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MICROECONOMICS NOTES

UNIT-1
NATURE OF ECONOMICS
Under this, we generally discuss whether Economics is science or art
or both and if it is a science whether it is a positive science or a
normative science or both.
Economics - As a science and as an art:
Often a question arises - whether Economics is a science or an art
or both.
(a) Economics is a science: A subject is considered science if It is a
systematised body of knowledge which studies the relationship
between cause and effect. It is capable of measurement. It has its own
methodological apparatus. It should have the ability to forecast.
If we analyse Economics, we find that it has all the features of science.
Like science it studies cause and effect relationship between economic
phenomena. To understand, let us take the law of demand. It explains
the cause and effect relationship between price and demand for a
commodity. It says, given other things constant, as price rises, the
demand for a commodity falls and vice versa. Here the cause is price
and the effect is fall in quantity demanded. Similarly like science it is

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capable of being measured, the measurement is in terms of money. It

has its own methodology of study (induction and deduction) and it
forecasts the future market condition with the help of various statistical
and non-statistical tools. But it is to be noted that Economics is not a
perfect science. This is because Economists do not have uniform
opinion about a particular event. The subject matter of Economics is
the economic behaviour of man which is highly unpredictable. Money
which is used to measure outcomes in Economics is itself a dependent
variable.
It is not possible to make correct predictions about the behaviour of
economic variables.
(b) Economics is an art: Art is nothing but practice of knowledge.
Whereas science teaches us to know a t teaches us to do. Unlike
science which is theoretical, art is practical. If we analyse Economics,
we find that it has the features of an art also. Its various branches,
consumption, production, pub c finance, etc. provide practical
solutions to various economic problems. It helps in solving various
economic problems which we face in our day-to-day life.
Thus, Economics is both a science and an art. It is science in its
methodology and art in its application. Study of unemployment problem
is science but framing suitable policies for reducing the extent of
unemployment is an art.
SCOPE OF MANAGERIAL OR BUSINESS ECONOMICS
Managerial economics is a developing science which generates the
countless problems to determine its scope in a clear-cut way. From the
following fields, we can examine the scope of business economics.
1. Demand analysis and forecasting. The foremost aspect regarding
scope is demand analysis and forecasting. A business firm is an
economic unit which transforms. productive resources into saleable

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goods. Since all output is meant to be sold, accurate estimates of

demand help a firm in minimising its costs of production and storage.
A firm must decide its total output before preparing its production
schedule and deciding on the resources to be employed. Demand
forecasts serves as a guide to the management for maintaining its
market share in competition with its rivals, thereby securing its profit.
2. Cost and production analysis. A firm's profitability depends much on
its costs of production. A wise manager would prepare cost estimates
of a range of output, identify the factors causing variati ns in costs and
choose the cost-minimising output level, taking also into consideration
the degree of uncertainty in production and cost calculations.
Production process are under the charge of ngineers but the business
manager works to carry out the production function analysis in order to
avoid wastages of materials and time. Sound pricing policies depend
much on cost control. The main topics discussed under cost and
production analysis are: Cost co cepts, cost-output relationships,
Economies and Diseconomies of scale and cost control.

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3. Pricing decisions, policies and practices. Another task before a

business manager is the pricing of a product. Since a firm's income
and profit depend mainly on the price decision, the pricing policies
and all such decisions are to be taken after careful
analysis of the nature of the market in which the firm perates.
The important topics covered in this field of study are : Market
Structure Analysis, Pricing Practices and Price For casting.
4. Profit management. Each and every busin ss firms are tended
for earning profit, it is profit which provides the chief measure of
success of a firm in the long p riod. Economists tells us
that profits are the reward for uncerta ity bearing and risk taking.
A successful business manager is one who can form more or
less correct estimates of costs and reve ues at different levels of
output. The more successful a manager is in reducing
uncertainity, the higher are the profits earned by him. It is
therefore, profit-planning nd profit measurement constitute the
most challenging area of business economics.
5. Capital management. Still another most challenging
problem for a modern business manager is of planning capital
investment. Investments are made in the plant and
machinery and buildings which are very high. Therefore,
capital management require top- level decisions. It means
capital management i.e., planning and control of capital
expenditure. It deals with Cost of capital, Rate of Return and
Selection of projects.

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6. Inventory management: A firm should always keep an ideal

quantity of stock. If the stock is too much, the capital is
unnecessarily locked up in inventories At the same time if the
level of inventory is low, production will be interrupted due to
non-availability of materials. Hence, a firm always prefers to have
an optimum quantity of stock. Therefore, managerial economics
will use some methods such as ABC analysis, inventory models
with a view to minimising the inventory cost.
7. Linear programming and theory of games : Linear
programming and theory of games have came to be regarded
as part of managerial economics recently.
8. Environmental issues: There are certain issu s of
macroeconomics which also form a part of managerial
economics. These issues relate to gen ral business, social and
political environment in which a busi ess enterprise operates.
9. Business cycles: Business cyc es affect business decisions.
They refer to regular fluctuati s in economic activities in the
country. The different phases f business cycle are depression,
recovery, prosperity, boom nd recession.
Thus, managerial economics comprises both micro and macro-
economic theories. The subject matter of managerial economics
consists of all those economic concepts, theories and tools of
analysis which can be used to analyse the business environment
and to find out solution to practical business problems.

DIFFERENCE BETWEEN BUSINESS ECONOMICS

AND ECONOMICS
Economics is the social science that studies the production,
distribution, and consumption of goods and services. Economics
aims to explain how economies work and how economic agents

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interact. Economic analysis is applied throughout society, in

business and finance but also in crime, education, the family,
health, law, politics, religion, social institutions, and war.
Economic textbooks distinguish between microeconomics ("small"
economics), which examines the economic behavior of agents
(including individuals and firms) and "macroeconomics" ("big"
economics), addressing issues of unemployment, inflation,
monetary and fiscal policy.
Business economics (also called managerial economics), is a
branch of economics that applies microeconomic analysis to
specific business decisions. As such, it bridges economic theory
and economics in practice. It draws heavily from quantitative
techniques such as regression analysis and corr lation,
Lagrangian calculus (linear). If there is a unifying theme that
runs through most of business economics it is the attempt to
optimize business decisions given the firm's obj ctives and given
constraints imposed by scarcity, for example through the use of
operations research and programming.

MICRO Vs. MACRO

ECONOMICS Micro Economics:
1. Micro Economics studies the problems of individual
economic units such as a firm, an industry, a consumer etc.
2. Micro Economic studies the problems of price
determination, resource allocation etc.
3. While formulating economic theories, Micro
Economics assumes that other things remain constant.

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4. The main determinant of Micro Economics is

price. Macro Economics:
1. Macro Economics studies economic problems relating to
an economy viz., National Income, Total Savings etc.
2. Macro Economics studies the problems of economic
growth, employment and income determination etc.
3. In Micro Economics economic variables are mutually
inter-related independently.
4. In Micro Economics economic variables are mutually
inter-related independently.
OPPORTUNITY COST
Opportunity cost is the cost of any act vity measured in terms of
the value of the best alternative that is not chosen (that is
foregone). It is the sacrifice related to the second best choice
available to someone, or gr up, who has picked among
[1]
several mutually exclusive choices. The opportunity cost is also
the cost of the foregone products after making a choice.
Opportunity cost is a key concept in economics, and has been
described as expressing "the basic relationship
[2]
between scarcity and choice". The notion of opportunity cost
plays a crucial part in ensuring that scarce resources are used
[3]
efficiently. Thus, opportunity costs are not restricted to
monetary or financial costs: the real cost of output foregone, lost
time, pleasure or any other benefit that provides utility should also
be considered opportunity costs.
Explicit costs

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Explicit costs are opportunity costs that involve direct monetary

payment by producers. The opportunity cost of the factors of
production not already owned by a producer is the price that the
producer has to pay for them. For instance, a firm spends $100
on electrical power consumed, their opportunity cost is $100.
The firm has sacrificed $100, which could have been spent on
other factors of production.
Implicit costs
Implicit costs are the opportunity costs that involve only factors of
production that a producer already owns. They are equivalent to
what the factors could earn for the firm in alternative uses, either
operated within the firm or rent out to other firms. For example, a
firm pays $300 a month all year for rent on a warehouse that only
holds product for six months each year. The firm could rent the
warehouse out for the unused six mo ths, at any price (assuming
a year-long lease requirement), and that would be the cost that
could be spent on other factors of production.
TIME VALUE OF MONEY
The time value of money is the value of money figuring in a
given amount of interest earned over a given amount of time.
The time value of money is the central concept in finance theory.
For example, $100 of today's money invested for one year and
earning 5% interest will be worth $105 after one year. Therefore,
$100 paid now or $105 paid exactly one year from now both

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have the same value to the recipient who assumes 5%

interest; using time value of money terminology, $100
invested for one year at 5% interest has a future value
[1]
of $105. This notion dates at least to Martín de
Azpilcueta (1491–1586) of the School of Salamanca.
The method also allows the valuation of a likely stream of
income in the future, in such a way that the annual
incomes are discounted and then added together, thus
providing a lump-sum "present value" of the entire
income stream.
All of the standard calculations for time value of money
derive from the most basic algeb aic expression for the
present value of a future sum, "discounted" to the present
by an amount equal to the time value of money. For
example, a sum of FV to be received in one year is
discounted (at the rate of i terest r) to give a sum of PV at
present: PV = FV − r·PV = FV/(1+r).
MARGINALISM
Marginalism refers to the use of marginal
concepts in economic theory. Marginalism is associated
with arguments concerning changes in the quantity used
of a good or service, as opposed to some notion of the
over-all significance of that class of good or service, or
of some total quantity thereof.
Market Forces and Equilibrium

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Summary: Explains market equilibrium and the relation

between market demand and supply. Details how
market forces determinepricing.
Market equilibrium is the situation where, at a certain
price level, the quantity demanded by consumers and the
quantity supplied by producers of a particular commodity
are equal. This means that the market is completely clear
of excess supply and demand, and there isn't any
tendency for change to either price or quantity. At market
equilibrium, consumers are willing to pay
the market pricefor the commodity in qu stion and
producers are willing and able to s ll th ir goods at that
market priceand at that quantity. The price mechanism is
a device used to determine the quilibriumprice
and equilibrium quantity of goods and also demonstrates
how market forces work to achieve market equilibrium.
The price mechanism assumes that there is no
intervention on the part of the government and the
market structure is a pure.

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UNIT-2
Cardinal Utility Analysis/Approach:
Definition and Explanatio :
Human wants are un imited and they are of different
intensity. The me ns at the disposal of a man are not only
scarce but they have alternative uses. As a result of
scarcity of recourses, the consumer cannot satisfy all his
wants. He has to choose as to which want is to be
satisfied first and which afterward if the recourses permit.
The consumer is confronted in making a choice.
For example, a man is thirsty. He goes to the market and
satisfy his thirst by purchasing coca cola instead of tea. We
are here to examine the economic forces which make him
purchase a particular commodity. The answer is simple.
The consumer buys a commodity because it gives

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him satisfaction. In technical term, a consumer

purchases a commodity because it has utility for him. We
now examine the tools which are used in the analyzes of
consumer behavior.
Assumptions of Cardinal Utility Analysis:
The main assumption or premises on which the
cardinal utility analysis rests are as under.
(i) Rationality. The consumer is rational. He seeks to
maximize satisfaction from the limited income which is
at his disposal.
(ii) Utility is cardinally measurable. The utility can be
measured in cardinal numbers such as 1, 3, 10, 15, etc.
The utility is expressed in maginary cardinal numbers tells
us a great deal about the preference of the consumer for
a good.
(iii) Marginal utility of money remains constant. Another
important premise of cardinal utility of money spent on the
purchase of a good or service should remain constant.
(iv) Diminishing marginal utility. It is also assumed that the
marginal utility obtained from the consumption of a good
diminishes continuously as its consumption is increased.

(v) Independent utilities. According to the Cardinalist

school, the utility which is derived from the consumption
of a good is a function of the quantity of that good alone. If
does not depend at all upon the quantity consumed of
other goods. The goods, we can say, possess

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independent utilities and are additive.

Law of Diminishing Marginal Utility:
Definition and Statement of the Law:
The law of diminishing marginal utility describes a familiar
and fundamental tendency of human behavior. The law
of diminishing marginal utility states that:
“As a consumer consumes more and more units f a
specific commodity, the utility from the su essive units
goes on diminishing”.
“The additional benefit which a pe son derives from an
increase of his stock of a thing diminishes with every
increase in the stock that already has”.
Law is Based Upon Three Facts:
The law of diminishing marginal utility is based upon three
facts. First, total wants of a man are unlimited but each
single want c n be satisfied. As a man gets more and
more units of a commodity, the desire of his for that good
goes on falling. A point is reached when the consumer no
longer ants any more units of that good.Secondly,
different goods are not perfect substitutes for each other
in the satisfaction of various particular wants. As such the
marginal utility will decline as the consumer gets
additional units of a specific good.Thirdly, the marginal
utility of money is constant given the consumer’s wealth.
Explanation and Example of Law of Diminishing
Marginal Utility:

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This law can be explained by taking a very simple

example. Suppose, a man is very thirsty. He goes to the
market and buys one glass of sweet water. The glass of
water gives him immense pleasure or we say the first
glass of water has great utility for him. If he takes second
glass of water after that, the utility will be less than that of
the first one. It is because the edge of his thirst has been
blunted to a great extent. If he drinks third glass of water,
the utility of the third glass will be less than that f second
and so on.
The utility goes on diminishing with the consumption of
every successive glass water till it d ops down to zero.
This is the point of satiety. It is the position of
consumer’s equilibrium or maximum satisfaction. If the
consumer is forced further to take a glass of water, it
leads to disutility causing total utility to dec ine. The
marginal utility will become negative.
Schedule of Law of Diminishing Marginal Utility:
Units Total Utility Marginal Utility
1st glass 20 20
2nd glass 32 12
3rd glass 40 8
4th glass 42 2
5th glass 42 0
6th glass 39 -3
From the above table, it is clear that in a given span of
time, the first glass of water to a thirsty man gives 20
units of utility. When he takes second glass of water, the

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marginal utility goes on down to 12 units; When he

consumes fifth glass of water, the marginal utility drops
down to zero and if the consumption of water is forced
further from this point, the utility changes into disutility (-3).
Curve/Diagram of Law of Diminishing Marginal Utility:
The law of diminishing marginal utility can also
be represented by a diagram.

Assumptions of Law of Diminishing Marginal Utility:

The law of diminishing marginal utility is true under
certain assumptions. These assumptions are as under:
(i) Rationality: In the cardinal utility analysis, it is
assumed that the consumer is rational. He aims at
maximization of utility subject to availability of his income.
(ii) Constant marginal utility of money: It is assumed in
the theory that the marginal utility of money based for

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purchasing goods remains constant. If the marginal

utility of money changes with the increase or decrease in
income, it then cannot yield correct measurement of the
marginal utility of the good.
(iii) Diminishing marginal utility: Another important
assumption of utility analysis is that the utility gained from
the successive units of a commodity diminishes in a
given time period.
(iv) Utility is additive: In the early versions of the theory
of consumer behavior, it was assumed that the utilities of
different commodities are independ nt. The total utility of
each commodity is additive.
1 1 2 2 3 3 n n
U = U (X ) + U (X ) + U (X )………. U (X )
(v) Consumption to be continuous: It is assumed in this
law that the consumption of a commodity should be
continuous. If there is interval between the consumption
of the same units of the commodity, the law may not hold
good. For inst nce, if you take one glass of water in the
morning and the 2nd at noon, the marginal utility of the
2nd glass of ater may increase.
(vi) Suitable quantity: It is also assumed that the
commodity consumed is taken in suitable and reasonable
units. If the units are too small, then the marginal utility
instead of falling may increase up to a few units.

(vii) Character of the consumer does not change: The law

holds true if there is no change in the character of the
consumer. For example, if a consumer develops a taste

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for wine, the additional units of wine may increase

the marginal utility to a drunkard.
(viii) No change to fashion: Customs and tastes: If there
is a sudden change in fashion or customs or taste of a
consumer, it can than make the law inoperative.
(ix) No change in the price of the commodity: there
should be any change in the price of that commodity as
more units are consumed.
Law of Equi-Marginal Utility:
Definition and Statement of Law of Equi-Marginal Utility:
The law of equi-marginal utility is simply an extension of
law of diminishing margi al utility to two or more than two
commodities. The law of equilibrium utility is known, by
various names. It is amed as the Law of Substitution, the
Law of Maximum Satisfaction, the Law of Indifference,
the Proportionate Ru e and the Gossen’s Second Law.
In cardinal utility analysis, this law is stated by Lipsey
in the following ords:
“The household maximizing the utility will so allocate the
expenditure between commodities that the utility of the
last penny spent on each item is equal”
As we know, every consumer has unlimited wants.
However, the income this disposal at any time is limited.
The consumer is, therefore, faced with a choice among
many commodities that he can and would like to pay. He,

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therefore, consciously or unconsciously compress the

satisfaction which he obtains from the purchase of the
commodity and the price which he pays for it. If he thinks
the utility of the commodity is greater or at-least equal to
the loss of utility of money price, he buys that commodity.
Assumptions of Law of Equi-Marginal Utility:
The main assumptions of the law of equi-marginal
utility are as under.
(i) Independent utilities. The marginal utiliti s of different
commodities are independent of each other and
diminish with more and more purchases.
(ii) Constant marginal utility of money. The marginal utility
of money remains constant to the consumer as he
spends more and more of it on the purchase of goods.
(iii) Utility is cardina y measurable.
(iv) Every consumer is rational in the purchase of goods.
Example and Explanation of Law of Equi-Marginal Utility:

The doctrine of equi-marginal utility can be explained

by taking an example. Suppose a person has $5 with
him whom he wishes to spend on two commodities, tea
and cigarettes. The marginal utility derived from both
these commodities is as under:
Schedule:
Units of MU of Tea MU of

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Money Cigarettes
1 10 12
2 8 10
3 6 8
4 4 6
5 2 3
Total Utility =
$5 Total Utility = 30
30

A rational consumer would like to get maximum

satisfaction from $5.00. He can spend money in
three ways:
(i) $5 may be spent on tea only.
(ii) $5 may be utilized for the purchase of cigarettes only.

(iii) Some rupees may be spent on the purchase of

tea and some on the purchase of cigarettes.
Curve/Diagram of Law of Equi-Marginal Utility:
The law of equi-marginal utility can be explained with
the help of diagrams.

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Theory of Ordinal Utility/Indifference Curve Analysis:

Definition and Explanation:
The indifference curve indicates the various
combinations of two goods which yield equal satisfaction
to the consumer. By definition:
"An indifference curve shows all the various combinations
of two goods that give an equal amount of satisfaction to
a consumer".
These economist re the of view that it is wrong to base
the theory of consumption on two assumptions:
(i) That there is only one commodity which a person
will buy at one time.
(ii) The utility can be measured.
Their point of view is that utility is purely subjective and
is immeasurable. Moreover an individual is interested in
a combination of related goods and in the purchase of
one commodity at one time. So they base the theory of

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consumption on the scale of preference and the

ordinal ranks or orders his preferences.
Assumptions:
The ordinal utility theory or the indifference curve
analysis is based on four main assumptions.

(i) Rational behavior of the consumer: It is assu ed that

individuals are rational in making decisions fr m their
expenditures on consumer goods.
(ii) Utility is ordinal: Utility cannot be m asured cardinally.
It can be, however, expressed ordinally. In other words,
the consumer can rank the basket of goods according to
the satisfaction or utility of each basket.
(iii) Diminishing marginal rate of substitution: In the
indifference curve analysis, the principle of
diminishing marginal rate of substitution is assumed.
(iv) Consistency in choice: The consumer, it is assumed,
is consistent in his behavior during a period of time. For
insistence, if the consumer prefers combinations of A of
good to the combinations B of goods, he then remains
consistent in his choice. His preference, during another
period of time does not change. Symbolically, it can be
expressed as:
If A > B, then B > A
(iv) Consumer’s preference not self contradictory: The
consumer’s preferences are not self contradictory. It

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means that if combinations A is preferred over

combination B is preferred over C, then combination A
is preferred over combination A is preferred over C.
Symbolically it can be expressed:
If A > B and B > C, then A > C
(v) Goods consumed are substitutable: The goods
consumed by the consumer are substitutable. The utility
can be maintained at the same level by consuming more
of some goods and less of the other. There are many
combinations of the two commodities which are equally
preferred by a consumer and he is indifferent as to
which of the two he receives.
Example:
For example, a person has a limited amount of income
which he wishes to spe d on two commodities, rice and
wheat. Let us supp se that the following commodities are
equally valued by him:
Various Combinations:
a)16 Kilograms of Rice Plus 2 Kilograms of
Wheat
b)12 Kilograms of Rice Plus 5 Kilograms of
Wheat
c)11 Kilograms of Rice Plus 7 Kilograms of
Wheat

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d) 10 Kilograms of Rice Plus 10 Kilograms

of Wheat
e) 9 Kilograms of Rice Plus 15 Kilograms
of Wheat
It is matter of indifference for the consumer as to which
combination he buys. He may buy 16 kilograms of rice
and 2 kilograms of wheat or 9 kilograms of rice and 15
kilograms of wheat. All these combinations are equally
preferred by him.
An indifference curve thus is compos d of a set of
consumption alternatives each of which yields the same
total amount of satisfaction. Th se combinations can also
be shown by an indifference curve.
Figure/Diagram of Indifference Curve:
The consumer’s preferences can be shown in a diagram
with an indifference curve. The indifference showing
nothing about the bsolute amounts of satisfaction obtained.
It merely indicates a set of consumption bundles that the
consumer views as being equally satisfactory.

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In fig. 3.1 we measure the quantity of wheat along X-

axis (in kilograms) and along Y-axis, the quantity of rice
(in kilograms). IC is an indifference curve.
It is shown in the diagram that a consumer may buy 12
kilograms of rice and 5 kilograms of wheat or 9 kilograms
of rice and 15 kilogram of wheat. Both these combinations
are equally preferred by him and he is indifferent to these
two combinations. When the scale of preference f the
consumer is graphed, by joining the points a, b, c, d, e,
we obtain an Indifference Curve IC.
Every point on indifference curve r pr sents a different
combination of the two goods and the consumer is
indifferent between any two points on the indifference
curve. All the combinations are equally desirable to the
consumer. The consumer s ndifferent as to which
combination he receives. The Indifference Curve IC thus
is a locus of different c mbinations of two goods which
yield the same level of satisfaction.
Marginal Rate of Substitution (MRS):
The necessity is to study the behavior of the consumer
as to how he prefers one commodity to another and
maintains the same level of satisfaction.
For example, there are two goods X and Y which are not
perfect substitute of each other. The consumer is
prepared to exchange goods X for Y. How many units of Y
should be given for one unit of X to the consumer so that
his level of satisfaction remains the same?

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The rate or ratio at which goods X and Y are to be

exchanged is known as the marginal rate of
substitution (MRS). In the words of Hicks:
“The marginal rate of substitution of X for Y measures the
number of units of Y that must be scarified for unit of X
gained so as to maintain a constant level of satisfaction”.

Marginal rate of substitution (MRS) can also be

defined as:
“The ratio of exchange between small units of two
commodities, which are equally valu d or preferred by a
consumer”.
Formula:
MRSxy = ∆Y
∆X
It may here be noted that the marginal rate of
substitution (MRS) is the personal exchange rate of the
consumer in contrast to the market exchange rate.
Diminishing Marginal Rate of Substitution:
In other words, as the consumer has more and more
units of good X, he is prepared to forego less and less of
good Y.
This behavior showing falling MRS of good X for good
Y and yet to remain at the same level of satisfaction is
known as diminishing marginal rate of substitution.

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Diagram/Figure:
The concept of marginal rate of substitution (MRS)
can also be illustrated with the help of the diagram.

In the fig. 3.3 above as the consumer moves down from

combination 1 to combination 2, the consumer is willing
to give up 4 units of good Y (∆Y) to get an additional unit
of good X (∆X).
When the consumer slides down from combinations 2, 3
and 4, the length of ∆Y becomes smaller and smaller,
while the length of ∆X is remain the same. This shows
that as the stock of the consumer for good X increases,
his stock of good Y decreases.
He, therefore, is willing to give less units of Y to obtain an
additional unit of good X. In other words, the MRS of
good X for good Y falls as the consumer has more of
good X and less of good Y. The indifference curve IC
slopes downward from left to the right. This means a
negative and diminishing rate of substitution of one
commodity for the other.

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Importance of Marginal Rate of Substitution (MRS):

(i) Measures utility ordinally: The concept of MRS is
superior to that of utility concept because it is more
realistic and scientific than the theory of utility. It does not
measure the utility of a commodity in isolation without
reference to other commodities but takes into
consideration the combination of related goods to which
a consumer is interested to purchase.
(ii) A relative concept: The concept of marginal rate of
substitution has the advantage that it is r lative and not
absolute like the utility concept giv n by Marshall. It is free
from any assumptions concerning the possibility of a
quantitative measurement of utility.
Budget Line:
Definition and Explanatio :
The understanding of the concept of budget line is essential
for knowing the theory of consumer’s equilibrium.

"A budget line or price line represents the various

combinations of two goods which can be purchased with
a given money income and assumed prices of goods".
For example, a consumer has weekly income of $60. He
purchases only two goods, packets of biscuits and
packets of coffee. The price of each packet of biscuits is
$6 and the price of each packet of coffee is $12. Given the
assumed income and the price, of the two goods, the

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consumer can purchase various combination of goods

or market combination of goods weekly.
Schedule:
The various alternative market baskets (combinations
of goods) are shown in the table below:
Packets of Biscuits Packets of Coffee
Market Basket
Per Week Per Week
A 10 0
B 8 1
C 6 2
D 4 3
E 2 4
F 0 5
Income $60 Per Week = Packets of Biscuits Costs $6
= Packets of Coffee is Priced $12 Each

(i) Market basket A in the table above shows that if the

whole amounts of $60 is spent on the purchase of
biscuits, then the consumer buys 10 packets of biscuits at
a price of $6 each and nothing is left to purchase coffee.
(ii) Market basket F shows the other extreme. If the
consumer spends the entire amount of $60 on the
purchase of coffee, a maximum of 5 packets of coffee
can be purchased with it at a price of $12 each with
nothing left over for the purchase of biscuits.
(iii) The intermediate market baskets B to E shows the
mixes of packets of biscuits and packets of coffee that the

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cost a total of $60. For example, in combination of market

basket C, the consumer can purchase 6 packets of biscuits
and 2 packets of coffee with a total cost of $60.
Budget Line:
The budget line is an important element analysis of
consumer behavior. The indifference map shows
people’s preferences for the combination of two goods.
The actual choices they will make, however, depends on
their income. The budget line is drawn as a continuous
line. It identifies the options from which the consumer can
choose the combination of goods.
Diagram/Figure:

In the fig. 3.9 the line AF shows the various

combinations of goods the consumer can purchase. This
line is called the budget line.
The slope of the budget line indicates how many packets
of biscuits a purchaser must give up to buy one more
packet of coffee. For example, the slope at point B on the
budget line is ∆Y / ∆X or two packets of biscuits 1 = packet

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of coffee. This indicates that a move from B to C involves

sacrificing two packets of biscuits to gain an additional
one packet of coffee. Since AF budget line is straight, the
slope is constant at -2 packets of biscuits per one packet
of coffee at all points along the line.
Consumer's Equilibrium Through Indifference Curve
Analysis:
Definition:
"The term consumer’s equilibrium ref rs to the amount of
goods and services which the consum r may buy in the
market given his income and given p ices of goods in the
market".
The aim of the consumer s to get maximum satisfaction
from his money income. Given the price line or budget
line and the indifference map:
"A consumer is said to be in equilibrium at a point where
the price line is touching the highest attainable
indifference curve from below".
Conditions:
Thus the consumer’s equilibrium under the indifference
curve theory must meet the following two conditions:
First: A given price line should be tangent to an
indifference curve or marginal rate of satisfaction of
good X for good Y (MRSxy) must be equal to the price
ratio of the two goods. i.e.

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MRSxy = Px / Py

Second: The second order condition is that

indifference curve must be convex to the origin at the
point of tangency.
Assumptions:
The following assumptions are made to determine
the consumer’s equilibrium position.
(i) Rationality: The consumer is rational. He wants to obtain
maximum satisfaction given his income and prices.

(ii) Utility is ordinal: It is assumed that the consumer can

rank his preference according to the satisfaction of
each combination of goods.
(iii) Consistency of choice: It is also assumed that
the consumer is consistent in the choice of goods.
(iv) Perfect competition: There is perfect competition in the
market from where the consumer is purchasing the goods.

(v) Total utility: The total utility of the consumer

depends on the quantities of the good consumed.
Explanation:
The consumer’s consumption decision is explained by
combining the budget line and the indifference map.
The consumer’s equilibrium position is only at a point
where the price line is tangent to the highest attainable
indifference curve from below.

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(1) Budget Line Should be Tangent to the

Indifference Curve:
The consumer’s equilibrium in explained by combining
the budget line and the indifference map.
Diagram/Figure:

In the diagram 3.11, there are three indifference curves

1 2 3
IC , IC and IC . The price line PT is tangent to the
2
indifference curve IC at point C. The consumer gets
the maximum satisfaction or is in equilibrium at point C
by purchasing OE units of good Y and OH units of good
X with the given money income.
The consumer cannot be in equilibrium at any other
point on indifference curves. For instance, point R and S
1
lie on lo er indifference curve IC but yield less
satisfaction. As regards point U on indifference curve
3
IC , the consumer no doubt gets higher satisfaction but
that is outside the budget line and hence not achievable
to the consumer. The consumer’s equilibrium position is
only at point C where the price line is tangent to the
2
highest attainable indifference curve IC from below.

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(2) Slope of the Price Line to be Equal to the Slope

of Indifference Curve:
The second condition for the consumer to be in equilibrium
and get the maximum possible satisfaction is only at a point
where the price line is a tangent to the highest possible
indifference curve from below. In fig. 3.11, the price line PT
2
is touching the highest possible indifferent curve IC at point
C. The point C shows the combination of the two
commodities which the consum r is maximized when he
buys OH units of good X and OE units of good Y.
Geometrically, at tangency point C, the consumer’s
substitution ratio is equal to price ratio Px / Py. It implies
that at point C, what the co sumer is willing to pay i.e., his
personal exchange rate between X and Y (MRSxy)is equal
to what he actually pays i.e., the market exchange rate.
So the equilibrium condition being Px / Pybeing satisfied at
the point C is:
Price of X / Price of Y = MRS of X for Y
The equilibrium conditions given above states that the rate
at which the individual is willing to substitute commodity X
for commodity Y must equal the ratio at which he can
substitute X for Y in the market at a given price.
(3) Indifference Curve Should be Convex to the Origin:
The third condition for the stable consumer equilibrium is
that the indifference curve must be convex to the origin at

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the point of equilibrium. In other words, we can say that

the MRS of X for Y must be diminishing at the point of
equilibrium. It may be noticed that in fig. 3.11, the
2
indifference curve IC is convex to the origin at point C.
So at point C, all three conditions for the stable-
consumer’s equilibrium are satisfied.
Summing up, the consumer is in equilibrium at point C
where the budget line PT is tangent to the indifference
2
IC . The market basket OH of good X and OE of good Y
yields the greatest satisfaction because it is on the highest
attainable indifference curve. At point C:
MRSxy = Px / Py
THEORY OF DEMAND
Meanings and Definition of Demand:
The word 'demand' is so common and familiar with every
one of us that it seems superfluous to define it. The need for
precise definition arises simply because it is sometimes
confused with other words such as desire, wish, want, etc.

Demand in economics means a desire to possess a good

supported by willingness and ability to pay for it. If your
have a desire to buy a certain commodity, say a car, but
you do not have the adequate means to pay for it, it will
simply be a wish, a desire or a want and not demand.
Demand is an effective desire, i.e., a desire which is
backed by willingness and ability to pay for a commodity
in order to obtain it.

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Characteristics of Demand:
There are thus three main characteristic's of demand in
economics.
(i) Willingness and ability to pay. Demand is the amount
of a commodity for which a consumer has the willingness
and also the ability to buy.
(ii) Demand is always at a price. If we talk of demand
without reference to price, it will be meaningless. The
consumer must know both the price and the commodity.
He will then be able to tell the quantity demanded by him.

(iii) Demand is always per unit of time. The time may be

a day, a week, a month, or a y ar.
Example:
For instance, when the milk is selling at the rate of $15.
per liter, the demand of a buyer for milk is 10 liters a day.
If we do not mention the period of time, nobody can
guess as to how much milk we consume? It is just
possible we may be consuming ten liters of milk a week,
a month or a year.
Law of Demand:
Definition and Explanation of the Law:
We have stated earlier that demand for a commodity is
related to price per unit of time. It is the experience of every
consumer that when the prices of the commodities fall, they
are tempted to purchase more. Commodities and

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when the prices rise, the quantity demanded decreases.

There is, thus, inverse relationship between the price of
the product and the quantity demanded. The
economists have named this inverse relationship
between demand and price as the law of demand.
Statement of the Law:
"Other things remaining the same, the quantity demanded
of a commodity will be smaller at higher market prices and
larger at lower market prices".
"Other things remaining the same, the quantity demanded
increases with every fall in the price and decreases with
every rise in the price".
In simple we can say that when the price of a commodity
rises, people buy less of that commodity and when the
price falls, people buy more of it ceteris paribus (other
things remaining the same). Or we can say that the
quantity varies inversely with its price. There is no doubt
that demand responds to price in the reverse direction
but it has got no uniform relation between them. If the
price of a commodity falls by 1%, it is not necessary that
may also increase by 1%. The demand can increase by
1%, 2%, 10%, 15%, as the situation demands.
Assumptions of Law of Demand:
There are three main assumptions of the Law:
(i) There should not be any change in the tastes of
the consumers for goods (T).

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(ii) The purchasing power of the typical consumer

must remain constant (M).
(iii) The price of all other commodities should not vary
o
(P ). Example of Law of Demand:

If there is a change, in the above and other assu ptions,

the law may not hold true. For example, according to the
law of demand, other things being equal quantity
demanded increases with a fall in price and diminishes
with rise to price. Now let us suppose that price of tea
comes down from $40 per pound to $20 per pound. The
demand for tea may not increase, because there has
taken place a change in the taste of consumers or the
price of coffee has fallen down as compared to tea or the
purchasing power of the co sumers has decreased, etc.,
etc. From this we find that demand responds to price
inversely only, if other thing remains constant.
Otherwise, the chances are that, the quantity demanded
may not increase with f ll in price or vice-versa.
Demand, thus, is a negative relationship between
price and quantity.
Limitations/Exceptions of Law of Demand:
Though as a rule when the prices of normal goods
rise, the demand them decreases but there may be a
few cases where the law may not operate.
(i) Prestige goods: There are certain commodities like
diamond, sports cars etc., which are purchased as a mark

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of distinction in society. If the price of these goods rise,

the demand for them may increase instead of falling.
(ii) Price expectations: If people expect a further rise in
the price particular commodity, they may buy more in
spite of rise in price. The violation of the law in this case is
only temporary.
(3) Ignorance of the consumer: If the consumer is
ignorant about the rise in price of goods, he may buy
more at a higher price.
(iv) Giffen goods: If the prices of basic goods, (potatoes,
sugar, etc) on which the poor spend a large part of their
incomes declines, the poor incr ase the demand for
superior goods, hence when the price of Giffen good
falls, its demand also falls. There s a positive price effect
in case of Giffen goods.
Importance of Law f Demand:
(i) Determination of price. The study of law of demand is
helpful for a trader to fix the price of a commodity. He
knows how much demand will fall by increase in price to
a particular level and how much it will rise by decrease in
price of the commodity. The schedule of market demand
can provide the information about total market demand at
different prices. It helps the management in deciding
whether how much increase or decrease in the price of
commodity is desirable.
(ii) Importance to Finance Minister. The study of this law is
of great advantage to the finance minister. If by raising the

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tax the price increases to such an extend than the

demand is reduced considerably. And then it is of no use
to raise the tax, because revenue will almost remain the
same. The tax will be levied at a higher rate only on those
goods whose demand is not likely to fall substantially with
the increase in price.
(iii) Importance to the Farmers. Goods or bad crop affects
the economic condition of the farmers. If a g ds crop fails
to increase the demand, the price of the crop will fall
heavily. The farmer will have no advantage of the good
crop and vice-versa.
MOVEMENT ALONG Vs. SHIFT IN DEMAND CURVE
Changes in demand for a commodity can be
shown through the demand curve two ways:
(1) Movement Along the Demand Curve and
(2) Shifts of the Demand Curve.
(1) Movement Along the Demand Curve:
Demand is a multivariable function. If income and other
determinants of demand such as tastes of the consumers,
changes in prices of related goods, income distribution,
etc., remain constant and there is a change only in price
of the commodity, then we move along the same demand
curve.
In this case, the demand curve remains unchanged.
When, as a result of change in price, the quantity

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demanded increases or decreases, it is technically

called extension and contraction in demand.

The demand curve, which represents various price

quantity has a negative slope. Whenever there is a
change in the quantity demanded of a good due to
change, in its price, there is a movement from one
point price quantity combination to another on the
same demand curve. Such a movement from one
point price quantity combination to another along the
same demand curve is shown in figure (4.3).
Diagram/Figure:

Here the price of a commodity falls from $8 to $2. As a

result, therefore, the quantity demanded increases from
100 units to 400 units per unit of time. There is extension
in demand by 300 units. This movement is from one
point price quantity combination (a) to another point (b)
along a given demand curve. On the other hand, if the
price of a good rises from $2 to $8, there is contraction in
demand by 300 units.

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We, thus, see that as a result of change in the price of a

good, the consumer moves along the given demand
curve. The demand curve remains the same and does
not change its position. The movement along the demand
curve is designated as change in quantity demanded.
(2) Shifts in Demand Curve:
Demand, as we know, is determined by many factors.
When there is a change in demand due to one or
more than one factors other than price, results in the
shift of demand curve.
For example, if the level of income in community rises,
other factors remaining the sam , the demand for the
goods increases. Consumers d mand more goods at each
price per period of me (rise or I crease in demand). The
demand curve shifts upward from he original demand
curve indicating that c nsumers at each price purchase
more units of commodity per unit of time.
If there is a fall in the disposable income of the consumers
or rise in the prices of close substitute of a good or decline
in consumer taste or non-availability of good on credit,
etc, etc., there is a reduction in demand (fall or decrease
in demand). The fall or decrease in demand shifts the
demand curve from the original demand curve to the left.
The lower demand curve shows that consumers are able
and willing to buy less of the good at each price than
before.
Diagram/Figure:

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/
In this figure, (4.4) the original demand curve is DD .
At a price of $12 per unit, consumers purchase 100 units.
When price falls to$4 per unit, the quantity demanded
increases to 500 units per unit of time. Let us assume
now that level of income increases in a community.
Now consumers demand 300 units of the commodity
at price of $12 per unit and 600 at price of $4 per unit.
As a result, there is an upward shift of the demand curve
2
DD . In case the community income falls, there is then
decrease in dem nd at price of $12 per unit. The quantity
demanded of a good falls to 50 units. It is 300 units at
price of $4 unit per period of time. There is a downward
shift of the demand to the left of the original demand
curve.
ELASTICITY OF DEMAND
TYPES OF Elasticity of Demand:

The quantity of a commodity demanded per unit of time

depends upon various factors such as the price of a

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commodity, the money income of the prices of

related goods, the tastes of the people, etc., etc.
Whenever there is a change in any of the variables stated
above, it brings about a change in the quantity of the
commodity purchased over a specified period of time.
The elasticity of demand measures the responsiveness of
quantity demanded to a change in any one of the above
factors by keeping other factors constant. When the
relative responsiveness or sensitiveness of the quantity
demanded is measured to changes, in its price, the
elasticity is said be price elasticity of d mand.
(1) Price Elasticity of Demand:
Definition and Explanation:

The concept of price elasticity of demand is commonly

used in economic literature. Price elasticity of demand is
the degree of resp nsiveness of quantity demanded of a
good to a change in its price. Precisely, it is defined as:
"The ratio of proportionate change in the quantity
demanded of a good caused by a given
proportionate change in price".

Formula:
The formula for measuring price elasticity of demand is:
Price Elasticity of Demand = Percentage in Quantity
Demand

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Percentage Change in Price

Ed = Δq X P
Δp Q
The elasticity coefficient is greater than one. Therefore
the demand for the good is elastic.
Types:
The concept of price elasticity of demand can be used
to divide the goods in to three groups.
(i) Elastic. When the percent change in quantity of a good
is greater than the percent change in its price, the
demand is said to be elastic. When elasticity of demand is
greater than one, a fall in price increases the total revenue
(expenditure) and a rise in price lowers the total revenue
(expenditure).
When with a percentage fall in price, the
quantity demanded incre ses so
much that it results in the increase in total
expenditure, the demand is
said to be elastic (Ed > 1).
For Example:
Quantity Total Expenditure
Price Per Unit ($)
Demanded ($)
20 10 Pens 200.0

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10 30 Pens 300.0

(ii) Unitary Elasticity. When the percentage change in the

quantity of a good demanded equals percentage in its
price, the price elasticity of demand is said to have
unitary elasticity. When elasticity of demand is equal to
one or unitary, a rise or fall in price leaves total revenue
unchanged.
When a percentage fall in price raises the
quantity demanded so much as to
leave the total expenditure unchang d, the elasticity
of demand is said to be
unitary (Ed = 1).
For Example:
Quantity Total Expenditure
Price Per Pen ($)
Demanded ($)
10 30 300
5 60 300

(iii) Inelastic. When the percent change in quantity of a

good demanded is less than the percentage change in
its price, the demand is called inelastic. When elasticity
of demand is inelastic or less than one, a fall in price
decreases total revenue and a rise in its price increases
total revenue.
When a percentage fall in price raises the quantity
demanded of a good so as to cause the total expenditure

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to decrease, the demand is said to be inelastic or

less than one, i.e., Ed < 1.

For Example:
Quantity Total Expenditure
Price Per Pen ($)
Demanded ($)
5 60 300
2 100 200
(2) Income Elasticity of Demand:
Income is an important variable affecting the demand for
a good. When there is a change in the level of income of
a consumer, there is a cha ge in the quantity demanded
of a good, other factors remaining the same. The degree
of change or responsiveness of quantity demanded of a
good to a change in the income of a consumer is called
income elasticity of demand. Income elasticity of demand
can be defined as:
"The ratio of percentage change in the quantity of a good
purchased, per unit of time to a percentage change in
the income of a consumer".
Formula:
The formula for measuring the income elasticity of
demand is the percentage change in demand for a good

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divided by the percentage change in income. Putting

this in symbol gives.
Ey = Percentage Change in Demand
Percentage Change in Income
Simplified formula:
Ey = Δq X P
Δp
Q.
Types:
When the income of a person incr ases, his demand for
goods also changes depe d g upon whether the good is a
normal good or an inferior good. For normal goods, the
value of elasticity is greater than zero but less than one.
Goods with an inc me elasticity of less than 1 are called
inferior goods. For example, people buy more food as
their income rises but the % increase in its demand is less
than the % increase in income.
(3) Cross Elasticity of Demand:
The concept of cross elasticity of demand is used for
measuring the responsiveness of quantity demanded of
a good to changes in the price of related goods. Cross
elasticity of demand is defined as:

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"The percentage change in the demand of one good as a

result of the percentage change in the price of another
good".
Formula:
The formula for measuring, cross, elasticity of demand is:
Exy = % Change in Quantity Demanded of Good X

% Change in Price of Good Y

The numerical value of cross elasticity d pends on
whether the two goods in question are substitutes,
complements or unrelated.
Types and Example:
(i) Substitute Goods. When two goods are substitute of
each other, such as coke and Pepsi, an increase in the
price of one good wi lead to an increase in demand for the
other good. The numerical value of goods is positive.

For example there are two goods. Coke and Pepsi

which are close substitutes. If there is increase in the
price of Pepsi called good y by 10% and it increases the
demand for Coke called good X by 5%, the cross
elasticity of demand would be:
Exy = %Δqx / %Δpy = 0.2
Since Exy is positive (E > 0), therefore, Coke and Pepsi
are close substitutes.

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(ii) Complementary Goods. However, in case of

complementary goods such as car and petrol, cricket bat
and ball, a rise in the price of one good say cricket bat by
7% will bring a fall in the demand for the balls (say by 6%).
The cross elasticity of demand which are complementary to
each other is, therefore, 6% / 7% = 0.85 (negative).
(iii) Unrelated Goods. The two goods which a re unrelated
to each other, say apples and pens, if the price f apple
rises in the market, it is unlikely to result in a hange in
quantity demanded of pens. The elasticity is zero of
unrelated goods.
Measurement of Price Elasticity of Demand:
There are three methods of m asuring price elasticity of
demand:
(1) Total Expenditure Method.
(2) Geometrical Method or Point Elasticity Method.
(3) Arc Method
(1) Total Expenditure Method/Total Revenue Method:
The price elasticity can be measured by noting the
changes in total expenditure brought about by changes
in price and quantity demanded.
(2) Geometric Method/Point Elasticity Method:
"The measurement of elasticity at a point of the
demand curve is called point elasticity".

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The point elasticity of demand method is used as a

measure of the change in the quantity demanded in
response to a very small changes in price. The
point elasticity of demand is defined as:
"The proportionate change in the quantity demanded
resulting from a very small proportionate change in price".
Graph/Diagram:

(ii) Measurement f Elasticity on a Non Linear Demand

Curve:
If the demand curve is non linear, then elasticity at a
point can be measured by drawing a tangent at the
particular point. This is explained with the help of a figure
given belo :

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/
In figure 6.10, the elasticity on DD demand curve is
measured at point C by drawing a tangent. At point C:
Ed = BM = BC = 400 = 2 (>1).
MO CA 200
(3) Arc Elasticity:
Normally the elasticity varies along the length f the
demand curve. If we are to measure elasti ity between
any two points on the demand curve, then the Arc
Elasticity Method, is used. Arc elasticity is a measure of
average elasticity between any two points on the
demand curve. It is defined as:
"The average elasticity of a ra ge of points on a demand
curve".
Formula:
Arc elasticity is ca culated by using the following formula:
Ed = ∆q X P 1 + P 2

1 2
∆p q + q
Here:
∆q denotes change in quantity. ∆p denotes
change in price.
1 2
q signifies initial quantity. q denotes
new quantity.

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1 2
P stands for initial price. P denotes
new price.

Graphic Presentation of Measuring Elasticity Using the

Arc Method:

IMPORTANCE OF ELASTICITY OF DEMAND

The concept of elasticity of demand is of great importance
in practical life. Its main points are given as under:

1. Useful for Business: It enables the business in general

and the monopolists in particular to fix the price. Studying
the nature of demand the monopolist fixes higher prices
for those goods which have inelastic demand and lo er
prices for goods which have elastic demand. In this way,
this helps him to maximise his profit.
2. Fixation of Prices: It is very useful to fix the price of
jointly supplied goods. In the case of joint products like
paddy and straw, the cost of production of each is not

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known. The price of each is then fixed by its elastic

and inelastic demand.
3. Helpful to Finance Minister: It helps the Finance
Minister to levy tax on goods. After levying taxes more
and more on goods which have inelastic demand, the
Government collects more revenue from the people
without causing them inconvenience. Moreover, it is also
useful for the planning.
4. Fixation of Wages: It guides the producers to fix
wages for labourers. They fix high or
low wages according to the elastic or inelastic demand
for the labour.
5. In the Sphere of Internat o al Trade: It is of greater
significance in the sphere of international trade. It helps to
calculate the terms of trade and the consequent gain from
foreign trade. If the demand for home product is inelastic,
the terms of trade will be profitable to the home country.
DEMAND FORECASTING
Forecasting simply refers to estimating or anticipating
future events. It is an attempt to foresee the future by
examining the past. Thus demand forecasting means
estimating or anticipating future demand on the basis
of past data.
Objectives of Demand Forecasting
A. Short Term Objectives

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1. To help in preparing suitable sales and

production policies.
2. To help in ensuring a regular supply of raw materials.
3. To reduce the cost of purchase and avoid
unnecessary purchase.
4. To ensure best utilization of machines.
5. To make arrangements for skilled and unskilled
workers so that suitable labour force may be maintained.
6. To help in the determination of a suitable price policy.
7. To determine financial requir ments.
8. To determine separate sales targets for all the
sales territories.
9. To eliminate the pr blem of under or over production.
B. Long term Objectives
1. To plan long term production.
2. To plan plant capacity.
3. To estimate the requirements of workers for long
period and make arrangements.
4. To determine an appropriate dividend policy.
5. To help the proper capital budgeting.
6. To plan long term financial requirements.

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7. To forecast the future problems of material

supplies and energy crisis.
METHODS OF DEMAND FORECASTING (FOR
ESTABLISHED
PRODUCTS)
There are several methods to predict the future de and.
All methods can be broadly classified into two. (A) Survey
methods, (B) Statistical methods
(A)Survey methods
Under this method surveys are conducted to collect
information about the future purchase plans of potential
consumers. Survey methods help in obtaining information
about the desires, likes and dislikes of consumers
through collecting the opinion of experts or by
interviewing the consumers. Survey methods are used for
short term forecasting. Important survey methods are (a)
consumers interview method, (b) collective opinion or
sales force opinion methodic) experts opinion method, (d)
consumers clinic and (f) end use method.
(a) Consumers' interview method (Consumers
survey): Under this method, consumers
are interviewed directly and asked the quantity they would
like to buy. After collecting the data, the total demand for
the product is calculated. This is done by adding up all
individual demands. Under the consumer interview method,
either all consumers or selected few are

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interviewed. When all the consumers are interviewed, the

method is known as complete enumeration method.
When only a selected group of consumers are
interviewed, it is known as sample survey method
Advantages
1. It is a simple method because it is not based on
past record.
2. It suitable for industrial products.
3. The results are likely to be more accurate.
4. This method can be used for o ecasting the demand of
a new product.
Disadvantages
1. It is expensive and time consuming.
2. Consumers may not give their secrets or buying plans.
3. This method is not suitable for long term forecasting.
4. It is not suitable when the number of consumer is large.
(b)Collective opinion method: Under this method the
salesmen estimate the expected sales in their respective
territories on the basis of previous experience. Then
demand is estimated after combining the individual
forecasts (sales estimates) of the salesmen.
This method is also known as sales force opinion method.

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Advantages
This method is simple.
1. It is based on the first hand knowledge of Salesmen.
2. This method is particularly useful for
estimating demand of new products.
3. It utilises the specialised knowledge f salesmen
who are in close touch with the prevailing market
conditions.
Disadvantages
1. The forecasts may not be r liable if the salespeople are
not trained.
2. It is not suitable for long period estimation.
3. It is not flexible.
(c)Experts' opinion method: This method was originally
developed at Rand Corporation
in 1950 by Olaf Helmer, Dalkey and Gordon. Under this
method, demand is estimated on the basis of opinions of
experts and distributors other than salesmen and
ordinary consumers. This method is also known as
Delphi method. Delphi is the ancient Greek temple where
people come and prey for information about their future.
Advantages
1. Forecast can be made quickly and economically

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2. This is a reliable method because estimates are

made on the basis of knowledge and experience of
sales experts.
3. The firm need not spare its time on preparing
estimates of demand.
4. This method is suitable for new
products. Disadvantages
1. This method is expensive.
2. This method sometimes lacks r liability
Statistical Methods
Statistical methods use the past data as a guide for
knowing the level of future demand. Statistical methods
are generally used for lo g run forecasting. These
methods are used f r established products. Statistical
methods include: (i) Trend projection method, (ii)
Regression and Correlation, (iii) Extrapolation method,
(iv) Simultaneous equation method, and (v) Barometric
method.
(i)Trend projection method: Future sales are based on
the past sales, because future is the grand-child of the
past and child of the present. Under the trend projection
method demand is estimated on the basis of analysis of
past data. This method makes use of time series (data
over a period of time). We try to ascertain the trend in the
time series. The trend in the time series can be estimated

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by using any one of the following four methods: (a)

Least-square method, (b) Free- hand method, (c) Moving
average method and (d) semi-average method.
(ii) Regression and Correlation: These methods
combine economic theory and statistical technique of
estimation. Under these methods the relationship
between the sales (dependent variable) and other
variables (independent variables such as price f related
goods, income, advertisement etc.) is ascertained. Such
relationship established on the basis of past data may
be used to analyse the future trend. The r gression and
correlation analysis is also called the conometric model
building.
(iii) Extrapolation: Under this statistical method, the
future demand can be extrapo ated by applying Binomial
expansion method. This method is used on the
assumption that the rate of charge in demand in the past
has been uniform.
(iv) Simultaneous equation method.-This involves the
development of a complete econometric model which
can explain the behaviour of all the variables which the
company can control. This method is not very popular.
(v) Barometric technique: This is an improvement over the
trend projection method. According to this technique the
events of the present can be used to predict the directions
of change m the future. Here certain economic and
statistical indicators from the selected time series are used
to predict variables. Personal income, non-agricultural

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placements, gross national income, prices of industrial

materials, wholesale commodity prices, industrial
production, bank deposits etc. are some of the most
commonly used indicators.
Advantages of Statistical Methods
1The method of estimation is scientific

2Estimation is based on the theoretical relati nship

between sales (dependent variable) and pri e,
advertising, income etc. (independent variables)
3These are less expensive.
4Results are relatively more r liable.
Disadvantages of Statistical Methods
1These methods involve complicated calculations.
2These do not re y much on personal skill and experience.
3These methods require considerable technical skill
and experience in order to be effective.

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UNIT-3
Meaning of Production
Production is the conversion of input into output. The
factors of production and all other things which the
producer buys to carry out production are called input. The
goods and services produced are known as output. Thus
production is the activity that creates or adds utility and
value. In the words of Fraser, "If consuming means
extracting utility from matter, producing means creating
utility into matter". According to Edwood Buffa, “Production
is a process by which goods and services are created"
Basic Concepts in Production Theory
The firm is an organisation that combines and organises
labour, capital and land or raw materials for the purpose of
producing goods and services for sale. The aim of the firm
is to maximise total profits or achieve some other related
aim, such as maximising sales or growth. The basic
production decision facing the firm is how much of the

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commodity or services to produce and how much labour,

capital and other resources or inputs to use to produce
that output most efficiently. To answer these questions,
the firm requires engineering or technological data on
production possibilities (the so called production function)
as well as economic data on input and output prices.
Production refers to the transformation of inputs or
resources into outputs of goods and services. F r
example: IBM hires workers to use machinery, parts and
raw materials in factories to produce personal computers.
The output of a firm can either be a final commodity (such
as personal computer) or an intermediate product such as
semiconductors (which are used in the production of
computers and oth r goods). The output can also be a
service rather than a good. Examples of services are
education, medicine, banking, communication,
transportation and many others. To be noted is, that
producti n refers to all of the activities involved in the
production of goods and services, from borrowing to set
up or expand production facilities, to hiring workers,
purchasing ra"w materials, running quality control, cost
accounting and so on, rather than referring merely to the
physical transformation of inputs into outputs of goods
and services.
Factors of Production
As already stated, production is a process of
transformation of factors of production (input) into goods
and services (output). The factors of production may be
defined as resources which help the firms to produce

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goods or services. In other words, the resources required

to produce a given product are called factors of
production. Production is done by combining the various
factors of production. Land, labour, capital and
organisation (or entrepreneurship) are the factors of
production (according to Marshall). We can use the word
CELL to help us remember the four factors of production:
C. capital; Entrepreneurship; L land: and L labour.
Characteristics of Factors of Production
1.The ownership of the factors of production is vested
in the households.
2.There is a basic distinction b tween factors of
production and factor services.
It is these factor services, which are combined in
the process of production.
3.The different units of a factor of production are not
homogeneous For example, different plots of land have
different level of fertility. Similarly labourers differ in
efficiency.
4.Factors of production are complementary. This means
their co-operation or combination is necessary for
production.
5.There is some degree of substitutability between factors
of production. For

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example, labour can be substituted for capital to a

certain extent.
Production Function
Production is the process by which inputs are transformed
in to outputs. Thus there is relation between input and
output. The functional relationship between input and
output is known as production function. The pr duction
function states the maximum quantity of output which can
be produced from any selected combination of inputs. In
other words, it states the minimum quantiti s of input that
are necessary to produce a given quantity of output.

The production function is larg ly determined by the level

of technology. The production function varies with the
changes in technology. Whe ever technology improves, a
new production function comes into existence. Therefore,
in the m dern times the output depends not only on
traditional factors of production but also on the level of
technology.
The production function can be expressed in an equation
in which the output is the dependent variable and inputs
are the independent variables. The equation is expressed
as follows:
Q= f (L, K, T……………n)
Where, Q = output L = labour
K = capital

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T = level of technology
n = other inputs employed in production.
There are two types of production function - short run
production function and long run production function. In
the short run production function the quantity of only one
input varies while all other inputs remain constant. In the
long run production function all inputs are variable.
Law of Variable Proportion
The law of variable proportion is the mod rn approach to
the 'Law of Diminishing Returns (or The Laws of
Returns). This law was first explained by Sir. Edward
West (French economist). Adam Smith, Ricardo and
Malthus (Classical economists) associated th s law with
agriculture. This law was the foundation of Recardian
Theory of Rent and Malthusian theory of population.
The law of variab e proportion shows the production
function with one input
factor variable while keeping the other input
factors constant.
The law of variable proportion states that, if one factor is
used more and more (variable), keeping the other factors
constant, the total output will increase at an increasing
rate in the beginning and then at a diminishing rate and
eventually decreases absolutely.

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According to K. E. Boulding, "As we increase the quantity

of any one input which is combined with a fixed quantity
of the other inputs, the marginal physical productivity of
the variable input must eventually decline".
Assumptions of the Law
The law of variable proportion is valid when the
following conditions are fulfilled:
1.The technology remains constant If there is an
improvement in the technology, due to inventions, the
average and marginal product will incr ase instead of
decreasing.
2.Only one input factor is variable and other factor
are kept constant.
3.All the units of the variable factors are identical.
They are of the same size and quality.
4.A particular product can be produced
under varying proportions of the input combinations.
5.The law operates in the short run.
Importance of the Law of Variable Proportion

The law of variable proportion is one of the most

fundamental laws of Economics. The law of variable
proportion is applicable not only to agriculture but also to
other constructive industries like mining, fishing etc. It is
applied to secondary or tertiary sectors too. This law helps
the management in the process of decision making.

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LAWS OF RETURNS TO SCALE

The law of variable proportion analyses the behaviour of
output when one input factor is variable and the other
factors are held constant. Thus it is a short run analysis. But
in the long run all factors are variable. When all factors are
changed in same proportion, the behaviour of output is
analysed with laws of returns to scale. Thus law of returns
to scale is a long run analysis. In the long peri d, output can
be increased by varying all the input Fa tors this law is
concerned, not with the proportions between the factors of
production, but with the scale of production. The scale of
production of the firm is determin d by those input factors
which cannot be changed in the short period. The term
return to scale means the changes in output as all factors
change in the same proportion. The law of returns to scale
seeks to analyse the effects of scale on the level of output.
If the firm i creases the units of both factors labour and
capita , its scale of production increases.

The return to sc le may be increasing, constant or

diminishing. We shall now examine these three kinds of
returns to scale.
Increasing Returns to Scale
When inputs are increased in a given proportion and
output increases in a greater proportion, the returns to
scale are said to be increasing. In other words,
proportionate increase in all factors of production results
in a more than proportionate increase in output It is a
case of increasing returns to scale. For example, if the

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inputs are increased by 40% and output increased by

50%, return to scale are increasing (= >1). It is the
first stage of production.
If the industry is enjoying increasing returns, then
its marginal product increases. As the
output expands, marginal costs come down. The price
of the product also comes down.
Constant Return to Scale
When inputs are increased in a given proportion and
output increases in the same propo tion, constant return to
scale is said to prevail. For example, if inputs are
increased by 40% and output also increases by 40%, the
return to scale are said to be constant ( = 1). This may be
called homogeneous production function of the first
degree.
In case of constant returns to scale the average output
remains const nt. Constant returns to scale operate when
the economies of the large scale production balance with
the diseconomies.
Decreasing Returns to Sale
Decreasing returns to scale is otherwise known as the
law of diminishing returns. This is an important law of
production.
If the firm continues to expand beyond the stage
of constant returns, the stage of

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diminishing returns to scale will start operate. A

proportionate increase in all inputs results in less than
proportionate increase in output, the returns to scale is
said to be decreasing. For example, if inputs are
increased by 40%, but output increases by only
30%, ( = < 1), it is a case of decreasing return to
scale. Decreasing return to scale implies increasing
costs to scale.
Production Function with Two Variable Inputs

So far we have assumed that the irm is increasing output

either by using more of one input (in laws of return) or
more of all inputs (in laws of returns to scale). Let us now
consider the case when the firm is expanding production
by using more of two i puts (varying) that are substitutes
for each other. A pr duction function with two variable
inputs can be represented by isoquants. Isoquant is a
combination of two terms, namely, iso and quant. Iso
means equal. Quant means quantity. Thus isoquant
means equal quantity or equal product. Isoquants are the
curves which represent the different combination of inputs
producing a particular quantity of output. Any point on the
isoquant represents or yields the same level of output.
Thus isoquant shows all possible combinations of the two
inputs (say labour and capital) capable of producing equal
or a given level of output. Isoquants are also known as
iso product curves or equal product curves or production
indifferent curves.

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An isoquant may be explained with the following example:

Equal Product Combinations

Combination Units of
labour Units of Capital TotalOutput
A B C D E 20 1 1000

15 2 1000

In the above schedule, there are five possible

combinations. All the five combinations yield the same
level of output i.e. 1000 un ts. 20 units of labour and 1 unit
of capital produce 1000 u its. 15 units of labour and 2
units of capital also pr duce 1000 units and so on. All
combination are equally likely because all of them
produce the same level of output i.e. 1000 units. Now if
plot these combination of labour and capital, we shall get
a curve. This curve is known as an isoquant.
In the below diagram units of capital are measured on
horizontal axis and units of labour on vertical axis. The
five combinations are known as A, B, C, D and E. After
joining these points, we get the iso product curve IQ. Here
we assume that the level of technology remains constant.
We also assume that the input can be substituted for each
other. If quantity of labour is reduced, the quantity of
capital must be increased to produce the same output.

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Thus an isoquant shows various combinations of the

two inputs
in the existing state of technology which produce the
same level of output.

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UNIT-4
Concept of Economic Costs:
We have discussed the important types of cost which a
firm has to face. The cost of production from the point
of view of an individual firm is split up into the following
parts.
(1) Explicit Cost:
Explicit cost is also called money cost or accounting cost.
Explicit cost represents all such xp nditure which are
incurred by an entrepreneur to pay for the hired services of
factors of production and in buying goods and services
directly. In other words, we can say that they are the
expenses which the bus ess manager must take into
account of because they must actually be paid by the firm.
Example:
The explicit cost includes wages and salary
payments, expenses on the purchase of raw material,
light, fuel, advertisements, transportation, taxes and
depreciation charges.
(2) Implicit Cost:
The implicit costs are the imputed value of the
entrepreneur's own resources and services. Implicit
costs can be defined as:

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"Expenses that an entrepreneur does not have to pay out

of his own pocket but are costs to the firm because they
represent an opportunity cost".
Example:
For instance, if a person is working as a manager in his
own firm or has invested his own capital or has built the
factory at his own land, the reward of all these factors
of production at least equal to their transfer pri es is,
included in the expenses of a business.
Implicit costs, thus, are the alternative costs of the self-
owned and self-employed resources of a firm. The total
costs of a business enterprise is the sum total of explicit
and implicit costs. If the implicit costs are not included in
the firm's total cost, the cost of the firm will be understated
and it will result in serious error.
(3) Real Cost:
Real costs are the pains and inconveniences experienced
by labor to produce a commodity. These costs are not
taken in the costing of a commodity by the firm. Real cost
has been defined differently by different economists.

Classical economists understood by real costs the

pains and sacrifices of labor. Alfred Marshall calls real
cost as social cost and describes it:
"Real costs of efforts of various qualities and real costs
of waiting".

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The Austrian School of Economists have criticized the

meaning given to real cost by the classical economists
and new classical economists. They say that to give a
subjective value to cost is a hopeless task as when real
cost is expressed in terms of sacrifices or pains, it is
not amenable to precise measurement and thus it fails
to explain the phenomenon of prices.
(4) Opportunity Cost:
The concept of opportunity cost has a very important
place in economic analysis. It is defined as:
"The value of a resource in its next best use. It is the
amount of income or yield that could have been earned
by investing in the next best alter ative".
Example:
The opportunity cost f a good can be given a money
value. For instance, a labor is working in a factory and is
getting $2000 P M. The entrepreneur is paying him this
amount because he can earn this amount in the next best
alternative employment. If he pays less than this amount,
he will move to next best alternative occupation, where
he can get $2000 P.M.
So in order to obtain a productive service say labor in the
present occupation, the cost should be equal to the
amount which he can get in some alternative occupation.
Similarly, a piece of land or capital must be paid as much
as they could earn in their next best alternative use. The
total alternative earnings of the various factors employed

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in the production of a good constitute the opportunity cost

of a good. In a money economy, opportunity or transfer
cost is defined as the amount of money which a firm must
make to resource suppliers m order to attract these
resources away from alternative lines of production. In
the words of Lipsay:
"The opportunity cost of using any factor is what is
currently foregone by using it"
Concept of Cost of Production:
Definition and Meaning:
By "Cost of Production" is meant the total sum of money
required for the production of a sp cific quantity of output.
In the word of Gulhrie and Wallace:
"In Economics, cost of production has a special meaning.
It is all of the payments or expenditures necessary to
obtain the factors of production of land, labor, capital and
management required to produce a commodity. It
represents money costs which we want to incur in order
to acquire the factors of production".
In the ords of Campbell:
"Production costs are those which must be received by
resource owners in order to assume that they will
continue to supply them in a particular time of production".
Elements of Cost of Production:

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The following elements are included in the cost

of production:
(a) Purchase of raw machinery, (b) Installation of plant
and machinery, (c) Wages of labor, (d) Rent of Building,
(e) Interest on capital, (f) Wear and tear of the machinery
and building, (g) Advertisement expenses, (h) Insurance
charges, (i) Payment of taxes, (j) In the cost of production,
the imputed value of the factor of production wned by the
firm itself is also added, (k) The normal profit of the
entrepreneur is also included In the cost of production.
Normal Profit:
By normal profit of the entrepr n ur is meant in economics
the sum of money which is ec ssary to keep an
entrepreneur employed in a business. This remuneration
should be equal to the amount which he can earn in some
other alternative occupation. If this alternative return is not
met, he will leave the enterprise and join alternative line of
production.
Types/Classifications of Cost of Production:
Prof, Mead in his book, "Economic Analysis and Policy"
has classified these costs into three main sections:
(1) Production Costs:
It includes material costs, rent cost, wage cost,
interest cost and normal profit of the entrepreneur.
(2) Selling Costs:

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It includes transportation, marketing and selling costs.

(3) Sundry Costs:
It includes other costs such as insurance
charges, payment of taxes and rate, etc., etc.
Analysis of Short Run Cost of Production:
Definition of Short Run:
Short run is a period of time over which at least one factor
must remain fixed. For most of the firms, the fixed
resource or factors which cannot be increased to meet
the rising demand of the good is capital i.e., plant and
machinery.
Short run, then, is a period of time over which output can
be changed by adjusti g the quantities of resources such
as labor, raw material, fuel but the size or scale of the
firm remains fixed.
Definition of Long Run:
In the long run there is no fixed resource. All the factors
of production are variable. The length of the long run
differs from industry to industry depending upon the
nature of production.
For example, a balloon making firm can change the size
of firm more quickly than a car manufacturing firm.
Categories/Types of Costs in the Short Run:

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The total cost of a firm in the short run is divided into

two categories (1) Fixed cost and (2) Variable cost. The
two types of economic costs are now discussed in brief.

(1) Total Fixed Cost (TFC):

Total fixed cost occur only in the short run. Total Fixed
cost as the name implies is the cost of the firm's fixed
resources, Fixed cost remains the same in the short run
regardless of how many units of output are produced.
We can say that fixed cost of a firm is that part of total
cost which does not vary with changes in output per
period of time. Fixed cost is to be i curred even if the
output of the firm is zero.
For example, the firm's resources which remain fixed in
the short run are building, machinery and even staff
employed on contract for work over a particular period.
(2) Total Variable Cost (TVC):
Total variable cost as the name signifies is the cost of
variable resources of a firm that are used along with the
firm's existing fixed resources. Total variable cost is linked
with the level of output. When output is zero, variable cost is
zero. When output increases, variable cost also increases
and it decreases with the decrease in output. So

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any resource which can be varied to increase or decrease

with the rate of output is variable cost of the firm.

For example, wages paid to the labor engaged in

production, prices of raw material which a firm. incurs on
the production of output are variable costs. A firm can
reduce its variable cost by lowering output but it cannot
decrease its fixed cost. These expenses remain fixed in the
short run. In the long run there are no fixed resources. All
resources are variable. Therefore, a firm has no fixed cost
in the long run. All long run costs are variable costs.
(3) Total Cost (TC):
Total cost is the sum of fixed cost and variable cost
incurred at each level of output. Total cost of production
of a firm equals its fixed cost p us its:
Formula:
TC = TFC + TVC
Where:
TC = Total cost.
TFC = Total fixed cost.
TVC = Total variable cost.
Explanation:
Short run costs of a firm is now explained with the help
of a schedule and diagrams.

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Schedule:
(in Dollars)

Total
Units of Output Total Variable
Fixed Total Cost
(in Hundred) Cost
Cost
0 1000 0 1000
1 1000 60 1060
2 1000 100 1100
3 1000 150 1150
4 1000 200 1200
5 1000 400 1400
6 1000 700 1700
7 1000 1100 2100

The short run cost data of the firm shows that total
fixed cost TFC (column 2) remains constant at $1000/-
regardless of the evel of output.
The column 3 indicates variable cost which is associated
with the level of output. Total variable cost is zero when
production is zero. Total variable cost increases with the
increase in output. The variable does not increase by the
same amount for each increase in output. Initially the
rd
variable cost increases by a smaller amount up to 3 unit
of output and after which it increases by larger amounts.

Column (4) indicates total cost which is the sum of TFC +

TVC. The total cost increases for each level of output. The

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th
rise in total cost is more sharp after the 4 level of
output. The concepts of costs, i.e., (1) total fixed cost (2)
total variable cost and (3) total cost can be illustrated
graphically.
(i) Total Fixed Cost Curve/Diagram:

In this diagram (13.1) the total fixed cost of a firm is

assumed to be $1000 at various l vels of output. It
remains the same even if the firm's output is zero.
(ii) Total Variable Cost Curve/Diagram:

In the figure (13.2), the total variable cost curve (TVC)

increases with the higher level of output. It starts from the
origin. Then increases at a diminishing rate up to the 4th
units of output. It then begins to rise at an increasing rate.
Total Cost Curve Curve/Diagram:

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In the figure (13.3), total cost curve which is the sum of

the total fixed cost and variable cost at various levels of
output has nearly the same shape. The difference
between the two is by only a fixed amount of $1,000. The
total variable cost curve and the total cost curve begin to
rise more rapidly as production is increased. The reason
for this is that after a certain
output, the business has passed its most efficient use of
its fixed costs machinery, bu lding etc., and its
diminishing return begins to set in.
Analytical Importance f Fixed and Variable Costs:
In the time of distinction between fixed cost and
variable cost is a matter of degree, it all depends upon
the contracts of a firm and .the period of time under
consideration.
For example, if a firm makes contract with the labor for a
certain period, then the firm has to bear the cost of the
labor irrespective of the total produce. Under such
conditions, the wages paid to the labor will be classified
as fixed cost and not variable cost, as discussed under
the heading of variable cost. Secondly, when the period of

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time is short, the distinction between fixed cost and

variable cost can be made rigid but not in a longer period
of time all fixed costs change into variable cost in the
long run.
Average Cost:
Definition and Explanation:
The entrepreneurs are no doubt interested in the total
costs but they are equally concerned in knowing the
cost per unit of the product. The unit cost figur s can be
derived from the total fixed cost, total variable cost and
total cost by dividing each of them with corresponding
output.
Types/Classifications:
(1) Average Fixed Cost (AFC):
Average fixed cost refers to fixed cost per unit of output.
Average fixed Cost is found out by dividing the total
fixed cost by the corresponding output.
Formula:
AFC = TFC
Output (Q)
For instance, if the total fixed cost of a shoes factory is
$5,000 and it produces 500 pairs of shoes, then the
average fixed cost is equal to $10 per unit. If it produces
1,000 pairs of shoes, the average fixed cost is $5 and if

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the total output is 5,000 pairs of shoes, then the

average fixed cost is $1 pair of shoe.
From the above example, it is clear, that the fixed cost,
i.e., $5,000 remains the same whether the output is
1,000 or 5,000 units.
Behavior of Average Fixed Cost (AFC):
The average fixed cost begins to fall with the increase in
the number of units produced, In our example stated
above, average fixed cost in the beginning was $10. As
the output of the firm increased, it gradually came down
to $1. The AFC diminishes with eve y increase in the
quantity of output produced but it never becomes zero.
Diagram/Curve:

The concept of average fixed cost can be explained with

the help of the curve, in the diagram (13.4) the average
fixed cost curve gradually falls from left to right showing the
level of output. The larger the level of output, the lower is
the average fixed cost and smaller the level of output, the
greater is the average fixed cost. The AFC never

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becomes zero.
(2) Average Variable Cost (AVC):
Average variable cost refers to the variable expenses per
unit of output Average variable cost is obtained by
dividing the total variable cost by the total output.
For instance, the total variable cost for producing 100
meters of cloth is $800, the average variable c st will be
$8 per meter.
Formula:
AVC = TVC
(Q)
Behavior of Average Variab e Cost:
When a firm increases its output, the average variable cost
decreases in the beginning, reaches a minimum and then
increases Here, a question can be asked as to why AVC
decreases in the beginning reaches a minimum and then
increases. The answer to this question is very simple.

When in the beginning, a firm is not producing to its full

capacity, then the various factors of production employed
for the manufacture of a particular commodity remain
partially absorbed. As the output of the firm is increased,
they are used to its fullest extent. So the AVC begins to
decrease. When the plant works to its full capacity, the

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AVC is at its minimum. If the production is pushed further

from the plant capacity, then less efficient machinery and
less, efficient labour may have to be employed. This
results in the rise of AVC. It is in this way we say that as
the output of a firm increases, the AVC decreases in the
beginning, reaches a minimum and then increases. The
AVC can also be represented in the form of a curve.
Diagram/Curve:

The shape of the average variable cost curve (Fig. 13.5)

is like a flat U-shaped curve. It shows that when the
output is increased, there is a steady fall in the average
variable cost due to incre sing returns to variable factor. It
is minimum when 500 meters of doth are produced. When
production is increased to 600 meters, of cloth or more,
the average variable cost begins to increase due to
diminishing returns to the variable factor.
(3) Average Total Cost (ATC):
Average total cost refers to cost (both fixed and variable)
per unit of output. Average total cost is obtained by
dividing the total cost by the total number of commodities
produced by the firm or when the total sum of average
variable cost and average fixed cost is added together, it

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becomes equal to average total cost.

Formula:
ATC = Total Cost (TC)
Output
(Q)
Behavior of Average Total Cost:
As the output of a firm increases, average total cost like
the average variable cost decreases in the beginning
reaches a minimum and then it inc as s. The reasons for
decline of ATC in the beginning a e that it is the sum of
AFC and AVC.
Average fixed cost and average variable costs have both
the tendency to fall as output is increased. Average total
cost will continue falling so long average variable cost
does not rise. Even if average variable cost continues
rising, it is not necessary that the average total cost will
rise. It can be due to the fact that the increase in average
variable cost is less than the fall in average fixed cost.
The increase in average variable cost is counterbalanced
by a rapid fall of average fixed cost. If the rise in the
average variable cost is greater than the fall in average
fixed cost, then the average total cost will rise.
The tendency to rise on the part of average total cost-
in the beginning is slow, after a certain point it begins
to increase rapidly.

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Diagram/Curve:

The average total cost is represented here by a shaped

curve in Fig. (13.6). The average total cost curve is also
like a U-shaped curve. It shows that as production
increases from 100 meters to 200 m t rs of cloth, the cost
falls rapidly, reaches a minimum but then with higher level
of output, the average fixed cost begins to increase.
Short Run and Long Run Average Cost Curves:
Relationship and Differe ce:
Short Run Average Cost Curve:
In the short run, the shape of the average total cost curve
(ATC) is U-shaped. The, short run average cost curve
falls in the beginning, reaches a minimum and then begins
to rise. The reasons for the average cost to fall in the
beginning of production are that the fixed factors of a firm
remain the same. The change only takes place in the
variable factors such as raw material, labor, etc.
As the fixed cost gets distributed over the output as
production is expanded, the average cost, therefore,
begins to fall. When a firm fully utilizes its scale of

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operation (plant size), the average cost is then at its

minimum. The firm is then operating to its optimum
capacity. If a firm in the short-run increases its level of
output with the same fixed plant; the economies of
that scale of production change into diseconomies and
the average cost then begins to rise sharply.
Long Run Average Cost Curve:
In the long run, all costs of a firm are variable. The factors
of production can be used in varying proportions to deal
with an increased output. The firm having time-period
long enough can build larger scale or type of plant to
produce the anticipated output. The shape of the long run
average cost curve is also U-shaped but is flatter that the
short run curve as is illustrated in the following diagram:
Diagram/Figure:

In the diagram 13.7 given above, there are five alternative

1 2 3 4 5
scales of plant SAC SAC , SAC , SAC and, SAC . In
the long run, the firm will operate the scale of plant which
is most profitable to it.

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For example, if the anticipated rate of output is 200 units

per unit of time, the firm will choose the smallest plant It
1
will build the scale of plant given by SAC and operate it
at point A. This is because of the fact that at the output of
200 units, the cost per unit is lowest with the plant size 1
which is the smallest of all the four plants. In case, the
volume of sales expands to 400, units, the size of the plant
will be increased and the desired output will be attained by
2
the scale of plant represented by SAC at p int B, If the
anticipated output rate is 600 units, the firm will build the
3
size of plant given by SAC and operate it at point C
where the average cost is $26 and also the lowest The
optimum output of the firm is obtained at point C on the
3
medium size plant SAC .
If the anticipated output rate s 1000 per unit of time the firm
5
would build the sca e of plant given by SAC and operate it
at point E. If we draw a tangent to each of the short run
cost curves, we get the long average cost (LAC) curve.
The LAC is U-shaped but is flatter than tile short run cost
curves M thematically expressed, the long-run average
cost curve is the envelope of the SAC curves.

In this figure 13.7, the long-run average cost curve of the

firm is lowest at point C. CM is the minimum cost at
which optimum output OM can be, obtained.

Marginal Cost (MC):

Definition:

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Marginal Cost is an increase in total cost that results

from a one unit increase in output. It is defined as:
"The cost that results from a one unit change in the
production rate".
Example:
For example, the total cost of producing one pen is $5 and
the total cost of producing two pens is $9, then the
marginal cost of expanding output by one unit is $4 only
(9 - 5 = 4).
The marginal cost of the second unit is the difference
between the total cost of the second unit and total cost
of the first unit. The marginal cost of the 5th unit is $5. It
is the difference between the total cost of the 6th unit
and the total cost of the, 5th unit and so forth.
Marginal Cost is g verned only by variable cost which
changes with changes in output. Marginal cost which is
really an incremental cost can be expressed in symbols.
Formula:
Marginal Cost = Change in Total Cost = ΔTC
Change
in Output Δq

The readers can easily understand from the table

given below as to how the marginal cost is computed:

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Schedule:
Units of Output Total Cost (Dollars) Marginal Cost (Dolla
1 5 5
2 9 4
3 12 3
4 16 4
5 21 5
6 29 8
Graph/Diagram:

MC curve, can also be plotted graphically. The marginal

cost curve in fig. (13.8) decreases sharply with smaller
Q output and re ches a minimum. As production is
expanded to a higher level, it begins to rise at a rapid
rate.
Long Run Marginal Cost Curve:
The long run marginal cost curve like the long run
average cost curve is U-shaped. As production expands,
the marginal cost falls sharply in the beginning, reaches a
minimum and then rises sharply.
Relationship Between Log Run Average Cost and

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Marginal Cost:
The relationship between the long run average total cost
and log run marginal cost can be understood better with

the help of following diagram:

It is clear from the diagram (13.9), that the long run
marginal cost curve and the long run av rage total cost
curve show the same behavior as the short run marginal
cost curve express with the short un average total cost
curve. So long as the average cost curve is falling with
the increase in output, the marginal cost curve lies below
the average cost curve.
When average total cost curve begins to rise, marginal
cost curve also rises, passes through the minimum point
of the average cost and then rises. The only difference
between the short run and long run marginal cost and
average cost is that in the short run, the fall and rise of
curves LRMC is sharp. Whereas In the long run, the
cost curves falls and rises steadily.
PRICING UNDER PERFECT COMPETITION
Market Structure:
Definition of Market:
A market is a set of conditions in which buyers and sellers
meet each other for the purpose of exchange of goods

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and services for money.

Elements of Market:
The essentials of a market are:
(i) Presence of goods and services to be exchanged.
(ii) Existence of one or more buyers and sellers.
(iii) A place or a region where buyers and sellers of a
good get in close touch with each other.
Types of Market/Market Model:
Markets are classified according to the number of firms
in the market and by the commodity to be exchanged.
The economists on the basis of variation in the features
of market describe four market models:
(i) Perfect Competiti n.
(ii) Pure Monopoly.
(iii) Monopolistic Competition.
(iv) Oligopoly.
In the analysis of each market model, it is examined as
to what determines the equilibrium price, output and
profit levels for the individual firm and for the industry, in
this chapter, we discuss the most important of the
various market models that is perfect competition.

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PERFECT COMPETITION
Definition:
The concept of perfect competition was first introduced
by Adam Smith in his book "Wealth of Nations". Later on,
it was improved by Edgeworth. However, it received its
complete formation in Frank Kight's book "Risk,
Uncertainty and Profit" (1921).
Leftwitch has defined market competition in the
following words:
"Prefect competition is a market in which there are many
firms selling identical products with no firm large enough,
relative to the entire market, to be able to influence
market price".
According to Bllas:
"The perfect competition is characterized by the presence
of many firms. They sell identically the same product.
The seller is a price taker".
The main conditions or features of perfect competition
are as under:
Features/Characteristics or Conditions:
(1) Large number of firms. The basic condition of perfect
competition is that there are large number of firms in an
industry. Each firm in the industry is so small and its output
so negligible that it exercises little influence over price of
the commodity in the market. A single firm cannot

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influence the price of the product either by reducing or

increasing its output. An individual firm takes the market
price as given and adjusts its output accordingly. In a
competitive market, supply and demand determine
market price. The firm is price taker and output adjuster.
(2) Large number of buyers. In a perfect competitive
market, there are very large number of buyers of the
product. If any consumer purchases more or purchases
less, he is not in a position to affect the market price of
the commodity. His purchase in the total output is just like
a drop in the ocean. He, therefore, too like the firm, is a
price taker.
(3) The product is homogeneous. Another provision of
perfect competition is that the good produced by all the
firms in the industry is ident cal. In the eyes, of the
consumer, the product of one firm (seller) is identical to
that of another se er. The buyers are indifferent as to the
firms from which they purchase. In other words, the cross
elasticity between the products of the firm is infinite.

(4) No barriers to entry. The firms in a competitive market

have complete freedom of entering into the market or
leaving the industry as and when they desire. There are
no legal, social or technological! barriers for the new
firms (or new capital) to enter or leave the industry. Any
new firm is free to start production if it so desires and
stop production and leave the industry if it so wishes. The
industry, thus, is characterized by freedom of entry and
exit of firms.

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(5) Complete information. Another condition for perfect

competition is that the consumers and producers
possess perfect information about the prevailing price of
the product in the market. The consumers know the
ruling price, the producers know costs, the workers know
about wage rates and so on. In brief, the consumers, the
resource owners have perfect knowledge about the
current price of the product in the market. A fir ,
therefore, cannot charge higher price than that ruling in
the market. If it does so, its goods will remain unsold
as buyers will shift to some other seller.
(6) Profit maximization. For perfect competition to
exist, the sole objective of the firm must be to get
maximum profit.
Equilibrium of the Firm Under Perfect
Competition orMarginal Revenue = Marginal Cost (MR =
MC) Rule:
Definition and Explanation:
A firm under perfect competition faces an infinitely
elastic demand curve or we can say for an individual
firm, the price of the commodity is given in the market.
The firm while making changes in the amounts of
variable factor evaluates the extra cost incurred on
producing extra unit MC (Marginal Cost).
It also examines the change in total receipts which results
from the sale of extra unit of production MR (Marginal
Revenue). So long as the additional revenue from the sale

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of an extra unit of product (MR) is greater than the

additional cost (MC) which a firm has to incur on its
production, it will be in the interest of the firm to
increase production.
In economic terminology, we can say, a firm will go on
expanding its output so long as the marginal revenue of any
unit is greater than its marginal cost. As production
increases, marginal cost begins to increase after a certain
point. When both marginal revenue and marginal cost are
equal, the firm is in equilibrium. The firm at this equilibrium
point is cither ensuring maximum profit or minimizing
losses. This is shown with the help of a diagram below:
Diagram/Figure:

In the figure (15.2) quantity of output is measured along

OX axis and marginal cost and marginal revenue on OY
axis. The marginal cost curve cuts the marginal
revenue curve at two points K and T.
The competitive firm is in equilibrium, at both these points
as marginal cost equals marginal revenue. The firm will not
produce OM quantity of good because for OM output,

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the marginal cost is higher than marginal revenue.

Marginal cost curve cuts the marginal revenue curve from
above. The firm incurs loss equal to the black shaded
area for producing 50 units (OM) of output.
As production is increased from 50 units to 350 units
(from OM to OS) marginal cost decreases at early levels
of output and then increases thereafter. The marginal cost
curve cuts the marginal revenue curve from bel w at point
T. The shaded portion between M to S level of output
shows profit on production. When a firm produces OS
quantity of output; it earns maximum profit. The point T
where MR = MC is the point of maximum profit.
In case, the firm increases the l v l of output from OS, the
additional output adds less to Its revenue than to its cost.
The firm undergoes losses as is shown in the shaded
area.
Summing up, profit maximization normally occurs at the
rate of output t which marginal revenue equals marginal
cost. This golden rule holds good for all market structures.
As regards the absolute profits and losses of the firm,
they depend upon the relation between average cost and
average revenue of the firm.
Short Run Equilibrium of the Price Taker Firm
Under Perfect Competition:
Definition and Explanation:
By short run is meant a length of time which is not enough
to change the level of fixed inputs or the number of firms in

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the industry but long enough to change the level of

output by changing variable inputs.
In short period, a distinction is made of two types of
costs (i) fixed cost and (ii) variable cost.
The fixed cost in the form of fixed factors i.e., plant,
machinery, building, etc. does not vary with the change in
the output of the firm. If the firm is to increase r decrease
its output, the change only takes place in the quantity of
variable resources such as labor, raw material, etc.
Further, in the short run, the demand curve facing the firm
is horizontal. No new firms enter or leave the industry.
The number of firms in the industry, th refore, remain the
same. Under perfect competition, the firm takes the price
of the product as determined in the market. The firm sells
all its output at the prevaili g market price. The firm, in
other words, is a price taker.
Equilibrium of a Competitive Firm:
The short-run equilibrium of a firm can be easily
explained with the help of marginal revenue = marginal
cost approach or (MR = MC) rule.
Marginal revenue is the change in total revenue that
occurs in response to a one unit change in the quantity
sold. Marginal cost is the addition to total cost resulting
from the additional of marginal unit. Since price is given
for the competitive firm, the average revenue curve of a
price taker firm is identical to the marginal curve. Average
revenue (AR) thus is equal to marginal revenue (MR) is

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equal to price (MR = AR = Price).

According to the marginal revenue and marginal cost
approach or (MR = MC) rule , a price taker firm is in
equilibrium at a point where marginal revenue (MR) or
price is equal to marginal cost The point where MR = MC
= Price, the firm produces the best level of output. From
this it may not be concluded that the perfectly co petitive
firm at the equilibrium level of output (MR = MC = Price)
necessarily ensures maximum profit. The fa t is that in the
short period, a firm at the equilibrium level of output is
faced with four types of product prices in the market which
give rise to following results:
(i) A firm earns supernormal profits.
(ii) A firm earns normal prof ts.
(iii) A firm incurs losses but does not close down.
(iv) A firm minimizes osses by shutting down. All these
short run cases of profits or losses are explained with
the help of diagrams.
Short Run Supply Curve of a Price Taker Firm:
Definition and Explanation:In a competitive market, the
supply curve of a firm is derived from its marginal cost
curve. Supply curve is that portion of the marginal cost
curve which lies above the average variable cost curve.

As we already know, the aim of the firm is to maximize

profits or minimize losses. The profits are increased it the

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difference between total receipts and total costs is

maximized. When a firm undertakes the production of a
particular commodity, it has to pay remuneration to all the
factors of production employed. The remuneration or cost
of the firm for a short period can be divided into two
parts, fixed costs and variable costs. If from the sale of
the commodity produced, a firm is earning much more
than what it has to spend on it. We say a firm is earning
abnormal profits if the total revenue of the firm is equal to
total cost, the firm is getting normal profits In both these
cases, it is profitable for the firm to produce the
commodity. But if the total receipts fall short of total
costs, then three situations can arise.
(i) A firm is not in position to m t its variable costs.
(ii) A firm is able to cover ts variable costs.
(iii) A firm is covering its full variable costs and a part
of the fixed costs.
Let us explain ll these situations with the help of a curve.
Diagram:

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Summing up, we can

say, that if price falls below the lowest point on the AVC
curve, the firm will not produce any output because it is
not able to cover even its total variable costs. But if the
price is such that it covers its total va iable costs, then the
firm may carry on production for a short period. So is also
the case when it covers its full variable costs and a part of
the fixed costs. In the long period, if the firm does not
cover its full costs, it will have to dose down its operations
sooner or later. So we co clude that the supply curve of
the firm that can be regarded as that portion of the MC
curve which lies above the AVC curve and not which lies
below the AVC curve because it is only at the lowest point
on the AVC curve that some output is forthcoming and
not below this point.
The supply curve of the firm or the rising portion of the
MC curve hich lies above the AVC curve can be split up
into two parts. One part consists of that portion which lies
above the lowest point of the ATC curve. If the price line
representing MR = AR intersects the MC curve at any
point on this rising portion, the firm will be earning
abnormal profit (see fig. 15.7). The second part of the
supply curve of the firm extends from the lowest point of

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the AVC curve to the lowest, point of the ATC curve. If

price line representing MR = AR passes through the
lowest point of the AVC curve, the firm is covering only
total variable costs. If the price line cuts the MC curve at
any point above the lowest point of the AVC curve and
below the lowest point of ATC curve, the firm will be
meeting its total variable costs and a part of the fixed
costs but not the total costs. The total costs are met only
when the price line forms a tangent to the ATC curve.
Short Run Supply Curve of the Industry:
Definition:
The short run supply curve of a competitive firm is that
part of the marginal cost curve which lies above the
average variable cost. As regards industry supply curve,
it is the horizontal summation of the short run supply
carves of the identical firms c nstituting an industry.
Explanation:
The industry short run supply curve is briefly
explained with the help of the diagram (15.8) below.
We assume here that prices of inputs do not change with
the change in the size of the firm; However, when all
firms increase or decrease output, the factor prices rise or
fall respectively.

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Diagram:

In figure 15.8(a), we assume that at point P, price or

marginal revenue equals marginal cost. The firm at
equilibrium point P. ($4) produces and sells 50 units of
a commodity. If the equilibr um of MR, MC, price occurs
at point K, the firm produces and sells 100 units.

In figure 15.8(b), let us suppose that there are 100 firms in

the industry. As all the firms by assumptions, have identical
costs, the industry will be producing 5000 units at a market
price of ($4) and 10000 units at industrial price of ($8). The
industry supply curve, therefore, has a positive

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slope.
Long Run Equilibrium of the Price Taker Firm:
Definition:
"All the firms in a competitive industry achieve long run
equilibrium when market price or marginal
revenueequals marginal cost equals minimum of average
total cost."
Formula:
Price = Marginal Cost = Minimum Av rage Total Cost
Explanation:
The long run is a period of t me during which the firms
are able to adjust their outputs according to the changing
conditions. If the dema d for a product increases, all the
firms have sufficient time to expand their plant capacities,
train and engage more labor, use more raw material,
replace old m chines, purchase new equipments, etc.,
etc.
If the demand for a product declines, the firms reduce the
number of workers on the pay roll, use less raw material.
In short, all inputs used by a firm are variable in the long
run. It is assumed that all the firms in the competitive
industry are producing homogeneous product and an
individual firm cannot affect the market price. It takes the
market price as given. It is also assumed that all the firms
in a competitive industry have identical cost' curves. The

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industry it is assumed is, a constant cost industry. In the

long run, it is for further assumed that all the firms in a
competitive industry have access to the same technology.

When the period is long and profit level of the

competitive industry is high, then new firms enter the
industry. If the profit level is below the competitive level,
the firm then leave the industry. When all the competitive
fir s earn normal profit, then there is no tendency for the
new firms to enter or leave the industry. The firms are
then in the long run equilibrium.

Diagram:
The case of long-run equ l br um of a firm can be easily
explained with .the help of a diagram given below:

Long Run Supply Curve for the Industry:

Definition and Explanation:

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While explaining the short run supply curve for the firm,
we stated that the supply curve in the short run is that
portion of the marginal cost curve which lies above the
average variable cost curve, it is because of the fact that
when the variable casts of a firm are realized, the firm
decides to produce the goods. In the short run, the firm is
in equilibrium when the MR is equal to MC and both are
equal to price. If this equilibrium takes place at the level
above the minimum point of ATC curve, the firm is earning
abnormal profits and if it is below the minimum point of
ATC, then it is suffering losses. In the long run, a firm
cannot operate at a loss, however small it may be.
The firm also cannot earn abnormal profits because in that
case new firms enter into the industry. The supply of the
goods increases in the market and price comes down to
the level of normal price. In case of fall in demand, the
capacity of the existing firms is contracted, old firms also
withdraw from the industry and thus supply is
automatically adjusted to demand. The firm, In the long
run, is in equilibrium when price = marginal revenue =
marginal cost = average total cost of the firm at the lowest
point. When all the firms producing a single commodity
are in equilibrium, the industry is in full equilibrium. Each
firm in the industry is earning only normal profits.
The short run supply curve of the industry is derived as
stated earlier by the lateral summation of that part of the
marginal cost curves of all the firms which lie above the
minimum point on the AVC curves. The long run supply
curve, however, cannot be obtained by this method

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because in the long run the variations is demand produce

long run adjustments in the output and also in the costs of
productions of these firms. The changes in output take
place because of the (1) greater or leaser production by
the existing firms, (2) entry of new firms in the industry or
withdrawals of old firms and (3) the emergence of
external economies and diseconomies.
The emergence of external economies and disec nomies
has a very important bearing on the shape of the long run
supply curve. When an industry in the long run expands its
size for greater production, it enjoys c rtain external
economies such as (1) technical economies, (2)
managerial economies (3) communications economies,
(4) financial economies and (5) risk b aring economies.
Internal economies may also arise out of the marketing
facilities enjoyed by the firms in the purchase of raw
material (6) in securing special concessional transport
rates, etc., etc. The internal economies also lead to
reduction in cost.
(1) If the size of the firm is expanded continuously, it meets
diseconomies as well. For instance, co-ordination and
organization of factors become difficult (2) capital may not
be available in the required quantity (3) entrepreneurial
inertia also stands in the way of expansion of the industry
(4) the prices of raw material also increase due to greater
demand by ail firms (5) the productivity of the additional
factors may also be less. The appearances of these
diseconomies result in increasing the marginal cost and
average total cost of the firms to the higher levels. If the

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economies and diseconomies cancel each other, the

industry wilt experience constant cost in the long run.

We, therefore conclude that the shape of the supply

curve of the industry, depends upon the behavior of the
cost in the long run.
Behavior of the Cost:
(1) If the industry is subject to constant cost, the shape
of the supply curve will be perfectly elastic, i e it will be
horizontal straight line parallel to the X-axis.
(2) If the industry obeys the taw of incr asing cost or
diminishing return, the shape of the supply curve will
be positive, i.e. it will rise from left to right.
(3) If the industry is governed by the law of diminishing
cost or increasing retur , the long run supply curve will be
negative, i.e., it wi fall downward from left to right.
(1) Supply Curve of a Constant Cost
Industry: Diagram:

In figure 15.10(a) the firm is in the long-run equilibrium at

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point N where:
Price = MC = Minimum Average Cost
The firm produces output OP and sells at price OK per unit
The firm like all other firms in the industry make normal
profits. In figure 15.10(b), it is shown that when the market
demand for .a product increases, the demand curve
/
DD shifts upwards. The new firms enter the industry and
each firm produces at its minimum point of average cost
which is OK. The industry is thus producing any quantity
of output at a price of OK. The supply curve of the industry
is perfectly elastic at a price OK in the long run.
(2) Supply Curve of the Increasing Cost
Industry: Diagram:

In the figure 15.11(a) it is shown that when the demand for

a commodity increases, more firms enter into the industry.
In order to attract more units of the factors, the firms pay
higher prices for them. The cost curves of the firms, move
up. The minimum average cost of the firm equals marginal
cost equals price at point F. The firm in the long run is in
equilibrium at point F and produce the best level of output

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OT.
When the costs of the firms rise with the expansion of
output, the supply 'curve of the industry Fig. 15.11(b) also
slants upward. The industry is now in equilibrium at point
R, with industry output OT and Price OK.

(3) Supply Curve of a Decreasing Cost

Industry: Diagram:

In the Fig. (15.12) the firm is in equilibrium at point K in the

long run because at point K, MR = MC = Price = Minimum
AC. It will produce OT output at price ON. The total supply
by all the firms (supply of industry) producing the
commodity at price ON will be OH. If the demand for the
product increases, the existing firms will expand their
sizes and the new firms will enter the industry/Due to

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technological developments and the economies of large

scale production, the MC, AC, and price fall. At the lower
price OP, the firm is in equilibrium at point F. Here MC =
AC = Price. The supply of a firm increases from OT to OH
at a decreasing cost. The supply of the industry at lower
price OP increases from OH to OK. The long run
equilibrium supply curve slopes downward from left to
right.
PRICING UNDER MONOPOLY
What is Monopoly? Definition
and Meaning:

Monopoly is from the Greek word meaning one seller. It

is the polar opposite of perfect competition. Monopoly is
a market structure in which one firm makes up the
entire market. Monopoly and competition are at the two
extremes. It is define as:
"Monopoly refers to a market where there is a single
seller for a product and there is no close substitute of the
commodity that is offered by the sole supplier to the
buyers. The firm constitutes the entire industry".
Explanation:
Monopoly, therefore, indicates a case where:
(i) There is only a single seller of a product or service
in the market.
(ii) The goods produced by a sole seller has not close

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substitutes.
(iii) The entry of new firms into the industry is
effectively barred by legal or natural barriers.
(iv) The firm being the sole supplier of a product
constitutes industry. Firm and industry thus have single
identity. Or we can say monopoly is a single firm identity.

(v) The single seller affects no other seller by its wn

action in the market. The other sellers too annot affect
the price and output of the monopolist.
(vi) The demand curve facing the monopolist is negatively
sloped. The monopolist being the only seller of the
commodity in the market can incr ase the total sale by
lowering the price and if, he raises the price, he would not
lose all his sale. The demand curve facing a monopolist
is less than perfectly elastic, i.e., . it slopes downward
from left to right.
For the monopoly to exist, it is not necessary that the size
of a firm should be large. Even a small firm may have a
monopoly. For instance, a local water company or a local
electricity company, supplying water and electricity in the
city possesses all the characteristics of a monopoly.

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Short Run Equilibrium Price and Output Under Monopoly:

Short Run Equilibrium of the Monopoly Firm:
In the short period, the monopolist behaves like any other
firm. A monopolist will maximize profit or minimize losses
by producing that output for which marginal cost (MC)
equals marginal revenue (MR). Whether a profit or loss is
made or not depends upon the relation between price and
average total cost (ATC). It may be made lear here that a
monopolist does not necessarily makes profit. He may
earn super profit or normal profit or ev n produce at a loss
in the short ran.
Conditions for the Equilibrium of a Monopoly Firm:
There are two basic cond t o s for the equilibrium of the
monopoly firm.
First Order Conditi n: MC = MR.
Second Order Condition: MC curve cuts MR curve
from below.
Explanation:
(a) Short Run Monopoly Equilibrium With Positive Profit:
In the short period, if the demand for the product is high,
a monopolist increase the price and the quantity of
output. He can increase the, output by hiring more labor,
using more raw material, increasing working hours etc.
However, he cannot change his fixed plant and
equipment. In case, the demand for the product falls, he

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then decreases the use of variable inputs, (like

labor, material etc.).
b) Short Run Equilibrium With Normal Profit
Under Monopoly:
There is a false impression regarding the powers of a
monopolist. It is said that the monopolistic entrepreneur
always earns profits. The fact, however, is that there is no
guarantee for the monopolist to earn profit in the short
run. If a monopolist firm produces a new commodity and
attempts to change the taste pattern of the consumers
through advertising campaigns etc., th n the firm may
operate at normal profit or even p oduce at a loss
minimizing price in the short run (Covering variable cost
only).
(c) Short Run Equilibrium With Losses Under Monopoly:
A monopolist also accepts short run losses provided
the variable costs of the firm are fully covered.
Long Run Equilibrium Under Monopoly:
The monopolist creates barriers of entry for the new firms
into the industry. The entry into the industry is blocked by
having control over the raw materials needed for the
production of goods or he may hold full rights to the
production of a certain good (patent) or the market of the
good may be limited. If new firms try to enter in the field, it
lowers the price of the good to such on extent that it
becomes unprofitable for new firms to continue production

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etc.
When there is no threat of the entry of new firms into the
industry, the monopoly firm makes long run adjustments in
the scale of plant. In case, the demand for the product is
limited, the monopolist can afford to produce output at sub
optimum scale. If the market size is large and permits to
expand output, then the monopolist would build an
optimum scale of plant and would produce g ds at the
minimum cost per unit. However, the monopolist would
not stay in the business, if he makes losses in the long
period. The long run equilibrium of a monopoly firm is now
explained with the help of the following diagram.
Diagram/Curve:

In the long run, all the factors of production including the

size of the plant are variable. A monopoly firm will maximize
profit at that level of output for which long run marginal cost
(MC) is equal to marginal revenue (MR) and the LMC curve
intersects the MR curve from below. In the

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figure (16.6), the monopoly firm is in equilibrium at point E

where LMC = MR and LMC cuts MR curve from below. QP
is the equilibrium price and OQ is the equilibrium output.
Monopoly Price Discrimination:
What is Price Discrimination?
While discussing price determination under monopoly, it
was assumed that a monopolist charges only ne price for
his product from all the customers in the market. But it
often so happens that a monopolist, by virtue of his
monopolistic position, may manage to s ll the same
commodity at different prices to di e ent customers or in
different markets. The practice on the part of the
monopolist to sell the identical goods at the same time to
different buyers at different prices when the price
difference is not Justified by difference in costs in
calledprice discriminati n. In the words of Mrs. Joan
Robinson:
"Price discrimin tion is the act of selling the same article
produced under single control at a different prices to the
different buyers".
Types and Examples of Price Discrimination:
Price discrimination may be of various types. It may
either be (i) personal (ii) trade discrimination (iii) local
discrimination.
(1) Price discrimination. It is persona!, when separate price
is charged from each buyer according to the intensity

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of his desire or according to the size of his pocket.

For instance, a doctor may charge $20000 from a rich
person for an eye operation and $500 only from a
poor man for the similar operation.
(2) Trade discrimination. It may take place when a
monopolist charges different prices according to the uses
to which the commodity is put. For example, an electricity
company may charge low rate for electric urrent used in
an industrial concern than for the electricity used for the
domestic purpose.
(3) Place discrimination. It occurs when a
monopolist charges different prices for the same
commodity at different places. This type of
discrimination is called dumping.
In Economics, a monopolist sells the same commodity at
a higher price in one market and at a lower price in the
other. Dumping may be undertaken due to several
reasons, (a) a monopolist may resort to dumping in order
to dispose off the accumulated stock or (b) he may, dump
the commodity with a desire to capture the foreign market,
(c) dumping may also be done to drive the competitors
out of the market, (d) the motive may also be to reap. the
economies of large scale production, etc.
PRICING UNDER MONOPOLISTIC
COMPETITION Definition:
Monopolistic/Imperfect competition as the name signifies

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is a blend of monopoly and competition. It is a

systematic and realistic theory of price analysis in this
imperfectly competitive world.
Monopolistic competition is a market situation in which
there are relatively large number of small firms which
produce or sell similar but not identical commodities to
the customers.
According to Leftwitch:
"Monopolistic competition is a market situation in which
there are many sellers of a particular product, but the
product of each seller is in some way differentiated in
the minds of consumers from the product of every other
seller".
In the words of J.S. Bain:
"Monopolistic competiti n is found in the industry where
there is a large number of small sellers selling
differentiated but close substitute products".
Examples of Monopolistic Competition:
For example, a firm supplies branded good 'Lux Soap' in
the market. There are many other firms in the market
which sell similar soaps (not identical) with different brand
names like Rexona, Palm Rose, etc., etc. The firm
supplying 'Lux Soap' enjoys a monopoly position over the
sale of its own product. It also faces competition from
firms selling similar products.

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Same is the case with many other firms in the market like
plywood manufacturing, jewellery making, wood
furniture, book stores, departmental stores, repair
services of all kinds, professional services of doctors,
technicians, etc., etc. These firms and others which have
an element of monopoly power and also face competition
over the sale of product or service in the market are
called monopolistically competitive firms.
Characteristics of Monopolistic/Imperfect Competition:
The main characteristic or features of
monopolistic competition are as under:
(i) A fairly large number of sell rs: The number of firms in
monopolistic competition is fairly large. Each firm
produces or sells a close substitute for the product of
other firms in the product group or industry. .Product
differentiation is thus the hallmark of monopolistic
competition.
(ii) Differentiation in products: Under monopolistic
competition, the firms sell differentiated products.
Product differentiation may be real or imaginary. Real
differentiation is done through differences in the materials
used, design, color etc. Imaginary differences may be
created through advertisement, brand name, trade marks
etc. The firms producing similar products in .this
imperfectly competitive world cannot raise the price of
product much higher than their rivals. If they do so, they
will lose much of their sale, but not all the sale. In case,
they lower the price, the total sale can be increased to a

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certain extent. How much will the sale increase or

decrease by lowering or raising the price will depend
upon the product differentiation of the different firms.
If the product of the various firms are very close
substitutes of one another and no imaginary or real
difference exists in the mind of the buyers, then a slight
rise or fall in the price of the product of one firm will
appreciably decrease or increase the demand f r the
product. If the product of one firm differs from that of
other firm, (though the difference may be an imaginary
one) a slight rise in the price of the product of one firm will
not drive away all its customers. A few faithless buyers
may be attracted by the low price of the other rival
product but not all the buyers.
(iii) Advertisement and propaganda: Another very
important characteristic of the monopolistic competition
is that each firm tries to create difference in its product
from the other by advertising, propaganda, attractive
packing, nice smile, etc , etc. When it succeeds in its
object, the firm occupies almost the position of a
monopolist. It is, thus, in a position to raise-the price of
the product without losing its customers.
(iv) Nature of demand curve: Since the existence of close
substitutes limits the monopoly power, the demand curve
faced by a monopolistically competitive firm is fairly elastic.
The precise degree of elasticity will however, depend upon
the number of firms in the group product or industry. If the
number of firms is fairly large and the product of each firm
is not very similar, the demand curve

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of a firm will be quite elastic. In case, there is close

competition among the rival firms for the sale of similar
products, the demand curve of a firm will be less elastic.

(v) Freedom of entry and exit of firms: The entry of new

firms in the monopolistically competition industry is
relatively easy. There are no barriers of the new firm to
enter the product group or leave the industry in the
long run.
(vi) Sales efforts: With heterogeneous products, the
sale of the products by the firms can no long r be taken
for granted sale depends upon sale efforts.
(vii) Non-price competition: In monopolistic competition,
the firms make every effort to win over the customers.
Other than price cutting, the firms may offer after sale
service, a gift scheme, discount not declared in the
price list etc.
Equilibrium Price and Output in the Long Run
Under Monopolistic/Imperfect Competition:
Long Run Zero Economic Profits:
In the long run, the firms are able to alter the scale of
plant according to the changed conditions of demand for a
product in the market. They can also leave or enter the
industry. If the firms are earning abnormal profits in the
short run, then new firm will enter the 'product group'
(industry). The tendency of the new firms to enter the
industry continues till the abnormal profits are competed
away and the firms economic profits are zero. In case the

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monopolistically competitive firms realize losses in the

short-run, then some of the firms will leave the industry.
The exit of the firm continues till zero economic profits
are restored with the operating firms.
In the long-run, there are no entry barriers for the new
firms. The incoming firms install latest machinery and try
to differentiate their products from those of the
established firms. The old firms operating with .the used
machinery try to match up with the new entrants by
improved variety of products in their group. They increase
expenditure on advertisement and on other sales
promotional measures. They employ more qualified staff
for. making technical improvement in their products. Since
all the firms for their existence incur additional exp nditure
for improving the quality of the products, the cost curves
of all the firms move up. Due to entry of new firms in the
industry and higher costs of productio , the output of each
competing firm is reduced. There is, therefore, a waste in
the economic resources of the country. The equilibrium
price and output in the long-run is explained with the help
of a diagram.
Diagram:

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In the figure (17.3), the higher shifted long-run marginal

cost curve intersects the higher shifted marginal revenue
curve at point M. The firm at this raised equilibrium point,
produces the reduced level of output OK. It sells this
output at price TK as at point T, LAC is a tangent to the
demand or average revenue curve at its minimum point.
The total revenue of the firm is equal to the area OETK.
The total costs of the firm are also equal to the area
OETK. The firm is earning only zero or normal economic
profits. As the monopolistically competitive firm sets a
price higher than that minimum av age cost in the long-
run, the firm therefore produces a smaller output. Since all
the firms in the product group produce less at higher
price, there is, therefore, an appare t waste of resources
and exploitation of the consumers.
The advocates of m n polistic competition are of the
opinion that if consumers get differentiated products at
slightly higher prices (than with no choice under perfect
competition), the consumers are then not exploited. There
is no wasting of resources either, as the consumer's
welfare increases with the product differentiation.

Short Run Equilibrium Under

Monopolistic/Imperfect Competition:
Monopolistic competition refers to the market
organization where there are a fairly large number of
firms which sell somewhat differentiated products.

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A single firm in the product group (industry) has little

impact on the market price. However, if it reduces price, it
can expect a considerable increase in its sales. The firm
may also attract buyers away from other firms by creating
imaginary or real difference through advertising, branding
and through many other sales promotion measures (non-
price competition). If the firm raises its price, it will not
lose all its customers. This is because of the fact that the
product is differentiated from competing firms due to price
and non-price factors. The demand curve (AR curve) of
the monopolistic firm is therefore, highly lastic and is
downward sloping. As regards the marginal revenue
curve, it slopes downward and lies below the demand
curve because price is lower d of all the units to sell more
output in the market.
Firm's Equilibrium Price and Output:
In the short-run, the number of firms in the 'product group'
remains the same. The size of the plant of each firm
remains unaltered. The firm whether operating under
perfect competition, or monopoly wants to maximize
profits. In order to achieve this objective, it goes on
producing a commodity so long as the marginal revenue
is greater than marginal cost. When MR = MC, it is then in
equilibrium and produces the best level of output. If a firm
produces less than or more than the MR = MC output, it
will then not be making maximum of profits.
In the short-run, a monopolistically competitive firm may
be realizing abnormal profits or suffering losses. If it is
earning profits, no new firms can enter the industry in the

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short-run. In case, it is suffering, losses but covering full

variable cost, the firm will continue operating so that the
losses are minimized. If the full variable cost is not met, the
firm will close down in the short-run. The short-run
equilibrium with profits and short run equilibrium with losses
of a monopolistically competitive firm are explained with the
help of two separate diagrams as under.

Diagram:

In the figure (17.1), the downward sloping demand curve

(AR curve) is quite elastic. The MR curve lies below-the
average curve except at point N. The SMC curve which
includes advertising and sales promotional costs is drawn in
the usual fashion. The SMC curve cuts the MR curve from
below at point Z. The firm produces and sells an output OK,
as at this level of output MR = MC. The firm sells output OK
at OE/KM per unit price. The total revenue of the firm is
equal to the area OEMK, whereas the total cost of
producing output OK is OFLK. The total profits of the firm
are equal to the shaded rectangle FEML. The firm

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earns abnormal profits in the short run.

OLIGOPOLY
Oligopoly is a situation in which few large firms compete
against each other and there is an element of
interdependence in the decision making of these firms. A
policy change on the part of one firm will have i ediate
effects on competitors, who react with their c unter
policies.
Features
Following are the features of oligopoly which distinguish
it from .other market structures :
1. Small number of large sellers.
The number of sellers dealing in a homogeneous or
differentiated product is small. The policy of one seller
will have a noticeab e impact on market, mainly on price
and output.
2.Interdependence.
Unlike perfect competition and monopoly, the oligopolist
is not independent to take decisions. The oligopolist has
to take into account the actions and reactions of his rivals
while deciding his price and output policies. As the
products of the oligopolist are close substitutes, the cross
elasticity of demand is very high.
3.Price rigidity.

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Any change in price by one oligopolist invites retaliation

and counter- action from others, the oligopolist normally
sticks to one price. If an oligopolist reduces his price, his
rivals will also do so and therefore, it is not advantageous
for the oligopolist to reduce the price. On the other hand,
if an oligopolist tries to raise the price, others will not do
so. As a result they capture the customers of this firm.
Hence the oligopolist would never try to either reduce or
raise the price. This results in price rigidity.
4.Monopoly element.
As products are differentiated the firms njoy some
monopoly power. Further, when i ms collude with each
other, they can work together to raise the price and
earn some monopoly income.
5.Advertising.
The only way open to the oligopolists to raise his sales is
either by advertising or improving the quality of the
product. Advertisement expenditure is used as an
effective tool to shift the demand in favour of the product.
Quality improvement ill also shift the demand favorably.
Usually, both advertisements as well as variations in
designs and quality are used simultaneously to maintain
and increase the market share of an oligopolist.
6. Group behaviour.
The firms under oligopoly recognise their
interdependence and realise the importance of mutual
cooperation. Therefore, there is a tendency among

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them for collusion. Collusion as well as competition

prevail in the oligopolistic market leading to
uncertainty and indeterminateness.
7. Indeterminate demand curve.
It is not possible for an oligopolist to forecast the nature
and position of the demand curve with certainty. The
firm cannot estimate the sales when it decides to
reduce the price. Hence the demand curve under
oligopoly is indeterminate.
TYPES OF OLIGOPOLY.
Oligopoly may be classified in the ollowing ways:
a. Perfect and imperfect oligopoly.
On the basis of the nature of product, oligopoly may
be classified into perfect
(pure) and imperfect (differentiated) oligopoly. If the
products are homogeneous,then oligopoly is called as
perfect or pure oligopoly. If the products are
differentiated and are close substitutes, then it is called
as imperfect or differentiated oligopoly.
b. Open or closed oligopoly.
On the basis of possibility of entry of new firms, oligopoly
may be classified into open or closed oligopoly. When
new firms are free to enter, it is open oligopoly. When few
firms dominate the market and new firms do not have a
free entry into the industry, it is called closed oligopoly.

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c. Partial and full oligopoly.

Partial oligopoly refers to a situation where one firm acts
as the leader and others follow it. On the other hand, full
oligopoly exists where no firm is dominating as the price
leader.
d. Collusive and non- collusive oligopoly.
Instead of competition with each other, if the firms follow
a common price policy, it is called collusive oligopoly. If
the collusion is in the form of an agreement, it is called
open collusion. If it is an understanding b tw en the firms,
then it is a secret collusion. On the other hand, if there is
no agreement or understanding b tween oligopoly firms, it
is known as non-collusive oligopoly.
e. Syndicated and organised oligopoly.
Syndicated oligopo y is one in which the firms sell their
products through a centralised syndicate. Organised
oligopoly refers to the situation where the firms
organise themselves into a central association for fixing
prices, output, quota etc.
MODELS OF OLIGOPOLY
1. Cournot's model of oligopoly : Augustin Cournot, a
French economist, published his theory of duopoly in
1838. Cournot dealt with a case of duopoly. He has
taken the case of two identical mineral springs

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operated by two owners. His model is based on the

following assumptions :

1.The product is homogenous.

2.There is no cost of production. The average c st and

marginal cost are zero.

3.Output of the rival is assumed to be constant.

4.The market demand for the product is linear.

DB is the market demand curve. OB is the total quantity

of mineral water which can be produced and supplied by
the two producers. If both the producers produce the
maximum quantity of OB, the price will be zero. This is
because cost of production is assumed to be zero.
Cournot assumes that one producer say X starts

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production first. He will produce OA output and his profit

will be OAPK. Suppose the second producer Y enters into
the market. He assumes that the first producer will
continue to produce the same. So Y considers PB as his
demand curve. With this demand curve, he will produce
AH amount of output. The total output will now be OA +
AH = OH and the price will fall to OF. The total profits for
both the producers will be OHQR. Out of this total profits,
producers X will get OAGF and Y will receive AHQG. Now
that the profits of producers X are reduced from OAPK to
OAGF by producers Y producing AH output, producer X
will reconsider the situation. But he will assume that
producer Y will continue to produce AH output. Therefore,
he reduces his output from OA to OT. Now the total output
will be OT + AH = ON and the price will be OS and the
total profits of the two wi be ONRS. Out of the total profits,
X will get OTLS a d Y will get TNRL. Now the producer Y
will reappraise his situation. Believing that producer X will
continue producing OT, the producer Y will find his m
ximum profits by producing output equal to 1/2 TB. With
this move of producer Y, producer X will find his profits
reduced. Therefore, X will reconsider his position. This
process of adjustment and readjustment by each producer
will continue, until the total output OM is produced and
each is producing the same amount of output. In the final
position, producer X produces OC amount of output and

producer Y produces CM amount of output and OC = CM.

2. Bertrand's model

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Joseph Bertrand, a French mathematician criticised

Cournot's duopoly solution and put forward a substitute
model of oligopoly. In Bertrand's model, each producer
assumes his rival's price to be constant. The products
produced and sold by the two producers are completely
identical. The two producers have identical costs.
Moreover, the productive capacity of the producers is
unlimited. Bertrand's model can be explained with an
example. There are two producers A and B. If A goes into
business first, he will set the price at the monopoly level,
which is the most profitable for him. Suppose B also
enters into the business and starts producing the same
product as produced by A. B assumes that A will go on
charging the same pricei Ther fore, he can undercut the
price changed by A to capture the whole market. He will
set a price slightly lower than I A's price. A's sales fall to
zero. Now A will reco sider his price policy. He assumes
that, B will continue to charge the same price. There are
two alternatives open to him. First, he may match the
price cut made by B or he may charge the same price as
B charges. In this case, he will secure half the market.
Secondly, he may undercut B and set a slightly lower
price than that of B. In this case A will seize the entire
market. Evidently the latter course

looks more profitable and thus A undercuts B and sets a

price lower than B's price. Now producer B will react and
think of changing his price, He also has two alternatives:
He may match A's price or undercut him. Since
undercutting is more profitable, B will set a price a little
lower than A and seize the whole market. But again A will

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be forced to undercut B. This price war will go on until

price falls to the level of cost. When price is equal to cost,
neither of them will like to cut the price further or raise the
price and therefore, the equilibrium has been achieved. In
Bcrtrand's model, equilibrium is achieved when market
price is equal to the average cost of production and the
combined equilibrium output of the two duopolies is equal
to the competitive output.

Constant returns: the PPF forms a straight line which

means that to produce 10 units of one good we
sacrifice 10 units of another.
Economic growth: with better technology for example the
economy can produce more of all goods and thus the
PPF shifts outwards.
Law of diminishing returns: as resources are
transferred from good A to Good B the extra output of B
becomes successively smaller whilst the amount
sacrificed by A larger.

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Advantages of the free market:

1. no Government intervention.Resources allocated by

the market forces and the price mechanism
2. The profit motive provides incentives to reduce
costs and be innovative.
3. The free market maximizes community
surplus without failures or imperfections.
Disadvantages of free market:
1. Public goods cause market failure.
2. Merit goods cause partial mark t failure.
3. Externalities by private firms due to lack of corporate
social responsibility and a d sire to minimize costs.
4. Instability and great income inequality.
Advantages of command economy:
1. The Government can influence the distribution
of income to equa ize it.
2. The government can determine which goods
are supplied.
Disadvantages of command economy:
1. Requires an enormous amount of information,
which means its often bureaucratic.
2. No incentive for firms or individuals to be innovative;
lack of profit motive; goods of poor quality and
limited choice.
3. Liable to lead to allocative and productive inefficiency
due to lack of competition and no profit motive.

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Law of Demand: a higher quantity will be demanded at

a lower price assuming ceteris paribus.
Non-price determinants of demand:
1. Real incomes have risen (assuming the god
is normal).
2. The price of a substitute has changed.
3. The price of a complement good has changed.
4. More effective advertisement.
5. Population growth.
6. Change in taste.
7. More credit available so people can borrow money.
Downward sloping demand curv : this happens due to the
law of diminishing marginal utility. Each extra unit of good
or service will eventually g ve less extra satisfaction thus
the consumers will be willi g to pay less to purchase it.
Upward sloping demand curves: Luxury goods or giffen
goods (very inferior goods). As the price of each good
rises consumers re willing to pay more to purchase them.
Income and substitution effects: The substitution effect
says that as the price of a good drops people will switch
from buying others to buying that so as to cover their
need. The income effect says that as your income
increases you will buy more luxury and normal goods
and less inferior and giffen goods.
Elasticity of demand: measures the sensitivity of
demand to a change in a variable which is either the
price of a good the price of other goods or income.

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Perfectly elastic: the percentage change in

quantity demanded is infinite.
Elastic: the percentage change in quantity demanded
is greater than the percentage change in the variable.
Unit elastic: the percentage change in the quantity
demanded is equal to the percentage change in
the variable.
Inelastic: the percentage change in the quantity demanded
is less than the percentage change in the variable.

Perfectly inelastic: there is no change in

quantity demanded.
Price elasticity of demand: percent change in
quantity demanded over percent change in price.
The size of price elasticity of demand depends on:
1. The number and availability of substitutes.
2. The time horizon.
3. The percentage of income spent on the good.
4. The type of good.
5. The idth of definition.
Price elasticity of demand and revenue: If demand is
price elastic a fall in price will lead to an increase in
revenue. If demand is price inelastic an increase in price
will lead to an increase in revenue.
Uses of elasticity of demand:

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Price elasticity:
1. Determine pricing policy.
2. Use it for planning.
3. Use it when price discriminating.
4. The government may use it to estimate the impact
of an indirect tax cut in terms of sales and
government revenue.
5. Used to estimate the impact on consumer spending,
producers revenue and income of any shift of supply.
Cross elasticity:
1. Effect on their demand of a competitor’s price cut.
2. Effect on demand for their product if they cut the
price of a complement.
Income elasticity:
1. What goods to pr duce or stock.
2. Firms plan production and employee requirements
as the economy grows.
3. Firms can estimate any potential change in demand.
Non-price determinants of supply:
1. Increase in suppliers.
2. Improvement in technology.
3. Fall in the prices of the factors of production.
4. Cut in an indirect tax or increase in subsidies
to producers.
5. Change in price of jointly supplied goods.

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6. Other factors such as changes in the weather

or improvement of management.
Determinants of Price elasticity of supply:
1. Number of producers.
2. Existence of spare capacity.
3. Ease of storing stocks.
4. Time period.
5. Factor mobility.
6. Length of production period.
Periods of supply:

1. supply is totally inelastic.Momentary

2. constrained by fixed factors the supply is usually
inelastic.Short run
3. all factors are variab e so supply is elastic.Long
run Price:
1. in the case of creation of excess demand at
theRationing device old price of a product due to
increase in demand the price will raise reducing
quantity demanded.
2. excess demand and increase in price leads other
firms to join the industry.Signal
3. higher prices encourage existing firms to produce
more.Incentive
Taxes: If demand is more inelastic than supply consumers
pay the greater proportion. If supply is more inelastic than

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demand the producer will pay the greater incidence

of taxation.
Problems with buffer stock schemes:
1. Storage costs.
2. Some goods may be perishable.
3. Administration costs.
4. Wine lakes and Butter Mountains if the price is set
too high.
5. Inadequate supplies with many bad years.
6. Increase in taxes to raise finance.
7. Intervention in other areas may be more important.
Reasons for market failure:
1. Market power.
2. Factor immobility.
3. Inequality.
4. Merit goods.
Government intervention to improve environment:
1. Provision of information.
2. Taxes and subsidies.
3. Establish property rights.
4. Legislate.
5. Introduce tradeable permits.
Instability as a reason for market failure: this
happens because the free market leads to cycles of
booms, recessions, slumps and recoveries.

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Problems of government intervention:

1. Lack of information.
2. Difficulty in quantifying the problem.
3. Political pressure.
4. Administration costs.
5. by the time the government has intervened the
problem may not be the same.Mistiming
Explain why firms in the short run if they get a price less
than AC stay in business? The firm continues operating
because if it closes down despite the fact it doesn’t have
to pay AVC it has to pay FC which is gr ater loss than the
loss before. So it stays in business until all factors are
variable where it can leave with no losses.
What is the difference between increasing returns to scale
and economies of scale? The difference is that
economies of scale refer to a fall in the cost per unit
whereas increasing returns to scale refer to a change in
output. Although incre sing returns to scale contribute to
economies of scale the one measures cost and the other
output.
Present and explain the law of diminishing returns. The
law of diminishing returns is when additional units of a
variable factor are added to a fixed factor the extra output
of the variable factor will eventually diminish. The three
main assumptions for the law of diminishing returns are
that at least one factor has to be fixed (in other words it
has to be in the short run), each unit of the variable factor
has to be equal (for example the labor force has to be

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equally trained etc.) and that the level of technology

must be held constant.
Difference between decreasing returns to scale and law
of diminishing returns. Decreasing returns to scale is in
the long run whereas the law of diminishing returns is in
the short run.
Present and explain internal and external ec n mies and
diseconomies of scale.
External economies of scale occur wh n the cost per unit
at every level of output is reduced b cause of factors
outside the firm. These occur when the industry is large
or with the construction of certain infrastructure such as
highways and airports.
Internal economies of sca e occur when the cost per unit
at every level of output is reduced because of factors
inside the firm. These c uld be related to the plant and are
specialization, division of labor, indivisibilities, container
principle, and efficiency of large machines and the use of
recyclable products. Moreover there may be better
management or marketing. Also there may be
experiencing financial economies of scale or in other
words due to the size of the firm be in the position of
negotiating lower interest rates.
Internal diseconomies of scale occur when cost per unit at
every level of output is increased because of factors
inside the firm. These could be management problems or
workers alienation which leads them to work inefficiently.

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Moreover there may be the creation of negative

industrial environment such as strikes, slow-downs or
working to rule. Lastly there might be production line
problems such as interdependencies or delays.
External diseconomies of scale occur when the cost per
unit at every level of output is increased due to factors
outside the firm. These may be that the industry has
grown too big or that there is high competiti n within the
industry on who gets the raw material. Lastly there may
be shortage in commodities.
Assumptions for perfect competition:
1. Many buyers and sellers.
2. Perfect information so that buyers know
what products are offered a d their price.
3. Product homoge eity so that firms can’t differentiate
their products.
4. No barriers to entry so firms can enter and leave
in the long run.
5. Producers have similar technology and there
are perfectly mobile resources.
6. The firm is a price taker which means that marginal
revenue equals to price and each firm can sell what it
ants at a given market price.
Why are perfectly competitive markets desirable?
1. Only normal profits in the long run.

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2. Firms are allocatively efficient because they

produce where the extra benefit of the unit equals
the extra cost.
3. Productively efficient because they produce at
the lowest cost per unit.
4. There is an incentive for firms to innovate
and become more efficient because they can
gain abnormal profits in the short run.
However
1. Firms may not be able to afford r s arch and
development due to lack of abnormal profits in
the long run.
2. Due to lack of product homogeneity there is no
variety for consumers.
Assumptions for monopoly:
1. A single seller in the market and many buyers.
2. The monopo ist is a price taker.
3. The monopolist faces a downward sloping
demand curve.
4. The monopolist can set the price or the output but
not both.
5. Only one price can be charged for all the goods i.e.
there is no price discrimination. Thus the firm gains
revenue from the sale of the extra unit but is losing
revenue on the ones before where the price has
been lowered. As more units are sold the marginal
revenue moves further and further away from the
average revenue line.

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Short run abnormal profits: monopolies can earn abnormal

profits in the short and in the long run because of the
barriers to entry which prevent abnormal profits from
being competed away.
Barriers to entry:
1. Legislation. The government may restrict the ability
of firms to compete in a market usually when the firm
is government owned.
2. Product differentiation usually done
through advertising.
3. Control over outlets so that comp titors can’t get their
products in the market.
4. Patents and trademarks.
5. Fear of the reaction of existing firms.
6. Cost advantage due to economies of scale
for example.
7. Control over supplies.

Monopolistic competition:
1. Many sellers with differentiated products.
2. Abnormal profits in the short run.
3. Normal profits in the long run.
4. Allocatively inefficient because the price
consumers are willing to pay is greater than the
extra cost of production.
5. Productively inefficient because firms aren’t
producing at the lowest cost per unit.
Assumptions for perfect price discrimination:

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1. The firm must be able to keep the markets separate.

2. The firm must have control over the price.
3. There must be different elasticities or demands in
the different markets.
Methods of price discrimination:
1. By time.
2. By geography.
3. By branding Zara=D&G.
Oligopoly:
1. A few firms dominate the ma k t.
2. There is interdependency.
3. There is no one price and output outcome
in oligopoly.
Competition and collusio : firms in oligopoly have two
main aims
1. To collude with other firms and thus maximise
their combined profits. When they collude :
1. They fix a profit maximising price and output
and give each other quotas.
2. This maximises the industry’s profit.
3. Sometimes individuals cut their price and
exceed their quotas to increase their own profit
at the expense of the industry.
They are more likely to collude:

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4. When there are only a few firms and thus it

is easy to check on each other and share
information.
5. Effective communicating and monitoring means
that any cheating can be identified early on.
6. Stable cost and demand conditions mean that
the quotas are easy to allocate and measure and
the policy is easy to administer.
7. Similar production costs so they make
similar profits.
2. To compete with other firms by taking business away
from them and making more profit independently.
Kinked demand curve:
Assumptions
1. If the firm increases its price other firms don’t
follow so it is price elastic.
2. If the firm decreases its price other firms do follow
so it is price inel stic.
Explanations
1. If price is increased demand is price elastic
and revenue falls. If the price is cut demand is
price inelastic and revenue falls.
2. The kinked demand curve cause discontinuity in the
marginal revenue changes in marginal cost
between MC1 and MC3 do not change the profit
maximising price and output.
Pricing and non pricing strategies:

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1. Cost plus pricing. The firm adds a percentage

profit on to their costs.
2. Predatory pricing. When firms deliberately undercut
their competitors to force them out of the market.
3. Limit pricing. Selecting the highest possible
price without encouraging entry.
4. Price wars. When firms in an oligopoly try to
undercut each other.
5. Price leadership. When there is an obvi us price
leader usually the dominant firm with the
greatest market share.
Non-pricing competition:
1. Advertising.
2. Branding.
3. Sales promotions.
4. Distribution.
Role of advertising:
1. Informs but lso misleads.
2. Can increase demand but can also create barriers to
entry such as making demand more inelastic,
shifting in ards the demand for other firms and
making the costs of entry higher.
Objectives of firms:
1. Profit maximisation.
2. Managerial utility maximisation:
1. The managers want to increase their salary
which is often linked to sales rather than profits.

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2. The managers want to increase in the number

of employees.
3. The managers want to invest.
4. The managers want to get additional benefits.
3. Sales revenue maximisation:
1. Because consumers value companies with
increasing sales and are more likely to buy
from them.
2. Because financial institutions may be m re willing
to lend to a company with increasing sales.
3. Because salaries may be link d to sales.
4. Growth maximisation:
1. Because large firms are less vulnerable
to takeover.
2. Because salary may be linked to firm size.
5. Satisficing:
1. To satisfy various factors such as the unions,
suppliers, c nsumers, and the local community.
2. The firms do not maximise anything.
Public Goods s Reason for Market Failure

Public goods are divided into Quasi (e.g. lighthouse)

and Pure (e.g. national defence and street lighting).
Private goods differ from public goods:
1. If one unit of a private good is consumed by
one person it can’t be consumed by another.
2. If one unit of a public good is consumed by one
person it doesn’t mean it prevents another from
consuming them due to the free rider principle which

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is based on two concepts non-excludability

(because of the nature of public goods consumers
can’t be prevented from consuming them once they
are provided ) and non-rivalry (because goods are
not diminishable the consumption of a good doesn’t
reduce its availability to others.
So with public goods there is market failure because the
free market would not provide them thus the g vernment
has to provide them. Note that the definition of a private
and a public good changes from time to time and from
place to place.

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