. Example people
continue to be born and die but births equal deaths so there is no change in the
numbers but the composition of population is changing. The major drawback is
that it takes us far from the actual picture assuming the variables constant.
Economic dynamics is a process of change through time.

The economy is at point A and in the

normal course of action it would have
D gone to the point B but changes make it go
C. Again had there been no changes it would
have gone to D but again the changes lead it
towards E.

E C

A B

Harrod’s view
c d
b
a

o
t t2
time

From a to b, that is upto the time period t, there is a static growth in the national
income but between b and c there is the govt. investment and through the
operation of the multiplier there is an increase in the income. This movement
between b and c is the subject matter of economic dynamics to Harrod.
Although the dynamic analysis is better than the static analysis but
in real life we make use of the comparative static situation in which we compare
one equilibrium position with the other and ignore the time element.
MICRO ECONOMICS AND BUSINESS
Microeconomics explains how an individual business firm decides to fix the price
and output of their product and what factor combination do they use to produce
them. Microeconomics is concerned with the choosing of an appropriate course of
action from the number of alternatives present for a business. Microeconomics tells
us how to make a rational choice in allocating the scarce resources of the firm while
making the decisions regarding price, output, technology, advertising expenditure
etc. A business has to make the following decisions with the use of microeconomics

Price output decisions that is how much qty. is to be produced and at what prices it
is to be sold.
Demand Decisions that is to estimate the correct demand so that there is neither the
shortage of the product not there is any surplus.
Choice of a technique of production that is what type of technique is to be used
whether the capital-intensive technique or the labour intensive technique.
Even the advertisement decisions of the firm are projected with the help of
microeconomics. A firm will spend on that mode of advertising which has the
maximum reach and which has the least costs.

In the long run the firm has to decide about the location of the plant, size of the
plant or the choice of the production technique etc.
It also tells a business about the investment decisions that is what is the rate of
investment over the years or is it profitable to takeover the other firms of not.
THEORY OF DEMAND
The demand in economics means both the desire to purchase as well as the
ability to pay for the good.
Demand is different from the quantity demanded. Demand is the quantities
that the buyers are willing and able to buy at alternative prices during the given
period of time whereas quantity demanded is a specific amount that buyers are
willing and able to buy at on price.
Nature of demand for a product

With the normal goods the demand has a negative relationship. It means as
the price of a commodity falls the quantity demanded for the product goes up.

x
D
Price P1

P
D
Q1 Q
Qty y
The law of demand operates due to the following reasons
1 Law of diminishing marginal utility
2 Income effect
3 Substitution effect
4 Different uses
5 Size of consumer group

Exceptions to the law of demand

1 Goods having the prestige value or the articles of distinction
2 Giffen goods
3 In case of emergencies
4 Ignorance
INDIVIDUAL DEMAND AND THE MARKET DEMAND
Individual demand is the quantity demanded by an individual person at different
possible prices at a given point of time.

Market demand is the quantity demanded by all the persons in the market at
different possible prices at a point of time.
A’s demand B’s demand Market demand
d
Price Price d1 Price D

d d1
D
Quantity Quantity Quantity

Determinants of demand
The demand for X commodity is affected by the following factors
1 Price of the commodity
2 Prices of related goods
3 Income of the consumer
4 Tastes and preferences of the consumer
5 Expectation of a price change of the commodity
6 Population
7 Income distribution
 8 Bandwagon Effect: it is also called cromo effect. It means that people
undertake certain tasks as other as also doing like that. People try to follow
the crowd without examining the merits of a particular thing.
9 Snob Effect: preference for the goods because they are different from the
good the community preferred. It is the demand for the exclusive goods.

Elasticity of demand and its determinants

Elasticity is a measure of the responsiveness of one variable to the change in other.
Ed can be
1. Price Elasticity of demand
2. Income elasticity of demand
3. It can be cross elasticity of demand

Methods to measure the price elasticity of demand

1 Total expenditure method as given by Marshall

T E>1

Price E=1

E E<1

Total expenditure

2 Proportionate method

Ed = (-) P  Q
 Q P

3 Point elasticity method

In case of a linear demand curve

M E=
Price . A E >1
. P E =1
. B E <1

O N
Qty

4 Arc elasticity method

B
C

Determinants of elasticity of demand

1. Nature of the commodity
2. Availability of substitutes
3. Postponement of the use
4. Income of the consumer
5. Habit of the consumer
6. Time period
7. Joint demand
8. Goods with the different uses

Demand as a multivariate function or a dynamic demand function

The demand in the long run is not only influenced by the price rather it is influences
by all other factors that we have assumed constant in the short run. The long run
demand for the product depends on the composite impact of all its determinants
operating simultaneously. To estimate the long run demand we have to take into
consideration all the relevant factors. A demand function, which describes the
relationship between demand and all its variables, is known as the multivariate
demand function.

Dx = f ( Px, M, Py, T, A )
Theory of consumer behaviour
Different theories have been developed time to time to explain the consumer
behaviour. The major breakthrough was achieved in the form of cardinal utility
analysis. Marshall gave this theory.
According to this theory as a consumer goes on consuming more and more units of
a commodity the utility derived from each successive unit goes on diminishing.
Assumptions;
1 Utility is measurable in cardinal numbers.
2 Marginal utility of money remains constant
3 Marginal utility of every commodity is independent
4 There is a continuous consumption f the commodity.
5 Every unit of the commodity consumed is same in size.
6 No change in the price of the commodity and its substitutes.
7 No change in the tastes character, fashion and habits of the consumer.

Cups of coffee consumed Total utilty (utils) Marginal utility

everyday
1 12 12
2 22 10
3 30 8
4 36 6
5 40 4
6 41 1
7 39 -2
8 34 -5
 ______________

Exceptions

1 Good book or poem

2 Misers
3 Drunkards
4 Initial units

Importance

Basis of laws of consumption

Varity in consumption
Difference in value in use and value in exchange
Basis of progressive taxation.

Criticism
Cardinal measurement of utility is not possible.
Marginal utility of money is not constant.
Every commodity is not an independent commodity
Unrealistic assumptions.

Law of equi marginal utility or law of substitution

This law was again developed by Marshall. It is also known as the Gossen’s second
law. According to this law, a consumer allocates his limited income in such a way
that the last unit of money spent on different commodities gives the consumer the
same level of satisfaction.
Assumptions
Same as above + consumer is a rational person
 Rupees spent MU of Mangoes MU of Milk
I 12 10
II 10 8
III 8 6
IV 6 4
V 4 2

MU of mangoes MU of milk

-------------------------------------------------

Importance

In the field of consumption

In the field of production
In the field of exchange
Distribution of income between saving and consumption.

Criticism

Consumers are not fully rational

Minute calculations are not possible
Ignorance of the consumer
Influence of fashions, customs and habits.
Cardinal measurement of utility is not possible
Constancy of marginal utility of money is not possible

Indifference curve analysis

Hicks and Allen gave this approach. An IC is a locus of all such points located on
an indifference curve, which gives the consumer the same level of satisfaction. The
different points on the depicted IC show the same level of satisfaction.

But we must bear in mind the concepts of the Marginal Rate Of Substitution
and the Diminishing Marginal Rate Of Substitution. The MRS is the rate at which
the consumer is willing to sacrifice the number of units of another commodity, so
that his over-all level of satisfaction may remain unchanged.

The marginal rate of substitution is the amount of one good (i.e. work) that has to be
given up if the consumer is to obtain one extra unit of the other good (leisure).

The equation is below.

The marginal rate of substitution (MRS) = change in good X /change in good Y

The DMRS states that the MRS of good X for good Y will go on diminishing while
the level of the satisfaction of the consumer remains the same.

Combination Mangoes Milk MRS

A 1 10
B 2 7 3:1
C 3 5 2:1
D 4 4 1:1
Indifference Map

ASSUMPTIONS
1 Rational consumer
2 Ordinal utility
3 DMRS
4 Consistency in selection
5 Transitivity.

Properties of IC
An IC has a negative slope or that it slopes downwards

IC are convex to the point of origin

Two IC cannot intersect each other

 Higher IC represents the
higher level of satisfaction

IC need not be parallel to each other

Straight line Indifference curve

 Price Line or the Budget Line

It may be defined as a set of combinations of two commodities that can be

purchased if whole of the given income is spent on them.
If there is an increase in the income of the consumer, the budget line shifts

It can also increase due to the change in the price

Consumer equilibrium through the Indifference curves

There are two conditions of the consumer equilibrium:
 1) Price line should be tangent to the Indifference curve
2) Indifference curve must be convex to the point of origin.

Income effect Substitution effect and Price effect

INCOME EFFECT

Another important item that can change is the income of the consumer. As long as
the prices remain constant, changing the income will create a parallel shift of the
budget constraint. Increasing the income will shift the budget constraint right since
more of both can be bought, and decreasing income will shift it left.
 Depending on the indifference curves the amount of a good bought can either
increase, decrease or stay the same when income increases. In the diagram below,
good Y is a normal good since the amount purchased increased as the budget
constraint shifted from BC1 to the higher income BC2. Good X is an inferior good
since the amount bought decreased as the income increases.

Price effect

These curves can be used to predict the effect of changes to the budget constraint.
The graphic below shows the effect of a price shift for good y. If the price of Y
increases, the budget constraint will shift from BC2 to BC1. Notice that since the
price of X does not change, the consumer can still buy the same amount of X if they
choose to buy only good X. On the other hand, if they choose to buy only good Y,
they will be able to buy less of good Y since its price has increased.To maximize the
utility with the reduced budget constraint, BC1, the consumer will re-allocate
consumption to reach the highest available indifference curve which BC1 is tangent
to. As shown on the diagram below, that curve is I1, and therefore the amount of
good Y bought will shift from Y2 to Y1, and the amount of good X bought to shift
from X2 to X1. The opposite effect will occur if the price of Y decreases causing
the shift from BC2 to BC3, and I2 to I3.
 How demand curve can be obtained through the price Effect

Substitution effect

Every price change can be decomposed into an income effect and a

substitution effect. The substitution effect is a price change that changes the slope of
the budget constraint, but leaves the consumer on the same indifference curve. This
effect will always cause the consumer to substitute away from the good that is
becoming comparatively more expensive. If the good in question is a normal good,
then the income effect will re-enforce the substitution effect. If the good is inferior,
then the income effect will lessen the substitution effect. If the income effect is
opposite and stronger than the substitution effect, the consumer will buy more of the
good when it becomes more expensive. An example of this might be a Giffen good.
Applications of Indifference curves

1 In the field of consumption.

With the help of consumer equilibrium one can find out the position of
consumer equilibrium.

2 Consumer surplus

Money Income

No. of Ice creams

3 It has helped us to solve the problems of price effect, income effect and
substitution effect.
4 In the field of exchange
5 In the field of Public Finance
6 Effects of rationing
7 In the field of production.

THEORY OF PRODUCTION AND COSTS

Production function refers to the functional relationship between the physical
output and the physical inputs. Thus it is the relationship between the quantity of
output and the quantities of inputs used in the process of production.
Example x = f ( a, b, c, d….)
Production function can be of both the fixed proportions type and the variable
proportions type.
In the fixed proportions type the labour as well as the capital are used in the fixed
proportions. Example if the technical coefficient of production is 1/5, i.e. to produce
200 units of a commodity 40 labourers are employed then it continues to be the
same for all the units.

Capital 300

200
100

5 10 15
Labour
Variable proportions type production function
In this type of the production function different factors of production can be used to
produce a given level of output.
One variable input
Law of increasing returns to a factor or diminishing costs: it occurs when more and
more units are employed and the marginal production goes on increasing or the
average costs start diminishing.

It could be due to the indivisibility of factors or the increase in efficiency arising out
of the division of labour.

AC
MP

Labour labour

Law of Diminishing returns or the increasing returns: It occurs when as a

result of increase in the factors of production cost of production per unit of the
commodity goes on increasing.

MP AC

Labour labour
It could be due to the fixed factors of production or more than the optimum
production or imperfect factor substitutability between the factors.
Law of constant costs or the constant returns to the factor: It takes place when
the additional application of the variable factor increases the output only at a
constant rate.
MP AC

Labour Labour
Law of variable proportions
Returns to scale
When all the factors of production are increased in the same proportion and as a
result output increases more than proportionately then it is known as constant
returns to scale. Example P = f (L, K)
If both the labour and capital are increased in the same proportion and a result
there is a change in the output it will be termed as returns to scale.
P1 = f (mL, mK)

Two variable input

Meaning of the equal product curves:
An iso product curve shows all the combinations of the two inputs physically
capable of producing a given level of output. In the able given below we can have
an estimate regarding the equal product combinations.

Combinations Factor Z1 Factor Z2

A 1 12
B 2 8
C 3 5
D 4 3
E 5 2

Consumer side Producer side

Indifference Curve
IC’s are level sets of consumer’s
utility function.
Every point on an IC represents
a combination of consumption
goods that yields the same level
of utility.
Iso – Product Map
Isoquant
Isoquants are level sets of
production function.
Every point on an isoquant
represents a combination of
inputs that yields the same
output.
 Marginal Rate of Technical Substitution Marginal Rate Of Technical
Substitution (MRTS) is the increase in productivity a company experiences when it
substitutes on unit of labour input - ie, an hour worked by a factory worker - for one
unit of capital - ie, a machine on the factory floor.

A positive MRTS indicates that it is advantageous for a company to make this

substitution, and a negative MRTS implies that the company would drop in
productivity if it did this.

An iso cost line is that line which shows the various combinations of two
factors that can be purchased with the given amount of money.

Change in the iso cost curves

Producer’s equilibrium with the equal product curves

 Cost Minimisation
45
40
Ca p ita l p e r w e e k 35 Cost minimising
30 point
25
20
15
10
5 50
0 £1000
0 5 10 15 20

La bour pe r w e e k

The expansion path

Deriving Long Run Total Cost

45
40
Ca p ita l p e r w e e k

35
30 Expansion path
25
20
100
15
10
50 £1600
5
0 £1000
0 5 10 15 20

L a b ou r p e r w e e k

INCREASING, CONSTANT AND DIMINISHING RETURNS TO SCALE

Decreasing returns to scale

 If an increase in all inputs in the same proportion k leads to an increase of
output of a proportion less than k, we have decreasing returns to scale.

Constant returns to scale

If an increase in all inputs in the same proportion k leads to an increase
of output in the same proportion k, we have constant returns to scale.
Example: If we increase the number of machinists and machine tools each by
50%, and the number of standard pieces produced increases also by 50%, then
we have constant returns in machinery production.
Increasing returns to scale
If an increase in all inputs in the same proportion k leads to an increase of
output of a proportion greater than k, we have increasing returns to scale .

RIDGE LINES OR THE ECONOMIC REGION OF PRODUCTION

Between the shaded area the factors of production can be substituted for each
other. No producer will operate at the points outside the ridge lines, as it is an
inefficient zone. The production outside the ridgelines involves an increase in both
the labour as well as capital to produce the same amount of output. Hence this area
is called the region of economic nonsense. A rational producer will operate in the
region bounded by the two ridgelines where the iso quants are negatively sloping
and marginal products of factors are diminishing but positive.

Cost analysis

Fixed costs: These are the costs that do not change with the change in the level of
output. These costs remain fixed at all the levels of output. Even if the output is zero
these costs are to be borne by the producer.
Variable costs these are the costs, which change with the change in the level of
output. These costs rise as the level of output also goes high.
Total cost: These costs are the summation of the fixed costs and the variable costs.
TC = FC + VC

Marginal cost
Marginal cost is the change in the total costs due to the production of one more or
one less unit of output.

Marginal cost = the change in total costs

the change in output

Using mathematical notation where the Greek letter delta is used to signify - change
in.
 MC = TC
Q

Average fixed costs: these are aobtained by dividing the fixed costs with output
Average variable costs: these are obtained by dividing the variable costs with the
output
Average total costs: these are obtained by dividing the total costs with the output.

Relationship between short run variable costs.

Relationship between AC and MC

Long run average cost curve

 Long run average cost curve is the summation of the short run average cost
curves. Therfore it is also called the envelope curve.
 The Saucer-Shaped LRAC curve
$/q
LRAC

q0 q1 q

Between 0 and q0: Economies of Scale

Between q0 & q1: Constant returns to scale
Between q1 and : Diseconomies of Scale

Revenue function

AR and MR curves
AR is the revenue per unit of the output sold. It is obtained by dividing the
Total Revenue with Q. Precisely it is the demand curve of the firm.
MR is the change in the TR due to the sale of one more or one less unit of the
output.

MR = TRn - TRn-1
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Cost/Revenue quantity sold. (TR = P x Q)
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Cost / Revenue
TC
Putting the two together:

If a firm was to target revenue

maximisation as an objective,
If we
this put the
would nottwo diagrams
necessarily
together with
correlate we can
the see that profit
profit
maximisation occurs where the
maximising output – revenue
difference between
maximisation occursTR and TR
where TC
isisat
greatest (where
a maximum (MRMC= =0)MR)

TR
Output/Sales
MC

D = AR
Output/Sales
Q1 Q2

MR

Copyright 2005 – Biz/ed

Deriving a firm’s AR and MR: price-taking firm

Price (£)

AR, MR (£)

D = AR
Pe
= MR

D
O O
Q (millions) Q (hundreds)

(a) The market (b) The firm

AR and MR curves for monopoly and monopolistic competition

Revenue Revenue

AR AR

MR MR

Monopoly monopolistic

BREAK EVEN ANALYSIS

PRICING UNDER PERFECT COMPETITION

 Perfect competition is a market situation characterized by the following
features:
Large number of buyers and sellers
Homogeneous products
No selling costs
Same AR and MR curves
Perfect mobility
Perfect knowledge
No extra transportation costs
In the pure competition the conditions of Perfect mobility and Perfect
knowledge are missing.

SHORT RUN EQUILIBRIUM IN PERFECT COMPETITION

In the short run in perfect competition the firms may get normal profits, super
normal profits of it may incur the loss. First of all the firm earning the super normal
profits is shown in the diagram.

Short-run equilibrium of industry and firm under

perfect competition

P £
S MC AC

Pe D = AR
AR
AC = MR

D
O O Qe
Q (millions) Q (thousands)

(a) Industry (b) Firm

 In the diagram the firm incurring the loss is shown but the extent of loss
should not exceed the average variable costs.

Loss minimising under perfect competition

P £ AC
S MC

AC
D1 = AR1
P1 AR1
= MR1

D
O O Qe
Q (millions) Q (thousands)

(a) Industry (b) Firm

The shut down point of the firm is given below

Short-run shut-down point

P £
S MC AC

AVC

D2 = AR2
P2 AR2
= MR2
D2
O O

Q (millions) Q (thousands)

(a) Industry (b) Firm

Long run equilibrium of the firm

Long-run equilibrium under perfect competition

Profits return
Supernormal
New firms enter to normalprofits
P £
S1
Se

LRAC
P1 AR1 D1
PL ARL DL

D
O O QL
Q (millions) Q (thousands)

(a) Industry (b) Firm

Long run equilibrium of the firm

Long-run equilibrium of the firm under perfect competition

£ (SR)MC
(SR)AC

LRAC

DL
AR = MR

LRAC = (SR)AC = (SR)MC = MR = AR

O Q
Constant cost industry
Various long-run industry supply curves under perfect competition

P S1 S2
b

a c
Long-run S

D1 D2

O Q
(a) Constant industry costs

Increaing cost industry

Various long-run industry supply curves under perfect competition

P S1 S2

Long-run S
c
a

D2
D1

O Q
(b) Increasing industry costs: external diseconomies of scale
 Decreasing cost industry

Various long-run industry supply curves under perfect competition

P
S1
b S2

a
c
Long-run S

D2
D1

O Q
(c) Decreasing industry costs: external economies of scale

Price and output determination under monopoly

A monopoly is a market situation in which there is
1. One seller
2. Large number of buyers
3. No entry or exit of firms
4. No distinction between firm and industry
5. Price discrimination
6. AR and MR curves downward sloping
7. No close substitutes
Causes of monopoly
1. Government policy
2. Entry lag
3. Unfair competition
4. Business mergers
Determination of price and equilibrium under monopoly

losses under monopoly

In the long run also the monopoly firm continues to earn the super normal profits.
Discriminating monopoly

When a monopolist charges different prices from different people for the same
product, he is said to be a discriminating monopolist.
Degrees of price discrimination

First-degree price discrimination: here the monopolist charges a different price for
each unit of the commodity sold. He charges what the consumer is willing and
able to pay. Thus there is the maximum exploitation of the consumers in this
case.

Second degree price discrimination: here the buyers are divided into different
groups and from each group the monopolist charges a different price.

Third degree price discrimination: here the monopolist splits the entire market into
a few sub markets and thus charge a different price in each sub market

MONOPOLISTIC COMPETITION
It is a market situation in which there are a large number of small sellers, selling
differentiated but close substitute products.
Assumptions
Large number of firms and buyers
Product differentiation
Freedom of entry and exit of firms
Selling costs
Imperfect knowledge
Non-price competition

Short and long run equilibrium in monopolistic competition

FIGURE 1:
FIGURE 1: Short-Run
Short-Run Equilibrium
Equilibrium
Under
Under Monopolistic
Monopolistic Competition
Competition
MC

AC

$1.80
Price per Gallon

P
$1.50
1.40
C

$1.00 E D

MR

12,000

Gallons of Gasoline per Week

Copyright© 2006 South-Western/Thomson Learning. All rights reserved.

 Monopolistic Competitor Taking a Loss in the
Short Run
24
MC
22

20

18 ATC

16

14

ATC is $12.80 12
Price is $11
10

Total Profit=(Price-ATC) XOutput 6

D
=($11-$12.80) X42 4

=(-$1.80) X42 2 MR

= -$75.60 0
0 10 20 30 40 50 60 70 80 90 100 120 140 160
Output

Output is 42
Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 24-7

FIGURE 2:
FIGURE 2: Long-Run
Long-Run Equilibrium
Equilibrium
Under
Under Monopolistic
Monopolistic Competition
Competition
MC

AC
Price per Gallon

P
$1.45 M
$1.35

MR
10,000 15,000

Gallons of Gasoline per Week

Copyright© 2006 South-Western/Thomson Learning. All rights reserved.

 Under utilization in the long run

Under-utilisation of capacity in the long run

£

LRAC

DL under monopolistic
competition

O Q1 Q2 Q

Group equilibrium

product differentiation in the long run

Selling costs

The costs incurred on advertising, publicity and salesmanship are known as

selling costs. The need for the advertising arises if the buyers are not available
about the product or there are many rivals for the firm. In this case the selling
cost is assumed to be a fixed cost. By adding selling costs to the original curve
the new curve so obtained will be above the original curve. The area FP
indicates the maximum net return in this case.

MC
F
E
AR
MR

Pricing under oligopoly

Kinked demand curve

Price leadership under monopoly
Under this system one firm becomes a leader and set the price which is to be
followed by all the firms. It often happens that price leadership is established
as a result of price war between the firms and as a result one firm comes out
as a leader.
Price leadership is mainly of the following types
By a dominant firm (which produces a bulk of ots products)
Barometric price leadership (which can predict furutre well as well as
custodian of othere firms)
Aggressive price leadership ( due to aggressive price policies)

MCb
MCa
Price
D
MR
N M
Quantity
Firm A has a lower MC. The profit maximising price of firm A is
lower than the firm B. It means that now the Firm A will dictate the terms for
the firm B whose profit maximising price is higher. If B does not follow the
conditions as dictated by A then it will be ousted by A.
COURNOT MODEL OF OLIGOPOLY

P
c
z R Q

0
A H B
 In the diagram before the entrance of B, A produces the output OA
which is 1/2 of OB. The price is OC and the profits are OAPC. B produces the
output AH which is 1/4 of OB. The price falls from OAPC to OARZ total
profit being OHQZ. When B produces the AH which is ¼ of the whole the
total output left for A is ½ ( 1 – ¼) = 3/8. What is now not produced by A is
produced by B that is (1-1/8) = 5/16. Now A may react by producing ½
(1 – 5/16) = 11/32. This process will continue till equilibrium utput and
price are reached.