Topic 1: An Introduction to Managerial Economics

Over the last two centuries, Economics has evolved as a formal discipline, putting in place
some general common rules that help manage resources better. As the discipline of
management evolved, Economics became an integral part of its curriculum and the tools that
needed to be taught to managers are now loosely classified as Managerial Economics. Before
we start with a formal discussion on Managerial Economics, it will be interesting to learn about
the origin of Economics.

On the Origin of Economics

Adam Smith Thomas Mun

Picture downloaded from

https://en.wikipedia.org/wiki/Adam_Smith#/media/File:Adam_Smith_The_Muir_portrait.jpg

Adam Smith is widely acknowledged as the person who presented Economics as a formal
discipline, as we know it today. His book titled, “An Inquiry into the Nature and Causes of the
Wealth of Nations”, written in 1776, created quite a storm, disrupting the existing philosophy
of those times. The philosophy prevalent then, called the Mercantilist Philosophy1, advocated
that the wealth of nations emerged from trade for which an export surplus was needed, which
in turn would bring in precious metals like gold and silver into the economy. Do remember that
gold and silver were the standard currency for exchange in those days. This was also the time
that East India Company had trade relations with India, and the British Crown objected to this
trade as it was a drain of precious metals from the British economy in exchange for the spices
and textiles obtained from India. Thomas Mun, the then Director of the East India Company
defended this trade on the grounds that England was re-exporting the goods obtained from
India to other countries and bringing in more precious metals into the country than those given
to India. According to the Mercantilist Philosophy, in order to have an export surplus, the
exports of the country should be cheap. For the exports to be cheap, wages had to be low, and
if the wages were low, a large section of the population would have a low standard of living.

1
If you are interested in the History of Economic Thought, read the book titled, “A history of Economic
thought” by Eric Roll.

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The Mercantilists also assumed the size of the pie to be fixed which would imply that if one
country grabbed a larger share of the pie, the other country would necessarily have a smaller
share.

Adam Smith, in contrast, was of the view that the wealth of nations emerged from
production rather than from trade. It is of significance here that this was also the time when
the Industrial Revolution was advancing in England, resulting in a shift from home production
to factory production. Factory production led to division of labour. The first chapter of Adam
Smith’s book describes how division of labour in a pin factory leads to a huge increase in
productivity. He opined that with division of labour and specialization, the size of the pie would
increase and all stakeholders would benefit from the same.

Over time, Economics branched into two major sub-streams, Macroeconomics and
Microeconomics. Macroeconomics deals with issues such as inflation, interest rates,
unemployment and Gross Domestic Product (GDP)- issues we read in pink newspapers that
affect the population as a whole. Microeconomics deals with issues of individuals and firms
and its main intention is to make the best possible use of available resources. This course deals
with Microeconomic concepts relevant for managers. With this background in mind, we are
ready to start with our course material.

The Concept of Managerial Economics

A common key problem that managers face is making the most efficient use of available
resources. It should be noted that the term ‘Management’ is not restricted only to professional
managers working in offices. The term has various applications. For example, students face a
management problem of how to make the best possible use of the limited time available to
maximize their grades; housewives have management problems in deciding what resources to
use to cook, clean and do other household chores to maximize efficiency and satisfaction in the
running of the household.

Let us take the example of a student’s problem of how to allocate their time to various subjects
to maximize their potential. Let’s assume students can predict the marks they will get for every
hour they decide to study. Let us also assume a student has decided on a total of three hours he
wishes to study. The marks he can get for any number of hours put in for a subject is given in
Table 1.1. The objective of the student is to maximize the total marks within the study time
period of three hours. If a layman was to solve this problem, he would approach it in the
following manner; look at all possible combinations (x, y) in which one can allocate time
between English and Economics, where x denotes the number of hours devoted to English and
y denotes the number of hours devoted to Economics. He would look at the total score for each
combination, and determine the combination that yields the maximum score. Therefore, the
total scores obtained for each of the combinations (3, 0), (2, 1), (1, 2) and (0, 3) are 70, 90, 90

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and 60, respectively. Therefore, the student would choose to either study 2 hours of English
and 1 hour of Economics or 1 hour of English and 2 hours of Economics.

Table 1.1: Number of hours studied and the corresponding marks obtained

Hours of study/subjects 0 1 2 3

English 0 40 60 70

Economics 0 30 50 60

Now let’s examine how an Economist would approach the same problem. If a student decides
to study for just one hour, they should allocate that study hour to English rather than Economics
and get 40 marks. If they were to study for a second hour, that would be dedicated to Economics
rather than to English, since the increase in total marks would be 30 rather than 20, and the
final score would be 70. As for the third hour, it does not matter whether one studies English
or Economics because the increase in marks would be 20, and the total score would be 90.

Table 1.2: Number of hours studied and the corresponding marks obtained

An Economist’s View

Hours of study/subjects 1 2 3

English 20 50 85

Economics 10 25 45

Now let us look at Table 1.2. If a student studies for 3 hours only, it is obvious that they should
devote all of that time to English. Can you comment on the difference between Tables 1 and 2,
and thereby the difference in allocation that results? As a parallel, recall what you studied about
velocity and acceleration from school days: the marks in Table 1 are increasing at a decreasing
rate, while those in Table 2 are increasing at an increasing rate. For that reason, a student
chooses to study both English and Economics for the situation in Table 1, and chooses to study
only English for the situation in Table 2. In Mathematics, we call the former an interior
solution and the latter, a corner solution. One can think of another example where a similar
situation happens. People in general feel most happy when they receive the first unit of any
product; the next unit makes them happy but not as much as the first unit did. Economists call
this property the Law of Diminishing Marginal Utility, and due to this reason, we spend our
money on all goods be it food, clothing or shelter. However, if a man is interested in only two
goods; alcohol and cigarettes, the scenario would be different. For both goods, happiness

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increases at an increasing rate for every additional unit of consumption. We would then find
that they would choose to spend their money completely on either alcohol or cigarettes.

The example above is of a situation where there is scarcity of time. Usually, when we think of
scarcity, we think of scarcity of resources and money. Economist Senthil Mullainathan and
psychologist Eldar Shafir wrote a book titled, “Scarcity: Why having too little means so much”,
which discusses how to handle scarcity of time and scarcity of money. The fact is that having
ample resources or money does not always solve all problems, although it makes life a lot
easier. As retailers frequently complain about scarcity of space in stocking up things, they must
make the best use of the limited space available and stock up wisely. Even households may
have the means to buy expensive curio items to display but may not indulge due to lack of
space.

Let us consider a simple retail store. Shaligram, the campus store at XLRI has the problem of
space for storage. The store has just enough space to keep 12 cartons of goods, each carton
having the same volume. Let us suppose the store owner, Mr. Agarwal is required to pay all
that he earns from the cartons to the respective wholesalers. How many cartons should Mr.
Agarwal store in his shop? The amount Mr. Agarwal is paid a commission per carton and the
total demand for the item is given in Table 1.3.

Table 1.3: Commission from Different Cartons

Demand Per
No.
Items Commission Month
1 Sugar 100 10
2 Lays Chips 750 8
3 Parle Biscuits 400 3
4 Old Spice Aftershave 2100 2

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As illustrated in the table, given that there is no monetary investment involved on the part of
Mr. Agarwal, he should ideally opt for cartons that give the maximum commission. Going by
this logic, 2 cartons of Old Spice Aftershave, 8 cartons of Lays Chips and 2 cartons of Parle
Biscuits would earn him a profit of Rs. 11,000.

Now, let us assume that in addition to the space constraint, Mr. Agarwal also has a cash
constraint of Rs. 10,000, with which he has to buy the cartons and then sell at a profit. The
amount he has to pay per carton, the net profit/commission earned per carton, and the total
demand per item is given in Table 1.4. The commission earned is the same as before. We now
have to answer the same question. How many cartons of each should Mr. Agarwal have in his
store?

Table 1.3: Commission from Different Cartons

Net Rate of Demand

Cost per Profit/Commission Return Per
No. Items Carton per carton (%) Month
1 Sugar 1000 100 10 10
2 Lays Chips 3000 750 25 8
3 Parle Biscuits 1000 400 40 3
4 Old Spice Aftershave 7000 2100 30 2
Total Money Available: Rs. 10,000

We immediately notice that it is not possible to do the same level of stocking as before. If we
proceed the same way as before and stock Old Spice first, we earn Rs. 2,100 of
commission/profit but we exhaust Rs. 7000 of cash. It is not possible to buy the second carton
of the aftershave. With the remaining Rs. 3000, we can buy Lays Chips, the next best option,
giving us Rs. 750 of commission. We would now earn a profit of just Rs. 2,850 while space
for 10 more cartons will be left empty due to a cash crunch. Is there a better way of stocking
up so that we earn a higher level of profit? Yes, let us compute the return on money as done in
Table 1.4 from buying each carton and then decide which one to stock first.

In this case, we can see that Parle biscuits give the maximum return. On stocking 3 cartons of
Parle biscuits, the extra storage space is for 9 cartons. However, the remaining income is INR
7,000. Since Old Spice provides the maximum return after Parle, and costs INR 7,000 for one
carton, the store owner stocks one carton of old spice, thereby exhausting his income with the
remaining extra space for 8 cartons. However, this bundle maximizes his profits of INR
3,300.We can see that this is definitely an improvement over the earlier figure of Rs. 2,850.

Sometimes, having more than one resource is an advantage as it may be possible to substitute
one thing for another. For example, if you have a deadline to reach a place for an event that is
important to you, if you find that it may not be possible to reach on time by train, you may
choose to fly if you have enough money. In this case, time and money are substituted for each
other. However, this is not always the case; you may sometimes need both to arrive at an
outcome. For example, by deciding to join a coaching class to ace a management entrance

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examination, you are investing both, time and money. There is no guarantee that you will ace
the examination if you take the course but the chances of doing well increase significantly. So
also, in the real world, we have to take decisions in an uncertain environment. This can be quite
challenging, unlike the examples discussed above where it is possible to get the optimum result
with some effort.

Space has been visualized from a different perspective by early economists like Adam Smith
and David Ricardo. Land was regarded an important resource for production in addition to
labour and capital. However, over time, with improvement in agricultural productivity, more
food could be produced on the same tract of land, and with sky-scrapers, more people could be
accommodated on the same piece of land. Thus, the need for land showed a decline.
Improvement in transport facilities and the availability of the internet made things even better.
However, an article in The Economist reports how space is once again becoming a constraint
due to urban regulations on height and density although there are equally convincing arguments
in favour offer such regulations in order to prevent over-crowding within city limits2.

In this course, we will discuss the following topics:

• Decision Making in the Household

• Decision Making in an Enterprise

• Markets: Perfect Competition, Monopoly and Oligopoly

• Market Failure: Externalities and Public Goods

• The Economics of Information

Decisions within the household are easy to conceptualize. A household comprising a husband,
wife and children has to decide whether both spouses would be working or not. If both work,
the household receives more material benefits and can enjoy a higher standard of living but the
downside of this would be the necessity to hire outside help for cooking, cleaning, and looking
after the children. A household also needs to make financial decisions which entail the amount
to be spent on goods and services on a monthly basis and the amount to save for future
contingencies. Also of consideration would be the amount that is going to be spent on which
goods and services. A lot of these decisions depend on one’s taste and preference, the monthly
income of the family and the prices of different goods and services. All these aspects need to
be looked into while we discuss the topic, Decision Making in the Household.

The goods and services that households wish to buy are provided by enterprises. What is the
incentive for firms to provide these services? It is Profits. Firms want to maximize/optimize
their profits. To enable this, they need to choose technology that is best suited to their needs as
well as budget. Firms need to settle for either labour-intensive or capital-intensive techniques

2
Look up http://www.economist.com/news/briefing/21647622-land-centre-pre-industrial-economy-has-returned-
constraint-growth

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or even a mix of both. These aspects will be examined while discussing Decision Making in
an Enterprise.

We know that profits consist of revenues minus the costs. While output prices have a large
impact on deciding revenues, input prices play a significant role in costs. Do firms have control
over output and input prices? It depends on the kind of Market they are playing in. If there is
a single firm in the market that caters to all consumers, the firm has absolute bargaining power
over prices and can thus charge a high price to maximize profits. This is termed a Monopolistic
market. However, if there are many firms that cater to consumers, no single firm or consumer
has control over the price that is going to prevail and we have what we call a Perfectly
Competitive market. A firm in such a market cannot charge a price higher than the others for
the risk of losing its customers. Given the large number of firms that coexist in the market, it
is physically impossible for firms to collude and set a high price and earn better margins. The
same is however possible if there are a limited number of producers, maybe two to four in the
market. Such markets are described as Oligopolistic markets. Strategic issues become very
important in oligopolistic markets. Should firms collude among themselves or compete? Do
producers have any strategies to deter entry of new firms? How rivals would react to what a
firm does should be taken into consideration when a firm needs to take a decision. For example,
the petroleum market is an oligopolistic market. Countries forming the Oil and Petroleum
Exporting Countries (OPEC) had decided to impose quotas on the amount of oil each country
could drill out, so as to limit the world supply of oil and keep oil prices high. This seemed to
work till the time every country decided to increase its profit margin by drilling an extra amount
of oil. This single act of individual countries resulted in the reduction of global petroleum prices
as the supply of oil increased manifold. Each country was negatively impacted and would have
been better off if each had remained committed to the agreement. These issues, along with how
firms decide how much to produce and what prices to charge in each market structure, will be
discussed in the section on Markets: Perfect Competition, Monopoly and Oligopoly.

Markets do not always function correctly. Some imperfections as a result of externalities,

causing market failure. Externalities results when some person’s consumption or production of
a good, has an impact on another persons’s welfare. For example, a mother may feel good if
her child is fed well, or a factory’s emission of waste water into a river may affect the fish catch
of a fisherman. The topic on Market Failure: Externalities and Public Goods discusses such
issues. Public goods are defined as goods that are (a) non-excludable and (b) non rivalrous.
There are instances where government intervention is required as we cannot always rely on
markets to provide certain goods and services like defense and foreign affairs which are non-
excludable and non rivalrous in consumption. If left to the market, there will be gross under-
provisioning of such goods.

Let us take the example of a residential building which requires a bulb to illuminate the
stairway. A bulb costs Rs.20 but each resident is willing to pay only Rs.15. Under the
circumstances, some other institutional mechanism will be required to solve the problem. One
option is for the government to collect taxes and provide such a service. The other option is for
an individual to buy the bulb and provide the service indirectly to all the residents. This is a
situation of externalities where an individual’s action has an impact on others. Since al the

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residents get the benefit of a lit-up staircase without paying a penny for it, they will ideally wait
for someone to take the initiative and make the purchase. This is a classic case of free riding.
Therefore, in the presence of externalities, public or government intervention may be required.
Benefits from consumption of private goods like food and clothing is not passed on to those
who do not pay for it. In contrast, the consumption of public goods like defence is not limited
to only those who pay taxes. For a public good, one person’s consumption is not affected by
how many others are also consuming the same good.

Externalities are not always of a positive nature as in the case discussed above. For example, a
factory emptying its waste into a river causes potential damage to fishermen as their catch
decreases. Can you think of ways to solve such externality problems? Possible solutions could
be to bring both the businesses, that of the factory and that of fishing, under the same
ownership, or both parties affected by the activity be brought to a negotiating table (Ronald
Coase’s solution), or taxes or subsidies be imposed to discourage or encourage particular
activities (Pigou’s solution).

Certain other goods which are supplied by the government do not share the characteristics of a
standard public good. These goods are termed ‘merit goods’, examples of which are education
and health. Such goods, if provided by the private sector, might not be optimally consumed
due to pricing issues. The view that the government should intervene as it has the best interest
of individuals is referred to as ‘paternalism’.

Contrary to popular view, competition is not always desirable in society. In many industries,
production is subject to decreasing average costs, and thus, a single producer can produce and
provide to the entire market.

Table 1.3 Cost structure of different industries based on number of units produced

Quantity Produced Industry A Industry B

1 2 4
2 5 7
3 9 9

Let us look at the scenario as shown in Table 1.3. For Industry A, as the output increases, the
cost to produce the output increases proportionately. For the first extra unit, the additional cost
is 3 (from 2 to 5), and for the second extra unit, the additional cost is 4 (from 5 to 9). However,
for Industry B, the cost to produce additional outputs decreases. It is then economical for one
firm to produce the entire quantity at 6 units of cost. In firms where the marginal productivity
of labour or capital decreases as the output increases, the cost to produce the output increases.
For firms that have a high fixed cost to produce the first output, but minimal marginal costs for
subsequent quantities, it is more beneficial that one firm produces the entire quantity. For
example, to produce one unit of A, if the cost incurred is 100, but for the second unit, it is 2,
the average cost of producing two units is 51. If two firms had to produce one unit each, the
total average cost would be 100.

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 However, in such a case, the monopolist charges a higher price and limits quantities (this shall
be covered in detail later in the course). It is thus imperative that the government steps in and
fixes a price that covers the cost in order to make it affordable to all. This was the reason sectors
like steel, railways and electricity were managed by the public sector post-independence.
Another reason for the intervention of the government is the ‘Universal Service Obligation’
(USO). USO entails three basic fundamentals: the availability, affordability and accessibility
of resources.

There are a lot of benefits when the government provides services to the economy. However,
a system run solely by the government has its own shortcomings. The major reasons for a high
level of inefficiency in government run sectors are: low productivity, excessive public debt
burden, lack of managerial skills and other similar factors. These and more reasons lend
credence to privatization. A good example of this is the opening up of the Indian economy in
1991, allowing foreign direct investment. This single measure resulted in a plethora of positive
outcomes such as a boost to economic growth, an increase in employment and productivity and
a stronger currency. Two reasons why the private sector works well are: incentives (wages are
competitive), and monitoring (which induces employees to put in their best effort). However,
the downside is that privatization comes with its own set of problems such as inadequate service
provision and high prices (in the case of a monopoly). To mitigate such concerns and to provide
a balance, regulatory authorities should impose relevant regulations on such industries.

Till now, we had assumed that both, the firm and the consumer shared common knowledge
with reference to a product or service. This may be true in only a few cases; for example,
perishable commodities like vegetable or fish can be judged on the quality and the buyer and
seller can settle on a mutually agreeable price. However, in many situations, the firm has a
better idea about the quality of the product. Let us consider a situation where a person wants to
sell a second-hand car. The seller obviously knows the state of the car better than the buyer.
George Akerlof, in a paper titled, “The Market for ’Lemons’: Quality Uncertainty and the
Market Mechanism” first demonstrated that a market for second hand cars may not exist. If
people could adjudge the quality of the car, there could be an agreement of a fair price that
would be paid. But in the absence of a fool proof way to check the quality of the used car, its
price would be that of a used car of average quality. If that be the case, only persons with less
than average quality cars will offer theirs for sale, and the buyers, knowing the same, will opt
to not buy. Thus, there will not be a market for second hand cars although buyers may be
willing to pay more than what the sellers ask for, for any quality type.

Such aspects about the asymmetry of information between the players in the market will be
discussed in the section on The Economics of Information. The problem that we just
discussed is termed adverse selection. In the absence of proper information, the worst of used
cars come into the market. Now, let us take another example: the Government of India, while
deciding to implement the Fifth Pay Commission in the late 1990’s, recommended a higher
pay for its employees. But it felt that staff strength was excessive and needed to be trimmed
down. So they came up with the concept of a “leaner, meaner bureaucracy”. The way to achieve
the same was the Voluntary Retirement Scheme (VRS). Initially, the VRS was open to all and
mostly the better employees availed it since they were confident of getting another job in the

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market. This was counter-productive to what the government had set out to accomplish. Now,
the government faced the problem of adverse selection, that is, as a result of offering the VRS
package, they had to per force retain the worst of the lot. This is adverse selection3.

The problem of adverse selection is of relevance in the insurance markets, too. If companies
were not allowed access to medical records of patients, and if there existed competition in the
insurance markets, the premium people would have to pay would reflect that to be paid by the
average customer. At such a premium, only people with below average health would opt for
insurance and the health insurance market would fail to survive. There is another interesting
problem that emerges if insurance companies were to offer full coverage for a car or a house.
Given that one is fully insured against any damage, people may choose to become careless as
opposed to being careful. Individuals may drive recklessly or be unmindful/negligent about
protecting their house if they have bought insurance with full coverage. This is termed a moral
hazard, which implies that insurance companies, unable to observe the behaviour of
customers, might end up inadvertently encouraging unwarranted behaviour. In order to prevent
such a problem, the trick is to offer part, rather than full insurance.

Problems of moral hazard are also encountered in interactions between employers and
employees. Prior to a discussion on this, let us be clear that most outcomes in social sciences
are not deterministic like those in physical sciences. For example, sales by an employee cannot
be exactly mapped to the number of hours he/she puts in. A lot depends on whether it is a boom
or slump period. Even with minimal effort, one can achieve more if one is lucky or vice-versa.
Nevertheless, a bigger effort reduces the possibility of a poor outcome. Employers realize this
and design their wage contracts accordingly. If an employee is offered fixed wages, he/she may
shirk work. To counter this problem, an employer may be forced to appoint monitors to monitor
employees, which would be an additional cost. In doing so, another problem arises – how does
an employer ensure that the monitor does not shirk his/her work? Think about it. An alternative
would be to design a wage structure with a fixed component and a bonus component. The latter
would be conditional on the outcome. The points to consider in this case are: How much should
the fixed component be? How should targets be set to earn the bonus? How high should the
bonus be? If the fixed component is too low, it will be difficult to attract employees. The
performance benchmark and the bonus are designed to warrant/generate high rather than low
effort. If the benchmark is set too low, people will tend to shirk their work since they will get
the bonus anyway. If it is set too high, some would find it too difficult to achieve and may not
even try to work towards it; so it is counterproductive. As far as the quantum of bonus is
concerned, it should be just high enough to ensure that individuals put in that extra effort to
earn it.

Now that we have a fair idea of the course outline, let us touch upon a few concepts that will
be needed going forward.

3
In fact, State Bank of India realizing this stopped the “voluntary retirement scheme” during the start of its
transformation process (ref: page 62, of “Grits, Guts and Gumption: Driving Change in a State Owned Giant” by
Rajesh Chakrabarti, Penguin 2010.

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Appendix 1: Some Elementary Mathematics

In Economics, we deal a lot with graphs. Graphs help to conceptualize better. Let us once again
refer to the table of marks obtained for the number of hours of study. Consider the data in Table
1.1. The same information can be shown/translated into a graph as seen in Figure 1.

Hours of study 0 1 2 3

Economics 0 50 75 80

Figure 1
Marks in Econmics

100
80
60
40
20
0
0 1 2 3 4
Hours of study

In Figure 1, you will notice kinks occurring at points 1 and 2 hours of study. A graph with such
kinks is not differentiable as Mathematicians would say. What would make the above graphs
smoother? If the same data of marks were available in minutes or preferably seconds rather
than after each hour, we would expect the graph to look like the one in Figure 2.

If we convert the same data into minutes, the graph would be smoother.

dy
If y increases as x increases >0
dx

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Marks
in
Econo
mics

Hours of study

Figure 2
Marks in Economics

Marks in Economics

Figure 3 Figure 4

dy
In both these graphs > 0, but the curves look different. Why?
dx d2y d2y
If at any point on the curve, if >0, the curve is locally convex, and if <0, the curve
dx 2 dx 2
is locally concave.

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 Concave Convex
y y

x x
Figure 5 Figure 6

If the chord joining any two points on the curve lies below the curve, it is globally concave.
But if it lies above the curve, it is globally convex.

x
Figure 7
x

dy d2y
Comment on and for these two curves. Are these curves convex or concave?
dx dx 2

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y y

x
x

Figure 9 Figure 10

dy d2y
Comment on and for these two curves. Are these curves convex or
dx dx 2

concave?

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Appendix 2: The Concept of Efficiency in Economics
Most organizations are concerned whether they are being run efficiently. Efficiency would
imply the best possible use of available resources. Efficiency is a relative concept in the sense
that, for a particular score, we determine who performs best and we give that entity the full
score. Other entities are marked inefficient to the extent they fall short of the score of the one
that performs the best. In Economics, discussions on efficiency centre on mainly two concepts,
namely:

 Productive or Technical Efficiency

 Allocative Efficiency

Productive efficiency is easy to conceptualize if there is a single input being used for the
production of a single output. In such a situation, the technology that uses minimal input to
produce a unit of output is the most efficient. The inefficiency of other technologies must be
measured relative to this. However, if two or more inputs are being used to produce a single
output; or a single input being used to produce two outputs, more than one production
technology may be efficient.

https://upload.wikimedia.org/wikipedia/commons/9/99/Vilfredo_Pareto.jpg

The concept of efficiency is attributed to Vilfredo Pareto (1848-1923)4. Let us take the example
of two products, X and Y, being produced; it is not possible to increase the production of X
unless the production of Y is reduced. Similarly, if 5 units of food and 2 units of cloth is being
currently produced, increasing food production to 6 units may imply reducing cloth production
to 1 unit. In both situations, the economy will be said to have achieved technical efficiency.
However, if the same economy produces 2 units of food and 1 unit of cloth, it is definitely
inefficient.

Outputs X and Y will ultimately be consumed by different households. If it is not possible to

redistribute X and Y such that one household stands to gain while another doesn’t, we can say

4
Look up The New Palgrave Dictionary of Economics for more information about Vilfredo Pareto’s academic
contributions.

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that allocative efficiency has been achieved .The distribution of goods and services among
individuals may be efficient but not equitable, and vice versa. For example, in an economy
comprising 100 individuals, let’s say 1000 units each of X and Y are produced. An allocation
of 10 units each of X and Y is an equitable allocation though not necessarily efficient. Of the
100 individuals, let there be one who prefers X to Y and another who prefers Y to X. These
two individuals can exchange X and Y between themselves. We now have 98 individuals who
are as well off as before and these two individuals who are better off than before. This shows
that the initial allocation of 10 units each of X and Y to each individual was not efficient.

Pareto proceeded to prove that if all markets (markets such as food and clothing) were
competitive, we would arrive at a set of prices in each market at which

• All producers maximize their profits

• All consumers maximize their welfare subject to a budget constraint

• Demand equals supply5.

The immediate implication of this theorem is that it is desirable to have competition in each
and every market. This is something that we investigate further in this course.

5
Refer to Hal Varian, Intermediate Economics, chapter 31, for a formal mathematical proof of the same, if
interested.

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Appendix 3: The Concept of Opportunity Cost in Economics
In Economics, we use not only the concept of absolute costs of production (the amount of
resources used to produce a certain good) but also the concept of opportunity cost. Since
resources are limited, the same may be used for the production of one or some other good.
While investing in any line of production, businesses have to evaluate and compare the profits
acquired to the profits earned through the next best alternative. For example, the opportunity
cost of studying for an MBA degree in XLRI is not just the tuition costs but must also include
the amount one would have earned by working with the current qualification and experience.

https://en.wikipedia.org/?title=David_Ricardo#/media/File:Portrait_of_David_Ricardo_by_Thomas_Phillips.jpg

David Ricardo (1772-1823) used the concept of opportunity cost to demonstrate that trade can
benefit both of two countries. With specialization, countries can manage to make the size of
the cake bigger, and thus, both can gain as compared to a situation where each country produces
all by itself and neither exports nor imports. Before we introduce his theory, let us first discuss
the idea of a Production Possibilities Frontier. The Production Possibilities Frontier is a
graph that shows the various combinations of output, such as food and clothing, that an
economy can produce with the given resources and technology available.

Figure 11
Clothing

2 Food

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For example, in Figure 11, with the available labour resources, an economy can produce either
4 units of clothing or 2 units of food, or a permutation combination of the two. The slope of
the line exhibits the opportunity cost of producing food. That is, the opportunity cost of
producing food in this economy is 2 units of clothing; that is, this economy has to sacrifice 2
units of clothing in order to produce a unit of food. Now let us look at another example in Table
1.2. The production possibility frontier for this technology is given in Figure 12. As we can
see, the graph is convex; the output is increasing at an increasing rate.

Table 1.2

Hours 1 2

Food 2 5

Clothing 2 5

Figure 12

5
Clothing

5 Food

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Now let us consider another example in Table 1.3. The production possibility frontier for this
technology is given in Figure 13. It is concave since the production is increasing at a decreasing
rate.

Table 1.3

Hours 1 2

Food 2 3

Clothing 2 3

Figure 13
Clothing

Food
We may now define the concept of absolute advantage. Let us assume that there are two
countries, A and B, each with two units of labour as given in Table 1.4 and 1.5, respectively.

Table 1.4 A

Hours 1 2
Food 1 2
Clothing 2 4

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Table 1.5 B

Hours 1 2

Food 2 4

Clothing 1 2

With 2 units of labour, country A can produce 2 units of food, while country B can produce 4
units of food. So, country B has an absolute advantage in food production if it uses fewer
resources to produce one unit of food. Likewise, country A has an absolute advantage in the
production of clothing. With the same example, let us now elucidate the concept of
comparative advantage. The opportunity cost of producing food is 2 units of clothing for A
and ½ unit of clothing for B. B has a lower opportunity cost in producing food, so it has a
comparative advantage in the production of food. Likewise, country A has a comparative
advantage in the production of clothing. In this example, country A has a comparative as well
as an absolute advantage in the production of clothing over country B. Is it like that always?
Not necessarily; the next example will illustrate the same.

In the next example, the production technology of country A is given in Table 1.6 and that of
B in Table 1.7.

Table 1.6
Hours 1 2 3

Food 1 2 3

Clothing 1 2 3

Table 1.7

Hours 1 2

Food 2 4

Clothing 6 12

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Country B has an absolute advantage in the production of both, food and clothing. The
opportunity cost of producing food is 1 unit of clothing for A and 3 units of clothing for B.
Therefore, country A has a comparative advantage in the production of food. By similar
reasoning, country B has a comparative advantage in the production of clothing. Country A has
3 units of labour while country B has 2 units. Before trade, A produces 1 unit of food and 2
units of clothing, while B produces 2 units of food and 6 units of clothing. Both countries
together produce 3 units of food and 8 units of clothing. Countries should specialize in the
commodity where they have a comparative advantage. Therefore, country A should specialize
in and produce 3 units of food and B should specialize in and produce 12 units of clothing.
With specialization, the total production of food is 3 units which is the same as before trade,
but that of clothing is 12 units which is 4 units higher than before trade.

The exchange rate between commodities is often termed as terms of trade.

If trading is to be done, what should the exchange rate between food and clothing be? How
many units of clothing should be exchanged for a unit of food? For both countries to benefit
from trade, the exchange rate should lie between the opportunity costs for producing food for
both countries. The opportunity cost of producing food is 1 unit of clothing for country A and
3 units of clothing for country B. Let the exchange rate be 1 unit of food in exchange for 2 units
of clothing.

In the situation after trade, at the exchange rate of 1 unit of food for 2 units of clothing, country
A can trade 2 units of food for 4 units of clothing. So, it consumes (3-2) = 1 unit of food and 4
units of clothing after trade, which is 2 additional units of clothing and thus a better deal. After
trade, country B gets 2 units of food and (12-4) = 8 units of clothing. It is better off in this
situation after trade as it has the advantage of 2 additional units of clothing. Therefore, trade is
beneficial for both countries. It should be noted that if the exchange rate is close to 1, all the
gains from trade accrue to country B; but if the exchange rate is close to 3, all the gains from
trade accrue to country A. The exchange rate is determined by the bargaining powers of country
A and country B. Very often, countries realize there is more to benefit from trade but are in
conflict as to how the gains from trade are to be shared.

The Impact of Comparative Advantage on the Cotton Industry in India

The concept of ‘comparative advantage’ among nations is also linked to the history of
industrialisation in the west. In the book, ‘Global Economic History: A Very Short
Introduction’, the author explains how the Industrial Revolution in the west drove Asian
manufacturers out of business for two reasons: Higher productivity in manufacturing and lower
transportation costs. Manufacturing became more productive in Europe, leading to cost
reduction. Industrial technology, however, was not cost-effective in other parts of the world
where wages were lower. For instance, the Indians could not compete against English textiles
by using spinning machines as the capital costs of spinning in India was more than the cheaper
labour. Asian producers had to depend on the British to improve on the spinning machines

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sufficiently to make them cost-effective in Asia (which eventually did happen) or to redesign
the machines to adapt them to their own circumstances (as was done by the Japanese). If, for
instance, India were cut off from the rest of the world, the only way to increase its consumption
of cotton cloth would be by reducing employment in farming and shifting the workers to
spinning and weaving. The efficiency of labour in these activities would determine how much
wheat had to be given up to get higher production of cloth. With free trade, the price of cloth
compared to wheat in the world market was less the Indians faced in the domestic market. India
therefore found it advantageous to export wheat and import cloth rather than producing the
cloth themselves. Indians became farmers rather than manufacturers. This reconfiguration in
trade pattern brought short-term prosperity at the cost of long-term development to India.

The productivity of cotton rose in Britain while it fell in India. Conversely, India’s comparative
advantage in the production of agricultural goods increased, while
England’s declined. Comparative advantage implies that the unbalanced productivity growth
of the Industrial Revolution furthered industrial development in England, while
De-industrializing India. And that is what happened. The effect of unbalanced productivity
growth and declining shipping costs can be seen in the history of cotton prices in England and
India. In 1812, a group of English cotton manufacturers met to oppose the extension of the East
India Company’s trade monopoly. They prepared a memorandum that revealed that a 40-count
yarn cost 43 pence per pound to spin in India but cost only 30 pence in England. The conclusion
was that India was a great potential market for British products if only competition
were allowed. India lost its advantage in manufacturing but gained an advantage in agriculture
– raw cotton, in particular. Similarly, every country has a comparative advantage in some
product or the other.

However, economists differ on the issue of whether trade benefits all countries. Joseph Stiglitz,
the 2001 Nobel Prize winner, in his book titled, ‘Globalization and its Discontents, outlines the
perils of globalization. In response, a famous Indian Economist, Jagdish Bhagwati, currently
based in Columbia University, wrote a book titled, “In Defence of Globalization”.

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 “The Globalization Paradox”, a comprehensive book by Dani Rodrik, critiques the effects of
globalisation. The book gives instances where trade between nations could be viewed as unfair.
When the Hudson Bay Company started trading with the American Indians in exchange for
blankets, kettles, rifles and brandy, there were charges that they were underpaying American
Indians for beaver furs and charging high prices for English goods. The Hudson Bay Company
justified the prices as fair citing the difficulty of conducting trade in the American wilds. The
crux is that, since they were the only trading partner to the American Indians, they could afford
to do so.

Different interest groups gain or lose with free trade. If a country is a net importer of a particular
good, consumers gain and producers in the domestic market lose and vice versa. In 2012, the
Indian government put a cap on the export of cotton yarn in order to help the textile industry
keep the price of cotton fabric low. However, this cap greatly hurt the cotton farmers who were
already facing difficulties due to inadequate rainfall6.

The applications of opportunity cost and the Ricardian model of trade are manifold. They do
not apply only to trade between countries but also to earning and sharing of household
responsibilities between spouses among other situations. Try to apply/replicate the Ricardian
model to another example or critique as to why things will not always work as suggested by
Ricardo.

6
Look up http://www.businesstoday.in/magazine/features/cotton-supply-chain-link-
struggling/story/23563.html for more details on this story.

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