Merged A level micro

CH#1(Utility)
Utility
UTILITY
is defined as the level of happiness and satisfaction that a person receives from
consuming a good or service, e.g. when a football player drinks a glass of water after playing a
match, that glass of water will quench his thirst and will satisfy the player.
TOTAL UTILITY
is defined as the overall satisfaction that a person derives from consuming all units of a
good or service over a given time period. It is calculated by summing the marginal utilities of all
units consumed.
TU   MU
MARGINAL UTILITY
is defined as the additional utility (change in total utility) derived from consuming one more
unit of a good or service. This can be calculated either as a change in total utility or by taking the
derivative of total utility.
MUt  TUt - TUt-1

or
TU
MU =
Q
Basic assumptions of Utility Theory (Cardinal approach)
 Utility can be measured in utils;

 Utility from different goods can be added;
 Consumers are rational, i.e. they are utility-maximizing consumers who are trying to
maximize their total utility;
 Tastes, at any one time, remains same.
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 Incomes, at one time, are constant.
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By Hammad Malik (Chand Bagh, L.G.S, Roots) 0331-4344108

CH#1(Utility)
1.1 Law of Diminishing Marginal Utility (DMU)
PRINCIPLE OF DIMINISHING MARGINAL UTILITY

states that the continuous and successive use of any product would reduce the marginal
utility derived from consuming an additional unit. For example, when the football player drinks the
first glass of water, he feels very satisfied. Every additional glass of water gives him lower
additional satisfaction (lower MU as shown in the diagram) than the satisfaction of the previous
glass of water that he drank.
If he drinks too much water, a point will come when an additional glass of water will actually
dissatisfy the player. This is the point of disutility and the marginal utility of this additional glass is
negative
The relationship between marginal utility and total utility are 0reflected in the figures below.
Quantity Marginal Total

total utility
1 10 10
2 5 15
3 2 17
4 0 17
5 -1 16
6 -2 14

CH#1(Utility)
1.2 Consumer’s Equilibrium

Single good
Rational consumers will only buy the commodity if
the MU gained from the extra unit is greater than the price
they pay. Rational consumers will therefore be in
equilibrium when:
P = MU
They will stop buying if price paid is greater than the
marginal utility.
Law of equi-marginal utility

The law explains consumer behavior when the consumer
spends on more than one products. It makes following
assumptions about consumer behavior.
 Consumers have limited income and cannot

purchase all the goods they want.
 Consumers behave rationally, i.e. they try
to maximize their total utility.
o To maximize their total utility, they consider the marginal utility of a product with its
opportunity cost.
o Consumers make their decisions at the margin, i.e. they do not look at their overall
spending every time they want to spend an additional amount. They only consider
the alternatives and select the one that maximizes their utility.
 Utility can be measured.
 Prices of products are fixed.
 Consumers tastes are constant. lik
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CH#1(Utility)
PRINCIPLE OF EQUI-MARGINAL UTILITY

states that consumer equilibrium takes place when the marginal utility of last dollar spent
on each product becomes equal.
MUA MUB MUC MUN

   ... 
PA PB PC PN
 If MUA/PA is greater than MUB/PB, the consumer would be able to increase his total utility
by consuming more of product A by switching expenditure from product B to product A.
o As he consumes more of product A, the marginal utility of product A falls. And as

he consumes fewer units of product B, the marginal utility of product B rises.
o The consumer will keep switching to product A from product B till the piarginal
utility per dollar of A and B are equal.
o At this point there will be no more opportunity to increase total utility by switching
expenditure from one product to another and the consumer will be in equilibrium.
To maximize their total utility, they consider the marginal utility of a product with its
opportunity cost.
It can be illustrated with the following example:

Px = $2; Py =$4; Income = $32
Consumer will be in equilibrium when MU per dollar spent on Good X is equal to MU per dollar
spent on Good Y. From the table it can be seen that consumer will buy 2 units of Good X and
7 units of Good Y. This combination also satisfies the income constraint. Two units of Good X
at a price of $2 per unit costs $4; and 7 units of Good Y at a cost of $4 per unit costs $28 at a
total cost of $32.
Units MUx MUx/Px MUy MUy/Py

1 9 4.5 28 7
2 8 4 26 6.5
3 7 3.5 24 6
4 6 3 22 5.5
5 5 2.5 20 5
6 4 2 18 4.5
7 3 1.5 16 4
8 2 1 14 3.4

CH#1(Utility)
1.3 Deriving demand curve

The LAW OF DEMAND
states that there is an inverse relationship between price and quantity demanded.
Using Law of Equi-Marginal Utility

An increase in price of a product
leads to a decrease in the quantity
demanded of that product. Assuming the
consumer consumes two products A and B
and is initially in equilibrium. At this point
MUA MUB
 .If there is an increase in the
PA PB
MUA
price of product . the ratio of will fall
PA
PA making product A less attractive.
Consumers will switch their expenditure
from product A to product B to increase
their total utility. This will lead to a fall in the
demand of product A hence proving the law of demand.
Using Law of Diminishing Marginal Utility

Consumers experience law of diminishing marginal utility. Marginal utility can be measured
in
money terms, i.e. the amount that a person will be willing to pay for one more unit of a
product. If, for instance, a person is willing to pay $5 for an extra burger, then we can say that
his marginal utility from consuming it is $5. As long as the actual price is less or equal to what
the person is willing to pay, the person will buy the product.
 As the price of a good falls, it will be worth buying extra units. The person will buy more
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as the price will now be less than what he was willing to pay, i.e. less than his marginal
utility.

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However, as he consumes more of the product, his marginal utility will fall. He will stop
buying more when his marginal utility has fallen to the new lower price of the good.
 Thus, it proves the law of demand which states that a fall in price will lead to a rise in
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quantity demanded.
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CH#1(Utility)
Market demand curve

Market demand curve can be derived by horizontally summing the individual demand curves.
Market demand =  indvidual demand

Limitations
Discussed later in this topic. Especially it will be difficult to add the demand curves of individuals
as the satisfaction that each customer derives from consuming a product is difficult.

CH#1(Utility)
1.4 Paradox of Value

PARADOX OF VALUE
is the proposition that the value (price) of a good is determined by its relative scarcity
rather than by its usefulness.
 Consumers are at times willing to pay a higher price for a non-essential item (e.g.
diamonds) and a lower price for an essential item (e.g. water).
 If goods are in limited supply, as with diamonds, then consumers are prepared to pay a
high price for them. This is because
there are relatively few of them and
the marginal utility of another unit of
diamond is high. The total utility for
diamonds is however quite low
because
of low consumption.
 If, on the other hand, goods are
plentiful, as with water, then
consumers are only prepared to pay
a low price. This is because the extra
utility of an extra unit of water is low.
The total utility, however, is high. This
does not mean they do not place a
high value on necessities when
they are in short supply.
 Consumers enjoy large amounts of
consumer surplus on water because
the price is low
and large amounts are bought. Far
less consumer surplus is enjoyed by
consumers on diamonds because far
fewer diamonds are bought.
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CH#1(Utility)
1.5 Consumer Equilibrium and Money

Consumers will keep consuming a product till the MU per dollar spent on tne product Becomes
equal to tne opportunity cost of money. Opportunity cost of money will be equal to the MU that can
be derived if one dollar of money is spent on consuming another product. For example, if price of
product A is $6 and the opportunity cost of $1=2 units of utility, then using the table below
consumer will consume 3 units of the product.
Units TU MU MU/P
1 22 22 3.67
2 38 16 2.67
3 50 12 2.00
4 60 10 1.67

CH#1(Utility)
1.6 Utility of Money

Money is used to purchase and to consume goods and services. Money hence provides utility to
individuals. There are different points of view on whether money experiences diminishing utility
or not.
1. Money experiences diminishing marginal utility

Some people believe that like other products, money experiences diminishing marginal
utility.
Initial supply of money gives a person more utility but more dollars will only change his marginal
utility at a diminishing rate
Redistribution of income
If the above opinion is correct, then, a rich person should have a lower MU than that of a
poor person.
 The Law of Diminishing Marginal Utility

would suggest that taking resources away
from an affluent individual to give to a poor
person will lead to an increase in the
combined utility of the two individuals. An
extra $10 a week to a poor family would
give them more utility than the
loss in utility from getting an extra $10 a
week from a richer family.
 One of the problems of this approach is that
the law of marginal utility refers specifically
to spending changes by a single individual.
The law in its strictest sense cannot be
used to compare income change between
individuals because it is not possible to
make direct utility comparisons between
individuals.
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 Another problem is that very high tax rates
would be a disincentive to work leading to lower supply of workers and less
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entrepreneurship as people will have little incentive to get rich. Similarly, very high
incentive payments to poor will again be a disincentive to work hard.
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CH#1(Utility)
2. Money does not experience diminishing utility

Other believe that money does not experience diminishing marginal utility. An
increase in money keeps increasing the marginal utility for a consumer as he can afford to buy
different
types of goods and services that he was not able to buy before. For example, a very high
income will enable a family to afford a recreational trip to Caribbean. The satisfaction that they
derive from this trip cannot be compared with the satisfaction that they derive from consuming
products that they use on a regular basis.

CH#1(Utility)
1.7 Rationality or Irrationality

The theory assumes that consumers are rational and they are trying to maximize their total utility.
They weigh the costs and benefits of their purchase decision and will be in equilibrium when the
marginal utility from the last dollar they spend on a product is equal to the opportunity cost.
However, sometimes consumers may act irrationally, i.e. taking a decision without weighing
the costs and benefits of the decisions.
Impulse buying
Many people go to shopping when they 'need' to buy something. IMPULSE BUYING are
purchases that were not intended and often not needed such as seeing a special offer of 'buy
one get one free' may produce an impulsive cognitive response to buy. It is usually the way that
the product is advertised that leads to impulse buying - seeing a colourful pen at the tills; a
beautiful dress advertised in the window of a shop; a huge discount advertised etc.
Economists assume that consumers are rational, i.e. they weigh up marginal costs and benefits
when making a decision. If the- marginal benefit is greater than the marginal cost, they would
buy the product and otherwise they will not.
 In case of impulse buying, consumers may give little thought to the costs and benefits of
the decision. If this is the case, then, it may be said that consumers are acting irrationally.
 On the contrary, if the consumer made the decision by judging the potential costs and
benefits even though they may be short term benefits, then, they cannot be deemed as
irrational. They have behaved rationally.
Advertising
Another case where consumer may be deemed to behave irrationally is of persuasive
advertisement where firms may try to sell their products to consumers by persuading them to
purchase the good. Persuasive advertisement is said to encourage irrational consumption and
may not be consistent with the principles of economic theory.
There is a counter-argument to this. Consumers buy. what they desire. As long as they
perceive
that a product will satisfy them, then, they are acting rationally. A poor experience from a
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product is not same as irrationality. Consumer was ignorant of the product's features when he
bought it. His act was rational (purchase decision based on weighing costs and benefits); but
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the decision did not turn out to be a good one. Ignorance is not same as irrationally.
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It can be argued that advertisement can actually improve decision making by providing useful
information to customers at a low cost. Therefore, it can be argued that advertisement does
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not decrease rationality rather it can improve the purchase decision by providing better
information to the customers.
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CH#1(Utility)
Deferred payment
When payments can be deferred, consumers can purchase beyond their ability to pay,
such as in the case of credit cards.
Conclusion
All of the above situations indicate that consumers may behave irrationally. Behavioural
economic models explore why consumers make irrational decisions.

CH#1(Utility)
1.8 Impact of advertisement and change in income on

equilibrium
Impact of advertisement
Firms carry out advertisements to inform customers about their offerings and to persuade
them to buy the product. Advertisement can improve the decision-making process by making
customers more informed about the
products, their prices and quality offered.
However, at times, advertisements can lead
to irrational decisions if they are persuasive.
 Effective advertisement will lead to

an increase in the demand for the
product as customers may perceive
that they can get a higher utility from
the product than previously thought.
 PED of the product is likely to-fall
and firms can therefore increase
price of the product.
 Consumer equilibrium is, therefore,
likely to shift and a new equilibrium MU per dollar
value will be reached.
Increase in income
A rise in income levels will increase the purchasing power of customers. Impact on
demand and prices will depend on whether the product is a normal good, or an inferior good.
NORMAL GOOD
is a good where demand has a direct relationship with income, i.e. a rise in income will
lead to a rise in demand and vice versa. These can be luxury goods such as luxury cars,
branded clothing etc.
 A rise in income will lead to a rise in demand for the product along with a rise in prices.
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 This will change the consumer equilibrium and a new equilibrium MU per dollar value
will be reached.
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CH#1(Utility)
INFERIOR GOOD
is a good where demand has an inverse relationship with income, i.e. a rise in income will
lead to a fall in demand and vice versa. These can included cheaper unbranded goods.
 A rise in income will lead to a fall in demand for the product resulting in a fall in price.

CH#1(Utility)
1.9 Limitations of Utility Theory

 It is difficult to measure the utility of consuming a product cardinally. There is no
utilometer available in the market as yet. It means that it will be difficult to measure
marginal utility and also difficult to add utilities to calculate total utility.
 Comparing utilities of two products is difficult because they will be giving different types
of satisfaction and it is not possible to compare the two. For instance, the utility we
derive from morning cup of coffee may come from outputs such as 'flavour' and 'the
quenching of thirst'. If we consume coffee in a coffee shop, then, utility is not just
coming from the characteristics of coffee but also from the characteristics of the
environment in which coffee is being drunk. It will make it difficult to add utilities of
different products due to different nature of satisfaction that they provide.
 Comparing utilities of two persons is difficult because individuals have different
characteristics and personality styles and they also consume different types of goods
and services. A walking stick provides an old man more utility than it provides to a
young lad. It will therefore make it difficult to find the market demand curve as adding
utilities of different individuals will be difficult.
 Diminishing utility only holds constant in the short run as a person consumes more units
of the same good. However the law of diminishing marginal utility will not hold when
the product is consumed after a considerable lapse of time.
 Utility is different from one place to another. For instance, a pen provides a much higher
utility when used during CIE examinations than it provides on other occasions.
 Consumers do not have complete information and may not be aware of substitutes.
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CH#2(Budget Lines and Indifference Curves)
Budget Lines and Indifference Curves
2.1 Budget Line

BUDGET LINE
(consumption possibility line) shows all possible combinations of two products
that a consumer can buy from a given income and fixed prices.
For example, if a consumer's weekly income is $100 and the prices of good A and good B are $20
and $10 respectively, then, the consumer will be able to buy the combinations of good A and good
B shown in the table below. This set of combinations in illustrated in the figure and is called the
budget line. The combinations meet the budget constraint, i.e.
Income = Px. Qx + Py. Qy
Product A
Product B (Price = $20)
0 5
2 4
4 3
6 2
8 1
10 0
 All combinations of the goods inside the line (e.g. point m) show attainable combinations of
the two goods that the consumer can purchase from his given income and the price of the
two goods. However, the consumer would not be able to spend all his income at this point.
He can buy more of both goods with given income and price levels.
 Any point on the line produces an outcome that maximizes consumption for the given
income.
 All points outside the line (e.g. point n) show unattainable combinations that cannot be
purchased with given income or price levels. These points would only be attainable if
there is a shift in the budget line.

2.2 Shifts in the Budget Line
Budget line can shift because of following reasons:

i. a change in income levels;
ii. a change in price of one product only (income and the price of other good remaining
constant);
iii. a change in price of both goods in the same proportion in the same direction
(income remaining same);.
iv. a change in price of both goods in same direction but with different proportions
(income remaining same);
v. a change in price of both goods in opposite direction (income remaining same);
vi. change in price of one good and a change in income;
i. Change in Income Levels (price of both goods remaining same) A change in income levels
lead to a parallel shift in the budget line.
 An increase in income would
mean that the consumer can buy
more goods and
services and the budget line will
see a parallel shift outwards.
 A decrease in income will lead
to an inward parallel shift in the
budget line.
BEWARE:
 The shift in budget line for a rise

and fall
in income as shown above is same for both normal and inferior goods unlike the
demand curve where the shifts were in the opposite direction.
 A shift in the budget line only shows the maximum combinations of two goods that are
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available. It does not show the actual amount of goods that would be consumed. That
will depend on individual preferences.
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ii. Change in Price of One Product only

(income and price of other good remaining same) It will lead to a pivotal shift in the budget
line.
 A rise in price of good Y will mean that consumers can now afford to buy fewer units of
good Y whereas the maximum units of good X remains the same.
 A fall in price of good Y will mean that consumers can now afford to buy more units of
good Y whereas the maximum units of good remains the same.
The impact on the demand for good will depend on substitution and income effects (explained in
the next section).

iii. Change in Price of Both Products in Same Direction And in Same

Proportion (income remaining same)
This leads to a parallel shift in the budget
line.
 A rise in price of both goods in the
same proportion will mean that
consumers can now
afford to buy fewer units of both
goods, The fall in consumption
possibilities of both goods is in the
same proportion as prices rose in
the same proportion.
 A fall in price of both goods in the
same proportion will mean that
consumers can now afford to
buy more units of both goods.
possibilities of both goods is in the
same proportion as prices fell in the same
proportion. For a fall in price of both goods in the same proportion For a rise in price of
both goods in the same proportion The rise in consumption
BEWARE:
A shift in the budget line only shows the maximum combinations of two goods that are
available. It does not show the actual amount of goods that would be consumed. That will
depend on individual preferences.
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iv. Change in Price of Both Goods in same direction but with different proportions
(income remaining same)
It leads to a pivotal shift in the budget line.
 A rise in price of both goods with a greater rise in price of good X (25% rise in price of
good Y and a 40% rise in price of good X) will mean that consumers can now afford to
buy fewer units of both goods however there will be greater fall in the consumption
possibility of good X due to larger rise in its price.
 A fall in price of both goods with a greater fall in price of good X (15% fall in price of
good Y and a 30% fall in price of good X) will mean that consumers can now afford to
buy more units of both goods however there will be greater rise in the consumption
possibility of good X due to larger fall in its price.

v. Change in Price of Both Goods in opposite direction (income remaining

same)
It leads to a pivotal shift in the budget line.
 A fall in price of Y means that consumers can afford to buy more of good Y and a
simultaneous rise in price of good X means that consumers can afford to buy less of
vi. Change in Both Income Level and Price Levels of one good (price of other
good remaining same)
A change in income leads to a parallel shift in the budget line whereas a change in price of a
good leads to a pivotal shift in the budget line. What actually happens to the shape of budget
line depends on the direction and power of both the forces. The impact of these two factors on
budget line have been identified independently earlier. Their combined impact in shown with the
help of figures below.
Increase in Income and Increase in Price of X
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Decrease in Income and Decrease in Price of X
Opposite movement in Income and Price of X

2.3 Slope of budget line and Relative prices of two goods

The SLOPE OF BUDGET LINE measure the relative price of two goods1 and is calculated as:
Price X
Price Y
If we look at the figure below, we can see that there has been a pivot in the budget line from
BL1 to BL2. This can happen due to following reasons:
a) Fall in price of Good Y and a rise in price of Good X.
b) Rise in income and a greater proportionate rise in price of X.
Quantity Y
1 Slope of budget line =
Quantity X
Income
where Quantity Y = ,and
PriceY
Substituting the figures gives the following equation:
income
Quantity X =
Price X
Substituting the figures gives the following equation:
Income
slope of the figure line = Price Y
income
Price X
and by cancelling, the equation simplifies and becomes:
Price X
slope of budget =
PriceY
c) Fall in income and a greater proportionate fall in price of Y So, by looking at the graph alone
and with no further information, we cannot make any of the following conclusions definitely:
There is no change in income - it is possible (scenarios b and c)
 Price of both goods have changed - it is possible that it did not happen (scenarios b and c)
 Price of good Y has fallen - It is possible that it did not fall (scenario b)
 Price of good X has risen- It is possible that it did not rise (scenario c)
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c) Fall in income and a greater proportionate fall in price of Y So, by looking at the graph alone
and with no further information, we cannot make any of the
following conclusions definitely:
 There is no change in income - it is possible (scenarios b and c)

 Price of both goods have changed - it is possible that it did not happen (scenarios
b and c)
 Price of good Y has fallen - It is possible that it did not fall (scenario b)
 Price of good X has risen- It is possible that it did not rise (scenario c)
However, whatever may have happened (scenarios a, b or c), we could see that the slope of the
line has increased therefore we can DEFINITELY make the following conclusion:
X has become RELATIVELY MORE EXPENSIVE than Y

or that
Y has become RELATIVELY CHEAPER than X
Similarly, if the budget line had moved from BL2 to BL1, then, we could have concluded that X
has become relatively cheaper and that Y has become relatively more expensive.

2.4 Indifference curves
Assumptions
 It is assumed that individuals are rational in making decisions.

 Utility cannot be measured cardinally but it can be expressed ordinallv, i.e. the
consumer can rank the basket of goods according to the satisfaction of each basket.
 The model assumes diminishing marginal rate of substitution.
 It is assumed that consumer is consistent in his behaviour during a period of time, i.e. if
he prefers combination A over combination B, then he remains consistent in his choice.
 The goods consumed by the consumer are substitutable, i.e. utility can be maintained at
the same level by consuming more of some goods and less of the other.
Indifference curves
An INDIFFERENCE CURVE shows all combinations of goods (such as chocolates and
milk) that yield the same satisfaction to the consumer.
 Points on the curve
(such as a, b, c, and
d) are combinations
which yield the same
level of satisfaction
and the consumer is
indifferent between
them.
 Points above and to
the right of the curve
(e.g. point f) yield
more satisfaction and
consumers would
prefer these
combinations to the
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combinations a to d.
 Points below and to
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the left of the curve (e.g. point e) yield lower satisfaction and are less preferred to the
bundles represented by points on the curve.
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 The slope of the curve indicates the marginal rate of substitution between the
two goods.
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Slope of the indifference curve

The slope of an indifference curve measures the marginal rate of substitution. MARGINAL
RATE OF SUBSTITUTION (MRS)

is the amount of one commodity a consumer could give up to get one more unit of
another commodity while leaving the level of satisfaction unchanged.
 MRS is negative, i.e. to gain an increase in consumption of one commodity, the
consumer is prepared to reduce her consumption of a second. It is shown by the
downward slope of the indifference curve.
 The theory assumes DIMINISHING MARGINAL RATE OF SUBSTITUTION which
states that, to hold constant satisfaction, diminishing quantities of one good must be
sacrificed to obtain successive equal increases in the quantity of the other good. This
is shown in the curve where MRS diminishes as consumer moves down the curve.
Indifference Map
INDIFFERENCE MAP is a set of indifference curves that show different levels of satisfaction that
a consumer is able to derive from
consuming different combinations of
two goods. The theory
assumes that more of any good is
usually preferred to less of that
good.
 On each curve, the level of
satisfaction remains
constant.
 On curves below and to the
left such as ICo, consumer
gets lower satisfaction.
 On curves above and to the
right such as IC2, consumer
gets higher satisfaction.
Thus, indifference curves
represent higher levels of
satisfaction the further they are from the origin of the graph.
NOTE: No two indifference curves can intersect or touch each other. If they did it would
mean that some combinations of goods were simultaneously superior to, as well as equal
to other combinations.

Indifference curves with special shapes
Refer to Appendix A to see some special shapes of indifference curves.
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2.5 Consumer equilibrium

CONSUMER EQUILIBRIUM takes place when with given income and prices, represented by the
budget line, the consumer
maximizes satisfaction by
moving to the highest
indifference curve.
 Consumer
equilibrium can be
shown by combining
budget line (XY) and
an
indifference map
(from ICo to IC2).
 Suppose consumer
decides to spend all
his income on
chocolates and is on
point a'. If the consumer decides to buy some milk as well, then, her possible combinations
can be points 'b', 'c', and 'd'.
 Consumer's goal is to maximize his satisfaction. He would select that combination of two
goods that is on the highest indifference curve, i.e. giving her the greatest satisfaction. In
the graph that is point 'c' where the budget line is tangent to the indifference curve.
Consumer equilibrium is identified at the point where the budget line is tangent to the
indifference curve. At this point the marginal rate of substitution is equal to the ratio of the
price of the two goods.
P
MRS xy  x
Py

2.6 Change in consumer equilibrium - Change in income

A change in income leads to parallel shifts in the budget line.
 For each level of income there will be an equilibrium position at which an indifference
curve is tangent to the relevant budget line.
Normal goods
 As consumer income
increases, the budget line
shifts outward from MN to
PQ to RS.
 For each budget line the
equilibrium changes from
point 'a' to 'b' to 'c'. If we
join all the points of
equilibrium we get the
INCOME-
CONSUMPTION LINE
that shows how
consumption changes as
income changes, with
relative prices held
constant. Tastes are held constant (indifference map doesn't change).
 The shape of the income-consumption line depends on the nature of the goods.
 In case of normal goods, consumption of goods rise with a rise in income. In the graph,
it is assumed that chocolates and milk are both normal goods so that their consumption
rises as income rises.
Inferior goods
In case of inferior goods, consumption falls with a rise in income levels.
 In the figure we assume that steak is a normal good and sausages are inferior goods.
 As income levels rise, equilibrium shifts from point 'a' to 'b'.
 Consumption of sausages fall from S1 to S2.
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2.7 Change in consumer equilibrium – Change in relative

prices
A change in relative prices cause a change in the slope of the budget line. Budget line, however,
does not tell the impact on the actual consumption of the good. This depends on consumer's
preferences and the impact on demand can be shown through substitution and income effects.
PRICE EFFECT
is the change in consumption of a product due to change in the price of the product ceteris
paribus. Price effect can be divided into substitution effect and income effect.
Price effect = Substition effect + Income effect
SUBSTITUTION EFFECT
of a price change refers to the changes in quantity demanded solely due to the relative
change in prices. Rational consumers will switch towards the product which has become relatively
cheaper.
INCOME EFFECT
of a price change refers to changes in quantity demanded because of a change in real
income of the consumer as the price of a good changes given that the money income remains
unchanged. The income effect will depend on the nature of the product, i.e. whether it is a normal,
an inferior or a Giffen good.
Price effect with Normal goods

NORMAL GOODS
are goods where demand rises following a rise in income levels. These included branded goods.
The figure shows a consumer with a budget line AB. His initial equilibrium is at point 'a' where
he consumes qi of good X. A fall in price of good X (a normal good), assuming money income
and price of good Y remains unchanged, shifts the budget line to AC. His new equilibrium is at
point 'b' on a higher indifference curve IC2. He now purchases q3 of good X. We can isolate this
price effect into substitution effect and income effect. We can find out the substitution effect of the
price change by holding consumer's real income constant. The relative prices of goods (as shown
in the slope of the budget line) have changed. We need to construct a new line A'C', parallel to
AC, so that the slope of the two lines are constant and A'C' therefore shows the new relative
prices of goods X and good Y. It's tangent to IC1 at point 'c' where the consumer buys q2 of
good X. Therefore, if price of good X falls and the real income remained same, he will increase his
consumption of good X from q1 to q2 that shows the substitution effect of the price change.

The income effect shows the extent
to which a change in real income
affects quantity
purchased, while keeping relative
prices constant. A fall in price of good
X will increase real income and
therefore increase demand for
normal goods. This is shown as the
difference in his consumption of good
X from point 'c' to point 'b', i.e. q2to
qs.
Price effect In case of normal goods,
both the income and substitution
effect move in the same direction. A
fall in price of good X led to increase
in its consumption both because the
consumer
substituted good X for good Y and also because his higher income led him to buy more good X.
Price effect with Inferior goods
INFERIOR GOODS
are goods where demand falls following a rise in income levels. These included unbranded
goods.
In case of inferior goods, the income
effect operates in the opposite direction
to the substitution effect. A fall in price
of an inferior good will result in an
increase in quantity purchased as a
substitution effect and a decrease in
quantity purchased as the income
effect.
In the figure the original equilibrium is at
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point 'a' where consumer buys q1 of
good X (an
inferior good). The price of good X falls
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leading to a pivot in budget line from AB

to AC. The
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substitution effect shifts consumer from

point 'a' to point 'c'. It results in an
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increase in the
quantity bought from q1 to q2. The income effect of the inferior good is a fall in quantity
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purchased from q2 to q3. The full price effect of a fall in price of the inferior good is for an
increase in quantity of the good from q1 to q3. THE SUBSTITUTION EFFECT IS GREATER
THAN THE INCOME EFFECT.
Price effect with Giffen goods

GIFFEN GOODS are a special type of
inferior goods where the income effect
is greater than
the substitution effect.
In the figure the original equilibrium is
at point 'a' where consumer buys q1of
good X (a Giffen good). The price of
good X falls leading to a pivot in
budget line from AB to AC. The
substitution effect shifts consumer
from point 'a' to point 'c'. It results in
an increase in the quantity bought
from q1 to q2. The income effect of the
Giffen good is a fall in quantity
purchased from q2 to q3.
The income effect is greater than the
substitution effect, therefore, the full
price effect of a fall in price of a Giffen good is a fall in quantity demanded indicating an upward
sloping demand curve. However, Giffen goods are very rare to find in practice, if at all.
Price effect- Summary and Derivation of the demand curve

Price effect is a combination of substitution effect and income effect. A change in price of a good
will pivot the budget line resulting in a new equilibrium and a new quantity purchased of the good
as shown in figures above. If we plot the different sets of prices and quantity demanded, we get a
demand curve for the product.
 Net effect on normal goods will be a
greater rise in demand for the good as
both substitution and income effects are
positive. This indicates an elastic
downward sloping demand curve.
 Net effect on inferior goods will be
smaller as substitution effect is positive
but income effect is negative. However,
demand will still rise as substitution
effect is greater than the income effect.
This indicates an inelastic downward
sloping demand curve

 Giffen goods are a special type of inferior goods such as bread where the income effect
is greater than the substitution effect. Net effect on Giffen goods will be a fall in
demand for the good indicating an upward sloping demanding curve.
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2.8 Analysis of indifference curve theory
Better than Utility analysis

 It does not need cardinal measurement of utility. Utility is a purely subjective phenomena
and cannot be exactly measured. On the other hand, indifference curve analysis is based
on ordinal utility function.
 Utility theory assumes marginal utility of money remains constant whereas the indifference
curve approach takes into consideration the income effect changes in the price of a
commodity.
 The law of diminishing marginal utility is replaced by the principle of diminishing
marginal rate of substitution that seems to be more scientific and realistic.
Criticisms
 Indifference hypothesises more complicated and therefore away from reality.
 There is no empirical method to measure the exact shape of an indifference curve.
 The consumer is not rational and acts under various social, economic and legal disabilities.
 Two good model is unrealistic because a consumer buys large number of commodities to
satisfy his unlimited wants.
 The indifference curve assumes that goods are divisible in small units. Commodities like
watches, cars, radios, etc. are indivisible and we cannot have 3 A watches or 2 A cars.
Despite these criticisms, the indifference curve technique is still considered superior to the
utility analysis.

2.9 Appendix A- Indifference curves with special shapes
(i) Perfect substitutes

PERFECT SUBSTITUTES
are goods that are identical to each other in the mind of the consumer, e.g. pins that come in
green packs and pins that come in red packs for a colour-blind consumer. Indifference curves for
perfect substitutes are straight lines.
(ii) Perfect complements

PERFECT COMPLEMENTS
are goods which are needed in fixed proportions, e.g. left-hand and right-hand gloves.
Indifference curves for perfect complements is L-shaped as an additional unit of one good does
not raise the satisfaction without an additional unit of the other good.
(iii) A good which gives zero utility

When a good gives no satisfaction at all, the consumer will not give up any quantity of another
good for it, e.g. meat for a vegetarian.
 Indifference curves in such cases are straight lines parallel to the axis measuring
quantities of an unwanted good.
 In the figure, consumer satisfaction is entirely dependent on vegetable consumption.
(iv) An absolute necessity

When a minimum amount of a good, such as water, is regarded as an absolute necessity, the
quantity of other goods a consumer would accept in return for cutting down on the necessity
would become increasingly vast- approaching infinity at the minimum level necessary.
 Indifference curves in such cases would be vertical at the minimum level. At this point,
the MRS reaches infinity.
(v) A good that confers negative utility after some level of consumption
Food is an example of such a good that gives negative marginal utility if forced to consume after
a certain level.
 Indifference curves would slope upwards from the point at which disutility sets in.
 The positive slope indicates that more of both goods gives the same satisfaction as less
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of both of them.
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Such cases are usually ignored as it is rare to find a commodity that consumers cannot
reject if they want to.
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(vi) A good that may not be consumed at all

There are many commodities of this type such as many kinds of foodstuffs or brands of
toothpastes etc. that consumer decides not to buy.
 If a consumer consumes a zero amount of a commodity, one or more indifferent curves
must cut the axis measuring quantities of other goods.
 The figure is not restricted to showing only two commodities. The vertical axis in the
figure measures quantities of 'all other goods'.

2.10 Example candidate response

Question 3a
Discuss whether demand schedules and budget Sne diagrams are similar in the way they
represent the sheet of
(i) a rise in the price of a good
(ii) a rise in a consumers income.
Marking scheme
A rise in the price of a good: a demand schedule has prioe and quantity of one good bought
against price; budget line diagrams have quantities of two goods- price is not on the axis;
one cannot tall how demand will change with budget line unless you also show preference
lines.
A rise in a consumer’s income: similarity, both move parallel out for a rise in income; but
cannot tall what wilt be bought unless have supply line- with demand- or preference lines
with budget Hue.
L4 For a sound discussion indicating the similarities/differences
Examiner checked response
Demander schedule is the graphical representation of changes in quantities that consumes would
demand or would want to purchase at different prices at a certain period of time. It is used for to
represent the demand for only one good.
Budget line is the graphical representation of the discount possible combinations of two goods that
consumer can purchase with their fixed income. As consumer wants are restricted to be fulfilled by
the income they earn and the price of product, it is important to produce a budget line as in to
show how two good, in what combination, will be purchased.
(i) A rise in price of product in case of demand schedule lead to a change in quantity
along the curve. As the price rises consumers would demand the good less as than
before. As in figure in the right, show the demand schedule for a good, with quantity
demanded in the x-axis and price in y- axis. It is shown that a rise in price from P to P1
will lead to a fall Q to Q1.
This will be also the same case for budget line as the quantity demand for the good will
sell as the price rise, However since Budget line shows the demand of one good in
compare to the other it would be represent in the same way. The figure shows, good X
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is x- axis and good Y in the y-axis.

Before the rise in price for good x, the quantity demand 1S – Qx after the rise it pirated
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at Qy and sell to QX1. However there could also be a rise in quantity demanded for
good Y as a rise in good X would lead to consumer demanding less of good X and
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possibly substitute it with good Y.

For both the demand schedule and budget line the fall in quantity demand of the good
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that rise in price is because consumer would substitute the good which appear costly,
to the good which appear cheap in compare this is returned to substitution effect.
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(ii) A rise in income would lead to a shift in curve to left in both the diagram for demand
schedule and budget line, as an increase in income would allow consumer to spend

more, so they would purchase & more of the good.

The figure shows a demand curve, with Qd in x- axis and price in y-axis. There, the rise
in income shifted the curve to left. It means for the same price P, more quantity is
demanded, i.e. Q1 to Q2.
Similarly is the case of budget line the curve shift to left meaning that both the good
can be purchased more that before without sacrising the other as there is an increase
in Income in the figure is budget line it is shown by an increase in Qd of the good, is Qy
to Qy1 and Qx to Qx1 it rise.
This refers to the income effect for both the diagrams, as an increase in income leads
to increased disposable income for the consumers.

CH#3(The Labour Market)
CH#3 The Labour Market
LABOUR:
is defined as the people in the working age who are both willing and able to work. It
includes both employed and unemployed.
3.1 Perfect Markets
Assumptions of perfect Labour market:
 Labour is homogenous, i.e. workers of a given category are identical in terms of

productivity.
 There is perfect knowledge in the labour market, e.g. workers are fully aware of nature
of jobs available and the wages they are paying.
 There are many buyers and sellers of labour so that no single firm or worker can
affect wages. Wages are determined by demand and supply forces in the industry (W m).
A firm is a wage taker because it employs a small fraction of the total labour force and
therefore is unable to influence the market wage rate. It can hire as many workers as it
likes at the market wage.
 The marginal cost of labour for a firm in a competitive market is thus
equal to the wage rate (i.e. each extra worker adds exactly his wage rate
to the firm’s total factor cost).
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 Firm is trying to maximize profits and operate where the marginal revenue product of
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labour MRPL is equal to the marginal cost of labour (MCL). Since in perfects markets,
MCL is equal to wage therefore profit maximization takes place where MRPL is equal
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to wage.

 There are no barriers which prevent wages rising and falling to accommodate
changes in the demand for and supply of labour. (no govt. intervention.)
 Labour is perfectly mobile, i.e. it is free to move to alternative jobs (occupational
mobility) or to other areas (geographical mobility).
 There is perfect competition in the factor market and the product market.
 The theory is based on the law of diminishing returns.
Marginal Revenue Product theory
MARGINAL REVENUE PRODUCT OF LABOUR (MRPL)

is defined as the amount of additional revenue that a firm gains by employing an
additional worker. In perfect markets. MRPL is calculated using the following formula:
MRPL = MPP x P where MP = Marginal product of Labour
P = Market price of the product (firm is a price taker in perfect
markets)
Labour Total Marginal Price MRPL=

product product MP x P
1 8 8 10 80
2 18 10 10 100
3 26 8 10 80
4 32 6 10 60
5 36 4 10 40
6 38 2 10 20
MRPL is a downward sloping curve in perfect markets due to the law of diminishing returns.
An increase in quantity of labour eventually leads to a fall in its marginal product assuming
capital is held constant. This is shown in the figure above.
Firm will be in equilibrium where it is maximizing profits, i.e. where MRPL = MCL. Since, in
perfect markets, wage is equal to MCL, therefore equilibrium takes place where MRPL = W. In
the graph this takes place at point 'e' where firm hires Q1 workers at the market wage rate Wm.
 If firm hires an additional worker, the MCL is greater than MRPL and therefore firm's total
profit falls.
 If firm hires fewer workers, the MRPL is greater than MCL and therefore firm can
increase its profits by hiring an additional worker.
 At point 'e' where MRPL = MCL, there is no more room for increasing profits by changing
the quantity of workers hired.

Firm's demand curve for labour = Downward sloping part of MRPL curve
The DEMAND CURVE FOR LABOUR shows the quantity of workers that will be employed at
any given wage rate over a particular time period. Demand is labour is DERIVED DEMAND, i.e.
firms demand labour because of their decision to produce goods and services.
At a wage rate of Wi, equilibrium

takes place at ei and firm hires Q1
workers. If wages rise in the
market (may be the demand for
workers rise in the market) to W 2,
the new equilibrium is e2 and firm
hires Q2 workers. If wages rise
further to W 3, new equilibrium is at
e3 where firm hires Q3 workers.
Thus, the MRPL curve shows the
quantity of labour employed at
each wage rate which is what the
demand curve shows. Thus, the
downward sloping part of MRPL curve is the demand curve for labour.
Factors affecting demand

Demand for labour depends on following three factors:
i. Productivity of workers:
A rise in productivity (may be due to higher skills, greater motivation, and training
and education of workers) increases marginal product and the MRPL. Firms will be
willing to hire more workers and the demand curve shifts to the right.
ii. Demand for the good:
A rise in demand for the product produced results in an increase in price of the
good and an increase in MRPL leading to a rightward shift in the demand curve.
iii. Price of substitutes (capital):
An increase in price of capital makes labour more attractive leading to a
rightward shift in the demand curve.
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Market supply curve
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The supply of labour in the market is upward sloping (figure 'a' above), i.e. an increase in real
wages attracts more workers into the industry. The extent to which new workers will join the
industry depends on availability of similar skilled workers and their wages in other industries.
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Market equilibrium
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Wages in perfect market are determined through the interaction of demand and supply curves in
the market as shown in figure 'a' above. Equilibrium takes place where market demand and
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supply curve intersect. Market wage rate is Wm and the workers employed are Qe.

 In the short run, wages may be above or below the equilibrium wage.
 If market wage is above equilibrium wage, there will be surplus workers who will be
willing to work at lower wages hence pushing wages down towards equilibrium.
 If market wage is below equilibrium wage, there will be shortages of workers who will
then demand higher wages hence pushing wages towards equilibrium.
Wages can change in the market due to a change in demand and supply forces.
 A rise in demand (may be due to higher productivity or higher demand for the goods
produced) leads to rise in both wage and workers employed.
 A fall in demand leads to a fall in both wage and workers employed.
 A rise in supply (may be due to more fringe benefits offered) leads to fall in wages and
a rise in workers employed.
 A fall in supply leads to a rise in wage and a fall in workers employed.
Criticisms of MRP theory

 Labour is not homogeneous and efficiency of labour differs from worker to worker.
 Labour is mostly immobile. The greater the degree of specialization in an industry, the
less is the factor mobility from one industry to another.
 Markets are rarely perfect. Rather there is usually imperfect competition that leads to
exploitation of workers.
 In case of unemployment, workers will be willing to work at a wage less than their MRPL.
 Production is not the result of one factor only which means that calculating marginal
productivity of each factor is not possible.
MRP theory is not an adequate explanation of wage determination. If focuses on the demand
side and makes a lot of unrealistic assumptions. It fails to explain the determination of wages in
a dynamic economy.

3.2 Supply of labour

SUPPLY OF LABOUR
refers to the total number of hours that Labour is able and willing to supply at a
particular wage rate.
Supply curve for individual workers

Economic theory assumes a positive relationship between Labour supply and wage rate. As
wage rates increase, more people are willing to offer their services. However, for an individual,
the supply curve is backward bending.
An individual experiences two effects for a change in wage rates:

 SUBSTITUTION EFFECT is defined as a change in willingness of a worker to work due
to relative change in price of work and leisure. It suggests that workers will like to work
longer hours if there is an increase in wage because the opportunity cost of leisure (i.e.
wage) has increased and the
worker is tempted to substitute
extra work for leisure.
 INCOME EFFECT is defined as
change in willingness of a worker
to work due to change in his real
income. It suggests that an
increase in wage leads to a higher
preference for leisure as the
worker can satisfy his daily
financial requirements by working
less
The graph shows that at low wages rates, an increase in wage leads to an increase in the
number of hours supplied because substitution effect is greater than the income effect.
However, at high wage rates (beyond point X in the graph), income effect becomes greater
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than the substitution effect therefore an increase in wage leads to a fall in number of hours
supplied in the market.
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The shape of the curve varies for different workers depending on their attitude toward work and
leisure. For those individuals who prefer leisure, point X will be lower and for individuals who
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prefer work, point X will be higher.

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Affect of income tax rates

Supply of labour will be affected by income tax rates. A higher tax rate will decrease the
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disposable income for workers that would lead to a fall in the number of hours supplied in the

market. Income tax rates tend to be progressive, i.e. higher income earners pay a higher rate of
tax. This discourages the efficient workers who are earning more to work hence reducing their
supply in the market. Taxes can thus have a disincentive for supply of workers in the market.
Market supply curve

MARKET SUPPLY CURVE is the horizontal summation of all individuals' supply of labour. It is
upward sloping throughout,
i.e. the number of workers
will increase with an
increase in wages.
A rise in real wage rates is
likely to attract new
workers into the industry
and also attract workers
from other industries doing
similar jobs.
 The ability of a firm
to attract new
workers by raising
wages depends a
lot on the availability of similar skilled workers in other industries. If similar skilled
workers are easily available, then the supply is likely to be elastic. If not, then supply is
likely to be inelastic.
 In a competitive market, one of the major determinants of the supply of labour to a firm
or the industry is the wage rates offered in other firms or industries that are competing
for same skilled workers. If wage rates offered by other industries increase, supply of
labour to the industry concerned is likely to fall.
Long run supply of labour - Shifts in

supply curve
Some of the major factors affecting
labour supply are explained below.
(i) Age structure of the population

In developed economies, total
population is relatively stable and life
expectancy is increasing.
This ageing population leads to
relatively fewer people of working age
leading to leftward shift in the supply
curve.
In developing countries, the population growth rate is high and there is a large proportion of

young in the population. This means that every year a large number of the population enter the
workforce leading to a rightward shift in the supply curve.
(ii) Labour participation rate

Some of the major factors affecting participation rate are discussed below:
 Increase in enrolment in higher education results in a fall in supply of labour.
 Greater participation of women in the workforce increases supply of labour.
 A lowering of retirement age reduces supply of labour.
 In some developed countries (such as France), people prefer leisure and some of them
decide to take early retirement leading to a leftward shift in supply curve.
(iii)Tax and benefits level
 Progressive tax rates (especially very high marginal tax rates) discourage workers to
stay in the market as most of their income goes to government in the form of taxes. This
decreases the supply of workers in the market.
 Very high levels of unemployment benefits (such as social security payments)
discourage worker participation and decrease the supply of labour.
The government must therefore be careful in its tax and benefit policies. It must try to
ensure that the policies do not adversely affect long run supply of labour in the market.
Immigration and emigration

 Net immigration (immigration > emigration) leads to an increase in the supply of labour.
This is a particularly useful strategy when an economy faces shortage of labour and
allows workers to relocate from developing countries (with high levels of unemployment)
to developed countries.
o Some countries use selective immigration to allow immigration in
particular areas where they are facing shortages.
 Net emigration (emigration > immigration) leads to a fall in supply of labour
Non-pecuniary factors
Non-pecuniary (non-monetary) considerations are also important in determining supply of labour
in a market. Some of the non-pecuniary considerations include:
 Individuals prefer a job where they get job security and are willing to accept even a lower
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wage to work in such occupations. This explains why government jobs are often lower
paid than similar private jobs.
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 Workers are prepared to accept lower wages if there is greater job satisfaction.
 Location - A job may be attractive to an individual worker if he is closer to relatives and
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friends, or close to the social circle. Firms that are trying to hire individuals to work in
distant areas or in dangerous locations will usually have to pay a higher wage to
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compensate the workers for additional risk or disturbance taken

 Some jobs are attractive because they involve working with friends and family.
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 Commuting - Time taken to travel to work, the pleasantness of the journey and its cost
affect people's choice of jobs.
 Other factors include holidays, perks, and other fringe benefits in a job.

3.3 Elasticity of supply and Elasticity of demand of Labour

Factors affecting elasticity of supply of Labour
 Availability of suitable workers in other industries - Supply is elastic if suitable
workers are easily available in other industries. It is relatively easier to 'poach' workers
from other industries by offering them higher wages.
 Extent of under-employment and unemployment - Supply is elastic if unemployment
is high in an economy. Firms will be able to recruit workers easily at the existing wage
rate from the pool of unemployed workers.
 Skills required to carry out a particular occupation - The more the skill required, the
more inelastic will be the supply of labour. This is because higher skilled workers are not
easily available and training is needed to increase their supply that will need some time
before workers are available for the job.
 Amount of education and training required to carry out a particular job - The higher
the requirement for education and training for a job (e.g. in case of doctors, engineers
and economics teachers), the more inelastic will be the supply curve. An increase in
wages will have a lower impact on the increase in supply of workers because it takes a
lot of time to train such workers before they are available for work.
 Time - Elasticity of supply is likely to be lower in the short run than in the long run. In the
long run, employees can be provided training and education to fill the jobs available
In the figure, L1 is inelastic supply curve

with respect to wages being paid. This is
likely to be for those industries or
professions that require highly skilled
workers, pay high wages and have
scarcity of labour. L2 is an elastic supply
curve that is likely for those professions
that require lower skill levels, have plentiful
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supply of labour, and pay low wages.
Factors affecting elasticity of demand

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for Labour
ELASTICITY OF DEMAND FOR LABOUR is a measure of the responsiveness of the quantity
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demanded of labour to changes in wage of labour. Following are the major determinants of
elasticity:
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 Elasticity of demand for the product - Demand for labour is a derived demand and its
elasticity depends on the elasticity of demand for the final good or service. An inelastic
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demand for the final product will mean an inelastic demand for labour and vice versa
 Availability of substitutes - Capital is a substitute for labour. Improvement in technology
and introduction of machines that perform the same tasks done by workers (tractors,
threshers, ATM machines etc.) increases the elasticity of demand for labour.
 Proportion of Labour cost to total cost - If labour costs are a small proportion of the total
costs, the demand for labour tends to be inelastic. An increase in wages will have little
impact on supply curve of the product leading to only a minute fall in demand for product
and for labour. If labour costs are a large proportion of total costs, an increase in wages
will lead to a significant fall in supply of the product and its quantity traded. This leads to
a large fall in demand for labour meaning that the demand for labour will be elastic.
 Time - In short run, it is not easy to substitute labour for capital therefore firm will have
little choice but to employ the same number of workers even if wage rates increase
rapidly. They would also be constrained by the contracts of employment and the
unwillingness of firms to reduce the skilled staff (skilled staff is difficult to replace in the
short run). This makes the demand curve inelastic. In the long run, it is easier to
substitute labour for capital. An increase in wages will lead to firm buying labour saving
machinery reducing the demand for labour. This makes the demand for labour elastic.

3.4 Market imperfections

MARKET IMPERFECTIONS take place when demand and supply forces are not allowed to
operate freely. Perfect market makes a lot of unrealistic assumptions and therefore fails to
satisfactorily explain wage determination in real life. Economic theory, however, allows for
market imperfections and explains their impact on the labour market.
Monopsony in labour market

MONOPSONY occurs when there is a single dominant buyer of labour such as a factory in a
small town can be the only
employer of certain types of labour
in that town. Similarly, the Post
Office is a monopsony employer of
postal workers. Where there are
just a few employers, this is called
oligopsony. Monosponists (and
oligopsonists) are wage setters.
Supply of labour in a Monopsony and the MCL curve
Monopsonist is the single firm in the market therefore its supply curve is same as the market
supply curve, i.e. the average cost curve that is upward sloping from left to right.
 Firm will have to pay a higher wage to employ more workers.
 MCL of the monopsonist is greater than the wage rate because the monopsonist will
initially hire the worker who is willing to work at the lowest wage (e.g. at $5 per
hour). It will have to increase the wage ($6) to hire the second worker. The extra
cost to the firm of hiring the second worker ($7) will therefore be the wage paid to
the second worker ($6) plus the additional wage paid to the first worker ($1).
Demand curve and MRPL for a monopsony
If the monopsonist faced perfect competition in product market, then MRPL = MP x P and
MRPL will be downward sloping only due to law of diminishing returns.
If the monopsonist faced imperfect competition in the product market, its MRPL is given by
the following formula:
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MRPL = MPP x MR where MPP (MP) = Marginal physical product of Labour (additional
output from using one more worker)
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MR = Marginal revenue (additional price received for

selling additional output)
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In imperfect markets, MRPL is downward sloping because of two reasons (i) law of diminishing
returns, and (ii) downward sloping demand curve (more workers lead to more output that can
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only be sold at a lower price). MRPL in this case is likely to be less than MRPL if it faced perfect
commodity market.
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Profit maximization and wage determination

The aim of a monopsony is to maximize profits
and will therefore try to operate where MRPL is
equal to the MCL. Monopsonist will hire Lm
workers and pay them Wm wage.
 If it were perfect market, equilibrium
would have taken place where demand
equalled supply. Workers hired would
have been Lp and wages paid would have
been W p.
 Presence of monopsonist hence results
in depressed wages and lower
employment.
Monopsonist is also exploiting workers by paying (Wm) them less than their effort (MRPL).
Trade unions
TRADE UNION is an organization of working people with the objective of improving the pay and
working conditions of their members and providing them with support and legal service.
 The rationale for forming trade union is the ability of workers to engage in collective
bargaining - i.e. when trade unions negotiate on behalf of all their members in a
business. This puts the workers in a stronger position than if they negotiated individually
to gain higher pay deals and better working conditions.
 Reason for union power is that the union can threaten to go slow - i.e. worker keep
working but at a minimum pace disrupting the productivity of a business; or work to rule -
i.e. employees do no more than the minimum required by the rules or the contract; or
call a strike action - i.e. employees totally withdraw their labour for a period of time
leading to closing down of the factory.
 Trade unions are therefore in a better position to negotiate higher wages, additional
working benefits, improved working conditions, and pay differentials between skilled and
unskilled workers. They also fight job losses and prevent unfair dismissal.
 Unions are strong when most workers belong to one union; all workers agree to take the
industrial action decided on; and the business is very busy, i.e. it is operating at full
capacity, does not want to disappoint customers and is making a lot of profits. It is also
strong when industrial action quickly costs the employer large amounts of lost output and
profits; there is public support for the union case (e.g. for very low paid workers); and
demand curve for labour is relatively inelastic so that a rise in wage rates will have far
less impact upon employment in the industry. Unions are also strong when inflation is
high so that union can justify its demand for higher wages to maintain the real income of
workers. Unions are also strong when labour costs are a low proportion of total costs (for
instance, in case of capital-intensive production process) so that a wage rise does not
affect total cost and therefore profits of the firm a lot.
 Unions will be weak (and employers strong) when unemployment is high (there are few
alternative jobs for workers to take); action taken by employer (e.g. lock-out) has a very
quick impact on workers' wages; there is public support for employer (e.g. when unions
are asking for much higher rises than other workers receive); profits are low and threats
of closure are taken seriously; and there is threat of relocating firm to low-cost countries
(e.g. business has already closed other plants and relocated them).
Impact of trade union on wages and employment in a perfect market

Figure shows the demand (Dd) and the supply (Si) curve in a perfectly competitive market where
wage is W e and workers employed are Le.
Power of trade unions enables them to
negotiate wages above the equilibrium wage
rate (Wu) in a competitive market.
 This leads to a shift in the supply curve.
Employers in the industry are not able to
hire workers below Wu and the supply
curve becomes perfectly elastic till point
B. Beyond point B, employers will have
to pay higher wage rates if they wanted
to employ more workers leading to an
upward sloping supply curve. The new
supply curve after union negotiated
wages will be ABC.
 The new equilibrium wage rate is Wu at which the demand for workers falls to Li and
their supply increases to L2. This leads to a shortfall equaling L2- Li.
There is a danger that these unemployed people will undercut the union wage, unless
union can limit supply by preventing firms from employing non-unionized labour. A good
example of a successful trade union is the US Actors Guild. Guild is able to restrict the
number of actors and actresses who are able to work in films, TV and theatre. This
increases the bargaining power of the union enabling them to successfully negotiate
higher wages.
 Unions can only succeed in increasing wage without a fall in the level of employment if
they agree to a productivity deal, i.e. the productivity of labour is increased.
Trade union intervention is therefore useful for those workers who remain employed as they get
higher wages buy it is harmful for workers who lose their jobs. If the union is more concerned
with securing higher wage rate, then it will have to accept some reduction in employment. And if
it wants to maximize employment, then it will have to accept the market wage rate unless
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Effect of trade union on wages and employment in a monopsony (Bilateral Monopoly)

In cases where trade unions operate in monopsony markets, a monopoly supplier of labour
(trade union) faces a sole buyer of labour (the monopsonist). Economic theory suggests that a
trade union will increase both wages
and employment compared to a factor
market with a monopsonist and no
trade union.
 The figure shows that without a
trade union, wage rates will be
Wm and the monopsonist will
hire Lm workers.
 Trade union will force the
wages up to Wu leading a new
kinked supply curve where the
monopsonist will not be able to
pay a lower wage than Wu till
AB and beyond that, it will have to increase wage rates to hire more workers. The supply
curve hence becomes ABC.
 The marginal cost curve is also kinked. As wages are constant in the interval AB, the
MC is equal to Wu. Beyond B, as the wages increases marginal cost also jumps up and
the new MC curve is ABD.
 With profit maximization as the objective, the firm will hire till the point where MCL is
equal to MRPL. Therefore, it employs more workers (Lu) and pays a higher wage Wu.
The wages can even go above the equilibrium wage rate of perfect market.
Efficiency of trade unions

Effect of trade unions on economic efficiency depends on the structure of markets in an
economy. In a perfect market, trade union will lead to increase in wages but a reduction in
employment, hence, indicating inefficiency because of trade union. In monopsony markets
though, the trade unions are able to negotiate higher wages (close to perfect markets) for their
workers and are also able to increase the employment. This suggests that trade unions increase
economic efficiency in imperfect markets.
 Benefits:
o Trade unions increases economic efficiency in imperfect markets.
o Trade unions may result in lower cost of production to the firm as they
perform many of the functions of a personnel department such as they
deal with workers' problems and the firm does not have to deal with each
worker to negotiate wages hence resulting in a smaller personnel
department and lower administrative costs. For this cooperation, unions
demand higher wages but then firms benefit in the shape of more
productive workforce that increases the profits for firms.
o Trade unions can help bring change in work practices as decided by the

management. If trade union has participated in the change decision, it

can convince workers on the importance of the change. Workers would
be more willing to listen to the trade union than the management.
o Trade unions also increase productivity of workers by providing training to
unionized members; and providing help in their personal matters.
o Trade union actions result in higher wages that results in higher income
levels of workers, a rise in the workers' living standards, and a multiplier
impact as other sectors of the economy are also going to gain from higher
consumption of these workers.
o They provide workers' perspective on different issues to the management.
 Drawbacks
o Trade unions promote disruptive activities leading to loss in output for the
firm, lower income levels for the workers, lower GDP for the country and a
multiplier impact due to a fall in aggregate demand.
o Higher wage demand can lead to higher cost of production that forces
some firms to reduce their demand for workers resulting in higher
unemployment. Higher costs can also result in lower exports and higher
imports resulting in deterioration in balance of payments.
o Higher wages of workers can be one of the reasons for inflation in the
economy.
Concluding remarks
Unions have traditionally been strong in manufacturing and less important in services. Power of
trade union has eroded overtime because of decrease in membership of trade unions; intense
competition from products made in low-cost Asian countries; threat of firms to shift production to
low-cost countries; and legislation that discourages trade union activity.
Government intervention and National Minimum Wage (NMW)

Governments intervene in the labour market to overcome exploitation of workers by firms.
Government can use different laws to protect the workers such as setting minimum wages,
setting maximum working hours, using anti-discriminatory laws, legislating for health and safety
conditions at work and like that.
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National minimum wages
The aim of the government in setting minimum wages is to reduce poverty and to reduce
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exploitation of workers who have little or no bargaining power with employers.

Those who argue for minimum wages state that it reduces poverty by increasing wages,
reduces exploitation of workers by firms, reduces the amount of state benefits paid to low-
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income families, and leads to increase in tax revenue as wages rise. Higher wages also lead to
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higher consumption and an expansion in the consumer goods' industries. This tends to have a
multiplier impact on the economy. Higher wages also motivate workers leading to higher
productivity levels in the economy. It reduces labour unrest and also result in a more equitable
distribution of income.
Economist who argue against minimum wages state that it leads to an increase in cost of
production and higher prices. Higher prices result in cost-push inflation and lower aggregate
demand. Other workers also demand higher wages to maintain pay differentials. Higher prices
can also reduce exports and may reduce national income. It also increases administrative costs
of the government as it also has to take the responsibility of enforcing minimum wages. A major
problem is that minimum wages can lead to job losses. Firms may try to pass on the higher
costs to consumers in the form of higher prices. Their ability to do so will depend on elasticity of
demand. In case of inelastic demand it will be easier to increase prices without a significant fall
in employment. If, however, demand is elastic, raising the wage level will lead to significant job
losses.
Effective minimum wage is one that is set above the equilibrium wage rate. It leads to excess
supply of labour and a fall in demand for labour resulting in job losses. Job loss is higher when
demand and supply are elastic.
Labour immobility
LABOUR MOBILITY refers to the ease of movement of labour from one area or one occupation
to another area or another occupation. Competitive labour markets presume a freely mobile
labour force. If there is a vacancy in one geographical area, labour will move in from other
geographical areas to fill the vacancies. In reality, much of the labour is immobile. There can be
two types of labour immobility - geographical immobility and occupational immobility.

GEOGRAPHICAL IMMOBILITY refers to the reluctance of labour to move away from the area
of their residence. This may be because of social costs of leaving friends and family, and of cost
of relocating to a new area. Geographical immobility can be reduced by providing security and
higher salaries to the workers.
OCCUPATIONAL IMMOBILITY refers to a situation where labour is restricted in the type of job
that they can take up because of their specific skills and training. For example, a textile worker
cannot easily switch to IT firms. This is especially a problem in those occupations that needs
specialist skills and extensive training. Occupational immobility can be overcome by providing
training to the workers so that they are able to work in different industries.
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3.5 Transfer earnings and Economic rent in the Labour

market
Earnings of workers can be split into two elements, i.e. transfer earnings, and economic rent.
TRANSFER EARNING is the minimum payment that is necessary to keep labour in its present
use. This is the amount of wage that
is demanded by individual worker
and is the area to the right of the
supply curve.
 Transfer earnings
are the 'opportunity
cost' of employing the
factor. If the
workers is paid $200
a week, but could only
earn $150 a week in
his next best paid
occupation, then his
transfer earnings would be $150 per week.
 A change in transfer earning will affect the allocation of resources. If the worker
could now earn $250 a week in his next best paid occupation, economic theory
predict that all other things remaining constant, he would leave his present $200
per week job and take the more highly paid job.
ECONOMIC RENT is the payment to the worker over and above the transfer earnings. This is
the amount of wage paid in addition to the wage demanded by individual. This is shown by the
area to the left of the supply curve.
Economic rent = Total wage — Transfer earning
 Economic rent will not affect the allocation of resources. If the transfer earning of a
worker were $150, he would remain in his present job whether he earned $200 a week
or $250 a week.
 Different workers receive different amounts of transfer earnings and economic rent in
the same job. Those who are willing to work at low wages receive low transfer earnings
and larger economic rent. Those who are willing to work at higher wages (close to We)
receive high transfer earnings and little or no economic rent.
 Economic rent will be greater the more inelastic the supply curve.
Exceptional talent
Exceptional talent such as the legendary squash player Jahangir Khan is scarce and is unique.

The supply curve of such talented individuals is completely inelastic and the earnings consist
entirely of economic rent. Transfer earnings will be zero because the talent will be supplied
whether the payment received is zero or infinity.
Unskilled workers
Unskilled workers are usually available in abundant supply. Employers can usually hire many
workers at wage W. In such cases supply curve is completely elastic and the earnings consist
entirely of transfer earnings.
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3.6 Wage differentials (a sample essay)

LABOUR is defined as the people in the working age who are both willing and able to work, it
includes both employed and unemployed.
Economic theory assumes a perfect market where labour is homogenous, there is perfect
knowledge, firms are trying to maximize profits by equating MRPL with MCL, there are no
barriers that prevent wages from rising and falling, labour is perfectly mobile, and the industry
experiences law of diminishing returns. In addition there are many buyers and sellers of labour
so that no single firm or worker can affect wages. Wages are determined by demand and supply
forces in the industry (Wm) and the firm is a wage taker.
The demand curve in perfect market is the marginal revenue product of labour (MRPL) which is
the amount of additional revenue that a firm gains by employing an additional worker. In perfect
markets,
MRPL = MPP × P where MP = Marginal product of Labour

P = Market price of the product (firm is a price taker in perfect
markets)
MRPL is a downward sloping curve in perfect markets due to the law of diminishing returns. An
increase in quantity of labour eventually leads to a
fall in its marginal product assuming capital is held
constant. This is shown in the figure Wage(S)
above.
Firm will be in equilibrium where it is maximizing
profits, i.e. where MRPL = MCL. In the graph this
takes place at point 'e' where firm hires Q1 workers
at the market wage rate W m.
In practice however, wages may be different for
different workers. This can happen because of

following reasons:
 Workers are not homogeneous and possess different skill levels leading to different
productivity levels. Workers who are more productive will have higher MRPL and will
therefore command higher wages. For instance, doctors are more skilled than nurses
and command higher wages.
 Some workers work in industries where the value added and therefore the price charged
for the product is very high. This again results in higher MRPL and higher wages for
these workers.
Wages tend to be low in those jobs where there are non-pecuniary benefits available
with the job such as fringe benefits, working close to friends and family, job protection
and job satisfaction. If firms want workers to work in distant locations or in dangerous
jobs, then, they are likely to offer workers a higher wage.
 Another reason for wage differential can be labour immobility. Geographical immobility
may result from high social and relocation costs. Presence of these costs will mean that
labour cannot easily switch from one area to another area. This implies that areas in
which there is a greater demand for workers and shortage of workers will offer higher
wages. Occupational immobility results from lack of skills and workers cannot easily
switch jobs or switch industries. This implies that industries that require more skills, have
higher demand for labour, and face labour shortages offer higher wages.
 Wages are higher in those professions where supply of labour is inelastic. This may
include professions like doctors and engineers who require more skills and the training
period is also very long. Earnings of workers can be split into two elements, i.e. transfer
earnings and economic rent. Transfer earning is the minimum payment that is necessary
to keep labour in its present use. It reflects the opportunity cost of worker. Economic rent
is the payment to the worker over and above the transfer earnings. This is the amount of
wage paid in addition to the transfer earnings.
Economic rent = Total wage - Transfer earning
Exceptional talent such as the singer Susan Boyle is scarce and is unique. The supply curve of
such talented individuals is completely inelastic and the earnings consist entirely of economic
rent. A rise in demand for such talented workers results in a very large rise in their wages.
Susan Boyle was a relatively unknown figure earning very low salary before her talent was
exposed in 'Britain Got Talent'. Since then demand for her music has risen and she has won
contracts worth millions of pounds.
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Unskilled workers are usually available in abundant supply and the supply curve is completely
elastic and the earnings consist entirely of transfer earnings. A rise in demand for such workers
leave wages unchanged resulting in low wages for such workers.
Demand and supply factors may be different in different industries giving rise to wage
differentials. Industries where demand is rising and supply is short are likely to offer higher
wages. Whereas industries where supply is increasing and demand is less are likely to offer
lower wages.

Wage differentials also arise due to market imperfections. In some industries, a monopsony
may be the single dominant buyer of labour. For instance, government is monopsony employer
of doctors and nurses. Monopsonists (and oligopsonists) are wage setters. Monopsonists is the
single firm in the market therefore its supply curve is same as the market supply curve, i.e. the
average cost curve that is upward sloping from left to right.
 Firm will have to pay a higher wage to employ more workers.
 MCL of the monopsonist is greater than the wage rate because the monopsonist will
initially hire the worker who is
willing to work at the lowest
wage (e.g. at $5 per hour). It will
have to increase the wage ($6) to
hire the second worker.
The extra cost to the firm of hiring
the second worker ($7) will
therefore be the wage paid to the
second worker ($6) plus the
additional wage paid to the first worker ($1).
MRPL of a monopsonist is equal to:

MRPL = MPP x MR where MPP (MP) = Marginal physical product of Labour (additional
output from using one more worker)
MR = Marginal revenue (additional price received for
selling additional output)
In imperfect markets, MRPL is downward sloping because of two reasons (i) law of
diminishing returns, and (ii) downward sloping demand curve.
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The aim of a monopsony is to maximize profits and will therefore try to operate where MRPL is
equal to the MCL. Monopsonist will
hire Lm Wage workers and pay them
Wm wage. The wages paid are less
than the wages paid in perfect
markets, i.e. W p.
Another major reason for wage

differential can be presence of trade
unions. In those industries where
trade unions are strong, wages are
likely to be higher whereas industries
that have weak trade unions are
likely to have lower wages.
Trade union is an organization of working people with the objective of improving the pay and
working conditions of their members and providing them with support and legal service. Trade
union allows workers to engage in collective bargaining that allows them to negotiate higher
wages. Union power results from the fact that they disrupt business activity by asking its
workers to 'work to rule', or 'go slow' and as a last resort can call strike action leading to closing
down of the factory. Unions are strong when
most workers belong to one union; all workers
agree to take the industrial action decided on;
and the business is very busy, i.e. it is operating
at full capacity, does not want to disappoint
customers and is making a lot of profits. It is also
strong when industrial action quickly costs the
employer large amounts of lost output and
profits; there is public support for the union case
(e.g. for very low paid workers); and demand
curve for labour is relatively inelastic so that a
rise in wage rates will have far less impact upon
employment in the industry. Unions are also
strong when inflation is high so that union can
justify its demand for higher wages to maintain
the real income of workers. Unions are also strong when labour costs are a low proportion of
total costs (for instance, in case of capital-intensive production process) so that a wage rise
does not affect total cost and therefore profits of the firm a lot.
Figure shows the demand (Dd) and the supply (Si) curve in a perfectly competitive market where
wage is We and workers employed are Le. Power of trade unions enables them to negotiate
wages above the equilibrium wage rate (W u) in a competitive market. The new equilibrium wage
rate is Wu at which the demand for workers falls to Li and their supply increases to L2. This
leads to a shortfall equalling L2 - Li. There is a danger that these unemployed people will
undercut the union wage, unless union can limit supply by preventing firms from employing non-
unionized labour.
Government intervention in labour market by

setting national minimum wages can reduce the
wage differentials as lower paid employees will get
a chance to earn higher wages.
Another reason for wage differential can be

discrimination against some group of workers.
Discrimination can be due to race, colour, gender,
religion and like that. Demand for group that is
discriminated against (Di) tends to be lower
resulting in lower wages (W i).
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3.7 Example candidate response June

Question 5
In imperfect competition, labour markets can lead to worker exploitation in terms of the wage
rates they receive compared with wage rates in perfect competition. Discuss this opinion.
[25]
Marking scheme
Candidates should explain the economic theory of wage determination (marginal revenue
product) and compare the situation in perfect and imperfect competition. The theory indicates
that wages are lower In an imperfect labour market especially if there la monopsony. The extant
of the reduction varies depending on whether the labour market is considered with a perfect or
imperfect product market. However, the comparative reduction in wage rates may be corrected,
at least In part, by the strength of unions or by government legislation, [25]
L4 For a thorough explanation of the analysis of wage determination with a clear comparison of
the two markets and a comment on trade unions and/or government policy. [18-25]a
(14-17 for demand and supply only with institutional factors and/or government policy)
Whether labour market under imperfect competition lead to worker exploitation in terms of wage
rates they receive compared to wages in perfect competition is highly subjective and dependant
on an analysis of the presence of a monopsonist, , trade union and government intervention in
an imperfect market.
Firstly, under perfect competition, the MRP theory best explains how wages are
determined in the market. Here, the wages of workers are dependent on their Marginal Revenue
Product (MRP). MRP, in essence is the amount of additional revenue a firm would earn perfect
competition are profit maximisers, firms will hire workers up to the point where MRP is

equivalent to the margins cost of labour (MCL) as illustrated in the graph below.
Since under perfect competition buyers (firms) and sellers (workers) are price takers, the wage
rate is set by the interaction of demand and supply in the market. The reason that the graph for
the individual firm is represented is to distinguish between prefect competition, all workers
homogenous. Hence, the cost of hiring an additional unit of worker to the firm is constant, There
is no exploitation of workers in terms of wage take under perfect competition as a firm who
offers a wage rate lower than the market rate would have no worker wanting to work for them
given the unlimited buyers (other firms) who offer the market wage.
There are several reasons as to way there could be exploitation in terms of wage rate under
imperfect competition. In the presence of a monopsonist has an upward sloping supply curve
and even steeper marginal cost of labour curve. The reason for this is that a monopsonist would
have to increase the current wage rate in order to attract more labour into the market.
To add a definition, a monopson exists when there is only a single buyer in the market.
This is illustrated by the diagram below:
Being a profit maximiser, a monopsony would hire workers up to the part where MCL =
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MRP. As observed form the diagram above, workers are paid a much lower wage rate (W 1) than
the market equilibrium (WE). Hence, one might conclude that under a monopsony, workers are
indeed exploited and paid lower wages. The reason a monopsony is able to do so is because
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that since it is the sale buyer of labour in the market, workers have no choice but to accept the
lower wage rate.
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Conditions however, are not too chire when a trade union enters the picture. Trade union
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(another key characteristic of imperfect labour markets) serve the purpose of collectively
representing workers in negotiating wage rates with employers. This is because collective
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bargaining power exerts a significantly big amount of influence than the individual bargaining

with an employer can. The entrance of a trade union in a situation of monopsony in as

illustrated below:
Here , the trade union has successfully negotiated a higer wage rate for workers than the
monopsonist had initially offered the wage rate the monopsonist offered (Wm) has now a wage
rate equivalent to the market equilibrium. However, a trade union with higher wage rate. This
would depend on factors like the union density and substitutability of labour. In essence through
we might derive from here that it is possible for wage rates to be higher than the market
equilibrium (and hence perfect competition) under circumstances of imperfect competition.
Intermediately, we can conclude that a monopsony drives wage lower than what they
would be under perfect competition. However with the presence of a trade union, wages could
potentially be much higher.
Besides this, there is no government intervention under perfect competition. Imperfect

competition, on the other hand may evake government legislature such as minimum wage
measurements that could drive up wages. This is illustrated in the graph that follows:

The government could set the minimum wage above what the market would have.
Hence, this would drive the wage higher than what it would have been under perfect
competition.(W min > W E).
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While intvitive wisdom suggest that exploitation may occur under imperfect competition,
the introduction of a minimum wage or trade union may set the wage rate higher than what it
would have been under as perfect competition. Those efforts, however, are highly controversial
as in some instances (Graph 5), they could result in an increase in unemployment.

CH#4(Principles of Production)
4 PRINCIPLES of PRODUCTION
4.1 Relationship between Marginal, Average and Total
Deriving total from marginal
Total is a sum of marginal. Total = Marginal

The two have following relationship:
 When marginal is positive, total is rising.
 When marginal is positive and rising, total is rising at an increasing rate.
 When marginal is positive and constant, total is rising at a constant rate.
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 When marginal is positive and falling, total is rising at a decreasing rate.
 When marginal is zero, total is maximum.

 When marginal is negative, total is falling.
Deriving marginal from total

Marginal is the change in total due to
change in one unit of output.
Marginaln = Totaln - Totaln-1
Marginal can be derived from a total

graph by calculating the gradient of
the tangents on the total curve.
 When total curve is rising at
an increasing rate (till point 'b'),
marginal must be positive and rising.
 When total curve is rising at a
constant rate, marginal must
be constant.
 When total curve is rising at a
decreasing rate (after point 'b' till point 'd'), marginal must be positive and falling.
 When total curve is maximum (point 'd'), marginal must be zero.
 When total curve is falling (after point 'd', e.g. point 'e'), marginal must be negative.

Deriving average from total

Average is the total divided by the output. Average = Total
Averages can be calculated from the total graph. Draw a to any point on the total graph. The gradient
of the ray is equal to the average.
 Where the ray from the origin is tangent to the total, the average is either maximum (if the
gradient was rising before it) or minimum (if the gradient was falling before it).
Relationship between marginal and average

The following relationship expresses how marginal and average values are related.
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 If marginal is less than the average (marginal is below the average curve), then average will fall. It
is true even if marginal is falling or rising.
 If marginal is greater than the average (marginal is above the average curve), then average will
rise. It is true even if marginal is falling or rising.
 If marginal cuts the average from above (marginal is equal to average at that point), average is
maximum at that point (as in MP and AP curve). If marginal cuts the average from below
(marginal is equal to the average at that point), average is minimum at that point (as in MC and AC
curve).
4.2 Law of diminishing returns (Law of variable proportions)

Time periods in production
1. MOMENTARY RUN is a time period in which firms are unable to change any factor of
production.
2. SHORT RUN is a time period when a firm can only change some and not all factor inputs. At
least one of the factors of production is fixed.
3. LONG RUN is the time period when all factors of production are variable. Firm may improve the
quantity and quality of its capital by building a new factory to increase its output. This leads to
greater efficiency in the long run.
4. VERY LONG RUN is a time period when all key inputs into production are variable. These key
inputs can include technology, government regulations, and social considerations.
Labour is usually the variable factor that can easily change and capital is usually the fixed factor that
takes longer to change. The duration of short run differs for different industries. It will be easier for a
tailor to add a sewing machine (may take a few weeks only) and hence increase his scale of
operations but it will be more difficult for an automobile manufacturer to set up a new factory (may
take several years) to increase its scale of operations.
Law of diminishing returns/ Law of variable proportions

TOTAL PRODUCT is defined as the quantity of output produce by a given number of inputs over a
period of time (it is expressed in physical terms and not money terms).
Total product (TP) = Marginalproduct(MP)
MARGINAL PRODUCT is defined as the change in total product that results from hiring an additional
unit of input (e.g. labour).
TP
MPn = TPn – TPn-1 MP =
Labour
AVERAGE PRODUCT is defined as the quantity of output per unit of input. When input is labour, it
becomes a measure of labour productivity and can be calculated by using the following formula:

Total output produced (Total product)

Average product =
No.of workers employed (Input used)
LAW OF DIMINISHING RETURNS (or LAW OF VARIABLE PROPORTIONS) states that as

additional units of a variable factor (such as labour) are added to a fixed factor (such as capital), the
extra output (marginal product) of the variable factor will eventually diminish.
 Note: the total output still increases but at a

decreasing rate as long as the marginal
output is positive.
 The law of diminishing return operates in the

short run and assumes that (i) at least one factor
is fixed, (ii) each unit of the variable factor is the
same (e.g. each worker is equally trained), (iii) the
level of technology is held constant, and (iv) the
firm is operating in the short run.
Assume there are four machines in a factory and each

machine requires one worker to function efficiently. The
first worker that the firm hires will be inefficient as he will
find it difficult to operate four machines. Second worker
will improve efficiency but two workers will still find it
difficult to operate four machines efficiently. Similarly it
happens when firm hires the third worker. Fourth worker
will maximize the efficiency level. Till the first four
workers that firm hires, efficiency levels rise and firm is
said to be experiencing increasing returns. If firm hires a
fifth worker, then there will be more workers than
machines. This reduces the efficiency of workers. As firm keeps adding more workers, their
Capital Workers MP TP=MP AP = TP/L Capital to Labour ratio
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4 i 20 20 20 4
4 2 34 54 27 2
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4 3 46 100 33 1.33
4 4 51 151 38 .1
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4 5 46 197 39 0.8
4 6 33 230 38 0.67
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4 7 10 240 34 0.57
4 8 -17 223 28 0.5
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efficiency keeps falling as the number of machines are fixed. This can be shown in the following table
where marginal product keeps rising till the fourth worker and then it starts to fall. Diminishing returns
therefore build after the fourth worker.
The total product keeps increasing at a decreasing rate as long as the marginal product is positive.
The reason for diminishing returns is that with an increase in the additional workers,
the capital to labour ratio falls so that each new worker will have a lower productivity as he will have
much less time to use the same machine that other workers are using.
Relationship between the Law of Diminishing Returns and the Cost curves
Marginal product and marginal cost
Law of diminishing returns was explained above where MP initially rises as more workers are hired
and then MP fall when diminishing returns build in. Assuming that wages of workers remain constant
in the short run:
Wage
MC =
MP
 A rise in marginal product (increasing returns), results in a fall in marginal cost.
 When marginal product is maximum, marginal cost is minimum.
 A fall in marginal product (diminishing returns), results in a rise in marginal cost.
 It can be said that marginal cost curve is therefore a mirror image of the MP curve.
Average product and average variable cost
Average variable cost can be calculated from average product using following formal if we assume
that factors prices such as wages are fixed:
Wage
AVC=
AP
 AVC falls when AP is rising.
 AVC is minimum when AP is maximum.
 AVC rises when AP is falling.
 Therefore, there is an inverse relationship between AP and AVC

4.3 Production function

PRODUCTION FUNCTION shows the maximum possible output from a given set of factor inputs.
This relationship may exist in the short-run or in the long run.
Short-run production function

SHORT-RUN PRODUCTION FUNCTION shows the relation between quantity of variable factor input
(such as labour) and the total product (output) when other factors of production remain constant.
Q = f (L)
The short-run production function is shown in the figure and is based on the law of diminishing
returns as explained above.
Long-run production function

LONG-RUN PRODUCTION FUNCTION shows the relationship between physical quantities of all
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factor inputs (e.g. labour and capital) and the output when all factors of production are variable. The
relationship can be depicted using the following functional notation:
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Q = f (I1,I2……In)
where
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Q is output of the product

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I, are quantities of various factor inputs used in producing output

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Production function assumes that the state of technology is fixed or given. A change in the state of
technology will change the production function. For instance, the microchip revolution has enabled
goods to be produced with fewer workers and less capital.
A firm can use different types of production methods in the long run (i.e. using different proportions of
factor inputs - land and capital) to produce the same amount of output. The firm is looking for the
least cost or the most efficient method of production where the total cost of the firm is minimum.
However, to achieve the lowest combination of factors of production, the firm must first know (i) the
cost of each factor of production, and (ii) the marginal physical output (marginal product) of each
factor of production. The aim of the firm is to minimize costs that is achieved when the marginal
products of every factor, per unit of money spent on them, shall be equal. This is known as the
LAW OF TECHNICAL SUBSTITUTION. This can be shown with the following equation:
Marginal product FactorA Marginal product FactorB Marginal product FactorC

 
Price of FactorA Price of FactorB Price of FactorC
If MPA/PA is greater than MUB/PB, the firm will switch its expenditure from input B to input A as A is
more productive. As the firm consumes more of input A, the marginal product of A falls and the
marginal product of B rises. Firm keeps switching to A from B till the marginal product per dollar of A
and B are equal. At this point there will be no more opportunity to reduce total cost by switching
expenditure from one input to another input.

CH#5(Firm’s Cost of Production)
CH#5 FIRM'S COST of PRODUCTION
5.1 :Economic vs. Accounting costs
Economists generally assume that a firm is trying to maximize profits where
Profit = Total Revenue -Total Cost
However, costs of an economist are different from costs considered by an accountant.

Accountant's view of costs
Accountants consider only those recognized expenditures that a firm incurs in its operations.
These include costs such as material costs, labour costs, factory rent etc. Accountants do not
include any opportunity cost when calculating profits.
Economist's view of costs

The ECONOMIC COST OF PRODUCTION for a firm is the opportunity cost of production, i.e.
the value that could have been generated had the resources been employed in their next best
use. Opportunity costs may have to be imputed if market data is not available for an activity.
• Opportunity cost of things which are paid for (e.g. materials, labour, electricity etc.) is
the payment itself. ‘
• Imputed cost is calculated for those resources which have an opportunity cost but for
which no payment is made. Some examples where opportunity cost has to be estimated
are given below:
o Market trader working on her own account must include the opportunity cost of
earnings that could have been gained from working elsewhere,
o A business investor must include the opportunity cost of capital (return he could
have earned by investing in another investment opportunity),
o Depreciation of machinery that is in use by the firm,
o Potential rent on the goodwill of the firm.
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5.2 Short-run costs
SHORT RUN is a time period when a firm can only change some and not all factor inputs. At
least one of the factors of production is fixed.
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• A firm can change its level of production in the SR by altering the variable input only.
• SR costs will hence include both (i) fixed costs and (ii) variable costs.
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Fixed costs
FIXED COSTS are defined as the costs that do not
change in total in the short run with a
change in the level of activity, e.g. rents, office staff,
advertising and promotion, interest on
loans, insurance and capital goods. These are also
defined as the 'total costs when the firm is
not producing any output' (output = 0).
• Total fixed costs (TFC) remain constant and
hence appear as horizontal straight line on a
graph.
• AVERAGE FIXED COST (AFC) is calculated as total fixed cost divided by output.
Total fixed cost

AFC = ________________
Output
AFC falls with an increase in output because TFC is spread over a larger number of
units. This is a critical success factor in those industries that incur high fixed costs (e.g.
steel, telecommunications). For success of a firm in such industries, it will be necessary
that a firm should produce large quantities of good or service and reduce its per unit cost.
Note: AFC curve slopes downward as the output increase. The AFC will become very
low at very large levels of output. However, it will never become equal to zero.
Variable costs
VARIABLE COSTS are defined as costs that
change in total with a change in the level of
activity.
Common examples of variable costs in a firm are
labour costs and material and component costs.
• Total Variable Cost (TVC) curve shows
the following pattern:
o It originates from origin as there
are no variable costs when output
is zero.
o TVC first increases at a decreasing
rate due to increasing returns and
then start to rise at an increasing
rate as diminishing returns set in.

• AVERAGE VARIABLE COSTS (AVC) are calculated by dividing total variable costs
with output.
Total variable costs

AVC = Output
AVC can be calculated from the TVC graph by finding the gradient of a ray drawn from
origin to any point on the TVC curve,
a) Gradient of the ray from the origin fall till point 'c', i.e. AVC is falling as output
rises because the firm is experiencing increasing returns.
b) At 'd’ the ray is tangent to the curve, and the gradient is minimum, i.e. AVC is
minimum.
c) After point 'd, the gradient of the

ray start to rise, i.e. AVC is rising
as output rises because
diminishing returns have built in.
Mixed costs
MIXED COSTS (semi-variable costs or semi-
fixed costs) include both the elements of fixed
costs and variable costs. An example of such
costs can be wages and salaries paid which will
be fixed for permanent staff but is variable for
employing hourly wage labour. Another
example can be salesman commission which
can include a basic pay (fixed) plus a commission on sales (variable).
Total costs
TOTAL COST (TC) includes both fixed costs and variable costs:
TC = TFC + TVC
• TC cure is parallel to TVC curve and the distance between the two curves is equal to
TFC.
• AVERAGE TOTAL COST (AC) shows the cost per unit
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of any chosen output. It is given as:
Total cost
ATC = — ------------
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Output
AC can be calculated from the TC graph by finding the

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gradient of a ray drawn from origin to any point on the

TC curve.
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a) Gradient of the ray from the origin fall till point 'c', i.e.
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AC is falling as output rises because the firm is experiencing increasing returns.
b) At ‘c’ the ray is tangent to the curve, and the gradient is minimum, i.e. AC is
minimum.
After point‘d, the gradient of the ray start to rise, i.e. AC is rising as output rises because
diminishing returns have built in.
ATC is also given as:
AC =AFC+AVC
AC curve is given as a classic U-shaped curve. It is formed by the interaction of AVC

and AFC. AC curve initially falls (increasing returns), gets to a minimum point, and then
starts increasing (diminishing returns build in).
AFC, as already discussed, ATCor AC

continuously falls with an increase in
output but does not become zero.
AVC curve, just like AC curve, initially

falls, gets to a minimum point, and
then starts increasing. The difference
between AC and AVC is equal to AFC.
Some key points that must be remembered

about AC and AVC curves are as follows:
• The difference between AC and AVC
is initially large because of large AFC.
• The difference between the two curves
starts to fall as output increases because of a falling AFC curve.
• The two curves never meet because AFC never becomes equal to zero.
• AVC curves gets to its minimum point before the AC curve.
Marginal cost
MARGINAL COST (MC) is the addition to total cost because of producing one more unit of
output. In SR, since FC do not change, marginal cost is equal to the variable cost. Therefore,
marginal cost must be equal to:
MCt = TVCt - TVCt.i
MCt = TCt – TVCt-1

which should also be equal to:
Mathematically, MC is:
A TC
MC curve is also u-shaped and is a mirror image of MP curve. It initially falls (increasing
returns), reaches a minimum point, and then starts to increase (reflecting diminishing returns).
Some of the key points that must be remembered about MC curve are as follows:
• If MC is below AC (AVC), AC (AVC) must be falling because the cost of last unit
produced (MC) is less than the average cost of previous units produced.
• If MC just equals AC (AVC), AC must be minimum. The last unit produced costs (MC)
exactly the same as AC (AVC) of all previous units so that MC=AC (or AVC)
• If MC is above AC (AVC), AC must be increasing because the last unit produced costs
(MC) more than AC (AVC) of all previous units
produced.
• It is always a rising MC curve always that cuts
the AC and the AVC curves at the lowest
point.
Optimum output
OPTIMUM OUTPUT is that level of output where unit cost
(AC) is lowest. This is the point where MC curve cuts the
AC curve. At this point firm is said to be productively
efficient in the SR.
However it must be remembered that it may be the
most profitable output as profits depends on both revenue
and cost.
Showing AC, AVC and MC on TC curve

TVC curve
• AVC is the gradient of the ray from origin. It initially falls and becomes minimum when
the ray becomes tangent to the curve. After that AVC starts to rise.
• MC is the instantaneous slope of the curve. It initially falls and becomes minimum before
rising again. The minimum of MC comes before the minimum of AVC. MC is equal to
AVC when AVC is minimum.
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TC curve
• AC is the gradient of the ray from origin. It initially falls and becomes minimum when the
ray becomes tangent to the curve. After that AC starts to rise.
• AVC is the gradient of the ray from the v-intercept. It initially falls and becomes minimum
when the ray from the y-intercept becomes tangent to the curve. After that AVC starts to
rise.
• MC is the instantaneous slope of the curve. It initially falls and becomes minimum before
rising again.
• The minimum of AVC comes before the minimum of AC.
• The minimum of MC comes before the minimum of AVC that comes before the minimum
of AC.
• MC is equal to AVC when AVC is minimum.
• MC is equal to AC when AC is minimum

5.3 Long-run costs

LONG RUN is the time period when all factors of production are variable. Firm may improve the
quantity and quality of its capital by building a new factory to increase its output. This leads to
greater efficiency in the long run.
• In long-run, all costs will be variable and there is no fixed cost.
SCALE OF PRODUCTION refers to the levels of all inputs a firm is using to produce a given
output. An increase in scale of production refers to an increase in all inputs used to increase the
production levels. A change in scale of production therefore only takes in the long-run.
RETURNS TO SCALE reflects responsiveness of total product when all inputs are changed
proportionally.
• INCREASING RETURNS TO SCALE refers to a situation when an equal percentage
increase in inputs leads to a more-than-proportional increase in output. For example, as
output increases from 100 to 200 units, the firm needs to hire relatively less labour and
capital per unit of output, thus indicating increasing returns to scale.
• DECREASING RETURNS TO SCALE occurs when an equal percentage increase in all
inputs leads to less-than-proportionate increase in total output. For example, as output
increases from 300 to 400 units, the firm needs to hire relatively more labour and capital
per unit of output, thus indicating decreasing returns to scale.
• CONSTANT RETURNS TO SCALE takes place when an equal percentage increase in
all inputs leads to an equal proportionate change in total output.
Long-run average cost (LRAC)

It is possible for a firm in the long run to find ways of lowering its cost structure. It can change
the production methods and use more capital to increase productivity of its operations hence
leading to a fall in unit costs.
LONG-RUN AVERAGE COST (LRAC) CURVE is an envelope curve that just touches or is
tangential to a series of short-run cost curves. It therefore shows the lowest possible average
cost of each level of output where the factors of production are all variable. However, the firm
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may not be producing at the minimum point

on each of its short-run average cost curves.
The LRAC curve initially falls, gets to a
minimum point and then increases. Between
points A and B, the firm is getting increasing
returns to scale or we say that the firm is
getting economies of scale. Point B is the
lowest point of LRAC curve and shows the
MINIMUM EFFICIENT SCALE (i.e. the scale
at which company has the lowest unit cost).
Beyond point B, the unit cost of a firm
increases with an increase in scale. The firm
is now getting diminishing returns to scale or
we say that the firm is experiencing
diseconomies of scale.
There is a general principle to guide the firm in the search for the minimum-cost method. It is
that the last dollar spent on each and every factor of production should yield the same extra
output (already discussed in production principles). This equality can be shown by the following
equation:
Economies of scale
Marginal product of capital Marginal product of labour

Price of capital Price of labour
ECONOMIES OF SCALE is defined as a reduction in unit cost of production because of an

increase in the scale of operations. The phenomenon is consistent with the long run only where
a firm can change all its inputs hence change the scale of operations. Firms can get either:
• internal economies of scale (movement on the curve) or
• external economies of scale (shifts LRAC downwards)
INTERNAL ECONOMIES OF SCALE refer to benefits that accrue to a firm as a result of its own
decision to increase its scale of operations. This leads to a fall in the unit cost and a fall in
LRAC. There can be many sources of internal economies, some of which are listed below.
• TECHNICAL ECONOMIES refer to the advantages gained by a firm in the production
process.
o Some production techniques (such as highly capital-intensive methods) only become
feasible beyond a certain level of output. A small builder may use a cement mixer on
average 3 days a week. If he were able to take on more work he might be able to use it
for 5 days a week. The total cost of cement mixer is the same whether it is used for 3

days or 5 days a week but the average cost per job done will be lower the more it is
used. Technical economies are, therefore, available to those firms that are able to fully
utilize their capacity and manage their bottleneck resource successfully.
o Technical economies also arise because larger plant size is often more productively
efficient. This is referred to as indivisibility. Smaller versions of equipment may be
available but are not as productive as the large versions. It is generally cheaper to
produce electricity in large power stations than in small ones. The average cost of
production of a car plant making 100,000 cars a year will be less than that of one
making 5,000 cars a year, o In large workplace, the production process can be broken
down into many separate operations thus allowing specialization and use of highly
specialized equipment.
o Firms benefit from increased dimensions where if a cubicle machine is doubled in length,
breadth and width, it results in 4x increase in surface area and 8x increase in volume.
Purchasing and Marketing economies

 Larger size of the firm enables it to buy stock in large orders hence getting bulk
discounts. This reduces the per unit input cost for the firm, o Large firms are able to
employ specialized buyer who is more likely to buy raw materials are a lower price.
 Larger firms also enjoy lower average costs from their marketing operations. A 30
second TV commercial for a product which has sales of $5 million per annum costs the
same as a 30 second TV commercial for one which has sales of only $1 million (hence
reducing average marketing costs for the larger firm), o Large firms are able to achieve
savings in unit costs from discounts received on advertising and packaging.
• Financial economies
o Investors generally perceive a lower risk in investing in large firms. This (i) provides
large firms with easy access to capital at (ii) lower costs, o Banks are likely to give
more loans to large firms and at a lower interest rate, o Large public limited
companies have access to large stock markets where they can sell shares and
bonds and raise finance at a lower cost.
• Managerial economies
Large firms are in a better position to lower their per unit overhead costs because of their
ability (i) to attract the best management talent at higher salaries and allow for
specialization, and (ii) reorganizing their structures to become more efficient.
• Technological economies
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Many firms can make cost savings through application of online ordering and booking
systems. For example, consumers can use online search engines to buy insurance,
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flights and hotel accommodation hence reducing costs of selling of firms.

• Risk-bearing economies
o Large firms can diversify their risk by spreading investment into a huge portfolio of
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assets. This enables them to earn higher returns at lower risks, o Large firms are also
at times able to reduce their risk by cooperating with rivals on large capital projects.
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EXTERNAL ECONOMIES OF SCALE are the benefits received by all firms in an industry as a
direct consequence of the growth in the industry. This is especially true for those industries that
are able to operate in a cluster. Some of the reasons for external economies are listed below:
• easy availability of a pool of skilled labour;
• convenient supply of components;
• greater access to knowledge and research; and
• better transport infrastructure.
External economies of scale will shift the LRAC curve of an individual firm downwards. At any
given output, its costs will be lower because the industry as a whole has grown.
Economies of scale is a major source of competitive advantage for large firms. This is especially
true for industries where fixed costs are a very high proportion of total costs. In such industries,
those firms are particularly successful that are able to increase their scale and output and
reduce costs by getting economies of scale.
Low costs can also act as a barrier to entry and restrict easy entry of firms into an industry
making the industry more attractive. This is especially true in the case of natural monopolies
where the fixed costs are so high that it is only feasible for only one firm to efficiently produce
and supply a good in a market.
Diseconomies of scale
 DISECONOMIES OF SCALE refer to the situation where an increase in scale of
operations leads to an increase in unit cost of production. The LRAC curve begins to rise
in this case. Diseconomies of scale can also be because of two sources.
INTERNAL DISECONOMIES (movement on the line) accrue to a firm as a result of its
decision to increase its scale of operations. This is largely because of managerial
problems.
 Managing a very large business becomes very difficult and it can lead to coordination
problems. Large firms are divided into many divisions and many departments that can lead
to coordination problems resulting in higher costs, o Communication problems can arise in
large firms that has many departments and many employees. A lot of time may be lost in
meetings and ensuring that everyone knows the objectives and other information, o Very
large size of firms can also lead to reduction in morale and motivation of employees as they
feel very distant from top management and less involved in decision making.
 Large plants also suffer from worse industrial relations than small firms.
EXTERNAL DISECONOMIES (shifts LRAC curve upwards) affect all firms in an industry as a
result of growth in the industry. This is because of excessive concentration of economic activity
in a narrow geographical location which can lead to: o traffic congestions leading to increase in
distribution costs; o land shortages leading to increase in factory and office rent; and o
shortages of skilled labour leading to an increase in wages of labour.

Effect on the curve

• Internal economies of scale lead to a shift in SRAC downwards from SRAC1 to SRAC2
in figure above. It is shown as a downward movement on the LRAC curve.
• Internal diseconomies of scale lead to a shift in SRAC upwards and is shown as an
upward movement on the LRAC curve.
• External economies of scale shift the LRAC down as shown in figure below.
Shifts in LRAC
Some of the reasons for the shift in LRAC curve are listed below:
• External economies of scale
Discussed below. External economies of scale will lead to a downward shift in LRAC
curve of an individual firm in the industry.
• Taxation
If government imposes a tax
upon the industry, costs will
rise, shifting the LRAC curve
of each firm upwards.
• Technology
LRAC curve is drawn on the
assumption that the state of
technology remains constant.
Introduction of new technology
that is more efficient than the
old will reduce average costs
and push the LRAC curve
downwards.
• External diseconomies of
scale Discussed below. These
shift the LRAC curve of an individual firm in the industry upwards.
Usefulness of LRAC to firms

Knowledge of LRAC can be very useful for firms. It gives them following benefits:
• Costs above the LRAC are attainable but are inefficient. Costs below LRAC are not
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possible in the current circumstances (may shift downwards for reasons discussed
above). Firms, therefore, know the least cost of production for any given level of output.
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Hence, to maintain their efficiency firms will try to operate on LRAC curve.
• Firm realizes that it needs to change its production methods to become more efficient in
the long run. It therefore strives to find the ideal mix of labour and capital that reduces
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the unit cost of production.

• In the LR, firms will try to get economies of scale by increasing their scale of operations.
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For this, a firm must strive to increase its sales and market share.
• Firm knows the minimum efficient scale. It can plan its production decisions accordingly.
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For instance, the number of factories and the number of locations that the firm would like
to operate in will depend on minimum efficient scale. If minimum efficient scale is very
high (for instance in those industries where fixed costs are very high), firm will try
to get economies of scale by limiting the number of factories in which it produces. If
minimum efficient scale is low, it gives the firm the flexibility to locate its production
in different areas.
• Knowledge of minimum efficient scale is also important as it indicates the scale of
operations that will enable a firm to get a competitive advantage by minimizing its unit
costs (especially important for firms that are pursuing the strategy of cost leadership).
• Knowledge of LRAC curve is also important for the firms as they realize that beyond a
certain point (point B), they will start getting diseconomies of scale. A firm may decide to
limit its operations if it is getting beyond point B (i.e. getting diseconomies of scale).
Limitations
Although knowledge of LRAC is very useful for firms in taking decisions, yet it has several
limitations that reduces its practical usefulness:
• It is difficult to draw the shape of LRAC that confuses firms in knowing what their lowest
cost may be.
• It is difficult to state when diseconomies will set in. This limits the ability of firms to take
correct decisions. The tendency is therefore to grow even if unit costs may start to rise.
• LRAC may shift over time. Therefore firms and their managers must realize this and be
prepared to adopt new technology or to change their strategy according to changing
market conditions.
Concluding remarks
Firms that are trying to maximize efficiency will try to produce at
• optimal output in the SR (where MC = AC)
• minimum efficient scale in the LR.
Industries that have low minimum efficient scale will usually have big population of firms. This is
because it will be easy for firms to enter such industries and many firms will try to enter in the
hope of making abnormal profits.
Industries that have high minimum efficient scale tend to have few firms in the industry. This is
because of a large minimum scale acts as a barrier to entry for firms. This encourages
monopoly practices in the industry. It also explains why some firms have the objective to get
bigger, gain scale economies, and amass monopoly power.

5.4 Small Firms

SMALL FIRMS are those firms that have relatively lower scale of operations; they employ few
employees, have lower sales and market share, and employ comparatively less capital. There is
no universal definition of small firm but firms can be judged as large or small based on their
sales, capital employed, market share, and number of people employed.
Economies of small-scale production
Economic theory generally supports the idea that large firms that get economies of scale are
likely to be more successful and survive in the longer term. However, small firms are able to
survive in all industries. Some of the major reasons for survival of small firms are given
below.
• Small market demand - In some economic activities, size of the market is too small to
support large firms, e.g. a barber operating in a small town. It is also true for firms
operating in niche markets such as firms supplying luxury or prestige items like high
quality jewellery where small market size results in small firms.
• Provide personalized services - Small firms can deal quickly and efficiently with
customer interests and their problems leading in better customer relations. Small firms
can even charge a premium in return for the personalized services that they offer.
• Quick decision making - Small firms can take quick decisions in response to changing
market conditions such as change in customer tastes, change in government laws, or a
change in competitor strategy.
• Requirement of specialist skills - The business may involve specialist skills possessed
by very few people. Accounting profession is an example where small auditing firms are
able to provide specialist advice.
• Inability to raise capital - One of the major obstacles to growth of small firms is their
inability to raise capital because of their high perceived risk. This means that many firms
remain small despite having a good business model.
• Retaining control - Large firms will need additional investors to finance growth. This
leads to loss of control of original owner in the business. Entrepreneurs who are more
interested in retaining control will limit the growth of the firm.
• Government assistance to small firms - Small businesses provide a lot of employment
in the economy and contribute to the GDP of the economy. Government, at times,
provides financial assistance such as subsidies and tax allowances to small firms that
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enables them to compete in the industry despite having cost disadvantages.
• Disintegration of large firms - Disintegration of large firms in an attempt to cut costs
and focus on more profitable core activities creates new business opportunities for small
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ones.
• Sub-contracting peripheral tasks - It is sometimes cheaper for large firms to contract
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out some of the peripheral tasks such as design, data processing and marketing, to
specialist small firms. Manufacturing firms may buy in components from small suppliers
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producing for a range of companies, because it is cheaper than the large firm trying to
supply small quantities itself.
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• Increased access to technology - Increased access to technology through personal

computers and mobile phones has reduced the optimum size of business unit and made
small businesses more efficient and therefore competitive with large ones.
• Innovation by small firms pioneering new products - Small firms have been very
successful in pioneering new products in the field of computing and technology.
• Formation of cooperatives - Formation of cooperatives has allowed small firms to get
scale advantages such as getting bulk discounts, buying expensive machinery and
having higher market power
• Economic recession and rising unemployment - Higher unemployment can trigger an
increase in number of business start-ups as former employees try to become self-
employed.
Large number of small firms can be misleading because small firms have a very high 'death
rate'; and many small firms eventually become large firms of tomorrow.
Diseconomies of small scale production refer to the economies of small-scale production

that small firms do not enjoy due to their small size.
Optimum size of a firm
OPTIMUM SIZE of the firm is the one where the firm is most efficient and where average costs
are at their lowest.
The optimum size of from varies from industry to industry. On one extreme would be natural
monopolies where just one firm can operate successfully in the market. Large firms are more
suitable in those industries where fixed costs are very high and a large amount of capital is
needed such as in steel industry. Small firms are suitable in those industries where quick
decision making is required, customer want personalized service and when firms to operate in
niches.

CH#6(REVENUES, PROFITS, and SHUT- DOWN POINT)
REVENUES, PROFITS, and SHUT- DOWN POINT
6.1 Key definitions
Revenues
REVENUE is the money received by a firm from selling its output of goods or services. Total
revenue (TR) is calculated by using the following formula:
TR = Price (P) x Quantity (Q)
AVERAGE REVENUE (AR) is equal to total revenue divided by quantity sold and is
always equal
to price. Firm's demand curve therefore is the average revenue curve.
TR
AR = =P
Q
MARGINAL REVENUE (MR) is defined as the addition in total revenue from sale of
one extra unit.
MRt = TRt - TR t-1
Revenue of the firms will behave differently in perfect markets and imperfect markets.
Profits
TOTAL PROFIT (Tff) of the firm is the difference between total revenue and total cost.
Total profit = Total Revenue (TR) — Total Cost(TC)
MARGINAL PROFIT (MJJ) is the additional profit from selling one more unit of output.
Marginal profit is the difference between marginal revenue and marginal cost.
M t = T t  T t-1
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M = MR- MC
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Shut-down point
SHUT-DOWN POINT is that level of activity where a firm will decide to close down the
factory.
It is different in the long run and in the short run.
• In the long-run firm will only continue production if it is at least making a normal profit.
Otherwise, the firm will shift its resources to another activity where it is at least able to
earn a normal profit.
• In the short-run, firm keeps producing as long as total revenue (average revenue) is
greater than or equal to total variable costs (average variable costs). If TR falls below TVC,
the firm will shut down its production. The reason is that fixed costs are not affected by a
firm's decision in the SR. Therefore, fixed costs are unavoidable and will be incurred
irrespective of a firm's decision to produce or not to produce. Variable costs, on the other
hand, are avoidable and can be avoided by ceasing production. Hence, it only pays to
produce if revenues from sales at least cover these avoidable (variable) costs.

6.2 Profit maximization and Equilibrium
Economic theory generally assumes that firms are profit-maximizers and they are trying to
maximize the difference between TR and TC. It should be noted that profits will be
maximized
when M becomes equal to zero. At this point MR is equal to MC. Therefore, the profit
maximizing output and the equilibrium for a firm is where MR = MC.
This can be explained with the

use of a figure. As long as MR is
greater than MC. marginal profit
is positive and sale of an
additional unit adds to the total
profit. If MC is greater than MR.
marginal profit is negative and
sale of an additional unit reduces
the total profit. Profit is
therefore maximized where MR
is just equal to MC as firm cannot
increase total profit by
increasing or reducing its output.
However, it must be noted that
the condition of MC equals
MR is a necessary but not a
sufficient condition. Profit maximization takes place when
MC is equal to MR and MC cuts MR from below. If MC is above MR and is falling then, at
the point of MC equals MR, the firm will be making a loss.
Understanding behaviour of revenues and costs

Firms need to know the behaviour of costs and revenues to find out the total profit at the
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profit-maximizing output. Firms can make normal profits, abnormal profits or losses at the
profit-maximizing output.
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6.3 Different levels of profits
Normal profit
NORMAL PROFIT for a firm exists when total revenue is equal to total cost (TR = TC or
AR=AC) or profit is zero.
 When profit is zero, the firm is still able to earn a profit equal to its opportunity
cost. Therefore, normal profit is based on the minimum level of profit that
entrepreneur expects and it reflects the opportunity costs of factors of
production.
 If the firm failed to earn normal profit, it would cease to produce in the long
run. Hence,
normal profits must be earned if fop are to be kept in their present use.
A firm needs to know the
behaviour of revenues and costs
to find out its profits. Costs are
Ushaped (as discussed earlier)
and shown in the figure.
Behaviour of costs does not
change with the change in the
market structure. Although it is
expected that larger firms can
have lower average costs as they
enjoy economies of scale.
 Optimum output is where
AC is minimum and MC is
equal to AC. But this may
not be the profit-maximizing output.
 Average cost curve shows the cost per unit of producing a certain level of
output.

6.4 Perfect markets
Revenues
Perfect market assumes that there are large number of buyers and sellers in the market so
that
no one firm is in a position to affect prices in the market. Price in perfect market is
determined
by the forces of demand and supply (figure a) and the firm is assumed to be a price taker
(figure b), i.e. it can sell as many goods as it likes at the market prices. The demand curve of
the firms is perfectly elastic and, as shown in the table, P = AR = MR = Demand
Units Price TR AR = P MR =TR

sold
0 - 0 - -
1 10 10 10 10
2 10 20 10 10
3 10 30 10 10
4 10 40 10 10
5 10 50 10 10
TR is increasing at a constant rate.
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Profits
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Profit maximization takes place where MR is equal to MC and at this point firms can make
normal profits, abnormal profits or losses.
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Normal profit
 Profit maximization is where MR = MC.
 At this point, AC curve is tangent to
the demand curve and P = AC, therefore
profit is zero.
 Note: At the profit maximizing output, firm is
also operating at the optimal
output (MC = AC)
Abnormal profit
 At this point, average cost is C and price is
P. Price is greater than AC therefore firm is
making profit per unit = P-C.
 Total profit = area PEMC, i.e. firm is
making abnormal profits
 Firm is producing above the optimal output
and the AC (C) is above the minimum cost
point.
Loss Positive contribution

 Profit maximization is where MR =
MC.
 At this point, average cost is C and
price is P. AC is greater than P
therefore firm is making loss per
unit = C- P. Total loss = area
PENC.
 CONTRIBUTION is the difference
between revenue and direct costs
(usually variable costs). Average
variable cost is less than price,
thus, indicating that firm is making
positive contribution.
 Fixed costs are equal to area
CNX(AVC) and contribution is equal
to area PEX(AVC). If firm decides to stop production, it will still have to incur fixed
costs in the short-run and the loss will be equal to fixed costs. If firm decides to keep
producing, it will incur
a loss but that would be less than the fixed costs. Hence, it is rational for the firm to
keep producing rather than shutting down.
 Firm is producing below the optimal output and the AC (C) is above the minimum
cost point.
Shut-down point = Loss with zero contribution

MC.
 Average cost is greater than price
therefore firm is making a loss equal
to PENC.
zero
 Contribution is zero as AVC is equal
to price. Fixed costs are equal to
area PNEC which is equal to loss.
Firm will incur the same amount of
loss if it decides to continue
producing or shut down. Hence, this
is the shut-down point for the firm.
Loss with MR = MC. negative

contribution - Firm is better off
shutting down in the short run.
 Profit maximization is where
 Average cost is greater than price therefore firm is making a loss equal to PENC.
 Contribution is negative as AVC is greater than price. Negative
contribution = PEX(AVC). Fixed costs are equal to area CNX(AVC). Loss is
greater than the fixed costs. Firm will incur a lower loss if it decides to shutdown
rather than keep producing.
Firms in perfect market in short-run can make normal profits or abnormal profits or losses
depending on their costs. In the long-run firms in perfect market will only make normal
profits.
 In case of abnormal profits, new firms will enter the industry hence increasing supply
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the market and reducing price. Lower prices will reduce profits till only normal profits
are made in the long-run.
 In case of losses, some firms will leave the market hence reducing supply in the
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market
and resulting in a rise in prices. Higher prices will increase profits till only normal
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profits
are made in the long-run.
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6.5 Imperfect markets - Monopoly and Monopolistic

Competition
Revenues
In imperfect markets, firms are assumed to be price-setters, i.e. they set their own price for
their goods. These firms therefore face a downward-sloping demand curve, i.e. to sell more
goods firms will have to decrease their prices as shown in the table. Total revenue initially
increases, reaches a maximum point and then starts to fall. Average revenue is also
decreasing and is equal to price. AR curve is the demand curve. Marginal revenue is falling
and is less than AR. This can be shown with the aid of a diagram which is explained in the
next section.
Units sold Price TR AR MR

0 - 0 - -
1 10 10 10 10
2 9 18 9 8
3 8 24 8 6
4 7 28 7 4
5 6 30 6 2
6 5 30 5 0
7 4 28 4 (2)
8 3 24 3 (4)
Relationship between PED and

Revenue
PRICE ELASTICITY OF DEMAND (PED) is a
measure of the responsiveness of quantity
demanded to a change in price of that product
alone. ELASTIC DEMAND refers to a situation
where quantity demanded is more responsive to a
change in price and the PED is greater than 1.
INELASTIC DEMAND refers to a situation where
quantity demanded is less responsive to a change
is price and the PED is less than 1.It must also be
remembered that revenue increases with a fall in
price in case of elastic demand and revenue
decreases with a fall in price in case of inelastic
demand.
The relationship between quantity, price, and
revenues is shown in the figure. AR curve reflects
the downward-sloping demand curve and is equal
to the price line. MR is below the AR curve
and at one point it becomes equal to zero. JR curve shows the following properties:
 initially increases at a decreasing rate because MR is positive but is falling;

 becomes maximum at a point where MR is zero; and
 starts to fall as MR becomes negative.
It can be shown from the figure that PED changes on the AR curve.
 PED > 1
Till the point where MR is positive. TR increases with a fall in price. Hence, in this
price range, PED is greater than one and the demand is said to be elastic.
 PED < 1
As MR fall below zero (is negative), TR starts to fall with a decrease in price. PED
is hence below one in this price range and the demand is said to be inelastic.
 PED = 1
TR is maximum when MR is zero. At this point, PED is one (i.e. elasticity is unitary).
Implications for a firm for this relationship is that in the elastic range, firm will reduce price to
increase revenue; in the inelastic range, firm will increase prices to increase revenue; and at
the
maximum revenue point, firm will try to hold prices to maximize revenue.
Profits
The following table summarizes the relationship between revenues, costs and profits in
imperfect markets.
 Profit-maximizing output is the point where MR is equal to MC.
 At the profit-maximizing output, firms can either make normal profits, abnormal profits
or loss.
Normal profit
 Profit maximization is where MC = MR.
 At this point, AC curve is tangent to the
demand curve.
 P = AC, so that total profit is zero, or firm
is making a norma! profit.
 Firm is operating below optimal output
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Abnormal profit
MC.
 At profit-maximizing output,
average cost is C, and P is greater
than AC.
 Profit per unit = P- C and Total
profit is = area PXYC, i.e. firm is
making abnormal profits.
Loss positive contribution

 Firm is producing below optimal
output
MC.
 At profit-maximizing output,
average cost is C, and P is less
than AC.
 Loss per unit = C - P and total loss
is area CXYP, i.e. firm is making a
loss.
 Firm is producing below optimal
output.
 Fixed costs are equal to area CXZ
(AVC) and contribution is equal to
area PYZ(AVC). It is rational for the firm to keep producing rather than shutting
down.
Shut-down point = Loss with

contribution zero
 Average cost is greater than price
therefore firm is making a loss equal to
PENC.
 Contribution is zero as AVC is equal to
price. Fixed costs are equal to area
PNEC which is equal to loss. Firm will
incur the same amount of loss if it decides to continue producing or shut down.
Hence, this is the shut-down point for the firm.

Short-run and long-run profits will depend on whether firm is operating in monopolistic
competition or it is a monopoly.
Firms in monopolistic competition in short-run can make normal profits or abnormal profits or
losses depending on their costs and ability to differentiate. In the long-run firms in
monopolistic competition will only make normal profits.
 In case of abnormal profits, new firms will enter the industry hence increasing
competition and lowering demand for existing firms. This reduces prices and the
profits
till firms only make normal profits in the long run.
 In case of losses, some firms will leave the market hence reducing competition and
increasing demand for existing firms. This increases prices and the profits till firms
only
make normal profits in the long-run.
Firms operating as monopoly can enjoy abnormal profits in both short-run and long-run
due to their ability to differentiate themselves from others.
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6.6 Imperfect markets - Oligopoly
Demand and profits

Firms in an oligopoly experience a kinked demand curve due to interdependence of
decisions of competing firms. Firms maximize profits where MC = MR. At this point, firms
can make normal profits, abnormal profits or losses depending on their cost structure. In the
figure shown, the average cost curve is tangent to the demand curve and at the profit
maximizing output, P is equal to C and hence firm is only making normal profits.

CH#7(Firm’s Objectives)
FIRM’S OBJECTIVES
Different firms can pursue different objectives. These objectives can include traditional
objectives such as profit maximization, managerial theories such as sales revenue
maximization; and output maximization; behavioural theories such as satisficing profits and
ethical considerations.
The follow figure shows the output levels consistent with different objectives. Discussion of
objectives will follow in later paragraphs.
(i) Profit maximization

Neo-classical economists assume
that the interests of owners or
shareholders are the most
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important. They are motivated
solely by maximizing their gain from
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the company. Therefore it

is argued that the goal of firms is to
maximize profits. Neo-classical
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economics assumes that it

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is short run profits that firms

maximize by equating marginal
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revenues and marginal costs.

This can be explained with the use of a figure. As long as MR is greater than MC. marginal
profit is positive and sale of an additional unit adds to the total profit. If MC is greater than
MR. marginal profit is negative and sale of an additional unit reduces the total profit. Profit is
therefore maximized where MR is just equal to MC as firm cannot increase total profit by
increasing or reducing its output. However, it must be noted that
the condition of MC equals MR is a necessary but not a sufficient condition. Profit
maximization takes place when MC is equal to MR and MC cuts MR from below. If MC is
above MR and is falling then, at the point of MC equals MR, the firm will be making a loss.
Short run profit maximization implies that firms will be prepared to supply even if they make
a loss in the short-run as long as price is above AVC. Firms will only continue operating in an
industry in the long run if they are at least able to get normal profits. If they are not able to
get normal profits in the long run, they will leave the market and invest their resources in
more productive activities.
Neo-Keynesian economists believe that firms maximize their long run profit rather than their
short run profits. They believe that firms may produce in the SR even if it fails to cover its VC
if it believes that in the LR it may make a profit on production of a particular good. On the
other hand, a firm may cease production in the SR if it can cover its VC because it may want
to keep prices above market price in the SR and sell nothing if it believes that price cutting in
the SR would lead to a permanent effect on prices and LR profitability.
Firms that are looking for abnormal profits try to innovate and advertise; try to decrease their
costs; try to gain monopoly power; and conduct research and development.
The ability of firms to operate at profit maximizing output is under question because of the
difficulty for firms to identify profit maximizing output. Firms need to have a clear
understanding of their costs and revenue curves to identify profit maximizing output. It is not
possible for firms to get an exact relationship because of:
 incomplete data; and
 availability of historical data which may have changed.
This problem is especially aggravated in the long run as the shape of the revenue and the
cost curves may change. Shape of revenue curve may change because of a change in
image of firm's products; change in the level of competition; change in consumer tastes etc.
Shape of cost curves may change because of availability of scale economies in the long run
and change in technology.
Sometimes the firms may not want to operate at profit maximizing output because they
believe that short run profit maximization may not be in their best interest. This is because:
 firms with large market shares will try to avoid attention of government watchdog
bodies (such as Competition Commission in Britain) by limiting their sales and
growth;
 large abnormal profits may attract new entrants into the market making the market
less
attractive;

 high profits only protect the interests of shareholders and may hurt the relationship of
firms with other stakeholders (such as consumers looking for quality and low prices;
workers looking for job security and higher wages; and suppliers looking for timely
payment) which may be detrimental for firm's health and survival in the long run;
 management of the firm may have different objectives (agency problem) and it may
not pursue the objective of profit maximization; and
 high profits may trigger actions from rivals who may launch takeover bid for the firm.
Because of the difficulty for the firm to operate at profit maximizing output, firms at times
decide to pursue alternative objectives. These alternative assumptions about firm behaviour
are referred to as managerial or behavioural theories in Economics.
(ii) Sales revenue maximization

SALES REVENUE MAXIMIZATION is a firm's objective to maximize turnover. It takes place
when marginal revenue becomes equal to zero. This is shown as point 'b' in the figure. The
output level is greater than the profit maximizing output. There may still be abnormal profits
at this level of output but it will be less than maximum profits. Firms pursue this strategy for
various reasons.
 Firms usually pursue this policy in continuation of their penetration pricing policy.
They
accept lower prices and produce above profit maximizing output to increase their
market share. They hope that by increasing their market share they will be able to get
either economies of scale leading to cost reduction in the LR with an increase in
profits;
or monopoly power enabling the firm to increase its price in the LR and increase
profits.
 Another reason for pursuing this objective is that management salaries and
management status are usually linked to value of sales. Management, in pursuing its
personal interest, tries to maximize revenues rather than profits. This gives rise to
agency problems. One possible solution for this problem is that management salaries
may be linked to profits. This may be done by offering shares to management.
(iii) Output/Sales maximization

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OUTPUT/SALES MAXIMIZATION refers to maximizing volume of sales subject to

making a normal profit. It is not same as sales revenue maximization. Firms may
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increase their output up to the point where total revenue equal total cost (point 'c' in the
figure). Output greater than this will lead to losses for the firm. Firms may pursue this
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objective for various reasons:

 State-owned firms may pursue this objective because they are not looking to
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maximize profits rather they pursue social objectives and produce beyond profit
maximizing output. However, they may still be looking to remain self-sufficient
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and try to cover their average costs, hence, deciding to operate at the break-even
point.
 Private sector firms will not go beyond break-even point unless they are part of a
diversified group and can practice cross-subsidization, i.e. they can cover losses
in one product category through profits made in other product categories. Private
sector firms pursue this objective (predatory pricing) to deter new entrants by
starting price wars and squeeze them out of the industry.
(iv) Satisficing profits
SATISFICING PROFITS refer to a reasonable level of profits that are sufficient to
satisfy many stakeholders, i.e. shareholders and other stakeholder groups such as
workers and customers.
Some of the reasons for pursuing this objective are elaborated in the following
paragraphs.
 There may be conflict of objectives of different stakeholders hence not
allowing firms to pursue their objective of profit maximization. The long run
success of firms not only depends on satisfied shareholders but also on
satisfied workers, suppliers, consumers, and society. Firms, therefore, are
seen as a coalition of interest groups or stakeholders who are trying to pursue
their own objectives. These objectives of different stakeholders may be in
conflict with each other and may also change over time. For instance,
shareholders are looking to maximize revenues and minimize costs to
increase profits; workers are looking for job security, improvement in working
conditions, and wage increases that increase the cost of firms and reduce
shareholder profits; consumers want better quality products at lower prices
again leading to reduction in profits. Firms, hence, cannot satisfy interests of
ail stakeholders. Firms may then decide to sacrifice some short run profits to
satisfy the diversified expectations of its stakeholders. This will ensure long
run survival and success of the firm.
 Conflict of interest between management and shareholders can also lead to
this objective. Whereas shareholders want maximum profits, management
may have its own personal objectives such as growth, comfortable working
conditions, job security, status and fringe benefits. These managerial
objectives lead to increase in costs and fall in profits. This conflict of interest
is called agency problem (principal agent problem).
 Risk averse management also leads to satisficing profits. If there is a lot of
rivalry and a threat to their job security and career advancement, senior
management may decide to remain risk averse and avoid investing in good
profitable business opportunities because of fear of loss. This leads to sub-
optimal profits being made by the firm.
 Some managers also pursue charitable and environmental objectives that
lead to a fall in profits for the firm.

 Complacency also leads to satisficing. Firms that are large and have high
market share sometimes become complacent and lose focus on cost
structures and innovation. This leads to a loss of profits for the firm.
 Firms also have to balance their short run and long run aims. Firms may
sacrifice their short term profits in return for larger long run profits.
(v) Survival or Loss minimization

Firms, in short-run, may focus on survival rather than profit maximization in following
situations:
 Downturn in the economy would result in loss of sales and profits. Firms bearing
heavy losses will focus on surviving this period before sales pick up.
 Entry of a new competitor especially if it is a large MNC will force local firms to focus
on surviving and countering the new threat. Once they have established their
position, they
can again focus on growth and profits.
 Loss of a major customer for a small firm can be threatening and shift its focus from
profits to survival. Firms may decide to shut-down in the short-run if they are not
covering their variable costs. If firms are making positive contribution, they can
continue in the hope of making profits in the long-run.
(vi) Ethical objectives
A growing number of firms are incorporating ethics in their mission statements and, in
addition to profits, are also focusing on how their goods are being produced, and from
where they source their raw materials. Some common examples of ethical dilemmas
include use of child labour, poor working conditions in the factory, damaging the
environment through pollution, and paying low prices to farmers in developing countries.
Firms that are pursuing ethical objectives have started supporting environmental projects
and educational programmes in developing countries. Some firms trade with fair trade
farmers where producers are given a guaranteed price for their produce. Ethical
objectives can increase costs of production and hence lower profits. However, this is
increasingly being seen as important as customer awareness has increased and they
have started demanding that firms adopt more ethical practices.
Conclusion
Based on the discussion above, it is simplistic to assume that all firms aim to maximize
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profits.
The profit-maximization objective has been retained for the perfectly competitive,
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monopolistic competitive, and monopolistic firms in economic theory. It has been

abandoned for oligopolistic firms as modern corporations are motivated by different
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objectives especially because of the divorce between ownership and control, and
because of interdependence in decision making of firms in oligopolistic markets.
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CH#8(Market Structures
MARKET STRUCTURES
Firm and the industry
FIRM is a business organization that buys or hires factors of production in order to produce goods
and services that can be sold to achieve its objectives. It can include sole traders, partnerships, co-
operatives, private companies, public limited companies, state-owned firms, and multinational
corporations. The characteristics and behaviour of the firm depends on the type of economic activity it
is performing and the nature of competition in the industry. A firm can use either capital-intensive or
labour-intensive production methods. The choice of production method depends on their cost and
availability of factors of production (factor endowment).
INDUSTRY is the sum of all firms making the same product and the supply of the industry is simply
the aggregation of supply of individual firms. A competitive market consists of many firms that
together form the industry.
MARKET SHARE of one firm is the proportion of total market sales taken up by the firm. It can be
calculated as
Sale of firm ($ or quantity)

Firm's market share =
Total sale of industry ($ or quantity)
Note: In a monopoly, one firm controls whole of the production, therefore, the firm itself is the
industry.
Market structures
MARKET STRUCTURES refer to the way in which goods and services are supplied by firms in a
particular market. These can include perfect competition, monopolistic competition, oligopoly,
monopoly, and contestable markets.
 Perfect competition is referred to as a perfect market and all other market structures are called
imperfect markets.
 The key distinguishing feature between perfect and imperfect markets is the presence or
absence of barriers to entry.
SALES CONCENTRATION RATIO is a measure of extent to which a market is in the hands of a

given or particular number of firms (used to measure the degree of oligopoly or monopoly).
 The sales concentration ratio of the largest firms in both perfect competition and monopolistic
competition is low so that no one firm dominates the industry.
 Few firms control the market in the case of an oligopoly.
 Monopoly is the single dominant producer in the market.

8.1 Barriers to entry

BARRIER TO ENTRY are defined as any factor that makes it difficult for a new firm from entering a
particular market
Barriers to entry Market Structure The table describes the relationship of barriers to entry
with market structures. Existence of barriers enables a
firm to exert more control over its decisions and the firm
No barriers Perfect markets
is able to charge a higher price for its products because
of less threat of a new challenger
Very few barriers Monopolistic entering the market. Firm's priority, hence, is to erect
competition such barriers that make it difficult for firms to enter the
Large barriers Oligopoly and market. Some major types of barriers are described
monopoly below:
 Government protection - A legal monopoly
exists if production of goods and services is either state-owned or can only be produced under
license from government.
o In case of natural monopolies, it is argued that state should control such industries
rather than allowing private sector monopolies. Some economists reject the presence
of natural monopolies.
o Patents give a firm the right to solely produce a product. This is in return for innovation
that the firm brings to the market. Till the time that the patent expires, the firm has a
monopoly over production and sale of the product.
 High fixed costs or setup costs or R&D costs - In some industries, such as electricity
generation, commercial aircraft production and car production, the initial setup costs are so
high that many firms cannot afford to invest in these industries. Only large firms are able to
fund such a huge investment.
 High exit barriers - EXIT BARRIERS are defined as factors that prevent firms from leaving a
particular market or industry. They typically take the form of legal or contractual commitments.
Exit barriers may include a long term contract with a client; high cost of closing down plant
(e.g. nuclear plants); government regulation; specialized resources that are not easily
transferable. Presence of exit barriers increases the risk of losing investment in the business
and deters new entrants from entering the market.
 Product differentiation - PRODUCT DIFFERENTIATION refers to the strategy followed by
many firms where they try to make their products look different from their competitors. This is
usually done through advertisement and branding. Successful differentiation campaigns
create brand loyalty and make it difficult for new firms to capture customers from existing firms
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in the industry. This is especially difficult if the existing firms have filled all the niches.
 Economies of scale- ECONOMIES OF SCALE refer to the ability of large firms to produce at
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lower average costs. This makes it difficult for new firms (small in size and not getting
economies) to compete with larger firms. Large firms can use predatory or destroyer pricing to
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eliminate high-cost producers.

o PREDATORY OR DESTROYER PRICING refers to pricing strategies of some firms
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where they reduce their prices (sometimes even below their cost of production) to
force new firms or inefficient firms out of the market. Once these firms have left the
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market, the remaining firms may increase their prices because of their monopoly
power.

Monopoly over raw material source or the distribution network- Vertically integrated
manufacturing firms can get access to either the raw material source (limiting supply of RM to its own
factories) or to the distribution network (limiting sales and displays of its own brands only). This limits
the ability of new firms to compete with the monopoly.
 Pace of product innovation - Very rapid pace of product innovation (e.g. in consumer
electronics industry) can act as a barrier to entry. It will be difficult for new entrants to compete
successfully with existing firms unless they come up with a very innovative idea that targets a
new market segment.
 Limit pricing- LIMIT PRICING refers to the deliberate setting of low prices by firms in an
industry (temporarily abandoning their abnormal profits) in an attempt to hide the existence of
abnormal profits. This usually results from collusion of large firms in the industry and limits
entry of new firms in the market. Limit pricing decrease short run profits but safeguards LR
abnormal profits because of lower competition.
 Collaboration between existing producers - Existing firms can collaborate on many issues
such as new product development that reduces the average cost of existing firms making it
difficult for a new firm to compete with existing firms.
 Market conditions such as economic recession and a fall in demand lead to excess capacity
in the market. Excess capacity reduces profits and increases competition and deters new
entrants from entering the market. Sunk costs-
 SUNK COSTS are costs that are not recoverable. The cost of advertising and the difference
between the purchase price and resale price of capital equipment are two examples of sunk
costs. High sunk costs will act as a barrier to entry as firms may be discouraged to enter the
market because of high risks. Low sunk costs will encourage firms to enter an industry if
abnormal profits are available (as in contestable markets).
The existence of barriers lead to reduction in the number of new firms entering the market.
Perfect competition, monopolistic competition and contestable market have low entry barriers
whereas Oligopoly and monopoly are characterized by high entry barriers. IMPERFECT
COMPETITION is any market structure except for perfect competition.

8.2 Perfect Competition (Total competition)

PERFECT COMPETITION is a largely theoretical market structure that is characterized by
existence of a large number of buyers and sellers acting as price takers. The model is efficient in
the long-run and the closest examples to the model are agriculture and foreign exchange market.
Assumptions/Characteristics
 There are large number of buyers and sellers in the market so that no one firm or
individual is in a position to influence market prices. Firms are price takers. Price in the
market is set by market demand and supply forces and the firm can sell as much output as
it wants at the market price. Market price can change with a change in the market demand
and supply and individual firms cannot influence the price. The demand curve for the firms
is. hence, perfectly elastic where P is equal to AR which is equal to MR.
 Buyers and sellers have perfect knowledge of market conditions and prices. If one firm
charges a higher price than the market price, the demand for its product will become zero.
The firm has to accept the market price if it wishes to sell in the market.
 There are homogeneous products, i.e. products are of same quality and are identical in
the eyes of the consumers.
 There are no entry or exit barriers, i.e. firms are free to enter or exit the market
 There must be mobility of factors of production.
 There is no preferential treatment, i.e. all buyers and sellers are treated equally.
 There must be independence in decision making, i.e. there are no external forces that
influence the decision of buyers and sellers
 Firms are seeking to maximize profits and operate at the output where MC is equal to MR
Demand and revenue curves

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Firms are price takers therefore the demand curve for a firm in perfect market is perfectly elastic.
 If a firm decides to double its output, change in market supply will be so minimal that there will
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be no impact on market prices.

 If a firm tried to raise price, it will lose all its sales (sales = 0) as products are homogeneous
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and customers have perfect knowledge about products and their prices.
 The demand curve is also the AR curve. Since prices have become constant, MR is equal to
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price and AR.

 Therefore P = AR = MR
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Decisions taken
 Firms cannot set their own prices as they are price takers.
 The only decision that they take is to decide how much to sell at the given market price.
This decision depends on their cost of production. Profit-maximizing firms will try to
produce the output where MC is equal to MR.
Firm's equilibrium in the short run

Firms are trying to maximize profits and they are in equilibrium when they equate their marginal costs
with marginal revenues. Firms in perfect competition can make normal profit, abnormal profit or
losses in the short run. The amount of profit that each firm makes depends on the individual firm's
cost curves. Therefore, to increase their profits, firms can try to increase their productivity and
decrease ATC in the short run.
SR shut-down point
If a firm is making a loss, it may continue its production in the SR as long as the price covers AVC.
NOTE: Refer to topic 06 for diagrams of normal profits, abnormal profits, losses and shutdown
point.
Industry equilibrium in the long run
In the long run, firms in perfect competition only make normal profits.

Abnormal profits to normal profits

Firms can only make abnormal profits in the SR. In the LR, abnormal profits will attract new firms into
the market as there are no entry barriers. This increases supply of goods in the market (as shown in
figure (a) below) leading to a fall in market prices and a fall in firm profits. Prices will continue to fall till
only normal profits are available in the market.
Losses to normal profits

If there are continuing losses in the LR, some of the firms will decide to leave the market. This will
reduce the supply in the market (as shown in the figure below) leading to an increase in price and
firm profits. Prices will keep rising till firms earn only normal profits.
Therefore, it can be concluded that in the LR only efficient firms will survive in the market and they
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will only be able to earn normal profits. The long-run equilibrium therefore takes place where:
LRAC = AC = MC = MR = AR
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Shut-down point in the LR

Firms, in LR, will at least like to make normal profits to keep their resources in their present use. If the
average cost is greater than the average revenue, the firm must cease production as it is inefficient
and may earn profits if it invests in some other industry.
Costs and Supply curve
Short-run supply curve

The supply curve of the firm is its MC curve above the average variable cost curve. As shown in
figure 'a', the firm is in equilibrium at Ei when price is Pi and quantity sold is Qi. If price in the industry
rises to P2, the new equilibrium is established at E2 and the quantity sold is Q2. At P3, the
equilibrium is E3 and the quantity sold is Cb- Ei, E2, and E3 show the different points on the supply
curve as they indicate the amount of output a firm will produce at different prices. Joining these points
produce the supply curve and that is the MC curve. However, it must be noted that a firm will cease to
supply if P is less than AVC. Firm's SR supply curve will therefore be that part of the MC curve that is
above AVC curve. This is shown by the dark MC line above AVC curve in the figure (a) below.
In the LR, there are no fixed costs and ATC is equal to AVC. Firm will not produce unless it covers all
its costs. Therefore, in LR. firm's supply curve is the MC curve above its AC curve. This is shown by
the dark MC line above LRAC curve in the figure (b) above.
The model of perfect competition predicts that all perfectly competitive firms will have identical costs
in the LR. For instance, if a firm discovers a new technique of production that reduces the firm's costs
and increases its profits, then, other firms will respond by copying the technique because there is
perfect knowledge in the market. Hence all firms in the market will have similar cost curves in the LR.

Economic efficiency
 Allocative efficiency takes place when P is equal to MC. In perfect competition, a profit
maximizing firm will always operate at this point (i.e. P = MC). Therefore, perfect competition
is allocatively efficient in both SR and
LR.
 Productive efficiency takes place
when firm is operating at the minimum
point of its average cost curve. Firms
in perfect competition may or may not
be productively efficient in the SR. If
they are earning normal profits, they
are then operating at their optimal
output and are productively efficient.
But if they are earning abnormal
profits or making losses, then, they are
operating above or below the optimal
output respectively and are productively inefficient. However, in the LR, firms in perfect
markets are only able to earn normal profits and are therefore productively efficient in the LR.
We can conclude from the above discussion that firms in perfect competition are economical efficient
(both productive and allocative efficiency) in the LR.
Is perfect competition good for consumers?

It can be argued from the above discussion that perfect competition is good for consumers.
 Price is equal to marginal cost indicating that the right quantity is being produced at which the
value placed by the consumer (P) is just equal to the extra cost of producing the item (MC).
 Prices are minimum at which firm only earns normal profit and operates at the lowest
average cost in the long run.
 Inefficient firms are driven out of the market and existing firms are forced to become
efficient due to competitive pressures.
 Perfect competition however is not possible where substantial economies of scale are
available. Perfect competition requires many firms that do not have any market power. This
implies that firm size must be small. However, to achieve economies of scale, firm size must
be large. Large firms will have market power that will allow them to undercut the prices of
smaller firms, which will thus be driven out of the market.
Conclusion
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The effect of these assumptions is that there is efficient production (discussed in topic 11) and there
is no possibility of exploitation. Hence, we say that there is consumer sovereignty. Since there are
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many firms in the market and there is perfect knowledge, it is not possible for firms to exploit
individual consumers by charging them a higher price or selling them an inferior quality product.
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However, this is a largely theoretical model with hardly any real life example. Most of the markets are
imperfect because they are dominated by few large firms; buyers do not have perfect knowledge
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about prices and quality; products are not homogeneous as there are either some quality differences
or firms differentiate by advertisement and branding; there are some barriers to enter or exit; and
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firms are not always seeking to maximize short term profits. This means then that consumers are not

always sovereign rather there is producer sovereignty where firms are able to set high prices (with
hidden charges), sell inferior quality goods (less than what was promised), and like that.
The closest examples to a perfect market is agriculture and foreign exchange market where there are
large number of buyers and sellers so that no one is able to influence prices, products are largely
homogeneous, firms are usually trying to maximize profits, and there are very little, if any, barriers to
entry.

8.3 Monopolistic competition
MONOPOLISTIC COMPETITION is a market structure that is characterized by presence of large

number of competing sellers which sell slightly differentiated products and therefore have some
market power. There are many examples of this structure such as barbers, tailors, dry cleaners,
restaurants, retailers, etc.
Characteristics/Assumption
 There are large number of buyers and seller so that each firm has small market share.
there is no collusion due to large number of firms, and each firm is independent from
others in determining its pricing policy. A single firm may get higher sales from cutting
prices but it is unlikely to trigger response from competitors as their sales are not affected
a lot.
 There is ease of entry and exit. There are limited scale economies available, and
investment requirements are low. However, there can be some barriers if firms hold
patents on their products. It is easy for firms to sell their assets and recoup their
investment.
 Firms offer differentiated products allowing consumers a choice from many brands. They
produce variations of a particular product offering slightly different physical characteristics,
different levels of service, choice of location, or different benefits. Differentiation allows
firms to have some control over the pricing decision.
 Firms are price makers or price setters. They have some influence over pricing decision
because of product differentiation. However, this control is limited due to numerous
substitutes available in the market.
 Firms have the objective to maximize profits and operate where MC is equal to MR.
Demand curve & use of price and non-price competition

Firms in monopolistic competition have the ability to set prices of their products. If they want to sell
more of their product, they will have to reduce their prices, hence, they face a downward sloping
demand curve. These firms also face competition from a large number of producers selling similar
products. Availability of these substitutes makes the firms' demand curve relatively price elastic.
Firms try to differentiate their offerings and build brand image by developing good products and
heavily investing in advertisement and promotion. This increases brand loyalty for the product and
consumers will be willing to pay a higher price and would not easily switch to competitors. This leads
to a rightward shift in the demand curve because of increase in demand for firm's products. It also
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makes the demand curve more inelastic because of strong brand image.
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However, any advantage gained through advertisement may be temporary as other firms also resort
to extensive advertisement to increase their monopoly power. Therefore, in the longer run, there may
not be a lot of benefit to the firm and additional advertisement only adds to the firm's costs.
SR equilibrium- Profit and output decision

Firms are profit maximizers and are trying to equate MC with MR. In the short-run, firm can either
make abnormal profits, normal profits or losses. The amount of profit that a firm makes depends on
firm's costs and its demand. Firms with lower costs and more inelastic demand curve will enjoy higher
profits in the SR.
NOTE: Refer to topic 06 for diagrams of normal profits, abnormal profits, losses and shut¬ down
point.
LR equilibrium
In the long run, firms in monopolistic competition only make normal profits.
Abnormal profits to normal profits

Abnormal profits attract new firms into the industry due to ease of entry.
 This increases competition that shifts the firm's demand curve to the left and makes it more
elastic leading to normal profits only in the LR.
 Higher competition increases demand for factors of production that results in an increase in
their costs. This shifts the average cost curve up.
 Lower prices and higher costs eats away the abnormal profits.

Firms can prolong LR by product innovation, and branding through marketing and advertisement.
This will delay the LR and enable a firm to earn abnormal period for a longer period of time.
However, eventually new firms will enter leading to reduction in profits.
Losses to normal profits

Losses will force some of the firms to leave the market.
 This reduces competition that shifts the demand curve for remaining firms to the right and
makes it more inelastic leading
to higher prices and normal profits
in the LR
 Lower competition reduces
demand for factors of
production that results in a fall in
their costs. This shifts the
average cost curve down.
 Higher prices and lower costs enable
firms to earn normal profits in the LR.
Efficiency
Firms are inefficient in both LR and SR. They
are both allocatively and productively
inefficient.
 Firms charge a price above MC; hence, they are allocatively inefficient.
 Firms produce below optimum output, hence, they are productively inefficient. Their AC is
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above the minimum AC.

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Benefits of monopolistic competition

 Consumers have more choice due to variety of products produced.
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 Firms try to differentiate their brands through product improvements. This provide better
quality products to the consumers.
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Wastes of monopolistic competition

 Firms spend on competitive advertisement to create unnecessary product differentiation. This
creates irrational preferences for some brands.
 Firms produce a variety of products by creating artificial differences between them. This
confuses the customers and enables firms to charge different prices for each brand that it
sells.
 There are additional transportation costs as producers try to sell in distant markets.
 There is a large number of inefficient firms (with higher average costs) that are able to survive
in the market on the strength of their customers' loyalty who are willing to pay a high price and
compensate the firm for its higher cost.
 There is excess capacity as firms produce less than the optimum output due to downward
sloping demand curve.
Differences between perfect competition and monopolistic competition

Similarities
 There are large number of firms in both markets.
 Firms compete with each other in both markets. There is freedom of entry and exit in both
markets.
 Firms in both markets are trying to maximize profits by equating MC and MR.
 Both markets allow firms to earn abnormal profit, normal profit or loss in the short run.
However, in the LR, firms only earn normal profits.
Differences
Criteria Perfect competition Monopolistic competition
Product Firms offer homogeneous There is product
products so that customers differentiation that allow
have no choice. choice to consumers.
Products are similar but not
identical.
Price Price is determined by Firm is a price setter and is
market demand and supply independent to set its own
and firm is price taker. price.
Demand curve The demand curve and the Demand curve is elastic and
AR curve is perfectly elastic. downward sloping and the
MR is equal to AR. MR curve lies below the AR
curve.
Allocative efficiency Firms are always allocatively Firms are allocatively
efficient and charge price inefficient and charge a price
equal to MC. higher than MC.
P = MC P> MC
Productive efficiency Firms are productively Firms are productively
efficient in the LR and inefficient and operate below
operate at the optimum the optimum output,
output.
P = MC = AC = AR
Intensity of competition Products are homogenous Products are differentiated
and firms are price-takers, and firms are price-setters,
therefore, the market is therefore, firms can compete
relatively stable with low with each other on either
intensity of competition. price or non-price factors.

Price and output Output of firm under monopolistic competition is smaller and
price higher than under prefect competition. This can be
explained using the graph.
 ARMC and MRMC are the average and marginal
revenue
curves of the
firm
 under
monopolistic
competition
 In perfect
competition,
firms are
price takers
and the
average and marginal revenue curves are perfectly
elastic and are shown as ARPC and MRPC.
 MC and AC curves are presumed to be constant in
both the markets
 Firm in perfect competition only makes normal profit
in the LR and is in equilibrium at EPC where the AC
curve is tangent to the AR curve. At this point, firm
produces QPC and charges a price PPC.
 Firm in monopolistic competition is in equilibrium at
EMC where it produces QMC and charges a price PMC-
The output is lower than that in perfect market and
the price is higher than in perfect market.
 The difference between QMC and QPC shows the
presence of excess capacity in monopolistic
competition.
 The lower output produced in monopolistic
competition leads to a loss in social welfare. The
deadweight loss is the area XEPCEMC.
Conclusion
 There are large number of competitors in the market who use both price and non-price
competition to increase their market power,
 Entry barriers are low, hence, abnormal profits are only temporary and market moves towards
normal profits in the LR.
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 Firms are inefficient in both LR and SR. They are both allocatively and productively inefficient.
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8.4 Monopoly
MONOPOLY is a market structure where there is one seller protected by barriers to entry. In practice,
a monopoly may technically exist where one firm has 25-30% of the total market. A very good
example of monopoly in Pakistan is WAPDA.
Key characteristics/assumption
 There is only one firm in the industry, i.e. the monopolist with 100% market share. Or we can
say that there is one firm dominating the industry and its market share is greater than 25%.
Monopolist usually has a large size but there can be local monopolies as well where small
firms can dominate small sized local markets.
 There is high degree of product differentiation where the monopolist sells a unique product
that has no close substitutes. This creates brand loyalty and makes the demand curve
inelastic.
 Barriers to entry are high that prevent new firms from entering the market.
 The monopolist is a SR profit maximizer. There is no difference between SR and LR and firm
can earn abnormal profits over a longer period of time.
 They can use price discrimination to earn abnormal profits
Threat to monopolies exists in the form of removal of government protection and the increase in
competition from imported products.
Sources of monopoly power

 Barriers to entry- Monopolists are protected from new entrants by barriers to entry. By keeping
new entrants out, the monopolist can then control the market. The higher the barriers to entry,
the stronger is the power of the monopolist over the market.
 Product differentiation - Some monopolists sell products which are clearly differentiated form
rival products. The higher the degree of product differentiation, the stronger is the monopoly
power. The lower the degree of product differentiation, the larger is the number of competitors
the monopolist faces in practice
Demand curve
A monopoly firm is itself the industry. As the industry faces a downward sloping demand curve, so too
must the monopolist. AR is same as price therefore the AR curve is the demand curve and the MR is
less than AR and falling at a faster rate.
 The demand curve for a monopolist is inelastic due to high degree of product differentiation.
Decisions made- either price setter or quantity setter

Because a monopolist faces a downward sloping demand curve, it can control either its price or
quantity sold. It cannot control both. This is because an increase in price will lead to lower quantity
demanded; and to sell more goods the monopolist will have to lower prices.

Equilibrium of a monopoly
A profit-maximizing firm will produce output where MC is equal to MR.
 At this point of equilibrium, firm can make normal profits, abnormal profits, or losses
depending on its cost structure.
 Monopolist can set higher prices by controlling their quantity. This enables them to earn
abnormal profits usually.
 However, there may be situations where a monopolist may incur losses especially where
fixed costs are very high and the consumers are not willing to pay a corresponding high price.
In such cases, monopolist can convert losses into profits by practicing price discrimination.
 It must also be noted that there is no distinction between SR and LR profits of a monopolist.
This is because even if a monopolist is earning abnormal profits, new firms will find it difficult
to enter the market because of high entry barriers. Therefore, the monopolist tries to keep
producing the profit-maximizing output. Equilibrium, therefore, is a permanent feature in a
monopoly.
NOTE: Refer to topic 06 for diagrams of normal profits, abnormal profits, losses and shutdown
point in case of imperfect market.
Price discrimination
PRICE DISCIMINATION is a feature of monopoly markets whereby the monopolist seeks to segment
the market by charging different prices to different customers for the same product thereby increasing
the profits of the monopolist.
 The aim of the discriminating-monopolist is to turn consumer surplus into producer surplus by
charging a higher price to those consumers who are willing to pay a higher price
o In case of a single-priced monopolist, some consumers would gain who were willing to pay
a higher price resulting in consumer surplus. The monopolist tries to segment the market
and charge different price from different consumer segments enabling it to eat their
surplus and earn higher profits.
Bases of segmentation
MARKET SEGMENTATION refers to dividing the market into small markets where demand of
consumers in each market is different from the demand of consumers in other markets. This allows
the firm to charge different prices from each segment of the market. Some of the bases of
segmentation are listed below:
 Time - Firm can charge different prices from customers at different time of usage. This is very
frequently practiced by mobile service providers.
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 Gender - Gender based segmentation are very frequently found in different product
categories. One common example in Pakistan is of 'driving classes' where driving centres
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charge higher price from females than from males for providing driving lessons.
 Age - This is frequently found in parks, cinemas, airlines and many other businesses where
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children are charged lower prices than those charged to adults

 Income- Income based segmentation is found in many industries where high prices are
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charged from consumers on getting a better seat etc. (first-class fares are higher than
economy fares in airlines).
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 Place - Monopolist is able to charge different prices in different places. For instance, many
firms sell Lower Priced Editions of textbooks in South Asian markets.
 Nature of usage - WAPDA in Pakistan charges different fares to domestic and commercial
users.
Conditions for successful price discrimination
Price segmentation will only be possible if following conditions are met.
 The monopolist is able to split the market into distinct group of buyers. There is proper
mechanism in place to keep market segments separate at relatively low cost. If it is possible
for consumers to buy from low-priced markets and sell in high price markets, then, market
segmentation will fail.
 Market segments have different price elasticities of demand. This enables the firm to charge a
higher price where demand is price inelastic and charge a lower price where demand is price
elastic. Firm will be in equilibrium where it equates MC with the combined MR of different
markets Degrees of price discrimination Price discrimination can be described in terms of
three degrees.
 First-degree discrimination or perfect price discrimination occurs when a business charges
each customer a different price. This is the most profitable solution for a monopolist however it
is very difficult for a monopolist to discriminate to this extent. Most examples are in the service
sector. A private doctor may charge each patient what he feels that person can afford to pay.
A car deal again looks at the ability to pay of a consumer before asking a price for a used car.
The demand curve is all such cases is the same as the marginal revenue curve indicating that
the marginal revenue is equal to price.
 Second-degree discrimination occurs when the monopolist discriminates according to the
volume of purchase by a particular customer.
 Third-degree discrimination occurs when the monopolist splits customers into two or more
separate groups and charges each group a different price. A good example is with air fares -
flights booked earlier have a lower price than those booked closer to departure. Rail travel is
usually priced on a peak and off-peak basis. The problem is that some consumer groups
benefit yet others do not because of the higher price they have to pay.

Example of perfect price

discrimination in
operation
The following graph shows a case
where a firm that is otherwise
incurring a loss is able to earn
abnormal profits if it resorts to price
discrimination. The figure shows that the
profit maximizing monopolist would
charge a price P when the cost is C. C is
greater than P indicating that the firm is
making a loss equal to the area CXYP.
If the monopolist resorts to first- degree
discrimination, then, it will convert
all of the consumer surplus (area MYP) into producer surplus. This additional surplus covers part of
the loss. Area A shows the extra surplus left and the area B shows the loss that is not covered.
Whether a firm makes a profit or not after price discrimination depends on the size of triangles A and
B.
 If area A is greater than B. firm will make an abnormal profit.
 If area A is equal to B. firm will make a normal profit.
 If area A is less than B. firm will incur a loss but this loss is much smaller than the original loss
Thus a discriminating monopolist can reduce its losses and even convert the losses into profits by
practicing price discrimination.
 It is said that there is no consumer exploitation in this case as the consumers were willing to
pay a higher price. And continuing losses in LR would mean that there will be no output in the
long run.
Justification for price discrimination

Price discrimination can at times be justified because of following reasons.
 Cost of providing service differs for different group of customers
If the cost of providing service differs in different markets, it will make sense for the firm to
charge different prices. For instance, if the firm has to hire additional staff for providing
service during peak hours, then, it makes sense that the firm should charge a higher price for
service during peak hours.
 Spreading out demand
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This is a rationale given by firms that face shortages (excess demand) during peak seasons
for instance in case of telephone calls and hotels in holiday locations. Hotels find excess
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demand during peak holiday season and charge a higher prices. However, during off peak
season they find that they have excess capacity. Hotels can hence try to spread demand to
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off-peak season by charging a lower price. This also improves efficiency and improves
service quality for the consumers.
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 Generates revenue to cover losses This is frequently the reason given by rail networks and
transport companies. They have high fixed costs which with a single price may result in
losses. Therefore, firms split travellers into different categories and charge different prices
from them. This enables them to make a profit from the service. Consumers are able to get
the service that they want.
 Social motives Some firms charge lower prices from children and older people to encourage
them to participate in activities. For instance, museums usually allow free or low price entry to
children so that love of arts can be developed in children.
 Awarding consumer loyalty One rationale for price discrimination given by firm is that it allows
them to award discounts to their loyal consumers hence making sure that these consumers
will continue using company's products.
These and many other reasons show that price discrimination is not always bad. Rather it may make
economic sense and benefit the consumers in the end.
Drawbacks of price discrimination

 It seems that there is consumer exploitation as firm is able to charge a higher price from some
consumer groups.
 Discriminating monopolist earn abnormal profits at the expense of reduced consumer
surplus.
 Consumers may get annoyed and reduce consumption of good.
Comparing Monopoly with Perfect Competition

It is generally believed that the conduct and performance of monopolies is undesirable when
compared with conduct and performance of firms in competitive markets. This can be shown with the
help of the diagram.
A profit-maximizing monopolist
produces the output level where
MC is equal to MR. Therefore, in the
figure, monopolist produces QM and
charges a price PM. Firms in perfect
competition, on the other hand,
only earn normal profit in the long run.
The industry produces where demand
(AR curve) and supply (MC curve)
intersect. Firms, in the long run,
produce at the output level where
the following condition holds: P = AR
= MR = MC = AC. This happens
at the lowest point of the average
cost curve where the AC curve touches
the MR curve. As shown in the figure, price and output levels in perfect competition will be P pc and
QPC respectively.

Based on the above discussion, following can be said about monopoly and perfect competition.
 Monopolist is allocatively inefficient whereas firms in perfectly competitive markets are
allocatively efficient. Monopolist charges a price that is greater than MC. This leads to
inefficient resource allocation.
 The monopolist charges a higher price and produces a lower output than perfectly competitive
markets.
o Price charged in monopoly (PM) > Price in perfect competition (PPC)
o Monopoly output (QM) < output in perfect competition (QPC)
 Monopolists are productively inefficient whereas firms in perfectly competitive markets are
productively efficient. Monopolist produces an output less than the optimum output. It leads to
x-inefficiency, i.e. the tendency of costs to drift upwards (produce at higher AC curve) in
monopolies and imperfect markets. This happens because a monopoly dominates a market
and has less incentive to improve its process to reduce the AC. t does not face the same
competitive pressure to keep costs low nor does it have the same threat of bankruptcy.
Monopolist can hence get away with higher costs because of a lack of rivalry. Costs,
therefore, tend to rise over time because of inefficiency and complacency.
 Monopolist makes SR and LR abnormal profits indicating that they can exploit the consumers
whereas firms in perfect competition only make normal profits in the LR. Monopolist captures
consumer surplus by charging a higher price and coverts it into abnormal profits.
o In case of monopoly there is a deadweight loss. DEADWEIGHT LOSS is the
reduction in total surplus (consumer and producer) that results from a market
distortion, such as a monopoly, a tax or negative externality. Shaded area in the
diagram above is the deadweight loss. Loss in output due to monopoly is the
difference between QPC and QM. Area between demand curve and the MC curve
(ecd) is loss in total surplus.
Therefore, the above discussion suggests that a perfect market is more efficient than an imperfect
market, especially if it is a monopoly. However, there are problems in this comparison and there are
also instances where a monopoly can turn out to be more useful.
Problems of comparing monopoly with perfect competition

It must be remembered that perfect competition is a largely theoretical model and there is hardly any
real life example of a perfectly competitive market. It would therefore be more realistic to compare
monopoly with other imperfect markets such as monopolistic competition or oligopoly. All imperfect
markets are characterized as productively and allocatively inefficient. Apart from this, both
monopolistic competition and oligopoly involve waste of resources in the form of competitive
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advertising. Hence, when monopoly is compared to other imperfect markets, we see that there are
imperfections in all markets.
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Another problem of comparing the two markets is that we are assuming in the above figure that costs
in monopoly is same as costs in perfect competition. It ignores the following things:
 There is a possibility that monopoly can achieve internal economies of scale hence leading to
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lower unit costs.

 It is possible for a monopolist to charge a lower price while making abnormal profits due to
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lower unit costs. Customers would therefore be better off having a monopoly rather than
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competition.

Case for monopoly

There are many circumstances when a monopoly can prove to be beneficial to the society and the
consumers. Following are some of the examples for this.
 Natural monopolies
NATURAL MONOPOLY exists if the market demand can only be fulfilled efficiently by one
firm. This happens, as shown in the figure, when large economies of scale are available and
the minimum efficient scale is at an output which is higher than the total demand in the
industry. In such instances, one firm will keep expanding to gain economies of scale; other
firms will not be able to compete due to cost disadvantages of operating at a smaller scale. If,
on the other hand, market is shared between two firms, then, the average cost in the industry
will increase manifold leading to an increase in price. Therefore, some economists suggest
that even consumers will be better off if such a market is served by only one firm.
 Greater certainty in monopoly
There is greater certainty in profits of a monopoly than profits in competitive markets. It makes
it easier for a monopolist to plan future investment that allows for growth in the economy. This
also allows better products to be produced for the consumers and gives more job security to
the employees. Process innovation Monopolist, with its abnormal profits, can afford to invest
in process innovation enabling the firm to introduce new techniques of production and hence
lower its cost of production and prices in the market. Product innovation Monopolist can use
its abnormal profits to finance market research and R&D. This leads to better products being
available to the consumers. This increases consumer welfare, improves products'
performance, widens consumer choice, and improves living standard in the economy.
Economies of scale
Consumer gains from a monopoly if the benefits of economies of scale (lower unit costs) and greater
investment (lower costs and better products) are passed on to the consumers.
Avoids duplication of effort and wastage of resources

It is argued that competitive market structure can lead to duplication of effort and wastage of
resources such as amount spent on advertisement. In case of monopoly where there is just one firm
operating in the market, there is little need for advertisement hence lowering overheads for the firm.
Price discrimination
Price discrimination allows a monopoly to operate loss making units; improve customer service; and
award customer loyalty.

Dynamic efficiency
Monopoly can use its excess profits to invest in research and development and product innovation. It
enables it to produce good quality products and operate at lower average costs than do firms in
perfect markets. Therefore, a monopoly will never be technically efficient but it may still allocate
resources more efficiently than firms in perfect markets due to its ability to achieve economies of
scale, and to use its excess profits to invest in R&D.
It is therefore argued that abnormal profits are not always bad. Whereas it may lead to consumer
exploitation in some instance, it may lead to increase in consumer welfare in other instances.
Disadvantages of monopoly
 Monopolist can charge a higher price by limiting output.
 There is producer sovereignty as monopolist is more powerful than the consumers.
Consumers lose their power.
 There is consumer exploitation as monopolist earns abnormal profits.
 Absence of competition means that there is no incentive for monopoly to become efficient.
This can lead to higher costs and prices, poor quality goods and less innovation.
 There is produce and allocative inefficiency.
Monopoly vs. Monopolistic Competition
Similarities
 In both market structures, equilibrium takes place where MC is equal to MR.
 In both market structures, demand curve is downward sloping.
 In both cases, there is excess capacity, i.e. firms operate below the optimum output.
 In both markets, firms are price setters.
Differences
Critia Monopoly Monopoly competition
Number of producers Only one producer. Many producers
Industry Firm is the industry Firm is a small part of the

industry
Substitutes Monopoly produces a highly Many firms produce slightly

different product so that differentiated products that
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there are no close means that there are many

substitutes close substitute in the market
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Costs Monopoly enjoys economies Firms need to spend

of scale and it can avoid aggressively on
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wasteful expenditure such as advertisement to differentiate

on advertisement. their products leading to
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higher overheads.
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Prices Can practice price Price discrimination is not

discrimination. usual

Demand Demand curve is inelastic Demand curve is elastic

due to absence of
competition
Barriers to entry Very high Very low
Profits It can earn abnormal profits In the LR, firms only earn
both the SR and LR normal profits.
Efficiency It can use it excess profits to Firms are both productively

achieve dynamic efficiency. and allocatively inefficient
Conclusion
Monopolies have both benefits and drawbacks. Therefore, each monopoly has to be judged as a
separate case. There is a need to carry out a cost-benefit analysis. It is dangerous to dismiss all
monopolies are essentially harmful.

8.5 Theory of contestable markets
CONTESTABLE MARKET is a market structure with few barriers to entry and where there are
potential entrants waiting to join if abnormal profits are being earned.
 The theory predicts that even in a market with few competitors, firms will only earn normal
profit if the barriers to entry and sunk costs are low.
Assumptions
 The number of firms in the industry may vary from one (monopoly) to many.
 Free entry - The theory assumes that firms are free to enter the market and that the cost
structure of both new and existing firms is similar.
 Firms compete with each other and do not collude to fix prices.
 Firms are short run profit maximizers and equate MC with MR.
 Firms may produce homogeneous or differentiated products. Firms can achieve differentiation
through branding.
 There is perfect knowledge in the industry.
 There are low sunk costs.
Important features
 Threat of new entrants - Since there are low entry barriers, threat of new entrants is
overriding. If firms in the market are earning abnormal profits, then, new firms will enter the
market, make a profit (abnormal) and leave the market.
o Fear of new firms entering the market will force existing firms to charge a low
price and earn normal profits only even in the short run.
 Low sunk costs - This is the key characteristic of contestable market. Contestable market
predicts that as long as the costs of exit are low, firms will only be able to earn normal profits.
Therefore, in industries which may be characterized as having high fixed costs but low sunk
costs, firms will not have a lot of risk if they enter the market, if sunk costs are low, firms can
easily reverse their decisions and leave the industry while recovering their investment.
o Assets which have high fixed costs but where the sunk costs are low include
buildings, cars, airplanes, and other assets that can be easily sold off.
o When assets include large investments where the assets have no alternative use
(such as nuclear power plants), then the fixed costs become sunk costs as these
investments cannot be easily recovered. In such cases, where sunk costs are
high, the threat of new entrants diminishes.
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 Normal profits only can be earned in the LR- The theory of contestable markets shows that
in a contestable market abnormal profits can be earned in the SR; and in the LR, firms will
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only earn normal profits.

o Since firms have very little risk in entering markets where barriers and sunk costs
are low, new firms will enter the market if existing firms are earning abnormal
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profits.
o These new firms may enter on a hit and run basis where they enter the market,
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earn abnormal profits, and leave at no cost. Entry of new firms will increase
supply in the market that will drive down prices to the normal profit levels.
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o Threat of new entrants forces firms to keep their prices low and only earn normal
profits even in the short run.
o The theory therefore suggests that the ability of firms to earn abnormal profits is
dependent on the barriers to entry and exit to the industry and not on the number
of firms in the industry. With low barriers, existing firms will price such that AR =
AC (normal profits) because they are afraid that otherwise hit-and-run entrants to
the industry will come in and damage the market for them. They are also afraid
that the new entrants may permanently stay in the market, reducing the market
share of the existing firms
 All firms are subject to same regulations and government control irrespective of their size.
 There are mechanisms in place to prevent use of unfair pricing so that existing firms do not
use price wars or limit pricing to stop new firms from entering the market.
 Cross-subsidization is eliminated because otherwise firms will charge artificially low prices to
keep competition out of the market.
 Firms in the long run in contestable markets must be both allocatively and productively
efficient.
o Firms, in the LR, will operate at the bottom of their average cost curve. If they did
not, then new firms will enter the market, operate at the lowest cost, cut prices
and increase market share. Because of the threat of new entrants, firms in
contestable markets must be productively efficient.
o Firms in contestable market must also be allocatively efficient.
 Firms can only earn normal profits in the LR (AR = AC).
 Firms must also be productively efficient (MC = AC).
 Since AR = AC and MC = AC, firms must produce where AR = MC
hence they must be allocatively efficient.
Conclusion
There are many industries that exhibit the characteristics of contestable markets. Some of the
examples of contestable markets can be local bus service and rail service; provision of public service
such as electricity, gas and water supplies; telecommunications (through choice of network
suppliers); and airline market- 'open skies' policy of deregulated airline market has led to lower fares,
greater choice of airlines for passengers, entry of new low-cost airlines, and alliances among carriers.
 A monopoly that operates in a contestable market is forced to behave more like a firm under
perfect competition. It will benefit consumers through low costs as it achieves economies of
scale and through low prices as it only earns normal profits

8.6 Oligopoly
OLIGOPOLY is a market structure with only a few firms dominating the industry.
 Decisions taken by firms are interdependent and each firm has to consider the reaction of
competitors when making price changes. Characteristics
 Market is dominated by few large firms (usually between 2 to 10 firms). If there are two
dominant firms it is called a duopoly. It is important to note that there can be many small firms
in the market but the market is dominated by few large firms.
 Decisions of firms are interdependent. The action of one firm will directly affect another large
firm. For instance, if a firm decides to pursue policies to increase sales, this is likely to be at
the expense of other firms in the industry (taking sales from other firms). Firms, hence, try to
anticipate the reaction of their rivals before taking any decision such as pricing decision.
 There are significant barriers to entry such as control over raw materials in the case of gold,
silver and copper mining; patents in the case of electronics, chemicals, and pharmaceuticals
industries; and product differentiation that firms create through making a successful brand by
aggressively advertising their products.
 Products may be homogeneous or differentiated. Examples of homogeneous oligopoly
include industrial products such as steel, aluminium, petroleum and cement where products
are standardized. Examples of differentiated oligopolies include many consumer goods
industries such as automobiles, electronics, cereals and mobile phones. The differentiated
oligopolies focus a lot on non-price competition.
 Firms advertise their products to brand their products, create differentiation, and to maintain
competitive advantage. There is price rigidity. Uncertainty and risks associated with price
competition leads to price rigidity.
 Firms may or may not choose to maximize profits.
Behaviour of firms
It is the most realistic market structure and the theory does not provide definite predictions regarding
price and output of the firm. There is no single dominant model of oligopoly within economics. There
are different competing models that make different assumptions and different conclusions.
Firms may exhibit two different types of behaviour in the market:

 In some industries there is aggressive competition which is explained through kinked demand
curve and game theory.
 In other industries there may be collusion and cooperation that can be explained through
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cartels, and price leadership.
Competition- Price and Non-price

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In markets that are characterized by intense competition, firms may compete on price or non price
factors.
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(i) Price competition

Oligopolists are price setters. However, any attempt by one firm to increase market share
by lowering prices leads to price wars in the market. Firms in the market cannot afford to lose market
share and therefore try to match price decreases of other firms.
Reasons for starting price wars

 There can be overcapacity in the market and firms lower their prices to gain market share and
get scale economies. Lower costs will enable firms to become more competitive. This is
especially true in those industries where fixed costs are very high.
 Existing firms can use price wars as an offensive strategy against new entrants into the
market. Lower prices will drive new firms out of the market hence enabling existing firms to
retain their dominant position.
 Price wars may be started by highly diversified firms who can afford to cross-subsidize losses
in the market from profits made in other markets. These firms sacrifice their SR profits to gain
market share. Once they achieve monopoly status, they can increase their prices to achieve
abnormal profits.
 Another reason for starting price wars is that a firm's cost of production may be significantly
lower than that of its competitors. This enables the firm to drive some of the competitors out of
the market; gain market share; and achieve monopoly status.
However, price wars are seldom in the interest of the firms. Price reduction by one firm is usually
followed by price reduction by other firms. This leads to a reduction in profit margins of firms and the
benefit passes on to the consumers in the form of lower prices. Keeping this in mind, firms in many
markets try to avoid price wars and focus on non-price competition.
(ii) Non-price competition

Non-price competition is a feature of certain imperfect markets by which firms compete each other by
using factors other than price such as use of branding, customer service, product and process
innovation, and advertising. Some of the examples of non-price competition are given below.
 Advertising and promotion - Firms extensively advertise their product to create product
differentiation in the eyes of consumers leading to high brand loyalty. Brand loyalty makes the
demand curve of the firm price inelastic and the firm is able to successfully increase its prices
and profits.
 Brand proliferation - Firms try to produce lots of brands to saturate the market and leave no
gaps in the market. This enables firms to restrict entry of new firms in the market, hence,
enjoying dominant position and abnormal profits in the market.
 Market segmentation and product innovation- Market segment is a smaller part of the
market where consumers have different characteristics and needs. Large firms usually ignore
the needs of small market niches enabling smaller firms to fill these gaps successfully
(produce products that satisfy needs of the niche market). Even larger firms have started
using niche marketing. One of the benefits of niche marketing is that there are few
competitors in the market that enables firms to enjoy abnormal profits.
 Process innovation - Process innovation means improving the production methods or
improving the process of procurement of raw materials or delivery of finished goods. Process
improvements lead to either cost reductions that allow firms to reduce prices without reducing
profit margins or improve service delivery that enables the firm to differentiate its products and
increase prices.
 Horizontal integration - When the intensity of competition increases or there is overcapacity

in the market or when profitability of the market is falling, firms may
 Emergence of conglomerates - If consolidation (through mergers or acquisitions) is resisted
in the market when profitability is low and there is excess capacity, then, firms may look for
growth in other markets. This leads to reduction in risk; and increase in profits. Therefore,
economic theory predicts that diversification becomes a feature of firms in oligopolistic
markets and this also explains the emergence of large multinational corporations.
Collusion and Cooperation

Firms in some markets realize that both price and non-price competition leads to additional costs and
few benefits. They see a lot of potential benefit it they cooperate and collude.
(i) Cooperation
Firms in oligopoly sometimes see that it is in their interest to cooperate rather than compete. For
example, if R&D costs are very high and the pace of technological change is very rapid, the firms
may then decide to pool knowledge and agree on technical standards. They may even take part in
joint ventures to improve the standards.
(ii) Collusion
COLLUSION is an anti-competitive action by producers which may be written (formal) or tacit
(informal). The purpose of collusion is to limit open competition and may involve dividing the market
amongst firms, setting prices, or limiting production. Some of the examples of collusion are given
below. There are different models that discuss the behaviour of firms in oligopolies. Some of the
models are discussed below.
1. Kinked demand curve model

KINKED DEMAND THEORY is a means of analysing the behaviour of firms in oligopoly where there
is no collusion. It suggests that oligopolists face a demand curve that is kinked at the current price,
demand being significantly more elastic above the current price than below. The effect of this is to
create a situation of price stability.
 The theory explains how, even when there is no collusion, prices can remain stable.
Assumptions
 There is an established market price for the product at which all sellers are satisfied.
 There is interdependence and each seller's strategy depends on potential reaction of other
sellers.
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 Price reduction by one firm is followed by other firms in the industry. Price rise by one firm is
not matched by other firms in the industry.
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 Marginal cost curves pass through the dotted portion of the MR curve so that there is price
rigidity.
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Kinked demand curve

Firms in an oligopoly face a kinked demand curve as shown in the figure below. The reason of a
kinked demand curve is that there is uncertainty in the outcome of price changes. The exact outcome
of a firm's strategy depends on the reaction of its competitors. The model assumes asymmetrical
reaction to a change in price by one firm
 The initial equilibrium is at point A.
 If firm decreases its price, other firms are likely to follow suit and there would not be much
change in quantity sold by the firm The demand curve below point A tends to be inelastic and
MR curve is negative. If firm increases prices, other firms are not going to match increase.
Customers are likely to switch to competitors resulting in a significant fall in demand for the
firm's product that decided to increase price. The demand curve above point A tends to be
elastic and MR curve is positive.
 There is a discontinuity in MR below point A. The size of the discontinuity depends on the
elasticity of the kinked demand curve. The more elastic is it to the left and more inelastic to
the right, the larger will be the discontinuity in the MR curve.
Equilibrium and price rigidity

Profit-maximizing firms in oligopoly will try to operate at the point where MC is equal to MR. The
model assumes that the MC curve will cut the MR in the gap. The figure shows that with initial
marginal cost curve being MC1, the equilibrium will take place at price P and quantity Q. If there is an
increase in marginal cost of the firm (MC2 or MC3), the equilibrium will not change. This happens
because of the uncertainty in changing price levels. Hence, it is said that there is price rigidity in
oligopoly as the firms may not be able to change their prices because of the reaction of rival firms.
The oligopolist will absorb the whole of cost increase by reducing its profit margins
Weaknesses
 There is no explanation of how original price, P, was set.
 Theory only deals with price competition and ignores the effect of non-price competition.
 Theory assumes a very limited range of reaction by rivals. It is unlikely that firms will react in
exactly the same way all the time. A much wider range of possible reactions need to be
explored.
 Price stability might be illusory as firms may deviate from posted price by offering special
offers, trade-ins, and bulk discounts.
 In an inflationary period. the rise in prices is industry-wide so the firms that have similar costs
will follow one another in raising prices.
Because of their inability to change prices, firms in oligopoly tend to focus on non-price factors and
sometimes even decide to collude with each other.

2. Game theory
GAME THEORY is where competing firms exhibit interdependent behaviour whereby the actions of
one will impact on all other firms.
 The behaviour of a firm under non-collusive oligopoly depends on how it thinks its rivals will
react to its decisions. Game theory studies the alternative strategies that oligopolists may
choose to adopt, depending on their assumptions about their rival's behaviour.
Prisoner's dilemma
Suppose there are two prisoners - Nikamma and Badtameez - who are both arrested for the same
crime and each is interviewed separately. They are given the following alternatives:
 If they say nothing, the court has enough evidence to sentence both to 2 years imprisonment.
 If either of the two alone confesses, he is likely to get a one-year sentence but the partner
could get up to 10 years.
 If both confess, they are likely to get three years each.
The pay-off matrix of the decision is shown in the table below.
Badtameez
Not Confess Confess
Nikamma Not confess Each gets 2 years Nikamma gets 10
years Badtameez
gets 1 year
Confess Nikkamma gets 1 Each gets 3 years
year
Badtameez gets 10
years
Dilemma facing the two prisoners

The dilemma is that their own ’pay-off' is wholly dependent on the behaviour of the other
prisoner.
 To avoid the worse-case scenario (10 years), the safest option is to confess and get 3 years.
 If collusion is possible they can both agree to deny (and get 2 years).
 There is a very strong incentive to cheat because, if one denies and the other confesses, the
best outcome of all is possible, i.e. 1 year. Fearing that the other may cheat, the safest option
is to confess.
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Types of strategy
 A MAXIMAX strategy is the strategy of choosing the policy that has the best possible outcome
(best of the best). This means they will prefer the alternative which includes the chance of
achieving the best possible outcome - even if a highly unfavourable outcome is possible.
o This strategy is often seen as overly optimistic strategy, in that it assumes a highly
favourable environment for decision making.
o The best pay-off for Nikamma from 'confessing' is 1 year (with Badtameez
denying), and the best pav-off from 'denying' is 2 years (with Badtameez also
denying) -so the 'best of the best' is to confess (I year)
 A MAXIMUM strategy is the strategy of choosing the policy whose worst possible outcome is
the least bad (best of the worst). This is commonly chosen when a player cannot rely on the
other party to keep any agreement that has been made, e.g. to deny.
o The worst pav-off to Nikamma from confessing is to get 3 years (with Badtameez
confessing), and the worst pav-off from denying is 10 years (with Badtameez
confessing) - therefore the 'best of the worst' is to confess.
 In this case, both the maximin and maximax strategies would be to confess. When this occurs,
it is said to be the dominant strategy. A DOMINANT STRATEGY is the best outcome
irrespective of what the other player chooses. In this case it is for each player to confess as
both the optimistic maximax and pessimistic maximin strategies lead to the same decision
being taken.
Firm's behavior
In general, 'game theory" suggests that firms are unlikely to trust each other, even if they collude and
come to an agreement such as raising price together. Consider the hypothetical example of two
Airlines and return ticket prices to New York.
Airline B
Low $250 Low $ 250 High $300
Airline B Both earn $100m A gets $140
B gets $70
High $300 A gets $70m Both earn $120
B gets $140m
 The aggressive maximax strategy for both Airlines is to earn $140m from a low price and
$120m from a high price, so a low price gives the maximax pay-off.
 The pessimistic maximin strategy tells that the worst outcome from a low price is $100m, and
from a high price is $70m, hence a low price provides the best of the worst outcomes.
 Therefore, lowering price is the dominant strategy, and the only wav to increase the pay-off
would be to collude and increase price together. Collusion creates two further risks:
o One of the airlines reneges on the agreement and lowers the price.
o The competition authorities investigate the airlines, and impose a penalty.

Nash equilibrium
NASH EQUILIBRIUM (named after Nobel winning economist, John Nash) is a solution to a game
involving two or more players who want the best outcome for themselves and must take the actions
of others into account.
 When Nash equilibrium is reached, players cannot improve their payoff by independently
changing their strategy. This means that it is the best strategy assuming the other has chosen
a strategy and will not change it.
 For example, in the Prisoner's Dilemma game, confessing is a Nash equilibrium because it is
the best outcome, taking into account the likely actions of others.
Implications of Game theory

Game Theory provides many insights into the behaviour of oligopolists. For example, it indicates that
generating rules for behaviour may take some of the risks out of competition. such as:
 Employing a simple 'cost-plus' pricing method which is shared by all participants would work
well in situations where oligopolists share similar or identical costs, such as with petrol
retailing.
 Implicitly agreeing a 'price leader’ with other firms as followers would improve overall pay-offs.
For example, in the Airline example, firm A may lead and raise price, with B passively
following suit. In this case, both would generate revenues of $120.
 Supermarkets implicitly agreeing some products where price cutting will take place, such as
bread or baked beans, but keeping price constant for most products.
 Generally keeping prices stable (sticky) to avoid price retaliation.
Functioning of a cartel
Profit maximizing output and price
The cartels set a price by equating market demand with the industry marginal cost. Industry MC is
obtained by horizontally summing the MC curves of its members. Profits are maximized at Qi where
price is set at Pi.
Behaviour of firms after price is set at Pi

 Members may compete against each other using non-price competition to gain as big a share
of Qi as they can.
 Each member may be given a quota. The sum of all the quotas add up to Qi. The most likely
method of dividing the quota is according to the members' current market share. This is most
likely to be accepted as 'fair'.
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 One of the problems of cartel is that there is a strong incentive for individual members to
cheat. Therefore, member selection becomes a very important factor in success of a cartel.
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Conditions for successful operation of a cartel

 There are a small number of participants, all well known to each other. Price agreements are
difficult to reach where there are many firms in the industry.
 It is likely to be easiest in stable, mature industries where no single firm has recently been
able to gain advantage by pursuing aggressive competitive strategies.
 There must be a strong element of trust among the member firms.
 They have similar cost structures so that no firm has the incentive to cheat.
o When oligopolists face different costs and demand curves, it is difficult for them to
agree on a price. This is usually the case when products are differentiated and
change frequently
 There must be a clear leader so that firms follow the leader.
 The agreement can be policed otherwise there will be a violation of the agreement.
o There is temptation for collusive oligopolists to engage in secret price cutting to
increase sales. Collusion is more likely to succeed when cheating is easy to
detect and punish.
 There is no danger from new entrants because otherwise abnormal profits will attract new
firms leading to a rise in competition.
o Potential entry of new firms attracted by higher profits will increase market supply
and reduce prices and profits. Therefore, for collusion to be successful,
oligopolists should block the entry of new firms.
 There must be stable market conditions.
 It is expected that government will not intervene.
o There are legal obstacles to formation of collusive oligopolies, e.g. US Antitrust
Law prohibits cartels and price-fixing collusion.
4. Price leadership
TACIT COLLUSION is where oligopolists take care not to engage in price cutting, excessive
advertising or other forms of competition. There may be unwritten rules of collusive behavior such as
price leadership.
 It allows firms whose decisions were interdependent to earn high profits.
Two types of price leadership have been identified: 1) dominant price leadership; and 2) barometric
price leadership.
DOMINANT FIRM PRICE LEADERSHIP exists when firms (the followers) choose the same
price as that set by a dominant firm in the industry (the leaders).
 Dominant firm is the one whose market share is high and whose cost of production is low
(due to large economies of scale).\
BAROMETRIC FIRM PRICE LEADERSHIP exists where the price leader is the one whose
prices are believed to reflect market conditions in the most satisfactory way.
 Industry may not be dominated by any single firm. Leadership role may rotate in an orderly
manner.

Operation of dominant firm price leadership

The pricing decision depends on the assumptions that it makes about its rivals' reactions to its price
changes. A simple model based on the assumption that rivals will follow the leader by making exactly
the same percentage price changes is shown below.
 The leader assumes to maintain a
constant market share (e.g. 50%).
 The leader maximizes profits where
its MC is equal to its MR.
 It decides to produce QL at price PL.
 At this price, market demand it QT.
The followers therefore supply the
remaining demand, i.e. QT-QL.
However, the model is based on the
assumption that followers will want to
maintain a constant market share. It is
possible that if leader raises price, the
followers may want to supply more at the
given price.
Price leadership in Duopoly

The following figures is based on the
assumption that there are two producers
only - A and B, Firm A has lower costs
(MCA) than Firm B (MCB). The individual
demand curve for each firm is Dd. MR is the
associated marginal revenue curve.
 Firm A is in equilibrium when MCA
cuts MR and charges a price PA and
produce output QA.
 Firm B is in equilibrium when MCB
cuts MR and wants to charge a
higher price PB but is unable to do
so because of competition from A. It
is therefore forced to accept the price
set by A although this price does not maximize its profits. Therefore the best output that B can
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produce is QB*.
Other forms of tacit collusion

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 There can be an established rule of thumb that everyone follows. One example is AVERAGE
COST PRICING where a firms sets its price by adding a mark-up on the average cost.
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Producers are not equating MC and MR here. If AC rises by 5%, price will also rise by 5%.
This is especially useful during period of inflation when all firms experience similar cost
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increases.
 Another rule of thumb can be have certain PRICE BENCHMARKS which is a price that is
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typically used, so that when firms raise prices, they will usually raise it from one benchmark to
another. Thus clothes may sell for $9.95, $12.95 etc.
Oligopoly and efficiency

Oligopolists sell at a price that is greater than marginal costs (allocative inefficiency) and produce an
output below the optimum output (technical inefficiency). However, it can achieve dynamic efficiency
by investing its excess profits in product and process innovation.
Benefits of oligopolies to consumers

Oligopolies when compared to perfect competition will have similar benefits and drawbacks as that of
comparison with monopoly.
Firm's objectives
It is often difficult in an oligopoly to choose a competitive strategy because of uncertainty stemming
from predicting response of rivals. This at times forces firms to change their objective from profit
maximization to satisfying profits and maintaining market share. This is because of uncertainty in the
market that forces management to more cautious and try to make just enough profits to keeps its
shareholders satisfied.
L-shaped average cost curves

Economic studies have established that in
the real world AVC curves are often more
L-shaped than U-shaped (as shown in the
figure). Over a wide range of output, large
firms face the same average variable
costs whether they increase or decrease
output.
Conclusion
 Markets are dominated by few
firms.
 There are high entry barriers.
 Firms are price setters but
because of uncertainty in the market, there is price rigidity.
 Firms can compete on price and non-price factors.
 In some oligopolistic markets, firms may decide to collude and cooperate.
 Firms in an oligopoly face a kinked demand curve.
 Firms are both productively and allocatively inefficient.

8.7 Pricing strategies
Firms can use following pricing strategies depending on the market conditions:
 Profit maximizing price (where MC=MR)
 Marginal cost pricing (leads to allocative efficiency even in imperfect markets) (where P=MC
or where MC=AR)
 Revenue maximizing price (where MR=0)
 Average cost pricing
 Limit pricing and predatory pricing
 Price discrimination
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8.8 Comparing different market structures

Perfect Monopolistic Oligopoly Monopoly Contestable
competition competition markets
Number of firm Many Many Few dominant; Single firm Few, many or
only two in dominates even one
duopoly
Product Homogenous Differentiated Differentiated Differentiated Homogeneous
or or
Homogeneous differentiated
Price setting Price takers Price setters Price setters Price setters Price setters
Entry and exit None Few Many Many Low exit
barriers barriers
Competition Very low Both price Price Single firm; Threat from
intensity; and non – competition; price new entrants
firms are price non – price discrimination
price takers competition competition;
collaboration;
and collusion
(both explicit
and implicit)
Profits SR – SR – Normal, Normal and Abnormal Normal profits
Normal, abnormal and abnormal profits in the LR
abnormal, loss LR – profits
and loss LR normal
– normal profits only
profits only
Demand curve Perfectly Downwards Kinked; price Downward Downward
elastic sloping; rigidity sloping sloping
elastic or
inelastic
Productive In LR Inefficient Inefficient Inefficient In LR
efficiency
Allocative Efficient Inefficient Inefficient Inefficient Efficient
Efficiency
Interrelationship Independent Interdependent
between
markets
Knowledge Perfect Imperfect Imperfect Imperfect Perfect
Objective Maximize Maximize Maximize Maximize Maximize
Profits Profits profits or other Profits Profits
objective such
as satisficing
profits
Power Consumer Firms have Firm becoming Producer Threat of new
soveriegnity some power more powerful sovereignty entrants
over setting
prices


June 2011, 22
Question 4
(a) Discuss whether it is always advantageous for a firm to grow in size. [12]
(b) Explain the economic theory of profit maximisation for a firm and consider whether firms are likely
to follow this theory in fixing their price and output.
Marking scheme
(a) Discussion of possible reasons for growth Including large market demand, economies of scale,
possible future profits, with a contrasting comment on reasons why it might not be advantageous to
grow in size; diseconomies of scale, small market demand, specialized products/services. Allow a
wider interpretalion which discusses effects on consumers and in the economy.
L4 For a sound discussion with contrasting explanations. [9 - 13]
(b) Explanation of the theory of profit maximisation. Candidates should then consider not only
whether it is possible to calculate marginal revenue and marginal cost to achieve profit maximisation
but also whether the firm might have alternative aims. Sates maximisation, behavioural, managerial,
satisficing, market share alms might be mentioned. [12]
L4 For a reasoned discussion and dearly structured answer with a conclusion [9 - 13]
a) Large scale production is often said to be advantageous for a firm due to the benefits that one with
expanding productive capacity. This is not, however, always the case as sometimes growth of a firm
may bring about negative effects.
One of the most commonly cited reason to support growth of a firm is the benefit of
gaining economies of scale. This refers to a situation in production where the average cost of
production decreases while the output level increases. In figure l, this is shown from output level Q to
Q1. As output rises, long run average cost decreases.
This can be due to technical economies of scale, where capital and labour are used to achieve their
maximum productivity levels, arrangenial economies of scale, which encourages specialization in a
job roles and functions and so on. Firms financing with large- scale production can be said to enjoy
lower average costs, which is an advantage for firms to engage in price competition as prices can be
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lowered without losing the profit margins. This is a benefit for consumers, as lower prices would
increase spending power. Also, if prices do not fall, then firms with the benefits of economies of scale
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would be able to gain more profits and would be more likely to gain abnormal profits. This is also a
benefit as it enables firms to invest in research and product innovation, providing an advantage in
terms of non – price competition that also benefits consumers with better quality.
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Economies of scale can generally be seen as an improvement in terms of efficiency as firm’s costs be
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minimized and the use of resources is maximized. In these ways, large – scale production may be
advantageous and firm’s growth would be positive for the market.
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However, this is not always the case as output levels above Q1 in figure 1 show diseconomies of
scale as firms find it increasingly difficult to manage production beyond a certain level. This
decreases efficiency and results in wastage of resources.
Also, firms may become monopolies if growth is allowed to continue without efficient
competition. Monopoly situations can results in consumer exploitation as the lack of competitions.
Monopoly situations can results in consumers exploitation as the lack of competition reduces the
incentive to minimize consumer costs order to maximize profits. Monopoly situations can result in a
lack of choices for consumers and this would be seen as undesirable, especially if consumes lose
sovereignty together in the market.
Exceptions way occur in the case of the natural monopolies, where high count costs and technology
or infrastructure way encourage a firm’s growth to center for more of the market. This is because it
may be better for the allocation of serve resource if infrastructure and capital are not duplicated by
having many small firms supply the same product.
In conclusion, there are advantages to a firm’s expansion of productive capacity, but there may also
be disadvantages. It is necessary to examine the conditions a each situation and the possible effects
should be evaluated before determining how advantages it would be for a firm to grow in size.
4(b) Part in firm’s decision regarding the level of output and price acting
Profit satisfying may also play a role, allot less frequently/ This refers to describes made
most often by staff at the managerial level, where there is no uncreative to increase most often by
staff at the marginal level, where there is no in creative to increase resource or profits beyond a
preatetmined level (usually the minimum returns to the observations) as it close not affect the wage
rate of the wonders involved. In these can output and price are likely to be moderately obserevtion
form the profit maximizing point of MC = MR.
In figure 2 MC = MR is shown as the profit maximizing level of output at quantity Q and prize level P.
The sales – maximizing level of output is likely to be closer to MC = AR while the profit satisfying level
is highly to be lower or less than P and Q.
The objectives of a firm differs between firms and markets, depending on such factors as competition,
schedules roles, market conditions and the position of the firm, but it can be said that a large fraction
of firms will emphasize profit maximization save point if not open during its operations.
Exceptions may occur in the case of natural monopolist, where high costs and costly technology
infrastructure way encourage a firm’s growth to center for move of the market. This is because it may
be better for the allocation of same resource if infrastruction and capital are not duplicated by having
many small firms supply the same product.
In conclusion, there are advantages to a firm’s expansion of productive capacity, but there may also
be disadvantages. It is necessary to examine the market conditions a each situation and the possible
effects should be evaluated before determining how advantages it would be for a firm to grow in size.

b) Profit maximization refers to a firm’s objective to maximize profits in the production of a good or
service, obtaining the highest possible profit margin. This is often illustrated for a firm are obtained at
the point where MC = MR, or where firm’s marginal cost is equal are on the marginal revenue
generated by the extra unit produced. At this point, firm’s are on the wage of grating a loss with the
next unit production.
Firm’s are said to aim for profit maximization in order to gain are returns for the
enterprises or shareholders. Also in some firms it would be ideal to gain more profits in the hopes of
earning, abnormal profits that can then be invested or used for researching and development or
innovation purposes. This would then increase a firm’s ability to compete in a non – price manner and
improve the productivity of capital and labour through technological advances and training.
However, not all firm’s any engage in profit maximization all of the time depending on the
circumstances of the firm’s and it’s position and industry. Particularly for firm’s and it’s in the market
and industry. Particularly for firm’s that have just entered a market, they may choose to maximize
cables instead in order to move firmly establish their position and control of market share. This results
in firm’s setting for a profits margin below the maximum attainable profit level in favor of increasing
their clientable or consumer base, possibly through getting lower prices. At is worth noting that firms
will rarely or go to the part of being unable to sustains variable costs in the short run, indicating that in
the large run profit maximization may after all be the motivating In the case of a near extent in a
market or industry, the firm is less likely to concern itself with profile maximization if it is a firm that so
able to drivingly and cross substitute its goods This refers to a firm’s ability too rusting losses for the
production of a good or service due to its pr established position and higher profit margins for another
good or service, again indicating that to serve extent, profit maximization is likely to play
Examiner comment
This candidate gave a good response to section a) which contained an explanation of the advantages
of growth through economies of scale, the disadvantages caused by diseconomies and the
undesirability
of some monopolies. Profit maximisation was discussed in section b) but there was also a discussion
of alternative aims of a firm including non-price competition, maximisation of sales, increasing market
share, cross-subsitisation, satisficing, all of which might need to be balanced against the desire to
gain maximum
returns for shareholders.

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Mark awarded = 19 out of 25

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Ch# 9 (Economic Efficiency and Government Intervention))
(Economic Efficiency and Government Intervention)

ECONOMIC EFFICIENCY exists when all scarce resources in the economy are being used in the
best possible way, i.e. greater levels of infinite wants are being met leading to maximum total
satisfaction in the economy. Efficiency can be static or dynamic.
9.1 Static efficiency

STATIC EFFICIENCY is concerned with efficiency at a point in time. There are two types of static
efficiency- productive efficiency and allocative efficiency.
 OPTIMUM RESOURCE ALLOCATION occurs when resources are efficiently used in such a
way as to maximize the welfare or utility of consumers.
 Economic efficiency is said to take place when both productive and allocative efficiencies are
present.
Productive efficiency
For a firm
PRODUTIVE EFFICIENCY takes place when products are being made using least possible
resources, i.e. with the lowest possible cost of production. There are two parts to productive
efficiency:
 X-EFFICIENCY - Production must take place on the lowest possible average cost curve. In
figure 'a' below, firm is x-efficient if it is producing on AC3. Firms can be x-inefficient because
of following reasons:
o Monopolies tend to be x-inefficient as there is no competition to force them to improve
their production process and introduce new technology to operate at the lowest AC curve.
o Firms using old methods of production tend to be x-inefficient.
o There is lack of incentive to improve process through R&D.
o Poor management practices and presence of trade unions can also mean that firm does
not operate at its lowest AC curve.
 TECHNICAL EFFICIENCY means that production takes place at the lowest point of lowest
cost curve where MC = AC.
 A firm is said to be productively efficient if it is both x-efficient and technically efficient. A firm is
productively efficient in the SR if it is operating on the bottom of its SRAC curve. It is
productively efficient in the LR if it is operating on the bottom of its LRAC curve.
For the economy

PRODUCTIVE EFFICIENCY can also be defined as a situation where it is impossible to reallocate
resources to produce more of some product without producing less of some other product. All points
on PPC are productively efficient.
 For instance, if one competitive firm is productively inefficient, then it would use up too many
resources to produce its output. Average costs could be minimized if this firm is closed down
or is taken up by another firm in the industry. This will release resources that can be used
elsewhere in the economy. However, there is no possibility of gaining extra production in the
economy if all firms are producing at lowest cost. Hence, there must be productive efficiency
only when the economy is operating on its PPC.
Productive efficiency in different markets

Perfect markets are productively efficient in the long run when they only make normal profits.
 When firms in perfect market make normal profits, they operate at the optimum output where
AC are minimized.
 Competitive markets provide the right incentives for firms to become productively efficient.
There is fear of bankruptcy that forces firms to reduce their costs to survive in the market.
Firms are trying to maximize profits and hence have the incentive to reduce costs.
Contestable markets (even if a monopoly) are productively efficient because of the threat of
new entrants as the entry barriers and sunk costs are low. Inefficient firms will be forced to reduce
their costs because otherwise they will lose out to more efficient firms.
Imperfect markets such as monopolistic competition, oligopoly and monopoly are not
productively efficient as they can hide their inefficiencies through developing product differentiation
and brand loyalty that enables them to charge a higher price.
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Allocative efficiency
ALLOCATIVE EFFICIENCY measures whether resources are allocated to those goods and services
demanded by consumers, i.e. goods and services most wanted in the economy are being produced.
This leads to the greatest satisfaction of infinite needs.
For a firm
Allocative efficiency takes place at the point where price is equal to marginal social cost.
P = MSC
 Price reflect the marginal utility of the last unit bought of a product. Marginal cost shows the
cost to firms of producing an extra unit of a good. 'Cost' means social costs and includes both
private and external costs.
Quantity 1 2 3 4 5 6 7
Price($) 5 5 5 5 5 5 5
MC ($) 2 3 4 5 6 7 8
 If P > MSC (till unit 3 in the table above), then it means that value to consumers of the last unit
produced is greater than the cost to the society. Producing the extra unit should therefore
generate net social benefit and therefore should be produced.
 If P < MSC (for unit 5 and more in the table), then the value to consumers of the last unit
produced is less than the cost to the society and producing an extra unit results in a net social
loss. It should therefore not be produced.
 Allocative efficiency should therefore take place where P = MSC (unit 4 in the table). At this
output level, the net social benefit is maximum.
For the economy

All points on PPC are potentially allocatively efficient. All points on PPC satisfy the condition
that P = MC. The exact production decision then depends on the preferences of consumers.
 Hence, allocative efficiency will exist if price is equal to marginal cost in each industry in the
economy. If P = MC in all industries, it will be impossible to make anyone better off without
making someone else worse off. The allocation of resources is said to be Pareto Efficient. If
an allocation is Pareto inefficient, then it must be possible to make some or all people better
off without making anybody worse off. All points within PPC are Pareto inefficient. All points
on PPC are Pareto efficient.
Allocative efficiency in different markets

Perfect markets are always allocatively efficient. They always produce at the point where price is
equal to marginal cost.
 Competitive markets provide the right incentives for firms to become allocatively efficient.
Incentive to maximize profits and fear of bankruptcy force firms to produce goods that
customers desire.
 Firms in perfect markets can be allocativelv inefficient if they ignore external costs.

Contestable markets (even if there is a monopoly) are allocativelv efficient because of the threat of
new entrants as the entry barriers and sunk costs are low. They minimize their price (P=MC) and only
earn normal profits in the long-run.
Imperfect markets such as monopolistic competition, oligopoly and monopoly are not allocativelv
efficient as they can exploit consumers by charging a higher price. Monopoly is in a position to charge
the highest price therefore we expect that allocative inefficiency is greatest in monopoly and lowest in
monopolistic competition.
Pareto optimality
PARETO OPTIMALITY occurs when it is impossible to make someone better off without making
someone else worse off.
 All points on PPC are Pareto efficient as it is not possible to increase quantity of good X
without reducing production of good Y.
 All points within PPC are Pareto inefficient as it is possible to increase quantity of one good
(e.g. X) without having to sacrifice output of the other (e.g. Y).
Compensation required
If there are welfare losses at one point of PPC, then reallocation of resources will lead to Pareto
improvement. However, any improvement in economic efficiency may require some form of
compensation to be paid where individuals are worse off.
 An example is construction of a new road to improve the efficiency of traffic flow. Users of the
new road benefit because their journey times are shorter and their travels costs are likely to
reduce. Other will be worse off such as those who lose their homes, unless they are provided
a compensation for their loss. Those living close to the road will be harmed by additional noise
and fumes and are unlikely to receive compensation.
 There is likely to be an overall efficiency gain in the above example.
Efficiency from global perspective

Economic efficiency is achieved when economies are using all of the world's resources in the best
possible way. However, protectionism and overuse of resources result in either loss in efficiency or a
question of sustainability.
 Oil consumption is one example where higher levels of this scare resource is leading to
inefficiency. Much of the oil is wasted through traffic congestion, the inefficient use of oil and
oil products in manufacturing, and the use of gas-guzzling vehicles.
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 Use of timber is another example where the excessive use of this resource is resulting in
deforestation. Consumers and producers both ignore the costs of deforestation.
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 Water is increasingly become a scarce resource and control over water is one of the major
causes of international conflicts.
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9.2 Dynamic efficiency

DYNAMIC EFFICIENCY is concerned with whether resources are used efficiently over a period of
time.
 It results from activities such as new products, new methods of production, and new methods
of management. Dynamic efficiency can increase with innovation, invention and research and
development.
 Dynamic efficiency is a longer-term phenomenon. To achieve it requires investment sourced
from within or outside of the firm. Firms invest either to cut costs or to make new products.
Investment can be in research and development, and in physical non-human capital. Initially,
the investment can result in higher costs; the payback comes later. Without investment, the
firm will become less efficient and may be forced to leave the market. When the firm is
dynamically efficient, its long-run average cost curve shifts downwards.
 A very good example of dynamic efficiency is the motor vehicle manufacturing industry. There
is a lot of competition and firms were forced to become more efficient to survive. Innovation
and extensive investment has resulted in highly efficient, automated production plants.
 Dynamic inefficiency can occur if firms fail to take into account all the future costs and benefits
of the investment (as most firms determine their rate of investment by looking at short run
considerations). With research and development which can have very long term pay offs,
firms may take no account of revenues to be received after, say, five years because they
regard these benefits as too uncertain. If all firms do this, there will be underinvestment in the
economy as a whole in long term research and development. This will reduce the socially
optimal rate of technological change over time.
Dynamic efficiency, and monopoly and oligopoly Oligopolistic firms and monopoly can earn excess
profits in both short-run and long-run. By using their excess profits, such firms are able to engage in
research, development and product innovation in order to protect their market share. This can bring
many benefits to consumers in the form of new technologies and lower prices while giving the firm a
more efficient means of production. Such firms may not therefore be allocatively efficient but still can
allocate resources more efficiently than perfect competition. Therefore efficiency and inefficiency of
monopoly depends on how it behaves.
 Monopoly would be x-inefficient if there is lack of competitive pressure, there is no incentive
for product innovation, it follows traditional methods of product innovation. there is lack of
profit maximization motive, or there is poor management.
 Monopoly would be x-efficient if there is threat of new firms entering, it is a natural monopoly
and enjoys economies of scale, it is involved in research and development and process
innovation, and it employs better management that overcomes problems of coordination.
 In short, monopoly is always technically inefficient but it can achieve dynamic efficiency that
can enable it to operate at lower average costs than firms in perfect markets.

9.3 Market failure

MARKET FAILURE exists whenever a free market, left to its own devices and totally free from any
form of government intervention fails to make the optimum use of scarce resources, it leads to sub-
optimal allocation of resources (over- or under-production) and leads to either productive or allocative
inefficiency. Typical examples of market failure include externalities, merit and demerit goods,
adverse selection or moral hazard, public goods and monopoly. Another example of market failure is
when there is inequitable distribution of income and wealth.
Reasons for market failure
(i) Existence of externalities

An EXTERNALITY is said to exist where a third party is affected, either negatively or positively, by
the decisions or actions which are taken by others. A NEGATIVE EXTERNALITY is a situation when
there are external costs associated with the production or consumption of a good or service. It leads
to overproduction of the product. A POSITIVE EXTERNALITY occurs when there are external
benefits associated with the production or consumption of a good or service. It leads to
underproduction of the product.
(ii) Public goods

PUBLIC GOODS are goods that possess the combined characteristics of non-excludability and non-
rivalry such as streetlights and defence. Such goods may not be produced in a free market because
of the problem of free-riding.
(iii) Merit and demerit goods

MERIT GOODS are goods which have positive externalities associated with them and the consumers
do not fully realize the benefits of consuming merit goods such as housing and education. This leads
to underconsumption and underproduction of these goods. DEMERIT GOODS are goods which have
negative externalities associated with them and the consumers do not fully realize the harm of
consuming these goods such as cigarettes and mp3 players. This leads to overconsumption and
overproduction of these goods,
(iv) Monopoly
MONOPOLY is a type of market structure that is characterized by high barriers to entry and is
dominated by a single firm. Monopolies lead to higher prices, lower output, quality concerns, lower
process and product innovation, productive (x-inefficiency) and allocative inefficiency, and
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deadweight loss.
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Reasons monopoly develop

Monopolies develop because of two basic reasons:
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 Economies of scale
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In those industries where significant economies are present, firms have to be very large to get
economies of scale. If demand is limited in such industries, there may be room for only one
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firm leading to creation of natural monopolies.

 Profit motive
Firms try to build barriers to entry and destroy competition. This leads to lower competition
and gives the firms the monopoly power to set prices. Fall in competition hence leads to
increase in profits.

9.4 Externalities
An EXTERNALITY OR SPILLOVER EFFECT is said to arise if a third party (someone not directly
involved) is affected by the decisions and actions of others, e.g. if a student decides to use his own
car to go to school in the morning, then others (third parties) are affected by smoke emissions of the
car, and road congestion by use of car.
 In an efficient market system, the transaction between two parties should only affect the
decision makers involved.
 Market failure arises if third parties are affected by a decision.
 This leads to inappropriate amount of product being produced.
 Free markets can hence lead to either overproduction or underproduction of the product.
Costs and benefits of a decisions

1) Costs (shown on the supply curve)
 Private costs of a decision are the costs involved in an action that accrues to the decision
makers alone. For a tannery, this can include cost of electricity, raw hides, chemicals, and
labour. Private businesses base their decisions on private costs only.
 External costs are the costs that are borne by third parties (rest of the society) because of the
decision taken by a decision maker (producer or consumer). For a tannery, this can include
the waste that they dump and the gases emitted during the manufacturing process. These
costs affect the rest of the society and are not considered by decision makers when taking a
decision.
 Social costs of an action are the total costs of a decision accruing to all individuals whether
the decision maker or the third parties. Social costs include both private costs and external
costs.
Social costs = Private costs + External costs
2) Benefits (shown on the demand curve)

 Private benefits of a decision are the benefits that accrue to the decision makers alone. For
example, the private benefit of getting inoculated against a disease is that the individual
getting inoculated will not catch the disease. Decision makers base their decisions on private
benefits only.
 External benefits are the benefits received by third parties (rest of the society) because of the
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decision taken by a decision maker (producer or consumer). External benefit of inoculation is
that the individual getting inoculated will not become a career of disease and other people are
not likely to catch disease from this person. These benefits affect the rest of the society and
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are not considered by decision makers when taking a decision.

 Social benefits of an action are the total benefits of a decision accruing to all individuals
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whether the decision maker or the third parties. Social benefits include both private benefits
and external benefits.
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Social benefits = Private benefits + External benefits

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Decision making on the margin

Decisions are made on margins, i.e. where marginal costs equal marginal benefits.
 MARGINAL COST of production is the extra cost of producing an extra unit of output.
o Marginal cost rises with an increase in production because a firm has to pay higher
prices to obtain more factors of production, e.g. to employ more workers it might have
to pay higher wages.
 MARGINAL BENEFIT is the benefit received from consuming an extra unit of output.
o Marginal benefit of consumption of a product falls as consumption increases. Each
extra unit of consumption brings less benefit to the consumer. The marginal benefit
curve is the same as the demand curve.
1) Decision makers (producers or consumers)
Firms are trying to maximize their profits while consumers are trying to maximize their utility
(satisfaction). Decision makers (producers or consumers) only consider private benefits and private
costs. They will produce or consume the quantity where marginal private cost is equal to marginal
private benefit.
MPC = MPB
2) Socially optimal decision
Society includes both decision makers (producers and consumers) and the third parties. Society
therefore bears and must consider social costs and benefits (i.e. private and external costs and
benefits). Socially optimal production takes place where marginal social cost is equal to marginal
social benefit.
MSC = MSB
Negative externalities
A NEGATIVE EXTERNALITY is a situation when there are external costs associated with the
production or consumption of a good or service. It leads to overproduction of the product. It can result
from:
 Production- External costs exist if MSC is greater than MPC
o There are no externalities if social costs equal private costs but this is unlikely to
happen. Although some decisions produce higher externalities and others may
produce lower externalities.
o The only situation where private costs may be greater than social costs is when there
is an external benefit in production such as research and development effects.
Consumption- (when MSB < MPB)
The figure shows the decision making process.

o S1 is based on marginal private cost. S2 is based on marginal social cost and is to the
left due to higher social costs. It is assumed that there are no externalities from
consumption and that MSB = MPB.
o Equilibrium for decision makers is at E1 where Do and Si intersect. The producer
hence produces a higher quantity Q1 and charges a lower price Pi. This happens
because he is not paying for the externalities and hence is bearing lower costs
o Socially optimal production takes place where MSC = MSB, i.e. E2 where Do is equal
to S2. Socially desirable production is Q2 (lower) and at this quantity price is higher at
P2

o The vertical distance between the two supply curves at the optimal production level is
equal to marginal external cost.
o Market has failed as it is allocating too many resources in producing the good, i.e.
production is more than socially desirable output leading to problem of overproduction
equal to Q1 - Q2
o At the production level Q1, there is welfare loss to the society equal to the shaded
triangle called the welfare loss triangle or deadweight loss triangle.
2) Negative externality from Consumption (MSB < MPB)

Negative externality from consumption arises when marginal social benefit is less than marginal
private benefit.
 When a motorist uses his car, the marginal benefit that he receives keeps on decreasing.
 When people use their cars, other people suffer from their exhaust fumes, the added
congestion, the noise etc. These negative externalities make the marginal social benefit
(MSB) of using cars less than the marginal private benefit (MPB) of the motorist.
o D1 is based on marginal private benefit. D2 is based on marginal social benefit and is to
the left due to negative externalities. It is assumed that there are no externalities from
production (MSC = MPC)
o Equilibrium for decision makers is at E1 where D1 and So intersect. The consumers hence
consume a higher quantity Q1 and pay a higher price P1 because they are associating a
greater benefit to the product ignoring external costs
o Socially optimal production takes place where MSC = MSB, i.e. E2 where D2 is equal to
So. Socially desirable production is Q2 (lower).
o The vertical distance between the two supply curves is equal to marginal external
o Market has failed as it is allocating too many resources in producing the good, i.e.
production is more than socially desirable output leading to problem of overproduction
equal to Q1 - Q2.
o At the production level Q1, there is welfare loss to the society equal to the shaded triangle
called the welfare loss triangle or deadweight loss triangle.
Positive externalities
A POSITIVE EXTERNALITY occurs when there are external benefits associated with the production
or consumption of a good or service. It leads to underproduction of the product. It can result from:
 Production (when MSC< MPC)
 Consumption- External benefits exist if MSB are greater than MPB.
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o There are no externalities if social benefits equal private benefits. This is very unlikely to
happen. Some decisions produce higher externalities and others may produce lower
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externalities.
o Private benefits are only greater than social benefits if the decision has an external cost.
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1) Positive externality from Production (MSC < MPC)
Positive externality from production arises when marginal social costs are greater than marginal
private costs.
 Example - If a forestry company plants new woodlands, there is a benefit not only to the
company itself, but also to the world through reduction of carbon dioxide in the atmosphere.
The MSC of providing timber is less than the marginal private cost to the company
 Another example is of research and development (R&D). If other firms have access to the
results of the research, then clearly the benefits extend beyond the firms that finances it.
Since the firm only receives the private benefits, it will conduct a less than optimal amount of
research.
 The figure below shows the decision making process.
o Decision maker only considers private costs and hence operates at S 1. Marginal social
costs are lower and therefore, the supply curve considering social costs is to the right, S2.
We are assuming no externalities from consumption (MSB = MPB) and the demand curve
is D0.
o Equilibrium for decision makers is at E1 where S1 and Do intersect. The producer hence
produces a lower quantity Q1 and charges a higher price P1 because it ignores the
external benefits
o Socially optimal production takes place where MSC = MSB, i.e. E2 where S2 is equal to D0.
This is also called decision making at the margin. Socially desirable production is Ch
(higher) and at this quantity price is lower at P2.
o The vertical distance between the two demand curves is equal to marginal external
benefit. o Market has failed as it is allocating too few resources in producing the good,
production is less than socially desirable output leading to problem of underproduction
equal to Q2- Q1
2) Positive externality from Consumption (MSB > MPB)

Positive externality from consumption arises when marginal social benefits are greater than marginal
private benefits.
 Private benefit of getting inoculated against a disease is that the individual getting inoculated
will not catch the disease. External benefit is that the individual getting inoculated will not
become a career of disease and other people are not likely to catch disease from this person.
 Another example can be of that when people travel by train than by car, other people benefit
by there being less congestion and exhaust and lower accidents on the road. Thus the MSB
of rail travel is greater than the MPB to the rail passenger.
 The figure below shows the decision making process.
o Decision maker only considers private benefits and hence operates at lower demand
curve D1. Total benefits to the society (social benefits) are higher and therefore, the
demand curve considering social benefits is to the right, D2. We are assuming no
externalities from production (MSC = MPC) and the supply curve is So.

o Equilibrium for decision makers is at E1 where D1 and So intersect. The producer hence
produces a lower quantity Q2 and charges a lower price P1. This happens because there is
less demand for the product.
o Socially optimal production takes place where MSC = MSB, i.e. E2 where D2 is equal to S0.
This is also called decision making at the margin. Socially desirable production is Q2
(higher) and at this quantity price is higher at P2.
o The vertical distance between the two demand curves at the optimal production level is
equal to marginal external benefit.
o Market has failed as it is allocating too few resources in producing the good, i.e.
production is less than socially desirable output leading to problem of underproduction
equal to Q2- Q1.
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9.5 Government intervention to correct market failure
Objectives of government's microeconomic policies There are two economic justifications for
government interference in the market, i.e. to create efficiency and to create equity.
(i) Efficiency
Government can try to restore economic efficiency in case of market failure by using various policies
such as imposing indirect taxes (reduce overproduction), giving subsidies (overcoming
underproduction), providing products directly (overcomes free riding), using regulation and other
policy measures. This improves both productive and allocative efficiency.
(ii) Equity
EQUITY deals with 'fairness'. It is not the same as 'equal'. Whereas socialist and communist
economies aim for 'equal distribution of wealth', free market economies deal with 'equitable
distribution of income and wealth', i.e. free markets do not try to achieve equality in income and wealth,
however, these markets will try to make sure that the distribution of income and wealth is fair so that
no segment of the society remains divorced from the fruits of economic activity. It must be kept in
mind that even if markets are efficient, they may not be judged as equitable.
 Some free markets can lead to inequitable distribution of income and wealth. Free market is
linked to economic democracy (and not political democracy) where the decision to produce
goods and services is influenced by consumer choice and the consumer choice is reflected in
their buying power. People with more money will have more votes (one dollar buys one vote).
Hence the decision of what is produced in an economy is influenced by the rich and the poor
may remain at a disadvantage. This leads to a situation where some people may own several
houses while others may be homeless. This is judged by some as unfair, inequitable, and
undesirable.
 However, what is considered fair and equitable is debatable and comes into the ambit of
normative economics- the part of economics where clear value judgments are made between
what is 'right' or 'wrong'. The role of economist is to identify inequality that allows others to
judge its desirability.
 If government feels that the outcome of market economy is unacceptably inequitable, it may
use policies to reduce this inequity.
Two elements of equity

Equity has two aspects:
 Horizontal equity where consumers and others with the same circumstances should pay the
same level of taxation.
 Vertical equity where taxes should be fairly apportioned between the rich and the poor in
society.
Government intervention is needed whenever there is a market failure. Government can intervene in
market in different forms which are summarized below. Government intervention to correct negative
production externality Government can take following actions to correct market failure due to negative
externality.
 Regulation - Government can lay down maximum pollution levels or might even ban pollution
creating activities altogether. This will lead to a leftward shift in the supply curve. In the figure
above, the government can aim to fix output at Ch. Government can set minimum age at
which a person can buy a product (e.g. alcohol, cigarettes and lottery ticket) thereby reducing
demand for the product. Government can set distribution controls such as regulating sale of
certain drugs through prescription of doctor only).
o Advantage- These steps would either reduce supply or reduce demand leading to a fall in
production and hence controlling negative externality.
o However, there are following problem with using regulation: It is often difficult for
government to fix the right level of regulation to ensure efficiency. Regulation might be too
lax or too tight. It does not allow market mechanism to operate. Government will incur
administrative costs in enforcing the law.
o There is some parentalism as government thinks it knows what is better for the consumer.
It, therefore, reduces choice (especially if a produce is banned or an age groups is
restricted to use it).
 Indirect taxes- Government can charge an indirect tax equal to the marginal external cost
(T=MEC). This will increase the cost of goods and shift the supply curve leftward. This
internalizes the externality by bringing it back into the framework of market mechanism and is
hence favoured by economists. This will lead to a reduction in quantity traded and an increase
in price. This will remove the problem of over production. Black markets can emerge for
products that are banned and there can even be smuggling of goods.
 Indirect taxes- Government can charge an indirect tax equal to the marginal external cost
(T=MEC). This will increase the cost of goods and shift the supply curve leftward. This
internalizes the externality by bringing it back into the framework of market mechanism and is
hence favoured by economists. This will lead to a reduction in quantity traded and an increase
in price. This will remove the problem of overproduction.
o Advantages of this method are listed below:
 It allows the market mechanism to allocate resources. Government collects
revenue.
 It is difficult to evade.
o Problems of using indirect taxes include:
 Difficulty in setting the optimal tax which must be equal to MEC. It is difficult to
place a monetary value to external costs. A higher estimation of external costs
leads to higher taxes and lower production. An underestimation of external
costs would mean lower taxes and negative externalities will remain.
 It is inflationary and leads to cost-push inflation.
 It reduces output and increases unemployment. It can even lead to a reduction
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in exports.
 It is regressive and poor bear the majority of the tax burden.
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o It is effective when demand and supply are elastic so that there is a greater fall in
quantity.
 Extending property rights- Externalities often arise because property rights are not fully
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allocated. For example, nobody owns the atmosphere or the oceans. Government can extend
the property rights to minimize externality. For instance, it can give water companies the right
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to charge companies which dump waste into rivers or the sea. It is a way to internalize the
externality - eliminating the externality by bringing it back into the framework of the market
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mechanism. If a polluting firm has property rights, then those who are affected by its activities
could pay the polluter to reduce the scale of activity and hence the pollution. The polluter will
require payment equal to its loss of profit.
 If those affected by negative externalities are assigned property right, then a polluting firm
may be sued by the owners and obliged to compensate them in some way. An individual with
property rights is likely to have a very low bargaining power against large MNCs. The chance
of success of property right owners will be greater if others with property right join the action
against the polluting firm.
o Advantage is that the government does not have to assess the cost of pollution and the
affected of externality receive a direct benefit from polluting firm (they charge them a
price for dumping waste).
o The problem is that the government may not be able to extend property rights and the
owners of property rights find it difficult to assess the value of those rights.
 Tradable pollution permits - POLLUTION PERMITS are a form of license given by
governments that allows a firm to pollute up to a certain level. It is a free market solution as
they can be bought and sold. If a firm emits a lower level of production, it can sell its spare
permits in the market to firms needing to buy more permits since they have used up those
allocated to them. The figure shows the operation of the system. When the system is
introduced, the demand and supply of permits are D1 and S1 respectively. The market price is
Pi. Assume that over time demand for permits rise as more pollutants are being emitted.
Given that supply is fixed, the price rises to P2. This gives polluting firms incentive
environmentally efficient. to become more
Government can even do more by planning to reduce supply over time. The supply curve shifts to
S2 and price of permits rises to P3. This puts even more pressure on firms to invest in greener
technologies.
However, the drawback of this approach is that if too many permits are issued and the price of
permits is very low, then it will not create incentives for firms to invest in green technologies.
Government will then have to reduce the pollution permits to achieve its objectives.
Government intervention to correct negative consumption externality

This market failure can be corrected by imposing indirect taxes, using legislation (such as banning
smoking in public places, and regulating aircraft take-off and landing times to reduce noise pollution),
and provide information (such as placing warnings and photographs on cigarette packs to deter
smoking).
Government intervention to correct positive consumption externality
Government can take following actions to correct the market failure resulting from positive externality.
 Subsidies - Government can provide subsidies to producers equalling the marginal external
benefits (S=MEB). This will reduce cost of good and shift the supply curve to the right. This
will lead to an increase in quantity and a reduction in price overcoming the problem of
underproduction.
o Advantages of this method are as follows:
 It allows the market mechanism to allocate resources.
 Subsidies lead to lower prices and therefore controls inflation.

 It also leads to higher output leading to lower unemployment and more

exports.
o Problems of this method include the following:
 Difficult in placing a monetary value to external benefits - It leads to the
problems of deciding on optimal amount of subsidy provided. A higher
estimation of external benefits leads to higher subsidies and much higher
production. An underestimation of external benefits would mean lower
subsidies and underproduction will remain.
 It will increase government expenditure subsidies have to be paid out.
 Government will have to raise taxes to provide subsidies. This leads to a
greater burden on the taxpayers.
 There is an opportunity cost of this decision as the same funds could have
been employed in another use such as building schools and hospitals or in
subsidizing another industry.
o It is more effective when demand and supply is elastic so that there is a greater
change in output.
 Regulation - Government may force consumers to purchase a positive externality, e.g.
government may make education compulsory. It leads to a rise in the demand for the product.
Government can also provide the good for free or at low prices. For example, governments in
many developing countries provide low-cost vaccines against some diseases such as
hepatitis and influenza. Polio vaccines are provided for free in many countries.
o Advantages
 These steps would increase demand or increase supply leading to an increase
in output levels hence controlling positive externality.
 Government expenditure would be lower in case of regulation (making it
compulsory to take education).
o However, there are following problem with using regulation:
 It is often difficult for government to fix the right level of regulation to ensure
efficiency. Regulation might be too lax or too tight.
 It does not allow market mechanism to operate.
 Government will incur administrative costs in enforcing the law.
 Provide information - Government can provide more information to persuade consumers to
buy more goods that produce positive externalities. In most developed countries, people are
urged to eat more fruit and vegetables to reduce the possible risk of health problems such as
diabetes and obesity.
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NUDGE THEORY is a concept that argues that positive reinforcements and indirect suggestions
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to try to achieve non-forced compliance can influence the motives, incentives and decision
making of groups and individuals at least as effectively as direction instruction, legislation or
enforcement.
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o Nudge theory is a way of achieving beneficial economic and social outcomes

without the need for regulations. Thaler and Sunstein argued that by presenting
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choices in a better way, people make wiser decisions.

o It is a form of parentalism whereby governments or individuals interfere with the
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affairs of people against their will yet with their best interests in mind.

o In the case of market failure, it can be applied through letters, emails or personal
communications. An example can be use of media campaign that focuses on the
benefits of cycling or of using other more environmentally acceptable forms of
transport like buses, in order to reduce the number of cars on roads.
Nudge theory has limited effectiveness and can be most effective if it is used alongside other
policies.
Other forms of government intervention

Maximum prices to overcome consumer exploitation Government sets maximum prices if it believes
that prices are too high and consumers are being exploited; or that the product is very important and
the price too high for consumers to afford (such as housing, education and food). These can be
imposed in monopoly markets to moderate prices and are especially used by many countries for
setting prices for utilities. An effective maximum price is below the market equilibrium price and it can
create shortages and black market
Price stabilization
Government may want to protect the real incomes of both consumers and suppliers by stabilizing
prices (by using minimum prices and buying and selling stock) in those markets which are susceptible
to price fluctuations (such as agriculture).
Direct provision
Government at times provide certain goods (such as public goods and merit goods) directly because
in the absence of government provision, these goods will be underprovided or may not even be
produced in the market.
Privatization
PRIVATIZATION refers to the sale of publicly owned businesses, assets or services to the private
sector; and it also includes deregulation and contracting out of former public sector activities.
There are however drawbacks of privatization.

 It creates private sector monopoly and firms will continue some of the practices of the
monopoly which does not lead to efficiency increase as expected.
 If there are natural monopolies, they are best left to the public sector.
 Private firms still have to be regulated to ensure that they are not using unfair practices and
that they are not exploiting the consumers. This leads to extra costs for the government.
Regulation
GOVERNMENT REGULATION is a form of intervention where there is use of legal intervention to
force consumers and producers to behave in certain ways. It is used when there is market failure and
tries to achieve an outcome that is more desirable than outcome achieved by free market. Some of
the examples of regulation are given below.
 Quality control to overcome consumer exploitation;
 Price controls;
 Labour laws such as national minimum wages, maximum working hours, enforcement of
employment contracts, protection against unfair dismissal and discrimination, etc.;
 Environmental laws to reduce pollution;

 Laws to stop excessive depletion of natural resources (such as natural pasture, forests and
fish stock); and
 Laws to control behavior of monopolies.
Economists generally do not favour use of regulation as it distorts operations of the market. Instead of
regulating the market, the government may use taxes and subsidies to promote or discourage
activities.
Steps to control monopolies

These may include various steps taken by the government such as:
 Outlawing formation of monopolies (Mergers policy) - Formation of monopolies is generally
considered undesirable and government would not allow merger of firms that creates a
monopoly.
 Forbid certain types of monopoly behaviour (such as predatory pricing) – PREDATORY
PRICING is deliberate setting of price below costs to destroy competition. This forces
competitors out of the market; discourages new firms from entering the market; strengthens
the monopolist's power; and leads to inefficiency.
 Insist on certain standards of provision so that it ensures that a minimum standard of quality is
being met in the monopoly market.
 Insist on certain levels of competition in the industry.
 Marginal cost pricing- MARGINAL COST PRICING is setting price equal to marginal cost.
Government can force monopolies to set price equal to marginal cost. This reduces price and
increases output. It allows leads to achieving allocative efficiency.
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9.6 Policies to redistribute income and wealth
INCOME is the reward for the services of a factor of production such as wages and salaries for
labour, rent for land, interest for capital and profit for enterprise. WEALTH is the accumulation of
stock of assets such as property, shares, bonds or bank accounts. These assets can provide income
stream in the future.
Measuring inequality
1. Lorenz curve
LORENZ CURVE is graphical representation of inequality. As shown in the figure, a 45° line on the
diagram represents a completely equitable distribution of income.
 Area A shows the extent of inequality. As inequality rises, this area increases. When area A
shrinks, the distribution of income becomes more equal.
2. Gini coefficient
GINI COEFFICIENT is a numerical measure of the extent of inequality. It is calculated using the
Lorenz curve:
Area A
Ginni coefficient =
Area A + Area B
 If income distribution is equal, Area A will be zero and Gini coefficient will have a value of 0.
 If all income is accrues to just one person, Area B will be zero and Gini coefficient will be 1
 Norm is for the Gini coefficient to be within the two extremes. A Gini coefficient of 0.3
therefore indicates a more equal distribution of income than a coefficient of 0.5
 The trend in the coefficient is more important as it indicates whether income distribution is
becoming more equal or unequal over time.
Policies to redistribute income and wealth

Government can adopt policies to tax the rich and subsidize the poor to decrease the income
disparities in the economy. Government can use various measures to remove inequity. Some of the
types of policies are described below.
(i) Monetary benefits

Monetary benefits are a means to distribute income to the poor by taxing the rich and giving benefit to
the poor to raise their disposable income. There can be two types of such benefits.
a. Means-tested
MEANS-TESTED BENEFITS are only paid to those who have low income levels, e.g. unemployment
benefits. They are the ones who are in most need. However, the drawbacks of this approach is that it
is not always claimed by those for whom it is designed and it can lead to poverty trap.
POVERTY TRAP is where an individual or a family are better off on means-tested benefits rather
than working. This occurs where there is a low income tax threshold and generous mean-tested
benefits are given up to a certain level of income.

b. Universal benefits
UNIVERSAL BENEFITS are benefits that are available to all irrespective of income or wealth such as
universal state pensions and child benefits. The drawback of such an approach is that it is expensive
and benefits are not just paid to those who are in need.
(ii) Tax system

Government can use different taxation policies to reduce inequalities in income and wealth. Taxes,
however, are also a source of revenue for the government. The impact of different taxation policies
on individuals is described below
Progressive taxes
a) PROGRESSIVE TAX is a tax where the revenue collected rises more than proportionally to a
rise in income. Income tax is a good example of a progressive tax where the rate of tax
increases with the increase in income. Since the rich pay a higher percentage of their income
in taxes and the poor pay a lower percentage of their income as tax, the differential in income
between the rich and the poor falls
b) Regressive taxes
REGRESSIVE TAX is a tax where the ratio of tax paid to income falls as income rises.
Indirect taxes such as value added tax or general sales tax are an example of regressive tax.
Regressive tax adds more burden of tax on the poor and results in an increase in income
disparities.
(iii) Other policies
• Direction provision of goods and services
Government sometimes directly provides certain goods and services (such as health, education and
defence) free of charge to the consumers. The expense on providing these services is borne by the
tax payers as the government raises more taxes to finance these expenses. If these services are
used equally by all citizens, then the lowest income groups gain most as a percentage of their
income. This leads to a reduction in inequality
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9.7 Effectiveness of government policy

GOVERNMENT FAILURE refers to when government intervention to correct market failure causes
further inefficiencies. Government may face following problems:
• Imperfect information
• Undesirable incentives
• Policy conflicts
Problems of imperfect information

Government collects information to develop its policies. The problem arises when government
collects incorrect information which may lead to policies that increase inefficiency. Some of the
examples of such inaccuracies are given below.
• Lack of information about true value of an externality - It is often difficult to give an accurate
monetary value to the effect of an externality such as pollution.
Overestimation of environmental costs will lead to a higher level of indirect tax imposed on the
product leading to underproduction of the good.
• Lack of information about the level of demand for a product - Government needs to have a very
accurate demand forecast if it were to provide the good directly to
consumers. An inaccurate demand forecast will lead to wrong production levels creating inefficiency
in the economy.
Problems of undesirable incentives
Government policies may create inefficiencies because of creation of undesirable incentives in the
market. Some of the examples of undesirable incentives are given below.
• Impact of income tax on incentive to work- Higher marginal rates of taxation2 create disincentive for
people to work harder and gain more income leading to reduced efficiency in the economy. Similarly
an indirect tax leads to deadweight loss in the economy creating loss in welfare.
• Political motives - Politicians may design policies to remain in power than to improve economic
efficiency. They may avoid an unpopular tax on a product with negative externality because of fear of
losing voters.
• Conflicting motives of public sector enterprises- Public sector enterprises do not have a profit
motive. Lack of clear motive leads to inefficiency in public sector entities.
Problems of distribution/policy conflicts

Whereas government intervention takes place on the ground of reducing inequity in income and
wealth of the rich and the poor, the actual effect of government policy may end up in an increase in
inequity.
• For example, imposition of any tax may have distributional effects. Tax on energy use may be
aimed at reducing harmful emissions of greenhouse gases. However this has different effect on
different groups of people. If the tax is on the use of domestic fuel, the older members of the society
may feel greatest effect because they use proportionately more domestic fuel for heating. This may
lead to inequity in society.
• Another example is subsidies on costs of fossil fuels. These encourage production and their use in
coal-fired power stations resulting in increased environmental pollution. On one hand, these subsidies
make manufacturing sector more competitive and increase employment. On the other hand, these
are not consistent with the need for more sustainable development policies.

• Another example is the deregulation of air transport market in many countries. This has increased
competition, reduced airfares and increased demand for air travel. Whereas it improves
transportation services but it has negative consequences in the form of reduced fuel resources and
increase in global warming. It can therefore be concluded that government intervention may be
necessitated by the failure of markets, however, it at times leads to furthering inefficiencies in the
market rather than removing them.
Marginal rate of taxation is the percentage of the last dollar of income that is paid in taxes. Marginal
rate of tax is greater than average rate of tax in a progressive tax system.
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9.8 Deadweight loss

DEADWEIGHT LOSS refers to a reduction in total surplus (consumer and producer) that results from
a market distortion, such as a monopoly, a tax or a negative externality. There is a loss of economic
welfare, i.e. potentially desirable production and consumption does not take place.
Deadweight loss due to monopoly- Discussed in the last topic
Deadweight loss due to externalities- Discussed in the previous section
Deadweight loss due to imposition of indirect tax of a product In a free market (without government
intervention) the market equilibrium takes place where demand (Dd) and supply (Si) curves intersect.
The initial equilibrium therefore takes place at price Pi and output Qi. Imposition of an indirect tax by
the government leads to reduction in supply as producers increase prices. This leads to leftward shift
in the supply curve and the new supply curve is S2. New equilibrium is at a higher price P2 and a
lower output 02.
Imposition of indirect tax therefore leads to a reduction in desirable production and consumption that
leads to welfare loss in the economy. The shaded triangle represents the welfare loss or the
deadweight loss resulting from imposition of indirect tax.
It can hence be shown that excessive taxation can undermine national competitiveness. It leads to
lower investment, lower production and higher prices. This leads to rising unemployment and lower
exports.
CBA is different from private sector investment.
• Private sector investment focuses on private benefits and costs only and uses decision making tools
such as NPV and IRR.
• CBA differs from private sector investment in two main aspects.
o It seeks to include all costs and benefits (social) and not just private ones.
o It imputes shadow prices on costs and benefits where no market price is available, e.g. it has to
estimate the value the degradation of scenic beauty in case of building new houses on an attractive
area.
Framework of CBA
CBA uses four stages discussed below.
1. Identify all relevant costs and benefits
The first step in CBA is to identify all costs and benefits that can arise from a particular project.This
can involve establishing:
• Private costs- Costs that accrue to the decision maker only, e.g. cost of raw material of a new
construction project.
• Private benefits- Benefits that go the decision maker only, e.g. revenue generated from the
construction project.
• External costs - Costs that are borne by the third parties because of a decision, e.g. a new
construction project can lead to more traffic and loss of scenic beauty.
• External benefits- Benefits that are received by third parties or the community because of a
decision, e.g. new jobs created and increase in business opportunities in the community as a result of
a construction project.
Problems faced in this stage include the following:
• It is difficult to establish external costs and benefits because they are not easy to define in a discrete
way.

• It is not always possible to draw the line in terms of a physical or geographical cut-off, e.g. spill over
effects of a new retail development are wide-reaching and often affect people and communities way
beyond the immediate vicinity of proposed development.
2. Putting a monetary value on all relevant costs and benefits
It is relatively straightforward where market prices are available, e.g. in case of new retail
development, monetary value can be put on increased profits arising from development.
• Where no market prices are available, a monetary value must be imputed for both cost and benefits,
e.g. valuation of time, especially travel time and savings in travel time, is difficult to calculate.
Similarly imputing costs of accidents is difficult. Problems faced in this stage include:
• Putting monetary values where no market prices are available. Estimates need to be made in such
cases.
• This can result in overestimation or underestimation of costs and benefits leading to a sub-optimal
decision.
3. Forecasting future costs and benefits

Future costs and benefits need to be estimated where a project will stretch into the future and is likely
to have longer-term implications.
• Economists apply statistical forecasting techniques to estimate costs and benefits over many years.
These techniques may be crude.
• This stage is particularly important to proposed projects where massive expenditure is involved and
most of the costs and benefits arise in the long term.
• This stage may not be needed if two alternatives are being considered and the long term implication
may be same and would not affect the decision. Problems in this stage can include:
• Difficulty in identifying and forecasting future costs and benefits.
• Statistical techniques used are often of a very crude nature and can result in over- or under-
estimation of costs and benefits.
4. Decision making- interpreting results of CBA

In this last stage, the results of the earlier stages are drawn together so that outcome can be
presented in a clear manner to aid decision.
• If value of social benefits are greater than value of social costs, the project is worthwhile and
provides an overall benefit to the community. Such project may be undertaken.
• If value of social costs are greater than value of social benefits, then there is an overall loss to the
community and the project should not be undertaken. The problems in decision making arise
because of the problems listed in the earlier three stages.
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CBA- Limitations
Some of the limitations of CBA are already discussed and are summarized below:
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• Problems of identifying costs and benefits.

• Difficulty in putting monetary value especially where no market prices are available.
• Forecasting difficulties of future costs and benefits.
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There are other problems particularly when it comes to the acceptance of the outcome by the
community as a whole. They can include the following:
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• CBA does not satisfactorily reflect the distributional consequences of certain decisions particularly
when public sector investment is involved. For example, in case of a new retail development, external
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costs are likely to be highly localized while external benefits (e.g. employment creation) are likely to
be widely spread.
• In some instances, the outcome of CBA is rejected for political reasons, e.g. many public sector
projects are very controversial and subject to much local aggravation form pressure groups.
Conclusion
• The four stages of CBA provide a coherent framework by which decisions can be made in situation
of market failure. It considers all costs and benefits to the society.
• However, the methods have several limitations as discussed above.
• It still cannot be dismissed as irrelevant as it brings outs important issues involved in a decision that
must be considered by decision makers.
• CBA hence should be used as an aid and not as a replacement for decision making.


June 2011, 22
Question 2
The use of cars causes market failure. To achieve an efficient use of resources it would be better if
governments intervened to affect bolh the production and the use of cars.
Explain the meaning of the terms ‘market failure' and the efficient use of resources’ and analyse
whether economic theory can be used to support this argument. [25]
Marking scheme
Candidates need to explain the two terms, market failure and the meaning of the efficient use of
resources, and then consider the argument Market failure can be explained by reference to possible
excessive profits, the need for very large investments, the existence of externalities and of merit
goods, and of the need for public goods. Economic efficiency should be explained in terms of
productive and allocative efficiency.
Government intervention can be through regulation, taxation or subsidies. There are negative and
positive externalities from car use. Negative externalities include pollution. Positive externalities
include less crowded public transport with greater comfort; benefits from the expenditure of the tax
receipts Unlike other positive externalities where subsidies have been used, it has never been
suggested that subsidies ought to be used to increase the positive externalities from private car use.
Any subsidies given are used to make alternative public transport more attractive. However, taxes
have been used to decrease negative externalities. Taxing the use erf cars is usually presented In the
context of negative externalities to achieve allocative efficiency. Taxing production might not result in
productive efficiency.
L4 Fora thorough explanation of both efficiency and market failure and a competent discussion of the
role of the government in promoting efficiency overcoming market failure. A reasoned conclusion
should be presented
Example candidate response
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Cars are modern means of transport and it is inevitable that everyone relies on it to travel from one
place to another. However production and usage of cars may not be beneficial to the whole economy
as it causes pollution and depletion of natural resources. There will be market failure and inefficient
allocation of resources.
Market failure refers to an insufficient allocation of resources where there exists negative
externalities, under – provision of merit goods, non provisen of public goods and even imperfect
markets. Negative externalities include pollution and traffic jam. Under provision of merit goods exist
due to lack of information while public goods are not provided because of free rider problem. Free
rider problem means a situation where everybody is waiting for somebody else to produce a public
good for benefit of the whole economy. Imperfect markets are markets which do not produce are
allocative and productive efficient points.
Efficient allocation of resources include allocative efficiency and productive efficiency. Allocative
efficiency occurs when price equals marginal cost which means there is production of goods and
services according to demand and supply of the economy. Productive efficiency occurs when price
equals to minimum average cost where production takes place at its lowest cost. In other words,
efficient allocation of resources refers to an economy producing at its production possibility curve
(PPC) and the three economic problems of for whom to produce, how to produce and what to
produce have been solve.
Diagram
At point A there is a underutility of resources and production is inefficient. At point B, there is efficient
allocation of resources to produce at that point. Production is unattainable.
Productive efficiency is where P = minimum AC
Diagram
If production is at X, then productive efficiency is not achieved and output has to be increased and
price lowered so that cost of production is at minimum AC. If it is at Y, then, price has to be lowered
and output decreased
Allocative efficiency is where P = MC (marginal cost)
Diagram
The pint where P equals to MC is allocative by efficient and points a and b are not allocatively
efficient. Price and output at b is too high whereas price and output at a is too low.
However, according to principle of paret optimality, Paret efficiency states that when someone is
better off, another will be worse off. For example, when John is able to enjoy more goods.All will be
worse off than before. Therefore, government intervention may be necessary to achieve efficient
allocation of resources.
Ways of government intervention in production and use of cars include regulation taxes etc. The
government intervenes so that pollution caused by usage of cars is reduced. Methods of intervention
include imposing road tax. For example, Malaysian government have increased the amount of road
taxes and price of tolls to discourage frequent use of cars and encourage the use of trains and other
public transports so that air and noise pollution can be reduced. Air pollution is a form of negative
externality.
Diagram
In the diagram above, when road taxes exist, the supply of car will decrease as cost of using cars
have increased. Therefore the quantity of cars on the road will decrease from Q0 to Q1 and cost of
using cars increase from P0 to P1. However, government intervention can cause deadweight loss as
shown in the shaded region. Dead weight loss are loss in potential welfare of consumers.
The government should also intervene so that there is no exploitation of natural resources in
production of cars. This would ensure that the current and future generations are able to consume
enough resources. The government sets regulations in production of cars such that only firms which
obtain approval and licences from the government are able to produce cars. For example the
government of Malaysia only issue licenses to perodua and proton for production of cars. However,
this will cause imperfect market structure where only two large firms are involved in production of
cars, i.e. monopoly market will exist and consumers welfare may be comprised due to high prices and
low output of a duopoly firm. The workings the invisible hand – price mechanism will also be affected.
Besides, the government intervenes so that quality of cars produced are high and consumers are not
exploited. This is because consumers usually lack complete information when buying carts. So, the
government monitors the production of cars by carrying spot checks in car factories. The government
also made it compulsory for car manufacturers to do multiple test runs before launching the product
so that money spent on buying cars are worth it. For example the Malaysian government sends
officers to do spot checks in car factories so that production of cars are smooth and there are no
faulty engines being used in production. However, there may be loop holes and transparency
problems as some enforcement officers do not carry out the duty properly.
As a conclusion, government intervention is necessary to reduce market failure. However it does not
mean that there will be a perfect allocation of resources and an economy free of market failure. The
analysis above is at caeris paribus and in reality, government intervention is a much more complex
process.
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CH#10(Growth of Firms)
GROWTH of FIRMS
Large firms have been able to dominate both national and international trade by virtue of
their size and their ability to grow successfully both locally and internationally.
10.1 Reasons/Motives for growth

 Pursuit of profits - Many firms are looking to increase their profits. One way of
increasing profits is to increase the size of the business and its revenues.
 Reduction of average total cost over time - Larger size will enable a firm to get
economies of scale making it more competitive in the market. Such firms can reduce
their prices while maintaining their profit margins.
 Aim for more market share - Higher market share will increase sales and profits of
a firm. Some firms can become so dominant that they can become a monopoly in the
market (in which case this will be called a monopoly motive). Other firms can use it
as a defensive strategy in anticipation of actions by rivals.
 Saturated local market- Firms try to grow internationally when they find that their
local market has saturated.
 Diversification of product range- Diversification refers to a reduction in risk
because of spreading investment (and hence risk) into a portfolio of assets. A multi-
product firm is able to spread its risk into different markets. A loss in one product
category can be offset by profits made in several other categories.
 Economies of scope - Apart from economies of scale, a company can get
ECONOMIES OF SCOPE, i.e. a reduction in cost per unit because of increase in the
scope of activities. For instance, a company may use its existing facilities to produce
more categories of goods hence reducing the cost of producing a product. Similarly,
salesman's cost per unit will be reduced if he is able to sell more categories of goods
than selling just one type of good.
 Capturing resources of another business - Firms enter into merger and
acquisition activity to capture the resources of other businesses. These resources
can include their intellectual property, cash resources, management skills,
technology etc. Sometimes companies acquire other companies for the purpose of
dismantling the firm and selling it in parts. This is called 'asset stripping'. This is
particularly useful if the acquired firm is underperforming and the value of its parts is
considered to be greater than the whole firm.
 Closeness to customer - Firms at times grow internationally to get closer to the
customer. This can both reduce their transportation costs (especially useful for
weight adding processes) and increase their knowledge about customers (essential
for new product development).
 Closeness to raw material source- Firms expand internationally to get closer to the
raw material source. Access to raw material is a critical success factor in many
extraction industries.

10.2 Methods of growth
Firms can grow (i) internally or (ii) externally.
Internal growth
INTERNAL GROWTH refers to the decision of the firm to expand by increasing its own
branches, factories and stores. This is usually achieved by a firm ploughing back its profits in
the business. Such growth usually takes place when national economy is growing (i.e. in
boom). Internal growth has major advantages of preserving the culture of the organization,
and leading to minimal management problems. However, the drawback is it leads to a slow
rate of growth.
External growth
EXTERNAL GROWTH refers to the decision of a firm to grow by joining (takeovers and
mergers) with other firms. TAKEOVER takes place when a firm is able to get controlling
interest in another business (usually by buying more than 50% shares of the business).
MERGERS refer to two firms deciding to combine their operations in a bid to reduce their
cost and improve efficiency. Merger activities usually take place when industry needs
consolidation in assets. This usually takes place in the time of recession or when profits are
falling. Firms, through mergers, are able to reduce competition and get economies of scale,
hence, enabling them to efficiently compete in the market. External growth has the
advantage of achieving rapid growth. However, this comes at the expense of high premiums
paid for the acquired firm; and cultural and management problems of merged firms.
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10.3 Integration - Direction of growth

Firms have many options when deciding to grow. They can integrate (i) horizontally, or (ii)
vertically, or (iii) venture into conglomerate integration.
Horizontal integration
HORIZONTAL INTEGRATION refers to the expansion of the firm in the same industry at the
same level in which it was already operating. For example, if a spinning mill decides to
increase its capacity by opening a new factory, this would be referred to as horizontal
integration. The major benefits of horizontal integration are that
 it enables a firm to get economies of scale and
 increase its market share.
The major drawback of this method is that
 it does not allow the firm to diversify its risk, and
 it may lead to monopoly investigations.
Vertical integration
VERTICAL INTEGRATION refers to the expansion of the firm in the same industry but at a
different level than its existing operations.
 If the business decides to acquire its supplier, it is called BACKWARD
INTEGRATION.
 If the firm decides to acquire its distributor, it is called FORWARD INTEGRATION.
The major benefits of vertical integration include:

 capturing profit margins of suppliers and distributors,
 controlling quality ofraw material, and
 getting control over distribution network.
Major drawbacks of this approach are:

 lack ofmanagement experience, and
 limited gainfrom economies of scale.
Conglomerate diversification
CONGLOMERATE DIVERSIFICATION refers to the expansion of the firm in unrelated
industries (i.e. into new industries).
The major benefits include:
 diversification of risk, and
 opportunistic investment.
Major drawbacks include:
 lack of management experience,
 no gain from economies of scale, and
 moving away from core activities

10.4 International growth
INTERNATIONAL GROWTH refers to expansion of firms outside their national boundaries.

Firms can grow internationally by
(i) exporting locally manufactured products to foreign countries,
(ii) entering into licensing agreements with firms,
(iii) establishing; o/nf ventures with foreign partners, or
(iv) setting up directly [foreign direct investment- FDI) in other countries.
Reasons for international growth

 Saturation of domestic market - This may be caused by too much competition in
the market that leads to a fall in growth of the firm. To find growth, firms may decide
to expand internationally.
 Domestic recession - Domestic recession will lead to lowering of firm's sales. Firm
can overcome its difficulties and utilize unused capacity by selling its goods in foreign
markets.
 Prospects of economies of scale - Firms can try to achieve minimum efficient scale
by increasing its operations. If local market is too small to achieve efficiency, a firm
may decide to expand internationally to increase the scale of operations and hence
get economies of scale. Economies will also enable a firm to get cost advantages
and allow the firm to compete more successfully in foreign markets.
 Identification of new growth markets - China, Brazil and India have been some
examples of growth markets in recent history. Because of their tremendous growth
and hence profit potential, many firms have decided to enter these markets and start
their operations in these countries.
 Access to materials, technology, patents or new management techniques –
Firms expand to get access to key resources. For instances, many technology firms
have their offices in Silicon Valley so that they can get access to latest technological
developments. International diversification - International growth will enable a firm to
spread its risk in different markets so that if it is facing losses in one market, these
losses can be overcome by profits made in other markets. This also reduces the
political and economic risk associated with operating in one country alone.
 Low labour costs - Many firms have shifted their production facilities from
developed countries to the developing countries (e.g. China) in search for low labour
costs that will reduce their cost of production and make them more competitive while
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at the same time increasing their profit margins
 Location specific advantages - These can include infrastructure facilities and
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government support. Government support can come in the form of subsidies and tax
breaks and other incentives for the foreign firms investing in the country. Closeness
to customer - International FDI enables a firm to get closer to its customers.
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Knowledge of their needs and the trends is essential for coming up with new product
developments that can satisfy customers' needs better than competitors' products.
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Avoiding import barriers - FDI enables a firm to set up its production facilities in a
foreign country. This enables the firm to avoid paying import duties.
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10.5 Multinational corporations
MULTINATIONAL COMPANIES are firms that are headquartered in one country but have
their operations in many countries. Some of these MNCs derive a substantial part of their
total revenue from non-domestic sources.
The objective of a MNC is to maximize profits. Such firms will switch their investment to
countries which offer the highest return to capital employed. Their strategy sometimes
involves rationalizing production and writing off investment in particular locations. MNCs
however face the problem of communication and control, and other management issues, if
the MNC becomes too large to control, the management may decide to break up the firm,
sell off least profitable parts, and concentrate on core activities.

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CH#1(Utility)

MUt  TUt - TUt-1

Basic assumptions of Utility Theory (Cardinal approach)

 Utility can be measured in utils;

By Hammad Malik (Chand Bagh, L.G.S, Roots) 0331-4344108

1.1 Law of Diminishing Marginal Utility (DMU)

PRINCIPLE OF DIMINISHING MARGINAL UTILITY

Quantity Marginal Total

By Hammad Malik (Chand Bagh, L.G.S, Roots) 0331-4344108

1.2 Consumer’s Equilibrium

Law of equi-marginal utility

 Consumers have limited income and cannot

By Hammad Malik (Chand Bagh, L.G.S, Roots) 0331-4344108

PRINCIPLE OF EQUI-MARGINAL UTILITY

MUA MUB MUC MUN

o As he consumes more of product A, the marginal utility of product A falls. And as

It can be illustrated with the following example:

Units MUx MUx/Px MUy MUy/Py

By Hammad Malik (Chand Bagh, L.G.S, Roots) 0331-4344108

1.3 Deriving demand curve

Using Law of Equi-Marginal Utility

Using Law of Diminishing Marginal Utility

By Hammad Malik (Chand Bagh, L.G.S, Roots) 0331-4344108

Market demand curve

Market demand =  indvidual demand

By Hammad Malik (Chand Bagh, L.G.S, Roots) 0331-4344108

1.4 Paradox of Value

By Hammad Malik (Chand Bagh, L.G.S, Roots) 0331-4344108

1.5 Consumer Equilibrium and Money

By Hammad Malik (Chand Bagh, L.G.S, Roots) 0331-4344108

1.6 Utility of Money

1. Money experiences diminishing marginal utility

 The Law of Diminishing Marginal Utility

By Hammad Malik (Chand Bagh, L.G.S, Roots) 0331-4344108

2. Money does not experience diminishing utility

By Hammad Malik (Chand Bagh, L.G.S, Roots) 0331-4344108

1.7 Rationality or Irrationality

By Hammad Malik (Chand Bagh, L.G.S, Roots) 0331-4344108

By Hammad Malik (Chand Bagh, L.G.S, Roots) 0331-4344108

1.8 Impact of advertisement and change in income on

 Effective advertisement will lead to

By Hammad Malik (Chand Bagh, L.G.S, Roots) 0331-4344108

By Hammad Malik (Chand Bagh, L.G.S, Roots) 0331-4344108

1.9 Limitations of Utility Theory

By Hammad Malik (Chand Bagh, L.G.S, Roots) 0331-4344108

Budget Lines and Indifference Curves

2.1 Budget Line

Income = Px. Qx + Py. Qy

By Hammad Malik (Chand Bagh, L.G.S, Roots) 0331-4344108

2.2 Shifts in the Budget Line

Budget line can shift because of following reasons:

 The shift in budget line for a rise

By Hammad Malik (Chand Bagh, L.G.S, Roots) 0331-4344108

ii. Change in Price of One Product only

By Hammad Malik (Chand Bagh, L.G.S, Roots) 0331-4344108

iii. Change in Price of Both Products in Same Direction And in Same

By Hammad Malik (Chand Bagh, L.G.S, Roots) 0331-4344108

By Hammad Malik (Chand Bagh, L.G.S, Roots) 0331-4344108

v. Change in Price of Both Goods in opposite direction (income remaining

Increase in Income and Increase in Price of X

By Hammad Malik (Chand Bagh, L.G.S, Roots) 0331-4344108

Decrease in Income and Decrease in Price of X

Opposite movement in Income and Price of X

By Hammad Malik (Chand Bagh, L.G.S, Roots) 0331-4344108