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NMIMS Microeconomics - Book
NMIMS Microeconomics - Book
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COURSE DESIGN COMMITTEE
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Copyright:
2020 Publisher
ISBN:
978-81-947804-7-2
Address:
4435/7, Ansari Road, Daryaganj, New Delhi–110002
Only for
NMIMS Global Access - School for Continuing Education School Address
V. L. Mehta Road, Vile Parle (W), Mumbai – 400 056, India.
1 Introduction To Economics 1
3 Demand Analysis 41
Case Studies 1 to 3 63
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4 Supply Analysis 73
5
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MIC RO E CO N O MICS
C U R R I C U L U M
Working of Economy And Its Basic Problems: Concept of Economy; How an Economy Works?;
Problem of Scarcity; Choice as an Economic Problem; Choice and Opportunity Cost; Production
Possibility Curve (PPC); Government and the Economy.
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Demand; Assumptions in the Law of Demand; Demand Schedule; Demand Curve; Exceptions to
the Law of Demand; Movement and Shift in Demand; Expansion and Contraction of Demand;
Increase and Decrease in Demand.
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Supply Analysis: Concept of Supply; Determinants of Supply; Law of Supply; Supply Schedule;
Supply Curve; Assumptions of the Law of Supply; Exceptions to the Law of Supply; Movement and
Shift in Supply; Expansion and Contraction of Supply; Increase and Decrease in Supply; Market
Equilibrium: Demand and Supply Equilibrium; Determination of Market Price; Shifts in Market
Equilibrium.
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Consumer Demand Analysis: Utility as a Basis of Consumer Demand; Concept of Cardinal Utility;
Total and Marginal Utility; Law of Diminishing Marginal Utility; Consumer Behaviour; Consumer
Preferences; Ordinal Utility Approach – Indifference Curve Analysis; Meaning of Indifference
Curve; Marginal Rate of Substitution; Properties of Indifference Curve; Criticism of Indifference
Curve; Consumer Equilibrium Effects; Income Effect; Substitution Effect; Price Effect.
Production Theory: Short Run: Basic Concepts of Production; Meaning of Production; Factors of
Production; Short Run and Long Run; Short-Run Production Function: Law of Variable Proportions.
Production Theory: Long Run: Long-Run Production Function: Isoquant Analysis; Isoquant
Curve; Iso-Cost Curves; Producer’s Equilibrium; Long-Run Production Function: Laws of Returns
to Scale; Increasing Returns to Scale; Constant Returns to Scale; Diminishing Returns to Scale.
Cost Analysis: Basic Cost Concepts; Actual and Opportunity Costs; Implicit and Explicit Costs; Fixed
and Variable Costs; Accounting and Economic Costs; Private and Social Costs; Short-run and Long-run
Costs; Cost Function; Short-run Cost Function; Long-run Cost Function; Economies and Diseconomies
of Scale.
Revenue Analysis: Concept of Revenue; Total Revenue (TR); Average Revenue (AR); Marginal Revenue
(MR); Relationship between TR and MR; Relationship between AR and MR.
Market Structure: Perfect Competition; Features of Perfect Competition; Equilibrium of the Firm
and Industry under Perfect Competition; Profit Maximisation and Perfect Competition; Monopoly;
Characteristics of Monopoly; Price Discrimination under Monopoly; Monopolistic Competition;
Characteristics of Monopolistic Competition; Oligopoly; Features of Oligopoly.
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INTRODUCTION TO ECONOMICS
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CONTENTS
1.1 Introduction
1.2 An Overview of Economics
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1.2.1 Nature of Economics
1.2.2 Branches of Economics
1.2.3 Applications of Microeconomics and Macroeconomics
Self Assessment Questions
Activity
1.3 Microeconomics: A Positive or Normative Approach
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1.5 Summary
1.6 Multiple Choice Questions
1.7 Descriptive Questions
1.8 Higher Order Thinking Skills (HOTS) Questions
1.9 Answers and Hints
1.10 Suggested Readings & References
INTRODUCTORY CASELET
Vinod sets a budget to get the most satisfaction for the least possi-
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ble rent. He wants to rent a 2-BHK apartment in Versova. Howev-
er, there are others also interested in renting similar apartments
in that area. This might force him to increase his budget. To make
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up the budget, he might have to curtail his expenses in other ar-
eas, such as eating out, entertainment or travel. This decision
shows that money or capital is a limited resource and it should be
allocated among various expenses wisely.
into account the demand for her apartment and the neighbour-
hood. She decides to set a rent of ` 50,000 per month. At this price,
she finds that renters are not interested, as there are other land-
lords who are charging at least ` 10,000 – 20,000 less for similar
apartments. Thus, Maithri must make decisions based on supply
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LEARNING OBJECTIVES
1.1 INTRODUCTION
Human wants are infinite or unlimited. However, not all wants are
equally urgent and important. Therefore, people have to make choices
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between wants with a limited amount of money. Economics deals with
the calculated decisions on how to use the limited money resources
to satisfy maximum of one’s needs. For example, Vinod Gawre (case-
let studied above) initially wanted to rent a 3-BHK flat in Mumbai.
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However, he could not afford the high rental price in the areas of his
choice. He liked the apartment of Maithri Rawat. Although it was a
2-BHK flat, he decided to rent it as he liked the neighbourhood. To
make up for the rental budget, he decided to reduce his expenses on
entertainment and eating out. Similarly, Maithri had initially set a
very high price of ` 50,000 per month for her apartment, but she did
not find anyone interested in that price. She subsequently reduced
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the price to ` 35,000 per month, which was closer to what other land-
lords in the area were charging.
Similarly, businesses also have limited time and money. They also
make thousands of big and small decisions to get the best outcome,
which usually is about maximising profit. These countless choices or
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In this chapter, you will first understand the concept of economics – its
nature and branches. You will learn the differences between micro-
economics and macroeconomics. Next, you will understand whether
microeconomics is a positive or a normative science.
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There are only scarce resources to satisfy human wants: These
resources can be natural resources (land), human resources (la-
bour), man-made resources (capital), entrepreneurship (those
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ness) time and information. All of these resources are limited with
respect to their demand. This scarcity of resources in relation to
infinite human wants gives rise to economic problems and forces
people to make choices. The problem of choices also arises due to
alternative uses of resources; each alternative use gives different
returns or earnings. For example, a land in Mumbai used to set up
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Since this view differentiates between material and non-material
activities, some economists criticised the neo-classical view of
having narrow scope. According to them, all goods and services
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that command a price should be regarded as economic activities,
whether they are material or non-material. According to Lionel
Robbins, there are various material activities that do not promote
human welfare, such as production and sale of tobacco, drugs,
and alcohol, but these activities are considered to be economic
activities. Therefore, the word ‘welfare’ should not be used with
material activities. Moreover, human welfare is a subjective issue
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Economics is a social science that focusses on the problem of
scarce resources and the idea of alternative uses of these re-
sources.
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The distribution and consumption of commodities for the ex-
isting and forecoming economic growth underlines the study
of microeconomics.
The use of modern techniques, such as cost-benefit analysis
will help determine how to use scarce resources.
The inclusion of time element makes the scope of economics
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Stability of price
For example, the topic of general widespread recession due to ? DID YOU KNOW
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COVID-19 pandemic and decline in national economies comes The foundation of
under macroeconomics. macroeconomics was also set
in the year 1933 by the great
Microeconomics and macroeconomics are inter-related and cannot be economist John Maynard
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isolated from each other. What affects the one affects the other and Keynes in his revolutionary
vice versa. For example, national income of a country is the sum total book, ‘The General Theory
of Employment, Interest and
of the incomes of individuals, businesses, and industries. Money’.
demand and supply forces to determine the price levels in the econo-
my. It includes various key principles, such as:
Demand, supply and economic equilibrium: The supply and de-
mand factors for a good or service in a market determine its prices.
In a perfectly competitive market, suppliers of goods or services
offer the same price as demanded by consumers. This creates eco-
nomic equilibrium.
Production theory: This theory studies how goods and services
are produced.
Costs of production: This theory states how the cost of resources
used in its manufacturing or providing services changes with pro-
duction.
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a. Physical b. Chemical
c. Perfect d. Social
2. The classical view of economics was proposed by:
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a. Adam Smith
b. Alfred Marshall
c. Lionel Robbins
d. Samuelson
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ACTIVITY
MICROECONOMICS: A POSITIVE OR
1.3
NORMATIVE APPROACH
In general, there are two view points or approaches to economics
namely positive approach (or simply positive economics) and norma-
tive approach (or simply normative economics).
From these two statements, you will get the following ideas regarding
the two approaches to economics:
Positiveeconomics helps us in determining ‘what is’ whereas nor-
mative economics helps us in determining ‘what should be’ or
‘what needs to be done’.
Positive economics does not depend on any ethical or normative
position. But normative economics depends a great deal on posi-
tive economics.
Positive economics aims to develop a theory or hypothesis that
yields a valid and meaningful predictions about the phenomena
that have not been observed yet.
Positive economics represents actual facts whereas normative eco- NOTE
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nomics talks about idealistic situations. As a social science,
microeconomics is both positive
Positive economics aims to answer the following questions which as well as normative approach
are of positive nature: to examine economic events and
recommend suitable actions.
What
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is?: For example, what is the trend of commercial prop-
erty prices in India?
Why is it?: For example, why are property prices high despite a
decrease in demand for commercial property after COVID-19?
What will be?: What will be the demand for commercial prop-
erty if prices decrease?
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tions change?
Let’s take another example. House rents in India are already high.
Considering the high rate of population growth and supply of houses,
if house rents are not controlled, they will continue to shoot up.
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NOTE be controlled and regulated in the interest of tenants? This question
Since microeconomics also is posed in the public interest. Here, microeconomics will take into
recommends methods to check account the interest of both landlords and tenants and recommend a
undesirable economic events, reasonable rate of house rents and measures to implement them. As a
it is also called a prescriptive
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normative approach, microeconomics evaluates values to decide what
approach.
is good or bad for the society. These values are derived from moral,
ethical, social and political goals of the society.
croeconomics?
a. What should be the employment rate of India?
b. Should online gambling be banned?
c. What is the trend of vehicle sales this quarter?
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ACTIVITY
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individual and social objectives. The more the economic system is
understood, the more efficient it will be to control and manage the
economy.
Predicts
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future economic events: Microeconomics helps estab-
lish the cause-and-effect relationship between economic events.
These relationships provide the foundation for forecasting the fu-
ture course of economic events. Economic forecasts are important
in planning the future course of economic activities by the peo-
ple (individual consumers, business firms, and the government).
However, economic forecast may be situational and inaccurate.
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knows the demand trend of oil and other associated factors, then
he/she can forecast the future trend in price with greater accura-
cy. Even an approximate forecast can help individual consumers
adjust their expense patterns, individual producers to plan their
production, and public policy-makers to draft policy regarding the
price of the commodity (which in this case is oil).
Frames and revises economic policies: A public economic policy
must adhere to economic laws in order to solve an economic prob-
lem. Microeconomics helps formulate effective economic policies.
Its theories help policy-makers to assess whether the prevalent
public economic policies are appropriate and effective. The poli-
cy-makers utilise relevant microeconomic theories to explain the
prevailing economic problem, evaluate the effects of alternative
policies on the problem, and then select the most appropriate one.
Helps in business decision-making: Microeconomic theories help
individual businesses make profitable business decisions. Using
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sumptions. These limitations restrict the applicability of microeco-
nomic theories. Let’s discuss some of them:
Assumption of a given level of economic factors: Microeconomic
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theories assume that economic factors (such as national income,
employment, savings, investment, supply and demand for money,
and general price level) are constant. In real life, however, these
factors are continuously changing, which limits the validity of mi-
croeconomic theories.
Assumption of a free enterprise system: Microeconomic theories
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d. Buffer theory
ACTIVITY
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Recall any instance from your past where you have utilised the con-
cept of opportunity cost.
1.5 SUMMARY S
Economics is a social science that studies economic behaviour of
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KEY WORDS
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1.6 MULTIPLE CHOICE QUESTIONS
MCQ
1. Which of the following subject attempts to study how people al-
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produce and consume goods to satisfy their unlimited wants and
maximise their gains?
a. Physics b. Economics
c. Ergonomics d. Civil Science
2. The deliberate choice and effort of the people to get maximum
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c. Economic behaviour
d. Selective behaviour
3. In comparison to human wants, resources are:
a. Infinite b. Considerable
c. Scarce d. Zero
4. Which view describes economics as the science of material wel-
fare?
a. Classical b. Neo-classical
c. Scarcity and choice d. Growth-oriented
5. Which economist said ‘economics is the science of human be-
haviour in a relationship between ends and scarce means with
alternative uses’?
a. Lionel Robbins b. Samuelson
c. Adam Smith d. Alfred Marshal
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8. Microeconomics approach is:
a. Both positive and normative
b. Only positive
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c. Only normative
d. Neither positive nor normative
9. Which branch of economics primarily studies the determination
of price in individual markets?
a. Microeconomics
b. Macroeconomics
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c. Negative economics
d. Positive economics
10. Microeconomics assumes that employment in a country is:
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a. Continuously increasing
b. Stable
c. An independent variable
d. Controlled by government
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c. How to produce it? d. How to stop its production?
3. Which statement below is a normative approach?
a. Increase in government spending will reduce poverty.
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b. The Indian economy is relatively stable as compared to other
South Asian countries.
c. The government should focus on increasing employment.
d. Higher taxes will lead to more tax evasion by the public.
4. All of the following are microeconomics topics, except:
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Q. No. Answer
1. b. Economics
2. c. Economic behaviour
3. c. Scarce
4. b. Neo-classical
5. a. Lionel Robbins
6. d. All of these
7. c. Production theory
8. a. Both positive and normative
9. a. Microeconomics
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10. b. Stable
Q. No. Answer
1. b. ` 250
2. d. How to stop its production?
3. c. The government should focus on increasing employment.
4. b. Why total employment may decrease?
SUGGESTED READINGS
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Ison, S., & Wall, S. (2007). Economics. Harlow: Financial Times
Prentice Hall.
Samuelson, P., & Nordhaus, W. (2010). Microeconomics. Boston:
IM McGraw-Hill Irwin.
E-REFERENCES
How Microeconomics Affects Everyday Life: Renting an Apart-
ment. (2020). Retrieved 7 July 2020, from https://www.investope-
dia.com/articles/personal-finance/032615/how-microeconomics-af-
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fects-everyday-life.asp
Overview of Economics: What Is Economics and Who Cares?.
(2020). Retrieved 7 July 2020, from https://www.infoplease.com/
homework-help/social-studies/overview-economics-what-eco-
nomics-and-who-cares
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CONTENTS
2.1 Introduction
2.2 Concept of Economy
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2.2.1 How an Economy Works?
Self Assessment Questions
Activity
2.3 Problem of Scarcity
Self Assessment Questions
Activity
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INTRODUCTORY CASELET
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entertainment. Will you be able to satisfy all of these wants with
` 20,000? In this case, you must make a decision on what you are
willing to sacrifice for what you can gain. What is more important:
Paying the semester fee or buying a computer? Renting a room
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or purchasing clothes? Buying a computer or saving money for
entertainment? The decision will be based on both the available
resources and the values with which you grew up.
The issue is that although we all have unlimited desires and wants
but the resources available to satisfy these wants are scarce. A re-
source is scarce when it is not freely available. Hence, we must se-
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lect from among our several wants. We must make a choice based
on our happiness and satisfaction now and in the future. Whatever
we choose, we must let go of the enjoyment of some other wants.
LEARNING OBJECTIVES
2.1 INTRODUCTION
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In the previous chapter, you were introduced to the concept of eco- Quick Revision
nomics and its branches. You learned how microeconomics analyses
the economic behaviour of individuals, households, firms, and govern-
ments. The main purpose of economic activities is to produce goods
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and services to satisfy people’s wants and needs. In an economic sys-
tem, individuals, households, firms, etc., are interlinked and interde-
pendent on each other. Therefore, economic activities must be per-
formed as a part of an economic system. The economic system affects
the economic behaviour of the people. Hence, it is important to know
how an economic system works and its basic problems.
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In this chapter, you will study about the concept of economy and how
it works. You will gain insights into the problems of economy i.e. scar-
city and choice. You will also learn about the concept of opportunity
cost and Production Possibility Curve (PPC).
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has emerged for the success
equipment, tools, airports, highways, railways and ports used
of the humankind was started by organisations to produce goods and services.
by entrepreneurs, such as Ford,
Human capital: The knowledge and skills are acquired by
Apple, Microsoft or Dell.
workers to enhance their productivity.
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Entrepreneurs and producers pay wages to resource owners for their
labour, interest for the use of their capital and rent for the use of their
natural resources. The effort of entrepreneurs or producers is reward-
ed through profit, which is:
NOTE Revenue from goods or services sold < Cost of resources employed
Resource payments have a time to produce goods or services
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demand, and the consumers can use only as many goods or services
as the producer can produce. This interdependence among economic
activities is reflected through interaction, collaboration and competi-
tion among consumers, producers and resource owners. The effect of
these activities can be direct or indirect, or positive or negative.
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ernment’s intervention in economic activities is minimal. The mar-
ket forces of supply and demand determine products, prices and
services. Businesses are free from government control. The US
and Singapore are free enterprise economies.
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Socialistor command economy: In this economy (also known as
communist economy), the government has total and all-pervasive
control of economic activities. The erstwhile Soviet Union and
present-day Cuba are communist economies.
Mixed economy: In this economy, the government plays a partial
role in economic activities. This economic system combines both
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You will study about these three types of economies in detail later in
this chapter.
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The above four entities interact and engage through markets. A mar-
ket is a set of arrangements through which buyers and sellers ex-
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change resources, goods and services at mutually agreeable terms.
The price and quantity of the exchange is determined by the market
forces of demand and supply. There are two main types of markets:
Product market: A market where a good or a service is purchased
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and sold. Examples include supermarkets, departmental stores,
shopping malls or flea markets.
Resource market: A market where resources are bought and sold.
One common example is the labour or job market.
my how these entities interact. This diagram illustrates the flow of re-
sources, products, income and revenue among economic participants:
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In Figure 2.1, on the left side are households, which supply input re-
sources or factors of production, such as land, labour, capital, natu-
ral resources and entrepreneurial ability. The households supply
these resources to firms (input demanders) through resource mar-
kets (lower part of the figure). In resource markets, the interaction
between households (input suppliers) and firms (input buyers) will
determine input prices, also known as resource or factor prices. Once
the factor prices are determined, inputs move from households to
firms.
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flow from firms to product markets. In these markets, the interaction
between the firms (product suppliers) and households (product buy-
ers) determines the prices of the finished products. Once product pric-
es are set, the products flow from the product markets to the house-
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holds. The households make payments to the firms in return of the
products. Thus, two circular flows are generated:
Real flow: Flow of inputs and final products (outer circle)
Money flow: Flow of money (inner circle)
Note that real flows move clockwise in the diagram, whereas money
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use the income earned to purchase goods and services that they and shelter), whereas ‘wants’
need. The firms are able to purchase factors of production from are something you would like to
have, but are not essential for
the households and convert them into final products. They sell
survival (e.g., cars, mobile phone
their products in the product market at profit. The continuous en- and chocolate).
gagement between households and firms is a constant economic
cycle.
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d. Germany
4. Which entity below supplies factors of production?
a. Households
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b. Firms
c. Governments
d. Rest of the world
5. In the circular flow model, products move ______________
from product market to households, while expenditure moves
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d. Anti-clockwise, clockwise
ACTIVITY
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es because all goods and services cannot be produced with the
available resources, and all that is produced may not be purchased
by the consumers. The objective of solving this problem is to satis-
fy the maximum needs of the maximum people.
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The next question within this context will be ‘how much to pro-
duce.’ You need to find the quantity of each product and service to
be produced. The root of this problem also lies in resource scarcity.
If surplus goods and services are produced, there will be wastage
of resources. Therefore, it is important to efficiently allocate input
resources.
How to produce: Once you have decided what to produce, you
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need to decide ‘how to produce it.’ This is the problem of the choice
of technique. You have to decide the best combination of inputs
(labour and capital) to produce goods and services. The scarcity
of resources adds to the severity of the problem, as you cannot
afford to waste them in employing wrong production techniques.
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the ability and the willingness to pay for it, and that there is no sur-
plus production leading to wastage. To determine demand pattern,
firms often use consumers’ pattern of selection, preference and in-
come distribution. The income distribution, in turn, is determined
by the employment pattern and resource (or factor) prices. The
resource prices are decided in the resource market by the demand
and supply forces for resources. The product of resource prices
and the number of resources gives the share of each resource in
the national income.
The resource owners who own a large quantity of expensive re-
sources are able to claim a higher share in the national output.
These households relatively consume a bigger chunk of the na-
tional output as compared to those who own low-priced resources.
In a capitalist or free enterprise economy, the supply (or produc-
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tion) pattern should perfectly match with the demand pattern by
the ‘invisible’ hands of the market. However, that is seldom the
case due to all-pervasive market imperfections, such as:
MARK IT!
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b. “Where to produce”
c. “How to produce”
d. “For whom to produce”
7. The problem of ‘how to produce’ is the problem of:
a. Choice of commodity
b. Market imperfection
c. Match of demand and supply
d. Choice of technique
ACTIVITY
Mention any five scarce resources. Explain why they are scarce.
In that context, write your ideas on what to produce using these
resources, how to produce and for whom to produce.
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the hockey match is reading the
2.4.1 CHOICE AND OPPORTUNITY COST novel (next best alternative).
8 pairs of footwear and 8 garments. Then, she decides that since, she
has to travel for 9 days, she should have a new garment for each day.
Now, if Vandana wants to buy an extra garment, the opportunity cost
in this case will be 4 pairs of footwear that cost ` 1,000.
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70 2
40 3
0 4
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Let us draw the PPC from Table 2.1, as shown in Figure 2.2:
A F
100 B
90
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C
70
A (In Lakhs) G
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40 D
0 1 2 3 4
B(‘000)
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purchased by individuals at a certain price. It helps in guiding the
movement of resources from consumer goods to capital goods, such
as machines, which, in turn, increases the productive resources of a
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country for achieving a high production level.
c. An opportunity cost
d. Giving up something for nothing
9. On a Sunday morning, you rank your choices in the following
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order:
Clean the house, go to the mall, watch a movie, and sleep late.
Suppose you decide to clean the house. What will be your op-
portunity cost?
a. Going to the mall, watching a movie, and sleeping late
b. Zero because you do not have to pay money to a cleaning
service
c. Going to the mall
d. None of the above
ACTIVITY
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The government can achieve this stimulus by directly increasing its
own spending, or indirectly through tax and subsidy measures to
stimulate consumption and investment.
? DID YOU KNOW
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The idea of government The government’s role in the economy can be broadly classified into
intervention in economy was three categories:
first proposed by John Keynes
in 1936. Most economists before Capitalist or free enterprise system: In this system (also known
him, including Adam Smith, as laissez faire system), the government’s main roles are to:
believed that depressions
were self-correcting. However, Maintain and foster free market mechanism to ensure compe-
Keynes argued that private tition
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activities and owns all the country’s resources. The free enterprise
and market mechanism are abolished by law. The government at
the centre takes decisions regarding production and distribution
of resources, employment, pricing, etc. Individual freedom rights
of choice and decision making with respect to economic activities
are drastically reduced. Individuals can make their decisions only
within the policy framework of the state. Unlike a capitalist econ-
omy where the motivation force is private profit, the aim of a so-
cialist economy is maximisation of social welfare.
Mixed economy system: This economic system combines the fea-
? DID YOU KNOW
ture of the capitalist and socialist economies. It is divided into the India is a mixed economy. This
following two sectors: means that some firms are
run by the private individuals
Private sector: This sector operates on the free enterprise sys-
(private sector), while some are
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tem within a wide political and economic policy. run by the government (public
sector). The public sector
Public sector: This sector is organised, owned and controlled includes railways, hospitals,
by the government. The government reserves certain indus- schools, which are managed and
tries, trade, services, and activities for the public sector and re- controlled by the government
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stricts private entry into this sector. The government can also to ensure maximum social
welfare. The private sector
nationalise private industries to increase the role of the public includes IT companies, press,
sector. airlines, hospitals, and schools,
which are managed by private
Thus, the role and responsibilities of the government in the mixed individuals or groups. Their main
economy system are much larger than in the free enterprise sys- objective is to make maximum
tem and much less than the socialist system. profit.
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10. All of the following are the reasons behind the failure of so-
cialist economies of the Soviet Union and the Eastern Bloc,
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except:
a. Profiteering
b. Fewer entrepreneurial opportunities
c. Lack of motivation by individuals
d. Slow economic growth
11. Which is a private sector business in India?
a. Bharat Dynamics b. Bharat Forge
c. Cochin Shipyard d. GAIL
ACTIVITY
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An economy is a social system made up of households, firms, fi-
nancial intermediaries and governments. These constituents par-
ticipate and interact in economic activities to produce and con-
sume goods and services
The participants in the economy include households, firms, gov-
ernments, and rest of the world. These entities engage, collabo-
rate, and compete through markets (product and resource).
The three main problems arising out of scarcity of resource are
what to produce, how to produce, and for whom to produce.
Opportunity cost is defined as the next best alternative that is giv-
en up when you make a choice.
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Production possibilities refer to the alternative combinations of
goods and services that can be produced with the given resources
and technology.
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The PPF is a concave curve that identifies all the possible alterna-
tive combinations of commodities that can be produced when all
the available resources are utilised fully and efficiently.
The government’s role in the economy can be classified into capi-
talist, socialist and mixed economy systems.
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KEY WORDS
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a. Money
b. Population
c. Scarcity
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d. Trade deficit
2. All of the following are factors of production, except:
a. The effort of farmers raising a crop
b. The water used to irrigate crops
c. The wages paid to workers in a cooperative unit
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a. Labour, rent
b. Labour, wages
c. Human capital, interest
d. Physical capital, wages
4. Human capital is:
a. Knowledge and skill of workers
b. Physical human effort
c. Mental human effort
d. Factories, equipment
5. What is the income earned by entrepreneurs called?
a. Profit
b. Rent
c. Interest
d. Wages
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d. Rest of the world
8. The question, ‘Should Britannia produce more bread or more
biscuits?’ is an example of the:
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a. ‘What to produce’ question
b. ‘How to produce’ question
c. ‘Where to produce’ question
d. ‘For whom to produce’ question
9. You choose to take a holiday, which costs you ` 1 lakh (or
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b. `100,000
c. ` 75,000
d. `125,000
10. The effect of resource expansion on the PPC curve will:
a. Make the curve flat
b. Make the curve convex
c. Create an outward shift
d. Create an inward shift
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a. The poor but not the rich
b. The rich but not the poor
c. Neither the rich nor the poor
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d. Both the rich and the poor
2. When India builds a road using a few machines and a great deal
of labour, it is answering the _________ question:
a. ‘What’
b. ‘How’
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c. ‘Where’
d. ‘For whom’
3. When a private automaker decides to manufacture more motor-
cycles than cars, it is answering the __________ question:
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a. ‘What’
b. ‘How’
c. ‘Where’
d. ‘For whom’
4. In India, people with higher incomes get to consumer more goods
and services. This statement answers the __________ question.
a. ‘What’
b. ‘How’
c. ‘Where’
d. ‘For whom’
5. Varun decides to attend summer school, which prevents him
from working at his usual summer job in which he normally
earns ` 10,000 for the summer. His tuition fee is ` 3000, books
and supplies cost ` 1000, and room and board cost `1500. The
opportunity cost of attending summer school is:
a. `5500
b. `15,500
c. `10,000
d. `0
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Concept of Economy 1. b. Wages
2. d. Banks
3. c. Singapore
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4. a. Households
5. c. Clockwise, anti-clock-
wise
Problem of Scarcity 6. a. “What to produce”
7. d. Choice of technique
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Q. No. Answer
1. c. Scarcity
2. c. The wages paid to worked in a cooperative unit
3. b. Labour, wages
4. a. Knowledge and skill of workers
5. a. Profit
6. d. The Wealth of Nations
7. a. Government
Q. No. Answer
8. a. ‘What to produce’ question
9. a. INR 175,000 (INR 100,000 + 75,000 = INR 1,75,000.
Here, we add the direct cost of vacation and the
amount of money a person could not earn)
10. c. Create an outward shift
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2. The root of the economic problem is the scarcity of resources,
while our wants are infinite. This problem exists in all econo-
mies in the world, whether they are the rich or the poor. To meet
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the infinite wants of the people by using scarce resources while
trying to meet the people’s desire to maximise gains, economies
must try to achieve efficiency in production and distribution of
resources. Refer to Section 2.3 Problem of Scarcity
3. Resources are scarce and we have infinite wants and needs. If we
cannot have everything we want, then we have to make choices.
This creates the economic problem of ‘choice.’ Refer to Section
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Problem
5. Ideally, the invisible hands of supply and demand forces should
ensure smooth, efficient, and systematic run of market econo-
mies. Although market economies are capable of bringing eco-
nomic growth, they do not ensure a stable, sustained and bal-
anced growth. Therefore, the government’s intervention with
the market mechanism is necessary. Refer to Section 2.5 Gov-
ernment and the Economy
Q. No. Answer
1. d. Both the poor and the rich
2. b. ‘How’
3. a. ‘What’
4. d. ‘For whom’
Q. No. Answer
5. b. INR 15,500 (INR 10,000 + 3,000 + 1000 + 1500 =
INR 15,500. Here, we add the amount of money Varun
could not earn with the various amounts he had to
spend to attend the summer school)
SUGGESTED READINGS
Dwivedi, D. Microeconomics theory and applications.
Mceachern, W. (2016). Macroeconomics + mindtap economics,
1-term access. [Place of publication not identified]: South-Western.
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Vane, H., &Mulhearn, C. (2009). Milton Friedman, Robert E. Lucas,
Jr. and Edmund S. Phelps. Cheltenham, UK: Edward Elgar.
E-REFERENCES
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(2020). Retrieved 10 July 2020, from https://www.pearsonschool
sandfecolleges.co.uk/secondary/BusinessAndEconomics/14-
(2020). Retrieved 10 July 2020, from http://faculty.washington.edu/
cnelson/Chap01.pdf
Theory and Applications of Economics - Table of Contents. (2020).
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DEMAND ANALYSIS
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CONTENTS
3.1 Introduction
3.2 Meaning of Demand
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3.2.1 Types of Demand
Self Assessment Questions
Activity
3.3 Determinants of Demand
Self Assessment Questions
Activity
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INTRODUCTORY CASELET
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thousands of people around the world jobless. This is ironic if you
consider that in 2019, these industries were steeply growing in-
dustries, fuelled by the global demand for air travel and tourism.
The forces of demand and supply interact to determine the price
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of a commodity in a market. In fact, the main role of microeco-
nomics is to explain the laws of demand and supply. In this chap-
ter, you will study about the law of demand.
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LEARNING OBJECTIVES
3.1 INTRODUCTION
In the previous chapter, you have studied about the critical role that Quick Revision
markets play in resolving economic problems. The chapter discussed
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the concept of scarcity and choice as economic problems. It is pivotal
to know the working of an economic system and how the problems in
economic system affect the market condition.
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A market is an arrangement where individuals, households and busi-
nesses are engaged in the buying and selling of products and services
through various modes. The working of a market is governed by two
forces, which are demand and supply. These two forces play a crucial
role in determining the price of a product or service and size of the
market. The demand and supply forces operating in a market natural-
ly sets the price of goods and services traded in the market. Theoreti-
cally, demand can be defined as a quantity of a product an individual
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In this chapter, you will study the concept of demand. You will gain
insights into the factors that determine demand. Then, you will under-
stand the fundamental Law of Demand, including its assumptions,
demand schedule, demand curve and exceptions. Finally, you will
learn about the ‘shift’ and ‘movement’ in demand.
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Desire, want and demand are different from each other.
The quantity demanded is the amount that a customer is willing to
purchase. However, the quantity demanded is not always equal to
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not be available in the required quantity.
Demand is always referred to in terms of price and bears no mean-
ing if it is not expressed in relation to price. For example, an indi-
vidual may be willing to purchase a shirt at a price of ` 500 but may
not be willing to purchase the same shirt if it is valued at ` 1000.
In addition, different quantities of a commodity are demanded at
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different prices.
Demand is always referred in terms of a time period and bears
no meaning if it is not expressed in relation to a time period. For
example, a garment manufacturer has a demand for 200 metres of
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a. Desire
b. Willingness to pay
c. Purchasing power
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d. Creditworthiness
2. During the festival of Diwali, the demand for sweets goes up.
Consequently, the demand for sugar will:
a. Decline
b. Increase
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ACTIVITY
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This relationship can be expressed through the following equation:
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Demand for commodities also depends on the consumers’ expec-
tations regarding the future price of a commodity, availability of
the commodity, changes in income, etc. Such expectations usually
cause rise in demand for a product. This relationship is subjective
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depending on the psychology of the consumer.
Effect of consumer’s income (B) on demand (Dx): The level
of income of individuals determines their purchasing power.
Generally, income and demand are directly proportional to each
other. This implies that rise in the consumers’ income results in
rise in the demand for a commodity. However, the relationship
depends on the type of commodities. As the consumer’s income
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will rise, he/she will purchase more of normal goods, such as tea,
sugar, cornflakes, noodles, watches and branded clothes. This
effect is called positive effect. Thus, the demand for an item is
directly related to consumer’s income, if the item is a normal good:
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Dx ∝ B, if x is a normal good
At the same time, the consumer will purchase less of inferior goods,
such as low quality rice, jowar and second-hand goods. This effect
is called negative effect. Thus, demand for an item x is inversely
related to consumer’s income, if the item is an inferior good:
? DID YOU KNOW
1 Increase in the Gross Domestic
Dx ∝ , if x is an inferior good Production (GDP) or national
B income of a country will have
a positive effect on demand.
Effect of consumer’s taste or preference (T) on demand (Dx): An increase in GDP means that
Consumers’ tastes or preferences are socio-psychological determi- the aggregate output of goods
nants of demand, and hence difficult to explain theoretically. and services in the country has
increased, signalling economic
Effect of advertisement expenditure (A) on demand (Dx): An growth. This will trigger an in-
increase in advertisement expenditure will increase the demand crease in the aggregate demand
for the item, but up to a certain point only. Therefore, demand for and consumption of products
and services.
an item x is directly related to advertisement expenditure:
Dx ∝ A
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b. Increase in the price of lower quality rice grains
c. Increase in the consumers’ income
d. Cutting of advertising expenditure
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ACTIVITY
Identify any product of your choice. List its substitutes and comple-
ments. Over a period, observe and note the effects of all determi-
nants discussed in this section on the demand of the product.
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modity, the price factor is the most important. The law of demand
represents a functional relationship between the price and quantity
demanded of a commodity or service. The law states that the quanti-
ty demanded of a commodity increases with a fall in the price of the
commodity and vice versa while other factors like consumers’ prefer-
ences, level of income, population size, etc., are constant. Demand is a
dependent variable, while price is an independent variable.
Where,
D= Demand
P= Price
f = Functional Relationship
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3.4.1 ASSUMPTIONS IN THE LAW OF DEMAND
The law of demand can be understood with the help of certain con-
cepts, such as demand schedule, demand curve and demand function.
Let us discuss these concepts in detail in the upcoming sections.
The data in Table 3.1 indicates that the demand for sanitisers (Qs) in-
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creases as the price of sanitisers (Ps) increases. For example, at the
price of ` 800, only 1 sanitiser is demanded per month. When the price
declines to ` 400, the demand for sanitisers increases to 3 units per
month. When the price reduces to ` 100, the demand rises up to 8 units
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per month. This inverse relationship between the price and the quan-
tity demanded for the sanitisers per month is the demand schedule
for sanitisers.
The law of demand can also be represented graphically with the help
of a demand curve, which is discussed in the next section.
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the same quantity. This induces them to buy more sanitisers. This
effect is called the income effect. However, note that this effect is
negative if the goods are inferior. If the price of an inferior good,
such as a lower quality sanitiser, falls substantially, then the real
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income of consumers increases. As a result, they substitute the
inferior good for a normal good, such as a good quality sanitiser.
Thus, the income effect on the demand for inferior goods becomes
negative.
Substitution effect: When the price of sanitisers decreases, it
becomes cheaper relative to its substitutes, provided their prices
remain constant. Consequently, the substitutes of the sanitiser will
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There are some instances when the fundamental law of demand does
not apply. Some of these exceptions are mentioned below:
Expectations regarding future prices of a commodity: When
consumers expect that the price of a durable commodity will keep
on increasing continuously, they will buy more of that commodity
despite increase in its price. They do so to avoid paying even higher
prices for that commodity in the future. Likewise, when consumers
expect a major decline in the price of a commodity in the future,
they will postpone buying it and wait for its price to come down
further. These decisions are contrary to the law of demand.
Veblen goods: Veblen goods are luxury or prestigious items such
as gold, precious stones, rare paintings and antiques. The law of
demand does not apply to these goods. Exceptionally rich consum-
ers buy Veblen goods because they serve as a status symbol. They
purchase these goods due to their exceptionally high prices so that
they can boost their social prestige by displaying them as symbols
of their wealth and affluence.
Giffen goods: These goods are cheap commodities that have a
very few close substitutes. It is considered to be opposite to a nor-
? DID YOU KNOW
mal good. It is mostly consumed by poor households and consti-
Veblen goods are named after
the American economist Thor-
tutes a substantial percentage of their income. The law of demand
does not apply to these goods. Therefore, if the price of a Giffen
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stein Veblen. He first pointed
out the concept of “conspicu- good increases (and the price of its substitute remains constant),
ous consumption” as a way of its demand will increase instead of falling. For example, suppose a
status-seeking in his book The poor household consumes 30 kg of food grains per month, which
Theory of the Leisure Class.
includes 20 kg of bajra (an inferior goods) and 10 kg of wheat
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(a superior good). The price of bajra is ` 5 per kg, while that of
wheat is `10 per kg. At these prices, the monthly expenditure of
the household on food grains is ` 200. This is the maximum price
that the poor family can afford to spend. Now, suppose the price
of bajra increases to ` 6 per kg. This will compel the household to
reduce its consumption of wheat by 5 kg and increase that of bajra
by 5 kg to meet its minimum monthly consumption requirement of
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ACTIVITY
Suppose the price of toned milk is ` 20 for 500 ml pouch. You must
decide how many 500 ml pouches of toned milk you will buy in one
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week when the price is at a specific level. In the following table, fill
in the number of pouches next to the price.
Now put your results into a graph. Plot the number of pouches on
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the x axis and the price on the y axis. Join the dots together to make
a line graph. What is the shape of the line? Explain why it is so.
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At the price OP, the quantity demanded is OQ units of a commodity,
keeping all the other factors constant.
y
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P2 C
Price (in rupees)
P A
B
P1
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Demand
Curve
x
O Q2 Q Q1
Quantity Demanded
(in units)
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D3
D2
D1
P2
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Px
P1
D3
D1 D2
O Q1
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Q2 Q3
Qx
ACTIVITY
Consider the demand curve for petrol and diesel. What effect will
the following cases will have on it? (You have 1 minute to answer
each option.)
1. The price of cars increases.
2. The percentage of the people owning cars increases.
3. The transport costs of shipping oil increases.
4. The environmental concerns regarding pollution-causing
petrol and diesel increase.
5. The Goods and Services Tax (GST) on petrol and diesel
increases.
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Illustrate each case above showing the change to demand.
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Demand for a commodity is defined as the quantity of that com-
modity, which a consumer wants to buy, at a given price per unit
of time.
For a demand to be effective, it must have the consumer’s desire,
ability to buy, and willingness to pay.
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KEY WORDS
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3.7 MULTIPLE CHOICE QUESTIONS
1. Varun is a salaried employee from a middle-class family. Being MCQ
a man of modest means, however, did not prevent him from
dreaming big. Since he saw the latest model of the Harley
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Davidson bike in an auto show, he wants to purchase. He is even
willing to pay for it. However, this is not a demand for the bike
because Varun does not have the:
a. Purchasing ability b. Permit
c. Desire d. Willingness to pay
2. If you are given that Dx = f(Px, Py, Pz, E, B, T, A, U); and,
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c. Consumer’s preference effect
d. Substitution effect
IM7. When the demand for printers increases, people start buying
more of ink cartridges. This is due to:
a. Substitution effect b. Complementary effect
c. Price effect d. Income effect
8. The normal demand curve has _______ slope.
a. Undefined b. Positive
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c. Downward d. Zero
9. People demand certain goods at higher prices not because of
their worth but because of their prestige value. This effect is
called:
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P2 C
Price (in rupees)
P A
B
P1
Demand
Curve
x
O Q2 Q Q1
Quantity Demanded
(in units)
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3. Which factors impact demand for an item and how?
4. Explain the law of demand. Mention its assumptions. Illustrate
using the demand schedule and the demand curve of a commodity.
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5. Is the law of demand universal? Give reasons for your answers.
Also, mention the conditions where it does not apply.
6. Why is the slope of the demand curve negative? Explain the
reasons.
a $15 8
b 12 14
c 9 20
d 6 26
e 3 32
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3.10 ANSWERS AND HINTS
Q. No. Answer
1. a. Purchasing ability
2. d. None of these
3. a. Derived demand
4. c. Derived
5. b. Positive
Q. No. Answer
6. d. Substitution effect
7. b. Complementary effect
8. c. Downward
9. b. Veblen effect
10. c. Expansion of demand
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flavors, and desire a Cornetto. Refer to Section 3.2 Meaning of
Demand
2. Demand can be categorized into the following types. Individual
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demand and market demand. Refer to Section 3.2 Meaning of
Demand
3. According to the demand theory, the quantity demanded
of a commodity is influenced by the certain factors called
determinants of demand. Refer to Section 3.3 Determinants of
Demand
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Q. No. Answer
1. a. Movement along the same demand curve
2. b. Right, left
3. a. Demand schedule
4. d. Substitutes
5. c. Direct and derived
SUGGESTED READINGS
Hubbard, R., Garnett, A., & Lewis, P. (2017). Microeconomics.
Pearson Australia Pty Ltd.
Taylor, J., &Weerapana, A. (2012). Microeconomics. [Mason, Ohio?]:
South-Western Cengage Learning.
E-REFERENCES
Law of Demand: Schedule, Curve, Function, Assumptions and
Exception. (2020). Retrieved 11 July 2020, from https://www.eco-
nomicsdiscussion.net/law-of-demand/law-of-demand-schedule-
S
curve-function-assumptions-and-exception/3429
Movement along the Demand Curve and Shift of the Demand
Curve. (2020). Retrieved 11 July 2020, from https://www.toppr.com/
IM guides/business-economics/theory-of-demand/movement-along-
the-demand-curve-and-shift-of-the-demand-curve/
What are the types of Demand? - Business Jargons. (2020).
Retrieved 11 July 2020, from https://businessjargons.com/types-of-
demand.html
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CONTENTS
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CASE STUDY 1
BACKGROUND
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customers always ended up paying for the ‘free food’ in the price
of drinks that they had to buy. The food was high in salt and so
customers were induced to purchase more drinks. Thus, the sa-
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loon keepers deliberately offered free lunches with the expecta-
tion that they would generate enough revenue in extra drinks to
balance the cost of the lunch. In fact, some saloon keepers were
sued for false advertising of ‘free lunch,’ as some customers could
not participate in it without first paying money to the saloon.
In this context, the economists joined the argument and the say-
ing ‘there’s no such thing as a free lunch’ was coined. Although
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it is not clear who initially said this phrase, theories suggest that
it was first used in response of the libertarian views of the US
Vice President Henry Wallace (1941-45). He wrote an article in a
newspaper where he had suggested a post-World War II economic
regime across the world, offering “minimum standards of food,
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ANALYSIS
CASE STUDY 1
But what about resources, such as air and water, which seem to
be in abundant supply in nature? Let us analyse them.
AIR
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sources have to be used to make clean air available to the citizens.
This will require cost. Although citizens may not directly pay for
the cleaned-up air, they will eventually end up paying for it as
taxpayers. Industries also have to pay for cleaned-up air through
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taxes. As consumers, citizens have to pay for cleaned-up air by
purchasing zero-emission vehicles or getting regular pollution
check certificates. When air purifiers or extractor fans have to be
installed to freshen up air in buildings, residents have to directly
pay for air. Even if someone lives in a non-polluted part of the
country, he/she may have spent money to move there to escape
the pollution. This is also an opportunity cost to get the clean air.
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WATER
RESULTS
CASE STUDY 1
CONCLUSION
QUESTIONS
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1. Can you recall any desirable good or service, which you
considered to be free? Identify the opportunity costs asso-
ciated with that good or service and justify whether it was
truly free.
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(Hint: Water, air, etc.)
2. Identify any ‘free’ election promises, which are promised
to people during elections. Find out the opportunity costs
associated with them and identify who in the end actually
paid for those things.
(Hint: Free healthcare, free transport, free water supply,
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etc.)
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The former Prime Minister of Canada, Stephen Harper, was the Case Objective
head of the Conservative Party. In Canada’s parliamentary sys- This case study highlights
tem, he had walked a political tightrope for five years. During that the choice that the Canadian
time period, he worked as the leader of the minority government. citizens had to make between
His opponents were upset by some of the policies. One such pol- economic development as
promised by the Conservative
icy was a reduction in corporate tax rates. In 2011, his opponents Party and greater economic
strived for a no-confidence vote in parliament. It passed the par- growth as promised by the
liament tremendously. It not only brought down Harper’s govern- New Democratic Party (NDP).
ment but also forced national elections for a new parliament.
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This political victory was momentary as the Conservative Par-
ty won the elections held in May 2011. This party had appeared
as the ruling party in Canada. This ruling party had allowed Mr
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Harper to continue practising the policy of deficit and tax reduc-
tion. This Conservative Party was opposed by the New Demo-
cratic Party (NDP) and the moderate Liberal Party at that time.
These opposition parties strived for higher corporate tax returns
and less deficit reduction as compared to the ruling party. In 2010,
the deficit had fallen by one-third under the rule of Mr Harper. At
that time, he had promised a surplus budget by 2015.
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All his efforts made Canadians decide and make a choice that re-
sulted in lower taxes and less spending. But this issue was not
considered to be prominent in the campaign held in 2011. With
the development of huge oil deposits in Alberta, Canada is at the
third place in the world for oil reserves. The NDP promised to
reduce the greenhouse gas emissions in Canada, whereas Mr
Harper and the Conservative Party had promised to work towards
the development of Canada’s economic growth.
(Source: https://2012books.lardbucket.org/books/macroeconomics-principles-v2.0/s04-eco-
nomics-the-studyof-choice.html)
CASE STUDY 2
QUESTIONS
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BACKGROUND
Case Objective
Use of tobacco is a major cause of deaths. Every year, smoking
This case study explores
kills more than seven million people. In addition to its huge toll of
two ways that public
disease, misery and death, smoking of tobacco also puts a burden policymakers can attempt to
of approximately $1.4 trillion on the global economy due to annual reduce demand for cigarettes;
costs in healthcare and the loss of productivity. thereby slashing the amount
that people smoke.
Today, there is a greater understanding of how to reduce the gi-
gantic burden of this deadly epidemic. Public policymakers have
implemented demand reduction policies such as higher taxes and
wide-ranging bans on tobacco marketing and smoking in public
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to curb tobacco use and its consequent damage to health and eco-
nomic development.
METHODS
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Two principle cost-effective means to reduce smoking are:
Shifting the demand curve for cigarettes
Increasing the price of cigarettes
If these policies are successful, they will shift the demand curve
for cigarettes to the left, as shown in Figure A:
Price of
Cigarettes, A policy to discourage
per Pack smoking shifts the demand
curve to the left.
B A
$ 2.00
D1
D2
0 10 20
Number of Cigarettes Smoked per Day
CASE STUDY 3
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Price of A tax that raises the price
Cigarettes, of cigarettes results in
per Pack a movement along the
demand curve.
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A
2.00
D1
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0 12 20
RESULTS
Shift in demand curve: In Figure 1, the demand curve shifts
from D1 to D2. At a price of $2 per pack of cigarettes, the quanti-
ty demanded drops from 20 cigarettes per day to 10 cigarettes
per day, as represented by the shift from point A to point B in
Figure 1.
Movement along the demand curve: If the price of cigarettes
is increased due to taxes, then the demand curve does not
shift. Instead, there will be a movement to a different point
on the demand curve. In Figure 2, when the price of a pack
of cigarettes is raised from $2 to $4, the quantity demanded
decreases from 20 to 12 cigarettes in a day, as shown by the
movement from point A to point C.
CASE STUDY 3
CONCLUSION
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QUESTIONS
SUPPLY ANALYSIS
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CONTENTS
4.1 Introduction
4.2 Concept of Supply
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4.2.1 Determinants of Supply
Self Assessment Questions
Activity
4.3 Law of Supply
4.3.1 Supply Schedule
4.3.2 Supply Curve
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INTRODUCTORY CASELET
S
resorted to panic buying. One of the medical store owners said
“Hand sanitizers have disappeared from the market. We have
given the order for it but it is difficult to get them. Masks that were
earlier sold for ` 50-60 are now being sold at `100-150.” Later, the
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government ensured that supply chain remains active and fulfils
the challenges faced in fulfilling the requirement of masks and
sanitisers. The Food and Drug Administration authorities speeded
up the licensing process of manufacturing these goods in order to
avoid the unethical price rise, hoarding and black marketing. Then,
regular supplies of masks and sanitisers result in the reduction in
the prices and there are many new manufacturing firms entering
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in the market fulfilling the demand at the right price and at the
right time.
will look at the part that producers play in the market, and how
they make decisions on what and how much to supply.
LEARNING OBJECTIVES
4.1 INTRODUCTION
In the previous chapter, you have studied that a market is an Quick Revision
arrangement where buyers and sellers are engaged in exchanging
goods at certain prices. The behaviour of buyers is understood with
S
the help of the concept of demand. In a market, the two forces demand
and supply play a major role in influencing the decisions of consumers
and producers. It is correct that demand is the engine on which the
economy runs, but demand must be met with the related supply as
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well. The behaviour of sellers is analysed using the concept of supply.
words, the law of supply states that the supply of a good increases with
an increase in its price, while other factors at constant and vice versa.
The interaction between demand and supply helps in determining
the market equilibrium price of a good. Equilibrium price is a price
where the quantity demanded of a good by buyers is equal to the
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In this chapter, you will study about the concept of supply and identify
its determinants. The chapter also describes the law of supply,
including the supply schedule, supply curve, basic assumptions and
exceptions. Moreover, you will study about market equilibrium price
at length. Also, you will study about the shifts and movements in
supply.
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3. Supply considers the stock and market price of the good. The
stock of a good refers to the quantity of the good available in the
market for sale within a specified point of time. Both stock and
market price of a good affect its supply to a greater extent. If
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the market price of a good is more than its cost price, the seller
would increase the supply of the good in the market. However, a
decrease in the market price as compared to the cost price would
reduce the supply of goods in the market.
Supply does not remain constant all the time in the market. There are
many factors that influence the supply of a good. Generally, the supply
of a good depends on its price and cost of production. Thus, it can be
said that supply is the function of price and cost of production. The
supply of a good is influenced by the following factors or determinants:
Input price: It is the cost incurred on the manufacturing of goods
that are to be offered to consumers. When the input prices reduce,
the use of inputs will rise. Increased use of inputs will increase
the supply of goods. Similarly, when the input prices increase, the
supply of goods will decrease.
Price of substitutes: The prices of substitutes and complementary
goods also influence the supply of a good to a large extent. For
instance, if the price of tea increases, the firm would produce more
tea and less coffee. As a result, there will be reduction in the supply
of coffee in the market.
Nature and size of the industry: If the industry of a good is
monopolised (i.e., under the hands of a few large players only),
the supply of the good will be limited. On the other hand, if the
industry is competitive (i.e., a healthy competition of small and
large companies), the supply of the good in the market will increase.
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The supply of the good will also increase when new producers join
the industry, increasing the industry size. Therefore, the supply of
goods is also dependent on the structure of the industry in which
a firm operates.
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Government policy: The production of a good declines in the face
of restrictive policies by the government, such as import quota on
resources, rationing on the supply of resources, etc. Consequently,
the supply of the good decreases. Government’s tax policies also
act as a regulating force in supply. If the rates of taxes levied on
goods are high, the supply will decrease. This is because high tax
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ACTIVITY
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Search on the Internet and find out the determinants that influence
the supply of cars in the Indian market.
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4.3 LAW OF SUPPLY
The law of supply explains the direct relationship between the price
and supply of a good. According to the law of supply, the quantity
supplied increases with a rise in the price of a good and vice versa
while other factors remain constant. The other factors may include
customer preferences, size of the market, size of population, price
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per kg. Therefore, the individual supply schedule shown in Table a good (such as pizzas) offered
4.1 indicates that the quantity supplied increases with a rise in for sale by a single producer
price. (pizza maker) at different prices.
A market supply schedule is the
2. Market supply schedule: This schedule represents the quantities total quantity of the good (pizza)
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of a good supplied by all firms or suppliers in the market at offered for sale by all producers
different prices during a specific period, while other factors (pizza makers) at different prices
are constant. In other words, the market supply schedule can in a given period. Therefore,
market supply is an aggregate of
be defined as the summation of all individual supply schedules. all individual supplies of a good
Table 4.2 shows the market supply schedule of two firms X and at different prices in a given
Y for good A: period.
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curve can be of two types, individual supply curve and market supply
curve. These two types of curves are explained as follows:
Individual supply curve: It is the graphical representation of
individual supply schedule. The individual supply schedule of
good A represented in Table 4.1, when plotted on a graph will
provide the individual supply curve, which is shown in Figure 4.1:
25
20
15
Price
10
S
5
0
0 5000 10000 15000 20000
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Quantity
25
20
15
Price
10
5
0
0 10,000 20,000 30,000 40,000
Quantity
able because they can afford to cover the higher marginal costs of
production, which results from increasing output. On the other hand,
the lower price of a good makes it less attractive to producers. Hence,
they are less willing and less able to supply the goods.
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not change.
The production technique should not change. This assumption
is significant because the cost of production should remain fixed.
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If the production technique improves, the cost of production will
decrease, which will make producers more willing and more able
to supply more quantity even at falling prices.
Transportation costs should not change. Lower transportation
costs will reduce the cost of production, which will make producers
more willing and supply more quantity even at lower prices.
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expect that the price of a certain good is going to drop in the future,
they will try to dispose of the good. This will increase the supply of
the good in the market, even at a lower price.
Goods for auction: Auction goods are offered for sale through
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bidding. Auction can take place due to various reasons, for instance,
a bank may auction the assets of a customer in case of his failure
in paying off the debts over a period of time. Thus, supply of these
goods cannot increase or decrease beyond a limit. In case of these
goods, a rise or fall in price does not impact the supply.
c. increase
d. reduce by the factor of one
4. According to the supply curve, supply is a _____________
function of price.
a. positive
b. negative
b. zero
d. unitary
5. The supply curve has a ____________ slope.
a. backward
b. downward
c. flat
d. upward
ACTIVITY
Create a supply curve from the given supply schedule. Plot the
price on the x-axis and the quantity on the y-axis.
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Answer the following questions:
1. What do you notice about the supply curve?
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2. What does the supply curve indicate about the relationship
between the price and the quantity?
3. Why do you think this relationship exists?
other than price (in this case, price is constant). Let us understand this
with the help of an example.
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PX
C S
15
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A Expansion
10
B
5
Contraction
0 10 20 30 Supply
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point at the price ` 10. When the price increases to `15, the quantity
supplied will move upward from point A to point C, reflecting
expansion or more supply at the higher price. When the price lowers
to ` 5, the quantity supplied will move downward from point A to point
B, reflecting contraction or less supply at a lower price.
INCREASE IN SUPPLY
Consider the supply curve SS in Figure 4.4. At the original price OP,
OX units of the good are supplied.
PX S
S1
P1
S
S
S1
O X X1 Supply
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Figure 4.4: Increase in Supply – Right Shift of the Supply Curve
At a lower price OP1, the same units of the good (OX) are supplied.
DECREASE IN SUPPLY
S1
PX
S
P1
S1
S
O X1 X Supply
At a higher price OP1, the same units of the good (OX) are supplied.
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a. Shift towards right b. Contract
c. Shift towards left d. Expand
IM 8. If the price of coffee increases, then the supply curve of the tea
will:
a. Shift towards right b. Contract
c. Shift towards left d. Expand
9. Covid-19 has caused the supply curves of airlines and hotels
to:
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ACTIVITY
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Markets allow these forces of demand and supply to coordinate and set
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the price of a good or a service on their own. These impersonal market
forces are what the economist Adam Smith called the “invisible
hands” of demand and supply. A market where forces of demand and
supply take their own course without any external control on price,
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demand or supply is called a free market.
quantity supplied equals the quantity demanded at the market price. The equilibrium price is also
called the market-clearing
At market equilibrium, the price and quantity do not tend to change. price because at this price
The price at market equilibrium is called equilibrium price and the there is neither unsold stock
quantity supplied and demanded is called equilibrium quantity. nor unsupplied demand, thus
clearing the market.
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In the above market schedule, there is only one price of pizza (` 300)
at which demand and supply are at par. At all the remaining prices,
the pizza market is in a state of imbalance between demand and
supply. At all prices below ` 300, demand exceeds supply indicating
the shortage of pizzas in the market. At the prices above ` 300, supply
exceeds demand indicating the surplus of pizzas in the market.
Now this imbalance itself will create the condition for equilibrium
automatically. Let us see how.
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Likewise, at all prices about `300, there is surplus supply of pizzas in
the market, forcing the pizza sellers to reduce the price. Therefore,
fewer pizzas will be supplied in the market. On the other hand, more
customers will be attracted to purchase the pizza at lower price.
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Therefore, the price of the pizza continues to fall till it reaches `300
(equilibrium price). This process of interaction between the demand
and supply forces to determine the equilibrium price is called the
market mechanism.
been obtained.
D S’
700
600 A B
Surplus
500
400
Price
300 E
200
Shortage
100
S J K D
0
10 20 30 40 50 60 70 80 Q
Quantity
The demand curve DD’ and the supply curve SS’ intersect at point
E, which is the equilibrium price ` 300. At this price, the quantity
demanded (40,000 pizzas) is equal to the quantity supplied (40,000
pizzas). Therefore:
Equilibrium price = ` 300
Equilibrium quantity = 40,000 pizzas
If the price is set at any price other than the equilibrium price above,
there will be either surplus or shortage of pizzas in the market.
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the demand curve: IM
D
D S’
M
P
Price
D’’
M
S
D’
O Q N
Quantity
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The original demand curve and the supply curve are DD’ and SS’,
respectively. These two curves intersect at point P. The equilibrium
price is determined at PQ and the equilibrium quantity is determined
at OQ. Now, if the demand curve DD’ shifts to DD”, while the supply
curve remains fixed, then the new intersection point of the two curves
will be M. Thus, the shift in the demand curve will shift the equilibrium
point from P to M. As a result, there will be:
Increase in the equilibrium price – From PQ to MN
Increase
in the equilibrium quantity demanded and supplied –
From OQ to ON
In conclusion, when the demand curve shifts to the right w the supply
curve remains constant, there will be an increase in the equilibrium
price and quantity. Now, let us consider the shift in the supply curve
with the demand curve remaining constant in Figure 4.8:
D
D S’
M
P
Price
D’’
S
D’
O Q N
Quantity
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(Source: Microeconomics: Theory and Applications by D. N. Dwivedi)
Consider Figure 4.8. Here, the supply curve SS’ shifts its position
rightward to SS”, with the demand curve DD’ remaining fixed. The
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two curves will now intersect at point M instead of point P. Therefore,
point M will be the new equilibrium point. As a result of the shift of the
supply curve, there will be:
Decrease in the equilibrium price – From PQ to MN
Increasein the equilibrium quantity demanded and supplied –
From OQ to ON
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Table 4.4 summarises the effects of shifts in demand and supply curves
on the equilibrium price and equilibrium quantity:
11. If a seller tries to sell cooling fans at lower price than ` 268,
then he will have:
a. Unsupplied demand
b. Neither unsold stock nor unsupplied demand
c. Unsold stock
d. Both unsold stock and unsupplied demand
ACTIVITY
Consider any market and find out the market equilibrium price of
any three items of your choice. What happens to the equilibrium
price?
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1. If there is an increase in demand, while supply is constant
2. If there is an increase in supply, while demand is constant
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3. If there is an increase in both demand and supply in equal
measures
4. If there is a larger increase in demand as compared to increase
in supply
5. If there is a larger increase in supply as compared to increase
in demand
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4.6 SUMMARY S
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KEY WORDS
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and sellers to exchange goods or services
Function: A figurative statement of relationship between a
dependent and independent variable
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4.7 MULTIPLE CHOICE QUESTIONS
MCQ 1. A trader has 10 bags of sugar in his store. This represents:
a. Supply b. Quantity supplied
c. Effective supply d. Non-supply
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9. If the supply curve shifts to the right while the demand curve
remains constant, the market price of the good will:
a. Drop
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b. Rise
c. Not change
d. First rise and then drop
10. If there is a demand curve with a negative slope and a supply
curve with a positive slope, a higher equilibrium price will be
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caused by:
a. Increase in price of good
b. Increase in demand of good
c. Increase in supply of good
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a. Increase the supply of natural gas
b. Decrease the supply of natural gas
c. Supply more quantity of natural gas
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3. At a price of ` 5000, a microwave oven manufacturer is willing to
produce 20,000 units in each quarter. If the price is increased to
` 6300, then the manufacturer may produce:
a. 20,000 units per quarter
b. 19,000 units per quarter
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a. Both the demand and the supply increase, but the rise in de-
mand is more than that in supply
b. Both the demand and the supply increase, but the rise in de-
mand is less than that in supply
c. Both the demand and the supply decrease, but the drop in
demand is more than that in supply
d. Both the demand and the supply decrease, but the drop in
demand is less than that in supply
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ANSWERS FOR MULTIPLE CHOICE QUESTIONS
Q. No. Answer
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1. d. Non-supply
2. c. price ceiling
3. a. Governments
4. c. Higher price
5. a. Price ceiling
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6. a. increase, increase
7. c. Shift the supply curve to the right
8. b. Shift the supply curve to the left
9. a. Drop
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Q. No. Answer
1. d. Higher equilibrium price, less output (This is because
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since the price is fixed too low, there will be surplus de-
mand.)
2. a. Increase the supply of natural gas
3. c. 21,000 units per quarter
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4. a. Both the demand and the supply increase, but the rise in
demand is more than that in supply
SUGGESTED READINGS
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E-REFERENCES
Supply | Boundless Economics. (2020). Retrieved 13 July 2020,
from https://courses.lumenlearning.com/boundless-economics/
chapter/supply/
The Law of Supply: Explanation, Assumption and Exception. (2020).
Retrieved 13 July 2020, from https://www.economicsdiscussion.
net/law-of-supply/the-law-of-supply-explanation-assumption-
and-exception/13703
ELASTICITY OF DEMAND
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CONTENTS
5.1 Introduction
5.2 Concept of Elasticity of Demand
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Self Assessment Questions
Activity
5.3 Price Elasticity of Demand
Self Assessment Questions
Activity
5.4 Income Elasticity of Demand
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5.6 Summary
5.7 Multiple Choice Questions
5.8 Descriptive Questions
5.9 Higher Order Thinking Skills (HOTS) Questions
5.10 Answers and Hints
5.11 Suggested Readings & References
INTRODUCTORY CASELET
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as consumers switched to cooking more at home.
LEARNING OBJECTIVES
5.1 INTRODUCTION
In the previous chapter, you have studied about the concept of demand Quick Revision
and supply. The chapter also discussed the law of demand and supply
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in detail. According to the law of demand, if the price of a good rises,
the quantity demanded falls. But by how much? This responsiveness
of demand is what elasticity measures. Elasticity is a measure of how
much the quantity demanded or supplied would be affected by a pro-
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portionate change in its determinants. The demand for a good can
be elastic or inelastic. Demand is said to be elastic when the quantity
demanded for a good changes with a change in any of its determinant.
On the other hand, inelastic demand does not change or remains con-
stant with a change in its determinants.
is used to determine how demand for a good changes when its price
changes. It varies from good to good because some goods are more
essential to us than others such as electricity. If the price of electricity
in Maharashtra increases by 20%, there is only 2% drop in demand.
This is because electricity is a necessity to the consumers’ daily life,
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Price
1.92
1.6
Demand
Quantity
98 100
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Figure 5.1: Demand Curve of Electricity
Price/Unit
$10
$5 Db
Da
Q/Time
0 60 100
ACTIVITY
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The price elasticity of demand measures the responsiveness of the
quantity demanded of a good to change in its price, when other deter-
minants of demand are constant. In other words, it can be defined as MARK IT!
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the ratio of the percentage change in quantity demanded to the per- The demand for a good can be
centage change in price. elastic or inelastic, depending on
the rate of change in the demand
with respect to change in the
MEASUREMENT OF PRICE ELASTICITY OF DEMAND price of the good.
The formula for calculating the price elasticity of demand is as follows:
∆Q
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Where,
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P = Initial price
ΔP = Change in price
Here,
P = ` 450
Q = 25,000 units
10,000
Percentage change in quantity demanded
e p= = 100
Percentage change in price 450
25,000
= 9/5 = 1.8
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The extent of responsiveness of demand with change in the price does
not remain the same under every situation. Therefore, price elasticity
of demand is grouped into five main categories, which are shown in
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Figure 5.2:
curve. Flatter the slope of the demand curve, higher the elasticity
of demand. In perfectly elastic demand, the demand curve is rep-
resented as a horizontal straight line (in parallel to X-axis), which
is shown in Figure 5.3:
Price
D D
S
O Q1
IM Q2
X
Quantity
the price of the good is fixed at OD, the demand for good rises from
OQ1 to OQ2. In such case, a slight fall in price will result in the rise
of demand to OX, whereas a slight rise in price will bring demand
to zero.
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Y D
Price
P1
P2
S
D
O Q1 X
Quantity
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Figure 5.4: Perfectly Inelastic Demand
In Figure 5.4, DD is the demand curve. Thus, it can be observed
that even when there is a change in the price from OP1 to OP2, the
quantity demanded remains the same at OQ1.
Example 3: The demand schedule for insulin consumed by diabetic
patients is as follows:
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Here,
ΔP = 2500 – 2000 = 500
And,
ΔQ = 50 – 50 = 0
Let us calculate the price elasticity of demand as:
∆Q 0
Percentage change in quantity demanded Q
ep = = = 50 =0
Percentage change in price ∆P 500
P 2000
D
P
P1
D
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Price
O Q Q1 X
Quantity
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Figure 5.5: Relatively Elastic Demand
In Figure 5.5, DD is the demand curve that slopes gradually down
with a fall in price. When price falls from OP to OP1, the demand
rises from OQ to OQ1. However, the rise in demand QQ1 is greater
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1,00,000 5,000
1,20,000 3,500
Here,
ΔP = 1,20,000 – 1,00,000 = 20,000
And,
ΔQ = 3,500 – 5,000 = –1500
Let us calculate the price elasticity of demand as:
1, 500 3
Percentage change in quantity demanded 5, 000 10 15
ep = = = = = 1.5
Percentage change in price 20, 000 1 10
1, 00, 000 5
Note that the price elasticity of demand for air tickets is greater
than 1. It means that the demand for air tickets is relatively elastic.
Also, it means that the percentage change in quantity demanded is
more than the percentage change in price of air tickets.
Y
D
S
P1
Price
D
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X
O Q Q1
Quantity
fall in price. When price falls from OP to OP1, the demand rises
from OQ toOQ1. However, the rise in demand QQ1 is less than the
fall in price PP1.
Example 5: The demand schedule for milk is as follows:
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Note that the price elasticity of demand for milk is less than 1.
It means that the demand for milk is relatively inelastic. Also, it
means that the percentage change in quantity demanded is less
than the percentage change in price of milk.
P2
P
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P1
X
O Q2 Q Q1
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Quantity
300 600
Here,
ΔP = 300 – 100 = 200
And,
ΔQ = 600 – 200 = 400
Let us calculate the price elasticity of demand as:
∆Q 400
Percentage change in quantity demanded Q
ep = = = 200 =1
Percentage change in price ∆P 200
P 100
c. Percentagechange in price
Percentage change in quantity demanded
Absolute change in price
d.
Percentage change in price
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4. The elasticity coefficient for an inelastic demand curve is:
a. 1
b. 0
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c. Between 0 and 1
d More than 1
5. Which one of the following has the most elastic demand?
a. A pair of slippers
b. A dress from a high-brand store
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c. A bottle of hair-oil
d. A mirror
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ACTIVITY
after deducting the personal income tax from personal income of the
individual.
For example, suppose your income increases by 5%. Now let us con-
sider how this percentage change in income will affect your demand for
two goods, salt and clothing. Due to increase in income, your demand
for clothing will increase relatively more than that for salt. This is
because salt is an item of necessity. An increase or decrease in your
income will not affect your consumption of salt. However, an increase
of income may persuade you to spend more on clothing so that your
dressing style reflects your improved lifestyle. Therefore, you can say
that clothing has more income elasticity of demand (responsiveness of
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demand) as compared to salt.
However, for an inferior goods (such as bajra, poor quality rice, cheap
alcohol, artificial jewellery, etc.), the income elasticity of demand is
negative. This is because the percentage increase in income causes a
percentage decrease in the quantity demanded for inferior goods and
vice versa.
EXHIBIT
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Necessities: These are normal goods and services, which con-
sumers will buy irrespective of change in their income. Exam-
ples include water, electricity, etc. An increase in income will
IM result in less than a proportionate increase in the quantity de-
manded of necessities. Therefore, the coefficient of income elas-
ticity is between 0 and 1.
Comforts: If necessities make life possible, then comforts make
life pleasant and easy. Thus, comforts are those normal goods
and services, which are less urgent than necessities. Examples
include healthy and tasty meals, a well-furnished house, cloth-
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Note that the above categories of goods are not rigid and fixed. The
income elasticity of demand may vary from household to household,
time to time and location to location, as per the consumers’ tastes and
preferences, levels of consumption, income levels and vulnerability to
‘show off.’ Another factor that may affect the normal pattern of income
elasticity is the frequency of increase in the consumers’ income. If
the income increases regularly and frequently, then income elasticity
will follow the general trend, otherwise not. Firms use the concept of
income elasticity to:
Predictthe future demand for goods, given the rate of increase in
income and income-elasticity of demand for the goods
Define whether a good is normal or inferior. A normal good is the
one whose income elasticity is positive for all levels of income,
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whereas an inferior good is the one for which income elasticity is
negative after a specific income level.
ACTIVITY
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20,000 kg to 30,000 kg per week, the price of coffee remaining constant.
By substituting these values in the above equations, you get the cross
elasticity of demand for coffee with respect to tea, as follows:
PT ∆QC 225 –1000
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eC ,T = . = . = 11.25
QC ∆PT 20000 –10
Note that cross elasticity of demand for substitute goods will always
be positive. This is because an increase in the price of one good will
lead to an increase in the demand for the other. If the price of tea
increases, there will be fall in its demand, as consumers would readily
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goods, such as bread and butter, electricity and electrical gadgets, pet-
rol and car, etc. The cross elasticity of demand for these complemen-
tary goods is always negative. This is because an increase in the price
of one good will lead to a decrease the demand for its complementary
good(s). For example, if the price of bread increases, then there will be
a drop in the quantity demanded of bread as well as in the quantity
demanded of butter. Thus, a change in the price of one good will cause
the quantity demanded of its complements to move in the opposite
direction. In conclusion, you can derive the following results:
If cross elasticity of demand between any two goods is positive,
these goods are substitutes. The higher their (positive) cross elas-
ticity, the closer the substitutes are to each other.
If cross elasticity of demand between two goods is negative, these
goods are complements for each other. The higher their (negative)
cross elasticity, the higher their degree of complementarity.
If cross elasticity of demand between two goods is zero, these
goods are unrelated to each other.
PC ∆QC PP ∆Q P
c. Q . ∆P d. Q . ∆P
P P C C
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ACTIVITY
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Consider any toothpaste. Identify its substitutes and complements.
Explain how cross elasticity of demand will affect the quantity
demanded of toothpaste with respect to its substitutes and comple-
ments.
5.6 SUMMARY S
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KEY WORDS
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Point elasticity: A measure of price elasticity of data is continu-
ous and allows only marginal changes
Total revenue: The amount of money a business firm receives
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on the sale of a good (disregarding total costs)
a. 1
b. 2
c. 0.5
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d. 10
2. A drop in the price of lemons from ` 100 per kg to ` 60 per kg in-
creases the quantity demanded from 1.75 to 7 kg per week. The
price elasticity of demand is
a. 7.5
b. 0.13125
c. 7.6
d. 0.133
3. If a 10% increase in the price results in _________ decrease in the
quantity demanded, then the price elasticity of demand is 5.
a. 2%
b. 15%
c. 20%
d. 50%
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D
O Quntity (units)
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a. Zero price elasticity of demand at all prices
b. Infinite price elasticity of demand
c. Different price elasticity of demand at all prices
d. Unit price elasticity of demand at all prices
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D
O Quntity (units)
a. Elasticity coefficient = 0
b. Elasticity coefficient = 1
c. Elasticity coefficient = 2
d. Elasticity coefficient = Infinity
7. Which of the following is not a possible base for calculating the
elasticity of demand?
a. Income of the consumer
b. Variable cost to consumer
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c. Premium
d. Inferior
10. If the cross elasticity of demand between two goods is positive,
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then it means:
a. The goods are substitutes
b. The goods are complements
c. The demand for both goods is price elastic
d. The demand for both goods is price inelastic
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c. Unrelated
d. Inferior
2. From the cross-elasticity of demand which two goods are the
closest substitutes to each other?
a. Tetley tea and Nescafe coffee (et,c= 7.3)
b. Tetley tea and Tata salt (et,t= 0)
c. Nescafe coffee and Bru coffee (ec,c= 22.9)
d. Amul milk and Nescafe coffee (ec,M= –5.3)
3. If a 4% increase in the price of soybean oil lowers the total reve-
nue received by the producers of soybean oil by 4%, the demand
for soybean oil:
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a. Has an elasticity of 2 b. Is unitary elastic
c. Is elastic d. Is inelastic
4. The cross elasticity of demand between Mother Dairy milk and
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Amul milk is:
a. Positive, thus they are complements
b. Negative, thus they are complements
c. Positive, thus they are substitutes
d. Negative, thus they are substitutes
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4. c. Between 0 and 1
5. b. A dress from a high-brand store
Income Elasticity of 6. b. 0.5
Demand (Hint:
Percentage change in quantity demanded
ei =
Percentage change in income
∆Q 60 − 30 30
Q 30 30
= = = = 0.5)
∆P 15, 000 − 5, 000 10, 000
P 5, 000 5, 000
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Percentage change in quantity demanded of onions
ep for onion=
Percentage change in price of onions
10%
= =0.5)
20%
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2. a. 7.5
7 − 1.75
(Hint: e p for lemons = 1.75
60 − 100
100
5.25
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5250
= 1.75 = = 7.5)
−40 1750
100
3. d. 50%
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4. c. Relatively inelastic
5. d. Unit price elasticity of demand at all prices
6. a. Elasticity coefficient = 0
7. b. Variable cost to consumer
8. a. Toothpicks
9. d. Inferior
10. a. The goods are substitutes
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5.4 Income Elasticity of Demand
4. Cross elasticity of demand is the measure of the responsiveness
of demand for a good to the changes in the price of its substitute
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and complementary goods, with other determinants being con-
stant. Refer to Section 5.5 Cross Elasticity of Demand
Q. No. Answer
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1. b. Substitutes
2. c. Nescafe coffee and Bru coffee (ec,c = 62.9)
3. c. Is elastic
4. c. Positive, thus they are substitutes
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SUGGESTED READINGS
Boyes, W., Melvin, M., &Madariaga, B. (2008). Micro economics.
Boston: Houghton Mifflin.
Deepashree, D. (2011). Principles of micro economics. [Place of
publication not identified]: Ane Books.
Taylor, J., &Weerapana, A. (2012). Microeconomics. [Mason, Ohio?]:
South-Western Cengage Learning.
E-REFERENCES
(2020).Retrieved 17 July 2020, from https://www.intelligentecono-
mist.com/price-elasticity-of-demand/
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ELASTICITY OF SUPPLY
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CONTENTS
6.1 Introduction
6.2 Concept of Elasticity of Supply
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6.2.1 Types of Elasticity of Supply
6.2.2 Factors Determining Elasticity of Supply
Self Assessment Questions
Activity
6.3 Measurement of Elasticity of Supply
Self Assessment Questions
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Activity
6.4 Summary
6.5 Multiple Choice Questions
6.6 Descriptive Questions
6.7 Higher Order Thinking Skills (HOTS) Questions
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INTRODUCTORY CASELET
18000
17000
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Price (` /month)
16000 H
15000
14000
A
IM 13000
12000
11000
10000
5 10 15 20
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LEARNING OBJECTIVES
6.1 INTRODUCTION
In the previous chapter, you have studied about the elasticity of de- Quick Revision
mand. Elasticity is a measure of how much the quantity demanded
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or supplied would be affected by a proportionate change in its deter-
minants. In this chapter, you will study about the elasticity of supply.
The above two examples indicate the elasticity of supply. The elastic-
ity of supply of a product indicates how quickly its producers will be
willing and able to increase its supply in the market when its demand
and price increase. It measures the percentage change in the quantity
supplied at a given percentage change in price. Mathematically, the
elasticity of supply is expressed as:
Percentage change in quantity supplied of commodity X
es =
Percentage change in price of commodity X
S
Change in quantity (∆S)
Percentage change in quantity supplied =
Original quantity supplied (S)
The elasticity of supply can be calculated with the help of the follow-
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ing formula:
∆S P
es = ×
S ∆P
∆S P
es = ×
∆P S
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Where,
∆S = S1 – S
∆P = P1 – P
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Example 1: Assume that a business firm supplied 450 units at the price
of ` 4500. The firm has decided to increase the price of the product to
` 5500. Consequently, the supply of the product is increased to 600
units. Calculate the elasticity of supply.
Solution: Here,
P = ` 4500
S = 450 units
150 4500
es = × = 1.5
1000 450
S
Elasticity coefficient, es= 0.
Products with very limited quantities have perfectly inelastic
supply. For example, a rare painting from Leonardo da Vinci is
a product with perfectly inelastic supply. Land can be another
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example of a commodity with perfectly inelastic supply.
2. Relatively inelastic supply: When a percentage change in the
quantity supplied is less than the percentage change in the price
of a product, it is called relatively inelastic supply. In this case,
the elasticity of supply is less than 1, i.e., e < 1.
The shape of the supply curve is upward sloping originating from
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circumstances. This is because it is influenced by a number of factors.
Some of the important factors that influence the elasticity of supply
are explained as follows:
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Time factor: It affects the elasticity of supply to a great extent.
For instance, in the short run, the elasticity of supply is low due to
various factors such as obsolete production techniques. Therefore,
changes in prices do not affect the supply of products immediately.
If the price remains high for a longer period, the supply of prod-
ucts is increased.
Nature of the product: The product’s nature is an important fac-
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a. Upward sloping from X-axis
b. Upward sloping from Y-axis
c. Straight horizontal line
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d. Straight vertical line
3. In a relatively elastic supply:
a. % quantity supply changes by a larger percentage than %
price
b. % quantity supply changes by a smaller percentage than %
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price
c. % quantity supplied is infinite at a given price and zero at
a lower price
d. % quantity supplied is fixed to the change in price
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ACTIVITY
Consider the cotton industry in India and calculate its price elastic-
ity of supply for the year 2015-16 as compared to the year 2014-2015.
(Hint: You can take the required data i.e., price per bale and sup-
ply/production from the official website of ‘The Cotton Corporation
of India Limited’.)
MEASUREMENT OF ELASTICITY OF
6.3
SUPPLY
An organisation is required to estimate the elasticity of supply for
making various business decisions under different situations such as
deciding the supply of products. Apart from this, the concept of elas-
ticity of supply is helpful for the government in deciding taxation pol-
icies. For instance, high taxes are levied on goods whose supply is in-
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The elasticity of supply can be calculated with the help of the
following formula:
∆S P
es = ×
IM S ∆P
∆S P
es = ×
∆P S
Here, es= Coefficient of price elasticity of supply
P = Initial price of the good
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∆S = S1 – S
∆P = P1 – P
The positive sign indicates a positive relationship between the
price and the quantity supplied. This indicates that the producers
will supply greater units of a commodity only at higher prices and
vice versa.
Example 2: Assume that a business firm supplied 450 units at
the price of ` 4500. The firm has decided to increase the price of
the product to ` 5500. Consequently, the supply of the product is
increased to 600 units. Calculate the elasticity of supply.
Solution: Here,
P = ` 4500
ΔP = ` 1000 (an Increase in price, ` 5500– ` 4500 = 1000)
S = 450 units
ΔS = 150 (600 – 450)
S
10 1000
Thus, es represents relatively elastic supply.
Point Method: Under this method, the elasticity of supply is mea-
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sured at the specific point of supply curve. In this method, we ap-
ply calculus (derivative) on the given supply equation to measure
the responsiveness of quantity supplied with change in price.
Thus, Q= a + bp (supply equation)
P dq
= ×
Q dp
Where,
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dq p
Slope of Q = = b and es = b ×
dp q
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es = ∞ (es =∞ or perfectly elastic supply)
ACTIVITY
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S 6.4 SUMMARY
The elasticity of supply measures the degree to which the quantity
supplied of a commodity will respond to a price change, all other
factors being constant.
The elasticity of supply measures the percentage change in the
quantity supplied at a given percentage change in price.
The five main type of elasticity of supply are perfectly inelastic
supply (es = 0), inelastic supply (0 < es < 1), unitary elastic sup-
ply (es =1), elastic supply (1 < es < ∞) and perfectly elastic supply
(es = ∞).
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KEY WORDS
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sults in a change in the quantity supplied, then, the supply is
_______________.
a. relatively inelastic b. elastic
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8. The price elasticity of supply of a good is 0.7. This means that:
a. Supply is inelastic
b. Supply is elastic
c. Supply is perfectly inelastic
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c. 30% d. 50%
10. If es of a good is 2, and a firm supplies 200 units at a price of ` 8
per unit, then at what price will the firm supply 250 units?
a. ` 6 b. ` 7
c. ` 8 d. ` 9
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from 300 to 345 units, then the elasticity of supply is:
a. 2.4 b. 0.56
c. 0.34 d. 1
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3. When the price of Mother Dairy milk rises from ` 20 to ` 30 per
unit, the revenue of Mother Dairy increases from ` 100 to ` 300.
The price elasticity of supply is:
a. 0.4 b. 1
c. 2 d. 3.5
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c. 2 d. 1
Q. No. Answer
1. d. Relatively elastic
2. c. If production capacity can easily be ramped up
3. a. 1
4. c. Zero elasticity
5. a. Relatively inelastic
6. a. Supply is relatively elastic
7. d. perfectly elastic
8. a. Supply is inelastic
9. a. 20%
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(Hint:
Percentage change in quantity supplied
es =
Percentage change in price
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0.5 = =
50%
= Percentage change in quantity supplied = 20%
10. d. `9
(Hint:
Percentage change in quantity supplied
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es =
Percentage change in price
∆S
= S
∆P
P
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250 − 200
2= 200
P1
P 1 −8
8
P1 – 8 = 1
P1 = 9)
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Q. No. Answer
1. b. Quantity supplied expands or contracts to any degree
without any change or with minimal change in price
2. d. 1
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(Hint: Percentage change in quantity supplied = (345-
300)/300 = 15%
Therefore,
Percentage change in quantity supplied 15%
es = = = 1)
Percentage change in price 15%
3. c. 2
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(Hint: P = 20; P1 = 30
Therefore, ΔP/P = (30-20)/20 = 50%
Revenue = R
R= 100; R1 = 300
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SUGGESTED READINGS
Friedman, M. (2000). Essays in positive economics. Chicago: Uni-
versity of Chicago Press.
Gillespie, A. (2016). Foundations of economics. Oxford: Oxford Uni-
versity Press.
Samuelson, P., & Nordhaus, W. (2010). Microeconomics. Boston:
McGraw-Hill Irwin.
E-REFERENCES
(2020).Retrieved 30 July 2020, from https://www.nr.edu/eco202/au-
S
thor_pps/pdf/econ2_micro_ch05.pdf
(2020). Retrieved 30 July 2020, from https://www.intelligentecono-
mist.com/price-elasticity-of-supply/
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How Does Price Elasticity Affect Supply?. (2020). Retrieved 30 July
2020, from https://www.investopedia.com/ask/answers/040615/
how-does-price-elasticity-affect-supply.asp
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CONTENTS
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CASE STUDY 4
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Since this was a newly introduced product with better features
than its competing products, GHI wanted to determine the price
at which the supply and demand would be equalised. Hence, GHI
analysed that the price of this product should be kept at 1.75 times
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the price of its competing products. Therefore, it was initially
priced at `3,500 per piece. At this price, GHI was supplying 10,000
pieces per month.
GHI and it analysed that the demand for SUPERCAM was only
2,000 pieces per month. During this phase, GHI incurred a huge
amount of loss. To avoid such situations again, GHI reduced the
price of SUPERCAM to `2,800 per piece. Along with it, GHI also
reduced the supply to 7,000 pieces per month. Due to the reduced
prices, the demand went up to 5,000 pieces per month.
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After this, GHI further reduced the price to `2,500 per piece and
increased the supply to 8,000 pieces per month. At this stage, the
demand and supply of SUPERCAM became equal. GHI also start-
ed earning high profits. It ultimately fixed the price and the sup-
ply quantity of SUPERCAM at `2,500 per piece and 8,000 pieces
per month, respectively.
QUESTIONS
CASE STUDY 4
Hint:
Price (in `) Demand Supply Surplus/ Price Rise
Shortage or Fall?
3,500 2,000 10,000 Surplus Fall
2,800 5000 ? ? ?
2,500 8,000 8,000 ? ?
2. What was the price of the competing products of SUPER-
CAM?
(Hint: The price of competing products of SUPERCAM
was `3,500/1.75 = `2,000.)
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CASE STUDY 5
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edible refined oil market in India was dominated by groundnut
and mustard oil brands. Today, Sundrop offers a wide range of
edible refined oils to suit different lifestyles of a wide variety of
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customers in the market.
CASE STUDY 5
The demand for Sundrop oil increased due to shift from other
edible oil species because of the following factors:
Price differential of only ` 1.45/litre
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Market leadership among edible sunflower oils
Competition among other oil segments
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Since Sundrop was the first to reduce the price of edible oils, it
got a major advantage over competition in terms of shift from oth-
er oils. By the year end (until March 2019), the Sundrop brand re-
duced its selling price to ` 143 and even then it continued to gain
the market. Moreover, the company ATFL ran a price offer for
two months, which further reduced the effective price of Sundrop
oil in the market.
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3 Postman 60
4 Vital 83
5 Sweekar 87
6 Flora 35
7 Dhara 350
8 Sundrop 250
Total 1205
ANALYSIS
CASE STUDY 5
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Therefore, at 180 metric tons, the company’s total earnings were:
∆Q P
ep = ×
∆P Q
RESULT
The price elasticity of demand for Sundrop oil was 3.05 by March
2019.
CASE STUDY 5
CONCLUSION
QUESTIONS
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Coefficient Revenue
e=0 Increase Increase
Decrease Decrease
e<1 Increase
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Decrease Decrease
e=1 Increase No change
Decrease No change
e>1 Increase Decrease
Decrease Increase
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CASE STUDY 6
BACKGROUND
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to 1974), the price of oil in the world market shot up by more than
50%. OPEC pocketed the increased income.
Four years later, they applied the same tactic again. From 1978
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to 1979, the price of oil increased by 14%. From 1979 to 1980, it
increased by 34%, and then another 34% in 1981. However, the
party was soon going to be over.
The price of oil started to decline by about 10% every year from
1982 to 1985. Divisions crept up among OPEC countries and in
1986, their cooperation to jointly raise the price of oil disintegrat-
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ed. Consequently, the price of oil fell by about 45%. It was only in
1990 that the price of oil regained the value that it had in 1970, and
that too after adjusting for overall inflation. Since then, the price
of oil remained more or less to that level throughout the 1990s.
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ANALYSIS
CASE STUDY 6
Price of oil
1. In the short run, when
supply and demand are
inelastic, a shift in supply...
S2
S1
2
P
2. ...leads
to a large –
increase P1
in price.
Demand
0 Quantity of oil
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Figure A: Oil Market in Short Run
Since both the supply and the demand of oil are relatively in-
elastic, when the supply of oil shifts from S1 to S2, the price of
oil increases significantly from P1 to P2.
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Long run: The supply and demand of oil in the long run are
relatively elastic. Supply is elastic because oil producing coun-
tries outside OPEC will respond to high prices of oil by increas-
ing their individual oil exploration capabilities and construct-
ing new extraction capacity. Demand of oil is relatively elastic
in the long run because customers will use oil conservatively.
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Price of oil
1. In the long run,
when supply and
demand are elastic,
a shift in supply...
S2
S1
2. ...leads
to a small P2
increase
P1
in price.
Demand
0 Quantity of oil
CASE STUDY 6
RESULTS
On the contrary, both the supply and the demand are more elas-
tic in the long run. Therefore, when OPEC countries reduced the
supply of oil, the same shift on the supply curve from S1 to S2
caused much smaller increase in the price of oil. Therefore, the
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OPEC countries’ coordinated tactic of reducing the supply of oil
proved to be less lucrative in the long run.
CONCLUSION
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Time and again, OPEC still continues and to some extent suc-
ceeded at reducing supply and increasing prices. However, after
being adjusted for overall inflation, the price of oil never touched
its peak value of 1981. Therefore, it is clear from this case study
that increasing oil prices is easier in the short run than in the long
run.
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QUESTIONS
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CONTENTS
7.1 Introduction
7.2 Utility as a Basis of Consumer Demand
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Self Assessment Questions
Activity
7.3 Concept of Cardinal Utility
Self Assessment Questions
Activity
7.4 Total and Marginal Utility
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CONTENTS
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7.15 Suggested Readings & References
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INTRODUCTORY CASELET
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Sarees Total utility Plays Total utility
1 22 1 16
2 43 2 31
3 63 3 45
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4 81 4 58
5 97 5 70
6 111 6 81
7 123 7 91
8 133 8 100
The first column in the above table shows the quantity of sarees
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bought, while the second column shows the total satisfaction she
derives from that quantity of sarees. This total amount of satisfac-
tion is called total utility. As you can see, consuming additional
units of sarees increases her total utility, but at a decreasing rate.
The other columns indicate the utility that she would get from
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Now, Vani has only $56 to spend. The price of sarees is $14 while
that of plays is $7. She has to decide how to spend her income on
these two goods so that she gets maximum satisfaction. What will
be this best combination, which gives her the highest utility pos-
sible? This will depend on her income, price of goods and prefer-
ences. This chapter describes the different approaches to explain
the demand behaviour of consumers like Vani.
LEARNING OBJECTIVES
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>> Discuss the income and substitution effects of price change
in normal goods
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7.1 INTRODUCTION
Quick Revision In the previous chapter, you have studied about the elasticity of sup-
ply and its various measures. It is important for producers to measure
the extent of utility or satisfaction received by a consumer after con-
suming a good in order to estimate the demand for their goods in the
future. A consumer is willing to buy a particular good to satisfy his/
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her various needs and wants. Thus, it can be said that the demand for
a good is closely related to the level of satisfaction that the consumer
derives from that good.
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? DID YOU KNOW
the other. For example, a car can be of utility to an office goer but The concept of utility was
is of no use to a beggar. introduced by Jeremy Bentham
in 1789. He introduced utility as
Similarly, the same good may provide an individual with different a social thought by describing it
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levels of satisfaction depending on circumstances. For example, a as “that property in any object
cup of tea in the morning may provide more satisfaction to a con- whereby it tends to produce
benefit, advantage, pleasure,
sumer compared to when consumed at noon. good, or happiness or to prevent
Utilitycan also change with a change in time and place. For ex- the happening of mischief, pain,
evil, or unhappiness to the party
ample, utility from the use of an air conditioner will depend on whose interest is considered.”
whether the individual is in Nagpur during summers or in Sri-
nagar during winters.
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1. Utility is:
a. The choice for a commodity
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ACTIVITY
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which is different from that of her friend Radha with a utility level of
11 utils. Similarly, the utility gained from watching a play by Vani will
be different from that of her husband Sachin, who is not a big fan of
the theatre.
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In contrast, ordinal utility represents utility from the consumption
of commodities based on a relative ranking of the commodity. For ex-
ample, Vani may prefer to purchase more sarees than suits, while her
friend Radha may prefer to purchase more suits than sarees.
less preferences, it does not attempt to determine how much one com-
modity is preferred to another. As per the ordinal utility approach,
utility can be measured in relative terms such as less than and greater
than. The approach advocates that consumer behaviour can be ex-
plained in terms of preferences or rankings. For example, a consumer
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may prefer ice-cream over soft drink. In such a case, ice-cream would
have 1st rank, while 2nd rank will be given to soft drink. Therefore, as
per the ordinal utility approach, a consumer identifies several pairs of
two commodities which would provide him/her the same level of sat-
isfaction. Among these pairs, he/she may prefer one commodity over
the other based on how he/she ranks them in order of utility. This
implies that utility can be ranked qualitatively and not quantitatively.
ACTIVITY
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Express you three wants as cardinal utility and ordinal utility.
Total utility (TU) from a single commodity is defined as the total sat-
isfaction obtained from consuming the given amount of the commod-
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The above table indicates that eating one apple per day gives Sachin a
TU of 10 utils. If he eats four apples and derives 10, 15, 20 and 22 utils
from the successive apples eaten, then
TU = 10 + 16 + 20 + 22 = 68 utils
TUn = U1 + U2 + … + Un
MU = TUn – TUn-1
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MU of 2nd apple = 16 – 10 = 6 utils
As the above table shows, the MU declines with an increase in the con-
sumption of apples. This is because after consuming a certain amount
TUX
22 MUX
Total utility of X
20
Marginal utility of X
16
TUX 12
10
10 8
6
4
2
5 6
0
0 1 2 3 4 5 6 QX 1 2 3 4 QX
−2
Quantity of X Quantity of X MUX
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Figure 7.1: Total and Marginal Utility
Source: https://global.oup.com/us/companion.websites/9780195336108/pdf/Salvatore_Chap-
ter_3.pdf
ACTIVITY
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Therefore, the consumer’s utility derived from the marginal unit goes
The law of diminishing marginal
on declining as he consumes more and more of that unit. For example,
utility is universally true under
the following assumptions: suppose Sachin is hungry and he is offered an apple to eat. He will get
maximum satisfaction from the first apple because the intensity of his
yyThe unit of consumer goods
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is a standard such as an hunger is the highest. When he eats a second apple, he will get a lower
apple, a pair of shoes, a satisfaction because his intensity of hunger has reduced. As he goes
cup of tea and a piece of
sandwich,etc. The law may
on eating more apples, the intensity of his hunger goes on declining,
not be valid for extremely and therefore the satisfaction or utility derived from the successive
large or small units of goods. apples goes on decreasing. If he continues to eat apples, he will reach
yyThe consumer’s tastes and a point when his hunger is fully satisfied. Figure 7.1 shows that the
preferences are fixed during saturation point is the fifth apple, which gives him zero utility. Eating
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the period of consumption. any more apples will give a negative utility in the form of discomfort
yyThe consumption period or stomach problems. This link between the units consumed and the
is continuous. Breaks in
consumption, if any, must be
utility obtained from each successive unit consumed is called the law
appropriately brief. of diminishing marginal utility.
yyThe consumer’s mental
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condition is normal during Example 2: Consider Table 7.2 again. The total utility increases with
the consumption period. If increase in consumption of apples, but at a decreasing rate. The total
a consumer, for instance, utility reaches maximum at 22 at consumption of 5 apples. At the same
is eating and also drinking time, the marginal utility decreases with an increase in consumption
alcohol, then the utility
of apples. At the consumption of 5th apple, MU = 0. Consumption of
pattern will not be reliable.
the 6th apple yields negative utility and the total utility starts declining.
In some cases, the marginal
utility may initially increase Graphical illustration: Consider Figure 7.1 again. The TUx and MUx
rather than decrease, but it curves are obtained by plotting the data given in Table 7.2. The TUx
does increase eventually. These rises, at a diminishing rate, till the 5th apple is consumed. The MUx
cases are collection of money, curve diminishes and after the 5th apple, it turns negative. This means
collection of rare paintings, etc.
that extra consumption of an apple gives discomfort or disutility.
c. Is bell-shaped
d. First falls and then rises after reaching zero
8. Total utility is maximum when marginal utility is:
a. Maximum
b. More than 1
c. Zero
d. Less than 1
ACTIVITY
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marginal utility relates to everyday life. Do you think there are ex-
ceptions to this law? Explain your reasons through examples.
MU x
=1
Px ( MU m )
Marginal utility
E
Px(MUm)
MUx
O Q
Quantity
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Figure 7.2: Consumer’s Equilibrium – One-Good Case
Source: D. N. Dwivedi: Microeconomics: Theory and Applications
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In the above figure, Px(MUm) represents the continuous utility of mon-
ey weighed by the price of good X. MUx represents the diminishing
marginal utility of good X. These two curves intersect at point E,
where MUx = Px(MUm).
At any point above E, MUx > Px(MUm) → This indicates that if a con-
sumer exchanges his income for X, he increases utility per unit of
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commodity.
At any point below E, MUx < Px(MUm) → This indicates that a consum-
er increases utility by reducing his purchase.
In real life, a consumer consumes more than one good. Some goods
give him higher utility than others. A rational consumer first chooses
a good that gives him the maximum utility, then he picks up the good
which gives him the second highest utility, and so on. In this way, he
continues to spend his given income until the marginal utility of each
good per unit of expenditure is the same. This is known as the law of
equi-marginal utility.
MU x MU y
Alternatively, = 1 and =1
Px ( MU m ) Py ( MU m )
MU x MU y
Combining the above two equations, we get = 1=
Px ( MU m ) Py ( MU m )
MU x Px ( MU m )
Or =
MU y Py ( MU m )
Since MU of each unit of money is fixed, the above equation becomes
MU x Px
=
MU y Py
MU y MU
Or P = P = MU m
x
x y
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ginal utility per unit of money of each good so that the entire income
is spent.
Example 3: Vani has a total income of $56. She has the option to spend
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it on saree-collection or watching plays. Table 7.3 shows the marginal
utility of each good.
2 43 21 2 31 15
3 63 20 3 45 14
4 81 18 4 58 13
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5 97 16 5 70 12
6 111 14 6 81 11
MU s MU p
=
Ps Pp
10. A rational consumer will first pick up the good that gives:
a. Maximum utility b. Second highest utility
c. Zero expenditure d. Minimum value
ACTIVITY
You have the budget of ` 500 or 1000 to spend. Choose any two
goods X and Y on which you can allocate this income as per the law
of equi-marginal utility and show the relationship numerically and
graphically.
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In real life, a consumer is unable to express his utility in cardinal or
quantitative terms. However, given any two goods, a consumer can
always state which of the two goods he prefers. For example, Vani may
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not be able to specify how much utility she derives by watching a play.
However, she can always tell what she prefers between watching a
play and watching a movie, between collecting a saree and a piece of
jewellery, and so on. Thus, a consumer can always list all commodi-
ties he consumes in the order of preference. Consumer preferences,
therefore, mark a significant departure on the analysis of consumer
behaviour from the cardinal utility approach to the ordinal utility ap-
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proach.
aims at maximising his/her utility at the given income level and the
market price.
Ordinal utility: The utility is not measurable. A consumer can
only specify his preference for a specific combination of goods, but
not by how much.
Transitivity of choice: If a consumer prefers good X to Y and good
Y to Z, then he must prefer good X to Z. Alternatively, if the con-
sumer treats goods X and Y equally, and goods Y and Z equal-
ly, then he must treat goods X and Z equally. This behaviour of a
consumer is called transitivity of choice. Symbolically, this is ex-
pressed as follows:
If X > Y, and Y > Z, then X > Z
Consistency of choice: If a consumer prefers good X to good Y in
a period, he must not prefer good Y to good X in another period.
Symbolically, this consistency of choice is expressed as follows:
If X > Y in one period, then Y is not > X in another period
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a. Absolute utility approach
b. Cardinal utility approach
c. Ordinal utility approach
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d. None of the above
12. What is the assumption of non-satiety?
a. If X > Y, and Y > Z, then X > Z
b. As a consumer substitutes X for Y, ∆Y / ∆X goes on de-
creasing
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ACTIVITY
Rank any five goods using the ordinal utility approach. Ensure that
all assumptions are covered as you list your preferences.
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Non-satiety: The consumer will always seek a higher volume of
goods.
Transitivity: If the consumer prefers X to Y and Y to Z, then he
will prefer X to Z.
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7.8.1 MEANING OF INDIFFERENCE CURVE
S
20
Unit of plays
15
IM
10
1 2 3 4 5 6 7
Unit of sarees
M
30
20
I4
I3
10 I2
I1
5
0
5 10 15 20
The locus of the above set of indifference curves I1, I2, I3, and I4 is called
the indifference map, which reflects the entire set of tastes and pref-
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is willing to substitute for an extra unit of another good on the same
indifference curve is called the marginal rate of substitution (MRS).
For example, the marginal rate of substitute of saree for play (MRSSP)
is the number of plays that Vani is willing to exchange per unit of sa-
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ree and maintain the same level of satisfaction. Note that MRSSP mea-
sures the downward vertical distance (i.e. per additional unit of saree
required) to remain on the same indifference curve.
QY
10 A
−4Y
Unit of plays
1X B
6
−3Y
2X C
3
−2Y F
3X
1 U1
1 2 4 6 7 QX
Unit of sarees
Hence, 4 is the absolute (positive value of the) slope of the chord from
point A to B on U1.
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For a consumer like Vani, all combinations of goods, such as saree
and play, on a given indifference curve refer to the same level of total
satisfaction or utility. Thus, for a downward movement along the indif-
ference curve, the gain in utility in consuming more of one good, such
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as saree, must be equal to the loss in utility in consuming less of plays.
Specifically, the increase in consumption of sarees (∆S) multiplied by
the marginal utility she receives from consuming each extra unit of
the saree (MUS) must be equal to the reduction in plays (∆P) multi-
plied by the marginal utility of plays (MUP).
ference curve. This means that as Vani moves down her indifference
curve, she is left with less and less plays and more and more sarees,
each remaining unit of play becomes more valuable to her and each
extra unit of saree becomes less valuable. Thus, she is willing to give
up less and less of plays to obtain each additional unit of saree. This
property makes MRSSP decline and indifference curves convex to the
origin.
Indifference curves have four main properties, which reveal the con-
sumer’s preferences:
1. They are negatively sloped: Indifference curves have a negative
slope because if one combination of goods contains more of X,
then it will have to contain less of Y than another combination so
that the two bundles give the same level of utility and remain on
10 A
Unit of plays
6 B
3 C
S
1 U1
1 2 4 7
Unit of sarees
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Figure 7.6: Indifference Curve
Since combination B on the indifference curve U1 contains more
sarees (good X) than combination A, combination B must con-
tain fewer plays (good Y) to be on the indifference curve.
If the indifference curve were positive, as in Figure 7.7, then it
would have meant that one combination containing more of both
M
B’
A’
Unit of sarees
2
Unit of plays
C*
B*
2
A*
1
S
Unit of sarees
S
tainties in the market and individual’s life are inevitable. John Von
Neumann and Oskar Morgenstern, authors of The Theory of Games
and Economic Behaviour point out that indifference curve analysis
has no ability to analyse consumer behaviour in the midst of sev-
IM eral risks and uncertainties that prevail in the market and real life.
Unrealistic assumptions: IC is based on an assumption that a con-
sumer is fully aware of his/her preference for various commodi-
ties. However, this is an unrealistic assumption as humans have
their limitations. A human brain cannot take quick decisions by
analysing different combinations of several commodities available
in the market.
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ACTIVITY
Suppose a consumer spends all his income on goods X and Y, then the
budget constraint is:
P Q X + PYQ Y = I
X
Here, PX and PY are the price and QX and QY are the quantity of goods
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X and Y, respectively. I is the income of the consumer.
The above equation states that the amount of money spent (price mul-
tiplied by quantity) on good X and the amount of money spent on good
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Y equal the given income of the consumer.
QY
J
10
M
L
8
Quantity of Y
B G
6
N
H
3
M
2
K
0 1 2 4 5 QX
Quantity of X
income. Due to the income and price constraints, the consumer can-
? DID YOU KNOW not reach a combination of X and Y above the budget line. Here, we
If MRSXY > PX/PY, it means that assume that the consumer is rational and wants to maximize his total
the consumer is willing to pay a utility given the budget constraint. This can be achieved through the
more price for X than the market ordinal utility approach, provided the two fundamental conditions of
price. Thus, the consumer will consumer’s equilibrium are satisfied:
purchase more units of X, which
will decline MRS till it is equal 1. At the point of consumer’s equilibrium, the slope of the budget
to the ratio of the prices of X line and slope of the indifference curve should be the same. The
and Y, and the equilibrium is
reached. Similarly, if MRSXY < PX/
slope of the budget line is PX/PY. The slope of the indifference
PY, it means that the consumer curve is MRSXY. Thus, MRSXY = PX/PY
is willing to pay a less price for
X than the market price. Thus,
2. The indifference curve should be convex to the point of origin.
the consumer will purchase less This means that the MRS (slope of the indifference curve) must
units of X and more units of Y, decline from left to right at the point of equilibrium.
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which will increase MRS till it is
equal to the ratio of the prices Let’s understand this with the help of Figure 7.10. It has three indiffer-
of X and Y, and the equilibrium is ence curves I1, I2, and I3 and the budget line AB.
reached.
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Y
B
D
C
I3
M
I2
I1
X
A
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Refer back to Section 7.9 and recall that during the analysis of the con-
sumer’s equilibrium, we assumed that his income of consumer and
the prices of goods X and Y will remain unchanged. But what happens
to the consumer’s behaviour if his income changes? Given that the
prices of goods remains fixed, change in the consumer’s income influ-
S
ences his purchases. The analysis of the effect caused by changes in
consumer’s income on his/her purchases while the prices of commod-
ities remain unchanged is called as Income Effect.
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If the income of consumer increases, he will move to the higher indif-
ferent curve and the equilibrium position also shift towards the right.
On the other hand, if the income of consumer decreases then he will
move to the lower indifferent curve and his equilibrium position also
shift leftward. Also note that higher indifferent curve yields the higher
level of satisfaction and vice versa.
are as follows:
The prices of both normal goods X and Y are unchanged.
The consumer’s tastes and preferences remain the same.
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Y Income consumption
curve
I3
X2
I2
X1
X0 I1
O X
B1 B2 B3
When the budget line is B1, the original consumer’s equilibrium point
is at X*. The budget line B1 touches the indifference curve I1 at X*. I1
is tangent to B1. Now, if the consumer’s income increases, B1 will shift
to the right. The new budget line will be B2. The new budget line B2
will touch the indifference curve I2 at X1, which will be the new equi-
librium point. As the consumer’s income increases more, the budget
line will again shift to the right. The new budget line B3 will touch the
indifference curve I3 at the new equilibrium point X2. Note that the
new budget lines B2 and B3 shift in parallel to the original budget line
B1. The slope of the budget line depends on the ratio of prices of goods
and hence remains constant.
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when the consumer’s income changes, provided their relative prices
remain unchanged.
NOTE When the income of a consumer increases, he will buy more and more
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quantities of normal goods. Normal goods can be necessities (such as
The income effect is positive in
case of normal goods. salt) or luxuries (such as car):
N Q
Quantity of Y
B1
Q1
N1
IC
A
A1
O M M1
Quantity of X
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Till now you have studied about the following two effects:
Income effect: Consumer’s equilibrium when income of consumer
changes keeping the prices of goods X and Y unchanged; and
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Substitution effect: Consumer’s equilibrium when income of con-
sumer is unchanged and the prices of both goods change.
In both these cases, the price of goods was unchanged. But what will
happen when the price of one normal good is changed?
Let us now study about the price effect wherein the price of only one
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A1
Good Y (NormaL)
E3 PCC
E1 E2
I3
I1 I2
O X
X1 X2B1X3 B2 B3
Good X (NormaL)
In Figure 7.13, the budget line A1B1 represents the given prices of
goods X and Y and a given income. The consumer’s equilibrium point
is at point E1 on the indifference curve I1. At E1, the consumer pur-
chases OX1 of the good X.
Suppose the price of the good X falls, while the price of the good Y and
his income remain fixed. Then, the budget line will shift to the right as
A1B2. The consumer is now in equilibrium position at E2 on a higher
indifference curve I2. Now he will buy OB2 of X. Thus, his level of sat-
NOTE isfaction has increased due to fall in the price of the good X and he is
Any increase in the price of X purchasing more of X than before. If the price of X decreases further,
will move the budget line inward AB3 will be the relevant budget line. The consumer’s new equilibrium
to the left of the original budget position is at E3 on the indifference curve I3. He buys OB3 of X (more
line towards the origin. quantity of X).
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If the equilibrium points E1, E2, and E3 are joined together, a new line
called the Price Consumption Curve (PCC) is drawn. The PCC is the
line that shows how the changes in the price of X will influence the
consumer’s purchase of X, given the price of Y, consumer’s income
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and tastes remain unchanged.
If the price of the normal good X decreases, then both income effect
and substitution effect will increase the demand for good X. Hence,
there is an inverse relation between price and demand.
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c. Vijay will demand less coffee
d. Vijay will demand less tea
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ACTIVITY
Study about the movement of the ICC when X is a normal good but
Y is an inferior good.
7.10 SUMMARY S
M
S
marginal rate of substitution (MRS).
Indifference curve are negatively sloped, convex to the origin, and
do not intersect.
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A budget line shows the different combinations of two goods that a
consumer can buy by spending all his given income.
The effect of determining the influence of the changes in the con-
sumer’s income on his purchases, given the prices of goods re-
mains fixed, is called the income effect.
The Income-Consumption Curve (ICC) displays the change in the
quantity purchased of two goods, X and Y, when the consumer’s
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KEY WORDS
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1. Who introduced the concept of utility? MCQ
a. Hicks and Allen b. Alfred Marshall
c. Jeremy Bentham d. John Maynard Keynes
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2. Marginal utility is:
a. An actual measure of utility
b. The utility based on relative ranking of the commodity
c. The aggregate utility derived from consuming a given quan-
tity of a good
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c. Increasing d. Decreasing
4. What is the marginal utility of a commodity at saturation point?
a. 0 b. Less than 0
c. More than 0 d. Increasing
5. A consumer reaches equilibrium point when:
a. Total utility = Price of good
b. Marginal utility > Price of good
c. Marginal utility < Price of good
d. Marginal utility = Price of good
6. When the income of an individual consumer increases, his de-
mand for a normal good will (given that everything else remains
unchanged):
a. Fall b. Rise
c. Remain the same d. First rise and then fall sharply
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10. The higher the indifference curve, the _______________ will be
the level of satisfaction.
a. lower b. higher
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c. same d. more relative
utility.
3. What is the difference between total and marginal utility? Ex-
plain through an example.
4. Write a note on the law of diminishing marginal utility.
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S
c. Price level of a country
d. Ratio of price of both goods
4. The income effect:
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a. Is always positive
b. Is always positive for normal goods
c. Is always negative for normal goods
d. Depends on the price effect
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5. Total utility
a. Increases at a decreasing rate
b. Is the utility derived from the last unit
c. Diminishes with the increasing rate of consumption
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S
Indifference Curve Analysis tion
14. b. indifferent
15. c. Tangential to each other
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Consumer Equilibrium 16. a. PX/PY
Effects
17. b. Vijay will demand more
tea
Q. No. Answer
1. c. Jeremy Bentham
2. d. The utility derived from one more unit
3. d. Decreasing
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4. a. 0
5. d. Marginal utility = Price of good
6. b. Rise
7. d. Price effect
8. c. Convex to the origin
9. a. Diminishing
10. b. higher
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is called the marginal rate of substitution (MRS). Refer to Sec-
tion 7.8 Ordinal Utility Approach – Indifference Curve Analy-
sis
7. The analysis of the effect caused by changes in consumer’s in-
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come on his/her purchases while the prices of commodities re-
main unchanged is called as Income Effect. Price effect can be
called the effect of change in price on consumer equilibrium
when price of one good changes keeping all other factors such as
the income of a consumer, his taste, and price of the other good
fixed. Refer to Section 7.9 Consumer Equilibrium Effects
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Q. No. Answer
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SUGGESTED READINGS
Mandal, R. (2007). Microeconomic theory. New Delhi: Atlantic.
Palgrave Macmillan. (2014). Contributions to Consumer Demand
and Econometrics.
Samuelson,P., & Nordhaus, W. (2010). Microeconomics. Boston:
McGraw-Hill Irwin.
E-REFERENCES
(2020).Retrieved 1 August 2020, from http://ebooks.lpude.in/com-
merce/mcom/term_1/DECO405_MANAGERIAL_ECONOMICS_
ENGLISH.pdf
(2020).Retrieved 1 August 2020, from https://global.oup.com/us/
companion.websites/9780195336108/pdf/Salvatore_Chapter_3.pdf
Consumer Choice and Utility | Microeconomics. (2020). Retrieved
1 August 2020, from https://courses.lumenlearning.com/wm-mi-
croeconomics/chapter/consumer-choice-and-utility/
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S
CONTENTS
8.1 Introduction
8.2 Basic Concepts of Production
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8.2.1 Meaning of Production
8.2.2 Factors of Production
8.2.3 Short Run and Long Run
Self Assessment Questions
Activity
8.3 Short-Run Production Function: Law of Variable Proportions
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INTRODUCTORY CASELET
S
because she simply could not expand her manufacturing unit at
least for the next year. Why did Ragini refuse orders? What limit-
ed her production capacity? What constraints did she face? In this
chapter, you will find these answers.
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LEARNING OBJECTIVES
8.1 INTRODUCTION
In the previous chapter, you have studied about consumer demand Quick Revision
analysis and two approaches to the measurement of utility, namely
S
cardinal utility approach and ordinal utility approach. Production is
a process of transforming tangible and intangible inputs into goods
or services. Raw materials, land, labour and capital are the tangible
inputs, whereas ideas, information and knowledge are intangible in-
IM
puts. These inputs are also known as factors of production. For an
organisation, the four major factors of production are land, capital,
labour and enterprise. An organisation needs to make an optimum
utilisation of these factors to achieve maximum output. The techni-
cal relationship between the inputs and the output is expressed by
production function. It enables an organisation to achieve maximum
output with the given combinations of factors of production in a par-
M
S
including:
Land: He will grow the sugarcane on land.
Labour: The sugarcane will be planted and harvested using
IM
labour.
Capital: The farmer will use tractors, spades, hoes, irrigation
ditches, sacks, fertilisers and pesticides.
Production is not just about physical outputs such as cloth, rice and
mobile phones. It also includes services of doctors, teachers, nurses,
consultants, etc. For attaining the maximum output, inputs are com-
bined in more than one way. The most efficient combination is chosen
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X = f (L, K, S)
Here,
X = Level of output
S
For example, a dairy needs 50 cows and 1 labourer to produce 50 litres
of milk per day, then the production can be shown as:
50X = L + 50K
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Here, 50X is the number of litres of milk, L is the number of workers,
and K is the capital input (number of cows).
Factors of production are the inputs that are used for producing the
final output with the main aim of earning an economic profit. Each
and every factor is important and plays a distinctive role in the organ-
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In the long-run production, Ragini can move her production unit into
a larger factory and purchase more machines, as well as employ more
labour and use more raw materials. Doing so will increase the produc-
S
tion capacity of her manufacturing unit, provided the technology does
not change.
c. Entrepreneur d. Capital
2. In a short-run production, __________ factors of production
are in _____________ supply.
a. all, variable b. all, fixed
c. some, infinite d. some, fixed
3. Which expression below defines the production function?
(X – level of output, L – labour, K – capital, S – land, T – state
of technology)
a. X = f (L,K,S) b. X = f(T/L+K+S)
c. S = f (X, T, K) d. f(X, T) = f (L,K,S)
ACTIVITY
S
X = f (S, L)
Now, consider Table 8.1. In this example, land is fixed at 1 unit, while
labour input is in variable supply:
S
Land Labour Total Product of Average Product Marginal Product
Labour (TPL) of Labour (APL) of Labour (MPL)
1 0 0 0 -
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1 1 4 4 4
1 2 10 5 6
1 3 18 6 8
1 4 24 6 6
1 5 28 5.6 4
M
1 6 30 5 2
1 7 30 4.3 0
1 8 28 3.5 -2
1 9 25 2.7 -3
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Now, let us plot the values of TPL, APL and MPL on the graph, as shown
in Figure 8.1:
TPL
TPL
Maximum
A B
TPL
Inflextion
Point
S
C IM
O QL(land)
APL
MPL
Power of diminishing
C’
marginal returns
Power of diminishing
average returns
M
A’
APL
B’ MPL= 0
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O QL(land)
APL MPL
As Figure 8.1 shows, the TPL curve starts from the origin, increases
at an increasing rate, then increases at a diminishing rate, reaches a
maximum, and then starts to fall. This means that as more and more
labour units are employed, TPL increases but at a diminishing rate.
APL and MPL curves are derived in the lower panel of Figure 8.1.
APL at any point on the TPL curve is the slope of the straight line from
the origin to that point on the TPL curve. It is positive as long as TPL is
positive. The APL curve is in the shape of inverted U. It initially rises,
reaches a maximum, and then falls.
MPL at any point on the TPLcurve is the slope of the TPL curve at that
point. MPL between two points on the TPLcurve is the slope of the line
connecting the two points on the TPL curve. The slope increases till
point C and then decreases. At maximum TPL the slope is zero and
then it is negative.
The MPL curve initially rises, reaches a maximum when the slope of
the tangent is highest, and then falls. When TPL is maximum, MPL is
zero (point B to B’). When TPL declines, MPL is negative. This means
that an extra worker results in fall of output (or slows down the pro-
duction process). Thus, the MP of that worker is negative.
The area under the MPL curve is TPL. MPL is positive as long as is TPL
S
positive, but it becomes negative when TPL starts to decrease.
From point C’ to A’, the APL curve is rising even though the MPL curve
M
is falling. At point A’, the APL curve neither rises nor falls. At this point,
MPL = APL.
TPL=APL.L
∂TPL ∂( APL .L)
MPL = = = APL + L(slope of APL curve)
∂L ∂L
This law is a short-run phenomenon that operates when the total out-
put or production is increased by increasing units of a variable factor.
Another name of this law is the Law of Diminishing Marginal Re-
turns. The law of diminishing returns is an important concept of the
economic theory. The law of diminishing returns is a short run con-
cept where some factors are fixed and some are variable.
It explains that when more and more units of a variable input are em-
ployed at a given quantity of fixed inputs, the total output may initially
S
There must always be some fixed factor and diminishing returns
must result from limitations on the use of this factor.
The law of variable proportions can be split into three specific stages
of production in the short-run:
IM
1. Stage of increasing returns
2. Stage of diminishing returns
3. Stage of negative returns
Product
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Stage I TPL
Stage II
Stage III
APL
O b d
MPL
S
Underutilisation of a fixed factor: The fixed factor (land) is
underutilised in relation to the labour employed on it. This
helps in better use of land, which, in turn, will increase the
TPL curve at an increasing rate.
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Indivisibility of factors: The factors employed in the pro-
duction process cannot be divided further into smaller units.
Therefore, when more units of variable factor (i.e., labour)
are mixed with the fixed factor (i.e., land), the returns will
keep on increasing.
Specialisation and division of variable factor: As the units
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S
a. The TPL curve falls.
b. The APL curve falls continuously.
c. The MPL curve is negative.
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It is a non-economic and inefficient stage. Since a producer can
increase his output by using less labour, he will not have any
incentive to operate in this stage.
S
c. maximum MPL
d. minimum MPL
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ACTIVITY
Search on the Internet and find out the significance of law of dimin-
ishing returns.
S 8.4 SUMMARY
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KEY WORDS
S
Fixed factor of production: A factor of production whose quan-
tity remains constant during a specific period
Variable factor of production: A factor of production whose
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quantity can be modified during a particular period
Production: The process of conversion of inputs into outputs
Production function: The relationship between factors of pro-
duction and output
MCQ
1. Addition of utility should be regarded as ___________, which
brings about an addition in the value of goods.
a. Production
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b. Consumption
c. Marginalisation
d. Profiteering
2. Total product divided by the amount of variable factor is:
a. Marginal product
b. Total product per unit of labour
c. Average product
d. Aggregate product
3. The technological relationship between physical inputs and the
maximum producible output is:
a. Total product
b. Marginal product
c. Production function
d. Law of variable proportions
4. The period of time during which a firm can change only some
factors of production (such as labour) is called:
a. Short run
b. Long run
c. Production run
d. Maximum run
5. In which production has all factors of production variable?
a. Total production
b. Marginal production
c. Short-run production
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d. Long-run production
6. When total product increases at a diminishing rate, the marginal
product will:
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a. Increase continuously
b. Increase, reach a maximum, and then fall
c. Remain fixed
d. Decrease
7. Total physical product is derived by ________ the marginal
M
physical product.
a. Summing up
b. Subtracting
c. Multiplying
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S
and variable factors with examples.
3. What is the difference between short-run and long-run
production?
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4. Define total product, average product and marginal product.
Use an example to plot their curves and explain the relationships
between:
a. TP and AP curves
b. TP and MP curves
c. AP and MP curves
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c. U-shaped
d. Downward sloping
3. In the third stage of the law of variable proportions, the total
product curve is:
a. L-shaped
b. Inverse U
c. U-shaped
d. Downward sloping
4. The shape of the marginal product and the average product
curves is:
a. U-shaped
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b. Inverse U-shaped
c. Downward sloping
IM d. Convex
5. Which stage of the law of variable proportions is relevant for
a rational producer who wants to get maximum efficiency or
profits for his firm?
a. First
b. Second
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c. Third
d. Both first and second
Q. No. Answer
1. a. Production
2. c. Average product
Q. No. Answer
3. c. Production function
4. a. Short run
5. d. Long-run production
6. c. Decrease
7. a. Summing up
8. c. Be negative
9. a. maximum
10. c. Third
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farmer decides to grow sugarcane. Then, sugarcane is an output
of the production process. Refer to Section 8.2 Basic Concepts of
Production
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2. Factors of production are the inputs that are used for producing
the final output with the main aim of earning an economic profit.
Refer to Section 8.2 Basic Concepts of Production
3. Economists usually refer to periods of production as either
short-run or long-run. Refer to Section 8.2 Basic Concepts of
Production
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Q. No. Answer
1. a. Convex
2. b. Concave
3. d. Downward sloping
Q. No. Answer
4. b. Inverse U-shaped
5. b. Second
SUGGESTED READINGS
Forsund, F. (2016). Topics in Production Theory. London: Palgrave
Macmillan Limited.
Frank, C. (2016). Production theory and indivisible commodities.
(psme-3). [Place of publication not identified]: Princeton Univer-
sity Pres.
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Katz, M., & Rosen, H. (2005). Microeconomics. Boston, Mass.: Mc-
Graw-Hill.
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E-REFERENCES
Microeconomics: Theory and Applications, 5th Edition. (2020). Re-
trieved 5 August 2020, from https://global.oup.com/us/companion.
websites/9780195336108/
Theory of Production - Tutorialspoint. (2020). Retrieved 5 August
2020, from https://www.tutorialspoint.com/managerial_economics/
M
theory_of_production.htm
Microeconomics: Production Theory. (2020). Retrieved 5 August
2020, from https://www.slideshare.net/salasvelasco/microeconom-
ics-production-theory
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S
CONTENTS
9.1 Introduction
9.2 Long-Run Production Function: Isoquant Analysis
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9.2.1 Isoquant Curve
9.2.2 Iso-Cost Curves
9.2.3 Producer’s Equilibrium
Self Assessment Questions
Activity
9.3 Long-Run Production Function: Law of Returns to Scale
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9.4 Summary
9.5 Multiple Choice Questions
9.6 Descriptive Questions
9.7 Higher Order Thinking Skills (HOTS) Questions
9.8 Answers and Hints
9.9 Suggested Readings & References
INTRODUCTORY CASELET
S
Table 9.1 that shows the short-run production function for RK De-
signs:
IM Table 9.1: Short-Run Production Function for
Jacket Manufacturing
Labour (# Tailors) 1 2 3 4 5 6
Total product (Jack- 5 7 8 8 8 8
ets/hour) For K = 1 Machine
Marginal product 5 2 1 0 0 0
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In the short run, the only variable factor was labour. Therefore,
the only way RK Designs could produce more jackets was by hir-
ing additional tailors.
From the given table, note that RK Designs initially had one tailor
(labour) and one sewing machine. Now, in the short-run, the num-
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When the data related to the number of tailors employed and the
total number of jackets produced is analysed, it is revealed that
adding any number of tailors beyond 3, i.e. (4, 5, 6, tailors) has no
impact on productivity.
INTRODUCTORY CASELET
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Labour (Tailors) 1 2 3 4 5 6
Total product 5 7 8 8 8 8
(Jackets/hour) For K = 1 Machine
Marginal product 5 2 1
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0 0 0
Total product 5 10 15 17 18 18
(Jackets/hour) For K = 3 Machines
Marginal product 5 5 5 2 1 0
LEARNING OBJECTIVES
9.1 INTRODUCTION
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Quick Revision In the previous chapter, you have studied about the production theo-
ry in the short run. Short-run production function refers to the time
period in which one input factor of production is variable and oth-
er input factors are fixed and increase in production can be brought
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by increasing only one factor of production, while keeping the other
factors constant. On the other hand, in the long run, the production
function includes the time period in which all inputs of production
are variable and increase in production can be achieved by increas-
ing all the input factors simultaneously. For example, in the long run
increase in production can be achieved either by installing new plant,
machinery, buildings or the extra units of labour.
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In this chapter, you will study about these curves and the producer’s
equilibrium. The chapter also explains the law of returns to scale. In
this chapter, you will study about the concepts of production in long
run.
Here,
X = Level of output
L = Labour (physical and mental efforts of workers)
K = Capital (factories, machines, equipment and other human manu-
factured aids to production)
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function. The word ‘iso’ means constant and the word ‘quant’ means
quantity. An isoquant is defined as a line that shows the various com-
binations of factors of production (labour and capital) which yield a
given quantity of output. According to Cohen and Cyert, an isoquant
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is a curve “along which the maximum achievable production is con-
stant.” It represents the flexibility of a firm when it makes production
decisions. Consider Table 9.3 that shows the Labour and Capital data
for different levels of output.
A 5 10 100
B 10 6 100
C 20 3 100
D 7 12 200
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E 12 8 200
F 22 5 200
G 9 15 300
H 15 11 300
I 25 8 300
Using the data from Table 9.3, isoquant curves are drawn as shown in
Figure 9.1:
In Figure 9.1, suppose isoquant I1 shows that a firm can produce 100
kg of output using 10 units of capital and 5 units of labour (combina-
tion A), 3 units of capital and 20 units of labour (combination B) or
any other combination which lies on isoquant I1. Note, however, that
you cannot determine which combination the firm actually uses to
produce the output, it only shows the technically possible combina-
tions of factor inputs which can produce 100 kg of output. Combina-
tion A, which requires more units of labour but less units of capital, is
a capital intensive method of production. On the other hand, combi-
nation B, which requires less units of capital but more units of labour,
is a labour intensive method of production. Figure 9.1 shows three
isoquants:
Isoquant I1: Suppose it shows 100 kg of output. This output can
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be produced by using either combination A or combination B or
any other combination on this isoquant. The firm or the producer
is indifferent between any of these combinations that lay on the
isoquant I1.
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Isoquant I2: This isoquant shows a higher quantity of output, say
150 kg.
Isoquant I3: This isoquant represents even higher quantity of out-
put, say 200 kg.
isoquant curve:
An isoquant slopes downward from left to right in the relevant
range: Isoquants are downward sloping as shown in Figure 9.1.
This means that if a firm wants to use more units of labour, it must
use less units of capital to produce the same units of output in or-
der to remain on the same isoquant curve. Such behaviour can
only be satisfied through a downward sloping isoquant because it
only shows the substitution of one factor with the other. Therefore,
the slope of the isoquant curve is negative.
An isoquant is convex to the origin: It implies that factor inputs
are not perfect substitutes. This property shows the substitution
of inputs and diminishing marginal rate of technical substitution
of isoquant. The marginal significance of one input (capital) in
terms of another input (labour) diminishes along with the iso-
quant curve.
A higher isoquant depicts a higher level of output: The great-
er the distance of an isoquant curve from the point of origin,
Units K2 B
of
K1 A
Capital Q2
S
Q1
X
O L1 L2
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Units of Labour
Y
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Units
of
Capital
A Q2 (=200)
K
Q1 (=100)
O L X
Units of Labour
C = PL × L + PK × K
Where,
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PL = Price of labour (i.e., wages – w)
Therefore, C = w × L + r × K
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For example, a producer has a total budget of `120, which he wants to
spend on the factors of production, namely X and Y. The price of X in
the market is `15 per unit and the price of Y is `10 per unit. Table 9.4
depicts the combinations:
D 2 9 120
E 0 12 120
X
10
8 T
1
Iso-cost Line
2
H
Y
0 2 4 6 8 10 12
other hand, if the producer purchases Y with the whole amount, then
he/she would be able to get 12 units. If points H and L are joined on
X and Y axes, respectively, then a straight line is obtained, which is
called iso-cost line. All the combinations of X and Y that lie on this
line, would have the same amount of cost that is `120. Similarly, other
iso-cost lines can be plotted by taking cost more than `120, in case the
producer is willing to spend more amount of money on the production
factors.
With the help of isoquant and iso-cost lines, a producer can determine
the point at which inputs yield maximum profit by incurring mini-
mum cost. Such a point is termed as producer’s equilibrium.
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In an earlier chapter, you studied about consumer’s equilibrium. In
this section, you will study about producer’s equilibrium. Producer’s
equilibrium implies a situation in which a producer maximises his/her
profits.
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In the long run, the producers can vary all the factors of production.
The producers or the firms usually aim at maximising their profits by
selecting the least cost combination of factors to produce a given level
of output. The combination of factors of production using which an
organisation can produce a given quantity of goods at the lowest cost
or at which the total cost of producing a given output is minimum is
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In Figure 9.5, note that the isoquant curve (for product quantity = 400
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units) is tangent to iso-cost line CD. Here, the cost outlay is Q units.
At point Q, the two conditions required for producer’s equilibrium are
satisfied as follows:
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c. parallel
d. independent
ACTIVITY
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Consider any manufacturing company of your choice. Note down
its factors of production and the units of output for the last 5 years.
Draw the isoquant curve of the company.
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duced, which is more than double of 100 Q. This more than double
output is represented by point B in Figure 9.6, which lies on a higher
isoquant than point A:
IM K
B
6
Q 300 Q
A
3
M
100 Q
L
0 3 6
Source: http://ebooks.lpude.in/commerce/mcom/term_1/DECO405_MANAGERIAL_ECONOM-
ICS_ENGLISH.pdf
case of constant returns to scale, when the inputs are doubled, the
output is also doubled. During this stage, the output increases by the
same proportion as the increase in factors of production. For example,
consider Figure 9.7. To produce 100 Q units of output (point A), 3 units
each of K and L are used. If 6 units of K and 6 units of L are used,
then the output produced is 200 Q (point B), which is double the initial
output. Similarly, if the factors of production are trebled, then treble
output will be produced, and so on.
B
6
S
200 Q
A
3
100 Q
0
IM L
3 6
ishing returns to scale. During this stage, the output increases by less
proportion than the increase in factors of production. For example, in
Figure 9.8, both capital and labour are doubled from 3 units to 6 units,
but the output rises by less than double—from 100 Q to 150 Q.
B
6
150 Q
A
3
100 Q
L
0 3 6
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SELF ASSESSMENT QUESTIONS
X units of output then the inputs are tripled, the output will
increase by _____________ under decreasing returns to scale.
a. 2X b. 3X
c. 4X d. 5X
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ACTIVITY
S 9.4 SUMMARY
An isoquant is defined as a line that shows various combinations of
the factors of production (labour and capital) which yield a given
quantity of output.
An isoquant curve is downward sloping in the relevant range and
convex to the origin.
The iso-cost or the equal-cost line shows various combinations of
labour and capital that a firm can hire or rent within the given
total cost.
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tion are increased in the same proportion and at the same time,
the output will increase. However, the increase may be at an in-
creasing rate or constant rate or decreasing rate.
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KEY WORDS
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_________ factor(s) of production in a fixed proportion.
a. no b. only one
c. some d. all
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7. What is the slope of an isoquant?
a. Marginal product
b. Ratio of input prices
c. Marginal rate of technical substitution
d. Average product
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1. Varun Beverages doubles its inputs and finds that its output has
increased by 25%. This is:
a. Constant returns to scale
b. Increasing returns to scale
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c. Decreasing returns to scale
d. Diminishing rate of marginal product
2. The overall output generated at a given level of input is shown
by:
a. An isoquant curve
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S
5. a. 2X
5. b. increased
6. d. all
7. c. Marginal rate of technical substitution
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are doubled, the output is also doubled. Refer to Section 9.3
Long-Run Production Function: Law of Returns to Scale
Q. No. Answer
1. b. Increasing returns to scale
2. d. The production function
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3. d. tangent
4. b. Increasing returns to scale
SUGGESTED READINGS
Richardson, G. (2013). Economic Theory. Hoboken: Taylor and
Francis.
Salvatore, D. (2003). Microeconomics. New York: Oxford University
Press.
Taylor, J., & Weerapana, A. (2012). Microeconomics. [Mason, Ohio?]:
South-Western Cengage Learning.
E-REFERENCES
(2020).
Retrieved 7 August 2020, from http://ebooks.lpude.in/com-
merce/mcom/term_1/DECO405_MANAGERIAL_ECONOMICS_
ENGLISH.pdf
Isoquant: Concept, Characteristics and Type | Production Func-
tion | Economics. (2020). Retrieved 7 August 2020, from https://
www.microeconomicsnotes.com/production-function/isoquant/
isoquant-concept-characteristics-and-type-production-func-
tion-economics/15331
Production in the Long Run | Microeconomics. (2020). Retrieved 7
August 2020, from https://courses.lumenlearning.com/wm-micro-
economics/chapter/production-in-the-long-run/
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CONTENTS
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CASE STUDY 7
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as essential to life as water be so much cheaper than that of a bau-
ble? This case study explores the reasons.
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ANALYSIS
RESULTS
The marginal utility of water is the reason that bottled water sales
grew exponentially in the US and the rest of the world during the
last 20 years. In 2019, the per capita consumption of bottled water
CASE STUDY 7
was approximately 43.7 gallons in the US, whereas it was just 16.2
gallons in 1999 as shown in Figure A:
50
45 43.7
42.3
40.6
40 38.5
Per capita consumption in gallons
35.9
33.6
35
31.6
30.4
29 28.1 28.7
30 27.6 27.8
27.0
25.4
25 23.2
21.6
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20.1
20 18.2
16.2 16.7
15
99
00
01
02
03
04
05
06
07
08
09
10
13
14
15
16
17
18
19
11
12
19
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
20
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Figure A: Per Capita Consumption of Bottled Water in US
(1999 – 2019)
(Source: https://www.statista.com/statistics/183377/per-capita-consumption-of-bottled-
water-in-the-us-since-1999/)
The per capita consumption of bottled water has also grown in the
rest of the world. In 2018, Mexico and Thailand were the leading
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Mexico 72.4
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Thailand 72.4
Italy 50.3
France 38.3
Germany 38.1
Spain 37.6
Belgium-Luxembourg 35.4
Indonesia 32.5
0 10 20 30 40 50 60 70 80
Per capita consumption in gallons
CASE STUDY 7
Now, the question is why would anyone pay a premium price for
water in a bottle when they can drink it for free from a tap? Eco-
nomics provides the following answers for this:
1. For most people, bottled water is a healthy alternative to
tap water. In a Gallup Poll, 50% respondents said that they
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would not drink water straight from the tap. Therefore, bot-
tled water and tap water are not good substitutes of each
other.
2. Even those people who drink tap water consider bottled
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water a convenient option when they are away from home.
According to the theory of utility maximisation, consumers
who purchase bottled water actually feel that the extra ben-
efit offsets the extra cost.
CONCLUSION
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Today, the sales of bottled water are threatening the gigantic soft
drinks industry. Consumers consider bottled water to be a healthy
alternative to soft drinks. Therefore, bottled water is on the menu
in fast food restaurants. However, soft drink companies might
have had the last laugh after all. If you cannot beat them, join
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them. Coke and Pepsi have launched their own brands of bottled
water, Dasani and Aquafina, respectively. Their business model is
hugely profitable.
(Source: https://sangu.ge/images/Economics1.pdf)
QUESTIONS
BACKGROUND
Case Objective
The Darbar Restaurant is a Mughlai restaurant in New Delhi. If
This case study analyses
you were to walk to the restaurant during lunch time on a week- when to open the restaurant
day, you will find it almost empty. The restaurant has a seating and when to close it so
capacity of around 50 people. It is luxuriously decorated as any that the restaurant remains
Mughal durbar of a bygone era. There are also classical instru- profitable, using the short-run
mental musicians playing live music at one side of the restaurant. production theory.
On the other side, buffet tables are laid out, with an assortment
of continental and Indian food. As you pick up a delicious spoon-
ful of gravy on your plate, you wonder why the restaurant even
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bothers to stay open when there are only a couple of customers
(including yourself). It would seem that the revenue from these
couple of customers cannot possibly cover the cost of running the
restaurant.
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ANALYSIS
clude:
Rent
Kitchen equipment
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RESULT
CASE STUDY 8
CONCLUSION
Costs
MC
Firm’s short-run
supply curve
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ATC
AVC
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shuts
down if
P < AVC
0 Quantity
QUESTIONS
It has been seen that in some industries, it is not easy for people to
adopt an industry standard that is beneficial to their own product Case Objective
in an easy way. It invariably involves a lot of marketing efforts,
This case study highlights
which helps to grow more productive, which makes the product the different instances where
market share grow bigger. Microsoft experienced
increasing and diminishing
A good example of this is Microsoft’s Windows. It is observed that returns.
when more customers adopt Windows, then there are more appli-
cations which are introduced by independent software develop-
ers in the market, and the more interesting applications that are
introduced which have a better chance of being accepted by the
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users. It is seen that with other products, the market can show re-
sults in diminishing returns towards the expenditure for promo-
tions, since it becomes saturated. But due to the latest standards
of technology and accepting these new industry standards, the
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law for increasing returns can continue. Taking advantage of this,
Microsoft is willing to spend big expenditures on promotion and
marketing to dominate the industry. Many would claim that this is
a limited practice, which can be justified by the recent anti-trust
suit filed against the company.
2000 included Word, Excel, PowerPoint and Access for its custom-
ers. It had certain advance features over the previous package of
Office 97. The new features allow more interaction with the In-
ternet. It is also beneficial for the firms since it also allows easier
collaborative work for them using an intranet. Therefore, many
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There are limitations in terms of scope for the users to take ad-
vantage of these beneficial features. Office 97 contained a num-
ber of features that most customers cannot finish using them, and
exhaust all its prospects. It was expected that with Word 97 even
skilled users were not likely to use more than a quarter of all its
benefits. Keeping these aspects in mind Microsoft is a victim of
the law of diminishing returns.
The small business and end-users from home may not be im-
pressed with the advanced features and further capabilities of Of-
fice 2000. Since there are large expenditures and costs involved
for upgrading and developing to the package, the next question is
where Microsoft moves from here. It is expected that the next ver-
sion of Office 2003, may bring in a speech-recognition program,
which would eventually make the keyboard and mouse useless.
But these kinds of programs need a good amount of investment
CASE STUDY 9
in terms of time and energies for the user to train the computer
to understand and interpret their commands correctly. It is also
a huge investment for the software producer for developing the
package.
(Source: http://marketworksasia.com/yahoo_site_admin/assets/docs/Excerpts_Ch5_Manage-
rial_Economics)
QUESTIONS
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for the law of diminishing returns in Microsoft’s case?
(Hint: Using the benefits of features and costs in terms of
variable and fixed factors)
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COST ANALYSIS
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CONTENTS
10.1 Introduction
10.2 Basic Cost Concepts
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10.2.1 Actual and Opportunity Costs
10.2.2 Implicit and Explicit Costs
10.2.3 Fixed and Variable Costs
10.2.4 Accounting and Economic Costs
10.2.5 Private and Social Costs
10.2.6 Short-Run and Long-Run Costs
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INTRODUCTORY CASELET
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per unit with the total number of units sold.
the company has a capacity to produce 3500 units per week. The
launch of new product range will enable to utilise its full capacity.
The total fixed overhead cost of the company was `1,00,000 per
week. This fixed overhead cost includes shared factory space,
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INTRODUCTORY CASELET
S
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LEARNING OBJECTIVES
10.1 INTRODUCTION
Quick Revision In the previous chapter, you studied about the long-run production
function, isoquant curves, iso-cost curve and the producer’s equilib-
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rium. The chapter also discussed about the laws of returns to scale.
In this chapter, you will study about the basic cost concepts used in
economics, the cost function and the economies and diseconomies of
scale.
Certain cost concepts are used by accountants while some are used
by economists. The cost concepts used by economists are basically to
analyse the cost of production for the year which has to be budgeted.
The economists are more focussed on rearranging the input cost and
Let us now study about these costs in detail in the next sections.
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the actual cost. These costs are recorded in the books of accounts and
are used for financial analysis. Let us understand the concept of actu-
al cost with the help of an example.
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Maya purchases raw materials for ` 5,000 and incurs transportation
costs of ` 500. The labour and machine costs are ` 5,000 for one week.
The goods are ready for sale and are transported to retail shops at a
cost of ` 500. Therefore, the total cost incurred on the production of
goods are:
1. Purchases 5000
2. Transportation (500 + 500) 1000
3. Labour and Machine cost 5000
Total Cost 11000
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Opportunity cost refers to the costs that a business could have in- NOTE
curred on producing other goods or services which the business did Opportunity cost is also known
not produce as it chose to produce some other goods. Opportunity cost as alternative cost.
is the cost of next best alternative which was available but the busi-
ness let it go.
Implicit costs, as the name suggests, are implied costs. This means an
implied cost is not an actual expense or cost incurred but a reduction
in revenue. This reduction in revenue is a loss incurred due to the
event or an action. However, as there is no actual money spent, it does
not get recorded in the books of accounts.
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` 10,000 per month. In this case, the interest of ` 50,000 is lost which is
the opportunity cost or the implicit cost.
Explicit costs are the actual expenses or costs incurred and these are
recorded in the books of accounts. They are also called actual costs.
For example, costs incurred on purchase of raw materials, paying
wages and salaries to workers, paying rent, etc.
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The total expenses incurred by businesses are classified into two main
categories, i.e., fixed costs and variable costs.
Fixed costs are expenses that are fixed in nature. It means that fixed
costs do not fluctuate according to production and are incurred by the
business even if it is not producing anything. For instance, rent of the
building is a fixed cost.
For example, Dayashankar starts a poultry farm on 1st May 2019. The
rent for the poultry farm is ` 10,000 per month. Workers salary is
` 10,000 per month. These two are fixed costs. Also, electricity bill
is approximate ` 2,000 per month. Food for the hens and chicken is
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July 2019 20000 25000 5000
August 2019 20000 30000 10000
September 2019 20000 35000 15000
October 2019 20000
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November 2019 20000 41000 21000
December 2019 20000 50000 30000
January 2020 20000 50000 30000
February 2020 20000 45000 25000
March 2020 20000 42000 22000
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Note that the fixed cost remains the same over the months and is not
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Variable costs are the costs that vary with the amount of production
or output. These costs can include raw materials, water, labour, etc.
It depends on the usage. For example, a construction site requires
more workers while constructing the building. But once the structure
has been built, only interiors need to be done which requires half the
number of workers. Therefore, wages salaries to workers on a site are
variable costs for a construction company as they vary every month.
On the contrary, the salary of office staff of the construction company,
such as engineers, accountants, site supervisor, office boy, salesper-
sons, is fixed cost.
Every business incurs both fixed and variable costs. Some of the costs
of the business are fixed in nature and some vary according to the
nature of the business.
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Month Fixed Cost Variable Cost Revenue Profit/Loss
May 20000 9000 0 -29000
June 20000 9500 0 -29500
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July 20000 9600 25000 -4600
August 20000 9000 30000 1000
September 20000 9400 35000 5600
October 20000 9600 40000 10400
November 20000 8000 41000 13000
December 20000 10000 50000 20000
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Variable costs vary according to the level of output. When the level
of output is zero, the variable cost is also zero. Therefore, if we plot
NOTE variable costs on a graph, the variable cost curve will emerge from the
origin.
The Total Variable Cost (TVC)
curve is in the form of an As the output increases, variable costs also increase. This results in
inverted S.
marginal costs. Therefore, in the beginning, the curve is concave and
when the value starts diminishing, it becomes convex in shape thus
forming an S shape.
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The business owner works full time for the business but does not take
a salary. The accounting cost will show zero as business owner’s sal-
ary. However, economic cost will show the implicit cost of the salary
that should be paid to the business owner for the skills and time he
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uses for the business.
business uses its own capital, building, machine, employees and ve-
hicles for production of its goods and services. The cost of employing
all these resources is its private cost. These costs are incurred by the
business but are passed on to consumers when it sells its goods or ser-
vices. Therefore, the society has to bear these private costs ultimately.
There are certain external costs that are created by a business but are
borne by the society or the government. For example, infrastructure
(such as roads), sewage disposal, etc. The entire society pays taxes
MARK IT!
for paying the expenses of all such infrastructure development. You
will find more business units in urban and metro areas than in rural Social costs are private costs
areas because there is a convenient infrastructure available in metros. plus external costs.
Therefore, the society as a whole has to bear private costs as well as
the external costs.
Therefore, social costs are private costs plus external costs. For main-
taining a good social environment, social costs have to be borne by
the society. Every business is treated as a separate legal entity from
its owner and thus should behave as a socially responsible unit of the
society. A society can progress only if every member of the society acts
responsibly and takes care of social costs created by them. Therefore,
every consumer and producer should review the decision of consump-
tion and production taking into consideration the external cost creat-
ed by this decision.
Short-run and long-run costs are costs involved in different time pe-
riods in an economy. In short-run, one factor of production is fixed.
Short-run is usually considered for up to one year. For example, if the
capital employed (factor of production) is fixed, then, for increasing
production in short-run, the business cannot increase its capital but
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it will have to increase the number of workers or machinery, etc. It is
also possible that the business would rent a machinery instead of pur-
chasing a machinery. Thus, in short-run, the business would observe a
rise in marginal costs resulting in diminishing marginal returns. This
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will affect the price of the product or cost of labour. For example, due
to the COVID-19 pandemic, the cost of all essentials went up because
there was an increase in demand but supply could not be increased in
the short run.
In the long-run, none of the factors of production is fixed, they are all
variable. Time period for long-run is usually more than a year. Here
the business has to consider the long-run impact and plan accordingly.
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run.
ACTIVITY
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Prepare a short note on the meaning and types of social and private
costs.
In the short-run, only one cost is fixed and the cost of production var-
ies with the output produced. The short-run cost function is mathe-
matically written as:
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C = f (X)
The total cost curve will be the summation of total fixed cost curve and
total variable cost curve.
Figure 10.1 shows the graphical presentation of total fixed cost curve,
total variable cost curve and total cost curve:
Y
TC
TVS
TVS
TFC
TC
S
TFC
X
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Figure 10.1: Total Fixed Cost Curve, Total Variable Cost Curve
and Total Cost Curve
The TFC curve is parallel to the X-axis. TFC shows the cost of out-
put is fixed even if the output is zero.
The TVC curve is an S-shaped curve. Initially, the increase in cost
gives increase value of output but after a point with every increase
of variable cost, the marginal cost diminishes giving the curve an
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S shape. The TVC curve starts from the origin as when the output
is zero, the variable cost is also zero.
The TC is the sum of TFC and TVC. The shape of the TC curve is
similar to the shape of the TVC curve but it does not start from the
origin instead it starts at the point of the fixed cost curve.
Let us now learn about the short-run average and marginal costs.
You are already aware that the TFC does not change with the output,
it remains constant. Therefore, the AFC decreases if the output in-
creases and the AFC increases if the output decreases.
The short-run average cost curves and marginal cost curve are shown
in Figure 10.2:
MC
ATC
AVC
Cost
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AFC
Q1 Q2 Q3
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Quantity of Output
In Figure 10.2, observe that the AFC falls till zero as the output in-
creases and takes a shape of a rectangular hyperbola.
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Average Total Cost (ATC) is calculated by dividing the total cost by the
output quantity.
ATC = TC/Q
It is known that the total cost is the sum of total fixed cost and total
variable cost. Therefore,
ATC = (TFC + TVC )/Q
It is also known that TFC/Q is AFC and TVC/Q is AVC. So, this formu-
la can be further modified as:
ATC = AFC + AVC
This formula also explains why the ATC curve is U-shaped like the
AVC curve in Figure 10.2. From Figure 10.2, observe that the ATC
curves keep falling as the AFC and AVC curve keep falling and the
ATC continues even when the AVC curve picks up after point Q2. AFC
decreases till it reaches the minimum output of Q3 and then it starts
rising up with the AFC and AVC.
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Therefore, we can write the above formula as:
SMC = (TFC + TVC)/Q
SMC = (TFC/Q) + (TVC/Q)
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And when we reach the marginal cost, the TFC is at 0 output. There-
fore,
SMC = 0 + (TVC/Q)
SMC = TVC / Q
Thus, it proves that the short-run marginal cost is the change in cost
M
that occurs from the change in the output quantity due to change in
the variable factor.
From Figure 10.2, observe that the marginal cost declines to the min-
imum output at Q1 and then starts rising up. This minimum output
is less than that of AVC and ATC. You can also see the intersection of
N
the marginal curve with the AVC and ATC at their minimum output
levels.
It can be said that for each additional unit of output, more cost is add-
ed to the average variable cost than to the total cost. Therefore, the
marginal cost curve is below the average variable cost curve.
However, when the marginal cost curve is above the average variable
cost curve, it means that for each additional unit of output, more cost
is added to the total cost than to the average variable cost.
In the long-run, fixed costs are zero and all the costs are variable. It
means that there would be minimum cost of production for a given
level of output. Therefore, it is observed that long-run costs are never
more than short-run costs but will always be lower or equal to short-
run average costs.
If we try to depict this graphically, you will find that the minimum
points of all short-run total cost curves at different levels when joined,
this gives us the long-run total cost curve. The long-run average cost
curve is the average cost per unit of production in the long-run. Math-
ematically, it is calculated by dividing the long-run total cost by the
output level. This is shown in Figure 10.3:
S
Y
E2 SAC SAC2
1
IM SAC3
E1
E
E3 LAC
Cost
R
M
O M2 M4 M1 M3 X
Output
N
For calculating cost schedules from long-run cost function, the follow-
ing assumptions are made:
The input level does not affect the input prices.
The business owner has measured the production function for the
level of output required and decides to expand the output.
The firm uses only two variable factors, i.e., capital and skilled
workers.
Example 1: Assume that the firm uses two variable factors, i.e., capi-
tal and workers which are available at ` 2 and ` 5 per unit of output,
respectively. In the below table, we will see the unique features of a
S
derived expansion path.
1 2 3 4 5 6
Output Skilled Least Cost Total cost at ` Average Marginal Cost
IM
(Units) Workers Usage of 2/- per Unit ` Cost (per Unit)
(Units) Capital of 5/- per Unit of Col 4 / Diff of Col 4 /
Workers Capital (col 2 × Col 1 Diff of Col 1
`2) + (col 3 × `5)
25 5 3 25 1.00 =(25-0)/(25-0)
= 1.00
50 7 5 39 0.78 =(39-25)/(50-25)
= 0.56
M
75 10 7 55 0.73 =(55-39)/(75-50)
= 0.44
100 12 9 69 0.69 =(69-55)/(100-75)
= 0.56
125 15 11 85 0.68 =(85-69)/(125-
N
100) = 0.64
150 20 13 105 0.70 =(105-85)/(150-
125) = 0.80
175 25 15 125 0.71 =(125-105)/(175-
150) = 0.80
200 30 20 160 0.80 =(160-125)/(200-
175) = 1.4
Column 4: Total cost of production for each level of output. For example,
for producing 75 units of output, the business has employed 10 skilled
workers and 7 units of capital. The cost thus comes to ` 55. Therefore,
column 4 gives the minimum cost for the given levels of output.
the long-run average cost first decreases to the minimum then starts
rising similar to the case in short-run.
I4
S
I3 IM
I2
Capital Employed
Expansion Path
S’
R’
I1
B’ Q4
M
Q3
K1 P’
Q2
Q1
N
L1 I1 I2 I3 I4
Skilled Workers
In Figure 10.4, we see two inputs K and L on the two axes. Observe the
iso-cost lines, I1I’1, I2I’2 and so on represent the fixed factor price ratio.
The isoquant maps Q1, Q2, and so on are derived from the production
function.
In the long-run production function, all input costs are variable costs.
Therefore, the business owner makes the best choice of producing a
certain level of output for minimum cost.
Thus, at a given factor price ratio and production function, the expan-
sion path is derived which depicts the levels of input that will allow
the business to produce the level of output at minimum possible cost.
The long-run average cost curve and the marginal cost curves are
shown in Figure 10.5:
LRMC
LRAC
Cost
L
S
IM O Q1 Q2
Quantity
The long-run average cost curve and marginal cost curve have the
same shape as in the short-run.
LRAC decreases and goes down to the minimum possible cost at
Q2 and then starts to increase.
N
S
c. very short run
d. very long run
7. In ________, additional cost is incurred with increase of every
IM
unit with maximum utilisation of input.
a. short-run cost
b. long-run cost
c. long-run average cost curve
d. long-run marginal cost curve
M
ACTIVITY
Graphically represent the long-run average cost curve and the long-
run marginal cost curve and fill in the following blanks.
N
ECONOMIES OF SCALE
S
discounts resulting in a favourable purchase price.
By-products: Usually, large-scale businesses create by-products in
the process of production of the main product. These by-products
IM can be reutilised or recycled or sold which results in an effective
and efficient use of resources. A small-scale business may not be
able to take an advantage of by-products due to limited capaci-
ty. For example, in sugar factories, sugar is produced as the main
product whereas molasses and bagasse are produced as by-prod-
ucts.
M
DISECONOMIES OF SCALE
ACTIVITY
Draw the LAC curve for the two stages of economies of scale.
10.5 SUMMARY S
S
Cost analysis involves determining the costs incurred for inputs
and how they affect the output or productivity of a company.
Actual
IM
costs are costs incurred on producing a certain quantity of
goods or for providing certain service.
Opportunity cost is the cost of next best alternative which was
available but the business let it go.
Implicit costs, as the name suggests, are implied costs. This means
implied cost is not an actual expense or cost incurred but a reduc-
tion in revenue. They are also called opportunity cost.
M
S
Long run average curve is total cost of producing a output divided
by the level of output.
In the long-run marginal cost curve, additional cost is incurred
IM with increase in every unit with maximum utilisation of input.
Economies of scale is an advantage that results due to large-scale
production. When costs are saved due to increased level of produc-
tion, it is a case of economies of scale. After a point, cost cannot be
reduced. After reaching the minimum cost, costs start to increase
and economies of scale cannot be achieved.
M
KEY WORDS
Fixed cost: The cost that remains constant even for zero output
quantity
Marginal cost: The additional cost incurred as a result of pro-
ducing one additional unit of a product or service
N
S
c. 47 lakhs, 50 lakhs d. 50 lakhs, 50 lakhs
4. Which of the following is not an example of fixed cost?
a. Rent of ` 5,000 payable in the contract of lease
IM
b. Lawyer’s fees ` 2,000
c. Insurance premium of ` 20,000
d. Wages to worker ` 3,000
5. To have an output level of 10 units, a business has to incur an
average fixed cost of `20 and average variable cost of `100. What
is the total cost for the given output level?
M
a. 120 b. 110
c. 1200 d. 900
6. A business has fixed costs of ` 40,000; average total costs of
N
`300 and average variable cost of `250. Its output level would be
_____________.
a. 100 units b. 200 units
c. 800 units d. 400 units
7. A business employs upgraded technology for production. Which
of the following options would be right for the MC curve?
a. It will shift down. b. It will shift up.
c. It will shift right. d. It will shift left.
8. A business’s short run marginal cost curve will start increasing
when the _____________.
a. total fixed cost starts increasing
b. average fixed cost starts decreasing
c. marginal output starts increasing
d. marginal output starts decreasing
S
? 1. Explain the LAC curve.
2. Explain the meaning of private and social costs?
IM3. Describe the economies and diseconomies of scale.
S
ANSWERS FOR MULTIPLE CHOICE QUESTIONS
Q. No. Answer
1. d. Salary of the owner
IM
2. d. None of the above
3. a. 50 lakhs, 47 lakhs
4. d. Wages to worker `3000
5. c. 1200
6. c. 800 units
M
Q. No. Answer
1. a. MC < AVC
2. a.
Marginal Cost, Average Variable Cost, Average Total
Cost
3. d. SMC = TFC/Q
SUGGESTED READINGS
S
Richardson, G. (2013). Economic Theory. Hoboken: Taylor and
Francis.
Salvatore, D. (2003). Microeconomics. New York: Oxford University
IM
Press.
Taylor, J., & Weerapana, A. (2012). Microeconomics. [Mason, Ohio?]:
South-Western Cengage Learning.
E-REFERENCES
Variable Cost & Fixed Cost - Economics. (2020). Retrieved 10 Au-
M
net/production/cost-of-production/difference-between-econom-
ic-cost-and-accounting-cost/16344
REVENUE ANALYSIS
S
CONTENTS
11.1 Introduction
11.2 Concept of Revenue
IM
11.2.1 Total Revenue (TR)
11.2.2 Average Revenue (AR)
11.2.3 Marginal Revenue (MR)
11.2.4 Relationship Between TR and MR
11.2.5 Relationship Between AR and MR
Self Assessment Questions
M
Activity
11.3 Summary
11.4 Multiple Choice Questions
11.5 Descriptive Questions
11.6 Higher Order Thinking Skills (HOTS) Questions
N
INTRODUCTORY CASELET
Suresh Mittal owns a bicycle mart. He has fixed the sale price for
Case Objective his bicycles, whereas other bicycle traders in the market give dis-
This caselet highlights how counts to their customers. Due to this, the sale of his bicycles is
Suresh, a bicycle mart owner, limited. He too is thinking of giving discounts on his bicycle and
learns about the need to in- proposes the below options:
crease revenue by increasing
sales and offering discounts. 1. The price will be fixed up to the sale of 10 bicycles, then, a
discount of 5% will be given. In the last week of the month, the
discount will be increased to 10%. Later, it was realised that
the customers who bought in the first week were extremely
disappointed to know this.
S
2. A discount of 2% will be given on all bicycles sold throughout
the month.
3. A discount will be given based on Suresh’s personal relation
with the customer and the cost of the bicycle purchased.
IM
Suresh is worried about possible losses in the bargain. Suresh
doesn’t know how he will be able to decide after what point he
must not give discounts or the price below which he should not
sell the bicycles.
LEARNING OBJECTIVES
11.1 INTRODUCTION
In the previous chapter, you studied about the basic cost concepts Quick Revision
S
such as the meaning of actual cost, opportunity cost, private cost, so-
cial cost, accounting cost and economic costs. You also studied about
short-run and long-run cost functions. The later sections also shed
light on the economies and diseconomies of scale.
IM
The most important objective of businesses is to earn revenue by sell-
ing goods or services. For instance, a chocolate company produces dif-
ferent types of chocolates and sells them at ` 50,000 in December 2019.
In this case, the revenue earned by the business is ` 50,000. Revenue is
different from profit. Therefore, one must not confuse between these
two economic terms. Revenue is the amount generated from sales or
the total income of the business. In contrast, profit is the margin or
M
In this chapter, you will study about the basic concepts of revenue
N
Total Revenue (TR) = Quantity of product sold (Q) × Price per unit (P)
For example, a business sells instant soup packets at the rate of `50
per packet and sells 1000 packets in June 2019. The total revenue of
S
the business for June 2019 will be ` 50,000 (1000 packets × `50 per
packet). Figure 11.1 shows the TR curve:
IM 50
TR
40
Total Revenue
30
20
10
M
0 1 2 3 4 5 6 7 8 9 10
Quantity
It can be observed from Figure 11.1 that when the quantity of prod-
ucts sold (sales) increases, the total revenue also increases. Therefore,
the TR curve is a positive and upward rising curve.
AR = TR/Q
AR = (Q × P)/Q
AR = P
S
11
10
9
8
Average Revenue
7
IM
6
5 AR
4
3
2
1
0 1 2 3 4 5 6 7 8 9 10
M
Quantity
From Figure 11.2, it can be observed that when price is constant and
the quantity of sales is increasing, it has no effect on AR. The AR re-
N
11
10
9
8
Average Revenue
7
6
5
4 AR
3
2
1
0 1 2 3 4 5 6 7 8 9 10 11 12
Quantity
From Figure 11.3, it can be observed that the quantity of products sold
increases at decreased prices, therefore, the average revenue made
per unit also decreases. In this case, the AR has a negative slope.
S
Therefore, MR would be New TR – Old TR.
TRn is the total revenue which is earned from the sale of the nth unit.
11
10
9
Marginal Revenue
8
7
6
5
4 MR
3
2
1
0 1 2 3 4 5 6 7 8 9 10
Quantity
Let us now continue with the preceding example. If on the last day,
five more laptops were sold and the total revenue now is ` 5,25,000;
then in this case MR would be calculated as:
MR = ΔTR /ΔQ
ΔQ = 15–10 = 5
MR = 1,25,000/5 = 25,000
S
Figure 11.5 shows the MR curve when the price is decreasing:
IM
Price
M
ar
gin
al
Re
ve
nu
e
Quantity
M
From Figure 11.5, it can be observed that the Marginal Revenue (MR)
N
very common. This means that the quantity of the units sold increases
but the TR does not increase. Also, the marginal rate will decrease
with every unit sold.
For example, Dough Bakers sell their Cakes at `300 per piece. From
1st March till 14th March, they sold 75 cakes. They had 20 cakes in their
shop on the 15th of March and the government declared lockdown
from 16th March to 31st March. These 20 cakes cannot be preserved till
that time so instead of facing a complete loss, Dough Bakers decide
to clear the stock on the 15th March itself by offering cakes at half the
price i.e. `150 and are able to sell all of them. Table 11.1 shows the TR
and MR of Dough Bakers:
S
Date Cakes Rate Daily Total Total Marginal
Revenue Revenue Quantity Revenue
1 3 300 900 900 3 300
2 4 300 1200 2100 7 300
IM
3 5 300 1500 3600 12 300
4 5 300 1500 5100 17 300
5 5 300 1500 6600 22 300
6 6 300 1800 8400 28 300
7 7 300 2100 10500 35 300
8 4 300 1200 11700 39 300
M
30000
25000
20000
15000
10000
5000
0
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15
Quantity TR MR
TR MR
350
300
250
200
150
100
50
0
–50 100 200 300 400 500
S
–100
When the MR curve touches the X-axis, the TR curve would have
reached the maximum height. Beyond this point, revenue cannot be
increased. Now, if the MR curve moves below the X axis, the TR curve
will start to move downwards. This is the time when the sale is hap-
N
Revenue
S
D D’
AR=MR
X
O
IM Output
TQ, AR and MR for Dough Bakers from 1st to 14th March are shown in
N
Figure 11.9:
350
300
250
200
150
100
50
0
300 300 300 300 300 300 300 300 300 275 270 265 260 250 150
Total Quantity Marginal Revenue Average Revenue
S
a. Total quantity × Price per unit
b. Total profit of the business
c. Total income of the business
IM
d. Deducting expenditure from total income
2. ΔTR/ΔQ is the formula to obtain ____________.
a. total revenue b. average revenue
c. marginal revenue d. total quantity
3. The AR curve is a parallel line to X-axis when the:
M
M
ar
gin
al
Re
ve
nu
e
Quantity
ACTIVITY
Calculate and draw the TR, MR and AR curve for Zen Ltd. with the
table shown below:
Quantity Price
50 200
60 150
70 100
80 50
90 10
S
100 0
10 -5
IM
S 11.3 SUMMARY
Total revenue is the total amount of money made by the business
by selling a certain number of products. Total revenue is calculat-
ed by multiplying the total quantity of product sold by the price
per unit at which the product is sold.
TR curve is a positive and upward rising curve. AR is obtained by
M
dividing the total revenue by the number of units sold. The formu-
la is written as TR/Q.
The AR, i.e., average price per unit can differ from the selling price
of the unit. In this case, the AR will decrease and will show a neg-
N
ative slope.
The additional revenue generated as a result of sale of one more
unit of the product is called the MR. This sale of one more unit
changes the TR as revenue from selling one more unit is added in
the TR.
If the price remains constant, the MR will also remain constant
and AR and MR will be the same curve that runs parallel to the
X-axis.
If the price is decreasing, the MR is a negative slope which falls
more rapidly and becomes zero when it cuts the X-axis. Here, the
total revenue is the maximum. After this point, it starts falling.
When MR becomes negative, TR starts falling.
When TR increases, MR decreases. But if the price remains con-
stant, even if TR increases, MR will remain constant.
If price decreases, MR will decrease at a greater rate, the increase
in TR and will become zero when TR is maximum.
KEY WORDS
S
ditional unit of revenue
Revenue analysis: An analysis of the amount of money generat-
ed by selling products
IM
Revenue: The income generated from the operations of a busi-
ness
Total Revenue (TR): The revenue that a business earns by sell-
ing goods in a given period
MCQ
1. If the price is kept constant which of the following options is
correct?
a. TR is constant
N
b. MR is constant
c. AR is constant
d. Both MR and AR are constant
2. For calculating which of the following quantities, total quantity is
not required?
a. TR
b. AR
c. MR
d. None of the these
3. For calculating ________, one requires price per unit.
a. TR
b. AR
c. MR
d. All of the these
S
b. minimum
c. zero
d. negative
IM
6. When TR increases with a decrease in price per unit, the AR
________.
a. increases
b. decreases
c. becomes zero
M
d. becomes negative
7. When AR increases, ___________.
a. MR decreases
b. MR increases at the same rate
N
10. The TR of T Ltd. is ` 30,000 for 100 units sold on 30th March. On
31st March, the TR is ` 35,000 for 120 units sold. Then, MR will be
__________.
a. `200
b. `250
c. `300
d. `350
S
2. Explain the relationship between the MR and AR curves.
3. Explain the relationship between the TR and MR curves.
b. ` 4,40,000
c. ` 44,000
d. ` 4,50,000
N
Q. No. Answer
1. d. Both MR and AR are constant
2. d. None of the these
S
3. a. TR
4. a. `200
(Hint: MR = Change in TR / Change in Total Quantity of
Units Sold
IM
MR = ΔTR /ΔQ
TR for 15 Kg Apples = `3,500
ΔTR = 3,500 – 2,500 = `1,000
ΔQ = 15–10 = 5
MR = 1,000/5 = `200)
5. a. maximum
M
6. b. decreases
7. c. Marginal Revenue increases at a greater rate than the
Average Revenue
8. a. Marginal Revenue is negative
N
9. a. negative slope
10. b. `250
(Hint: MR = Change in TR / Change in Total Quantity of
Units Sold
MR = ΔTR /ΔQ
TR for 120 units = `35,000
ΔTR = 35,000 – 30,000 = `5,000
ΔQ = 120–100 = 20
MR = 5,000/20 = `250)
Q. No. Answer
1. b. ` 4,40,000
S
(Hint: Total Revenue (TR) = Quantity of product sold (Q)
× Price per unit (P)
= (1000 X 100) + (2000 X 90) + (2000 X 80)
= 1,00,000 + 1,80,000 + 1,60,000
IM
= 4,40,000)
2. b. AR is 1.38 and MR is 1
(Hint: ΔTR = 56,000 – 55,500 = `500
ΔQ = 500
MR = ΔTR /ΔQ = 500/500 =1
AR = 56,000/40,500 = 1.38)
M
SUGGESTED READINGS
N
E-REFERENCES
(2020).
[Ebook]. Retrieved from http://edudel.nic.in/welcome_fold-
er/SupportMaterial2019_20/XI/English%20Medium/11_sm_eco-
nomics_eng_2019_20.pdf
Total Revenue, Average Revenue and Marginal Revenue. (2020).
Retrieved 13 August 2020, from https://www.economicsdiscussion.
net/revenue/total-revenue-average-revenue-and-marginal-reve-
nue/6890
MARKET STRUCTURE
S
CONTENTS
12.1 Introduction
12.2 Perfect Competition
IM
12.2.1 Features of Perfect Competition
12.2.2 Equilibrium of the Firm and Industry Under Perfect Competition
12.2.3 Profit Maximisation and Perfect Competition
Self Assessment Questions
Activity
12.3 Monopoly
M
INTRODUCTORY CASELET
S
outlets which generate high sales and returns. Due to stoppage
of international flights and cargo, exports were also affected. Jain
Foods needed to sell its products fast and to stock unsold products
IM
in a safe place.
Jain Foods wanted to know what its competitors are doing in the
given situation and at what prices they are selling their goods,
whether they are offering discounts or are increasing their price.
Jain Food analysis that dry fruits are a non-essential does not
come under essentials. Jain Foods sees that the demand for dry
fruits is almost low and the supply is also low. They can sell only
M
LEARNING OBJECTIVES
S
Describe the meaning and characteristics of oligopoly
12.1 INTRODUCTION
IM
In the previous chapter, you studied about major concepts of revenue. Quick Revision
You studied about the Total Revenue (TR), Marginal Revenue (MR)
and the Average Revenue (AR). You also studied about the relation-
ship that exists between TR and MR and between AR and MR.
A market refers to any physical or virtual place where buyers and sell-
ers meet. In a market, the price of a product is fixed by the demand
M
for the product and the supply of the product. Virtual markets refer
to online marketplaces. For instance, after the spread of COVID-19
pandemic, many people purchase their daily essential requirements
through virtual markets or shops.
N
In this chapter, you will study about four basic types of market struc-
tures, namely perfect competition, monopoly, monopolistic competi-
tion and oligopoly. The chapter will start by explaining about perfect
competition, its features and the equilibrium conditions. Thereafter,
you will study about the monopoly market structure, its characteris-
tics and the equilibrium conditions. The later sections of the chapter
will shed light on the meaning and features of the monopolistic com-
petition and oligopoly market structures, respectively.
S
Large number of buyers and sellers: Under this market structure,
the number of buyers and sellers is large enough. This implies that
their position in the market is as a drop in the ocean, hence, they
are unable to influence the market price of the product. In this
IM
market structure, firms deemed to be the price takers.
Homogeneous products: Under perfect competition, the products
offered in the market are close substitutes or homogeneous in na-
ture. This means that high competition prevails in the market and
no competitor enjoys a competitive advantage over the rival firms.
Freedom of entry and exit: There are no financial, technological
M
and legal restrictions prevalent in the market for the entry and exit
of the firms under this market structure.
Perfect mobility of factors of production: Under perfect compe-
tition, the factors of production are free to move in or out of any
N
P S
E
P1
S
D
O
IM
Qe Q
market equilibrium price E. Figure 12.2 shows the perfect competition of India Ltd., Essar Steel Ltd.,
in the case of a firm: etc., are a part of the Indian steel
industry.
MC
N
AC
P1 D
D=AR=MR
Q1
Also note that the firm makes maximum profits at Q1, the point where
the marginal cost curve and marginal revenue curve intersect each
other. Marginal revenue is the demand curve.
This is the normal profit for the firm as the average revenue meets the
average cost also in the same point. However, if the AC curve is below
the AR curve, the point at which the MC and AC meet would be the
price where the firm makes normal profits.
SHORT-RUN EQUILIBRIUM
S
IM S
D2
D1
Q1 Q2 Q
M
Profit is the difference between the revenues and the costs of a compa-
ny. Profits may be broadly categorised as normal profits, supernormal
profits and negative profits (losses). If a company earns less than nor-
mal profits in the long run, it usually leaves the industry.
Figure 12.4 shows the firm price in the short run under perfect com-
petition when it earns supernormal profits:
Supernormal MC
Profit
AC
P2
P1 D = AR = MR
S
Q1 Q2
When the AR of a firm is equal to its ATC, it earns normal profits. Fig-
ure 12.5 shows the firm price in short run under perfect competition
M
Y MC
N
ATC
Price
E
AR = MR
P
O X
Q Output
Figure 12.6 shows the firm price in short run under perfect competi-
tion when it is making losses:
Y
ATC
MC
Price
A R
Losses
P E AR = MR
O Q Output X
S
Figure 12.6: Firm Price in Short Run under
Perfect Competition: Losses
IM
In Figure 12.6, MC > MR. Equilibrium output is EQ. Also, ATC > AR.
No firm can continue to make losses in the long run; ultimately, it will
be forced to leave the industry if losses persist for long time.
LONG-RUN EQUILIBRIUM
Long run refers to a period more than a year. In the long run, new
M
sellers can enter the market, thus, increasing the supply of the prod-
uct. Therefore, in the long run, both change in demand and change in
supply determine the price. Figure 12.7 shows the industry price in
long run under perfect competition:
N
S
S2
P2
P1
D2
D1
Q
Q1 Q2 Q3
intersects S1 at price P2, the profit increases to Q2. Then new sellers
enter the market and the supply increases to S2 and now D2 intersects
S2 to get the prices at P1 and the profits increase to Q3. Therefore, the
price is controlled by the movement of demand and supply in the long
run, but the profit in the overall industry increases.
There would be an opposite effect when the demand falls. When de-
mand falls, the price will come down and some firms will make losses.
Small firms that cannot withstand the losses will exit the market. This
will bring down the supply. Thus, instead of the supply curve moving
upwards, it will shift down to the left. As the supply decreases, the
price will increase bringing it back to the previous level to give normal
profits.
Figure 12.8 shows the firm price in the long run under perfect compe-
S
tition:
MC
IM
AC
P2
D2 D = AR = MR
P1
D1
M
Q1 Q2
In Figure 12.8, the firm makes normal profit Q1 at price P1 in the long
run. With an increase in demand, the price goes up to P2 and firm
makes supernormal profits at Q2. These supernormal profits attract
more firms in the market and due to the contribution of these new NOTE
firms, the supply increases from S1 to S2. As the supply increases, the In the long run, the firms make
price decreases and again comes back to P1. This brings the profit only normal profits.
back to Q1.
In the long run, all the factors of production are variable. Also, there is
free entry and exit in the industry.
Also, the firms that are making losses will leave the industry. This
will lead to a decrease in industry supply and increase in the industry
price. This will continue till the remaining firms in the industry are
making normal profits.
Therefore, all the firms in perfect competition will make only normal
profits in the long run.
A firm always seeks to maximise its profits. Profit is earned when the
total revenue is more than the total costs incurred. Therefore, to maxi-
mise profits, the firm needs to increase its revenue and minimise costs.
A firm can maximise its profits when it produces a quantity where
marginal revenue is equal to marginal cost. Figure 12.9 shows profit
maximisation of a firm under perfect competition:
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8 Profit MC
Maximisation
7
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5
4
3
2
MR
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1 2 3 4 5 6 7 8 Q
profit is achieved. We see that the combination of price 4.5 and output
5 is derived when MC and MR intersect each other. Beyond this point,
if output 6 is produced, the MC increases and marginal revenue with
that one output produced falls. At output 4, marginal cost will be lower
than marginal revenue which means that production is not done at
full capacity and that there is scope for increasing production. Figure
12.10 shows that the firm can achieve maximum profit at quantity 5:
Total Profit
1 2 3 4 5 6 7 8 Q
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d. Market information is available to everybody
3. The market equilibrium price is obtained when ________.
a. demand is a line parallel to the x-axis
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b. MC = MR
c. supply and demand curve intersect
d. supply and demand curve are parallel to each other
4. In a perfectly competitive market, _________ remains constant
in the short run.
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a. supply b. demand
c. MR d. MC
ACTIVITY
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12.3 MONOPOLY
In perfect competition, there are many buyers and sellers. But, in the
monopoly market structure, there is either one seller or only one buy-
er. Since, there is only one seller, he can influence the entire market
and is usually in a strong position to dictate the terms and market
prices. In case, there is only one buyer and many sellers, the buyer is
usually in a strong position and dictates the market prices.
A monopoly firm can dictate the prices and maximise its revenues.
For example, Google and Microsoft are the best examples of monopo-
ly. There is no competitor close enough to these two IT giants in terms
of the product range and the services they provide. Therefore, the
prices are determined and dictated by these firms. Other examples of
monopoly include Facebook, WhatsApp, Twitter, Indian Railways, etc.
Since, the Indian Railways do not have any competition, the railway
tickets pricing and the number of trains to be allotted is decided by
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the Indian Railways. There is also an entry barrier for other players.
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available in market, the monopoly sells at its discretionary prices.
EXHIBIT
paying it. Here, the average revenue curve and marginal rev-
enue curve are the same. The firm will sell till the marginal
revenue is more than the marginal cost. However, most firms
in the actual market have fixed price lists and discounts in
place and prefer to stick to it rather than negotiate such as
street vendors.
2. Second-degree price discrimination: The monopoly firm
sells at lower price for clearing its stock to create capacity.
This type of price discrimination occurs when a firm charges
different prices for different quantities of the same product.
Two-part tariffs and volume discounts are the examples of
second-degree price discrimination.
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3. Third-degree price discrimination: Early bird discounts and
various other discounts are given based on some eligibility
criteria. Air tickets when booked six months before are avail-
able at cheaper rates than last minute bookings. Various edu-
IM cational institutions offer early bird discounts and charge late
fees penalties for late admissions.
ACTIVITY
Find out five monopolies in the market and list down products or
services they offer. Find out how they price their products or ser-
vices.
12.4.1 CHARACTERISTICS OF MONOPOLISTIC
COMPETITION
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The name monopolistic competition is derived from the two market
structures namely monopoly and perfect competition. A monopolisti-
cally competitive market structure exhibits the following characteris-
tics:
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Presence of many buyers and sellers
No entry and exit barriers
Presence of similar but differentiated products
Demand curve is downward sloping
ACTIVITY
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Complete the following table.
No. Product Differentiation Examples
1 Physical appearance
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3 Packaging
4 Employees
12.5 OLIGOPOLY
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You studied that, in monopoly, there is only one firm in the industry.
In oligopoly, there are a few firms in the industry. Although there are
not many sellers, the number is more than one. For example, airlines
such as Indigo, Spice Jet, Air India and Vistara are a part of oligopoly.
Similarly, LPG gas providers such as Bharat Gas and HP are part of
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oligopoly.
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nor the exit is easy in oligopoly market.
Mutual interdependence: It is one of the most important char-
acteristics of the oligopoly market structure. Interdependencies
among the sellers influence various important decisions related
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to price, supply and output. In other types of market structures,
such as perfect market or monopoly, organisations do not get af-
fected by the pricing of others so they do not take the reactions and
decisions of the rival organisations into consideration. However,
in case of oligopoly market, firms are not able to make indepen-
dent decisions since a small number of sellers are competing with
each other. Hence, the sales and prices of one organisation depend
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COST-PLUS PRICING
In cost-plus pricing, the firm adds a certain mark-up price to the aver-
age production cost to get the desired profit. Cost-plus pricing can be
calculated in two ways:
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Full-cost pricing: It takes place when all costs (fixed plus vari-
able) are added to a profit mark-up price to determine the price of
a product.
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Contribution pricing: It takes place when only variable costs are
calculated with accuracy. Under contribution pricing, selling price
is set at a rate higher than variable costs so as to cover some fixed
costs.
ACTIVITY
Calculate the H-H index for four telecom firms, Firm I, Firm V, Firm
A, Firm J, having market shares of 23%, 47%, 34% and 56%.
S 12.6 SUMMARY
Market structures are categorised majorly on the basis of the na-
ture of market and levels of competition existing in the market.
There are four basic types of market structure: perfect competi-
tion, monopoly, monopolistic competition and oligopoly.
In perfect competition, there are a large number of buyers and
sellers.
In perfect competition, the demand curve is perfectly elastic, rep-
resented as a line running parallel to the X-axis. The firm makes
normal profits when average revenue meets average cost.
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In a monopolistic competition market structure, there are many
sellers in the market but every seller’s product is unique or dis-
tinct.
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In oligopoly, there are a few firms in the industry. Therefore, they
are concentrated markets and concentration ratios are calculated
by the Herfindahl-Hirschman (H-H) index.
The H-H Index is calculated by adding together the squared val-
ues of the percentage market shares of each firm operating in the
oligopoly market.
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KEY WORDS
c. Monopolistic competition
d. Oligopoly
2. Which of the following phenomenon occurs when the firms are
making abnormal profits in an industry?
a. New firms enter into the market
b. Industry supply increases
c. Industry price decreases
d. All of these
3. Under what conditions would a company leave the industry in
the long run?
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a. Company is earning less than normal profits
b. Company is earning less than supernormal profits
c. Company earning negative profit for five years
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d. Both a. and c.
4. Lokesh is a gym trainer and has opened his new gym recently.
Madan and Sudan both took admission in Lokesh’s gym but
Lokesh charged `2,000 per month from Madan whereas he
charged `2,600 per month from Sudan. What kind of price dis-
crimination was done by Lokesh?
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a. Geographical
b. Personal
c. Utility-based
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d. None of these
5. Which of the following is not a type of product differentiation
under the monopolistic competition market structure?
a. Physical variation
b. Price variation
c. Human resource variation
d. Distribution variation
6. Which of the following represents the correct formula for calcu-
lating the H-H Index?
a. The percentage values of the squared market shares of each
firm in the monopoly monopolistic competition market are
added together
b. The squared values of the percentage market shares of each
firm operating in the oligopoly market are added together
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ATC plus
25%
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ATC
Price
Cost
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Quantity
a. Full cost pricing b. Contribution pricing
c. Difference pricing d. Equilibrium pricing
N
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a. Agricultural produce b. Share market
c. Oil and petrol d. All of the above
2. State which of the following comes under the monopolistic com-
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petition.
a. Electricity board
b. Iron and steel industry
c. Automobile manufacturing industry
d. Automobile servicing industry
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Q. No. Answer
1. b. Perfect Competition
2. d. All of these
3. a. Company is earning less than normal profits
4. b. Personal
5. b. Price variation
6. b. The squared values of the percentage market shares of
each firm operating in the oligopoly market is added
together
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7. a. elastic
8. a. Full cost pricing
9. a. First Degree – Price discrimination
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10. c. create barriers for customers
ers and sellers, no price fixing, etc. Refer to Section 12.2 Perfect
Competition
2. In monopoly, there is either one seller or only one buyer. Since,
there is only one seller, he can influence the entire market and
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Q. No. Answer
1. d. All of the above
2. d. Automobile servicing industry
SUGGESTED READINGS
Chauhan. (2017). Microeconomics. [S.l.]: PHI Learning.
Atmanand. (2009). Managerial economics. New Delhi: Excel Books.
E-REFERENCES
(2020). Retrieved 20 August 2020, from https://www.georgebrown.
ca/sites/default/files/uploadedfiles/tlc/_documents/market_struc-
tures.pdf
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ECON101: Principles of Microeconomics, Topic: Unit 6: Market
Structure: Competitive and Non-Competitive Markets | Saylor
Academy. (2020). Retrieved 20 August 2020, from https://learn.say-
lor.org/course/view.php?id=8§ionid=62
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CONTENTS
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CASE STUDY 10
In India, the multiplexes first emerged in the 90s and since then,
they have enjoyed a fantastic run. The number of multiplexes in
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India grew faster than the number of single-screens, eventually
wiping them out almost. The same growth pattern can be seen
elsewhere in the world—US, Europe, China, Middle-East and
South-East Asia.
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In 2018, there were 2950 multiplexes in India. If not for COVID-19,
the multiplex market was expected to grow by more than 7% to
cross 4500 screens by 2024. The primary multiplex owners in In-
dia are cinema chains such as PVR, INOX and Big Cinemas. On
an average, a multiplex runs about 5-6 screens per theatre. What
is the reason for multiplex operators to add more screens to a
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ANALYSIS
CASE STUDY 10
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cannot control. As the number of screens to a multiplex will grow,
so will the congestion around the multiplex. In addition, popu-
lar films may not be released quickly enough to fill up so many
screens.
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Finally, a multiplex operator cannot control time, which is also
a resource. Only some specific hours and days are popular with
moviegoers. Addition of more screens will make scheduling of
movies highly complicated for the manager. This is because he/
she may need to space out starting and ending times of each mov-
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RESULT
CASE STUDY 10
CONCLUSION
Long-run
average cost
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O A B Output per period
Eventually, the average cost stops falling and then becomes con-
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QUESTIONS
CASE STUDY 10
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CASE STUDY 11
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negative territory and contracting the global economy.
Therefore, what was the reason for Alberta oil prices and future
prices from West Texas Intermediate (WTI) shift into the negative
marginal revenue? It began with the future’s contract for WTI
where it needs to deliver oil in a few months at the present price.
With time several rigs will stop working and a new balance be-
tween supply and demand will be set up at a cost that beats the
total average cost. But this does not bode well for either Alberta
or the United States.
COLLATERAL DAMAGE
Alberta is now facing collateral damage due to the oil war be-
tween Saudi Arabia and Russia and the COVID-19 situation creat-
ing an extra hit. On the other hand, these two factors have caused
trouble for Alberta’s oil production, but the global pandemic and
Russia-Saudi conflict have proven to be disastrous for Canada
and can have same outcomes for the U.S Energy Industry. Both
CASE STUDY 11
The lowest cost producer of the world Saudi Arabia can make a
significant amount of money when the price of oil per barrel gets
above $20 and Russia when the price gets above $40. However, get-
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ting a profit when prices are higher than the costs is not enough.
Saudi Arabia requires a price of $80 per barrel to maintain its
budget, understand its plan to broaden its economy and sustain
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a heavily subsidized economy. To be determined is the steadiness
of both the Russian and Saudi Arabian political frameworks and
current systems.
The more drawn out the COVID-19 pandemic keeps going, the
more prominent the harm oil makers will persevere. It is diffi-
cult to tell now how high oil costs will rise once the pandemic
dies down. They will probably go higher as peripheral makers are
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wiped out, however not for long. Utilising oil and other non-re-
newable energy sources is not, at this point reliable with evading
the normal fiascos of environmental change. Oil is progressively
turning into an abandoned resource.
(Source: https://www.weforum.org/agenda/2020/04/negative-oil-prices-covid19/ )
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QUESTIONS
CASE STUDY 12
Credit cards are the medium of money exchange that allows the
Case Objective
customers to charge purchases rather than making them pay cash
This case study discusses at the time of transaction. In case of credit cards, no interest is
the various characteristics charged if payment is made within 30 days.
of the credit card market
which makes it a perfectly These cards are the source of credit through which people can de-
competitive market.
fer payment for a purchase for an extended time period by paying
an interest rate. As per the number of banking players offering
credit card services, it is a perfect competition industry where-
in the competition should decrease the rate of interest drawn on
credit cards. The majority of customers prefer Visa, Mastercard
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and American Express which are offered by a large number of
banks and credit unions. Credit cards are homogenous products
and mostly similar in appearances and used for the same purpos-
es. Entry and exit from the credit card industry are easy which is
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the reason why there are so many institutions offering this ser-
vice. However, a new firm may find it challenging to enter into
the market but a financially stable bank or even a modest size
banks or credit unions can obtain the right to issue Visa card or
Mastercard from the parent companies with little difficulties. In
case of exit, banks can exit the field by selling their accounts to
other suppliers of credit cards. Therefore, the credit card industry
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QUESTIONS