Index

INDEX
SR Name Page Note

No. Number
1 Business Economics- 1.1 – 1.12
Basic Concepts
2 Utility Analysis and 2.1- 2.10

Consumer Behaviour
3 Demand Analysis 3.1- 3.16
4 Supply Analysis 4.1- 4.7
5 Production Concepts 5.1- 5.19
6 Cost and Revenue 6.1- 6.13

Concepts
7 Market Forms and 7.1- 7.17

Price –output
Determination
8 Business Cycle 8.1- 8.9
Business Economics-Basic Concepts
Chapter 1:
Nature & Scope of Business
Economics
Unit 1: Introduction
1. Definition.
The word ‘Economics’ originates from the Greek work ‘'Oikonomia’ which can be divided
into two parts:
(a) ‘Oiko’, which means ‘House’, and
(b) ‘Nomia’, which means ‘Management’.
Thus, Economics means ‘House Management’.
Till 19th century, Economics was also known as ‘Political Economy’
2. Fundamentals of Economics.
1. Human beings have unlimited wants, and

2. The means to satisfy these wants are relatively scarce.
These two fundamentals forms the subject matter of Economics
Further,
3. The available resources will be efficiently used when they are allocated to their highest
valued uses.
4. Economics is, thus, the study of how individual and society work together to transform
the scarce resources into goods and services to satisfy the most important of our
infinite wants and how we distribute these goods and services among ourselves.
5. Economics deals with-
(1) how a nation allocates its scarce productive resources to various uses.
(2) the processes by which the productive capacity of these resources is increased.
(3) the factors which have led to sharp fluctuations in the rate of utilisation of these
resources.
3. Meaning and role of decision making in Economics
Decision making refers to the process of selecting an appropriate alternative that will
provide the most efficient means of attaining a desired end, from two or more alternative
courses of action’. Thus decision making arises only if there is choice available.
In other words, the question of choice arises because our productive resources such as
land, labour, capital, and management are limited and can be employed in alternative
uses.
Types of business decisions.

 Continue or shut down decision-Should our firm be in this business or shut down?
 New Product-Should the firm launches a product, given the highly competitive market
environment?
 Make or buy- Should the firm make the components or buy them from other firms?
 Marketing- Which marketing strategy should be chosen? How much should be the
marketing budget?
1.1
Decision making on the above as well as similar issues is not simple and straightforward as
the economic environment in which the firm functions is highly complex and dynamic.
4. Business Economics
 Business Economics may be defined as the use of economic analysis to make business
decisions involving the best use of an organization’s scarce resources.- Joel Dean
 Business Economics, also referred to as Managerial Economics, generally refers to the
integration of economic theory with business practice.
 The theories of Economics provide the tools which explain various concepts such as
demand, supply, costs, price, competition etc., Business Economics applies these tools
in the process of business decision making.
 Thus, Business Economics comprises of that part of economic knowledge, logic, theories
and analytical tools that are used for rational business decision making. Applied
Economics that bridges the gap between economic theory and business practice.
 The economic world is extremely complex as there is a lot of interdependence among the
decisions and activities of economic entities.
 Economic theories are hypothetical and simplistic in character as they are based on
economic models built on simplifying assumptions.
 Therefore, usually, there is a gap between the propositions of economic theory and
happenings in the real economic world. Business Economics enables application of
economic logic and analytical tools to bridge the gap between theory and practice.
5. Micro and Macro Economics
Difference between Micro and Macro Economics

Micro Economics Macro Economics
The term is derived from Greek work The term is derived from Greek work “Makros’
‘Mikros’ which means ‘Small’ which means ‘large’
“Micro Economics is the study of particular “Macro Economics examines the Forest and
firm, particular household, individual price, not the Trees. Thus, it analyses and establish
wages, income, individual industries, the functional relationship betweenlarge
particular commodities”- Prof. Boulding aggregates”- Prof.Mc.Connel
It is the study of economic behavior of It is the study of overall economic
individual firm or industry in national phenomena as a whole rather than its parts
economy
It is also called as ‘Price Theory’ as it It is also called as ‘Income Theory’ as it
explains the composition of total production. explains level of total production, total
consumption, total savings and total
investment and the rice or fall in these levels
Micro economics deals with issues like- Macro-economics deals with issues like-
(i) Product pricing; (i) National Income and National Output
(ii) Factor pricing, (ii) The level of employment and rate of
(iii) Location of industry. economic growth.
(iv) Consumer behavior, (iii) The general price level and interest rates;
(v) Behavior of firms. (iv) Balance of trade and balance of payments,
(vi) The economic conditions of a section of (v) External value of currency and
society, etc. (vi) The overall level of savings and investment;
(i) Lock out in TELCO (i) Per capita income of India.
(ii) Finding the causes of failure of X & co. (ii) Underemployment in agricultural sector.
1.2
(iii) Total savings in India.

(iv) Determining the GNP of India.
(v) Identifying the causes of inflation in India.
(vi) Analyse the causes of failure of industry in
providing large-scale employment.
(vii) The national economy's annual rate of
growth
(viii) Increase in the corporate income tax
rate will affect the national unemployment.
6. Nature of Business Economics
The Nature of Business Economics is described as under-
1. Business Economics is a Science-

(a) Science is a systematized body of knowledge which establishes cause and effect
relationships. It follows scientific methods and empirically tests the validity of the
results.
(b) Business Economics integrates the tools of decision sciences such as Mathematics,
Statistics and Econometrics with Economic Theory to arrive at appropriate
strategies.
2. Business Economics is an art as it involves practical application of rules and

principles for the attainment of set objectives.
3. Micro Economics based- Since Business Economics is concerned more with the
decision making problems of individual establishments, it relies heavily on the
techniques of Microeconomics. For example, a business manager is usually concerned
about achievement of the predetermined objectives of his organisation so as to ensure
the long-term survival and profitable functioning of the organization.
4. Macro Analysis based-Business unit is affected by its external environment such as,
the general price level, income and employment levels in the economy and government
policies with respect to taxation, wages and regulation of monopolies, interest rates,
exchange rates, industries, prices, distribution.
5. Analysis from Private Enterprises Economy viewpoint-Business Economics uses the

theory of markets and private enterprise. It uses the theory of the firm and resource
allocation in the backdrop of a private enterprise economy.
6. Inter-Disciplinary- Business Economics is interdisciplinary in nature as it

incorporates tools from other disciplines such as Mathematics, Operations Research,
Management Theory, accounting, marketing, Finance, Statistics and Econometrics.
7. Pragmatic Approach- While Micro-Economics is abstract and purely theoretical and

analyses economic phenomena under unrealistic assumptions, Business Economics is
pragmatic in its approach as it tackles practical problems which the firms face in the
real world.
1.3
8. Normative and positive –
Points Positive Economics Normative Economics

Meaning 1. It states 'what is' or it makes a real 1. The term, ‘normative’ is derived
description of an economy. from the word ‘norm’ or a
2. It explains relationship between ‘standard’ implying ‘what ought
cause & effect and there will be no to be’.
value judgments/suggestions. 2. It makes an assessment of an
activity and offers advice.
3. It passes value
judgments/suggestions
Based on According to Robbins, Economics is It is based on welfare economics -
neutral between ends. (Marshall &Pigou) Complete
neutrality between ends is, however,
It does not pass value judgments. neither feasible nor desirable.
Anyone with the limited amount of
money may use it for buying liquor It is because in many matter the
and not milk. economist has to suggest measures
for achieving certain socially
desirable ends.
Examples  Planned economies allocate  Reducing inequality should be
resources via government major priority for mixed economy.
departments.  Changing the level of interest
 Most transitional economies have rates is a better way of managing
experienced problems of falling the economy than using taxation
output and rising prices. and government expenditure.
 There is a greater degree of  Govt. ought to guarantee that
consumer sovereignty in the market. farmer's income will not fall if
 Faster economic growth should harvest is poor.
result if an economy has a higher
level of investment.
 Higher levels of unemployment will
lead to higher levels of inflation.
 The average level of growth in the
economy was faster in the 1990s
than the 1980s.
 Analysis of the relationship between
the price and quantity demanded.
(Law of demand).
7. Scope of Business Economics
The scope of Business Economics may be discussed under the two heads given below-
 Microeconomics applied to operational or internal Issues
 Macroeconomics applied to environmental or external issues
1. Microeconomics applied to operational or internal Issues

Operational issues include all those issues that arise within the organization and fall within
the purview and control of the management. These issues are internal in nature.
Example: Issues related to choice of business and its size, product decisions, technology
and factor combinations, pricing and sales promotion, financing and management of
investments and inventory are a few examples of operational issues. The following
Microeconomic theories deal with most of these issues.
1.4
a) Demand Analysis-
i. Demand analysis pertains to the behavior of consumers in the market and the effect
of changes in the determinants of demand such as, price of the commodity,
consumers’ income, prices of related commodities, consumer tastes and preferences
etc.
b) Demand Forecasting-
i. Accurate demand forecasting is essential for a firm to enable it to produce the
required quantities at the right time and to arrange, well in advance, for the various
factors of production.
ii. Business Economics provides the manager with the scientific tools which assist him
in forecasting demand.
c) Cost analysis-
i. Cost analysis enables the firm to recognize the behavior of costs when variables such
as output, time period and size of plant changes.
ii. The firm will be able to identify ways to maximize profits by producing the desired
level of output at the minimum possible cost ensuring that the firm is not incurring
undue costs.
d) Production analysis-
i. Production theory explains the relationship between inputs and output.
ii. Production analysis enables the firm to decide on the choice of appropriate
technology and selection of least - cost input-mix to achieve technically efficient way
of producing output, given the inputs.
e) Inventory Management-
i. Inventory management theories pertain to rules that firms can use to minimise the
costs associated with maintaining inventory in the form of ‘work-in-process,’ ‘raw
materials’, and ‘finished goods’.
ii. Inventory policies affect the profitability of the firm.
iii. To help the firm in maintain optimum stock of inventories,business economists use
methods such as ABC analysis, simple simulation exercises and mathematical
models.
f) Market Structure and Pricing Policies-
i. Analysis of the structure of the market provides information about the nature and
extent of competition which the firms have to face.
ii. This helps in determining the degree of market power (ability to determine prices)
which the firm commands and the strategies to be followed.
iii. Price theory explains how prices are determined under different kinds of market
conditions and assists the firm in framing suitable price policies.
g) Resource Allocation-Business Economics, with the help of advanced tools such as
linear programming, enables the firm to arrive at the best course of action for optimum
utilisation of available resources.
h) Profit analysis- Profit theory guides the firm in the measurement and management of
profits under conditions of uncertainty.
i) Risk and Uncertainty Analysis-Analysis of risks and uncertainties helps the business
firm in arriving at efficient decisions and in formulating plans on the basis of past data,
current information and future prediction.
j) Theory of Capital and Investment Decisions-
i. The firm has to carefully evaluate its investment decisions and carry out a sensible
policy of capital allocation decision and investment decision.
1.5
ii. Theories related to capital and investment provide scientific criteria for choice of
investment projects and in assessment of the efficiency of capital.
iii. Business Economics supports decision making on allocation of scarce capital among
competing uses of funds.
2. Macroeconomics applied to environmental or external Issues

Environmental factors have significant influence upon the functioning and performance of
business. The major macro-economic factors relate to
1) The type of economic system.
2) Stage of business cycle.
3) The general trends in national income, employment, prices, saving and investment.
4) Government’s economic policies like industrial policy, competition policy, monetary and
fiscal policy, price policy, foreign trade policy and globalization policies.
5) Working of financial sector and capital market.
6) Socio-economic organizations like trade unions, producer and consumer unions and
cooperatives.
7) Social and political environment.
Unit 2: BASIC PROBLEMS OF AN ECONOMY AND ROLE OF

PRICE MECHANISM
1. Central Economic Problems.
a) All countries, without exceptions, face the problem of scarcity because their resources
are limited and these resources have alternative uses.
b) If the resources were unlimited, people would be able to satisfy all their wants and there
would be no economic problem.
c) Alternatively, if a resource has only a single use, then also the economic problem would
not arise.
d) In other words, since the human wants are unlimited and the productive resources to
satisfy those wants are scarce,there is a need to make the best possible use if the
resources so as to get maximum satisfaction. This is generally called as‘the central
economic problem’
e) The central economic problem is further divided into four basic economic problems.
i. What to produce?
ii. How to produce?
iii. For whom to produce?
iv. What provisions (if any) are to be made for economic growth?
2. The 4 Central Economic Problems.
a) What to produce?
1) Since the resources are limited, society has to decide which goods and services
should be produced and how many units of each good (or service) should be produced.
2) Every Society has also to decide in what quantities each of these goods would be
produced.
b) How to Produce?
1) The society has to decide the method of production, i.e. whether to use labour-
intensive techniques or capital - intensive techniques.
1.6
2) Obviously, the choice would depend on the availability of different factors of production
(i.e. labour and capital) and their relative prices.
c) For whom to produce?

1) Society has to decide on how the goods (and services) should be distributed among the
members of the society.
2) In other words, it has to decide about the shares of different people in the national
product.
d) What provisions (if any) are to be made for economic growth?
1) If society uses all the resources for current consumption and no provision is made for
future production, it will become static and lead to decline in standards of living.
i. Therefore, a society has to decide how much saving and investment (i.e. how much
sacrifice of current consumption) should be made for future progress.
3. The Capitalist Economy.
Capitalist economy, also known as free market

economy or laissez-faire economy is an economic
system in which all means of production are owned and
controlled by private individuals for profit. In short,
private property is the mainstay of capitalism and
profit motive is its driving force.
Decisions of consumers and businesses
determine economic activity with limited role of
government in the management.
3.1 Solution to central Economic problems under Capitalist Economy
Capitalist economy uses the impersonal forces of market demand and supply or the
price mechanism to solve its central problems.
Problem Solution
What To a) In a capitalist economy the question regarding what to produce is
produce? ultimately decided by consumers who show their preferences by
spending on the goods which they want.
b) The aim of an entrepreneur is to earn as much profits as possible.
This causes businessmen to compete with one another to produce those
goods which consumers wish to buy
How to a) An entrepreneur will produce goods and services choosing that
produce? technique of production which renders his cost of production
minimum.
b) If labour is relatively cheap, he will use labour- intensive method and if
labour is relatively costlier he will use capital-intensive method.
For Whom to a) Goods and services in a capitalist economy will be produced for those
produce? who have buying capacity.
b) The buying capacity of an individual depends upon his income. How
much income he will be able to make depends not only on the amount
of work he does and the prices of the factors he owns, but also on how
much property he owns.
What a) Consumption and savings are done by consumers and investments are
provisions done by entrepreneurs.
are to be b) Consumers’ savings, among other factors, are governed by the rate of
1.7
made for interest prevailing in the market. Higher the interest rates, higher will
economic be the savings.
growth? c) Whereas, Investment decisions depend upon the rate of return on
capital. The greater the profit expectation (i.e. the return on capital), the
greater will be the investment in a capitalist economy.
3.2 Characteristics Capitalist Economy.
a) Right to private property- The right to private property means that productive
factors such as land, factories, machinery, mines etc. can be under private ownership.
And the owners are free to use them in any manner in which they. The government
may, however, put some restrictions for the benefit of the society in general.
b) Freedom of enterprise- Each individual, whether consumer, producer or resource
owner, is free to engage in any type of economic activity.
c) Freedom of economic choice-All individuals is free to make their economic choices
regarding consumption, work, production, exchange etc.
d) Profit Motive-Profit motive is the driving force in a free enterprise economy and directs
all economic activities.
e) Consumer Sovereignty-Consumer sovereignty means that buyers ultimately determine
which goods and services will be produced and in what quantities and unbridled
freedom to choose the goods and services. In other words, the question regarding what to
produce is ultimately decided by consumers who show their preferences by spending on
the goods which they want.
f) Competition-Competition brings out the best among buyers and sellers and results in
efficient use of resources.
g) Absence of Government Interference-In this system, all economic decisions and
activities are guided by self interest and price mechanism which operates automatically
without any direction and control by the governmental authorities.
3.3 Merits Capitalist Economy.
a) Self-regulating and works automatically through price mechanism.

b) Incentive for efficient economic decisions and their implementation.
c) Greater efficiency and incentive to work, due existence of private property and profit
motive.
d) Faster economic growth, since the investors try to invest in only those projects which
are economically feasible.
e) Optimum allocation of the available productive resources of the economy.
f) High degree of operative efficiency.
g) Lower cost of production, as every producer tries to maximize his profit by employing
methods of production which are cost-effective.
h) Better standard of living of consumers as competition forces producers to bring in a
large variety of good quality products at reasonable prices ensuring maximum
satisfaction to consumer.
i) Incentive for innovation and Technological progress.
j) Preservation of Fundamental rights such as Right to private Property is preserved
under capitalism
k) Rewards men of initiative and enterprise and punishes the imprudent and inefficient.
l) No costs for collecting and processing of information and for formulating, implementing
and monitoring policies.
1.8
3.4 Demerits Capitalist Economy.
a) Precedence of property rights over human rights.

b) There is vast economic inequality and social injustice, Inequalities reduces the
aggregate economic welfare of the society.
c) Economic inequalities lead to wide differences in economic opportunities and perpetuate
unfairness in the society.
d) The pattern of demand does not represent the real needs of the society due to income
inequality.
e) Exploitation of labour is common under capitalism. Very often this leads to strikes and
lock outs. Moreover, there is no security of employment.
f) Consumer sovereignty is a myth as consumers often become victims of exploitation.
g) There is misallocation of resources as resources will move into the production of
luxury goods. Less wage goods will be produced on account of their lower profitability.
h) Less of merit goods like education and health care will be produced. On the other
hand, a number of goods and services which are positively harmful to the society will be
produced as they are more profitable.
i) Due to unplanned production, economic instability in terms of over production,
economic depression, unemployment etc., is very common under capitalism. These
result in a lot of human misery.
j) There is enormous waste of productive resources as firms spend huge amounts of
money on advertisement and sales promotion activities.
k) Capitalism leads to the formation of monopolies as large firms may be able to drive out
small ones by fair or foul means.
l) Excessive materialism as well as conspicuous and unethical consumption lead to
environmental degradation.
Socialist Economy
The concept of socialist economy was propounded by Karl Marx and Frederic Engels in
their work ‘The Communist Manifesto’ published in
1848.
Following are the characteristics of Socialist Economy
a) Collective Ownership of means of production-

1) Major factors of productions are collectively owned by
the community, represented by the state.
2) However, small farms, workshops and trading firms
which may remain in private hands.
3) Profit- motive and self- interest are not the driving
forces of economic activity as it is in the case of a market economy.
4) The resources are used to achieve certain socio-economic objectives.
b) Centrally planned economy-

1) There is a Central Planning Authority to set and accomplish socio- economic goals.
2) The major economic decisions, such as what to produce, when and how much to
produce, etc., are taken by the central planning authority.
3) Socialist economy is also called a centrally planned economy.
1.9
c) Absence of Consumer Choice-

1) Freedom from hunger is guaranteed, but consumers’ sovereignty gets restricted by
selective production of goods.
2) The range of choice is limited by planned production. However, within that range, an
individual is free to choose what he likes most.
3) The right to work is guaranteed, but the choice of occupation gets restricted because
these are determined by the central planning authority on the basis of certain socio-
economic goals before the nation.
d) Relatively Equal Income Distribution-

1) A relative equality of income is an important feature of Socialism.
2) Differences in income and wealth are narrowed down by lack of opportunities to
accumulate private capital.
3) Educational and other facilities are enjoyed more or less equally; thus the basic causes
of inequalities are removed.
e) Minimum role of Price Mechanism or Market forces-

1) Since allocation of productive resources is done according to a predetermined plan, the
price mechanism as such does not influence these decisions.
2) Price mechanism exists in a socialist economy; but it has only a secondary role, e.g., to
secure the disposal of accumulated stocks.
3) In the absence of the profit motive, price mechanism loses its predominant role in
economic decisions.
4) The prices prevailing under socialism are ‘administered prices’ which are set by the
central planning authority on the basis of socio-economic objectives.
f) Absence of Competition-Since the state is the sole entrepreneur; there is absence of
competition under socialism.
3.1 Merits of Socialist Economy
a) Equitable distribution of wealth and income and provision of equal opportunities for
all help to maintain economic and social justice.
b) Rapid and balanced economic development since the central planning authority
coordinates all resources in an efficient manner according to set priorities.
c) Planned Economy- Socialist economy is a planned economy
d) Minimum Wastage and optimum utislisation of resource- Wastes of all kinds are
avoided through strict economic planning. Since competition is absent, there is no
wastage of resources on advertisement and sales promotion.
e) Unemployment is minimized, business fluctuations are eliminated and stability is
brought about and maintained.
f) The absence of profit motive helps the community to develop aco-operative
mentality and avoids class war. This, along with equality, ensures welfare of the
society.
g) Socialism ensures right to work and minimum standard of living to all people.
h) Labourers and consumers are protected from exploitation by the employers and
monopolies respectively.
i) There is provision of comprehensive social security under socialism and this makes
citizens feel secure.
1.10
3.2 Demerits of Socialist Economy
a) Inefficiency and delays, corruption, red-tapism, favoritism, etc. may exist due to
predominance of bureaucracy.
b) All material means of production and nearly all economic activity are under the control
and direction of state. This restricts freedom of individual.
c) Socialism takes away the basic rights such as the right of private property.
d) There is no incentive for hard work in form of profit, private ownership.
e) Administered prices are not determined by the forces of the market or proper cost
computation. The most economic and scientific allocation of resources and the efficient
functioning of the economic system are impossible.
f) State monopolies become uncontrollable, and more dangerous than the private
monopolies under capitalism.
g) Consumers have no freedom of choice. Therefore, what the state produces has to be
accepted by the consumers.
h) No importance is given to personal efficiency and productivity. This acts as a
disincentive to work.
i) The extreme form of socialism is not at all practicable as it restricts personal
freedom.
4 Mixed Economy
a) The mixed economic system depends on both
markets and governments for allocation of
resources. In a mixed economy, the aim is to
develop a system which tries to include the best
features of both the controlled economy and the
market economy while excluding the demerits of
both.
b) Since the private property, profit motive and self-
interest of the market economy may not promote
the interests of the community as a whole; the
Government itself must run important and
selected industries and eliminate the free play of
profit motive and self-interest. Also, the state
imposes necessary measures to control and to
regulate the private sector to ensure that they function in accordance with the welfare
objectives of the nation.
c) In mixed economy there are three sectors of industries-
1) Private Sector-Production and distribution in this sector are managed and
controlled by private individuals and groups. Industries in this sector are based on
self-interest and profit motive. The system of private property exists and personal
initiative is given full scope. However, private enterprise may be regulated by the
government directly and/or indirectly by a number of policy instruments.
2) Public Sector-Industries in this sector are not primarily profit-oriented, but are set
up by the State for the welfare of the community.
3) Joint Sector- A sector in which both the government and the private enterprises
have equal access, and join hands to produce commodities and services, leading to
the establishment of joint sectors.
1.11
4.1 Merits Mixed Economy
a) Economic freedom and existence of private property which ensures incentive to

work and capital formation.
b) Price mechanism and competition forces operating in the private sector promoting
efficient decisions and better resource allocation.
c) Consumers are benefitted through consumers’ sovereignty and freedom of choice.
d) Appropriate incentives for innovation and technological progress.
e) Encourages enterprise and risk taking.
f) Advantages of economic planning and rapid economic development on the basis of
plan priorities.
g) Comparatively greater economic and social equality and freedom from exploitation
due to greater state participation and direction of economic activities.
h) Disadvantages of cut-throat competition averted through government’s legislative
measures such as environment and labour regulations.
4.2 Demerits Mixed Economy
a) Excessive controls by the state results in reduced incentives and constrained growth of
the private sector.
b) Poor implementation of planning, higher rates of taxation, lack of efficiency,
corruption, wastage of resources.
c) Undue delays in economic decisions and poor performance of the public sector.
My Notes
1.12
Utility Analysis and Consumer Behaviour
Chapter 2:
Utility Analysis and Consumer
Behaviour
1. Utility.
1. Utility is Power of a commodity to satisfy human wants. In Other words, want

satisfying power of a commodity is called as utility.
2. Utility is subjective term and differs from person to person
3. Utility does not mean usefulness. Therefore even the items like cigarettes, liquor, etc
may be said to have utility from economic point of view
4. In Economics the concept of utility is ethically neutral.
5. Utility theories seek to explain how a consumer spends his income on different goods
and services so as to attain maximum satisfaction.
2. Difference between Cardinal and Ordinal Approach to utility
Cardinal Approach Ordinal Approach

Assumptions Utility is measurable and Utility cannot be expressed in
quantifiable aspect and can be terms of money, i.e. Utility is not
expressed in numbers quantifiable
Rationale Human satisfaction can be expressed Human Satisfaction is
in monetary terms, and price of a psychological phenomenon and
commodity in the market indicates the cannot be measured quantitatively
level of consumer satisfaction
Economists Alfred Marshall Hicks and Allen
Approach  Law of diminishing marginal Indifference curve approach
and utility.
Theories  Law of Equi-Marginal utility
3. Cardinal Approach
3.1 Difference between Total utility and Marginal utility
Total Utility- The sum total of utility derived from different units of commodity consumed
by a consumer is called as total utility.
Marginal Utility-It is the additional utility derived from additional unit of a commodity.
Marginal Utility can also be defined as change in the total utility resulting from one- unit
change (tun-tu(n-1)) in consumption of commodity, per unit of time.
3.2 Assumptions under Marginal utility analysis and cardinal approach
1. Cardinal Measurability of Utility-

Cardinal Measurability of Utility means that the utility is measurable and quantifiable.
A person can express the satisfaction derived from consumption of a commodity in
quantitative terms.
2. Comparability of Utility across the goods-
CA. Aditya Sharma Page 2.1

The Satisfaction derived by a person from different commodities can be compared. Thus,
it is easy to express which commodity gives better utility and by how much.
3. Independence of Utilities-
Utilities derived from different commodities are independent of one another and does
not affects one another. And the total utilities derived by the person is the sum total of
individual utilities.
4. Constant Marginal Utility of Money-
a) Money is measuring rod of utility.
b) The amount of money a person is prepared to pay for a unit of good rather than go without
it, is the measure of utility which he derived from the goods.
c) It is assumed that marginal utility of money is constant
3.3 Law of diminishing Marginal utility
Law:
a) The Law of Diminishing Marginal Utility states that all else equal as consumption
increases the marginal utility derived from each additional unit declines.
b) As a consumer consumes more of stock, the extra satisfaction that he derives from an
extra unit, declines with the increase in consumption of that item.
Explanation:
a) Human beings have virtually unlimited wants, However each single want is satiable
(capable of being satisfied)
b) Since each want is satiable, as a consumer consumes more and more of an item, the
satisfaction derived from addition unit goes on decreasing. In other words the intensity
of his want goes on decreasing, and at a particular point of time he no longer wants it.
c) Further, Goods are imperfect substitute of each other. If same goods have capacity to
satisfy other wants then their marginal utility would not have decreased.
Example:
Mr. Rasna likes to eat Oranges. The first Orange he eats gives him lots of
satisfaction. The second Orange he eats gives him lesser satisfaction than the
earlier one and so on. If he eats 9 Oranges in a row continuously, he may lose
interest in oranges. In other words utility goes on reducing and reaches zero and
further negative.
Quantity of Oranges consumed per day Total utility Marginal Utility

0 0 0
1 60 60
2 110 50
3 150 40
4 180 30
5 200 20
6 210 10
7 210 0
8 200 -10
9 180 -20
Conclusion:
1. Total Utility increases at diminishing rate.
2. Marginal Utility is Downward Sloping curve, moving from left to right

3. Marginal utility is negatively sloped curve.
4. Where Marginal Utility is negative, Total utility decreases.
5. Marginal utility goes on decreasing and becomes negative beyond a certain point of
time.
3.4 Assumptions and Exception to Law of Marginal utility
Following are the assumption to law of Diminishing Marginal utility and law will hold good
only if these Assumptions are met:
1. Standard Units- The law will hold good when units are of suitable size.
2. Homogeneous units- Different units consumed should be identical in all respect
3. Constant Income- The law will hold good when income of the person is constant.
4. Constant Taste/ fashion- The Fashion, habit or taste of the consumer must remain
constant. If the liking of the person increases on additional consumption the law will
not hold good.
5. Continuous consumption- There should be no time gap between consumption of one
unit and another unit. Therefore Consumption of one Orange per day for 9 days will not
have diminishing marginal utility, but 9 Oranges in one day will be covered by this law.
6. Cardinal approach- Law applies only if cardinal approach to measurement of utility is
assumed.
Exceptions to Law-
1. Personal Aspects- law of Diminishing Marginal utility does not apply to music,
hobbies, etc where personal preference is dominant.
2. Money is excluded- law of Diminishing Marginal utility does not apply money and
items like gold, etc. where a greater quantity may increase the lust for it.
3. Other possessions- Utility may be affected by presence or absence of articles which are
substitute or complimentary. Example- utility of coffee may be affected by availability
sugar.
3.4 Significance of Law
The law of diminishing marginal utility has following significance-

1. Law of diminishing marginal utility forms the basis of Law of demand.
2. Law of diminishing marginal utility indicates consumer’s equilibrium and price
[Refer section 3.6]
3. Law of diminishing marginal utility explains the concept of consumer surplus [Refer
section 3.6]
4. Price and MU moves together up and down. If price changes, its MU also changes
accordingly.
5. Marginal utility varies inversely with the supply. If the supply is greater, its MU will
be less.
6. MU of the goods increases as the quantity of complementary goods with the
consumer increases- Example, Tea and sugar are complementary goods. If more tea is
acquired MU of sugar also increases.
7. MU of the goods decreases as the quantity of substitute goods with the consumer
increases. Example, tea and coffee are substitute goods. If Consumer purchases more
coffee, MU of tea decreases.

3.5 Law of Equi- marginal utility
As per the law of Equi- marginal utility, If marginal utility of money spent on commodity
X is greater than marginal utility of money spent on commodity Y, then the consumer will
withdraw some money from purchase of Product Y and will spent on purchase of X, till MU
of money in two cases becomes equal.
And
The consumer will attain maximum satisfaction, and will be in equilibrium when
MU of money spent on various goods that he buys, are equal.
3.6 Consumer surplus and Consumer Equilibrium
Consumer’s Equilibrium:
a) As per the law of diminishing marginal utility, the additional consumption of item leads
to decreasing MU.
b) The consumer will be willing to buy a commodity, as long as the MU( additional
satisfaction) derived is equal to price of the commodity. In other words, consumer will
not buy a commodity if the price he pays is more that the additional satisfaction he
derives.
c) Thus the consumer is in equilibrium when price of the commodity = Marginal utility.
d) Similarly for more than two products, consumer will be in equilibrium if-
MU X = MU Y = MU Z
Price X Price Y Price Z
e) The consumer will attain maximum satisfaction, and will be in equilibrium when MU of
money spent on various goods that he buys, are equal.
Consumer Surplus:
1. Consumer surplus means, what a consumer is ready to pay – what he actually
pays.
2. The consumer continues to buy a commodity till MU = Price of the commodity
3. For all the earlier units purchased, MU > price paid. This difference is called as
consumer’s surplus
Example: consider the schedule in 3.1.1
Quantity of Oranges Total Marginal Price Consumer’s
consumed per day utility Utility Surplus in rupees
0 0 0 0 0
1 60 60 40 20
2 110 50 40 10
3 150 40 40 0
4 180 30 40 -10
5 200 20 40 -20
6 210 10 40 -30
7 210 0 40 -40
8 200 -10 40 -50
9 180 -20 40 -60
Conclusions:
a) Consumer is in equilibrium at 3 units, where price = MU.
b) Consumer surplus is INR 20 and INR 10 at consumption level of 1 Orange and 2
oranges respectively.

3.6 Limitations to Consumer surplus
1. The concept of Consumer’s surplus is relevant only if cardinal approach to

measurement of utility is assumed.
2. Consumer’s surplus cannot be measured precisely, since it is difficult to measure the
MU of different units of commodity consumed by a person.
3. Consumer’s surplus derived is affected by availability of substitutes.
4. In case of necessaries, consumer’s surplus is infinite since the MU of first few units
are infinitely large.
5. Concept of consumer’s surplus does not apply in case of prestigious items such as
Diamond, gold.
6. It is assumed that MU of the money is constant, which is unrealistic. As more
purchases are made and consumer’s stock of money diminishes, MU of money also
changes
4. Ordinal Approach.
The Ordinal approach to utility analysis was given by Hicks and Allen and hence it is also
called as Hicks and Allen Approach.
4.1 Indifference curve analysis- Assumptions
1. Ordinal Approach to utility-

a) This means that UTILITY is not measurable in monetary terms.
b) A person can express satisfaction derived from consumption of commodity, in
relative or comparative term.
2. Consistency in ranking-
a) As per ordinal approach it is assumed that the consumer has consistent
consumption pattern.
b) If a consumer prefers X to Y and Y to Z , this automatically means that he must
prefer X to Z.
3. Rational Consumer- It is assumed that the consumer is rational and possesses full
information about all the relevant aspects of economic environment in which he lives.

4. Ranking and preferences-
a) The consumer is capable of ranking all combination of goods according to
satisfaction they yield.
b) If a consumer prefers A to B then he cannot tell quantitatively how much he prefers
A over B.
5. Number of Goods-
a) If combination A has more quantity than combination B, then A must be preferred
over B. This is because the customer prefers more to less, and tries to maximize
his satisfaction.
4.2 Indifference curve analysis
1. In Indifference curve analysis, customer’s preference is arranged/ranked in order of

his preference, rather than measuring them in terms of money.
2. An Indifference curve is a curve which represents all those combination of goods which
gives same satisfaction to the consumer.
3. Since all the combinations on IC curve give him equal/ same satisfaction, he prefers
them equally and does not mind which combination he gets. He remains indifferent
among those combinations.
4. General assumption in consumer behavior under Indifference curve analysis is that more
goods are preferred to less of them.
Example
Combination Roses Lilies Marginal Rate of
substitution ( MRS)
A 15 1 -
B 11 2 5 Roses per lily
C 8 3 4 Roses per lily
D 6 4 3 Roses per lily
E 5 5 2 Roses per lily
4.3 Indifference Map
1. A set of indifference curves is called as Indifference Map.

2. An indifference map depicts complete picture of customer’s taste and preferences.
3. The consumer is indifferent for any combination lying on same IC.

4. However he prefers combination on Higher IC to combinations on lower IC, as the
combinations of higher IC give more satisfaction. So IC4 > IC3>IC2>IC1.
5. Farther the IC from the origin, higher is the satisfaction level.
Indifference Map
4.4 Marginal rate of Substitutions
1. Marginal rate of substitutions (MRS) indicates how much of one commodity is

substituted for how much of another commodity.
2. MRS is indicated by Slope of IC curve at a particular point. Thus, MRS indicates
movement along an IC.
3. MRS show decreasing trend similar to concept of diminishing marginal utility.
4.5 Property of indifference curve
Properties of indifference curve are-

1. Downward sloping to right-
a) IC curve is negatively sloped. This is because when the quantity of one commodity
is increased, the quantity of other commodity is reduced.
b) This is an essential property of IC curve, if the level of satisfaction is to remain same
on an IC.
2. Convex to the origin-
a) IC is L- shaped to origin, with a bent instead of right angle.
b) This is due to diminishing nature of MRS.
3. All point on an IC gives same satisfaction-
a) All the combination on an IC gives same satisfaction to the consumer.
b) Hence the consumer is indifferent among different point on IC.
4. Higher level of satisfaction-
a) In an indifference map, every higher IC gives higher satisfaction to the consumer.
b) Combination lying on higher IC contains more of either on one or both goods and
more goods are preferred to less of them.
5. Non Intersecting
a) No two IC will cut/ intersect/touch each other
b) Since every higher IC gives higher satisfaction, the same level of satisfaction cannot
lie on two ICs. And if they intersect it will show that two different levels are equal,
which is not possible.

4.5 Budget line
1. A Budget line shows all those combinations of

two goods which a consumer can buy
spending his given money income on two
goods at their given prices.
2. Budget line is also called as Price line, Price
opportunity line, Price- income line,
Budget constraint line.
3. Every point on Budget line represents full
spending by the consumer.
4. A Point below budget line represents under
spending by the consumer (Point U), while any
point above the budget line will be beyond the
reach of consumer (Point O)
4.6 Consumer Equilibrium under indifference curve approach

1. A higher IC shows higher level of satisfaction than a lower one. So, to maximize his
satisfaction, a consumer will try to reach the highest possible IC.
2. However his objective of buying higher quantity of goods is restricted by Budget line.
3. Thus a consumer is in equilibrium when he derives maximum possible satisfaction
from the goods, and is in no position to re- arrange his purchase of goods.
Assumptions:
1. The consumer has fixed money income which he hast to spend wholly on goods X and
goods Y.
2. Prices of goods X and Goods Y are given and are constant.
3. The consumer has given an indifference map which shows his scale of preferences for
various combinations of two goods X and Y.
Explanation:
1. In the given diagram Pl is the Budget line and A,B,C are the point on price/budget line.
Every point on budget line costs same to the consumer.
2. In order to maximize his satisfaction the consumer will try to reach to farthest IC, but
will be forced to remain on price line.
3. Point B gives maximum satisfaction to the consumer since it lies on farthest IC, and
also lies on budget line.
4. The point B constitutes consumer’s equilibrium and at that point consumer will buy QX
and Qy quantities of goods X and Y.
5. At equilibrium price line is tangential to farthest IC.
6. At equilibrium, slope of price line is equal to slope of Indifference curve IC 2
7. Consumer will not be able to reach IC3 and IC4 with his current budget, and Point A
and C will not be preferred as they lie on lower IC.
4.6 Relationship of MRS and price at equilibrium,

1. At equilibrium, slope of price line is equal to slope of Indifference curve.
2. Slope of the line is PX/PY.
3. Slope of indifference curve indicates Marginal rate of substitution of X for Y.
MRSXY=MUX/MUY.
4. Hence at equilibrium MRSXY=MUX/MUY= PX/PY, alternatively, MUX/ PX = MUY/PY.

My Notes


Chapter 3- Demand Analysis
Chapter 3:
Demand Analysis
Part A. - Basics
1. Meaning
‘Demand’ refers to the quantity of a good or service that consumers are willing and able to
purchase at various prices during a given period of time.
Effective demand of any goods or services depends on the following factors
(a) Desire for a specific commodity,
(b) Resources/Means to purchase the desired commodity. Unless desire is backed by
purchasing power or ability to pay, and willingness to pay, it does not constitute demand,
(c) willingness to use those means for that purchase, and
(d) Availability of commodity at certain, (i) Price (ii) place or (iii) time.
Two things are to be noted about the quantity demanded.
(a) The quantity demanded is always expressed at a given price.
(b) The quantity demanded is a flow. And not a single isolated purchase. Hence we express
demand as ‘so much quantity per period of time’.
2. Types of Demand
1. Individual Demand.
(a) Individual demand represents quantity demanded by a particular
consumer at various prices.
(b) It is a sub-system of total demand.
(c) It is depicted by Individual Demand Schedule or Individual demand
curve.
2. Market Demand.
(a) Market demand is the demand of whole market at various prices of the
commodity.
(b) It is the sum total demand of all individual demand in the market.
(c) It is depicted by Market Demand Schedule or Market demand curve.
3. Price Demand
(a) It refers to quantity of goods or services which will be purchase by the
consumer at various prices
4. Income demand
(a) It refers to quantity of goods or services which will be purchase by the consumer at various
income level
(b) Accordingly as the income level increases, superior goods have greater demand and as the
level of income lowers, inferior goods have higher demand.
5. Cross demand
(a) It refers to quantity of goods or services which will be purchase
by the consumer based on the change in price of related
commodities.
(b) Example Substitute goods or complementary goods.
CA Aditya Sharma Page 3.1

3. Factors of Demand
1. Price of the commodity:

(a) Other things being equal, the demand for a commodity is
inversely related to its price.
(b) This means that a rise in the price of a commodity brings
about a fall in the quantity purchased and vice-versa.
(c) This happens because of income effect and substitution
effect.
2. Price of related commodities-Related commodities are of two types: (a) complementary goods
and (ii) competing goods or substitutes.
(a) Complementary goods- Complementary goods are those goods

which are consumed together or simultaneously. When two
commodities are complements, a fall in the price of one (other
things being equal) will cause the demand for the other to
rise. For example; tea and sugar, automobile and petrol and
pen and ink.
(b) Substitute goods- Two commodities are called competing

goods or substitutes when they satisfy the same want and
can be used with ease in place of one another. When goods
are substitutes, a fall in the price of one (ceteris paribus)
leads to a fall in the quantity demanded of its substitutes.
Demand of a commodity is directly related with price of
substitute goods. For example, tea and coffee, ink pen and
ball pen, are substitutes for each other and can be used in
place of one another easily.
3. Income of the consumer

(a) Other things being equal, the demand for a
commodity depends upon the money income of
the consumer.
(b) In most cases, the larger the average money income
of the consumer, the larger is the quantity
demanded of a particular good. But, the change in
quantity demanded and the change in income need
not be of same proportion.
(c) As the level of income rises, increase in demand of
necessities is proportionally less than increase in
income.
(d) As the income level increase and people become richer, there is a relative decline in the
importance of food and other non durable goods in the overall consumption basket and a
rise in the importance of durable goods such as a TV, car, house etc.
(e) However, there are some commodities for which the quantity demanded decreases with an
increase in money income beyond this level. These goods are called inferior goods.[ Also
called as Giffen goods]
4. Tastes and preferences of consumers-

(a) The demand for a commodity also depends upon the tastes and preferences of consumers
and changes in them over a period of time.

(b) Goods which are in fashion are demanded more than goods
which are of out of fashion.
(c) Sometimes, a consumer may even discard a commodity even
before it is fully utilised and prefer another item which is in
fashion.
(d) Tastes and preferences of consumers are also influence by
‘Demonstration effect’ or ‘bandwagon effect’, i.e. by seeing
another person use a particular product/ commodity.
(e) Also sometimes, when a product becomes common among all,
some people decrease or altogether stop its consumption. This
is called ‘snob effect’. Highly priced goods are consumed by
status seeking rich people to satisfy their need for conspicuous
consumption. This is called ‘Veblen effect’
5. Population aspect-
(a) Size of the population-Generally, larger the size of
population of a country or a region, greater is the demand for
commodities in general
(b) Composition of population: If there are more old people in
a region, the demand for spectacles, walking sticks, etc. will
be high. Similarly, if the population consists of more of
children, demand for toys, baby foods, toffees, etc. will be
more
(c) The level of National Income and its Distribution:
i. If the national income is unevenly distributed [few very
rich people while the majority are very poor], the
propensity to consume of the country will be relatively
less and consequently, the demand for consumer goods will be comparatively less.
ii. However, if the distribution of income is more equal, then the propensity to consume of
the country as a whole will be relatively high indicating higher demand for goods.
(d) Consumer-credit facility and interest rates: Availability of credit facilities induces people
to purchase more than what their current incomes permit them. Also, Low rates of interest
encourage people to borrow and therefore demand will be more.
6. Apart from above, factors such as government policy in respect of taxes and subsidies, business
conditions, wealth, socioeconomic class, group, level of education, marital status, weather
conditions, salesmanship and advertisements, habits, customs and conventions also play an
important role in influencing demand.
2. Demand distinction.
Time Short run demand- refers to the Long run demand- refers to demand
demand with its immediate reaction to
which exists over a long period.
price change, income fluctuation, etc.
For example, if electricity rates are
For example. reduced, in the short run, the existing
If the rate of electricity are reduced, the
users will make greater use of electric
existing users will make greater use of
appliances. In the long-run, more and
electrical appliances more people will be induced to use electric
appliances.
Market Industry demand- The term industry Company demand denotes the demand
demand is used to denote the total for the products of a particular firm.

demand for the products of a particular E.g. demand for steel produced by the
industry. Tata Iron and Steel Company
E.g. the total demand for steel in the
country
Dependency Derived demand-The demand for a Autonomous demand- If the demand for
commodity that arises because of the a product is independent of the
demand for some other commodity demand for other goods, then it is
called ‘parent product’, ‘is called called autonomous demand. It arises on
derived demand. For example, the its own out of an innate desire of the
demand for cement is derived demand, consumer to consume or to possess the
being directly related to building commodity
activity.
Goods Producers goods are used for the Consumer goods are used for final
production of other goods - either consumption. Eg readymade clothes,
consumer goods or producer goods prepared food.
themselves. Examples of such goods are It may be subdivided into-
machines, plant and equipments. (a) Durable goods are those which can
be consumed more than once. Eg.
cars, refrigerators and mobile phones
(b) Non durable goods are those which
cannot be consumer more than once.
It meets only current demand. Eg:
Bread, milk, etc.

Part B- Theory of Demand
1. Law of Demand
Law of Demand:
(a) Other things being equal, if the price of a commodity falls, the quantity demanded of it will
rise and if the price of a commodity rises, its quantity demanded will decline.
(b) There is an inverse relationship between price and quantity demanded, other things being
equal.
Other Factors remaining constant-
The other things which are assumed to be equal or constant are:-
(a) Prices of related commodities (complementary goods or substitute goods)
(b) Income of consumers
(c) Tastes and preferences of consumers, and
(d) Such other factors which influence demand.
If these factors which determine demand also undergo a change, then the inverse price-demand
relationship may not hold good. Thus, the constancy of these other factors is an important assumption
of the law of demand.
Illustration:
Price Quantity demanded
5 10
4 15
3 20
2 35
1 60
2. Features of the Demand Curve
1. Demand curve slopes downwards from left to right

2. Demand curve is negatively sloped
3. Demand curve may sometimes be a straight-line or sometimes a free hand curve
4. Demand curve is also called Average Revenue curve (ARC). Since the price paid for each unit
by the consumer is revenue per unit for the seller.
5. The Market Demand curve is a lateral summation of individual Demand curve, and also slopes
downwards from left to right
3. Rationale of the Law of Demand
Other things being equal, if the price of a commodity falls, its Demand quantity will rise, and Vice-
versa. This is due to the following reasons
1. Law of diminishing marginal utility
(a) Consumer will buy more quantity at lower price because they want to equalise the marginal
utility of the commodity and price.
(b) The Diminishing Marginal utility and equalising price is the cause of downward sloping of
demand curve
2. Substitution effect:
(a) When the price of a commodity falls, it becomes relatively cheaper than other commodities.
(b) So, consumers now substitute the commodity whose price has fallen for other commodities
which have now become relatively expensive.
(c) Therefore total demand for the commodity whose price has fallen increases

3. Income effect:
(a) When the price of a commodity falls, the consumer can buy the same quantity of the
commodity with lesser money.
(b) In other words, as a result of fall in the price of the commodity, consumer’s real income or
purchasing power increases.
(c) This increase in the real income induces him to buy more of that commodity. Thus, the
demand for that commodity (whose price has fallen) increases. This is called income effect.
4. Arrival of new consumer:

(a) When the price of a commodity falls, more consumers start buying it because some of those
who could not afford to buy it earlier may now be able to buy it.
(b) This raises the number of consumers of a commodity at a lower price and hence the
demand increases.
5. Different uses:
(a) Certain commodities have multiple uses. If their prices fall, they will be used for varied
purposes and therefore their demand for such commodities will increase
(b) On the other hand, when the price of such commodities are high (or rises) they will be put to
limited uses only.
4. Exceptions to the Law of Demand
1. Conspicuous goods:
(a) Articles of prestige value or snob appeal or articles of
conspicuous consumption are demanded only by the rich
people and these articles become more attractive if their
prices go up.
(b) This was found out by Veblen in his doctrine of “Conspicuous
Consumption” and hence this effect is called Veblen effect or
prestige goods effect.
(c) Example- Higher the price of diamonds, higher is the prestige value attached to them and
hence higher is the demand for them.
2. Giffen goods:
(a) Those goods which are inferior, with no close substitutes easily
available and which occupy a substantial place in consumer’s
budget are called ‘Giffen goods’
(b) Such goods exhibit direct price-demand relationship.
(c) Sir Giffen found out that as the price of bread increased, it caused
a large decline in the purchasing power of the poor people that
they were forced to cut down the consumption of meat and other
more expensive foods. Since bread, even when its price was higher than before, was still the
cheapest food article, people consumed more of it and not less when its price went up.
(d) Examples of Giffen goods are- Bajra, low quality rice and wheat etc
3. Conspicuous necessities:
(a) The demand for certain goods is affected by the
demonstration effect of the consumption pattern of a social
group to which an individual belongs.
(b) Due to their constant usage these goods have become
necessities of life.
(c) For example, TVs, refrigerators, coolers, cooking gas etc.

4. Future expectations about prices:
(a) When the prices show increasing trend, consumers tend to buy larger quantities of such
commodities, expecting that the prices in the future will be still higher
(b) For example, when there is wide-spread drought, people expect that prices of food grains
would rise in future. They demand greater quantities of food grains even at the higher price.
5. Irrational consumer- It is assumed that consumers are rational and knowledgeable about
market-conditions. However, at times, consumers tend to be irrational and make impulsive
purchases without any rational calculations about the price and usefulness of the product.
6. Demand for necessaries

(a) Irrespective of price changes, people have to consume the minimum quantities of necessary
commodities. Example- cooking gas, Petrol.
7. Ignorant consumer: A household may demand larger quantity of a commodity even at a higher
price because it may be ignorant of the ruling price of the commodity.
8. Speculative goods: In the speculative market, more will be demanded when the prices are
rising and less will be demanded when prices decline. Example stocks and shares showing
increasing trend.
5. Expansion and contraction in Demand
Meaning- Expansion and contraction in demand

takes place as a result of change in price, while
the other factors influencing demand remains
constant.
Movement along the curve- The position of

Demand curve remains the same. The consumer
merely moves upwards or downwards on the Same
Demand Curve
Example-
(a) The present price is P and the quantity
demanded at Price P is M.
(b) Expansion- When the price falls from P to P’ the quantity demanded increases from M to N, on
the same demand curve. Thus this downward movement along the same Demand curve is
called as Expansion of demand.
(c) Contraction- When the price rises from P to P’’ the quantity demanded decreases from M to L,
on the same demand curve. Thus this Upward movement along the same Demand curve is
called as Contraction of demand.
Note- Expansion of Demand is also called as Extension of Demand
Term Meaning Effect

Expansion/ Extension of Quantity demanded Increases, Downward movement along same
Demand due to decrease in price Demand curve
Contraction of Demand Quantity demanded decreases, Upward movement along same
due to increase in price Demand curve

6. Increase in Demand
Meaning- Increase or decrease in demand as a result of changes in factors other than price, while
price remains constant.
Shift of Demand Curve- Increase or decrease in demand

indicate rightward/leftward shift of the Demand curve
respectively.
Example
Current level of demand is depicted by demand curve D 0
Increase in Demand-When the curve shifts rightward from
D0 to D3, it is called as increase in demand. Increase in
Demand happens when more quantities are demanded at
each price.
Decrease in Demand- When the curve shifts leftward from
D0 to D2, it is called as decrease in demand. Decrease in
Demand happens when lesser quantities are demanded at each price.
Reasons for Increase in Demand

 Rise in income,
 Rise in the price of a substitute,
 Fall in the price of a complement,
 Change in tastes in favour of this commodity,
 An increase in population, and
 Redistribution of income to groups who favour this commodity
Reasons for Decrease in Demand

 Fall in income
 Fall in the price of a substitute,
 Rise in the price of a complement,
 Change in tastes against this commodity,
 Decrease in population, and
 Redistribution of income away from groups who favour this commodity.
7. ‘‘Movement along’’ vs ‘‘shift of’’ Demand
Movement along Demand curve Shift of Demand curve

1 Demand curve remains the same There is shift in Demand curve itself
2 This happens due to price change while This happens due to changes in factors other
the other factors remains constant than price, price remaining constant
3 It may be Expansion or contraction It may be Increase or Decrease in Demand
4 Expansion=Downward movement Increase= Rightward shift
Contraction= Upward movement Decrease= Leftward shift

Part C-Elasticity of Demand

1. Elasticity of Demand
Meaning
(a) Elasticity of demand is defined as the responsiveness of the quantity demanded of a good to
changes in one of the variables on which demand depends.
(b) the percentage change in quantity demanded divided by the percentage change in one of the
variables on which demand depends
Factors affecting demand and name of their elasticity

Factors Name of Elasticity Denoted by
Price of the commodity Price Elasticity EP
Income of the consumer Income Elasticity EI
Price of the related product Cross Elasticity EC
Availability of the substitute Substitution Elasticity ES
2. Price Elasticity of Demand
1. Meaning:
(a) Price Elasticity of Demand (EP) measure the responsiveness of quantity demanded of a
commodity, to a change in Price, assuming all the other factors as constant.
(b) In other words, it is measured as the percentage change in quantity demanded divided by the
percentage change in price, other things remaining equal.
2. Formula:
Price Elasticity of Demand = (EP) = % change in quantity demanded
% change in Price
= (Change in quantity/Original quantity) x 100

(Change in price/ Original Price) x 100
= (Δ q/ q) x (p/ Δ p)
= (Δ q / Δ p) x ( p/ q)
Here q= quantity, p= price, Δq = change in quantity, Δp=change in price
3. Negative sign -since price and quantity are inversely related (with a few exceptions), price
elasticity is negative. But, for the sake of convenience, we ignore the negative sign and consider
only the numerical value of the elasticity.
4. Example
Quantity Price % change in quantity demanded= (3500-5000) ÷ 500= 30%
5000 100 % change in price =(150-100) ÷ 50%
3500 150 Therefore EP= 30% ÷ 50%= 0.6
3. Measuring Price elasticity of demand
1. Percentage change or proportional Method [ Refer point 2 above]

2. Point Elasticity- Method of derivative [Refer point 4 below]
3. Point Elasticity –Method of Graph [ Refer point 5 below]
4. Arc Elasticity Method [Refer point 6 below]
5. Total Outlay Method [ Refer point 7 below]

4. Point Elasticity – method of Derivative
Meaning
a) In point elasticity, we measure elasticity at a given
point on a demand curve.
b) The concept of point elasticity is used for measuring
price elasticity where the change in price is
infinitesimal (very small)
c) Point elasticity makes use of derivative rather than
finite changes in price and quantity.
Formula
Ep = -dq p ÷ dp q
Where dq /dp is the derivative of quantity with respect to price at a point on the demand curve, and
p and q are the price and quantity at that point.
5. Point Elasticity – Graphical method
a) This method is applicable only for Straight- line Demand curve touching both the axes.
b) Under Graphical method Elasticity is calculate using
the following formula-
EP Lower segment
Upper segment
c) It is to be noted that elasticity is different at different
points on the same demand curve, since the length of
lower and upper segments will differ at various points
on the Demand curve
Example: Consider the following graph and find the

Elasticity using Graphical method and state the reason for the same.
Point EP Reason
V tT/tt = ∞ tT is a line while tt is appoint, hence tt =0
W ST/tS >1 Length of ST> tS
X tR/RT = 1 Length of tR= RT
Y LT/Lt<1 Length LT<Lt
Z TT/tT =0 TT is a point while tT is a line
6. Arc Elasticity of Demand
1. Arc Elasticity is a measure of average responsiveness to Price

change exhibited by a Demand curve over some defined arc of
Demand curve
2. Arc Elasticity measures elasticity in case of large change in
prices and quantities (i.e. over an arc) on the Demand curve
rather than a point
3. Since point elasticity differs at various points on Demand
curve, Arc elasticity takes average of two prices and
quantities to measure Elasticity
4. EP= q1-q2 x p1+p2

q1+q2 p1-p2
7. Total Outlay Method
Meaning:
In Total Outlay method, Elasticity is calculated by analysisng the change in Total expenditure or
Outlay of the household.
Explanation:
1. As the total expenditure made on a commodity is the total revenue received by the seller, we can
say that the price elasticity and total revenue received are closely related to each other.
2. By analysing the changes in total expenditure (or revenue), we can know the price elasticity of
demand for the good.
3. However by this method we can only say whether the demand for a good is elastic or inelastic;
we cannot find out the exact coefficient of price elasticity.
Elasticity Situation Effect Example

EP < 1  Price and Expenditure moves in same direction. Demand is Situation E, F, G
 As the price of a commodity decreases, total said to be (Refer example
expenditure on that commodity decreases. less below)
 As the price of a commodity increases, total elastic, or
expenditure on that commodity increases. inelastic
 In both the above cases, % change in quantity
demanded is less than % change in price.
EP = 1  Total Expenditure remains Unchanged. Demand is Situation C, D, E
 Due to change in price, Total expenditure on that said to be (Refer example
commodity remains unchanged. unit below
 Increase in price is exactly balanced by a elastic
proportional reduction in quantity purchased.
EP > 1  Price and Expenditure moves in opposite Demand is Situation A, B, C
direction. said to be (Refer example
 As the price of a commodity decreases, total elastic below
expenditure on that commodity increases.
 As the price of a commodity increases, total
expenditure on that commodity decreases.
 In both the above cases, % change in quantity
demanded is more than % change in price.
The Relationship between Price elasticity and Total Revenue (TR)

Demand
Elastic Unitary Elastic Inelastic
Price Increase TR Decreases TR remains same TR Increases
Price decrease TR Increases TR remains same TR Decreases
Moves in opposite direction Remains same Moves in same direction
Situation Quantity Demanded (In units) Price Total Outlay

A 1000 50 50000
B 1500 40 60000
C 2000 37.5 75000
D 2500 30 75000
E 3000 25 75000
F 3500 20 70000
G 4000 15 60000

8. Interpretation of the numerical values of elasticity of demand

1. Perfectly inelastic
Numeric Value EP =0
Description Quantity demanded does
not changes as price
changes
Nature of the curve Vertical line Parallel to Y
axis
2. Inelastic or less elastic

Numeric Value Greater than zero but less
than one 0<EP <1
Description Quantity demanded
changes by smaller
percentage than price
Nature of the curve Relatively steeper Demand
curve
3. Unit Elastic
Numeric EP =1
Value
changes exactly by
same percentage as
price
Nature of the 45 degree straight
curve line
Or rectangular
hyperbola
4. Elastic
Numeric Value 1<EP <∞
changes by larger
percentage than price
Nature of the curve Relatively flatter demand
curve
Numeric Value EP =∞
Description Purchasers are
prepared to buy all they
can obtained at some
price and none at all at
an even slightly higher
price

Nature of the curve Parallel to X axis
8. Determinants of price Elasticity
1. Availability of substitutes:
Elasticity of demand is affected by availability of substitutes.
Fall in price of substitute leads to increase in demand of
substitute and fall in demand of commodity and vice- versa.
 Goods which typically have close or perfect substitutes have
highly elastic demand curves.
 Goods which do not have close substitute or few substitutes
have less elastic demand curve.
2. Position of a commodity in a consumer’s budget:

 Goods having higher proportion of consumers’
spending are more elastic to demand. Eg. Clothing,
provisions and groceries, milk etc.
 Goods having lower proportion of consumers’
spending are less elastic to demand. Eg. Matches, button, salt.
3. Number of uses to which a commodity can be put:

 Commodity having possible multiple uses, have more
elasticity to demand. Eg. Milk has several uses. If its price falls,
it can be used for a variety of purposes like preparation of curd,
cream, ghee and sweets. But, if its price increases, its use will be
restricted only to essential purposes like feeding the children and
sick persons.
 Goods which have specified or particular use have inelasticity to demand,
since they can and should be used only for that purpose.
4. Time period:
 The long run demand for a commodity is more elastic. This is because consumer has a longer
run to adjust his consumption pattern accordingly. E.g. the prices of petrol increases, the
consumer can do little in short run, whereas in long run, he can buy more fuel efficient car.
 The short run demand for a commodity is less elastic to change in price.
5. Consumer habits:
 If the consumer is not habitual to a commodity, demand for that particular commodity is more
elastic and vice-versa.
6. Tied demand:
 Goods which have autonomous demand on their own are more elastic
 Goods which have tied or joint demand are less elastic. Eg. Modular kitchen and oven.
7. Nature of the need that a commodity satisfies:

 In general, luxury goods are price elastic while necessities are price inelastic or less elastic to
price change.
8. Price range:
 Goods which are in medium range of price level are more elastic to price change.
 Goods which are in very high price range or in very low price range have inelastic demand.

8. Income Elasticity of Demand
Meaning: Income elasticity of demand is the degree of responsiveness of quantity demanded

of a good to changes in the income of consumers, while the other factors are constant. It is
denoted by Ei.
Formula:
Ei =Percentage change in quantity Demand change in quantity X 100
_____________________________________ = Original quantity
Percentage change in income Change in income X 100
Original income
=∆q × i
q ∆i
Ei = Income elasticity of demand; ∆ q Change in demand; q = Original demand; i = Original
money income; ∆ i = Change in money income.
Note-Income effect is positive, so Income Elasticity of demand is also positive. However there
may be negative Income Elasticity in case of inferior goods.
 Factors affecting Elasticity of Demand or Determinants of Elasticity of Demand:
Factors Type of Explanation Example

Elasticity
of demand
Nature of the Inelastic Necessities. Food grains
commodity
Elastic Luxurious goods. Air Conditioner
Durability Inelastic Durable goods. Plastic
Elastic Perishable goods. Vegetables
Level of income Inelastic Goods demanded by high income group. Luxurious Cars
Elastic Goods demanded by low income group.
Custom and habit Inelastic Goods purchase under influence of Custom Ring for
and habit. Engagement
Proportion of Inelastic Commodity on which Proportion of Salt, matches
expenditure expenditure is low.
Elastic Commodity on which Proportion of Cloths
expenditure is large.
Level of price Inelastic When price level of a commodity is too high
and change in and change in price is smaller.
price
Elastic If price level is low and change in price is
large.
Number of uses Inelastic Commodity which has limited uses.
Elastic Commodity which used to satisfy several Milk
wants.
Substitutes Inelastic Commodity which have less substitutes. Petrol
Elastic Commodity having several substitutes. Coca cola
Urgency Inelastic Commodity which is required urgently. Medicines
Elastic Commodity which is not required urgently.
The Period Inelastic Demand for commodity is inelastic in long
run.
Elastic Demand for commodity is elastic in short
period.
Tied demand or Inelastic Demand for those goods, which are tied to Accessories with

Joint demand others. vehicles
Elastic Demand for those goods, which are
demanded independently.
Consumer habits Inelastic Demand for commodity used by habitual Cigarettes,
consumer. Alcohol
Income Elasticity of Demand

It refers to amount of change in demand for a commodity due to change in income. It is
the degree of responsiveness of demand to a change in income
YED/ Ey = Percentage or proportionate change in Income = % Q = Q Y

Percentage or proportionate change in demand % Y Y Q
Type of Relation Example Formula Curve

Income between
Elastic income &
demand
Positive Positive Normal Ey = 1
Income and Luxury Ey > 1
Elasticity goods Ey < 1
Negative Inverse Inferior Ey < 0

Income goods
Elasticity
Zero Constant Necessaries E = 0

Income (No goods
Elasticity change in
demand
though
there is
change in
income)
Cross Elasticity of Demand

 It refers to amount of change in demand for one good due to change in price of other good.
 Thus cross elasticity of demand is degree of responsiveness of demand for one good to a
change in price of other good.
 It is defined as a ratio between percentage or proportionate change in demand for one

commodity and % or proportionate change in price of other commodity i.e.

Ec = % Qx or Ec = Qx Py
% Py Py Qx
Where x & y = Substitute/complimentary goods
Type of Relation between Example Formula Curve

Cross price of one
Elasticity product & demand
for other product
Positive Direct or Positive Tea & CED = 1
Cross relation Coffee, CED > 1
Elasticity (Goods must be CED < 1
substitute)
Negative Inverse relation Car & CED < 0

Cross (Goods must be Petrol
Elasticity complementary goods)
Zero Cross Constant Cloth & CED = 0

Elasticity (No change in demand salt
of one product though
there is change in price
of other product)
goods must be unrelated
My Notes

Theory Of Supply
Chapter 4:
Theory of Supply
Part A - Basics
Meaning of supply
1. Supply refers to amount of a commodity seller is able to sell and willing to sell.
2. Ability to sell of a seller depends upon stock of a commodity; willingness to sell depends
upon price of a commodity.
Definition of Supply
The supply is defined as amount of a commodity seller is ready to sell in the market at a
certain price per unit of time.
Determinants of supply on Factors affecting supply:

Factors affecting Relation Explanation
individual supply between supply
& factor
Price Positive When price of a commodity rises supply will also rise and
if price fall supply will fall.
Stock Positive When seller has larger stock of goods he will supply more
but if he has smaller stock of goods he will supply less.
Time Positive Relation During short time period supply will be less but during
long time period supply will be more.
Cost of Inverse Relation With the increase in cost of production supply of the
Production commodity will decrease and if cost of production
decreases supply of the commodity will increases.
Improved Positive Relation With the improvement in technique of production supply
Techniques of of the commodity will increase.
Production
Infrastructure Positive/Inverse It refers to basic facilities such as transportation,
Relation communication, power supply etc. If infrastructure is
improved in the country supply of various goods will
increase and vice –versa.
Weather Positive/Inverse If there are good weather conditions supply of certain goods
conditions Relation like agricultural products will increase and vice –versa.
Taxation policy Positive/Inverse If government reduces the taxes, business men will be
Relation encouraged to produce more and supply more but if
taxes increase business in the society will discouraged.
Hence, supply will decrease and vice –versa.
Monetary Policy Positive/Inverse If monetary policy is liberal in the country so that loans
Relation are available at low rate of interest supply of various
goods will increases in the country. This is because at a
low rate of interest business-men would borrow and
Page 4.1
Theory Of Supply
increase the production and vice –versa.

Trade policy Positive/Inverse It refers to government policy related to exports and
Relation imports if trade policy is liberal business-men can import
the raw materials and increase the supply and vice –
versa.
Natural Positive/Inverse A country with plenty of natural resources will be able to
Resources Relation produce more amounts of different goods. Hence, supply
of goods in the country will be more.
Law of Supply
 The law of supply is explained by Dr. Alfred Marshall.
 Law explains that at a higher price seller will supply more and at a lower price seller will supply
less.
 Law of supply states that “other things being equal” there is a direct relationship between price
and supply.
 In other words, under given conditions supply rises with the rise in price and falls with the fall in
price. Law of is explained by following table.
Law of supply is explained by following Table & Curve

Explanation of schedule
 When the price is low at Rs. 5. 10 units supplied Price Supply
by seller 1 10
 When price starts increasing, a seller supplies 2 20
more units. 3 30
 It shows direct relationship between price of 4 40
commodity and quantity supplied. 5 50
Explanation of Curve
 In above diagram upward sloping line SS is
market supply curve.
 Upward slope indicates that there is a direct
relationship between price and supply.
Page 4.2
Theory Of Supply
Features of Supply curve

1. Supply Curve slopes upwards from left to the right.
2. Supply Curve is positively sloped.
3. Supply Curve may be sometimes a straight—line or

sometimes a free hand curve.
4. The sloping of the Supply Curve explains the Law of

Supply, which describes a direct Price—Demand
relationship.
5. The Market Supply Curve is a lateral summation (totaling)

of Individual Supply Curves of all Producing Firms, and also slopes upwards from left to the
right.
B.3 Increase and Decrease in the Quantity Supplied
1. Meaning: Increase or Decrease in the quantity supplied takes place as a result of changes in
price, while all other factors influencing Supply remain constant.
2. Movement on the Supply Curve: Change in quantity supplied refers to downward or upward
movement by the Producer Firm, on 8 p the same Supply Curve. The position of the Supply Curve
remains the same.
Example:
1. Present price is P and quantity supplied is Q units.
2. When price falls from P to Pd, the quantity supplied reduces from Q to Qdunits, on the same supply
curve.
3. Similarly, when price rises from P to Pi, the quantity supplied rises from Q to Q units, on the same
supply curve.
Increase and Decrease in Quantity supplied

1. Meaning: Increase & Decrease in Supply take place as a result of changes in factors other than
price, while price remains constant.
2. Shift of Supply Curve: Increase / Decrease in Supply indicates
rightward / leftward shift of the Supply curve respectively.
A. Increase in Supply: When Supply Curve shifts rightward from So to

52, it is called Increase in Supply. It means that more quantities are
supplied at each price.
B. Decrease in Supply: When Supply Curve shifts leftward from So to
Si, it is called Decrease in Supply. It means that lesser quantities
are supplied at each price
Page 4.3
Theory Of Supply
Assumptions of supply Law

No change in It is assumed that cost of production does not change. This is because if
cost of cost of production decreases supply will increase even after a fall is price.
production
No change in It is assumed that technique of production does not change this is
technology because technique of production is improved supply will increase even
after a fall in price.
Normal weather Weather conditions must be normal. This is because if weather conditions
conditions are bad supply may not increase even after a rise in price.
No change in It is assumed that infrastructural facilities will remain same. This is
infrastructural because if infrastructure is improved supply will increase even after a fall
facilities in price.
No change in Quantity of natural resources available in the country should not change.
amount of This is because if amount of natural resources increase, supply of various
Natural goods will increase even after a fall in price.
Resources
No change in There should not be any change in the taxation policy of the government.
Taxation policy This is because if taxes are reduced supply will increase even after a fall in
price.
No change in It is assumed that monetary policy of the government does not change.
monetary and This is because if monetary policy is liberalized supply will increase even
trade policy after a fall in price.
Exceptions to law of Supply

1. Labour  In case of supply of labour, law of supply is not applicable.
supply  This is because when price of labour or wage rate increases labour supply or
number. of hours a worker is ready to work decreases. This is shown in the
following table:
Wage rate Labour Total

supply income
Rs.100/hr 12 hr. 1200/day
Rs.250/hr. 15 hr. 3750/day
Rs.700/hr. 10 hr. 7000/day
 From the table we notice that initially with the increase in wage rate labour supply increases but
when wages increase beyond a certain limit labour supply will decrease.
 This is represented by backward bending labour supply curve.
Page 4.4
Theory Of Supply
2. Need for cash
 If a seller is going to supply his product because he needs certain amount of cash, then ata lower
price he will supply more and at a higher price he will supply less.
3. Savings
 If a person wants a fixed amount of income in the form of interest then, he will save moreat a
lower rate of interest and save less at a higher rate of interest.
4. Future Expectations
 With a small rise in price, if seller expects a further rise in future he will decrease the supply.
 Similarly, with little fall in price if seller expects a further fall in future he will increase the supply.
Price elasticity of supply
 Elasticity of Supply refers to amount of change in supply due to change in price of a

commodity.
 Elasticity of Supply refers to degree of responsiveness of supply to change in its price.
 Elasticity of Supply refers to the ratio between percentage or proportionate change in supply and
percentage or proportionate change in price.
No. Types Curve Equations

1. Perfectly Elastic Supply
It is a situation in which supply of a
commodity continuously change
without any change in demand in Es =
price. In Perfectly elastic supply, the
supply curve will behorizontal
2. Relatively Elastic Supply

It refers to a situation by which Q> P
percentage change in supply of a Q1Q2 > P1P2
commodity is higher than Es> 1
percentage change in price.
E.g. Change in price is 20% &

change in supply is 40% then
40% 20% = 2 i.eEs> 1
Page 4.5
Theory Of Supply
3. Unitary Elastic Supply Q= P

It refers to a situation by which Q1Q2 = P1P2
percentage change in demand of a Es = 1
commodity is equal to percentage
change in price.
E.g. Change in price is 10% &

10% 10% = 1 i.e. Ed = 1
4. Relatively Inelastic Supply Q< P

When percentage change in supply Q1Q2 < P1P2
of a commodity is less than Es< 1
percentage change in price.
E.g. Change in price is 10% but

6% 10% = 0.60 i.e. Ed < 1
5. Perfectly Inelastic Supply

When demand for a commodity is
fixed and it does not change for any
change in price it is described as
perfectly inelastic supply. Es = 0
In Perfectly Inelastic supply, the

demand curve will be Vertical
Methods of measurement of Elasticity of supply

1. Percentage / Proportionate Method: According to this method elasticity of supply is calculated
by dividing a % or proportionate change in supply with the % or proportionate change in price.
As explained above
2. Point Method:This method is used to find out elasticity at a point on supply curve. The elasticity
at a point on the supply curve can be measured with the help of following formula.
ES =dq p
dp q
Where
dq
dp is differentiation of supply function with respect to Price.
p = Price and q = quantity supplied

3. Arc Elasticity: when the price change is somewhat larger and we have to measure elasticity over
an arc rather than at a specific point on it, in such cases, the concept of arc elasticity is used. In arc
elasticity we use the average of the two prices and quantities (Original & new)
ES =
Page 4.6
Theory Of Supply
Where P1and Q1 are original price and quantity respectively and

P1 and P2 are new price and quantity respectively.
EQUILIBRIUM PRICE
AND EFFECT OF INCREASE / DECREASE IN DEMAND I SUPPLY
D.1 Price Determination
1. Price Determination:
1) 'Demand' refers to the quantity of goods or services that Consumers are willing and able
to purchase / buy in a given market, at various prices, in a given period of time.
2) 'Supply'refers to the quantity of goods or services that Producers are willing and able to
offer in a given market, at various prices, in a given period of time.
3) The interaction between Demand and Supply leads to the determination of Price and
Quantity. It is the level at which both Buyers and Sellers are ready to buy / sell the
product.
2. Equilibrium Price: The determination of Equilibrium Price using Demand and Supply
is explained in the following manner –
(a) Demand Curve slopes downwards
from left to right, while Supply Curve
slopes upwards from left to right.
(b) At the point E in the graph, Demand
and Supply curves meet each other.
(c) Point E constitutes the Stable
Equilibrium for the product, other
things remaining equal.
(d) The Equilibrium Price is OP, and the
quantity bought and sold at that level
is OQ units.
(e) Thus, the. market forces of Demand
and Supply lead to the determination
of Equilibrium Price.
Page 4.7
Chapter 5 Production concept
Chapter 5:
THEORY OF PRODUCTION AND
COST
PART A- Production Concept
Meaning
1. According to James Bates and J.R. Parkinson “Production is the organized

activity of transforming resources in to finished products in the form of goods and
services and the objective of production is to satisfy the demand of such
Transformed Resources".
2. In Economics, Production is any economic activity, which is directed at the
satisfaction of human wants.
3. Production = Creation of Utility and it also includes Creation or Addition of Value,
i.e. creation of want—satisfying goods and services.
Methods of Creation of Utility

Methods of Explanation Examples
Utility
Form Conversion of Raw material into Finished Conversion of wooden into furniture
Utility goods.
Place Changing place of resources this can be Removal of gold, coal from earth &
Utility obtained from extraction & transferring sand from sea.
goods like sand from one place to another
Time Making available material at times when Frozen eatable products.
Utility they are not normally available.
Personal Making use of personal skills in the form Skill as organizer, dancer, painter
Utility of services.
Factors ofproduction
A. LAND
Meaning
1. Land refers to surface of the earth.
2. In economic land includes not only the surface of the
earth but it includes every free gift of nature found on
the surface of the earth, above the surface of the earth
and below the surface of the earth, i.e. natural
resources, water, air, lightning, heating, mines and fertility
of soil etc..
Characteristics
1. Natural Resources: Land is a gift of nature.
CA ADITYA SHARMA Page 5.1

2. No Social Cost: Society has made no sacrifice in creation of land. Hence, Social cost of
land is zero.
3. Permanent factor: It is a permanent factor of production.
4. Passive factor: Land cannot produce anything of its own unless used by labour.
5. Heterogeneous factor: All land is not uniform. Fertility of land changes from plot to plot.
6. Mobility: Geographically land is immobile but occupationally it is mobile.
7. Site Value: Value of land depends upon location. A land which is located in developed
areas will have greater value.
8. Subject to diminishing returns: Land is subject to diminishing returns.
9. Supply: Supply of level is perfectly inelastic.
B. Labour
Meaning:
1. 'Labour' refers to mental or physical exertion directed to
produce goods or services, and with a view to gain an
economic reward.
2. To have an economic significance, Labour must be done with
the motive of some economic reward. So, Activities done out
of pleasure, love and affection, pastime, hobbies, etc. although
very useful in increasing human well-being, is not Labour.
Labour Not a Labour

Services of Maid Servant. Services of Housewife.
Singing against payment of a fee. Singing in the company of friends for the sake of
Features of labour
Aspect Explanation
 Labour involves human efforts, with a view to gain an economic reward.
Human Efforts
 Human and psychological considerations come up .

Labour is 'perishable', since a day's labour lost cannot be completely
recovered subsequently. Whatever is lost in a day cannot be recovered
Perishable Nature wholly by extra work on the following day.
 So, a Labourer cannot store his Labour, for use at a later time. Hence
Labour is said to have no reserve price.
Weak bargaining  Since there is no reserve price, Labour has a weak bargaining power.
power  However, labour laws maintain Labour Welfare, to a certain extent.
Self- Source  Labour is inseparable from the Labourer himself.

 Whereas if Labour is sold, the Producer of Labour retains the capacity
to work. Thus, a Labourer is the source of his own labour power.
 Labour may be classified as Skilled, Semi—Skilled and Unskilled Labour.

Variations  Labour power depends upon — (i) physical strength, (ii) education, (iii) skill,
and (iv) motivation to work.
 All Labour is not productive in the sense that all efforts are not sure
Productivity to produce want—satisfying goods and services.

Aspect Explanation
Peculiar Direct Relationship: Generally, Supply of Labour and Wage Rates are
relationship directly related, as per general Law of Supply. So, as Wage Rates increase, the
between Labourer tends to increase the supply of Labour by reducing the hours of
labour supply leisure.
and Wage rate Reverse Relationship at Higher Prices: However, at a higher level of income
(wage rates), the Labourer reduces the supply of Labour and Increases the
hours' of leisure in response to further rise in the wage rate. He may prefer to
have more of rest and leisure, than earning more money So, Supply of Labour
reduces at very high wage rate levels.
Reverse Relationship at Lower Prices: Similarly, when wage rates fall below
a minimum level, some more members of the family, who were not working
before, may start working to supplement the family income. So,
Supply of Labour may also increase at very low wage rate levels.
C. Capital
Meaning: Capital is that part of wealth of an individual or

community, which is used for further production of wealth,
or which yields an income.
Examples: Plant and Machinery, Tools and Accessories,

Factories, Dams and Canals, Equipments, etc.
2. Features of Capital:
Aspect Explanation
• Capital is a stock concept, which yields a periodical income which is a flow
Stock Concept
concept. Capital is not a flow concept by itself.
• Wealth refers to all goods and human qualities which are useful in
production, and which can be passed on for value.
Capital Wealth • Capital refers to only that part of wealth, that is used for further
production Resources lying idle will constitute wealth, but not
Capital.
Produced means • Capital is considered as 'produced means of production', unlike
of Production Land and Labour which are considered as primary or original factors of
production.
Man—made means • Unlike Land and Labour, Capital is produced by man by working with
/ factor nature. So, Capital is a man—made means of production.
• Capital is mobile, and can flow from one use to another, one country to
Mobility another, etc. subject to certain restrictions.
• Capital is perishable, i.e. it is not like land which is indestructible and
Perishable permanent.
Capital used for Textile Machinery, cannot be reversed back to the same
3. Land vs Capital:
Land Capital
(a) Free gift of nature, i.e. original or primary. Man—made or produced means of production.

(b) Indestructible and Permanent. Perishable.

(c) Lacks mobility in geographical sense. Has mobility.
(d) Quantity of land is fixed and limited. Amount of Capital can be increased.
(e) Rent from Land varies from place to place. Return on Capital is comparatively fixed.
4. Types of Capital:
1) Fixed Capital: Those types of capital goods that are used again and again for
production such as machinery.
2) Working Capital: They refer to those types of capital that are used up at once. Such as
raw materials
3) Sunk Capital: Those types of capital that have specific use hence no occupational
mobility e.g. sewing machine.
4) Floating Capital: Capital goods which have various alternative uses and occupational
mobility. E.g. A computer.
5) Money Capital: Money funds used in production is known as money capital.
6) Real Capital: It refers to real productive asset, lime Plant &Machinery.
Stages in capital Formation
Savings
Mobilization of savings
Investments
Capital formation includes following stages

1) Savings: Ability to save depends upon the income capacity of
individual. Higher savings generally
followshigherincome.Itisnotabilitytosavebutalsowillingnesstosavewhic
hcounts great deal.
2) Mobilization of Savings: Saved money should enter into circulation &

facilitates the process capital formation. There should be widespread
network of banking and other financial institutions to collect public
saving and take them to prospective investor.
3) Investments: The process of capital formation gets completely only

when the real savings get converted into real capital assets. An
economy should have a entrepreneurial class which is prepared to bear
the risk of business and invest savings in productive avenues so as to
create new capital assets.
D. Entrepreneur

1. Meaning: Entrepreneur is the person who combines the various

factors of production in the right proportions, initiates the process of
production and bears the risk involved in it.
2. Features of Entrepreneurship:
(a) Entrepreneur is also called as the Organiser, Manager or
the Risk—Taker. But
EntrepreneurshipisawidertermthanOrganizationandManagementofabusiness.
(b) Without the Entrepreneur, the other factors of production would remain unutilized or
idle. Hence, he is the catalyst in the process of using the factors of production.
(c) Entrepreneur holds the final responsibility of the business.
(d) Enterprise function gives direction to the usage of other factors of production. Land,
Labour and Capital, by themselves, will not lead to production activity.
(e) Entrepreneurship gets its reward (i.e. Profit),only after all other factors of production
have been rewarded, i.e. after Rent, Wages and Interest.
Functions of an Entrepreneur
Initiating and Running the business:
(a) The Entrepreneur has to collect the other factors of production (Land, Labour, and
Capital) and bring co—ordination among them.
(b) He has to pay the fixed contractual remuneration to the other factors of production —
(i) Rent for Land,(ii) Wages for Labour, and (iii) Interest towards Capital.
(c) Surplus, if any, after meeting all Fixed Costs and Variable Costs, accrues to the
Entrepreneur as his reward for his efforts and risk—taking.
(d) Reward for an Entrepreneur (i.e. Profit) is not fixed. He may earn profits, or
sometimes incur losses.
2. Risk—Bearing:
(a) The final responsibility for the success and survival of business lies with the
Entrepreneur.
(b) In a dynamic economy, there are constant changes in — (i) demand for a commodity,
(ii) Cost structure, (iii) tastes and fashions of consumers, (iv) Government's
industrial, taxation and economic policies, (v) credit availability and rate of
interest, etc.
(c) What is planned and anticipated by the Entrepreneur may not come true, and the
actual course of events may differ from what was anticipated and planned. In case
of adverse changes, there may be losses for the Firm.
(d) The Entrepreneur has to assess and bear different risks, viz. Financial Risks,
Technological Risks, etc. These tasks cannot be insured, and are also called
Uncertainties.
(e) The role of the Entrepreneur is to manage all these uncertainties and risks, and yet
earn profits.
3. Innovations:
(a) The Entrepreneur is to introduce and bring about innovations, on a continuous
basis.

(b) Since the Entrepreneur seeks to maximize profit, he will innovate so as to find better
products, methods of production etc. to overcome the effects of competition, and emerge
as a leader.
Enterprise Objective
1. Organic Objectives
Aspects Explanation
Survival 1. To stay alive in competition and ensure the continuance of its business
activity,
2. Toproduceanddistributeproductsorservicesatapricewhichenablesitto recover its
costs,
3. To meet its obligations to its Creditors, Suppliers and Employees,
4. To avoid bankruptcy or insolvency,
5. To provide the basis or growth.
Growth 1. Growth as an objective has assumed importance with the rise of Professional
and Managers, and the structural division of ownership and management in Corporate
Expansion Firms.
2. The goal that Managers of a Corporate Firm set for themselves is to maximize the
Firm's balanced growth rate subject to managerial and financial constraints.
2. Economic Objectives: These relate to the Profit Maximizing Objective and Behavior of
Business Firms, which forms one of the basic assumptions of Micro Economic Theory.
3. Social Objectives: An Enterprise lives in a society, and can grow only if it meets the needs of the
Society. Some of the major Social Objectives of Business would include—
a) To avoid profiteering and anti—social practices,
b) To create opportunities for gainful employment for the people in the society,
c) To maintain a continuous and sufficient supply of unadulterated goods.
d) To ensure that the Enterprise's output does not cause any type of pollution—air, water or
noise,
e) To contribute to the quality of life of its community in particular and the society in general.
4. HumanObjectives:HumanBeingsarethemostpreciousresourcesofanorganisation.Someof
the major Human Objectives of Business would include—
a) To ensure comprehensive development of its Human Resources or Employees',
b) To provide fair deal and treatment to the employees at different levels,
c) To provide the Employees an opportunity to participate in decision—making in matters
affecting them,
d) To make the job contents interesting and challenging,
e) To develop new skills and abilities in Employees, and provide a work climate in which they
will grow as mature and productive individuals,
f) To enable Employees enjoy a good standard of living and maintain work—life balance,
g) To secure the loyalty and support of its Employees, by being conscious of its duties towards
them.
5. National Objectives: An Enterprise should work towards fulfillment of national needs and
aspirations and work towards implementation of National Plans and Policies. Some of the National
Objectives of Business would include —

a) To produce goods and services, according to national priorities,

b) To remove inequality of opportunities and provide fair opportunity to all to work and to
progress,
c) To help the country become self—reliant and avoid dependence on other nations,
d) To train the Country's youth and contribute in skill formation for economic growth and
development.
Constrains in achieving the objectives
Constrains Description
Information Business Enterprises operate in an uncertain world with lack of accurate
information.
Many variables that affect the Firm's performance cannot be correctly predicted for
short/long runs.
Infrastructure There may be infrastructural inadequacies and Supply Chain bottlenecks
resulting in shortages and unanticipated emergencies.
Examples: Issues like frequent power cuts, irregular supply of Raw—
Materials or Non—Availability of proper transport, impact the ability of
enterprises to maximise profits.
Factors of There may be constraints imposed by the Government on the production,
Production price and movement of factors. Also, there are practical hindrances for
free mobility of Labour and Capital.
Firms may not be able to find skilled workforce at competitive wages, or
may have recurring need for personnel training. There may also be
restrictions as to availability of Capital.
Example: Trade Unions may place several restrictions on the mobility of
labour or specialised training may be required to enable workers to change
occupation. Such constraints may make attainment of maximum profits a
difficult task.
Economic Aspects such as Inflation, rising Interest Rates, unfavourable Exchange
Aspects Rate fluctuations cause increased Raw Material, Capital and Labour
Costs and affect the budgets and financial plans of Firms.
Events like Demonetisation may have an impact on the operational
activities of Firms in the short run.
Others Due to inter—connected nature of economies, small changes in business
and economic conditions in one country, become contagious, and place
constraints in another Country, by causing demand fluctuations and
instability in Firms' Sales and Revenues.
External Factors like sudden change in Government Policies with regard
to location, prices, taxes, production, etc. or Natural Calamities like fire,
flood, etc. may place additional burdens on the Business Firms and affect
their plans.
When Firms are forced to react in response to fiscal limitations, legal,
regulatory, or contractual requirements, these have adverse
consequences on the Firms' Profitability and Growth Plans.

Enterprise's Problems
Some major areas of problems in the context of Business Economics are given below —
Nature Explanation
Objective a) An Enterprise operates in the economic, social, political and cultural
environment, and hence it has — (i) Organic, (ii) Economic, (iii) Social, (iv)
Human, and (v) National Objectives — in relation to its environment.
b) These objectives are multifarious and very often conflict with one another.
c) The enterprise faces the problem of not only choosing its objectives but also
striking a balance among them. There is a need for setting priorities amongst
objectives.
d) Example: Profit Maximisation Objective conflicts with the objective of
increasing the Market Share which generally involves improving the quality,
reducing prices, etc.
Location of An Enterprise has to decide about the location of its Plant — a Plant near the
Plant source of Raw Material will lead to lower material costs, whereas a Plant near
the market may cost high in terms of Materials.
Size of The Firm has to decide whether it is to be a Small Scale Unit or Large Scale
Plant: Unit.
Physical a) A Firm has to make decision on the nature of production process to be

Facilities employed and the type of equipment to be installed — based on factors like
product design, technology available for production, required output levels, etc.
b) The Enterprise has to make a choice of equipment and processes, based on the
evaluation of their relative cost and efficiency.
Finance: There may be various problems facing the Enterprise relating to availability of
Capital at an appropriate Cost, availability of adequate Primary and Collateral Security
for obtaining Bank Finance etc.
Organisation a) Division of the total work of the Enterprise into major specialised functions,
b) Creation of proper departments for each of the specialized functions,
Structure:
c) Clear definition of the functions of all the positions and levels and establishing the
inter— relationships.
a) Discovering the target market by identifying its actual and potential customers,
Marketing:
b) Determining the marketing tools that can be used, to produce desired responses
from its target market,
c) ProperDecisionsregardingthe4P'sofMarketing—viz.
 Product: Variety, Quality, Design, Features, Brand Name, Packaging,
Associated Services, Utility, etc.
 Promotion: Communicating with Consumers — Personal Selling,
Social Contacts, Advertising, Publicity, etc.
 Price: Policies regarding Pricing, Discounts, Allowance, Credit Terms, Concessions,
etc.
 Place: Policy regarding Coverage, Outlets for Sales, Channels of Distribution,
Location and Layout of Stores, Inventory, Logistics, Supply-Chain
Management, etc.
a) Assessing and paying different types of taxes (Corporate Income Tax, GST, Customs
Legal Duty, etc.),
Compliance: b) Maintenance of records for specified number of years and showing them

for inspection by Authorities,

c) Submission of various types of information/Returns/Forms to various authorities
from time to time,
d) Adhering to various Rules and Laws(e.g. laws relating to location, environmental
protection and control of pollution)etc.
d) The problem of winning workers' cooperation—Management has to devise
Industrial
special measures to win the cooperation of a large number of workers employed in
Relations:
industry.
e) The problem of enforcing proper discipline among workers,
f) The problem of dealing with organised labour and Trade Unions,.
PART B – PRODUCTION FUNCTION

Meaning:
1. Production Function is the functional relationship between physical inputs(i.e. factors of

production), and physical outputs (i.e. quantity of goods/services produced).
2. Production Function states the relationship between inputs and output, i.e. the maximum
amount of output that can be produced with given quantities of inputs, in the existing
state of technology.
3. Production Function gives the minimum quantities of various inputs that are required to yield a
given quantity of output.
Cobb-Douglas Production Function
1. Paul H. Douglas and C.W. Cobb of U.S.A studied production function of American
Manufacturing Industries.
2. Output is manufacturing production and inputs used are Labour and Capital.
3. Cobb-Douglas Production Function is Q=KLaC(1-a), where Q is output, L is Quantity of Labour and
C the quantity of Capital. K and a are Positive Constants.
4. Labour contributed about 3/4w and Capital about1/4th of the increase in the Manufacturing
Production.
Short run and long run production function
Short Run Long Run

Meaning It is the period of time which is too short It is the period of time in which all the factors
for a Firm to install New Machineries / production are variable. So, the Firm will
Capital Equipments to increase be able to install new machineries /
production. Equipments, apart from increasing the units of
Labour, Materials, etc.
Fixed Only one Factor of Production is kept There is no Fixed Factor of Production in the
Factor constant or fixed. [Generally and, long—run planning horizon.
Capital or Enterprise is taken as fixed.]

Variable All Factors of Production other than the

All Factors of Production are variable.
Factor Fixed Factor are considered variable.
Proportion Proportion between factors changes, i.e. Quantity of Factors changes, i.e. more use
between more use of the Variable Factor, keeping Factors, keeping the proportion as constant.
Factors Fixed Factor as constant.
Theory Law of Variable Proportions is Law of Returns to Scale is applicable in
. applicable in the short—run. the long—run.
Assumptions:
The production function is based on certain assumptions;
 It is related to a particular unit of time.
 The technical knowledge during that period of time remains constant.
 The factors of production are divisible into most viable units.
 The producer is using the best technique available.
Terms Involved:
Total TP is the total output resulting from the efforts of all the factors of
Production production combined together at any time.
Average Average product or average physical product (APP) may be defined as total
Production product per unit employment of the variable input. Thus
AP = TP/Units of variable input (labour)
Marginal MP is the change in TP due to change in the quantity of variable factori.e.

Production labour. In other words, it is the additional TP due to an additional unit of
(MP) input. MP = Change TP I change in Labors OR
Mp = MP = TPn - TPn_1
Relationship 1. Both AP and MP can be calculated by TP.
between AP 2. When AP rises then MP also rises but MP>AP.
and MP 3. When AP is maximum then MP =AP or say MP curve cuts the AP curve at its
maximum point
4. When AP falls then MP also falls but MP<AP.
5. There may be a situation when MP decreases and AP increases but
opposite never happened.
Labour TP AP MP Analysis
1 2 2 2
Schedule MP &AP both increases; MP>AP; TP also
2 5 2.5 3
increases
3 9 3 4
4 12 3 3 MP=AP, AP = maximum
5 14 2.8 2
MP &AP both decreases, MP<AP; TP
6 15 2.5 1
increases MP = 0, TP=maximum
7 15 2.1 0
8 14 1.7 -1
AP > MP both decreases TP decreases
9 12 1.3 -2

Relationship between Average Product and Marginal Product
Rule Relationship between AP and Points to Remember

MP
When AP rises as a result of an  When AP rises, MP >AP.
1 increase in the quantity of variable  MP Curve rises steeply and is higher than AP,
input, MP is more than AP. when AP increases.
 When AP is maximum, MP =AP.
When AP is maximum, MP=AP. So,  MP declines slightly earlier than AR
the MP Curve cuts the AP Curve at  MP Curve cuts AP Curve, when AP is
2 its maximum. maximum.
 MP Curve cuts AP Curve only from above, and not
from below.
When AP decreases due to increased  When AP decreases, MP <AP.
use of the variable input factor, MP is  MP Curve declines steeply than AP.
less than AP.  MP may become zero and negative later,
3
but AP continues to remain positive(i.e. not
zero or negative).
Note: The above relationship is based on the Law of Variable Proportions in the same
sequence of stages as stated in that law, i.e. First Increasing, then Diminishing and then
Negative Returns.
Relationship between Total Product and Marginal Product I
Note: The point on the TP Curve when MP is maximum, is called Point of Inflexion
LAW OF VARIABLEPROPORTION
1. The Law of Variable Proportions analyses the production function with one factor as
variable, keeping quantities of other factors fixed.
2. So, the Law refers to input—output relationship, when the output is increased by varying
the quantity of one input.
3. This Law operates only in the short—run, i.e. when all factors of production can not be
increased or decreased simultaneously.
4. This Law is also called—(i)LawofProportionality,(ii)LawofDiminishingReturns,(iii)Lawof
Diminishing Marginal Physical Productivity.
Assumptions:
 The technology remains unchanged.

 There must be some inputs whose quantity is kept fixed.

 Law does not apply where factors are used in fixed proportions.
 Only physical input and output are considered.
 All the units of variable factors are homogeneous.
Schedule Labour TP AP MP Analysis

1 2 2 2
2 5 2.5 3 Stage-I- Law of increasing returns
3 9 3 4
4 12 3 3 MP=AP, AP = Maximum
5 14 2.8 2
6 15 2.5 1 stage-II- Law of decreasing returns
7 15 2.1 0 MP =0, TP is Maximum
8 14 1.7 -1
stage-III-Law of Negative returns
9 12 1.3 -2
Curve
Explanation to Stage 1
Reason Explanation
Full Use of (a) Initially, the quantity of Fixed Factors is abundant (and also unutilized),
Fixed in relation to the quantity of the Variable Factor.
Indivisible (b) As more units of Variable Factors are added to the constant quantity of
Factors the fixed factors, the Fixed Factors are more intensively and
effectively utilized. This causes the production to increase at a rapid
rate.
(c) So, the efficiency of the Fixed Factors increases, as additional units of
the Variable Factors are added to it.
(d) Example: If a Machine can be efficiently operated when 15 persons are
working on it, and if initially the machine is operated with only 10
persons, production increases till the point 15 th person is employed,
since the machine will be effectively utilised to its optimum.
Efficiency of (a) As more units of the Variable Factors are put to use, the efficiency of
Variable the Variable Factors itself increases.
Factors (b) This is attributed to reasons like specialization of functions,
division of labour, use of standardized tools and processes, etc.

This results in higher productivity.
No Scarcity (a) Returns may diminish only when Variable Factors are affected by scarcity,
of Variable e.g. additional workers are not available.
Reaching the (a)Production Efficiency (i.e. increased output) is possible, till the right
right combination between Fixed Factors and Variable Factors is achieved.
combination Based on the example in Point 1 above, the output will continue to increase,
till the 15thperson is employed.
Explanation to Stage 2-
Note: Stage II is called Law of Diminishing Returns since MP and AP both show
decreasing trend. However, both MP and AP remain positive.
The Law of Diminishing Returns operates due to the following reasons —
Reason Explanation
Inadequacy 1. Once the point of right combination is reached, further increase in the
of Fixed Variable Factor will cause MP and AP to decline. This is because the Fixed
Factor Factor then becomes inadequate, in relation to the quantity of the
Variable Factor.
2. Example: Based on the Machine example given above, putting the
16thperson on the same machine, makes the contribution of the latter
Nil. So, Average Output, (as well as Marginal Output) will decline.
Less 1. Once the Fixed Factor has reached its maximum capacity, there is
efficiency of no further scope/ possibility of efficiency of the Variable Factor.
Variable 2. Average Efficiency of the Variable Factors can increase only if the
Factor Fixed Factors supports such extra output.
3. Average Product of the Variable Factor diminishes, when the Fixed
Indivisible Factor is being worked too hard.
1. It is assumed that there is no perfect substitute for the scarce Fixed
Imperfect
Factor.
Substitutes
2. If such perfect substitutes were available, then the shortage of the
scarce Fixed Factor can be made up by using its perfect substitute,
such that output could be increased.
1. Any deviation from the right or optimum combination will result in
Wrong
lower productivity of the factors of production.
combina
2. Using more and more of the Variable Factor disturbs the optimum
tions
combination, and reduces output /productivity.

Explanation to Stage 3
Note: Stage II is called Law of Negative Marginal Returns
The Law of Negative Returns operates when the quantity of Variable Factor becomes too
Reason excessive, in relation to the Fixed Factor, so that they get in each other's ways. Dueto
this, the total output falls instead of rising.
Based on the Machine example given above, putting the 16th or 17th person on the
Example same machine becomes a nuisance and causes obstruction to the other workers.
This will reduce the Total Output.
Since the second stage is the most important, So stage II will be stage of operation
and because of that in practice we normally refer to the law of variable proportion
as the law of diminishing returns.
Law of Return to scales

LAW OF RETURNS TO SCALE
Law In the long run, all factor inputs in the production function can be changed.
The behavior of output consequent to change in the quantities of all factor
inputs in the same proportion(i.e. keeping, the factor proportions unaltered) is
known as 'returns to scale'.
Types of  Increasing Returns to Scale:
returns to  Constant Returns to Scale:
scale  Diminishing Returns to scale:
Increasing 1. Increasing returns to scale

Returns to occur when a simultaneous
Scale increase in all the inputs in
the same given proportion
result in a more than
proportionate increase in the
output.
2. For example, if input is
increased by 100% but the
output increases by 125%
Constant 1. Returns to scale are said to be
Returns to constant when a proportionate
Scale: increase in all the inputs
results in proportionate
increase in output. For
example if input is increased
by 100% but the output also
increases by 100%.
2. Constant return to scale is also
called 'Linear Homogeneous
Production Function'.

Diminishi 1. Diminishing returns to scale

ng occur when a simultaneous
Returns to increase in all inputs in the
scale: same given proportion result
in a less than proportionate
increase in the output.
2. For example, if Input is
increased by 100% but the
output increases only by75%
Cobb-Douglas Production Function exhibits returns to scale in production:.

Increasing returns to scale. Output increased more than proportionate to use of
a+b>1
factors (labour and capital)
a+b =1 Constant returns to scale. Output increased in same proportion with all factors.
Decreasing returns to scale. Output decreased more than proportionate to use of
a+b<1
factors (labour and capital)
S. Scale / Factor Total Marginal

No Input used Product Product
1 1M+3W 2,000 2,000

2 2 M+ 6 W 5,000 3,000
3 3 M+ 9 W 9,000 4,000
4 4 M+ 12 W 14,000 5,000
5 5 M + 15 W 19,000 5,000
6 6 M + 18 W 24,000 5,000
7 7 M + 21 W 28,000 4,000
8 8 M + 24 W 31,000 3,000
9 9 M + 27 W 33,000 2,000
Causes of the application of the law returns to scale

 Internal and external economics of scale.
 Internal and external diseconomies of scale.
Internal Economies and Diseconomies to Scale
Use of greater degree of division of Labour and specialised machinery at higher levels of
output are generally termed as Internal Economies.
Aspect Economies Diseconomies
Advantages Disadvantage
Technical 1. More specialised and efficientFurther increase in the Plant size
Machinery/Equipments can be used towill lead to high long—run cost,
produce a large output yields a lower costbecause of difficulties of
per unit of output. management, co—ordination and
2. Introduction of a greater degree of Divisioncontrol,
of Labour or Specialization, leads to
reduction in cost per unit.

Managerial 1. Specialized functional areas like Production, It may be difficult for Managers to
purchasing, marketing, Finance, etc. can be exercise control and co—
created. Each Department can also be ordination among various
further sub—divided. departments.
2. Thus, management efficiency and
Productivity improve significantly.
Mass Production creates the need for 1. Higher quantities of Raw
(a)
bulk purchase of raw materials and Materials may have to be
components, and leads to lower prices purchased at higher prices,
being paid for such bulk purchase. since there is an increasing
(b) Selling Costs can be minimized with demand for that Raw Material.
Commercial the existing sales staff, lower advertising 2. Advertising Costs tend to
costs per unit, etc. increase disproportionately
beyond certain levels of output.
Risk— A large Firm with diverse and multiple However, the Firm's Risk may
bearing production capability will be in a better increase of diversification instead
position to withstand economic ups and of giving a cover to economic
downs. So, it enjoys economies of risk disturbances, increases risk.
bearing.
A large Firm can
Financial Financial Costs will rise more
(a) Offer better security to Bankers
proportionately after the optimum
and obtain credit easily.
scale of production. This may
(b) Raise money at lower cost, since
happen because of relatively
investors have confidence in it
more dependence on external
sources of finance.
4.1
External Economies are explained below —

Aspect Explanation
Cheaper Raw 1. Greater demand for various kinds of materials and capital equipment
Materials and required by the industry leads to exploration of new and cheaper sources
Capital of raw material, machinery and other types of capital equipment.
Equipment 2. This makes it possible to purchase on a large scale from other industries.
3. This reduces their cost of production and hence their prices.
Technological There is scope of discovery of new technical knowledge and the use of
improved and better machinery as per new techniques of production and will
enhance productivity of Firms in the industry and reduce their cost of
production.
Development 1. Workers become well—accustomed to do the various productive processes
of Skilled and learn from the experience obtained due to expansion of industry.
Labour 2. Apool of trained and skilled labour is developed, which has a favourable
effect on the level of productivity and cost of the Firms in that industry.

Growth of 1. As an industry expands, a number of ancillary industries who specialise in

ancillary production of raw materials, tools and machinery, etc. can provide them at a
industries lower price to the main industry.
2. Further, new Firms may come up, to process the waste products of the
industry and make some useful product out of it.
Better 1. Transportation and marketing network develops to a great extent, and
transportation reduce cost of production of the Firms.
and marketing 2. Communication Systems may get modernised resulting in quick and effective
information flow.
External Diseconomies: These factors are called as External Diseconomies.

1. Rise in Factor Prices: When an industry expands, the requirement of various factors of
production increases. This may result in pushing up the prices of such factors of production
especially when they are short in supply.
2. Higher Costs: Too many Firms in an industry at one place may also result in higher
transportation cost, marketing cost and high pollution control cost.
3. Government Restrictions: The Government may prohibit or restrict expansion of an industry
at a particular place, by way of its policies.
Production Optimisation
Isoquant Curve
1. Isoquant Curve:
1. "Iso" means equal and "quant" means quantity. Hence, an Isoquant represents a constant
quantity of output.
2. An Isoquant is a Curve that shows all the combinations of inputs that yield the same level of
output.
2. Relationship with Consumer Indifference Curve:

1. An Isoquant represents all those combinations of inputs which are capable of producing the
same level of output.
2. So, the Producer is indifferent as to which combination he chooses.
3. Thus, Isoquants are similar to Indifference Curves in the Theory of Consumer Behaviour.
4. Isoquants are also called Equal—Product Curves, Production Indifference Curves or Isoproduct
Curves.
3. Illustration: Consider two Factor Inputs (Labour and Capital) required for producing 100 units of a
Product. Different combinations in which the same output of 100 units of Product can be achieved
are given below.
MRTS always shows diminishing trend.

MRTS=Marginal Rate of Technical Substitution
MRTS= Change in units of capital/ change in units of labour

Combinatio Units of Labour (x) Units of Capital (y) Product Output MRTS (See Note)
nA 5 9 100 units
B 10 6 100 units (9- 6)/(10-5) = 0.6
C 15 4 100 units (6 – 4)/( 15 -10) = 0.4
D 20 3 100 units (4 -3)/(20-15)= 0.2
Features of Isoquants:
1. Isoquants are convex to the origin, due to
diminishing trend of MRTS

2. Isoquants are negatively sloped, i.e. downwards from left to right.
3. Isoquant do not touch either axis, since it indicates that Output can be producing by using
only one factor, which is not considered under the study of Isoquants.
4. An Isoquant lying above and to the right of another Isoquant represents a higher level of
output.
5. Two Isoquants cannot cut each other, i.e. Isoquants are non—intersecting.
6. Isoquants need not be parallel.
ISOCOST LINES
Isocost Lines:
1. Isocost Line shows the various alternative combinations of two Factor Inputs, which a Firm can buy
with given amount of money.
2. It is also called Equal—Cost Lines or Budget Line or the Budget Constraint Line.
3. All points on a Budget Line would cost the Firm the same amount. Whatever the combination of Factor
Inputs the Firm chooses; the Total Cost to the Firm remains the same.
4. Various Isocost Lines representing different combinations of Factors with different outlays / costs can
be drawn, in the manner similar to Isoquants.
5. Whenever there is a parallel shifting of the Isocost Line due to a change in Total Expenditure, then the

slope of the Isocost Line would remain the same. However, a change in the relative Input Price will
cause a change in the slope of the Isocost Line
Production Optimisation
Meaning:
1. A Firm may try to minimise its cost for producing a given level of output, or it may try to
maximise the output for a given cost or outlay.
2. A Profit Maximising Firm is interested to know what combination of factors of production (or
inputs) would minimise its Cost of Production for a given output, and also the optimum level of
output.
3. This is obtained by combining the Firm's Production and Cost Functions, namely Isoquants and
Isocost Lines respectively.
4. Isoquants represent the technical conditions of production for a product, and Isocost Lines
represent various "levels of cost"(given the prices of two factors). Together, these can help the Firm
to optimize its production.
Principle
1. Suppose a Firm has already decided about the level of output to be produced (say, 100
units, denoted by the Isoquant P in the diagram). The Firm will try to use the least—cost
combination of factors, to produce the pre—decided level of output.
2. This can be found by super—imposing the Isoquant that represents the pre—decided level of
Output, on the Isocost Lines.
3. The point of tangency between any Isoquant and an Isocost Line gives the lowest—cost
combination of inputs that can produce the level of output associated with that Isoquant.
4. This point gives the maximum level of output that can be produced, for given Total Cost of Inputs.
1. For 100 units Output as per Isoquant P, the point on Isocost Line B represents the least
cost combination,
2. When a Firm grows and increases output to 200 units (denoted by Isoquant Q), the on
Isocost Line D represents the least cost combination.
3. A line joining tangency points of Isoquants and Isocosts (with Input Prices held
constant) is called Expansion Path.
Space of diagram

Cost and Revenue Concept
Chapter 6:
THEORY OF COST AND REVENUE
PART A – COST CONCEPT
Meaning
1. Business decisions are generally based on cost of production i.e. the money value of inputs
and output is considered.
2. Cost analysis refers to the study of behaviour of cost in relation to one or more
production criteria, namely, size of output, scale of operations, prices of factors of
production and other relevant economic variables.
3. In other words, cost analysis is concerned with the financial aspects of production
relations as against physical aspects which were considered in production analysis.
Types of cost
1) Explicit cost and Implicit cost.

Explicit cost Implicit cost
Costs which involve payment made by the Costs which do not involve any cash
Entrepreneur to providers of other factors payment to outsiders are called Implicit
of production, i.e. Land, Labour and Costs. It is the monetary reward for all
Capital, factor of production owned by
entrepreneur himself
Recorded in books of accounts. Not recorded in books of account.
Rent, Wages & Salaries, Interest on Interest on own Capital, Rent of own
Loans borrowed for business, etc. premises, Salary to Entrepreneur, etc.
Out—of—Pocket Costs / Outlay Costs. Notional / Imputed / Opportunity Costs.
2). Accounting cost and Economic cost
Accounting Costs = Explicit Costs.

Economic Costs = Explicit Costs + Implicit Costs.
Comparison of Explicit and Implicit cost in different situation
Factors of Reward / The reward is Explicit Cost if — The reward is Implicit Cost if —
Production Costs
Land Rent Rent is paid to the Landlord Land is owned by the Entrepreneur.
separately.
Labour Salary/ Salary/ wages paid to employee/ Own people are employed in the firm
Wages workers
Capital Interest Capital is borrowed and used in Entrepreneur employs his own
business
funds as Capital.
Entrepreneur Profit Not Applicable Entrepreneur himself manages the
business.
6.1
3. Opportunity cost:
1. Opportunity Cost refers to the value of sacrifice made, or benefit of opportunity foregone in
accepting a next best alternative course of action.
2. Opportunity Cost arises only when alternatives are available. If a resource can be put only to
a particular use, there are no Opportunity Costs.
3. It is the cost of the missed opportunity and involves a comparison between the policy that was
chosen and the policy that was rejected.
4. Opportunity Costs do not involve any cash payment as such. Thus, they are different from
Outlay Costs, which involve some payment to outsiders.
5. Opportunity Cost is not recorded in books of accounts. It is considered only for decision—
making and analytical purposes.
6. Examples: A person quits his job and enters into business. Here, the Salary foregone from
employment constitutes Opportunity Cost.
4. Direct cost vs Indirect Cost
Basis Direct cost or traceable cost Indirect cost or non-traceable cost

Meaning Direct costs are those which haveIndirect costs are those which are not
direct relationship with a easily and definitely identifiablein
component of operationlike relation to a plant, product, process or
manufacturing a product, department.
organizing a process or an activity
Therefore, such costs are not visibly
etc. traceable to specific goods, services,
operations, etc.; but are nevertheless
charged to different jobs or products in
standard accounting practice.
Example Cost of Raw Materialused in Factory Rent, Electric Power, and other
manufacture, Wages paid to WorkersCommon Costs contract,
in a construction incurred etc.
for general
operation of business benefiting all
products jointly.
Relationship They can be generallyquantified Though not quantifiable, they may bear
and expressed per unit of some functional relationship to
output, e.g. 5 kg of Raw production, may vary with the volume of
Materials per unit of product, etc. output in some definite way.
Accounting They are charged directly to Apportioned on suitable basis
product
5. Fixed costs and Variable costs
Basis Fixed Costs Variable Costs

Fixed Costs are costs that do not vary with Variable Costs are costs that vary,
Meaning
output, up to a certain level of activity. based on the level of output.
Relationship They are period—related. They are taken They are product—related. They are
as a function of time and not of taken as a function of output and not of
output. time.
When They are incurred even at zero level of They are incurred only when
incurred? output, i.e. even before output is produced. production commences.
Avoidable Some portion of Fixed Costs cannot be Variable Costs are avoidable costs, as it
Nature avoided even when operations are is incurred only when production takes
suspended. place.
6.2
Cost per Fixed Cost per unit of output decreases Variable Cost per unit of output
unit with increase in output, and vice—versa, generally remains constant, if Total
upto certain level of output. Variable Costs vary proportionately with
output.
Example Rent, Insurance, Interest on Loans, Cost of Raw Materials and Wages are
Depreciation, etc. are Fixed Costs. Variable Costs.
6. Committed cost and Discretionary costs
Particulars Committed Fixed Costs Discretionary Fixed Costs

These are Fixed Costs that arise from the These are Fixed Costs incurred as a
possession of —
result of management's discretion.
1. Plant, Building and Equipment (e.g.
1. It arises from periodic(usually yearly)
Meaning Depreciation, Rent, Taxes, Insurance
decisions regarding the maximum outlay to be
Premium etc.), or incurred; and
2. A basic organisation (e.g. Salaries of 2. It is not fixed to a clear cause and effect
Staff) relationship between inputs and outputs.
Effect on Any reduction in Committed Fixed Costs Discretionary Fixed Costs can change from
long—term under normal activities of the Firm would year to year, without disturbing the long—
Objectives have adverse effects on the Firm's long—term term objectives of the Firm.
objectives.
Control These costs cannot be controlled. These costs can be controlled.
Inference Also known as "Unavoidable" Fixed Costs. Also known as "Avoidable" Fixed Costs.
7. Marginal Costs
Meaning: Marginal Cost is the addition made to the total cost by production of an additional unit of output.
Impact of Fixed & Variable Costs: Marginal Cost is independent of Fixed Cost. Since Fixed Costs do not
change with output, only Variable Costs and output quantity will have an influence on Marginal Costs.
Marginal Costs per unit = Difference in Output Quantity at those levels
Difference in Total Cost (TC) between two output levels
Behaviour of Marginal Cost Curve:
The behaviour of MC Curve is the reverse of the behaviour of the Marginal Product (MP)
Curve under the Law of Variable Proportions.
Marginal Product (MP) Curve rises first, reaches a maximum and then declines, as seen in
the Law of Variable Proportions.
So, Marginal Cost (MC) Curve of a Firm declines first, reaches its minimum and then rises.
Hence, Marginal Cost Curve of a Firm is U—shaped.
6.3
8. Other costs
Type Explanation
Historical cost Historical cost refers to the cost incurred in the past on the
and Replacement acquisition of a productive asset such as machinery, building etc.
cost Replacement cost is the money expenditure that has to be incurred
for replacing an old asset.
Instability in prices makes these two costs different. Other things
remaining the same, an increase in price will make replacement costs
higher than historical cost.
Incremental cost Incremental costs are related to the concept of marginal cost.
and Sunk Cost Incremental cost refers to the additional cost incurred by a firm as
result of a business decision.
For example, incremental costs will have to be incurred by a firm
when it makes a decision to change its product line, replace worn out
machinery, buy a new production facility or acquire a new set of
clients.
Sunk costs refer to those costs which are already incurred once and
for all and cannot be recovered. They are based on past commitments
and cannot be revised or reversed if the firm wishes to do so.
Examples of sunk costs are expenses incurred on advertising, R&
D, specialised equipment and fixed facilities such as railway lines.
Sunk costs act as an important barrier to entry of firms into
business.
Private cost and
Private costs are costs actually incurred or provided for by firms
Social Cost
and are either explicit or implicit. They normally figure in
business decisions as they form part of total cost and are
internalized by the firm.
Social cost refers to the total cost borne by the society on
account of a business activity and includes private costand
external cost.
It includes the cost of resources for which the firm is not required to
pay price such as atmosphere, rivers, roadways etc. and the cost in
terms of dis-utility created such as air, water and environment
pollution.
Cost Function
1. Meaning: Cost Function refers to the mathematical relationship between cost of a product and
the various determinants of cost.
2. Variables: The following are the dependent and independent variables in a Cost Function —
Dependent Variable Independent Variable can be —
1. Total Cost or 1. Size / Quantity of Output,
2. Unit cost 2. Scale of Operations,
3. Price of Factors of Production.
4. Other relevant phenomenon having a bearing on cost, e.g.
Technology, Level of capacity utilisation, Efficiency, Time Period
under study, etc.
6.4
Short run and Long run cost Behaviour
A. Short Run Cost curves:
Meaning of shot run:
Short Run is a period in which some factors are fixed and some factors are variable.Fixed
factor have fixed cost and variable factor have variable cost.
So, law of variable proportion applies here. In short-run, output can be increased or
decreased by changing variable factors only but fixed factors cannot be varied.
Types of Cost in Short- Run
1. Total fixed cost (TFC)

2. Total Variable Cost (TVC)
3. Total Cost (TC)
4. Average fixed cost (AFC)
5. Average Variable Cost (AVC)
6. Average Total Cost (ATC OR AC)
7. Marginal Cost (MC)
Total Fixed TFC is parallel to X-axis. In the figure

cost (Short given below, even at zero output-fixed
run) cost remain the same in the short run.
e.g. rent and insurance
Total Variable Costs are those costs that

Variable change with changes in level of output. It
cost (TVC) has inverse’s' shape and start from origin.
Figure given below shows that as output
is zero cost is also zero and as output
increases cost increases. e.g. raw
material, power etc.
There are some costs which are neither perfectly variable, nor absolutely
fixed in relation to the changes in the size of output. They are known as
semi-variable costs.
Example: Elasticity charges include both a fixed charge and a charge

based on consumption.
6.5
Short run It can be noticed that TFC is constant at

Total cost all levels of output.
behaviour
TVC increases with the increase in
output but rate of increase is
changing.
Initially TVC increases at decreasing
rate but after some time it increases at
increasing rate.
Behaviour of TVC is determined by law
of variable proportion.
TC increases with increase in output.
Changes in TC are determined by TVC.
TFC curve is a horizontal line starting
from y–axis.
TVC curve is upward slopping. Initially
it is fatter and later on steeper.
TC curve is upward sloping starting
from y-axis.
Short Run Average Cost
Average Fixed Average fixed cost is the total fixed cost divided by the output. (Per
Cost (AFC) unit FC) or TFC/Q.
The general shape of the AFC curve is downward slopingit does not
touch the X-axis as AFC cannot be zero.
It is not 'U' shape. This curve is also called Rectangular
Hyperbola (R.H.)
Average Average variable cost is the total variable cost divided by the output.
Variable Cost (Per unit VC) or TVC/Q.
(AVC) The average cost curve will first fall, then reach a minimum and then
rise again. It has 'U' shape. .
Average Total Average total cost is total cost divided by the output. (Per unit TC) or
Cost (ATC) TC/Q or AFC+AVC.
The ATC curve first falls, reaches it’s minimum and then rises.
The ATC curve is 'U' shape due to law of variable proportions.
Marginal Cost Marginal cost is the change in total cost due to change in the output.
(MC) MC= Change in Total Cost / Change in Qty. produced or MC =
6.6
Change Total Variable Cost / Change Qty. produced.
The MC curve is also 'U' shape.
For Ex. 15 units produced at Rs. 200 and 20 units produced at Rs.
250, then calculate MC? MC = 10 units.
Behaviour of AFC goes on diminishing with the

Average – increase in output but it never
costs in Short becomes zero.
- Run AVC initially declines but later on
goes on increasing.
ATC initially decreases, constant for
a while & finally goes on increasing.
MC initially decreases & finally
increases.
The point at which ATC is minimum.
It is equal to MC.
AFC curve is a ‘rectangular
hyperbola’ because AFC x Q is
always constant.
Short run cost table

Output Total Total Total Average Average Average Marginal
fixed
(Unit) variable cost fixed cost variables Total Cost Cost Rs.
cost
TFC TVC TC AFC AVC AC MC
0 10 - 10 - - - -
1 10 10 20 10 10 20 10
2 10 18 28 5 9 14 8
3 10 24 34 3.33 8 11.3 6
4 10 28 38 2.5 7 9.5 4
5 10 32 42 2 6.4 8.4 4 4
6 10 38 48 1.67 6.33 8 6
7 10 46 56 1.43 6.57 8 8
8 10 56 66 1.25 7 8.25 10
9 10 68 78 1.11 7.55 8.67 12
Relationship between Average Cost and Marginal Cost Curves
Rule Relationship between AC and MC Point to Remember

1 When AC falls as a result of an  When AC falls, MC < AC.
increase in output, MC is less 0 MC Curve is lower than AC, when AC
2 When AC is minimum, MC =
than AC. decreases.
When AC is minimum, MC = AC.
AC. So, the MC Curve cuts the  MC increases slightly earlier than AC.
3 When AC increases
AC Curve due to
at its minimum.  When AC decreases,
MC Curve MC > when
cuts AC Curve, AC. AC is
increase in output, MC is minimum.
MC Curve rises steeply than AC.
greater than AC.  MC Curve cuts AC Curve only from
below, and not from above.
6.7
Relationship between ATC and MC
It is stated as follows:
 Initially ATC & MC both decline with increase in
output. In this situation ATC > MC.
 When ATC is minimum ATC = MC.
 When ATC & MC both are increasing MC > ATC.
 When AC is decreasing, MC may be decreasing or
increasing.
 When AC is increasing MC must be increasing.
Item Behaviour of Cost Behaviour of Curve
 AFC = TFC /Q.  AFC Curve is negatively sloped,


9 TFC remains constant irrespective of i.e. slopes downwards from left
AFC increase in Q. to the right.
 So, AFC is inversely related to Q  AFC Curve will not touch the axis
since AFC cannot be = 0.
•  AVC = TVC / Q  AVC Curve will fall first, for the
 Upto normal capacity output, AVC output level upto normal capacity.
• decreases as output increases, due to  AVC Curve will reach a minimum,
AVC initial increasing returns. and then rise again.
•  Beyond normal capacity output, AVC will
 AVC is not exactly a U—Shaped
rise steeply, due to the operation of Curve.
diminishing returns.
•0  AC = TC + Q (or) AC = AFC + AVC.
 In the initial stages, AC will decline  AC Curve will fall first, due to
• sharply due to fall in AFC. sharp decline in AFC.
AC or  Even when AVC rises, AC continues to  AC Curve will reach a minimum,
ATC • decrease since the fall in AFC is greater and then rise again, due to
than the rise in AVC. increase in AVC.
 As output increases further, AC starts  AC is a U—Shaped Curve.
• increasing, since the sharp rise in AVC is
more than fall in AFC.
••  Marginal Costs p.u. = Diff. in TC + Diff.  MC Curve will fallfirst, reach
in Q. a minimum, and then rise again.
MC •  MC declines initially, reaches a  MC is a U—Shaped Curve.
minimum, and thereafter increases.  MC cuts AC from below, when AC
•
is minimum.
6.8
Long run average cost curve

 LAC Curve: A Long Run Average Cost Curve (denoted as LAC Curve) depicts the functional
relationship between output and the long—run cost of production.
 No distinction of Fixed—Variable: All factors of production are variable in long—run, and hence every
cost is variable. The distinction between Fixed and Variable Costs does not arise in the long—run.
 LAC = Least Cost:
a) In the long—run, the cost of production is the least for any given level of output, as all
individual factors are variable. So, a Firm can move from one Plant to another, acquire a bigger
Plant if it wants to increase its output, and a small plant if it wants to reduce its output.
b) The shift will be to ensure the least cost for that level of output, in the long—run.
c) Hence, AC cannot be higher in the long—run, than in the short—run. Thus, LAC is the least—
cost combination, for any particular output level.
 Planning Curve: LAC Curve is called Planning Curve, since the Firm plans to produce any
output in the long—run by choosing a Plant on the LAC Curve corresponding to the given output.
Thus, LAC Curve helps the Firm in the choice of the size of the plant for producing a specific
output at the least possible cost. Note: SAC (Short—Term Average Cost) Curves are called Plant
Curves, and LAC (Long Run Average Cost) Curve is called Planning Curve.
5. LAC derived from SAC: LAC Curve is derived as an envelop / tangent of all SAC Curves. Further, the
LAC Curve is a U—Shaped Curve, due to the operation of Law of Returns to Scale. The determination of
LAC Curve from the various SAC Curves is explained below-
6. Selecting the suitable SAC Curve at different output levels:
In the long—run, for any output level, the Firm will examine and decide which size of plants it should
operate, so as to minimize its Cost (i.e. AC). The firm will decide on which SAC Curve it should
operate to produce a given output, so that its AC is minimum.
Note: The Firm should select the SAC, not the lowest point of that SAC.
 The points of operation, i.e. B, D, F and G need not be the minimum points of the respective
SACs. However, it should be the SAC on which the lowest cost is obtained for that level of output.
 So, the Firm will choose the appropriate lowest cost SAC for an output level, and not the lowest
point on that SAC.
 The Smooth Curve connecting points B, D and G, constitutes the LAC Curve for the Firm.
2. Deriving LAC Curve in case of numerous / infinite SAC Curves:
6.9
(a) If the Firm has choice between infinite
number of plants (with infinite SAC
Curves), the LAC Curve will be a smooth
curve enveloping all these SAC Curves.
(b) In the diagram, the LAC Curve is drawn as a
smooth curve, so as to be tangent to
each of the SAC Curves. [See Note below]
(c) If a Firm desires to produce any particular
output level, it will build a corresponding
Plant and operate on that Plant's SAC
Curve.
(d) Higher levels of output can be produced
at the lowest cost, with a larger plant, and
vice—versa.
Note: LAC Curve is tangent to each of the SAC Curves, not the minimum points of the SAC Curves. So
When LAC Curve is — LAC will be tangent to Principle

—
The falling portions of the Returns to Scale will first increase, due to
declining SAC Curves. internal and external economies. So, LAC will
decline.
The rising portions of the Returns to Scale will decrease later, due to
rising SAC Curves. internal and external diseconomies. So, LAC
will rise.
Thus, as a result of initial fall and subsequent increase in LAC, it will be a U—shaped Curve.
6.10
REVENUE CONCEPT
Meaning Revenue refers to money received by a seller by selling his product in the market.
Hence, revenue is sales receipts or sales proceeds.
Total Revenue It is the total money received from the sale of all units of the product.
Total Revenue = Price x Quantity (P x Q)
50 Rs. = Rs. 5 x 10 Units
Average It is the average sales receipts.
Revenue (AR) Average Revenue = Total Revenue/Quantity (TR/Q)
Average Revenue is always equal to Price
Marginal MR is the change in TR resulting from the sale of an additional unit of a commodity.
Revenue (MR)
Marginal Revenue = Change in TR/ Change in Qty. sold or
Marginal Revenue= TRn – TRn-1
MR, AR, TR and Marginal Revenue = Average Revenue (E – 1/E)
Elasticity of Where E = Price elasticity of demand
Demand If E = 1, Then MR = 0
If E > 1, Then MR will be Positive
If E < 1, Then MR will be Negative
Behaviour of A firm should produce at all if Total Revenue(TR) from its product is equal to or
TR, AR & MR exceeds its Total Variable Cost (TVC) or say TR > TVC (Price > AVC).
If TR = TVC, firm's maximum loss will be equal to its Fixed Cost. As we know P x Q =
TR and AVC x Q = TVC
It will be profitable for the firm to increase output whenever MR > MC and decrease
output whenever MR < MC and the firm should continue production till
MR = MC and MC curve should cut to MR from below.
Relationship between TR, AR, MR and Price Elasticity of Demand
1.Relationship between TR, AR and MR:

Qtty Price pu TR MR
(Q) (AR=P) = Y
PxQ
1 22 22 22
2 20 40 18
3 18 54 14
4 16 64 10
5 14 70 6
6 12 72 2
7 10 70 -2
8 8 64 -6
9 6 54 -10
10 4 40 -14
Summary of Relationships:
 If TR increases, MR will be positive.

TR and MR  When TR is maximum, MR = 0.
 If TR decreases, MR will be negative.
 MR and AR both decline, but MR falls rapidly than AR.
 AR Curve is flatter than MR.
MR and AR  MR can be zero and even negative, while AR will never cross below the X axis.
 At the point where MR = 0, Elasticity of Demand on AR Curve will be 1.
6.11
E qui libr ium Poi nt o f t he Fi rm
1. It will be profitable for the Firm to expand its output

Y
whenever Marginal Revenue (MR) is greater than
Marginal Cost (MC), and to keep on increasing 1. MC = MR
output until MR = MC. 2. MC cuts MR
"C iCL) from below.
If any unit of production adds more to Revenue
C
2.
than to Cost, production and sale of that unit will CC >
D
increase profits. Similarly, if it adds more to Cost 0 4)

than to Revenue, it will decrease profits. U
3. Profits will be maximum at the point where

Additional Revenue (MR) from a unit equals its Note: For achieving Equilibrium Position, the
Additional Cost (MC). So, MC = MR. conditions to be satisfied are —
4. Further, the MC Curve should cut the MR  MC = MR, and

Curve from below (and not from above). This is so  MC Curve should cut MR Curve from below, i.e.
MC should have +ve slope.
because, upto this point MR > MC, hence there is an incentive for further production. Beyond
this point, MC > MR.
5. This position (i.e. where MC = MR, and MC cuts MR from below) is called Equilibrium position
for the Firm.
6. Merely being in Equilibrium position does not mean that the Firm is making profits.
The actual position of profits can be known only on the basis of AR and AC Curves.
6.12
Meaning and Types of Market
Market basics
Meaning:
1) Market is a place where Buyers and Sellers meet and bargain over a commodity for a price.
2) Also, market can be defined simply as all those buyers and sellers of a good or service who
influence price.
Elements of a Market: The elements of a Market are —
1) Buyers and Sellers,
2) Product or Service,
3) Bargaining for a Price,
4) Knowledge about market conditions, and
5) One Price for a Product or Service at a given time.
Classification of Market
In Economics, generally the classification of markets is made on the basis of
Area Time Nature of Regulation Volume of Types of

Transaction Business Competition
Local market Very Short Spot Market Regulated Wholesale Perfectly
period Market market competitive
Regional Market Short period Future Unregulated Retail Imperfectly

Market Market Market Competitive
National Market Long Period
International Very long/

Market Secular
Types of Market
The Market Structures analysed in Economics are --
1) Perfect Competition: Many Sellers selling identical products to many Buyers.
2) Monopoly: Single Seller producing differentiated products for many Buyers.
3) Monopolistic Competition: Many Sellers offering differentiated products to many Buyers.
4) Oligopoly: A Few Sellers selling competing products to many Buyers.
5) Duopoly: Duopoly is a market situation in which there are only two Firms in the market. It is
a sub—set of Oligopoly,
6) Monopsony: Monopsony is a market characterized by a Single Buyer of a product or service.
It is mostly applicable to Factor Markets in which a Single Firm is the only Buyer of a Factor.
7) Oligopsony: Oligopsony is a market characterized by a small number of large buyers. It is
also mostly relevant to Factor Markets.
8) Bilateral Monopoly: It is a market structure in which there is only a Single Buyer and a
© CA. Aditya Sharma Page 7.1

Single Seller. Thus, it is a combination of Monopoly Market and a Monopsony Market.

Summary of Different Market
Perfect Monopolistic
Aspect Monopoly Oligopoly
Competition Competition
Number of
Many Only One Many A Few
Sellers
Homogeneous / Highly Slightly Nature of
Nature of Identical differentiated / differentiated / Differentiation
Product Product. No specialized specialized varies.
differentiation. product. product.
Ease of Entry / Free Entry / Free Entry /
Only One Seller. Only Few Sellers.
Exit Exit. Exit.
Each Firm is a
Absolute. [Firm =
Price—
Control over Nil [Firm = Price Price Maker.]
Maker for its Reasonable.
Price Taker]
own
product.
Price Elasticity Different Elasticity
of Infinity. Less Elastic. More Elastic. at
Demand Different Levels
Foodgrains, Railways, Cars, Soaps, Pharmaa, Cold
Examples Vegetables, etc. Electricity Toothpaste, etc. Drinks, etc.
Supply.
Horizontal Negatively Negatively
Demand Curve Kinked Curve.
Line. Sloped Sloped.
Profit in Long— Normal Profits Super—Normal Normal Profits —
Run Only. Profits Only.
can also be
earned.
Optimality in Each Firm is an Can operate at Idle Capacity. —
Long— Optimal Firm. sub— Not an
Run optimal level Optimal Firm.
also.

Perfect Competition
Features of Perfect Competition
Aspect Explanation
 There are a large number of Buyers & Sellers who compete among
Large No of themselves.
Buyers & Sellers  No individual Buyer or Seller will be in a position to influence the
demand or supply in the market.
Homogeneous  Homogeneous = Similar or Identical in nature.
Products  Goods produced by different firms are identical in nature.
Free Entry /  Every Firm is free to enter the market or to go out of it, at any point of
Exit time.
 There is a perfect knowledge, on the part of Buyers and Sellers, of the
Perfect
quantities of stock of goods in the market, market conditions, and the
Knowledge
prices.
 There are adequate facilities for the movement of goods from one
Transportation
center to another.
 The commodity or the goods are dealt on at a uniform price
Uniform Market throughout the market at a given point of time.
Price  All Firms individually are Price Takers. They have to accept the price
determined by the market forces of Demand and Supply.
 Buyers have no preference as between different Sellers (since product
Indifference /
is homogeneous), and as between different units of commodity offered
Lack of
for sale.
Preference
 Sellers are indifferent as to whom they sell (since price is uniform).
Mobility of
 There is perfect mobility of factors of production.
Factors of
Why?_________________________
Production
How Demand Curve is determined
1. Uniform Market Price- In Perfect Competition, no individual Buyer or Seller will be in a

position to influence the demand or supply in the market.
2. Price Taker- All Firms individually are Price Takers. They have to accept the price
determined by the market forces of Demand and Supply.
3. Same Price- All output can be sold at the same price only. Price Elasticity of Demand is
infinity.
4. If any Seller tries to increase his price above the Market Price, (i.e. price charged by Other
Firms), he would lose his customers. Also, no Seller would try to sell his product below the
Market Price since there is no incentive for lowering the price (by way of additional quantity
sold).
5. Hence, the Equilibrium Price determined by Market Demand and Supply forces, constitutes
the Demand Curve for the Firm. This Price is also the Average Revenue (AR) and Marginal
Revenue (MR) for the Firm, since the price is uniform in the market. So, in Perfect
Competition, D = AR = MR = Price.

Quick Recap
Draw MC curve
Draw demand/Average
Revenue/ Marginal revenue
curve
Draw Average cost curve
Draw short run equilibrium

price curve in Market
Short Run price determination, Optimum output and profit Determination

For achieving Equilibrium, the conditions to be satisfied are —
1. MC = MR, and
2. MC Curve should cut MR Curve from below, i.e. MC should have positive slope.

In Perfect Competition, the short—run equilibrium of the Market and Firm is represented below
—
1. For the Firm, the Equilibrium is 0Q2 units of output at Price P, since it satisfies both the
conditions given above.
2. 0Q1 units cannot be considered as Equilibrium position since the 2nd condition (MC
cutting MR from below) is not satisfied. [Note: As output increases from OQi to OQ2, MR >
MC, and there is scope for earning more profits. Only beyond 0Q 2, MC > MR, which should
be avoided.]
3. Merely being in Equilibrium position does not mean that the Firm is making profits.
The actual position of profits can be known only on the basis of AR and AC Curves.
4. In the short run, a firm will attain equilibrium position and at the same time it will earn
supernormal profits, normal profits or losses depending upon its cost conditions.
In the short run a competitive depending upon its average cost conditions firm may earn the
followings.
Q2
Quantity
Super profits: When a firm earn super normal

profits its average revenue are more than its average
total cost or say AR > ATC. Super profits also called
Economic Profits, abnormal profits and super
normal profits.

Normal profits: When the firm just meets its

average total cost, it earns normal profits and this
normal profit is included in average total costs.
Normal profit is normal rate of return on capital and
the remuneration for the risk bearing function of
the entrepreneur. Here AR = ATC. It is also called
B.E.P (Break-even-Point) means No Loss No Profit. It
is called Marginal Firm.
Losses: A firm in the short run may incur losses if

AR < ATC. When a firm is incurring losses then firm
n will try to minimize its losses and to minimize
losses firm will cover total variable costs, then
losses may be equal to or part of fixed costs. If firm
is unable to meet its variable cost, it will be better
for it to shut down.
Shut Down point: In the diagram givenhere,

the Firm will be in equilibrium at OQ units and
Price OP. But, at that level, AR < AVC, as depicted
by the shaded area. Hence, the Firm will refuse to
produce output at that level, since even Variable
Costs are not recovered. This constitutes the
Shut—Down Point for the Firm.
Note: A Firm will shut down, if AR < AVC, at a
point where MC = MR (MC cutting from below).
Long – run Equilibrium of a firm under Perfect Competition.
In the Long run the firms will be earning just NORMAL PROFITS, which are included in the AC,
due to -Free entry and exit of firms. To earn normal Profits, LAR should be equal to LAC or say
LAR = LAC

In the above figure industry has decided the price 'P' and firm has taken over the same price at
the same time firm is earning just normal profits because at E 1 point LMR = LMC = LAR =
LAC.
In the long run, following conditions are satisfied:
 The output is produced at the minimum feasible cost or minimum LAC
 Consumers pay the minimum possible price.
 Full utilization of plants is possible, MC = AC
 There is no wastage of resources. optimal allocation
 Firms earn only normal profits i.e. AC = AR.
 Firms maximize profits i.e. MC = MR, but level of profits will be normal.
 In the long run LMC = LMR = P = LAR = LAC = SMC = SAC
 When LAC falls LAC> LMC and when LAC raises LMC > LAC
Long Run Equilibrium in the Industry

The Industry is said to have attained long—run equilibrium when —
1. All the Firms are earning normal profits only, i.e. all the Firms are in long—run equilibrium,
and
2. There is no further entry or exit of Firms to / from the market.
Question 1: What can be the profit/ loss condition in long run in Perfect competition?
Answer:___________________________________________________________________________________
Question 2: Why not Super- Normal profit?

Answer- New Firms will be attracted and enter the industry. So, there will be increase in Supply,
causing a reduction in the Market Price. Further, there will be an upward shift of Cost Curves
due to the increase in prices of factors of production, as the industry expands. These changes will
continue until the LAC is tangent to the Demand Curve.
Question 3: Why Not Losses?

Answer- If existing Firms make losses, they will leave the industry in the long—run. So, there
will be reduction in supply, leading to increase in Market Price. Also, Cost Curves may fall as
the industry contracts, until the remaining Firms in the industry cover their total costs,
inclusive of the normal rate of profit.

Identification of the Supply Curve of a Perfect Competition Firm
MC curve of the firm is the firm's supply curve. In perfect competition firm, MC curve above
AVC is considered the supply curve of the firm, because when P <AVC then firm will not
supply any output and actually shutdown.
In the above figure

 D I, D2, D3 and D4 are different demand curves.
 On each demand curve AR=MR=PRICE. PI, P2, P3 and P4 are different price levels on
which QI, Q2, Q3 and Q4 is the equilibrium quantities supply, because at all points,
MC = MR.
 For Prices below AVC, the firm will supply zero units because here the firm is unable to
meet even its variable cost, and when price is PI it is equal to AVC and at the same
time firm incurring losses equal to fixed costs. It is also called shut down point and
here P = AVC.
 In perfect competition the firm's marginal cost curve above AVC has the identical shape
of firm’s supply curve.
Monopoly
Aspect Explanation
a) The word 'Monopoly' means "alone to sell". In a Monopoly, there is only
one Seller.
Single Seller b) If one Producer can produce a product which has no substitutes and
exclude competition, such that he controls the supply of that product, he
will be a 'Monopolist'.
Firm = a) Under Monopoly, the distinction between Firm and Industry disappears,
Industry since there is only one Seller, and he constitutes the entire Industry.
a) In a monopolistic market, there are strong barriers to entry of new Firms.
Entry b) Barriers to entry could be — (i) economic, (ii) institutional, (iii) legal, or
Restrictions (iv) artificial.
a) A Monopolist sells a product which has no close substitute.

No
b) The Cross Elasticity of Demand for the Monopolist's Product and any
substitutes
other product is zero or very small.

Elasticity of a) Price Elasticity of Demand for Monopolist's Product is less than one.
demand b) The Monopolist faces a downward—sloping Demand Curve.
Why Monopoly exists?

Monopoly is caused by "barrier to entry", i.e. other Firms cannot enter the market. Some reasons
for occurrence and continuation of Monopoly are -
1. Strategic Control over scarce resources, inputs or technology by a Single Firm, thereby
limiting the access of other Firms to these resources.
2. Developing or acquiring control over a unique product that is difficult or costly for other
Companies to copy.
3. Patents and Copyrights given by Government to protect Intellectual Property Rights and to
encourage innovation.
4. Governments granting exclusive rights to produce and sell a good or a service.
5. Substantial Goodwill enjoyed by a Firm for a considerably long period, which create difficult
barriers to entry.
6. Natural Monopoly due to very large economies of scale - Suppose, a Single Firm is able to
produce the industry's whole output at a lower unit cost than two or more Firms could. In
such case, it is often wasteful (for Consumers and the economy) to have more than one such
Supplier because of the high costs of duplicating the infrastructure, e.g. Telephone Service,
Natural Gas Supply, Electrical Power Distribution, etc.
7. Stringent Legal and Regulatory Requirements that effectively discourage entry of New Firms
without being specifically prohibited.
8. Very high initial start—up costs even to enter the market in a modest way and requirement
of extraordinarily costly and sophisticated technical know—how, may discourage new Firms
from entering the market.
9. Use of Anti—Competitive Practices or Predatory Tactics, (e.g. Limit Pricing or Predatory
Pricing) intended to do away with existing or potential competition.
10. Business Combinations or Cartels (Note: This is illegal in most countries) where former
Competitors co—operate on pricing or market share.
Note:
In the practical world, Monopolies are either regulated or fully prohibited. Hence, Pure
Monopolies are not common.
However, a single Producer may dominate the supply of a good or group of goods. In Public
Utilities, e.g. Transport, Water, Electricity Generation, etc. Monopolistic Markets existed earlier in
India, so as to reap the benefits of large scale production. But these markets have now been
deregulated and opened to competition. In India, Indian Railways has monopoly in Rail
Transportation. Government has monopoly in Nuclear Power production.
Effects of Monopoly-
Some negative effects of Monopolies are as under —
1. Higher Prices for Consumers,
2. Loss of Consumer Surplus,
3. Inability of Consumers to substitute the goods or services, with a more reasonably priced
alternative,
4. Transfer of Income from Consumers to Monopolists,
5. Restriction of Consumer Sovereignty and reduction in opportunities for Consumers to

consume goods they desire,

6. Payment of lower prices by Monopolies to their Suppliers (of goods and services), i.e. lower
Factor Payments,
7. Lower levels of Output, that what would be produced in a competitive environment,
8. Ability of Monopolist to influence political process and thereby obtain a favourable
legislation,
9. Lack of Innovation,
10. Higher Costs of Output, the burden of which will be shifted to Consumers
11. Lack of Productive and Allocative Efficiency,
12. Possibility of misuse of scarce resources,
13. Earning of Economic Profits (above Normal Profits) in the long run, which is unjustifiable,
14. Use of Monopoly Power to create barriers to entry by undue means,
15. Scope for X—Inefficiency, i.e. the difference between efficient behaviour of businesses
assumed or implied by economic theory and their observed behavior in practice caused by a
lack of competitive pressure, etc.
Is monopolist a Price Maker or Price taker?
1. In Perfect Competition, Firms are Price—Takers, i.e. they take the price determined by market
forces, and determine only their optimum output.
2. However, a Monopolist has to determine Output and also the Price for his product.
3. Since Price and Demand Quantity are inversely related, the Monopolist has to carefully try to
attain the equilibrium level of output, at which his profits are maximum.
4. Based on the equilibrium level of output, the Price will be determined by the Monopolist.
Thus, a Monopolist is a Price—Maker, not a Price—Taker.
Determination of Demand/ Revenue curve
1) Demand Curve of a Monopolist Firm is the same as

Market Demand Curve for the product. (Since Firm =
Industry).
2) Market Demand Curve indicates the quantity that
the Buyers will be ready to buy at various prices, and is
negatively sloped, i.e. falls from left to right.
3) Hence, Market Demand Curve = Firm's Demand
Curve = Average Revenue (AR).
4) If the Monopolist sets a single price and supplies to all
Buyers who wish to purchase at that price, then his
Average Revenue and Marginal Revenue Curves will be as
depicted here.
5) Relationship between AR & MR under Monopoly:
a) Both AR and MR are negatively sloped (downward sloping) curves.
b) MR Curve lies half—way between the AR Curve and the Y—axis, i.e. it cuts the
horizontal line between Y axis and AR into two equal parts.
c) AR cannot be zero, but MR can be zero or even negative.

Short Run price determination, Optimum output and profit Determination
For achieving Equilibrium, the conditions to be satisfied are —

1. MC = MR, and
2. MC Curve should cut MR Curve from below, i.e. MC should have positive slope.
1. Diagram: From the Diagram, Equilibrium Level is 0

the point where MC Curve cuts MR from below, i.e.
when output = OQ units. Hence, the Monopolist will
produce OQ units and sell them at Price OP.
2. Profits / Losses: At Short—Run Equilibrium Level,
The Monopolist may make — (a) Super—Normal
Profits, or (b) Normal Profits (sometimes), or (c) Losses,
which can be known based on his AC Curve.
Super profits: To earn super profits AR >ATC. In the

figure the firm's output is OQ, for OQ output MC is equal
to MR at the point E. The OQ can be sold at price OP
(AQ). In equilibrium position, by fixing its price on OP and
output OQ, the firm is making supernormal profits equal
to the area PABC.
Losses: When a monopoly firm will incur losses then AR

<ATC. If the demand conditions relative to cost conditions
are not favourable to the monopolist firm, it may earn
losses also. Figure depicts that firm is in equilibrium at
output OQ and price OP and at the same time firm's
demand curve and AR lies below the AC, so firm is
rendering losses equal to PABC.
Long – run Equilibrium of a firm under monopoly

Long run Equilibrium: Super profit (LAR > LAC):
 Monopoly firm in the long run gets abnormal

profits. It is so because the new firms are not
allowed to enter the market. To earn super profit
LAR > LAC.
 In figure, firm's equilibrium is attained at point E
where the firm's LMC intersects MR. At
equilibrium price OP, the firm produces OQ
output. Since at the output level OQ firm's AR is
more than its LAC, it gets profit AB per unit, total
profit being equal to the shaded is PABC.
 Under long-run a monopoly firm can produce at
optimal or sub-optimal level. In other words it can
produce at minimum LAC curve and also he can
produce before or after the minimum LAC curve.
Price Discrimination
1. Meaning:
a) Price Discrimination occurs when a Producer sells a commodity to different Buyers, at
different prices, for reasons not related to differences in cost.
b) Price Discrimination is possible under Monopoly, where the Seller can influence the price of
the product. [Note: Price Discrimination is not possible under Perfect Competition, since
each Firm has no influence over market price.]
2. Objectives:
a) To earn Maximum Profit
b) To Dispose of Surplus stock
c) To enjoy Economies of Scale
d) To capture foreign markets
e) To secure equity thorough pricing.
3. Examples:
a) Doctors may charge more from a rich patient than from a poor patient, for the same
treatment.
b) Electricity Rates for home consumption in rural areas are less than that for industrial
use.
c) Export Prices of Products are cheaper than the domestic market selling price.
d) Railways charge different rates from different type of passengers e.g. AC, Non—AC, Tatkal,
etc.
4. Conditions for Price discrimination
a) Full control over supply: Price discrimination is applicable only in monopoly situation use
there is full control over the supply, where there are no rivals firms. It is not possible in
perfectly competitive market where a large number of sellers are selling a homogeneous
product.
b) Division of market into two or more sub-markets: The buyers or markets must be
arable. A seller can practice price discrimination only when he is able to divide the markets
into two or more sub-markets.
c) Different price elasticity under different markets: The monopolist can discriminate the
prices only if the price elasticities in the two markets are different. This is because,
monopolist charge higher price from that market whose price elasticity is less than one and

can charge lower price from that market whose price elasticity is greater than one.
d) No possibility to resale: It should not be possible for the buyers of low-priced market to
resell the product to the buyers of the high priced market
Process of price discrimination
1. MR at Same Price: Assume that a Monopolist charges a single price of 30 for his product,
and sells them in two markets A and B, with elasticities of demand 2 and 5 respectively.
Since MR = AR x e-1/e
MR for Market A will be 30 x (2-1)/2 = 15.
MR for Market B will be 30 x (5-1)/5 = 24.
2. Impact of different MR: From the above, the following observations can be made —
a) At the same price, MR in the two markets are different, due to difference in elasticities of
demand.
b) MR is more in Market B where elasticity is high.
3. Output transfer by Monopolist:
a) If MR is higher in Market B (with high elasticity), the Monopolist will earn more profit by
transferring some quantity of the product from Market A to Market B.
b) For every unit of product transferred so, the Monopolist will gain 24 — 15 = 9
4. Effect of Output Transfer: When output quantity is transferred from A to B, the price in
Market A will increase (due to lower supply) and price will decrease in Market B (due to higher
supply). This means that the Monopolist is now discriminating between Markets A and B.
5. Point of Equality: The Monopolist will reach a point, when the MR in both markets become
equal as a result of some transfer of output. Then, it will not be profitable anymore to shift
more output from Market A to Market B.
6. Differing Prices: When this point of equality is reached, the Monopolist will be charging
different prices in the two markets — a higher price in Market A with lower elasticity of
demand, and a lower price in Market B with higher elasticity of demand. This practice of
charging different prices to different segments is known as Price Discrimination.
Monopolistic Competition
Meaning Imperfect competition is found in the industry where there are a large numbers
of small sellers, selling differentiated but close substitutes products. E.g. LUX,
HAMAM, LIRIL etc. This market contains features of both competitive and
monopoly markets.
Features  Large number of sellers and buyers
 There is free entry and exit of firms. It implies that in the long run firm will
earn only normal profits.
 Product differentiation: Each firm produces a different brand or variety of
the same product. The varieties produced are very close substitutes of one
another. Products like toothpaste, soap.


Features  Non price competition: - In these types of market sellers try to compete on
basis other than price, and it is called non-price competition. They incur
advertising costs. It is because of the need to maintain a perception in the
mind of the potential consumers that their respective brands are different
compared to other brands.
 Every firm is price maker and price taker of his own product: In
monopolistic competition product are different of every firm and so costs of
product are also different. Thus every firm is price maker and price taker of
his product.
 Imperfect mobility: Here factors of production are completely not mobile.
Buyers have own preference and sellers have own preference.
 AR and MR: In monopolistic competition AR will be greater than MR but
AR/demand curve AR/MR will be more elastic than monopoly market.
PRICE-OUTPUT DETERMINATION (EQUIBRIUM OF A FIRM)

The equilibrium price and output of a monopolistically competitive firm is determined at the
point where
 MC = MR and
 MC cuts to MR from below point .
Short Run Equilibrium

Super profits- To earn super profits AR >ATC. In the
figure given below, firm is earning supernormal
profits because AR > AC or say AQ > BQ at the
equilibrium output OQ. A super normal profit is equal
to the area PABC.
Losses: But if the AR < AC then firm will incur losses.

In the figure given below the firm is in equilibrium at
output OQ and setting price is OP (or AQ) and it is
rendering losses equal to area PABC. Further, a firm
may be making only normal profits even in the short
run if demand curve happens to be tangent to the
average cost curve or say AR = AC.
Long Run Equilibrium

Normal profit (LAR = LAC/ TAC)

The final equilibrium in the long run will take place at
that level of output and price at which MC = MR. The
firm, in the long-run will earn normal profits, because
there is free entry and exit of firms. This will continue
until AR curve becomes tangent to the AC curve and
abnormal profits are wiped out.
MC = MR at the point E and output is OQ 1, where AR
= AC at point A. Here the firm will be making only
normal profits.
The AR curve in the long-run is not tangent to the
ATC curve at the lowest point. This shows each firm
produces at before the lowest TAC/LAC or produces
less than the optimum output and Charges from the
customers a price higher than the competitive price.
A firm under monopolistic petition has always excess
capacity but perfect competition never has excess
capacity and monopoly mayor may not be
OLIGOPOLY MARKET
Meaning An oligopoly is a market in which there are few producers of a product.

Oligopoly is an important form of imperfect competition.
In other words, when there are few (two to ten) sellers in a market selling
homogeneous or differentiated but close substitutes products, oligopoly is said
to exist. Consider the example of cold drinks industry or automobile industry.
Types of  Pure / Perfect oligopoly - deals in homogeneous products- Aluminum

Oligopoly industry Differentiated / imperfect oligopoly - deals in product
differentiated.
 Open oligopoly - New firms can enter the market and compete with
existing firms Closed oligopoly - new entry is restricted.
 Collusive oligopoly - common understanding or collusion in fixing price
and output Competitive oligopoly - Lack of understanding and compete
with each other.
 Partial oligopoly - when industry is dominated by one large firm i.e. price
leader Full oligopoly - absences of price leadership.
 Syndicated oligopoly - Firms sells their products through centralized
syndicate/channel
 Organized oligopoly -: Firms organize into a central association for fixing
price, output etc…

Features  Few sellers

 Interdependence: In oligopoly, when the number of competitors is few,
any change in price, output, and advertising technique, by a firm will have
a direct effect on the fortune of the rivals, who will then retaliate by
changing their own prices, outputs or advertising techniques the case may
be. So, oligopoly firm must consider the market demand and the reactions
of the firms in the industry to any major decision it takes.
 Advertising and selling costs (Non price competition): There is a great
importance advertising and selling costs in an oligopoly market. It is to be
noted that firms in such type market should avoid price cutting and try to
compete on non-price basis (advertisement bas because if they start
under-cutting one another a type of price-war will emerge which will drive
few of them out of the market as customers will try to buy from the seller
selling at the cheap price.
 There is no generally accepted theory of group behaviour. In oligopoly,
the members of a group agree to pull together in promotion of common
interest or they fight to promote their individual interests. Each oligopolist
closely watches the business behaviour of the other oligopolists in the
industry and then designs his moves on the basis of some assumptions of
how they behave or are likely to behave.
 Kinked demand curve / Indeterminateness of demand curve: Because
interdependence of the firms in oligopoly and because of inability of a
particular firm to pre the behaviour of other firms, the demand curve
facing an oligopolistic firm loses its definite and determinateness.
The demand curve facing an oligopolist may have a 'kink' at the level of the
prevailing suggesting stickiness in the price level. The kink is formed at the
prevailing price level at because the segment of the demand curve above the 'K'
is highly elastic and the below the 'K' is inelastic.
This difference in elasticities is due to the particular competitive reaction

pattern. Oligopolist believes that if it lowers their price below 'K', his
competitors will follow him and accordingly lower their prices, whereas if he
raises the price above the 'K', his competitors not follow his increase in price.
 Price rigidity: Price rigidity is found in the oligopolist market because
when an oligopolist lowers the price its competitors will feel that, if they
do not follow the price cut their customers will run away and buy from
the firm, which has lowered the price.
Thus in order to maintain their customers they will also lower their prices.

Thus the upper portion of the demand curve is price elastic.
On the other hand, if a firm increases the price of its product there will be
a substantial reduction in its sales because as a result of the rise in its
price, its customers will withdraw from it and go to its competitors, which
will welcome the customers and will gain in sales. These happy competitors
will have, therefore, no motivation to match the price rise.
The oligopolist who raises price will lose a great deal and will, therefore,
refrain from increasing price. This behaviour of oligopolists explains the
inelastic lower portion of the demand curve.
Each oligopolist will, thus, adhere to the prevailing price seeing no gain in
changing it and a will be formed at the prevailing price i. e. OP = KQ.
 Substantial barriers to entry: In oligopoly there is no free entry and no
blocked entry, we can say that there is substantial barriers to the entry.
Self Notes

Business Cycle
Meaning, Phases of Business cycle
Fluctuations in aggregate economic activity that an

economy experiences over a period of time, i.e.
periods of prosperity alternating with periods of
economic downturns, are called Business Cycles or
Trade Cycles.
Business Cycles refer to alternate expansion and

contraction of overall business activity as reflected in
fluctuations in measures of aggregate economic
activity, like Gross National Product, Employment
and Income.
Phases: The four distinct phases of the Business

Cycle are-
a) Expansion / Boom / Upswing),
b) Peak / Prosperity,
c) Contraction / Downswing / Recession), and
d) Trough / Depression).
A Trade Cycle is composed of periods of

a) Good trade characterised by rising prices and low unemployment levels.
b) Bad trade characterized by falling prices and high unemployment levels.
Features of Business cycle
a) Business cycles occur periodically although they do not exhibit the same regularity.
b) The duration of these cycles vary. The intensity of fluctuations also varies.
c) Business cycles have distinct phases of expansion, peak, contraction and trough. These phases
seldom display smoothness and regularity. The length of each phase is also not definite.
d) Business cycles generally originate in free market economies*****.
e) They are pervasive as well. Disturbances in one or more sectors get easily transmitted to all other
sectors.
f) Although all sectors are adversely affected by business cycles, some sectors such as capital
goods industries, durable consumer goods industry etc, are disproportionately affected. Moreover,
compared to agricultural sector, the industrials sector is more prone to the adverse effects of trade
cycles.
g) Business cycles are exceedingly complex phenomena; they do not have uniform characteristics
and causes. They are caused by varying factors.
h) It is difficult to make an accurate prediction of trade cycles before their occurrence.
i) Repercussions of business cycles get simultaneously felt on nearly all economic variables viz.
output, employment, investment, consumption, interest, trade and price levels.
j) Business cycles are contagious and are international in character. They begin in one country and
mostly spread to other countries through trade relations.
k) Business cycles have serious consequences on the well-being of the society.
© Aditya Sharma Page 8.1

Business Cycle
Phases of Business cycle
Expansion:
1. The expansion phase is characterised by increase in national output, employment, aggregate
demand, capital and consumer expenditure, sales, profits, rising stock prices and bank credit.
2. This state continues till there is full employment of resources and production is at its maximum
possible level using the available productive resources.
3. Involuntary unemployment is almost zero and whatever unemployment is there is either frictional
(i.e. due to change of jobs, or suspended work due to strikes or due to imperfect mobility of labour)
or structural (i.e. unemployment caused due to structural changes in the economy).
4. Prices and costs also tend to rise faster. Good amounts of net investment occur.
5. Demand for all types of goods and services rises.
6. There is altogether increasing prosperity and people enjoy high standard of living due to high levels of
consumer spending, business confidence, production, factor incomes, profits and investment.
7. The growth rate eventually slows down and reaches its peak.
Peak:
1. The term peak refers to the top or the highest point of the business cycle.
2. In the later stages of expansion, inputs are difficult to find as they are short of their demand and
therefore input prices increase.
3. Output prices also rise rapidly leading to increased cost of living and greater strain on fixed income
earners.
4. Consumers begin to review their consumption expenditure on housing, durable goods etc.
5. Actual demand stagnates.
6. This is the end of expansion and it occurs when economic growth has reached a point where it will
stabilize for a short time and then move in the reverse direction.
Contraction:
1. The economy cannot continue to grow endlessly.
2. As mentioned above, once peak is reached, increase in demand is halted and starts decreasing in
certain sectors. During contraction, there is fall in the levels of investment and employment.
3. Producers do not instantaneously recognise the pulse of the economy and continue anticipating
higher levels of demand, and therefore, maintain their existing levels of investment and
production. The consequence is a discrepancy or mismatch between demand and supply. Supply
far exceeds demand. Initially, this happens only in few sectors and at a slow pace, but rapidly
spreads to all sectors.
4. Producers being aware of the fact that they have indulged in excessive investment and over
production, respond by holding back future investment plans, cancellation and stoppage of
orders for equipments and all types of inputs including labour. This in turn generates a chain of
reactions in the input markets and producers of capital goods and raw materials in turn respond by
cancelling and curtailing their orders. This is the turning point and the beginning of recession.
5. Decrease in input demand pulls input prices down; incomes of wage and interest earners

Business Cycle
gradually decline resulting in decreased demand for goods and services.

6. Producers lower their prices in order to dispose off their inventories and for meeting their financial
obligations.
7. Consumers, in their turn, expect further decreases in prices and postpone their purchases. With
reduced consumer spending, aggregate demand falls, generally causing fall in prices. The
discrepancy between demand and supply gets widened further. This process gathers speed and
recession becomes severe.
8. Investments start declining; production and employment decline resulting in further decline in
incomes, demand and consumption of both capital goods and consumer goods. Business firms
become pessimistic about the future state of the economy and there is a fall in profit expectations
which induces them to reduce investments. Bank credit shrinks as borrowings for investment
declines, investor confidence is at its lowest, stock prices fall and unemployment increases despite fall
in wage rates.
9. The process of recession is complete and the severe contraction in the economic activities pushes the
economy into the phase of depression.
Trough and Depression:

1. Depression is the severe form of recession and is characterized by extremely sluggish economic
activities.
2. During this phase of the business cycle, growth rate becomes negative and the level of national
income and expenditure declines rapidly.
3. Demand for products and services decreases, prices are at their lowest and decline rapidly forcing
firms to shutdown several production facilities.
4. Since companies are unable to sustain their work force, there is mounting unemployment which
leaves the consumers with very little disposable income.
5. A typical feature of depression is the fall in the interest rate. With lower rate of interest, people’s demand
for holding liquid money (i.e. in cash) increases. Despite lower interest rates, the demand for credit
declines because investors' confidence has fallen. Often, it also happens that the availability of
credit also falls due to possible banking or financial crisis.
6. Industries, especially capital and consumer durable goods industry, suffer from excess capacity.
7. Large number of bankruptcies and liquidation significantly reduce the magnitude of trade and
commerce.
8. At the depth of depression, all economic activities touch the bottom and the phase of trough is
reached. It is a very agonizing period causing lots of distress for all.
Activity: Write about the business cycle and its phases in your own words
Question: How does the economy recover?
1. The economy cannot continue to contract endlessly. It reaches the lowest level of economic activity
called Trough and then starts recovering.
2. Trough lasts for some time and marks the end of pessimism and the beginning of optimism. This
reverses the process.

Business Cycle
3. The process of reversal is first felt in the Labour Market. Pervasive Unemployment forces the workers
to accept wages lower than the prevailing rates. Producers
anticipate lower costs and better business environment.
4. Business Confidence slowly increases, consequently Firms start
to invest again and to build stocks.
5. Technological Advancements require fresh investments into new
types of Machines and Capital Goods. The spurring of investment
causes recovery of the economy. This acts as a Turning Point
from Depression to Expansion.
6. Banking System now slowly starts expanding credit, matching
with the business confidence.
7. As Investment rises, there is increase in Production, Employment,
Factor Payments, Disposable Incomes, Consumer Spending,
Aggregate Demand, etc. To meet the Aggregate Demand, more
goods and services are produced. Employment of Labour increases,
unemployment falls and expansion takes place in the economic
activity.
Example of business Cycle
Great Depression of 1930:

The world economy suffered the longest, deepest, and the most widespread depression of the
20th century during 1930s. It started in the US and became worldwide. The global GDP fell by
around 15% between 1929 and 1932. Production, employment and income fell. As far as the
causes of Great Depression are concerned, there is difference of opinion amongst economists.
While British economist John Maynard Keynes regarded lower aggregate expenditures in the
economy to be the cause of massive decline in income
and employment, monetarists opined that the Great
Depression was caused by the banking crisis and low
money supply. Many other economists blamed
deflation, over- indebtedness, lower profits and
pessimism to be the main causes of Great Depression.
Whatever may be the cause of the depression, it caused
wide spread distress in the world as production,
employment, income and expenditure fell. The
economies of the world began recovering in 1933.
Increased money supply, huge international inflow of
gold, increased governments’ spending due to World
War II etc., were some of the factors which helped
economies slowly come out of recession and enter the phase of expansion and upturn.
Information Technology bubble burst of 2000: Information Technology (IT) bubble or Dot.Com
bubble roughly covered the period 1997-2000. During this period, many new Internet–based
companies (commonly referred as dot-com companies) were started. The low interest rates in
1998–99 encouraged the start-up internet companies to borrow from the markets. Due to rapid
growth of internet and seeing vast scope in this area, venture capitalists invested huge amount

Business Cycle
in these companies. Due to over- optimism in the market, investors were less cautious. There
was a great rise in their stock prices and in general, it was noticed, that companies could cause
their stock prices to increase by simply adding an "e-" prefix to their name or a ".com" to the
end. These companies offered their services or end products for free with the expectation that
they could build enough brand awareness to charge profitable rates for their services later. As a
result, these companies saw high growth and a type of bubble developed. The "growth over
profits" mentality led some companies to engage in lavish internal spending, such as elaborate
business facilities. These companies could not sustain long. The collapse of the bubble took
place during 1999–2001. Many dot-com companies ran out of capital and were acquired or
liquidated. Nearly half of the dot –com companies were either shut down or were taken over by
other companies. Stock markets crashed and slowly the economies began feeling the downturn
in their economic activities.
Global Economic Crisis (2008-09): The recent global economic crisis owes its origin to US financial
markets. Following Information Technology bubble burst of 2000, the US economy went into recession.
In order to take the economy out of recession, the US Federal Reserve (the Central Bank of US) reduced the
rate of interest. This led to large liquidity or money supply with the banks. With lower interest rates, credit
became cheaper and the households, even with low creditworthiness, began to buy houses in
increasing numbers. Increased demand for houses led to increased prices for them. The rising prices
of housing led both households and banks to believe that prices would continue to rise. Excess liquidity
with banks and availability of new financial instruments led banks to lend without checking the
creditworthiness of borrowers. Loans were given even to sub-prime households and also to those
persons who had no income or assets. Houses were built in excess during the boom period and due to
their oversupply in the market, house prices began to decline in 2006. Housing bubble got burst in the
second half of 2007. With fall in prices of houses which were held as mortgage, the sub - prime
households started defaulting on a large scale in paying off their instalments. This caused huge losses
to the banks. Losses in banks and other financial institutions
had a chain effect and soon the whole US economy and the world
economy at large felt its impact.
Indicators
Meaning: Economists use changes in a variety of activities to

measure the Business Cycle and to predict where the
economy is headed towards. These are called Indicators.
There are three types of Indicators viz. (a) Leading Indicators,
(b) Lagging Indicators, and (c) Coincident or Concurrent
Indicators.
Leading Indicators:
It is a measurable economic factor that changes before the
economy starts to follow a particular pattern or trend.
It represents Variables that change before the Real Output changes, i.e. prior to large
economic adjustments.
Examples:
 Changes in Stock Prices, Profit Margins and Profits, Indices like Housing, Interest Rates
and Prices, etc. are generally seen as precursors of upturns or downturns.

Business Cycle
 Value of New Orders for Consumer Goods, Capital Goods, Building Permits for Private
Houses, fraction of Companies reporting slower deliveries, Index of Consumer Confidence
and Money Growth Rate are also used for tracking and forecasting changes in Business
Cycles.
Demerits:
 Leading Indicators, though widely used to predict changes in the economy, are not always
accurate.
 Experts disagree on the timing of these Leading Indicators, e.g. it may be weeks or months
after a Stock Market Crash before the economy begins to show signs of receding. Further,
it may never happen.
Lagging Indicators:
It reflects the economy's historical performance and changes in these indicators are
observable only after an economic trend or pattern has already occurred.
It represents variables that change after the Real Output changes, i.e. measures that change
after an economy has entered a period of fluctuation.
If Leading Indicators signal the onset of Business Cycles, Lagging Indicators confirm these
trends.
Examples: Unemployment, Corporate Profits, Labour Cost per unit of Output, Interest Rates,
Consumer Price Index, Commercial Lending Activity, etc.
Coincident or Concurrent Indicators:

It coincides or occurs simultaneously with the business—cycle movements.
It gives information about the rate of change of the expansion or contraction of an economy
more or less at the same point of time it happens.
It coincides fairly closely with changes in the cycle of economic activity, and describes the
current state of the Business Cycle.
Examples: Gross Domestic Product, Industrial Production, Inflation, Personal Income, Retail
Sales and Financial Market Trends like Stock Market Prices, etc.
Role/ Importance of Business cycle in Business Decision making
1. Demand Impact: Business Cycles affect all aspects of an economy. So, a proper
understanding the Business Cycle is a must for all businesses, since such Cycles affect the
demand for the Firm's products and also their Profits, Survival and Growth prospects.
2. Expansion Decisions: Business Cycles have significant influence on business decisions. A
profit—seeking Firm should consider the nature of the economic environment in making
business planning and managerial decisions, e.g. relating to expansion or down—sizing.
3. Policies: Knowledge of Business Cycles and their inherent characteristics is important for a
Business Firm to frame appropriate policies. The period of prosperity creates more
opportunities for investment, employment and production and thereby promotes business.
The period of recession or depression reduces business opportunities and profits.
4. Production Aspects: Businesses have to properly respond to the need to alter production
levels relative to demand. Different Phases of the cycle require fluctuating levels of input use.
Firms should exercise the capability to expand or rationalize production operations so as to
suit the stage of the Business Cycle. Business managers need to work effectively to arrive at
sound strategic decisions in complex times across the whole business cycle, managing
through boom, downturn, recession and recovery.
5. Market Entry / Product Launch:

Business Cycle
6. The phase of the Business Cycle is important for a new business to decide on entry into the
market, and determines the success of a new product launch.
7. Businesses are required to plan and set policies with respect to product, prices and
promotion, in tune with the stage of the Business Cycle.
8. Cyclical Businesses:
 Business Cycles do not affect all sectors uniformly. Some businesses are more vulnerable
to changes in the Business Cycle than others.
 Businesses whose fortunes are closely linked to the rate of economic growth are called
"Cyclical" Businesses. Examples: House—Builders, Construction, Infrastructure,
Restaurants, Advertising, Overseas Tour Operators, Fashion Retailers, etc.
 During a boom, such businesses see a strong demand for their products but during a
slump, they usually suffer a sharp drop in demand.
 Some Businesses may actually benefit from an economic downturn, e.g. when their
products are perceived by Customers as representing good value for money, or a cheaper
alternative compared to more expensive products.
Causes of Business Cycle
Internal causes
Fluctuations in Effective Demand: In a free market economy, where maximization of profits is the
aim of businesses, a higher level of aggregate demand will induce businessmen to produce more.
As a result, there will be more output, income and employment. However, if aggregate demand
outstrips aggregate supply, it causes inflation. As against this, if the aggregate demand is low,
there will be lesser output, income and employment. Investors sell stocks, and buy safe-haven
investments that traditionally do not lose value, such as bonds, gold and the U.S. dollar. As
companies lay off workers, consumers lose their jobs and stop buying anything but necessities.
That causes a downward spiral. The bust cycle eventually stops on its own when prices are so low
that those investors that still have cash start buying again. However, this can take a long time,
and even lead to a depression.
Fluctuations in Investment: According to some economists, fluctuations in investments are the
prime cause of business cycles. Investment spending is considered to be the most volatile
component of the aggregate demand. Investments fluctuate quite often because of changes in the
profit expectations of entrepreneurs. New inventions may cause entrepreneurs to increase
investments in projects which are cost-efficient or more profit inducing. Or investment may rise
when the rate of interest is low in the economy. Increases in investment shift the aggregate
demand to the right, leading to an economic expansion. Decreases in investment have the
opposite effect.
Variations in government spending: Fluctuations in government spending with its impact on
aggregate economic activity result in business fluctuations. Government spending, especially
during and after wars, has destabilizing effects on the economy
Macroeconomic policies: Macroeconomic policies (monetary and fiscal policies) also cause business
cycles. Expansionary policies, such as increased government spending and/or tax cuts, are the
most common method of boosting aggregate demand. This results in booms. Similarly, softening
of interest rates, often motivated by political motives, leads to inflationary effects and decline in
unemployment rates. Anti- inflationary measures, such as reduction in government spending,
increase in taxes and interest rates cause a downward pressure on the aggregate demand and the

Business Cycle
economy slows down. At times, such slowdowns may be drastic, showing negative growth rates
and may ultimately end up in recession.
Money Supply: According to Hawtrey, trade cycle is a purely monetary phenomenon. Unplanned
changes in supply of money may cause business fluctuation in an economy. An increase in the
supply of money causes expansion in aggregate demand and in economic activities. However,
excessive increase of credit and money also set off inflation in the economy. Capital is easily
available, and therefore consumers and businesses alike can borrow at low rates. This stimulates
more demand, creating a virtuous circle of prosperity. On the other hand, decrease in the supply
of money may reverse the process and initiate recession in the economy.
Psychological factors: According to Pigou, modern business activities are based on the
anticipations of business community and are affected by waves of optimism or pessimism.
Business fluctuations are the outcome of these psychological states of mind of businessmen. If
entrepreneurs are optimistic about future market conditions, they make investments, and as a
result, the expansionary phase may begin. The opposite happens when entrepreneurs are
pessimistic about future market conditions. Investors tend to restrict their investments. With
reduced investments, employment, income and consumption also take a downturn and the
economy faces contraction in economic activities.
According to Schumpeter’s innovation theory, trade cycles occur as a result of innovations which
take place in the system from time to time. The cobweb theory propounded by Nicholas Kaldor
holds that business cycles result from the fact that present prices substantially influence the
production at some future date. The present fluctuations in prices may become responsible for
fluctuations in output and employment at some subsequent period.
External Causes: The External causes or exogenous factors which may lead to boom or bust:
Wars: During war times, production of war goods, like weapons and arms etc., increases and
most of the resources of the country are diverted for their production. This affects the production
of other goods - capital and consumer goods. Fall in production causes fall in income, profits and
employment. This creates contraction in economic activity and may trigger downturn in business
cycle.
Post War Reconstruction: After war, the country begins to reconstruct itself. Houses, roads, bridges
etc. are built and economic activity begins to pick up. All these activities push up effective
demand due to which output, employment and income go up.
Technology shocks: Growing technology enables production of new and better products and
services. These products generally require huge investments for new technology adoption. This
leads to expansion of employment, income and profits etc. and give a boost to the economy. For
example, due to the advent of mobile phones, the telecom industry underwent a boom and there
was expansion of production, employment, income and profits.
Natural Factors: Weather cycles cause fluctuations in agricultural output which in turn cause
instability in the economies, especially those economies which are mainly agrarian. In the years
when there are draughts or excessive floods, agricultural output is badly affected. With reduced
agricultural output, incomes of farmers fall and therefore they reduce their demand for industrial
goods. Reduced production of food products also pushes up their prices and thus reduces the
income available for buying industrial goods. Reduced demand for industrial products may cause

Business Cycle
industrial recession.
Population Growth: If the growth rate of population is higher than the rate of economic growth,
there will be lesser savings in the economy. Fewer saving will reduce investment and as a result,
income and employment will also be less. With lesser employment and income, the effective
demand will be less, and overall, there will be slowdown in economic activities.
Economies of nearly all nations are interconnected through trade. Therefore, depending on the
amount of bilateral trade, business fluctuations that occur in one part of the world get easily
transmitted to other parts. Changes in laws related to taxes, trade regulations, government
expenditure, transfer of capital and production to other countries, shifts in tastes and preferences
of consumers are also potential sources of disruption in the economy.

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INDEX

SR Name Page Note

2 Utility Analysis and 2.1- 2.10

3 Demand Analysis 3.1- 3.16

4 Supply Analysis 4.1- 4.7

5 Production Concepts 5.1- 5.19

6 Cost and Revenue 6.1- 6.13

7 Market Forms and 7.1- 7.17

1. Human beings have unlimited wants, and

3. Meaning and role of decision making in Economics

Types of business decisions.

5. Micro and Macro Economics

Difference between Micro and Macro Economics

(iii) Total savings in India.

6. Nature of Business Economics

The Nature of Business Economics is described as under-

1. Business Economics is a Science-

2. Business Economics is an art as it involves practical application of rules and

5. Analysis from Private Enterprises Economy viewpoint-Business Economics uses the

6. Inter-Disciplinary- Business Economics is interdisciplinary in nature as it

7. Pragmatic Approach- While Micro-Economics is abstract and purely theoretical and

8. Normative and positive –

Points Positive Economics Normative Economics

7. Scope of Business Economics

1. Microeconomics applied to operational or internal Issues

2. Macroeconomics applied to environmental or external Issues

Unit 2: BASIC PROBLEMS OF AN ECONOMY AND ROLE OF

2. The 4 Central Economic Problems.

c) For whom to produce?

3. The Capitalist Economy.

Capitalist economy, also known as free market

3.1 Solution to central Economic problems under Capitalist Economy

3.2 Characteristics Capitalist Economy.

3.3 Merits Capitalist Economy.

a) Self-regulating and works automatically through price mechanism.

3.4 Demerits Capitalist Economy.

a) Precedence of property rights over human rights.

a) Collective Ownership of means of production-

b) Centrally planned economy-

c) Absence of Consumer Choice-

d) Relatively Equal Income Distribution-

e) Minimum role of Price Mechanism or Market forces-

3.1 Merits of Socialist Economy

3.2 Demerits of Socialist Economy

4.1 Merits Mixed Economy

a) Economic freedom and existence of private property which ensures incentive to

4.2 Demerits Mixed Economy

1. Utility is Power of a commodity to satisfy human wants. In Other words, want

2. Difference between Cardinal and Ordinal Approach to utility

Cardinal Approach Ordinal Approach

3.1 Difference between Total utility and Marginal utility

3.2 Assumptions under Marginal utility analysis and cardinal approach

1. Cardinal Measurability of Utility-

CA. Aditya Sharma Page 2.1

3.3 Law of diminishing Marginal utility

Quantity of Oranges consumed per day Total utility Marginal Utility

CA. Aditya Sharma Page 2.2

3.4 Assumptions and Exception to Law of Marginal utility

3.4 Significance of Law

The law of diminishing marginal utility has following significance-

CA. Aditya Sharma Page 2.3

3.6 Consumer surplus and Consumer Equilibrium

CA. Aditya Sharma Page 2.4