CAF Economics Study Book

CA-Foundation: Economics Study Book
CA Foundation
Economics
Prof. Sandip Sengupta

Prof. Bhavesh Rajani
Bhagwati Education Institute Page 1


Index
Sl. No. Chapter Name Page No.
1. Nature & Scope of Business Economics 01 – 18
2. Theory of Consumer Behavior 19 – 31
3. Theory of Demand 32 – 56
4. Elasticity of Demand 57 – 70
5. Demand Forecasting 71 – 77
6. Theory of Supply 78 – 88
7. Equilibrium 89 – 92
8. Theory of Production 93 – 112
9. Theory of Cost 113 – 127
10. Price Determination in Different Market 128 – 134
11. Behavioral Principles 135 – 142
12. Monopoly 143 – 150
13. Monopolistically Competitive Market 151 – 152
14. Oligopoly 153 – 155
15. Business Cycle 156 – 163


Chapter – 01 – Nature and Scope of Business Economics
Economics is an important branch of social science, which deals with the behavior of human
beings in relation to economic activities. The term ‘Economics’ owes its origin to the Greek word
‘Oikonomia’ meaning ‘management of household’.
Economics is, thus, the study of how we work together to transform scarce resources into goods
and services to satisfy the most pressing of our infinite wants and how we distribute these goods
and services among ourselves.
In fact, out of social sciences, it is economics which has more practical applicability, hence
regarded as “Queen of Social Sciences”.
Economics, concerns itself not just with how a nation allocates to various uses its scarce
productive resources but it also deals with the process by which the productive capacity of these
resources is increased.
In the day-to-day events, we come across several economic problems like changes in price of
individual commodities as well as general price level changes; economic prosperity and higher
standards of living of some people despite general poverty of the masses; problems of
unemployment of certain class of persons or in some areas. These are some of the matters
connected with economic analysis. The study of Economics will help in analyzing the possible
causes contributing to these problems and might suggest a number of alternative courses, which
could be adopted for tackling these problems.
Consider the following situation.

It is your birthday, and your mother gives you `1000 as birthday gift. You are free to spend the
money as you like. What will you do? You have many options before you, like:
Option 1: You can give a party to your friends and spend the whole money on them.
Option 2: You can buy yourself a dress for `1000.
Option 3: You can go for a movie and eat in some restaurant.
Option 4: You can buy yourself a book and save some money.
What do you notice? You have so many options before you. You will have to go for one option or
a combination of one or more options. But why can’t you have everything? Given the choice you
would like to spend not only on your friends, but would also like to see movie, eat in the
restaurant, buy a dress and a book and save some money. But you cannot. Why? Because you
have only 1000 Rupees with you.

We can use our limited resources to satisfy only some of our wants, leaving many others
unsatisfied.
The two fundamental facts of economics are that:

i) Human beings have unlimited wants; and
ii) The means of satisfying these wants are relatively scarce form the subject matter of
Economics.
Hence, economics is the study of how the society uses its limited resources to satisfy its infinite
wants and how these resources are distributed among different sections of the society.
Definition of Economics
Several definitions of Economics have been given by different authors. For the sake of
convenience, let us classify the various definitions into four groups:
a) Science of wealth or Classical Economics
b) Science of material well-being or Neo-classical Economics
c) Science of choice making by Lionel Robbins
d) Science of dynamic growth and development by Paul A. Samuelson
We shall examine each one of these briefly.
Science of wealth
Although the activity of acquiring and increasing material wealth is as old as civilization, a
disciplined study of the wealth producing activities commenced back in 1776 when Adam Smith,
the father of Economics, published “The Nature and Causes of Wealth of Nations”. He defined
Economics as: “An inquiry into the nature and causes of wealth of nations.”
Many other classical economists also defined Economics:
According to J B Say, Economics is a “Science which deals with wealth”
According to J.S. Mill, economics is “The principal science of production and
distribution of wealth”.
Science of material well-being

Under this group of definitions, the emphasis is on welfare as compared with wealth in the
earlier group. According to Alfred Marshall
“Economics is a study of mankind in the ordinary business of life. It examines that

part of individual and social action which is most closely connected with the
attainment and with the use of the material requisites of well-being. Thus, it is on

the one side a study of wealth and on the other and more important side a part of
the study of man.”
This definition was propounded by Prof. Alfred Marshall in his book “Principles of Economics”,
published in 1890. This definition lays emphasis on welfare as compared to wealth.
Prof. Marshall clearly points that economics is first, a study of human welfare and only then is
the emphasis given on wealth. According to Prof. Alfred Marshall, wealth is a “mean” and
welfare is an “end”.
According to A.C. Pigou “The range of our inquiry becomes restricted to that part of
social welfare that can be brought directly or indirectly into relation with the
measuring rod of money”.
Science of choice making

Prof. Lionel Robbins of the London School of Economics gave a new definition to Economics in
his famous book “Nature and Significance of Economics” which he brought out in 1931.
Robbins gave a more scientific definition of Economics.
His definition is as follows:

“Economics is the science which studies human behavior as a relationship between ends and
scarce means which have alternative uses”.
a) Economics is a science: Economics studies human behaviour scientifically. It studies how
human beings use the scarce resources optimally under given constraints.
b) Human behaviour: this definition shifted the focus of economics on study of human
behaviour bringing to life the reasons behind as to when and how decisions are made by
individuals in the quest of satisfying their wants.
c) Unlimited ends: Ends refer to wants. It is a general human tendency that when one want is
satisfied, another want crops up. Thus, a choice has to be made between more important and
less important wants.
d) Scarce means: Means refer to resources. Resources may be natural (oil, mineral ore) or man-
made (capital goods, consumer goods). Wants are unlimited, but the resources (means) to
satisfy these wants are limited.
Example: A construction firm wants to produce steel, iron and cement. It also wants to
diversify geographically, but the amount of capital it has is limited. The labour force is also
limited. Availability of steel and iron is also scarce. Hence, it has to restrict itself to the
scarce means.

e) Alternative uses: Resources are not only scarce, but they can also be put to many uses. Thus,
a choice has to be made between the most urgent and the less urgent needs.
Example: coal can be used as a fuel for the production of industrial goods, it can be used
for running trains, and it can also be used for domestic cooking purposes and for so many
other purposes.
It follows from the definition of Robbins that Economics is a science of choice. An important
thing about Robbin’s definition is that it does not distinguish between material and non
material, and between welfare and non-welfare. Anything which satisfies the wants of the
people would be studied in Economics. Even if a good is harmful to a person, it would be the
subject matter of Economics if it satisfies his wants.
Science of dynamic growth and development.

Although the fundamental economic problem of scarcity in relation to needs is undisputed, it
would not be proper to think that economic resources - physical, human, financial-are fixed and
cannot be increased by human ingenuity, exploration, exploitation and development.
According to Prof. Samuelson “Economics is the study of how men and society choose,
with or without the use of money, to employ scarce productive resources which
could have alternative uses, to produce various commodities over time and
distribute them for consumption now and in the future amongst various people
and groups of society”.
Samuelson’s definition is known as a modern definition of economics. It is a combination of

wealth, welfare and scarcity definition. It includes choice making in the present and in the
future. Although the fundamental economic problem of scarcity remains undisputed, Samuelson
goes a step further and discuss how a society uses limited resources for producing goods and
services for present and future consumption of various people or groups.
Business Economics may be defined as the use of economic analysis to make business
decisions involving the best use of an organization’s scarce resources.
Joel Dean defined Business Economics in terms of the use of economic analysis in the
formulation of business policies. Business Economics is essentially a component of Applied
Economics as it includes application of selected quantitative techniques such as linear
programming, regression analysis, capital budgeting, break even analysis and cost analysis.

Microeconomics
The term Microeconomics is derived from the Greek word ‘mikros’, meaning “small”. In Micro-
Economics we study the economic behavior of an individual, firm or industry in the national
economy. It is thus a study of a particular unit rather than all the units combined. It is basically
concerned with the mechanism of allocation of given resources. Further, it is a partial
equilibrium analysis as it seeks to determine price and output in an industry independent of
those in other industries. We mainly study the following in Micro-Economics:
i) Product pricing;
ii) Consumer behaviour;
iii) Factor pricing;
iv) Economic conditions of a section of the people;
v) Study of firms; and
vi) Location of industry.
Thus, when we are studying how a producer fixes the prices of his products, we are studying
Micro-Economics. Similarly, when we are studying why an industry is located at a particular
place, we are studying Micro-Economics.
Example:
a) Study of lock out at TELCO, finding causes of failure of A & Co.
b) How does the change of price of a good influence a family’s purchasing decisions? If wages
rise, will the person be inclined to work more hours or less hours?
Macro Economics
The term Macro Economics is derived from the Greek word ‘makros’, meaning “large”.
It is the study of overall economic phenomena or the economy as a whole, rather than its
individual parts.
Thus, in Macro-Economics, we study the economic behaviour of the large aggregates such as the
overall conditions of the economy such as total production, total consumption, total saving and
total investment. It includes:
i) National income and output;
ii) General Price level;
iii) Balance of trade and payments;
iv) External value of money;
v) Saving and investment; and
vi) Employment and economic growth.

Thus, when we study why we continue to have balance of payments deficits, or why the value of
rupee vis à-vis dollar is falling or why saving rates are high or low in a particular country, we are
studying Macro-Economics.
Micro approach Macro approach
1. Studies a particular part or a component of the Studies the economy as a whole
economy
2. It is known as “Price Theory” It is known as “Income Theory”
3. Makes assumptions while studying an economy Doesn’t make any assumptions
4. It gives a worm’s eye view of an economy It gives a bird’s eye view of an economy
5. It is unrealistic study It is more realistic study
Example: Study of per capita income of India, under-employment in the agriculture sector,
savings of India causes of inflation, etc.
It may be noted that the classification of Economics into micro and macro-economics is purely
for analytical purpose. In fact, there is really no opposition between micro and macroeconomics.
Both are absolutely vital, and, in most cases, they play a complementary role, e.g. national
income cannot grow unless the production in individual firms and factories rises.
It is difficult to distinguish between the two terms as belonging to water-tight compartments.
What is macro from the national standpoint is micro from the world point of view. Similarly,
what is micro from a national angle becomes macro from a regional angle. Unless we define
what is the whole, we cannot say about a phenomenon whether it is micro or macro.
Nature of Business Economics

The economic world is extremely complex as there is a lot of interdependence among the
decisions and activities of economic entities. Economic theories are hypothetical and simplistic
in character as they are based on economic models built on simplifying assumptions. Therefore,
usually, there is a gap between the propositions of economic theory and happenings in the real
economic world in which the managers make decisions. Business Economics enables application
of economic logic and analytical tools to bridge the gap between theory and practice.
The following points will describe the nature of Business Economics:

a) Business Economicsisa Science: Science is a systematized body of knowledge which
establishes cause and effect relationships. Business Economics integrates the tools of
decision sciences such as Mathematics, Statistics and Econometrics with Economic Theory

to arrive at appropriate strategies for achieving the goals of the business enterprises. It
follows scientific methods and empirically tests the validity of the results.
b) Basedon Microeconomics: Business Economics is based largely on Micro-Economics. A
business manager is usually concerned about achievement of the predetermined objectives
of his organisation so as to ensure the long-term survival and profitable functioning of the
organization. Since Business Economics is concerned more with the decision making
problems of individual establishments, it relies heavily on the techniques of
Microeconomics.
c) Incorporates elements of Macro Analysis: A business unit does not operate in a vacuum. It is
affected by the external environment of the economy in which it operates such as, the
general price level, income and employment levels in the economy and government policies
with respect to taxation, interest rates, exchange rates, industries, prices, distribution, wages
and regulation of monopolies. All these are components of Macroeconomics. A business
manager must be acquainted with these and other macroeconomic variables, present as well
as future, which may influence his business environment.
d) Use of Theory of Markets and Private Enterprises: Business Economics largely uses the
theory of markets and private enterprise. It uses the theory of the firm and resource
allocation in the backdrop of a private enterprise economy.
e) Pragmatic in Approach: Micro-Economics is abstract and purely theoretical and analyses
economic phenomena under unrealistic assumptions. In contrast, Business Economics is
pragmatic in its approach as it tackles practical problems which the firms face in the real
world.
f) Interdisciplinary in nature: Business Economics is interdisciplinary in nature as it
incorporates tools from other disciplines such as Mathematics, Operations Research,
Management Theory, Accounting, marketing, Finance, Statistics and Econometrics.
g) Normative in Nature: Economic theory has developed along two lines – positive and
normative. A positive or pure science analyses cause and effect relationship between
variables in an objective and scientific manner, but it does not involve any value judgement.
In other words, it states ‘what is’ of the state of affairs and not what ‘ought to be’. In other
words, it is descriptive in nature in the sense that it describes the economic behavior of
individuals or society without prescriptions about the desirability or otherwise of such
behavior. As against this, a normative science involves value judgements. It is prescriptive in
nature and suggests ‘what should be’ a particular course of action under given
circumstances. Welfare considerations are embedded in normative science.

Business Economics is generally normative or prescriptive in nature. It suggests the

application of economic principles with regard to policy formulation, decision-making and
future planning. However, if the firms are to establish valid decision rules, they must
thoroughly understand their environment.
This requires the study of positive or descriptive economic theory. Thus, Business
Economics combines the essentials of normative and positive economic theory, the emphasis
being more on the former than the latter.
Scope of Business Economics

The scope of Business Economics is quite wide. It covers most of the practical problems a
manager or a firm faces. There are two categories of business issues to which economic theories
can be directly applied, namely:
1. Microeconomics applied to operational or internal Issues
2. Macroeconomics applied to environmental or external issues
Therefore, the scope of Business Economics may be discussed under the above two heads.
1. Microeconomics applied to operational or internal Issues
Operational issues include all those issues that arise within the organization and fall within
the purview and control of the management. These issues are internal in nature. Issues
related to choice of business and its size, product decisions, technology and factor
combinations, pricing and sales promotion, financing and management of investments and
inventory are a few examples of operational issues. The following Microeconomic theories
deal with most of these issues.
a) Demand analysis and forecasting: Demand analysis pertains to the behavior of
consumers in the market. It studies the nature of consumer preferences and the effect of
changes in the determinants of demand such as, price of the commodity, consumers’
income, prices of related commodities, consumer tastes and preferences etc.
Demand forecasting is the technique of predicting future demand for goods and services
on the basis of the past behavior of factors which affect demand. Accurate forecasting is
essential for a firm to enable it to produce the required quantities at the right time and to
arrange, well in advance, for the various factors of production viz., raw materials, labour,
machines, equipment, buildings etc. Business Economics provides the manager with the
scientific tools which assist him in forecasting demand.

b) Production and Cost Analysis: Production theory explains the relationship between
inputs and output. A business economist has to decide on the optimum size of output,
given the objectives of the firm. He has also to ensure that the firm is not incurring
undue costs. Production analysis enables the firm to decide on the choice of appropriate
technology and selection of least - cost input-mix to achieve technically efficient way of
producing output, given the inputs. Cost analysis enables the firm to recognize the
behavior of costs when variables such as output, time period and size of plant change.
The firm will be able to identify ways to maximize profits by producing the desired level
of output at the minimum possible cost.
c) Inventory Management: Inventory management theories pertain to rules that firms
can use to minimize the costs associated with maintaining inventory in the form of
‘work-in-process,’ ‘raw materials’, and ‘finished goods’. Inventory policies affect the
profitability of the firm. Business economists use methods such as ABC analysis, simple
simulation exercises and mathematical models to help the firm maintain optimum stock
of inventories.
d) Market Structure and Pricing Policies: Analysis of the structure of the market
provides information about the nature and extent of competition which the firms have to
face. This helps in determining the degree of market power (ability to determine prices)
which the firm commands and the strategies to be followed in market management
under the given competitive conditions such as, product design and marketing. Price
theory explains how prices are determined under different kinds of market conditions
and assists the firm in framing suitable price policies.
e) Resource Allocation: Business Economics, with the help of advanced tools such as
linear programming, enables the firm to arrive at the best course of action for optimum
utilization of available resources.
f) Theory of Capital and Investment Decisions: For maximizing its profits, the firm
has to carefully evaluate its investment decisions and carry out a sensible policy of
capital allocation. Theories related to capital and investment provide scientific criteria
for choice of investment projects and in assessment of the efficiency of capital. Business
Economics supports decision making on allocation of scarce capital among competing
uses of funds.
g) Profit Analysis: Profits are, most often, uncertain due to changing prices and market
conditions. Profit theory guides the firm in the measurement and management of profits

under conditions of uncertainty. Profit analysis is also immensely useful in future profit
planning.
h) Risk and Uncertainty Analysis: Business firms generally operate under conditions of
risk and uncertainty. Analysis of risks and uncertainties helps the business firm in
arriving at efficient decisions and in formulating plans on the basis of past data, current
information and future prediction.
2. Macroeconomics applied to environmental or external issues

Environmental factors have significant influence upon the functioning and performance of
business. The major macro-economic factors relate to:
a) the type of economic system
b) stage of business cycle
c) the general trends in national income, employment, prices, saving and investment.
d) Government’s economic policies like industrial policy, competition policy, monetary and
fiscal policy, price policy, foreign trade policy and globalization policies
e) working of financial sector and capital market
f) socio-economic organizations like trade unions, producer and consumer unions and
cooperatives.
g) social and political environment.
Business decisions cannot be taken without considering these present and future
environmental factors. As the management of the firm has no control over these factors, it
should fine-tune its policies to minimize their adverse effects.
Central Economic Problems

Human wants are unlimited and productive resources such as land and other natural resources,
raw materials, capital equipment etc. with which goods and services are produced to satisfy
those wants are scarce. The problem of scarcity of resources is felt not only by individuals but
also by the society as a whole. This gives rise to the problem of how to use the scarce resources
to attain maximum satisfaction. This is generally called ‘the economic problem’. Every economic
system, be it capitalist, socialist or mixed, has to deal with this central problem of scarcity of
resources relative to wants for them. The central economic problem is further divided into four
basic economic problems. These are:
i) What to produce?
ii) How to produce?
iii) For whom to produce?

iv) What provisions (if any) are to be made for economic growth?
What to produce?
As human wants are unlimited and resources are scarce and have various alternatives, an
important decision as to what goods are to be produced among various alternatives available
and how much is to be produced should be taken by the society so that there can be optimum
utilization of scarce resources. What to produce means, what type of goods to be produced?
Whether to produce high quality or low quality goods? Whether to produce more durable goods
or perishable goods? Whether to produce more of consumer goods or capital goods? This
fundamental question to be decided, because resources are scarce. If resources were abundant,
we might have produced all type of goods, without any worries.
How to produce?
After deciding what and how much to produce, the society has to decide the method of
production i.e., whether it would use labour intensive techniques or capital intensive techniques.
This decision is based on the availability of the factors of production, or we can say inputs i.e.,
labour and capital. How to produce involves three sub problems. They are: What resources to be
used? Which technology to be used and where to be produce it?
Note:
- Labour intensive technique refers to the use of more labour in the production process.
- Capital intensive technique refers to the use of more number of machines compared to
labour in the production process.
For whom to produce?

Another important decision which a society has to take is for whom to produce. The society
cannot satisfy all wants of all the people. Therefore, it has to decide who should get how much of
the total output of goods and services. In other words, it has to decide about the shares of
different people in the national cake of goods and services.
Market provision are to be made for economic growth.

A society should not use all of its scarce resources for current consumption only, without making
any provision for the future as the society’s production capacity would not increase. So, the
economy has to decide how much to save and investment for future growth. Nowadays we speak
about sustainable development, wherein which, the economy concentrates on satisfying the
needs of the present generations, without compromising with the needs of the future generation.

Types of economies
An economic system refers to sum total of arrangements for the production and distribution of
goods and services in a society. We divide all the economies into three broad classifications
based on their mode of production, exchange, distribution and the role which government plays
in economic activity. These are:
- Capitalist economy
- Socialist economy
- Mixed economy
Capitalist economy
A capitalist economy is an economic system in which the production and distribution of
commodities take place through the mechanism of free markets. Hence, it is also called market
economy or free trade economy or laissez-faire. Each individual, be it a producer, consumer or
resource owner, has considerable economic freedom. In a market economy, there is no
Government interference in economic affairs.
Example: The United States of America, Brazil, Japan etc.
The salient features of market economy are as follows:

- Right to private property: The various factors of production viz., land, labour, capital
and enterprise should be under private ownership. Inputs can be used by the owner as
per their requirement. However, the government is free to put restrictions for the benefit of
the society.
- Freedom of enterprise: This means that any individual is free to engage in any economic
activity of his choice. He is also free to start a new enterprise.
- Freedom to choose: This highlights consumer power. Consumers have the freedom to
make choice. Hence, producers should take utmost care to ensure that they produce only
those goods which the consumers are willing to buy.
Note: Consumer sovereignty means people are free to spend their income as they like.
- Profit motive: It is the main objective of a firm which induces people to work and to
produce.
- Competition: There always exists competition among sellers to sell their goods and among
buyers to obtain those goods that satisfy their wants. Advertisements and discounts are tools
used to handle competition.
- Inequalities of income: Due to unequal distribution of wealth, there exists a wide gap
between the rich and the poor.

A capitalist economy’s solutions:

In the absence of a central planning authority to solve the problems, a capitalist economy uses
the forces of demand and supply or price mechanism to solve its problems.
- Deciding what to produce: The main motive of an entrepreneur is to earn profit.
Therefore, to earn more profit, and entrepreneur produces only those goods that are
demanded by the consumers. In a free market economy, allocation of resources is
determined by consumer preference.
Example: If consumers want more motorcycles, then there will be an increase in price due
to an increase in demand, which will lead to more profit. This will induce the producers to
produce more motorcycles.
- Deciding how to produce: To earn more and more profits, the entrepreneur will use the
technique of production in such a manner that the cost of production is minimal. There are
two techniques or methods of production.
- Labour intensive method: are primarily used in labour rich countries.
- Capital intensive method: used primarily in capital rich countries.
- Deciding for whom to produce: In the capitalist economy goods and services are
produced based on the capacity of the buyer. The capacity will be based on the income. The
higher the income, the higher will be buying capacity.
Example: AUDI cars are not manufactured for the middle class of the society. It is
manufactured for the upper class of the society.
- Deciding about consumption, savings and investment: Entrepreneurs invest, and
consumers save and consume. But consumer’s savings depends on interest rates. More
savings is possible when the interest rates are high on saving. Investment decisions depend
upon the rate of return on capital. The greater the profit expectation (i.e. the return on
capital), the greater will be the investment in a capitalist economy.
Advantages of a capitalist economy:

- Increase in productivity: In a capitalist economy, ever farmer, trader or industrialist can
hold property and use it in any way he likes. He increases the productivity to meet his own
self-interest. This, in turn, leads to an increase in income, savings and investment.
- Welfare maximization: It is claimed that there is efficiency in production and use of
resources to optimum level. The self-interest of individuals also promotes the society’s
welfare.

- Flexible system: The shortages and surpluses in the economy are generally adjusted by
the forces of demand and supply. Thus, it operates automatically through the price
mechanism.
- Non-interference of the state: The State (government) has a minimum role to play.
There is no conflict between the individual interest and the society. The economic
institutions function automatically without the interference of the Government.
- Low cost and quality products: The consumers and producers have full freedom and
therefore, it leads to production of quality products at low costs.
- Technological improvement: The element of competition under capitalism drives the
producers to innovate something new to boost sales and thereby bring about progress.
- Awards men for dynamism: A capitalistic economy fosters research leading to better
quality products.
Disadvantages of a capitalist economy:

- Inequalities: Capitalism creates extreme inequalities in income and wealth. The
producers, land-lords, and traders reap huge profits and accumulate wealth. Thus, the rich
become richer, and the poor becomes, poorer. The poor with limited means are unable to
compete with the rich. Thus, capitalism widens the gap between the rich and the poor, thus
creating inequality.
- Leads to monopoly: Inequality leads to monopoly. Mega corporate units replace smaller
units of production. Firms combine to form cartels, trusts and in this process, bring about a
reduction in the number of firms engaged in production. They ultimately emerge as
multinational corporations (MNCs) or transnational corporations (TNCs). They often hike
prices against the welfare of consumers.
- Depression: There is over-production of goods due to heavy competition. The poor are not
able to take advantage of the production and hence, are exploited. At another level, over
production leads to glut in the market and hence, to depression. This leads to economic
instabilities.
- Mechanization and automation: Capitalism encourages mechanization and
automation. This will result in unemployment, particularly in labour surplus economies.
- Welfare Ignored: Under capitalism, private enterprise produces luxury goods which yield
higher profits and ignore the basic goods required which yields less profit. Thus, the welfare
of the public is ignored.

- Exploitation of labour: Stringent labour laws are enacted to prevent the damages of
capitalists. Hire and fire policy will become the order of the day. Such laws also help to
exploit the labour by keeping their wage rate at its minimum level or subsistence level.
- Basic social needs are ignored: There are many basic social needs such as literacy,
public health, poverty, drinking water, social welfare and social security. As the profit
margin in these sectors is low, capitalists will not invest in these sectors. Hence, most of
these vital human issues will be ignored in a capitalist system.
Socialist economy
In a socialistic economy, the means of production are owned and operated by the State. All
decisions regarding production and distribution are taken by the central planning authority.
Hence, the socialist economy is also called as a planned economy or command economy. The
government plays an active role social welfare is given importance; hence, equal opportunity is
given to all.
Note: In today’s world there is no country which has controlled economy.
Features of a socialist economy:

- Social welfare motive: In socialist economies, social or collective welfare will be the
prime motive. Unlike capitalism, profit will not be the aim of policy making. The decisions
will be taken keeping the maximum welfare of the people in mind.
- Limited right to private property: The right to private property is limited. All
properties of the country will be owned by the State. That is, the ownership is collective in
nature. Hence, no individual can accumulate excessive property as is the case of capitalism.
- Central planning: Most of the decisions on economic policies will be taken by a
centralized planning authority. Each and every sector of the economy will be directed by
well-designed planning.
- No market forces: In a centralized planned system of development, market forces have a
limited role to play. Production, commodity and factor prices, consumption and distribution
will be governed by development planning with welfare motive.
Advantages of a socialist economy:

- Effective use of resources: The resources are utilized to produce socially useful goods
without taking the profit margin into account. Production is increased by avoiding wastage
due to competition.
- Economic stability: A socialist economy is free from business fluctuations. Government
plans well in advance, and everything is well coordinated to avoid over-production or

unemployment. There is stability because the production and consumption of goods and
services are well-regulated.
- Maximization of social welfare: All citizens work for the welfare of the State. Everybody
receives his or her remuneration. The State concentrates on the production of basic
necessaries instead of luxury goods. The State provides free education, cheap and congenial
housing, public health amenities and social security for the people.
- Absence of monopoly: The elements of corporation and monopoly are eliminated since
there is an absence of private ownership. The state is a monopoly but produces quality goods
at reasonable prices.
- Basic needs are met: In socialist economies, basic human needs like water, education,
health, social security, etc. are provided. Human development is more in socialist
economies.
- No extreme inequality: As social welfare is ultimate goal, there is no concentration of
wealth. Extreme inequality is prevented in a socialist system.
Disadvantages of a socialist economy:

- Bureaucratic control: A socialist economy is operated under a centralized command and
control system. People here work out of fear of higher authorities. It does not give any
initiative for the people to work hard.
- No freedom: There is no freedom of occupation. Allocation of factors of production is not
done rationally. Jobs are provided by the State. Place of work is also provided by the State.
The consumer’s choice is very limited.
- Absence of technology: Work is monotonous, and no freedom is provided. Any change in
the production process will alter the entire plan. Hence, any innovation cannot be enforced
easily. Everything is rigid and technological changes are limited.
- Absence of competition: Absence of competition makes the system inefficient.
- Less choice for consumer: As the production and distribution is in hands of the state,
consumers have less freedom of choice. Consumers have to choose from whatever the states
produce.
Mixed economy
In a mixed economy, both public and private institutions exercise economic control. The public
sector functions as a socialistic economy and the private sector, as a free enterprise economy. All
decisions regarding what, how and whom to produce are taken by the state. The private sector

produces and distributes goods and services. Cost-benefit analysis is used to answer the
fundamental questions – what, how and for whom to produce?
Example: India
Features of a mixed economy:

i) Co-existence of private and public sector: The first important feature of a mixed
economy is the co-existence of both private and public enterprise. In fact, in a mixed
economy, there are three sectors of industries:
a) Private sector: Production and distribution in this sector are managed and controlled
by private individuals and groups. Industries in this sector are based on self-interest and
profit motive. The system of private property exists, and personal initiative is given full
scope.
However, private enterprise may be regulated by the government directly and/or
indirectly by a number of policy instruments.
b) Public sector
Industries in this sector are not primarily profit-oriented but are set up by the State for
the welfare of the community.
c) Combined sector
A sector in which both the government and the private enterprises have equal access,
and join hands to produce a commodity, leading to the establishment of joint sectors.
ii) Existence of Economic Planning: A mixed economy is a planned economy, i.e. an
economy in which the government has a clear and definite economic plan. Public sector
enterprises have to work according to a plan and to achieve the objectives laid down. The
government has also to create necessary atmosphere for the private sector to develop on its
own. Thus, it must prepare plans of development for both the private and the public sector
enterprises.
Allocation of resources in a mixed economy should be better since it attempts to combine the
productive efficiency of capitalism and distributive justice of socialism.
iii) Positive role of the government: In a mixed economy, balanced regional development is
expected. Public sector enterprises may be located in the backward regions so as to ensure
their development. Further, by way of subsidies and other incentives private sector may be
lured to establish and develop industries in backward regions.
iv) Administered Pricing: In a mixed economy, a dual system of pricing exists. In the private
sector, prices of goods and factors of production are determined through the free play of
market forces of demand and supply. In the public sector, the state determines the prices of

various products. The state may also fix the prices of certain essential commodities which
are used by common man. For example, in India, the prices of essential commodities like
diesel, LPG, etc. are fixed by the government. Overall planning is done by the State Authority
called Planning Commission in countries like India who have adopted mixed economy.
Merits of Mixed Economy

1. Mixed economy secures the merits of both capitalism and socialism while avoiding the evils
of both.
2. 2. Mixed economy protects individual freedom. Under the system, individuals have the
freedom of consumption, choice of occupation, freedom of enterprise and freedom of
expression.
3. Price mechanism is allowed to operate under mixed economy.
4. Reducing the inequalities of wealth and class struggle is one of the aims of mixed economy.
5. Economic fluctuations can be avoided due to the presence of a centrally planned economy.
6. Mixed economy helps under-developed countries to have rapid and balanced economic
development.
Demerits of Mixed Economy

1. Mixed economy is difficult to operate. Balancing and adjusting the public and private sectors
is often difficult.
2. Excessive controls and heavy taxes are likely to prevail under mixed economy. These will
discourage production in the private sector.
3. Problems of red-tapism, nepotism, favoritism, officialdom, etc. are also found in this type of
economic system.

Chapter – 02 – Theory of Demand
This theory shows how consumer preferences determine consumer demand for commodities.
Moreover an insight into this topic will help us understand reasons behind a number of
phenomenon occurring in the real world scenario.
Meaning of demand- Demand refers to the quantity of a good or service that the consumers are
willing and able to purchase at various prices during a period of time.
Demand, in Economics, is something more than desire to purchase though desire is one element
of it. A beggar, for instance, may desire food, but due to lack of resources to purchase it, his
demand is not effective.
Thus, effective demand for a thing depends on
i) Desire for the goods/service
ii) Means to purchase and
iii) Willingness to use those means for that purchase.
Unless demand is backed by purchasing power or ability to pay, it does not constitute demand.
Two things are to be noted about quantity demanded of a commodity.

a) One is that quantity demanded is always expressed at a given price. At different prices
different quantities of a commodity are generally demanded.
b) The second thing is that quantity demanded is a flow concept. We are concerned not with a
single isolated purchase, but with a continuous flow of purchases and we must therefore
express demand as so much per period of time – one thousand dozens of apples per day,
seven thousand dozens apples per week and so on.
A more comprehensive look at the concept can be reveals: By demand, we mean the
various quantities of a given commodity or service which consumers would buy in market over a
given period of time, at various prices, or at various incomes, or at various prices of related
goods.
Demand for a good is determined by the following

factors Price of commodity: Ceteris paribus i.e. other
things being equal, the demand for a commodity is
inversely related to its price. Thus, if price increases,
demand decreases and vice-versa. This is mainly due to
income effect and substitution effect. This phenomenon is known as the law of demand. Thus

when price a commodity effects its demand there would be a movement along the demand curve
better known as change quantity in demand. It is also termed as “price demand”.
Price of related commodities:

There are two types of related goods:
Complementary goods: Consumption of complementary
goods takes place simultaneously i.e., they are jointly used.
For example: pen and ink, tea and sugar etc. If the price of
one of the goods falls, the demand for the other will rise
and vice-versa. Price of one commodity and demand for
another commodity are indirectly related.
(Cars are the commodity in question)

Example: If the price petrol (a complementary commodity to cars) increases, then the demand
will fall moreover it will also lead to a fall in demand for cars.
Note- A further analysis reveals a shift in the demand curve of Car and a movement along the
demand curve of petrol. The effect of a change in price of complementary goods will bring about a
shift in the demand curve of the commodity in question.
Substitute goods: Here, the commodities are used in

place of another as alternative. A rise in the price of one
commodity will lead the consumers to shift to the
purchase of the other commodity. If the price of a
commodity rises, it becomes relative expensive compared
to other commodities. So, the consumers shift to the
purchase of the cheaper commodity in place of the commodity, the price of which has not

changed. Such goods are also known as substitutes. Price of one commodity and demand for
another commodity are directly related.
Example: If the price of Coke (a substitute of Pepsi) rises, relative to the price of Pepsi,
consumers will shift to the purchase of Pepsi from coke, since it has now become comparatively
cheaper. Thus we notice an increase in demand of Pepsi due to a change in price of its substitute
coke. Coke and Pepsi are also known as substitute goods.
(Commodity in question is Pepsi)
Note- A further analysis reveals a shift in the demand curve of Pepsi and a movement along the
demand curve of coca cola. The effect of a change in price of substitute commodity will bring about
a shift in the demand curve of the commodity in question. The impact of related goods on the
demand of a commodity is termed as “cross demand”.
Consumers’ income: Generally, higher the income of a consumer, higher is his purchasing power
and thus, higher is the quantity demanded. Thus, if the income of a consumer increases, he will
demand more of the good. However, there are certain commodities the demand of which falls
with an increase in income. These goods are called inferior goods. In case of necessities, the
demand will rise initially, but will gradually stabilize. This is because, people will become richer
and their demand shifts from necessities to other durable goods like T.V., house, car etc. We
generally discuss two types of Income: (a) Money income and (b) Real income. Money income
deals with income of an individual in terms of money or cash. Real income deals with the
purchasing power of money income. The change in demand of a commodity due to income of
the consumer is termed as “income demand”

Normal goods Necessities Inferior goods
Tastes and preferences: Consumers’ tastes and preferences for various goods keep changing,
thus changing the demand for those goods. Demand would be high for those goods whose tastes
and preferences are greater. Change can also be due to changes in fashion. Goods which are in
fashion have greater demand compared to those which are not. ‘Demonstration effect’ plays an
important role in determining the demand for a product. Demonstration effect refers to a
change in demand by seeing another person use a particular product or commodity.
Example: People now prefer to buy LED’s, when they want to buy TV.
Age factor: The age composition, for instance, plays a vital role in determining demand.
Generally, a country with higher youth population spends more and saves lesser than a country
with a greater population of the old. On the other hand, if the population of a country has more
number falling under young age (below 14), then demand for toys, baby food, nursery, etc.
increases.
Other Factors:
These factors effect the market demand for a commodity. These are:
Size of population: Size of the population of a country is an important determinant of market

demand. For instance, larger the population more will be the demand for certain goods like food
grains, and pulses etc. When the number of consumers increases, there will be greater demand
for goods.
Distribution of income: Distribution of income affects consumption pattern and hence, the
demand for various goods. The wealth of a country may be so distributed that there are a few
very rich people while the majority are very poor. Then under such scenario propensity to
consume of the country will be relatively less, for the propensity to consume of the rich people is
less than that of the poor people. Consequently, the demand for consumer goods will be

comparatively less. If the distribution of income is more equal, then the propensity to consume
of the country as a whole will be relatively high indicating higher demand for goods.
Demographic structure of the market: If the market consists of a large proportion of

children, demand for toys, baby food, etc. increases. On the other hand, if the population consist
of old people, demand for walking sticks, and reading glasses would be high.
Innovation: When there is a change in the technology people generally prefer new version than
the old one. So, change in the technology changes the demand for a product.
Change in money supply: When money supply in the country increases it in turn increases
the demand for goods. On the other hand, when the money supply decreases demand also comes
down.
Season or climatic condition: Seasonal goods like umbrella. Raincoat will be more
demanded in the rainy season than any other season.
Note- A change in price brings a movement along the demand curve. Whereas a change in
other factors brings about a shift in the demand curve.
Demand Function: The demand for any commodity mainly depends on the price of that
commodity. The other determinants include price of related commodities, the income of
consumers, tastes and preferences of consumers, and the distribution of income in the country.
Hence, the demand function can be written as:
Dx = f (Px , Pr , Y, T, Yd) , where
Dx = demand for good X
Px = price of good X
Ps = price of related goods
Y = income
T = tastes and preferences of the consumers
Law of Demand: The law of demand is one of the most important laws of economic theory.
According to law of demand, other things being equal, if the price of a commodity falls, the
quantity demanded of it will rise and if the price of a commodity rises, its quantity demanded
will decline. Thus, there is an inverse relationship between price and quantity demanded, other
things being same.
Assumptions of the law:

- No change in the consumer’s income

- No change in consumer’s tastes and preferences

- No changes in the prices of other goods
- No new substitutes for the goods have been discovered
- Consumers have perfect knowledge of the market
- Consumers are rational human beings
Thus, the constancy of these other factors is an important assumption of the law of
demand.
Demand schedule: A tabular representation of the relationship between price and quantity
demanded is known as the demand schedule. A demand schedule is drawn upon the assumption
that all the other influences remain unchanged. It thus attempts to isolate the influence exerted
by the price of the good upon the amount sold. Demand schedule may be of two types:
individual demand schedule and market demand schedule.
Individual demand schedule: It shows the quantity of the commodities that a consumer will
buy at a selected price. We can take a hypothetical data of an individual consumer for a list of
prices and the corresponding quantities demanded of commodity X. It is also called household
demand.
Price (Rs.) Quantity (Units)
50 2
45 3
30 7
25 12
20 18
When price of commodity X is `50 per unit, a consumer purchases 2 units of the commodity.
When the price falls to `45, he purchases 3 units of the commodity. Similarly, when the price
further falls, the quantity demanded by him goes on rising until at price `20, the quantity
demanded by him rises to 18 units. The above table depicts an inverse relationship between
price and quantity demanded; as the price of the commodity X goes on falling, its demand goes
on rising.

Demand curve: We can now plot the data from

Table on a graph with price on the vertical axis and
quantity on the horizontal axis. In the figure, we
have shown such a graph and plotted the five
points corresponding to each price-quantity
combination shown in Table. We now connect
these points. The curve is called the demand curve
for commodity ‘X’. The curve shows the quantity of
‘X’ that a consumer would like to buy at each price; its downward slope indicates that the
quantity of ‘X’ demanded increases as its price falls.
Market Demand Schedule: When we add up the various quantities demanded by the
number of consumers in the market we can obtain the market demand schedule. Suppose there
are three individual buyers of the goods in the market. The Table shows their individual
demands at various prices.
Note: In the above table we are able to notice that as price decreases new buyers join the
market.
Market Demand Curve: If we plot the market

demand schedule on a graph, we get the market
demand curve. The Figure shows the market demand
curve for commodity. The market demand curve, like
individual demand curve, slopes downwards to the
right because it is nothing but the lateral summation
of individual demand curves. Besides, as the price of
the good falls, it is very likely that new buyers will
enter the market which will further raise the quantity demanded of the good.

Reasons for downward slope of demand curve: Why does demand curve slope
downwards?
Different economists have given different explanations for the operation of law of demand.
These are given below.
1) Law of diminishing marginal utility: According to Marshall, people will buy more
quantity at lower price because they want to equalize the marginal utility of the commodity
and its price. If the consumer is at MUx = Px and the price falls then the equation would
change to MUx > Px, thus in such a scenario the consumer has to purchase more units of a
commodity in order to reach MUx = Px. He is induced to buy additional units in order to
maximize his satisfaction or utility. The diminishing marginal utility and equalizing it with
the price is the cause for the downward sloping demand curve.
2) Income effect: When the price of a commodity falls, the consumer can buy the same
quantity of the commodity with lesser money or he can buy more of the same commodity
with the same amount of money. In other words, as a result of fall in the price of the
commodity, consumer’s real income or purchasing power increases. This increase in the real
income induces him to buy more units of that commodity. Thus, quantity demanded for that
commodity (whose price has fallen) increases. This is called income effect.
3) Substitution effect: Hicks and Allen have explained the law in terms of substitution effect
and income effect. When the price of a commodity falls, it becomes relatively cheaper than
other commodities. It induces consumers to substitute the commodity whose price has fallen
as against other commodities (substitute commodity) which have now become relatively
expensive. The result is that the total quantity demanded for the commodity whose price has
fallen increases (commodity in question). This is called substitution effect.
PRICE EFFECT = INCOME EFFECT + SUBSTITUTION EFFECT
4) Arrival of new consumers: When the price of a commodity falls, more consumers start
buying it because some of those who could not afford to buy it previously may now afford to
buy it. This raises the number of consumers of a commodity at a lower price and hence the
quantity demand for the commodity in question increases.
5) Different uses: Certain commodities have multiple uses. If their prices fall they will be
used for varied purposes and quantity demanded for such commodities will increase. When
the price of such commodities rises they will be put to limited uses only. Thus, different uses
of a commodity make the demand curve slope downwards reacting to changes in price.

Expansion and contraction of demand

Other things being equal the law of demand, show an inverse relationship between price of the
commodity and quantity demanded. If demand for a particular commodity changes as a result of
changes in its price alone, we denote is as expansion and contraction of demand. Thus, we see
that expansion or contraction of demand takes place as a result of changes in price, while all
other factors influencing demand remain constant.
- When the quantity demanded of a good rises due to a fall in price, it is called expansion of
demand.
- When the quantity demanded of good decreases due to a rise in price, it is called contraction
of demand.
Scenario A Scenario B
Price Quantity Price Quantity
Combination Combination
(Y) (X) (Y) (X)
A 80 10 A 60 15
B 70 12 B 70 12
The phenomena of expansion and contraction of demand are shown in the above Figure. The
figure which is based on Scenario A Shows that when price is `80 quantity demanded is 10, given
other things equal. As the price decreases to `70, the quantity demanded increases to 12, we say
that there is ‘an increase in quantity demanded’ or ‘expansion of demand’ or ‘a
downward movement on the same demand curve’.
Similarly, in Scenario B as a result of increase in price to `70, the quantity demanded falls to 12,
we say that there is ‘contraction of demand’ or ‘a fall in quantity demanded’ or ‘anupward
movementon the same demand curve.’

Increase and decrease in demand

Till now we have assumed that other determinants remain constant when we are analyzing
demand for a commodity. It should be noted that expansion and contraction of demand take
place as a result of changes in the price while all other determinants of Demand viz. income,
tastes and price of related goods remain constant. These other factors remaining constant
means that the position of the demand curve remains the same and the consumer moves
downwards or upwards on it.
When all the other factors influencing demand also change, there is an increase or decrease in
demand and the demand curve shifts either to its right or left. If the income of a consumer rises,
he would be able to purchase more number of units of a commodity which he earlier could not
afford. This would result in increase in demand and therefore, the demand curve shifts to the
right. If, on the other hand, the goods are out of fashion, the demand of that good will decline,
resulting in the shift of the demand curve to the left.
Demand may also increase and decrease due to the following reasons
Increase in demand - Rise in income
(A shift in the demand curve towards the - Rise in the price of substitutes
right) - Fall in the price of a complement
- Favourable change in taste towards the
commodity
- Increase in population
Decrease in demand - Fall in income
(A shift in the demand curve towards the left) - Fall in the price of substitutes
- Rise in the price of a complement
- Unfavourable change in taste towards the
commodity
- Decrease in population
A rightward shift in the demand curve: When demand changes not because of price but
because of change in other determinants of demand, it is a case of either increase or decrease in
demand. “Increase in demand means more demand at same price”. In case of increase in
demand, the demand curve shifts to the right hand side or shifts away from the origin.

A leftward shift in the demand curve: When

demand changes not because of price but because
of change in other determinants of demand, it is a
case of either increase or decrease in
demand.“Less demand and same price”. In case of
decrease in demand, the demand curve shifts
towards the origin or to the left hand side.
Movements along demand curve vs. Shift of curve

It is important in Economics to make a distinction between movements along a demand curve
and a shift of the whole demand curve.
A movement along the demand curve indicates changes in the quantity demanded because of
price changes, other factors remaining constant. A shift of the demand curve indicates that there
is a change in demand at each possible price because one or more other factors, such as income,
taste or the price of some other goods, have changed.
Thus, when an economist speaks of an increase or a decrease in demand, he refers

to a shift of the whole curve because one or more of the factors which were assumed to
remain constant earlier have changed. When the economist speaks of change in quantity
demanded he means movement along the same curve (i.e., expansion or contraction of demand)
which has happened due to fall or rise in price of the commodity other things remaining
constant.
Exceptions to the Law of Demand

According to the law of demand, more of a commodity will be demanded at lower prices than at
higher prices, other things being equal.
The law of demand is valid in most cases; however there are certain cases where this law does
not hold good. The following are the exceptions to the law of demand.
i) Conspicuous goods: Articles of prestige value or snob appeal or articles of conspicuous
consumption are demanded only by the rich people and these articles become more
attractive if their prices go up. Such articles will not conform to the usual law of demand.
This was found out by Thorsten Veblen in his doctrine of “Conspicuous Consumption” and
hence this effect is called “Veblen effect” or prestige goods effect. Veblen effect takes place
as some consumers measure the utility of a commodity by its price i.e., if the commodity is
expensive they think that it has got more utility. As such, they buy less of this commodity at
low price and more of it at high price. Diamonds & gold are often given as example of this
case.
ii) Giffen goods: Sir Robert Giffen, an economist, was surprised to find out that as the price of
bread increased, the British workers purchased more bread and not less of it. This was
something against the law of demand. Why did this happen? The reason given for this is that
when the price of bread went up, it caused such a large decline in the purchasing power of
the poor people that they were forced to cut down the consumption of meat and other more
expensive foods. Since bread, even when its price was higher than before, was still the
cheapest food article, people consumed more of it and not less when its price went up.Thus,
this is a clear exception to the law of demand hence, the demand curve has a positive slope.
Such goods which exhibit direct price-demand relationship are called ‘Giffen goods’.
For a commodity to qualify as a “giffen good”
a) The goods are inferior goods
b) The goods form a substantial part of consumer’s budget
c) The household is poor with limited income
It is to be understood that all inferior goods do not show such trend as they may not qualify
for the other requisites. Hence all giffen goods are inferior goods but all inferior goods are
not necessarily giffen goods.
Examples of giffen goods are coarse grains like bajra, low quality rice and wheat etc.
iii) Conspicuous necessities: The demand for certain goods is affected by the demonstration
effect of the consumption pattern of a social group to which an individual belongs. These
goods, due to their constant usage, have become necessities of life.
Example: Demand for refrigerator, TV sets etc. does not fall even if their price rises. This is
because they have become necessities of life due to continuous usage.
iv) Future expectations about prices: It has been observed that when the prices are rising,
households expecting that the prices in the future will be still higher, tend to buy larger
quantities of the commodities.
For example, when people expect that prices of petrol would rise in future. They demand
greater quantities of petrol as their pricesare on a rise.
It is to be noted that here it is not the law of demand which is invalidated but there is a
change in one of the factors which was held constant while deriving the law of demand,
namely change in the price expectations of the people.

v) Imperfect knowledge: The law has been derived assuming consumers to be rational and
knowledgeable about market-conditions. However, at times consumers tend to be irrational
and make impulsive purchases without any rational calculations about price and usefulness
of the product and in such contexts the law of demand fails.
vi) Emergency: In case of emergency, people will buy the goods no matter how high the prices
are.If there is a scenario of emergency in a country, people will tend to buy goods required
even if their prices are high.
vii) Demand for necessaries: The law of demand does not apply much in the case of necessaries
of life. Irrespective of price changes, people have to consume the minimum quantities of
necessary commodities.
viii) Speculative goods: In the speculative market, particularly in the market for stocks and
shares, more will be demanded when the prices are rising and less will be demanded when
prices decline.
When there is an exception to the law of demand we would be generally coming up with an
upward sloping demand curve.

Chapter – 03 – Theory of Consumer Behavior
All desires, tastes and motives of human beings are called wants in Economics. Wants may arise
due to elementary and psychological causes. Since the resources are limited, we have to choose
between the urgent wants and the not so urgent wants.
Characteristics of wants.
1. Wants are unlimited: Human wants are unlimited. They are never completely satisfied.
When one want is satisfied, another want will crop up to take its place.
2. Every want is satiable: Wants, in general, are unlimited. But a single or a particular want
is satiable. We can completely satisfy a single want.
3. Wants are competitive: wants generally compete with each other. We all have a limited
amount of money at our disposal. Therefore, we must choose some things and reject the
others.
Example: Mr. X has `1000. With this amount, he has to choose between buying a book or
having food. Thus a utility maximizing consumer will choose the more urgent wants and
distribute his income on several goods in such a manner so as to get maximum satisfaction.
4. Wants are complementary: It is a common experience that we wants things in groups. A
single article out of a group cannot satisfy human wants by itself.
Example: A motor-car needs petrol and oil to start working. Thus, the relationship between
motor-car and petrol is complementary.
5. Wants are alternative: There are several ways of satisfying a particular want. If a person
wants a chair he may opt for either wooden or plastic chair. The final choice depends upon
the availability of money and the relative prices. These alternative goods are also called
‘substitutes’.
6. Wants vary with time, place and person: Wants are not always the same. They vary
from one individual to another. People want different things at different times and in
different places. We require hot tea or coffee in winter and cold drinks in summer. People of
England require warn woollen suits and rain coats. People of India require more of cotton
cloths. The wants of a villager are different from that of a businessman living in metropolitan
city. So, wants vary with generation, culture, society, geographical location and the extent of
economic development.
7. Some wants are recurring: Some wants are recurring in nature. There are wants which
get satisfied but tend to recur time and again.
Example: We require food and water recurrently.
8. Wants become habits and customs: There are certain goods which do not form
necessaries are consumed on regular basis as the consumer is into a habit of consuming the
same.
Example: Smoking of cigarette and alcohol
Classification of wants
The existence of human wants is the basis of all economic activities in a society.
In Economics, wants are classified into three categories, viz., necessaries, comforts and luxuries.
Necessaries:
Necessaries are those which are essential for living. Man cannot do well with the barest
necessaries of life alone. Necessaries of efficiency helps a consumer to keep him fit for taking up
productive activities. There are other types of necessaries called conventional necessaries. By
custom and tradition, people require some wants to be satisfied.
Comforts:
Comforts refer to those goods and services which are not essential for living, but which are
required for a happy living. They lie between ‘necessaries’ and ‘luxuries’.
Luxuries:
Luxuries are those wants which are superfluous and expensive. They are not essential for living,
however, they may add efficiency to the consumer.
From time to time, different theories have been advanced to explain consumer behavior and
thus to explain his demand for the product. Predominantly the theory of consumer has been
ruled by the following two approaches.
a) Cardinal approach
b) Ordinal approach

Cardinal Approach Ordinal Approach

This approach was developed by Alfred This approach was developed by J. R. Hicks and
Marshall R. J. D. Allen
This analysis assumes that satisfaction that This analysis condemns cardinal measurability
a consumer derives from various goods and of utility and argues that satisfaction can’t be
services could be expressed in terms of measured in terms of numbers but only could be
cardinal numbers. arranged/ranked in the order of preference
Concepts covered under this approach: Concepts covered under this approach:
-Marginal Utility Analysis - Indifference Curve Analysis
a) Law of Diminishing Marginal Utility.
b) Consumer’s Equilibrium with Single
Commodity
c) Law of Equi-Marginal Utility.
d) Consumer Surplus
Marginal Utility Analysis

This theory which is formulated by Alfred Marshall, a British economist, seeks to explain how a
consumer spends his income on different goods and services so as to attain maximum
satisfaction.
Important Terms
Utility: Utility is the want satisfying power of a commodity. Demand for a commodity
depends on the utility it offers to the consumer. Utility means the level of satisfaction which
people derive from the consumption of a commodity.
Features of utility
a) It is a subjective entity and varies from person to person and moreover differs from time to
time for the same person.

b) It should be noted that utility is not the same thing as usefulness. Even harmful things like
liquor, may be said to have utility from the economic stand point because people want them.
Thus, in Economics, the concept of utility is ethically neutral.
c) Utility is the anticipated satisfaction by the consumer, and satisfaction is the actual
satisfaction derived.
Modes of creation of utility

Time utility- satisfaction derived from receiving the commodity at the right time. In other
words the consumer would derive a higher level of satisfaction if he is able to procure the
commodity when he wants it.
Place utility- satisfaction derived by receiving the commodity at the right place. Utility
discussed here is in the form of convenience derived by the consumer in procuring the
commodity.
Form utility- satisfaction derived by receiving the commodity in the right form. Getting the
commodity in a form usable by the consumer is another type of utility.
Types of utility
Marginal utility: It is the additional utility derived from the consumption of an additional unit
of a commodity. In short, Marginal utility = the addition made to the total utility by the addition
of consumption of one more unit of a commodity.
Total utility: It is the sum of utility derived from different units of a commodity consumed by a
consumer. In other words, Total utility = the sum total of all marginal utility.
Assumptions of Marginal Utility Analysis

a) The Cardinal Measurability of Utility: According to this theory, utility is a cardinal
concept i.e., utility is a measurable and quantifiable entity. Thus, a person can say that he
derives utility equal to 10 utils from the consumption of 1 unit of commodity A and 5utils
from the consumption of 1 unit of commodity B. Since, he can express his satisfaction
quantitatively, he can easily compare different commodities and express which commodity
gives him greater utility or satisfaction and by how much.
According to this theory, money is the measuring rod of utility. The amount of
money which a person is prepared to pay for a unit of a good rather than go
without it, is a measure of the utility which he derives from the good.

b) Constancy of the Marginal Utility of Money: The marginal utility of money remains
constant throughout when the individual is spending money on a good. This assumption,
although not realistic, has been made in order to facilitate the measurement of utility of
commodities in terms of money.
c) Independent units of a commodity have independent Utility: The total utility
which a person gets from the whole collection of goods purchased by him is simply the sum
total of the separate utilities of the goods. The theory ignores complementarity between
goods.
Law of Diminishing Marginal Utility (LDMU)

One of the important laws under Marginal Utility analysis is the Law of Diminishing Marginal
Utility.
The law of diminishing marginal utility is based on an important fact that while total wants of a
person are virtually unlimited, each single want is satiable i.e., each want is capable of being
satisfied.
Since each want is satiable, as a consumer consumes more and more units of a good, the
intensity of his want for the good goes on decreasing and a point is reached where the consumer
no longer wants it.
The Law of Diminishing Marginal Utility is one of the very important and fundamental laws of
consumption. This is also known as “Gossen’s 1st Law of Consumption”, named after an Austrian
economist Gossen’s who introduced it. This law is based on one of the important characteristic
of human want i.e., “Some Human wants could be satisfied”. Prof. Alfred Marshall has further
developed LDMU.
Marshall stated the law as follows: “The additional benefit which a person derives from
a given increase in stock of a thing diminishes with every increase in the stock that
he already has.”
In other words, as a consumer increases the consumption of any one commodity keeping
constant the consumption of all other commodities, the marginal utility of the variable
commodity must eventually decline.
It is to be noted that it is the marginal utility and not the total utility which declines
with the increase in the consumption of a good.

Assumptions to Law of Diminishing Marginal Utility (LDMU):

The LDMU is based on certain assumptions. They are
a) Homogeneous units: The different units of a particular commodity consumed by a
person should be identical or same in all respect i.e., color, size, quantity, taste, etc., The
Units must be similar.
b) No time gap in consumption: In the process of consumption the successive units
must be consumed successively one after the other. If there is a long interval between the
consumption of one unit and the other unit, then LDMU will not hold good.
c) No changes in the taste, habits and the income of the consumer: During the
course of consumption there should not be any change in the taste, habits and income of
the consumer. If there is any change, this law will not hold good.
d) Cardinal measurability of utility: According to this theory, a person can express the
satisfaction he derives from the commodity in quantitative cardinal terms. In other
words, utility can be expressed in the form of numbers. The amount of money which
a person is prepared to pay for a unit of a good rather than go without it, is a
measure of the utility which he derives from the good.
e) Constancy of the Marginal Utility of money: This is an important assumption
without which Marshall could not have measured Marginal Utilities of goods in terms of
money. It states that the Marginal Utility of money remains constant throughout the
period when the individual is spending money on a commodity.
f) Independent units have independent utility: This assumption states that the Total
Utility which a person derives from a collection of goods purchased is simply the sum
total of the separate utilities of goods i.e., separate utilities of different goods can be
added to obtain the total sum of the utilities of all the goods purchased.
g) Rationality: Here the consumer is assumed to be rational. The consumer will prefer to
spend money on the commodity from which he will derive maximum utils.
Number of cups of tea TU MU – TUn - TUn-1
1 50 50
2 75 25
3 95 20
4 110 15
5 120 10
6 120 0
7 100 -20

Let us illustrate the law with the help of an example. Consider the above table, in which we have
presented the total utility and marginal utility derived by a person from tea consumed by him.
When one tea is taken per day, the total utility derived by the person is 30 utils (unit of utility)
and the marginal utility derived is also 30 utils. With the consumption of 2nd tea per day the
total utility rises to 50 but marginal utility falls to 20. We see that as the consumption of tea
increases to 10 tea, marginal utility from the additional tea goes on diminishing (i.e., the total
utility goes on increasing at a diminishing rate). However, when the tea consumed increases to
11, instead of giving positive marginal utility, the eleventh tea gives negative marginal utility (it
may cause him sickness).
Here, we may note that TU increases with the consumption of every successive units but at a
diminishing rate. On the other hand MU goes on diminishing with the consumption of every
successive unit. When MU = 0, the TU will be the maximum. If a consumer goes on consuming
beyond this point, the TU goes on decreasing and MU will be negative.
Graphically we can represent the relationship between total utility and marginal utility
From the above table, we can conclude the three important relationships between total utility
and marginal utility
a) When total utility rises, the marginal utility diminishes.
b) When total utility is maximum, the marginal utility is zero.
c) When total utility is diminishing, the marginal utility is negative.
As will be seen from the figure provided below, the marginal utility curve goes on declining
throughout and the total utility curve increases initially. Till MU remains positive TU keeps on
rising. As more units of the commodity is consumed the TU keeps on increasing till the point
MU becomes 0, at this point TU is maximum. Thereafter we are able to see a fall in the TU as
MU becomes negative. Tu
C
B
Tu
Exception to the Law A
The law of diminishing marginal utility has the following exceptions.
Rare Collections: The law of LDMU is not applicable to some of the

rare collections like stamps, coins, rare currency, antique goods etc.
because our satisfaction increases with every increase in the stock of
these goods.

Not applicable to items of habit formation: The level of intoxication of the drinker
increases with every additional drink of liquor.
No applicable for money or asset class: The LDMU is not applicable for money or other
asset class. With every increase in the stock of money or asset class, the greed goes on
increasing.
Criticisms of Law of Diminishing Marginal Utility (LDMU):

The main criticisms of the LDMU are as follows:
a) Cardinal measurability of utility is not possible. Nobody can express their utility in terms of
numbers.
b) Constancy of marginal utility is an irrational assumption because as the stock of money with
a person keeps on decreasing then utility of the money left with him keeps on increasing.
c) The LDMU is a single commodity model.
d) It does not consider complementarity of goods into account. This approach propounds that
individual units provide separate level of satisfaction which is not possible with all classes of
commodities.
Example: car has hardly any utility without petrol and also the other way round.
e) The Law fails in the case of prestigious goods, the law may not apply to articles like gold,
cash where a greater quantity may increase the lust for it.
f) Continuous Consumption is another irrational assumption under the LDMU states that
there should be no time gap or interval between the consumption of one unit and another
unit i.e. there should be continuous consumption.
Application of the Law of Diminishing Marginal Utility:

LDMU concept is used to explain “Value Paradox”: This “Value Paradox” was developed
by Prof. Adam Smith. This concept is also known as ‘Diamond –water paradox’. He says that
water is more useful than diamond, but it is priced low and diamond is less useful than water
and it is priced high. This is because more is the quantity or the stock of a product the marginal
utility for such commodity is low and if the availability of a product is less, marginal utility will
be high.
Useful for Government to fix the Tax Rate: The value of additional money for a rich
person is relatively less. But whereas the value of the same additional money to a poor person is
more. Hence the government follows ‘Progressive Tax System’. Government levies high rate tax
on rich people and low tax on poor people. This approach of taxation is also based on LDMU.

To explain ‘Law of Demand’: The Law of diminishing marginal utility helps us to

understand how a consumer reaches equilibrium in case of a single good. It states that as the
quantity of a good with consumer increases, marginal utility of the good decreases. In other
words, the marginal utility curve is downward sloping. Now, a consumer will go on buying a
good till the marginal utility of the good becomes equal to the market price. In other words, the
consumer will be in equilibrium (will be deriving maximum satisfaction) in respect of the
quantity of the good where marginal utility of the good is equal to its price. Here his satisfaction
will be maximum.
What happens when there is a change in the price of the good? When the price of the good falls,
the equality between marginal utility and price is disturbed. The consumer will consume more of
the good so as to restore the equality between marginal utility and price. When he consumes
more of the good, the marginal utility from the good will fall. He will continue consuming more
till the marginal utility becomes equal to the new lowered price.
On the other hand, when price of the good increases he will buy less so as to equate the marginal
utility to the higher price. We can say that the downward sloping demand curve is
directly derived from marginal utility curve.
Used to explain Consumer Surplus: Consumer surplus might be defined as the difference
between the price, what consumer is actually prepared to pay (MU) and the price that he
actually pays. Initially a consumer will be ready to pay more price for a product, gradually as the
consumer consumes more number of units of a commodity he will be ready to offer less price for
the same product. This is because law of diminishing marginal utility.
Consumer’s equilibrium with one commodity:

In an economy, where the commodities are available freely, the consumer will go on consuming
a commodity, till marginal utility becomes zero. At the point consumer gets maximum
satisfaction and will be in equilibrium.
But in an economy, where consumer has to pay, he will be in equilibrium, when Marginal Utility
is equal to Price. At this point consumer gets maximum satisfaction and will be in equilibrium.
How many units of commodity, that the consumer buys to get maximum satisfaction depends
on the price of the commodity.
A consumer continues to demand a commodity till Marginal Utility that he gets is greater than
Price. He stops when Marginal Utility is equal to Price. This concept could be explained with an
example:
Market Price of
Units M. Utility Derived
commodity
MU > Price
1 20 30Utils
2 20 25Utils
3 20 20Utils MU = Price
4 20 15 Utils
MU < Price
5 20 10 Utils
Assumptions of the example:

a) Market Price of the commodity remains constant.
b) Law of Diminishing Marginal Utility operates.
c) No substitutes available. The consumer has to buy the same product.
In the above diagram, Marginal Utility curve slopes downward and market price remains
constant. If the consumer purchases2 units of commodity, at this level MUx >Px and this will
induce him to purchase more. If the consumer purchases 3units of commodity, at this level MUx
= Px, consumer gets max satisfaction and will be in equilibrium. If the consumer purchases
5unitsof commodity, at this level MUx<Px, consumer will move into a negative zone.
The Law of Equi-Marginal utility (LEMU):

The idea of equi-marginal utility was first mentioned by H. H. Gossen (1810-1858) of Germany.
Hence, it is called Gossen’s second Law of consumption. Alfred Marshall made significant
refinements to this law in his ‘Principles of Economics’.
According to this law, the consumer will try to maximize his satisfaction when there are
substitutes available in the market. So, he will substitute one item in place of the other such that
his Marginal Utility is proportional to the price. The law of equi-marginal utility explains the
behavior of a consumer when he consumes more than one commodity. Wants are unlimited, but
the income which is available to the consumer to satisfy all his wants is limited. This law
explains how the consumer spends his limited income on various commodities to get maximum
satisfaction.
According to Alfred Marshall, “Other things being equal, a consumer gets maximum satisfaction
when he allocates his limited income to the purchase of different goods in such a way that the
Marginal Utility derived from the last unit of money spent on each item of expenditure tend to
be equal”.
Assumptions to Law of Equi-Marginal Utility (LEMU):

a) The consumer is rational, so he wants to get maximum satisfaction
b) The utility of each commodity is measurable
c) The Marginal Utility of money remains constant
d) The income of the consumer is given
e) The prices of the commodities are given
f) The law is based on the law of diminishing marginal utility.
Explanation of Law of Equi-Marginal Utility (LEMU)

Suppose there are two goods, A and B, on which a consumer has to spend a given income, the
consumer being rational, will try to spend his limited income on goods A and B to maximise his
Total Utility or satisfaction. Only at that point of maximum satisfaction, the consumer will be in
equilibrium. According to the law of equi-marginal utility, the consumer will be in equilibrium
at the point where the utility derived from the last rupee spent on each item is equal.
Symbolically, the consumer will be in the equilibrium when:-
MU x Px
= = MU m per unit of money income
MU y Py
Or
MU x MU y
= = MU m per unit of money income
Px Py
Where,
MUx = Marginal Utility of commodity X
MUy = Marginal Utility of commodity Y

Px = Price of commodity X
Py= Price of commodity
MUm = Marginal Utility of money
Let us illustrate the law of equi marginal utility with the help of the following table:
Suppose a lady has a budget of `40 with her, which she wishes to spend on two commodities,
chocolates and ice creams. The marginal utility derived from both these commodities is as
under:
MU of MU of Ice
Units MUx/Px MUy/Py
Chocolates (X) creams (Y)
1 80 8 35 7
2 70 7 30 6
3 60 6 25 5
4 50 5 20 4
5 40 4 15 3
6 30 3 10 2
7 20 2 5 1
8 10 1 0 0
Note-if the consumer has unlimited budget then the most ideal scenario would be a
combination of 8 units of X and 7 units of Y as it would satisfy the condition of equilibrium
assuming there is no constraint of resources.
A rational consumer would like to get maximum satisfaction from `40.
Px = `10 and Py= `5. She can spend this money in three ways:
a) `40 may be spent on chocolates only.
b) `40 may be utilized for the purchase of ice creams only
c) Some amount may be spent on the purchase of chocolates and some on the purchase of ice
creams.
If the prudent consumer spends `40 on the purchase of chocolates, she gets 260utils by
consuming 4 units of chocolate.
If she spends `40 on the purchase of ice creams, the total utility derived is 140 utils by
consuming 8 units of ice cream. Which is lesser than utility derived from consumption of
chocolates.

In order to make the best of the available budget, she can purchase the following combinations
as per the law of equi marginal utility.
Combination Budget utilized Total utility
A= 2X + 1Y 25 185
B= 3X + 2Y 40 275
Any combination above combination B would require more than the budget available. Thus,
MUx MUy
following the rule of equi marginal utility of =
Px Py
The best possible combination available to the consumer with the limited budget available
would be B = 3X + 2Y. With this available combination the consumer would be generating
maximum total utility of 275 than any other option.
Law OfEqui Marginal Utility
Limitations of Law of Equi-Marginal Utility (LEMU)

a) Rational behavior: It is true that consumer is irrational sometimes. It is behavior is
greatly influenced by habits, advertisements etc. Moreover a consumer has to keep a
complete record of income and continuously calculate the marginal utilities which is
practically not possible.
b) Cardinal Measurement of Utility: Critics point out that utility is an abstract term,
which cannot be measured.
c) Utility is subjective: Utility is subjective and psychological concept. It is difficult to
measure.
d) Marginal Utility of Money is not constant: Marshall assumes that marginal utility of
money is constant but Hicks argues that money is also a commodity and the marginal utility
also diminishes slowly.

e) Multiplicity: Multiplicity of commodities prevent the consumer from making a rational

choice. He neither has time nor the ability to calculate marginal utilities.
f) Indivisible goods: It is not applicable to indivisible goods. There are certain goods such
as fan, TV, car etc., which cannot be divided or sub divided. If divided they will lose their
utility.
g) Durable goods: It is difficult to measure the utility in respect of durable goods such as car
and machinery. For example: if the consumer purchases a car and a cup of tea, it is very
difficult to equalize the Marginal Utility of a car which lasts for several years with a cup of
tea, which exhausts at the single act of consumption.
h) Customs, fashions, ignorance, scarcity etc. Customs make the consumption of an
article compulsory irrespective of marginal utilities. Fashion of the day impede the operation
of the law as one may purchase a commodity much against his wish to tune with the fashion.
Consumer does not possess complete knowledge of all commodities and their prices in the
market. Moreover prices are subject to change. Scarcity consumer is compelled to purchase
an alternative or a substitute good if there is scarcity.
Importance of Law of Equi-Marginal Utility (LEMU)

The law of Equi-Marginal utility is not only theoretical, but also has practical application in our
daily life. Some of the areas, where it could be used are:
The Theory of Consumption: The expenditure pattern of every consumer is based on this
law. The consumer distributes his limited income among various commodities in such a way
that the Marginal Utility or the satisfaction that he gets is equal MU from the last rupee spent.
At that point he stops further consumption, because he knows that if he continues consumption,
the satisfaction will be less and the price he is going to pay is more. This helps the consumer to
maximize his satisfaction.
Choice between Savings and Consumption: If the future consumption yields more
satisfaction than the present consumption, in the case the consumer will decide to save his
income rather than spending it.
Scarcity aspect: This law applies to all fields of economic activity where limited resource are
to be profitably employed. Thus the law has very wide application. Prof. Marshall puts the
significance of the law in the following words: “The application of this principle could be
extended to every field of economic enquiry”.

Consumer’s Surplus
The concept of consumer’s surplus was evolved by Alfred Marshall. This concept occupies an
important place not only in economic theory but also in economic policies of government and in
decision-making of monopolists.
It has been seen that consumers generally are ready to pay more for certain goods than what
they actually pay for them. This extra satisfaction which consumers get from their purchase of
goods is called by Marshall as consumer’s surplus.
Marshall defined the concept of consumer’s surplus as the “excess of the price
which a consumer would be willing to pay rather than go without a thing over that
which he actually does pay”, is called consumer’s surplus.”
Thus consumer’s surplus = what a consumer is ready to pay - What he actually pays.
Or
Thus consumer’s surplus = marginal utility - What he actually pays.
The concept of consumer’s surplus is derived from the law of diminishing marginal utility. As we
know from the law of diminishing marginal utility, as we purchase more of a good, its marginal
utility goes on diminishing. The consumer is in equilibrium when marginal utility is equal to
given price i.e., he purchases that many number of units of a good at which marginal utility from
the last unit is equal to its price (It is assumed that perfect competition prevails in the market).
Since the price is the same for all units of the good he purchases, he gets extra utility for all units
consumed by him except for the one at the margin.
This extra utility or extra surplus for the consumer is called consumer’s surplus.
It is often argued that the surplus satisfaction cannot be measured precisely. In case of very
essential goods of life, utility is very high but prices paid for them are low giving rise to infinite
surplus satisfaction (example- water). Further, it is difficult to measure the marginal utilities of
different units of a commodity consumed by a person.
No. of units Marginal Utility Price Consumer’s Surplus
1 30 20 10
2 28 20 8
3 26 20 6
4 24 20 4

5 22 20 2
6 20 20 0
7 18 20 –
We see from the above table that when consumer’s consumption increases from 1 to 2 units, his
marginal utility falls from `30 to `28. His marginal utility goes on diminishing as he increases his
consumption of good X. Since marginal utility for a unit of good indicates the price the
consumer is willing to pay for that unit, and since price is assumed to be fixed at `20, the
consumer enjoys a surplus on every unit of purchase till the 6th unit. Thus, when the consumer
is purchasing 1 unit of X, the marginal utility is worth `30 and price fixed is `20, thus he is
deriving a surplus of ` 10. Similarly, when he purchases 2 units of X, he enjoys a surplus of Rs 8
[`28 – `20]. This continues and he enjoys consumer’s surplus equal to `6, 4, 2 respectively from
3rd, 4th and 5th unit. When he buys 6 units, he is in equilibrium because his marginal utility is
equal to the market price thus he enjoys no surplus. Thus, given the price of `20 per unit, the
total surplus which the consumer will get, is Rs 10 + 8 + 6 + 4 + 2 + 0 = `30.
Consumer Surplus
The concept of consumer’s surplus can also be illustrated graphically. Consider the above figure,
On the X-axis we measure the amount of the commodity and on the Y-axis the marginal utility
and the price of the commodity. MU is the marginal utility curve which slopes downwards,
indicating that as the consumer buys more units of the commodity, its marginal utility falls.
Marginal utility shows the price which a person is willing to pay for the different units rather
than go without them. If OB is the price that prevails in the market, then the consumer will be in
equilibrium when he buys OE units of the commodity, since at OE units, marginal utility is equal
to the given price OE. The last unit, i.e., 6thunit does not yield any consumer’s surplus because
here price paid is equal to the marginal utility of the 6 thunit. But for units before 6thunit,

marginal utility is greater than price and thus these units fetch consumer’s surplus to the
consumer.
The total utility is equal to the area under the marginal utility curve up to point C i.e. OACE.
But, given the price equal to OB, the consumer actually pays OBCE. The consumer derives extra
utility equal to BAC which is nothing but consumer’s surplus.
Limitations
a) Consumer’s surplus cannot be measured precisely - because it is difficult to measure the
marginal utilities of different units of a commodity consumed by a person.
b) In the case of necessaries, the marginal utilities of the earlier units are infinitely large. In
such case the consumer’s surplus is always infinite.
c) The consumer’s surplus derived from a commodity is affected by the availability of
substitutes.
d) There is no simple rule for deriving the utility scale of articles which are used for their
prestige value (e.g., diamonds).
e) Consumer’s surplus cannot be measured in terms of money because the marginal utility of
money changes as purchases are made and the consumer’s stock of money diminishes.
f) Marshall assumed that the marginal utility of money remains constant. But this assumption
is unrealistic.
g) The concept can be accepted only if it is assumed that utility can be measured in terms of
money or otherwise. Many modern economists believe that this cannot be done.
Indifference Curve Analysis

In order to overcome with drawback and to explain utility analysis in a more acceptable and in
an appropriate manner two economists by name R. J. D. Allen and J. R. Hicks developed an
alternative approach in 1939. That newly developed approach is known as ‘Indifference curve
analysis’.
This Indifference Curve Analysis is also known as ‘Ordinal Analysis’, because in this the
consumer expresses his satisfaction in the ‘order of preference’ A very popular alternative and
more realistic method of explaining consumer’s demand is the Indifference Curve Analysis.
This approach to consumer behavior is based on consumer preferences. It believes that human
satisfaction, being a psychological phenomenon, cannot be measured quantitatively in monetary
terms as was attempted in Marshall’s utility analysis. In this approach, it is felt that it is much
easier and scientifically more sound to order preferences than to measure them in terms of
money.

Based on the quality and the level of satisfaction, consumer arranges different combination of
goods in the order of preference. This kind of conceptual ordering is technically known as “Scale
of Preference”.
The consumer preference approach is, therefore, an ordinal concept based on ordering of
preferences compared with Marshall’s approach of cardinality.
Indifference curve-An indifference curve is a curve which represents all those combinations
of two goods which give same satisfaction to the consumer. Since all the combinations on an
indifference curve give equal satisfaction to the consumer, the consumer is indifferent among
them. In other words, since all the combinations provide the same level of satisfaction the
consumer prefers them equally and does not mind which combination he gets.
Assumptions in Indifference Curve Approach

i) The consumer is rational and possesses full information about all the relevant aspects of
economic environment in which he lives.
ii) The consumer is capable of ranking all conceivable combinations of goods according to the
satisfaction they yield. Thus, if he is given various combinations say A, B, C, D and E he can
rank them as first preference, second preference and so on. If a consumer happens to prefer
A to B, he can not tell quantitatively how much he prefers A to B.
iii) Transitivity and consistency of choice. If there are three combinations of goods say A, B and
C and if the consumer prefers A to B and B to C, he must also prefer A to C. This is because,
when a consumer reveals that he prefers A to B, it means that he gets greater satisfaction
from A as compared to B and his preference of B over C implies that he gets more
satisfaction from B as compared to C. Since the consumer always prefers a combination,
which gives him maximum satisfaction, he must prefer A to C also and the consumer taste
and preference are consistent.
iv) If combination A has more commodities than combination B, then A must be preferred to B.
Explanation of indifference curve

To understand indifference curve, let us consider the example of a consumer who has one unit of
burger and 21 units of cold drink. Now, we ask the consumer how many units of cold drink he is
prepared to give up to get an additional unit of burger, so that his level of satisfaction does not
change. Suppose the consumer says that he is ready to give up 6 units of cold drink to get an
additional unit of burger.

We will have then two combinations of burger and cold drink giving equal satisfaction to
consumer: Combination A which has 1 unit of burger and 21 units of cold drink, and
combination B which has 2 units of burger and 15 units of cold drink. Similarly, by asking the
consumer further how much of cold drink he will be prepared to forgo for successive increments
in his stock of burger so that his level of satisfaction remains unaltered, we get various
combinations as given below:
Indifference Schedule
Combination Burger (X) Cold drink (Y) MRSxy
A 1 21 -
B 2 15 6
C 3 10 5
D 5 6 2
E 8 3 1
F 12 1 0.50
Now, if we draw the above schedule we will get the following figure.
An indifference curve IC is drawn by plotting the various combinations of the indifference

schedule. The quantity of burger is measured on the X axis and the quantity of cold drink on the
Y axis. As in indifference schedule, the combinations lying on an indifference curve will give the
consumer the same level of satisfaction.
Hence indifference curve is a locus of points representing all those different combinations of two
goods, which yield the same level of satisfaction to the consumer. Hence it is also known as ‘Iso-
Utility Curve’.
Marginal Rate of Substitution: Marginal Rate of Substitution (MRS) is the rate at which the
consumer is prepared to exchange goods X and Y. Moreover when we refer to MRSxy it indicates

the number of units of commodity Y sacrificed for gaining a unit of commodity X. Consider the
above table, in the beginning the consumer is consuming 1 unit of burger and 21 units of cold
drink. Subsequently, he gives up 6 units of cold drink to get an extra unit of burger, his level of
satisfaction remaining the same. The MRSxy here is 6. Likewise when he moves from B to C and
from C to D in his indifference schedule, the MRS are 5 and 2 respectively.
Thus, we can define MRS of X for Y as the amount of Y whose loss can just be compensated by a
unit gain of X in such a manner that the level of satisfaction remains the same. We notice that
MRS is falling i.e., as the consumer has more and more units of burger, he is prepared to give up
less and less units of cold drink. There are two reasons for this.
1) The want for a particular good is satiable so that when a consumer has more of it, his
intensity of want for it decreases. Thus, when the consumer in our example, has more units
of burger, his intensity of desire for additional units of burger decreases.
2) As the stock of particular commodity goes on depleting the consumer wants to sacrifice less
of it. In our example we noticed that as the stock of cold drink goes on decreasing the
consumer is willing to sacrifice less of it.
Properties of Indifference Curves: The following are the main characteristics or properties
of indifference curves:
i) Indifference curves slope downward to the
right: This property implies that when the amount of
one good in the combination is increased, the amount of
the other good is reduced. This is essential if the level of
satisfaction is to remain the same on an indifference
curve.
ii) Indifference curve is convex to the origin: It has been observed that as more and
more of one commodity (X) is substituted for another (Y), the consumer is willing to part
with less and less of the commodity being substituted (i.e. Y). This is called diminishing
marginal rate of substitution. Thus, in our example of burger and cold drink, as a consumer
has more and more units of burger, he is prepared to forego less and less units of cold drink.
This happens mainly because the want for a particular good is satiable and as a person has
more and more of a good, his intensity of want for that good goes on diminishing. This
diminishing marginal rate of substitution gives convex shape to the indifference curves.

iii) Indifference curves can never intersect each other:

No two indifference curves will intersect each other
although it is not necessary that they are parallel to each
other. In case of intersection the relationship becomes
logically absurd because it would show that higher and
lower level indifference curve show equal level of
satisfaction which is not possible.
IC1 and IC2 intersect at A. Since A and B lie on IC1, they give same satisfaction to the
consumer. Similarly since A and C lie on IC2, they give same satisfaction to the consumer.
This implies that combination B and C are equal in terms of satisfaction. But a glance will
show that this is an absurd conclusion because certainly combination C is higher and hence
better than combination B because it contains more units of commodities X and Y. Thus we
see that no two indifference curves can touch or cut each other.
iv) A higher indifference curve represents a higher level of

satisfaction than the lower indifference curve: This is
because combinations lying on a higher indifference curve
contain more of either one or both goods and more goods are
preferred to less of them.
v) Indifference curve will not touch either axes Another

characteristic feature of indifference curve is that it will not
touch the X axis or Y axis. This is born out of our assumption
that the consumer is considering different combination of two
commodities. If an indifference curve touches the Y axis at a
point A as shown in the figure, it means that the consumer is
satisfied with OA units of Y commodity and zero units of X
commodity. This is contrary to our assumption that the consumer wants both commodities
although in smaller or larger quantities. Therefore, an indifference curve will not touch
either the X axis or Y axis.
vi) Indifference curve cannot be upward sloping: An

upward sloping indifference curve is not possible as it
indicates that the consumer is deriving equal amount of
satisfaction with higher quantities of either good X or Y or

both. As the quantity of the commodities increase it will lead to a higher level of satisfaction.
Unusual indifference curves

Perfect substitutes: In case of perfect substitutes, we come across a
straight line indifference curve with a constant MRSxy. This is because
the consumer derives equal amount of satisfaction from commodity Y
as well as X.
Perfect complements: In case of perfect complements,

we come across “L” shaped indifference curve. As the goods
are perfect complements they have to be used in pairs. Thus,
if the consumer has more units of commodity Y and one unit
of X he would derive equal amount of satisfaction had he
consumed one unit of each.
Horizontal indifference curve: This type of

indifference curve is observed when the consumer does
not consume one of the commodities. Considering an
example of a vegetarian who derives no utility from meat
would find no change in his level of satisfaction if offered
more units on meat. In our example meat is a neuter
commodity.
Indifference Map
The collection of indifference curves/the family of indifference curves, is known as “Indifference
Map”. In an indifference map, an Indifference curve at the extreme right represents highest level
of satisfaction and the curve at the extreme left represents lowest amount of satisfaction. Hence
IC4> IC3> IC2> IC1.
An indifference map depicts the complete picture of consumer’s

tastes and preferences. In the given figure, an indifference map
of a consumer is shown which consists of three indifference
curves.
We have taken good X on X-axis and good Y on Y-axis. It should

be noted that while the consumer is indifferent among the
combinations lying on the same indifference curve, he certainly prefers the combinations on the
higher indifference curve to the combinations lying on a lower indifference curve because a
higher indifference curve signifies a higher level of satisfaction. Thus, while all combinations of
I1 give him the same satisfaction, all combinations lying on I2 give him greater satisfaction than
those lying on I1.
Budget Line
Price line/budget line represents all the different
combination of two goods that can be purchased by the
consumer at a given level of income and prices of two
goods.
A higher indifference curve shows a higher level of

satisfaction than a lower one. Therefore, a consumer, in
his attempt to maximize satisfaction will try to reach the
highest possible indifference curve. But in his pursuit of buying more and more goods and thus
obtaining more and more satisfaction, he has to work under two constraints:
a) First, he has to pay the prices for the goods and,
b) Second, he has a limited money income with which to purchase the goods.
These constraints are explained by the budget line or price line. All those combinations which
are within the reach of the consumer (assuming that he spends all his money income) will lie on
the budget line.
Consumer’s Equilibrium under indifference curve

A consumer is in equilibrium when he is deriving maximum possible satisfaction from the goods
and therefore is in no position to rearrange his purchases of goods.
We assume that:
a) He has a fixed money income which he has to spend wholly on goods X and Y.
b) Prices of goods X and Y are given and are fixed.
c) All goods are homogeneous and divisible.
d) The consumer acts ‘rationally’ and maximizes his
satisfaction.
To show which combination of two goods X and Y the

consumer will buy to be in equilibrium we bring his
indifference map and budget line together.
Consider the above Figure, in which IC1, IC2 and IC3, are

shown together with budget line AB for good X and good Y. Every combination on the budget
line AB costs the same. Thus combinations E, F and G cost the same to the consumer. The
consumer’s aim is to maximize his satisfaction and for this, he will try to reach highest
indifference curve.
Since there is a budget constraint, he will be forced to remain on the given budget line, that is he
will have to choose combinations from among only those which lie on the given price line.
Which combination will he choose? Suppose he chooses E. We see that E lies on a lower
indifference curve IC1, when he can very well afford F lying on higher indifference curve. Similar
is the case for other combination on IC1. Again, suppose he chooses combination G lying on IC1,
here again we see that the consumer can still reach a higher level of satisfaction remaining
within his budget constraints i.e., he can afford to have combination F lying on IC2because it lies
on his budget line. Now, what if he chooses combination F? We find that this is the best choice
because this combination lies not only on his budget line but also puts him on the highest
possible indifference curve i.e., IC2. The consumer can very well wish to reach IC3 but this
indifference curves are beyond his reach given his money income. Thus, the consumer will be at
equilibrium at point F on IC2. What do we notice at point F? We notice that at this point, his
budget line AB is tangent to the indifference curve IC2. In this equilibrium position (at F), the
consumer will buy OC1 of X and OC2 of Y.
At the tangency point F, the slopes of the price line AB and the indifference curve
IC2are equal. The slope of the indifference curve shows the marginal rate of
substitution of X for Y.
Therefore we can conclude that at the point of equilibrium the consumer would be having the
following equation.
Px
= MRSxy
Py
Convergence of marginal utility analysis and indifference curve analysis

A deeper understanding of the two approach reveals that they offer the same answer to the
consumer equilibrium.
MU x Px
Equilibrium as per marginal utility is arrived by the consumer at =
MU y Py
Px
Whereas equilibrium as per the indifference curve approach is attained at = MRSxy
Py

MU x Px
Thus, at the point of equilibrium = = MRS xy
MU y Py
The indifference curve analysis is superior to utility analysis:

i) It dispenses with the assumption of measurability of utility
ii) It studies more than one commodity at a time
iii) It does not assume constancy of money
iv) It segregates income effect from substitution effect.

Chapter – 04 – Elasticity of Demand
Till now we were concerned with the direction of the changes in prices and quantities
demanded.
Now we will try to measure these changes, or to say, we will try to answer the question “by how
much”?
The law of demand explains that demand will change due to a change in the price of the
commodity. But it does not explain the rate at which demand changes to a change in price. i.e,
Law of Demand explains only the direction of change but not the magnitude. Hence Law of
Demand is only a qualitative statement. Whereas the concept of ‘elasticity of demand’ measures
the rate of change in demand and hence is a quantitative statement.
The concept of elasticity of demand was introduced by Alfred Marshall. According to him, “the
elasticity (or responsiveness) of demand in a market is great or small according as the amount
demanded increases much or little for a given fall in price and diminishes much or little for a
given rise in price”. Elasticity of Demand is the “measure of responsiveness or the degree of
change in quantity demanded due to changes in one of the variables on which demand depends
– these variables are price of a commodity, price of related commodities and income of
consumers”.
Types of elasticity of demand

Elasticity of demand can be broadly classified under
a) Price elasticity
b) Cross elasticity and
c) Income elasticity.
It is to be noted that when we talk of elasticity of demand, unless and until otherwise mentioned,
we talk of price elasticity of demand.
In other words, it is price elasticity of demand which is usually referred to as elasticity of
demand.
Price Elasticity: Price elasticity of demand expresses the response of quantity demanded of a
good to a change in its price, assuming the consumer’s income, his tastes and prices of all other
goods as constant.
Methods of measuring price elasticity of demand
- Percentage method or proportional method or Formula Method.
- Point elasticity method or Geometric Method.

- Are elasticity method

- Total outlay method or Expenditure method
Percentage method or proportional method or formula method: This is measured as percentage

change in quantity demanded divided by the percentage change in price, other things remaining
equal. That is
%change in quantity demanded

Price Elasticity = E p =
%change in Price
Change in quantity
×100
Original quantity
Ep =
Change in Price
×100
Original Price
Change in Quantity Original Price

Ep = 
Original quantity Change in Price
Symbolically :
Δq p Δq p
Ep = × = ×
q Δp Δp q
Where,
Epstands for price elasticity
q Stands for quantity
p Stands for price
Δ Stands for a very small change
Since price and quantity are inversely related (with a few exceptions) price elasticity is negative.
But, for the sake of convenience, we ignore the negative sign and consider only the numerical
value of the elasticity.

Note: Thus if a 10% change in price leads to 20% change in quantity demanded of good X
and 40% change in quantity demanded of good Y, then we get elasticity of X and Y as 2
and 4 respectively, showing that demand for Y is more elastic or responsive to price
changes than that of X. Had we considered minus signs (-2 > -4) we would have concluded
that the demand for X is more elastic than that for Y, which is not correct. Hence, by
convention, we take the absolute value of price elasticity and draw conclusions.
Example- if the price of the commodity A is 25 and the quantity demanded is 50. What would
be the elasticity of demand if the price goes up to 30 and quantity demanded goes down to 40?
Δq p
On applying the formula E p = ×
Δp q
10 25
We get- E p = × = -1
-5 50
Point elasticity or geometric method: It measures elasticity of demand at a particular point on
the demand curve. We can calculate the price elasticity of demand at a point on the linear
demand curve. This method is usually used when the change is extremely small. Formula to find
out Ep through point method is
Lower segment of the demand curve from the point
Upper segment of the demand curve from the point
Point elasticity makes use of derivative rather than finite changes in price and quantity. It may
be defined as:
-dq p
Ep = ×
dp q
dq
Where is the derivative of quantity with respect to price
dp
at a point on the demand curve, and p and q are the price
and quantity at that point.
It is to be noted that elasticity is different at different points
on the same demand curve. Given a straight line demand
curve DD’, point elasticity at any point can be found by
using the formula. Let us assume DD’ to be 20cms divided
into 4 equal parts of 5cms each. In the table given below we
calculate the elasticity at various points.

Sl. Ep at different Point on the demand Ep = lower segment Price

No. curve as seen in the figure above / upper segment elasticity
R Ep at point R RD’/RD = 10/10 = 1 Ep = 1
L Ep at point L LD’/LD = 5/15 =0.33 Ep < 1
S Ep at point B SD’/SD = 15/5 = 3 Ep > 1
D’ Ep at point D’(bottom of the demand curve) D’D’/DD’ = 0/20 = 0 Ep = 0
D Ep at point D (top of the demand curve) DD’/DD = 20/0 = ∞ Ep = ∞
Arc-elasticity: When the price change is somewhat larger or when price elasticity is to
be found between two points on the demand curve, the question arises which price and
quantity should be taken as base. This is because elasticities found by using original price and
quantity figures as base will be different from the one derived by using new price and quantity
figures. Therefore, in order to avoid confusion, generally midpoint method is used i.e.
averages of the two prices and quantities are taken as (i.e. original and new) base.
The arc elasticity can be found out by using the formula:
q 1 - q 2 P1 + P2
Ep = ×
p1 - p 2 q 1 + q 2
Where,
q1 = original quantity
q2 = new quantity
p1 = original price
p2 = new price
Note: If the problem is silent about the method to calculate price elasticity, then Arc method
should be used.
Example: where p1, q1 are the original price and quantity and p2, q2 are the new ones.
Thus, if we have to find elasticity of cricket bat between:
p1= `500 q1 = 100
p2 = `400 q2 = 150
q 1 - q 2 P1 + P2
So, by using the formula, E p = ×
p1 - p 2 q 1 + q 2

100 - 150 500 + 400

Ep = ×
500 - 400 100 + 150
-50 900
Ep = ×
100 250
E p = -1.8
Total outlay method: This method is also known as Total Expenditure method. We can
measure elasticity though a change in expenditure on commodities due to change in price. This
method provides only the direction of elasticity rather than the exact extent of elasticity. We can
only know whether elasticity is equal to, greater than or less than 1. Formula for this method is
TE= P X Q
Changes in Types of elasticity of demand
price ep = 1 ep < 1 ep > 1
Fall in price Total outlay remains constant Total outlay falls Total outlay rises
Rise in price Total outlay remains constant Total outlay rises Total outlay falls
Example:
Price of X (P) Quantity demanded Total outlay Elasticity of demand
(`) (Q) (P  Q) (e)
10 2,000 20,000
8 3,000 24,000 > 1 Relatively elastic
4 7,000 28,000
Price of Y (P) Quantity demanded Total outlay Elasticity of demand

(`) (Q) (P  Q) (e)
20 2,000 40,000
16 2,500 40,000 = 1 Unitary Elastic
8 5,000 40,000
Price of Z (P) (`) Quantity demanded Total outlay Elasticity of demand

(Q) (P  Q) (e)
15 2,000 30,000
12 2,250 27,000 <1 Relatively inelastic
10 2,500 25,000

In the figure give we are able to notice that as the price goes
down from P3 to P2 the total expenditure from T1 to T2
denoting E>1. As the price further falls from P2 to P1 we
notice that there is no change in total expenditure as the
total expenditure stays at T2. Thereafter when the price falls
from P1 to P then the expenditure falls from T2 to T denoting
E < 1. Thus by considering the price of the commodity and
total expenditure of the same is used by this method in
order to provide direction of elasticity.
Interpretation of Numerical Values of Elasticity of Demand
Perfectly Elastic Demand: In this case, a very small

change in price leads to a very large change in demand. The
demand curve is a horizontal curve and is parallel to X axis.
Under such a case, consumers will buy all that they can
obtain of the commodity at the reduced price. If there is a
slight increase in price, they would not buy anything from
the particular seller. This type of demand curve is found in a
perfectly competitive market and the numerical co-efficient of perfectly elastic demand curve is
∞.
Perfectly inelastic: In this case, whatever may be the change

in price quantity demanded will remain perfectly constanti.e.
when quantity demanded does not respond to a price change.
The demand curve is a vertical straight line and is parallel to Y
axis. The numerical co-efficient of perfectly inelastic demand is 0
(Zero). This is generally seen in case of necessary goods like
water.
Unitary elastic: Any change in price brings about an

equally proportionate change in the quantity demanded.
The numerical co-efficient of unitary elastic demand is
always 1. (Ep = 1). In this case the demand curve would be
rectangular hyperbola.

Relatively elastic: In this case a slight change in price leads to more than proportionate
change in quantity demanded. This can be represented by
a gradually sloping demand curve (it will be flatter). The
numerical co-efficient of relatively elastic demand is > 1.
In this case the demand curve would be flatter or wider.
This holds good in case of luxuries.
Relatively inelastic: In this case, a large change in

price leads to less proportionate change in demand.
This can be represented by a steeply sloping demand
curve. The numerical co-efficient or relatively inelastic
demand is < 1. This condition holds goods in case of
necessaries.
In the given diagram we notice as the price moves from
P1 to P2 the quantity decreases from Q1 to Q2.
Numerical measure
Description Terminology
of elasticity
Quantity demanded does not change as price
Zero Perfectly inelastic
changes
Greater than zero, but Quantity demanded changes by a smaller
Relatively Inelastic
less than one percentage than change in price
Quantity demanded changes by exactly the
One Unit elasticity
same percentage as change in price
Greater than one, but Quantity demanded changes by a larger
Relatively Elastic
less than infinity percentage than change in price
Buyers are prepared to buy all they can obtain
Infinity at some price and none at all at an even Perfectly elastic
slightly higher price
Determinants of Price Elasticity of Demand

Now an important question is: what are the factors which determine whether the demand for a
good is elastic or inelastic? We will consider the following important determinants of price
elasticity.

1) Availability of substitutes: One of the most important determinants of elasticity is the

degree of availability of close substitutes. Some commodities like butter, carrot, Maruti Car,
etc. have close substitutes. There are margarine, other green vegetables, Chevrolet or other
cars, respectively. A change in price of commodity in question (the prices of the substitutes
remaining constant) can be expected to cause substitution effect– a fall in price leading
consumers to buy more of the commodity in question and a rise in price leading consumers
to buy more of the substitutes.
Commodities such as salt, housing, and all vegetables taken together, have few, if any,
satisfactory substitutes and a rise in their prices may cause a smaller fall in their quantity
demanded. Thus, we can say that goods which typically have close or perfect substitutes have
highly elastic demand curve whereas lack of availability of substitutes leads to inelastic
demand for a commodity.
It should be noted that while as a group a good or service may have inelastic demand, but
when we consider its various brands, we say that a particular brand has elastic demand.
Example: While demand for petrol is inelastic, the demand for Bharat Petroleum’s petrol is
elastic.
2) Proportion of consumers’ budget: Goods which occupy a higher proportion of
consumers’ budget or goods on which the consumers spend a major portion (like clothing,
milk, provisions etc.) of their budget have more elastic demand compared to those goods on
which the consumers spend only a small portion of their income (like salt, sugar etc.) This is
because, when the price of goods which occupy a major portion of the consumers’ budget
rises, it will impact the expenses of a consumer drastically when compared to the goods
which occupy a small portion of the consumers’ budget.
3) Nature of the need that a commodity satisfies: In general, luxury goods are price
elastic while necessities are price inelastic. The consumers do not react to change in price in
case of necessities whereas they tend to reduce consumption in case of increase in price of
luxuries. Thus, while the demand for ovens is relatively elastic, the demand for food and
housing, in general, is inelastic.
4) Number of uses to which a commodity can be put: The more the possible uses of a
commodity the greater will be its price elasticity and vice versa. To illustrate electricity has
several uses. If its price falls, it can be used for a variety of purposes like cooking, electric
cars, vacuum cleaner. But, if its price increases, its use will be restricted only to essential
purposes like light and fan.

5) Time period: The longer the time-period higher would be the elasticity of demand for a
commodity and vice-versa. This is because of –
a) The consumers take time to adjust their taste and preferences and hence would make
greater changes in their habits over a longer period of time.
b) The supplier requires time to come out with new products and services which would be
an appropriate substitute to the existing product whose price has changed.
Example: In response to a higher petrol price, one can, in the short run, make fewer
trips by car. In the longer run, not only can one make fewer trips, but can also purchase
an electric car when the time comes for replacing the existing one. Hence, one’s demand
for petrol falls more when one has made long term adjustment to higher prices.
6) Consumer habits: Goods which are not habitually used by the consumer have more elastic
demand than those that are habitually used by the consumer.
Example: cigarettes, alcohol have less elastic demand.
7) Tied demand: The demand for those goods which are tied to others is normally inelastic as
against those whose demand is of autonomous nature. Where as, goods which have
independent demand have more elastic demand.
Example: like pen and refill, car and petrol etc.
8) Price range: Goods which are in very high price range or in very low price range have
inelastic demand, but those in the middle range have elastic demand. As a change in the
price of goods in the very high price range would not affect the decisions of the buyer as the
buyers of such goods belong to elite class and do not respond much to changes in the prices
of such premium product. Whereas goods at a very low price range are purchased in the
required quantities by those who want it and thus a price variation in the price of such
product do not bring about a substantial response from the consumers in the form of change
in quantity demanded. Thus commodities lying in the medium price range have greater
elasticity.
9) Postponement: Goods, the use or purchase of which can be postponed, have more elastic
demand while those goods which have to be purchased immediately have less elastic
demand.
Example: Purchase of car, TV can be postpone, but food or clothing cannot be postpone.
Income elasticity of demand

It is the degree of responsiveness of the quantity demanded of a commodity to a change in the
income of the consumers.

In Can be represented as:

%change in quantity demanded
Price Elasticity = Ey =
%change in income
Or
Change in Quantity
×100
OriginalQuantity
Ey =
Change in income
×100
Original income
Or
Change in Quantity Original income
Ey = 
OriginalQuantity Change in income
Or in symbolic terms
Δq Y Δq Y
Ey = × = ×
q ΔY ΔY q
Ey = Income elasticity of demand
Δ q = Change in demand
q = Original demand
Y = Original money income
Δ Y = Change in money income
Interpretation of income elasticity.

Elasticity greater than one (Ey> 1): If income levels increase, and the demand for certain
goods increase by more than proportionate extent. If the income elasticity for a good is greater
than one, it shows that the commodity forms a larger part of consumer’s expenditure as he
becomes richer. Such goods are called luxury goods. The income elasticity is greater than unity.
Elasticity equal to one (Ey = 1): If the proportion of income spent on goods remains the
same as income increases, then the income elasticity is equal to one. It provides a useful dividing
line which helps to divide luxuries and necessities.
Elasticity lesser than one (>0 Ey< 1): If income levels increases, and the demand for goods
increase by less than proportionate extent, such goods will be necessary goods. The income
elasticity is lesser than unity in case of necessities.

Elasticity lesser than zero (Ey< 0): If demand decreases with an increase in money income
of consumers, such goods are called inferior goods. As the consumer has more money income
than before he would substitute superior commodity in place of inferior one. The income
elasticity is lesser than zero.
In other words,
- In case of inferior goods, income elasticity is < 0.
- In case of necessary goods, income elasticity is > 0 but <1
- In case of luxury goods, income elasticity is >1.
The following examples will make the above concepts clear:
a) The income of a household rises by 20%, the demand for Rice increases by 10%.
b) The income of a household rises by 10%, the demand for Refrigerator rises by 20%.
c) The incomes of a household rises by 10%, the demand for Jowar falls by 5%.
d) The income of a household rises by 10%, the demand for shirt rises by 10%.
e) The income of a household rises by 15%, the demand for salt does not change at all.
Serial Income
Commodity Interpretation
number elasticity
(ey < 1) as the income elasticity is less than 1the
10%
A Rice = 0.5 commodity in question isnormal goods and fulfills
20%
the criteria of necessaries.
15% (ey > 1) as the income elasticity is more than 1the
B Refrigerator = 1.5
10% commodity in question isa luxury.
(ey < 0) as the income elasticity is negative(less than
-5%
C Jowar = -0.5 0)the commodity in question is inferior
10%
commodity.
10% (ey = 1) the income elasticity of the commodity is
D Shirt =1
10% unitary.
0%
E Salt =0 (ey = 0) the income elasticity of the commodity is 0.
15%
Note-In case of shirt the elasticity is 1 and they can be construed as normal goods. On the other
hand elasticity of salt is 0 which denote that it is an essential commodity and the consumer
avoids altering its consumption with a change in his income.

Cross elasticity of demand:

In measures the responsiveness of the quantity demanded of a commodity to a change in price
of related commodities (substitute and complements), other things remaining constant. In other
words, we study the changes in demand for one commodity in response to the change in the
price of other goods.This type of relationship is studied under ‘Cross Demand’. Cross demand
refers to the quantities of a commodity or service which will be purchased with reference to
changes in price, not of that particular commodity, but of other related commodities, other
things remaining the same.
Cross elasticity of demand (Exy) can be computed as follows:

%change in demand of commodity x
E xy =
%change in price of commodity
Or
Change in Quantity of commodity x
×100
Original Quantity of commodity x
E xy =
Change in price of commodity x
×100
Original price of commodity y
Symbolically the formula can be represented as:

Δq x p y
E xy = ×
q x Δp y
Δq x p y
E xy = ×
Δp y q x
Exy Stands for cross elasticity

qx Stands for original quantity demanded of x
Δ qx Stands for change in quantity demanded for x
py stands for the original price of good Y
Δ py stands for a small change in the price of Y

Substitute Products: In case of the substitute products,

rise in price of substitute product will increase the
demand of the commodity in question and vice versa. In
case of rise in the price of coke, consumer will opt for
substitute products like Pepsi. In the graph given the
curve slopes upward showing more quantity of Pepsi will
be demanded in case of price rise of coke. So there is direct relationship between price of
substitute and demand for commodity in question.
Complementary Goods: In the case of

complementary goods, as shown in the figure, a
change in the price of complementary good will have
an opposite reaction on the commodity in question
which is closely related or complementary. The case
with complementary goods such as or car and petrol is
that whenever there is a increase in the price of petrol
the demand for petrol due to a rise in prices of petrol, the demand for cars will fall down, not
because the price of cars has gone up, but because the price of petrol has gone up. So, we find
that there is an inverse relationship between price of a commodity and the demand for its
complementary good (other things remaining the same).
Interpretation of cross elasticity.

a) If two goods are perfect substitutes for each other, the cross elasticity between them is
infinite. (Red pins and green pins)
b) If two goods are totally unrelated, cross elasticity between them is zero. (Shoes and butter)
c) If two goods are substitutes (like coke and Pepsi), the cross elasticity between them is
positive, that is, in response to a rise in price of one good the demand for the other good
rises.
d) If two goods are complementary (tea and sugar) to each other, the cross elasticity between
them is negative so that a rise in the price of one leads to a fall in the quantity demanded of
the other.
Demand classification are as follows

Producer’s goods and consumers goods: Producer’s goods are those which are used for
the production of other goods- either consumer goods or producer goods. e.g. Plant, Machines

etc. The goods which are used for a final consumption are called consumer’s goods. e.g. Food
articles, Watches etc.
Durable and non-durable (perishable) goods: Consumer’s goods may be further sub-
divided into durable and non-durable goods. The goods which are durable in nature i.e. can be
consumed more than once, like watches, TV etc. The goods which are perishable in nature are
called Non durable goods. Ex: these goods cannot be consumed more than once and also cannot
be stored for long time, like food items.
Derived and autonomous demand: If the demand for the good is derived from the demand
of other parent good it is called derived demand. e.g. demand for cement is derived from
demand for buildings. If the demand for a product is independent of the demand for other
goods, then it is called autonomous demand e.g. food. This distinction is purely arbitrary and it
is very difficult to find out which product is entirely independent of other products.
Industry demand and company demand: An industry is an aggregate of firms. Industry

demand means it’s an aggregate demand of the companies of a particular industry. e.g. FMCG
Industry. The company demand is the demand of an individual company or firm.
Short run and long run demand: Short run demand immediate response of demand if
there is a change in price, income etc. whereas long-run demand is that which will ultimately
exist as a result of changes in pricing, promotion or product improvement, after enough time is
allowed to let the market adjust to the new situation.
New and replacement demand: If the purchase or acquisition of an item is means as an

addition to stock it is called new demand. Ex: New plant of machinery as s measure of capacity
expansion. If the purchase of an item is meant for maintaining the old stock of capital/asset it is
called replacement demand. Ex: demand for spare parts of the machine.

Chapter – 05 – Demand Forecasting
Forecasting, in general, refers to knowing or measuring the status or nature of an event or

variable before it occurs. Forecasting of demand is the art and science of predicting the probable
demand for a product or a service at some future date on the basis of certain past behaviour
patterns of some related events and the prevailing trends in the present. It should be kept in
mind that demand forecasting is no simple guessing, but it refers to estimating demand
scientifically and objectively on the basis of certain facts and events relevant to forecasting.
Usefulness
The significance of demand or sales forecasting in the context of business policy decisions can
hardly be over emphasized. The effectiveness of the plans of business managers depends upon
the level of accuracy with which future events can be predicted. Forecasting of demand plays a
vital role in the process of planning and decision-making, whether at the national level or at the
level of a firm. The importance of demand forecasting has increased all the more on account of
mass production and production in response to demand. A good forecast enables the firm to
perform efficient business planning. Forecasts offer information for budgetary planning and cost
control in functional areas of finance and accounting. Good forecasts help in efficient production
planning, process selection, capacity planning, facility layout and inventory management. A firm
can plan production scheduling well in advance and obtain all necessary resources for
production such as inputs, and finances. Capital investments can be aligned to demand
expectations and this will check the possibility of overproduction and underproduction, excess
of unused capacity and idle resources. Marketing relies on sales forecasting in making key
decisions. Demand forecasts also provide the necessary information for formulation of suitable
pricing and advertisement strategies.
It is said that no forecast is completely fool-proof and correct. However, the very process of
forecasting helps in evaluating various forces which affect demand and is in itself a reward
because it enables the forecasting authority to know about various forces relevant to the study of
demand behaviour.
Scope of Forecasting
Demand forecasting can be at the international level depending upon the area of operation of
the given economic institution. It can also be confined to a given product or service supplied by a
small firm in a local area. The scope of the forecasting task will depend upon the area of
operation of the firm in the present as well as what is proposed in future. Much would depend
upon the cost and time involved in relation to the benefit of the information acquired through
the study of demand. The necessary trade-off has to be struck between the cost of forecasting
and the benefits flowing from such forecasting.
Types of forecasts
1) Macro-level forecasting deals with the general economic environment prevailing in the
economy as measured by the Index of Industrial Production (IIP), national income and
general level of employment etc.
i) Industry- level forecasting is concerned with the demand for the industry’s products as
a whole. For example, demand for cement in India.
ii) Firm- level forecasting refers to forecasting the demand for a particular firm’s product,
say, the demand for ACC cement.
2) Based on time period, demand forecasts may be short-term demand forecasting and long-
term demand forecasting.
i) Short-term demand forecasting covers a short span of time, depending of the nature of
industry. It is done usually for six months or less than one year and is generally useful in
tactical decisions.
ii) Long-term forecasts are for longer periods of time, say two to five years and more. It
provides information for major strategic decisions of the firm such as expansion of plant
capacity.
Methods of demand Forecasting

There is no easy method or simple formula which enables an individual or a business to predict
the future with certainty or to escape the hard process of thinking. The firm has to apply a
proper mix of judgment and scientific formulae in order to correctly predict the future demand
for a product. The following are the commonly available techniques of demand forecasting:
i) Survey of Buyers’ Intentions: The most direct method of estimating demand in the
short run is to ask customers what they are planning to buy during the forthcoming time
period, usually a year. This method involves direct interview of potential customers.
Depending on the purpose, time available and costs to be incurred, the survey may be
conducted by any of the following methods:
a) Complete enumeration method where nearly all potential customers are interviewed
about their future purchase plans
b) Sample survey method under which only a scientifically chosen sample of potential
customers are interviewed

c) End–use method, especially used in forecasting demand for inputs, involves

identification of all final users, fixing suitable technical norms of consumption of the
product under study, application of the norms to the desired or targeted levels of output
and aggregation.
Thus, under this method the burden of forecasting is put on the customers. However, it
would not be wise to depend wholly on the buyers’ estimates and they should be used
cautiously in the light of the seller’s own judgement. A number of biases may creep into the
surveys. The customers may themselves misjudge their requirements, may mislead the
surveyors or their plans may alter due to various factors which are not identified or
visualised at the time of the survey. This method is useful when bulk of sale is made to
industrial producers who generally have definite future plans. In the case of household
customers, this method may not prove very helpful for several reasons viz. irregularity in
customers’ buying intentions, their inability to foresee their choice when faced with multiple
alternatives, and the possibility that the buyers’ plans may not be real, but only wishful
thinking.
ii) Collective opinion method: This method is also known as sales force opinion method or
grass roots approach. Firms having a wide network of sales personnel can use the
knowledge, experience and skills of the sales force to forecast future demand. Under this
method, salesmen are required to estimate expected sales in their respective territories. The
rationale of this method is that salesmen being closest to the customers are likely to have the
most intimate feel of the reactions of customers to changes in the market. These estimates of
salesmen are consolidated to find out the total estimated sales. These estimates are reviewed
to eliminate the bias of optimism on the part of some salesmen and pessimism on the part of
others. These revised estimates are further examined in the light of factors like proposed
changes in selling prices, product designs and advertisement programmes, expected changes
in competition and changes in secular forces like purchasing power, income distribution,
employment, population, etc. The final sales forecast would emerge after these factors have
been taken into account.
Although this method is simple and based on first hand information of those who are
directly connected with sales, it is subjective as personal opinions can possibly influence the
forecast. Moreover salesmen may be unaware of the broader economic changes which may
have profound impact on future demand. Therefore, forecasting could be useful in the short
run, for long run analysis however, a better technique is to be applied.

iii) Expert Opinion method: In general, professional market experts and consultants have
specialised knowledge about the numerous variables that affect demand. This, coupled with
their varied experience, enables them to provide reasonably reliable estimates of probable
demand in future. Information is elicited from them through appropriately structured
unbiased tools of data collection such as interviews and questionnaires.
The Delphi technique, developed by Olaf Helmer at the Rand Corporation of the USA,
provides a useful way to obtain informed judgments from diverse experts by avoiding the
disadvantages of conventional panel meetings. Under this method, instead of depending
upon the opinions of buyers and salesmen, firms solicit the opinion of specialists or experts
through a series of carefully designed questionnaires. Experts are asked to provide forecasts
and reasons for their forecasts. Experts are provided with information and opinion
feedbacks of others at different rounds without revealing the identity of the opinion
provider. These opinions are then exchanged among the various experts and the process
goes on until convergence of opinions is arrived at. This method is best suited in
circumstances where intractable changes are occurring and the relevant knowledge is
distributed among experts. Delphi technique is widely accepted due to its broader
applicability and ability to address complex questions. It also has the advantages of speed
and cheapness.
iv) Statistical methods: Statistical methods have proved to be very useful in forecasting
demand. Forecasts using statistical methods are considered as superior methods because
they are more scientific, reliable and free from subjectivity. The important statistical
methods of demand forecasting are:
a) Trend Projection method: This method, also known classical method, is considered
as a ‘naive’ approach to demand forecasting. A firm which has been in existence for a
reasonably long time would have accumulated considerable data on sales pertaining to
different time periods. Such data, when arranged chronologically, yield a ‘time series’.
The time series relating to sales represent the past pattern of effective demand for a
particular product. Such data can be used to project the trend of the time series. The
trend projection method assumes that factors responsible for the past trend in demand
will continue to operate in the same manner and to the same extent as they did in the
past in determining the magnitude and direction of demand in future. The popular
techniques of trend projection based on time series data are;
a) graphical method and

b) Fitting trend equation or least square method.

b) Graphical Method: This method, also known as ‘free hand projection method’ is the
simplest and least expensive. This involves plotting of the time series data on a graph
paper and fitting a free- hand curve to it passing through as many points as possible. The
direction of the curve shows the trend. This curve is extended into the future for deriving
the forecasts. The direction of this free hand curve shows the trend. The main draw-back
of this method is that it may show the trend but the projections made through this
method are not very reliable.
c) Fitting trend equation: Least Square Method: It is a mathematical procedure for
fitting a line to a set of observed data points in such a manner that the sum of the
squared differences between the calculated and observed value is minimised. This
technique is used to find a trend line which best fit the available data. This trend is then
used to project the dependant variable in the future. This method is very popular because
it is simple and inexpensive. Moreover, the trend method provides fairly reliable
estimates of future demand.
The least square method is based on the assumption that the past rate of change of the
variable under study will continue in the future. The forecast based on this method may
be considered reliable only for the period during which this assumption holds. The major
limitation of this method is that it cannot be used where trend is cyclical with sharp
turning points of troughs and peaks. Also, this method cannot be used for short term
forecasts.
d) Regression analysis: This is the most popular method of forecasting demand. Under this
method, a relationship is established between the quantity demanded (dependent
variable) and the independent variables (explanatory variables) such as income, price of
the good, prices of related goods etc. Once the relationship is established, we derive
regression equation assuming the relationship to be linear. The equation will be of the
form Y = a + bx. There could also be a curvilinear relationship between the dependent
and independent variables. Once the regression equation is derived, the value of Y i.e.
quantity demanded can be estimated for any given value of X.
v) Controlled Experiments: Under this method, future demand is estimated by conducting

market studies and experiments on consumer behaviour under actual, though controlled,
market conditions. This method is also known as market experiment method. An effort is
made to vary separately certain determinants of demand which can be manipulated, for

example, price, advertising, etc., and conduct the experiments assuming that the other
factors would remain constant. Thus, the effect of demand determinants like price,
advertisement, packaging, etc., on sales can be assessed by either varying them over different
markets or by varying them over different time periods in the same market. The responses of
demand to such changes over a period of time are recorded and are used for assessing the
future demand for the product. For example, different prices would be associated with
different sales and on that basis the price-quantity relationship is estimated in the form of
regression equation and used for forecasting purposes. It should be noted however, that the
market divisions here must be homogeneous with regard to income, tastes, etc.
The method of controlled experiments is used relatively less because this method of demand
forecasting is expensive as well as time consuming. Moreover, controlled experiments are
risky too because they may lead to unfavourable reactions from dealers, consumers and
competitors. It is also difficult to determine what conditions should be taken as constant and
what factors should be regarded as variable so as to segregate and measure their influence
on demand. Besides, it is practically difficult to satisfy the condition of homogeneity of
markets.
Market experiments can also be replaced by ‘controlled laboratory experiments’ or

‘consumer clinics’ under which consumers are given a specified sum of money and asked to
spend in a store on goods with varying prices, packages, displays etc. The responses of the
consumers are studied and used for demand forecasting.
vi) Barometric method of forecasting: The various methods suggested till now are related
with the product concerned. These methods are based on past experience and try to project
the past into the future. Such projection is not effective where there are economic ups and
downs. As mentioned above, the projection of trend cannot indicate the turning point from
slump to recovery or from boom to recession. Therefore, in order to find out these turning
points, it is necessary to find out the general behaviour of the economy. Just as
meteorologists use the barometer to forecast weather, the economists use economic
indicators to forecast trends in business activities. This information is then used to forecast
demand prospects of a product, though not the actual quantity demanded. For this purpose,
an index of relevant economic indicators is constructed. Movements in these indicators are
used as basis for forecasting the likely economic environment in the near future. There are
leading indicators, coincidental indicators and lagging indicators. The leading indicators
move up or down ahead of some other series. For example, the heavy advance orders for

capital goods give an advance indication of economic prosperity. The lagging indicators
follow a change after some time lag. The heavy household electrical connections confirm the
fact that heavy construction work was undertaken during the past with a lag of some time.
The coincidental indicators, however, move up and down simultaneously with the level of
economic activities. For example, rate of unemployment.

Chapter – 06 – Theory of Supply
Introduction
The term ‘supply’ refers to the amount of a good or service that the producers are willing and
able to offer to the market at various prices over a period of time. Supply is different from stock.
Stock is the total quantity of goods, which is stored in the warehouse, but it may not be offered
for sale. Hence supply is only a part of the stock, which is offered for sale. The concept of supply
should be studied from the manufacturer point of view.
Important points to understand concept of supply:

i) Supply refers to what firms offer for sale, not necessarily to what they succeed in selling.
What is offered may not get sold.
ii) Supply is a flow concept. The quantity supplied is ‘so much’ per unit of time, per day, per
week, or per year.
iii) A given quantity is offered by sellers at a given price, hence the quantity offered by producers
offer for sale changes with the change in the price of that commodity.
Determinants of supply
Price of the commodity: If the price of a commodity increases, quantity supplied will
increase and if the price of a commodity decreases, the quantity supplied will also decrease. This
is because goods and services are produced by the firm in order to earn profits and profits rise
with the rise in the price of the product subject to other things remaining constant.
Price of the related goods: If the price of other goods rise, they become relatively more
profitable to the firm to produce and sell, than the good in question. If a farmer is producing
radish as well as carrot which are being sold at the same price then it implies, that if the price of
carrot rises, the farmer may deploy more of his land to carrot production and go away from
producing radish.
Factors of production: If the cost of factors of production increase then the cost of making
goods increases and may affect the profitability. Hence the price of factors of production plays
an important role in the supply of a commodity.
Technology: Inventions and innovations tend to make it possible to produce more or better
goods with the same resources and tend to increase the supply of some products and to reduce
the supply of products that the displaced.

Government policy: Production of goods may be subject to the imposition of commodity

taxes such as excise duty, sales tax and import duties. These increase the cost of production and
so the supply of a commodity would decrease subject to the prices being stable. Subsidies, on the
other hand, reduce the cost of production and thus provide an incentive to the firm to increase
supply.
Goals of the firm: If the firm aims at profit maximization then it would supply less in order to
charge higher prices of its commodity. On the other hand if the firm is attempting to maximize
sales and increase market coverage then the firm would increase supply.
Market structure: If the firm is operating in a perfect competition market then it would
supply what ever it can and on the other hand if the firm is operating under monopoly market
then it would constrain its supply.
Supply function
Supply function is a mathematical relationship between supply of a commodity and its
determinants.
Sx = f (Ps, Pr, T, C, Ex, Gp)
Where,
Sx = Supply of commodity X
Px = Price of commodity X
Pr = Price of related goods, Y
T = state of technology
C = Cost of production
Ex = Expected price of commodity X
Gp = Government policy
Law of Supply
The law of supply explains the functional relationship between price of a commodity and its
quantity supplied. It states that: Other things being equal (ceteris paribus), the quantity of a
good produced and offered for sale will increase as the price of the good rises and decrease as
the price falls.
Assumptions of the law of the supply:
The law of supply holds good provided:
- Price of the related goods is not changed.
- No change in technology
- Cost of production to be constant

- Government policy should remain same

Supply schedule
A tabular representation of the relationship between price and quantity supplied is known as the
supply schedule. With the help of the supply schedule, a supply curve can be drawn. A supply
curve is a graphical representation of the supply schedule.
There are two types of supply schedule:
- Individual supply schedule
- Market supply schedule
Individual supply schedule: Individual supply schedule is a list of the prices and quantities
of a given commodity offered for sale by an individual seller or producer. The following is an
individual supply schedule. It shows that as the price goes up, an individual seller increases the
quantity supplied in the market.
Combination Price of Shirt (Rs.) Quantity of Shirt (Units of good)
A 100 200
B 200 400
C 300 600
D 400 800
E 500 1000
The table shows the quantities of shirt that would be produced and offered for sale by a supplier
at a number of alternative prices. At combination A, for example, 200 units of shirts are offered
for sale at `100 per shirt. Moreover at combination C, for example, 600 units of shirts are offered
for sale at `300 per shirt.
Individual supply curve

We draw a diagram below and the price is plotted on the vertical axis and quantity on the
horizontal axis, and various price-quantity combinations of the schedule above are plotted.

When we draw a smooth curve through the plotted points, what we get is the supply curve for
shirts. The supply curve slopes upwards from the left to the right i.e., it has a positive slope. Like
the supply schedule, the supply curve also shows a direct relationship between price and
quantity supplied.
Market supply schedule

By adding up the quantity supplied at various prices by all the sellers in the market, we can get
the market supply schedule. Market schedule is the lateral summation of the individual supply
schedules of all the suppliers in the market. The table given below depicts various quantities of a
given commodity that the various producers are ready to produce and offer for sale at different
prices. The last column is the summation of the first three denoting the market supply schedule.
Micro approach Macro approach
1. Studies a particular part or a component of the Studies the economy as a whole
economy
2. It is known as “Price Theory” It is known as “Income Theory”
3. Makes assumptions while studying an economy Doesn’t make any assumptions
4. It gives a worm’s eye view of an economy It gives a bird’s eye view of an economy
5. It is unrealistic study It is more realistic study
6. Has limited scope Has wider scope
Market supply curve

The market supply curve is a diagrammatic representation of the market supply schedule. The
diagram depicts three individual supply schedule plotted from the data given regarding the
individual suppliers. The market supply curve is the lateral summation of the individual supply
curves.
Reasons for upward slope of the supply curve

a) Profit motive: The main objective of the suppliers is to make more profit. This is
possible only when they can sell the goods at the higher prices. That’s why supply curve
shows upward trend as suppliers supply more at higher price other things remaining
constant.
b) Increasing marginal cost: The producer in order to produce more units of a

commodity has to increase the quantity of variable factors which entails higher cost. So,
in order to cover the increased costs producer have to supply at higher prices.

c) More number of suppliers: As the price of a commodity increases more number of

suppliers would join thereby leading to increase in quantity of goods supplied.
Expansion or contraction of supply:

When the supply of a good increases as a result of increase in its price, we say there is an
expansion of supply which leads to an upward movement on the supply curve. When supply of a
good decreases as a result of decrease in its price, we say there is a contraction of supply, which
leads to downward movement on the supply curve. It can be shown in the form of a diagram.
Earlier price was OP1 and quantity supplied was OQ1.

When price increases to OP2, quantity supplied also
increases to OQ2, similarly when price decreases to OP3
supplied also decreases to OQ3. Expansion and
contraction refers to an increase or decrease in the
quantity supplied respectively. Hence it is called as
movement on the supply curve.
SHIFTS IN SUPPLY CURVE – INCREASE OR DECREASE IN SUPPLY

When the supply curve shifts to right or left as a result of a change in one of the factors that
influence the quantity supplied other than the commodity’s own price, we say there is an
increase or decrease in supply.

Increase in supply - Fall in the price of substitutes

(A rightward shift in the supply curve) - Fall in the cost of production
- Favourable changes in Government policy
- Improvement in techniques of production.
Decrease in supply - Rise in the price of substitutes
(A leftward shift it the supply curve) - Rise in the cost of production
- Unfavourable changes in Government
policy
- Obsolete techniques of production
Difference between movement and shift in supply curve.

Basis of difference Movement along the curve Shift of the curve
Meaning It takes place as a result of change It takes place due to changes in
in price, other things remains factors other than price, i.e.
constant. It is also known as a price remains constant. It is
change in quantity supplied also known as a change in
supply
Supply curve Supply curve remains the same Supply curve shifts either to the
right or to the left
Terminology Expansion and contraction of Increase and decrease in supply
Supply
ELASTICITY OF SUPPLY
The elasticity of supply is defined as the responsiveness of the quantity supplied of a good to a
change in its price. Law of supply is a qualitative statement on the other hand elasticity of supply
is a quantitative statement.
There are three ways of computing of elasticity of supply.
1) Percentage method
2) Arc method
3) Point method / Geometric method
Percentage method
%Change in Quantity Supplied

Es =
%Change in Price

Change in Quantity Supplied

Quantity Supplied
Es =
Change in Price
Price
Symbolically-
Δq
q Δq p
Es = = ×
Δp Δp q
p
Where,
q = denotes original quantity supplied
∆q = Change n quantity supplied
p = Original price
∆p = Change in price
Note: As per the law of supply, there is a direct relationship between price and quantity
supplied. So, price elasticity of supply is positive.
Example:
Quantity (units) Price (Rs.)
50 100
80 150
Δq
q Δq p -30 100
Applying the formula: E s = = × = × = 0.40
Δp Δp q -50 150
p
Point elasticity: The elasticity of supply can be considered with reference to a given point on
the supply curve or between two points on the supply curve.
When elasticity is measured at a given point on the supply curve, it is called point elasticity.
Point-elasticity of supply can be measured with the help of the following formula:
dq p
Es = ×
dp q

dq
Where is the derivative of quantity with respect to price at a point on the supply curve, and p
dp
and q are the price and quantity at that point.
Where,
p = Price
q = Quantity
Δp = Change in price
Δq = Change in quantity
Example: The Supply function is given as q = -200 + 20p. Find the elasticity of supply using
point method, when price is Rs 30.
Applying the formula
dq p
Es = ×
dp q
dq
= 20,P = 30
dp
At price 40 the quantity supplied would be q = -200 + 20 (30)
q = 400
Es = 20 x 30/400
Es = 1.5
Arc-elasticity: When the price change is somewhat larger or when price elasticity is to
be found between two points on the supply curve, the question arises which price and
quantity should be taken as base. This is because elasticities found by using original price and
quantity figures as base will be different from the one derived by using new price and quantity
figures. Therefore, in order to avoid confusion, generally midpoint method is used i.e.
averages of the two prices and quantities are taken as (i.e. original and new) base.
The arc elasticity can be found out by using the formula:
q -q p + p2
Es = 1 2 × 1
p1 - p2 q1 + q 2
Where,
P1 = original price
P2 = new price
q1 = original quantity
q2 = new quantity

Quantity (units) Price (Rs.)

250 100
280 120
Applying the formula

q -q p + p2
Es = 1 2 × 1
p1 - p2 q1 + q 2
We get
= 30 / 20 x (100 + 120) / (250 + 280)
= 0.6
Types and Interpretation of elasticity of

supply
i) Perfectly inelastic supply: If as a
result of a change in price, the quantity
supplied of a good remains unchanged, we
say that the elasticity of supply is zero or
the good has perfectly inelastic supply. In
the diagram as the price increases from Rs
2 to Rs 4 the quantity supplied remains 4
units.
Thus we notice that the quantity supplied of the commodity does not change with a change
in price. Thus the elasticity of supply is 0.
ii) Perfectly elastic supply: Elasticity of

supply said to be infinite when nothing is
supplied at a lower price but a small increase
in price causes supply to rise from zero to a
large amount indicating that producers will
supply large quantity demanded at that price.
This leads to a supply curve which is parallel
to X axis indicating infinite elasticity of
supply.

iii) Relatively less-elastic supply: If as a

result of a change in the price of a good its
supply changes less than proportionately, we
say that the supply of the good is relatively
less elastic or elasticity of supply is less than
one. In the diagram provided the price
increase from `30 to `40 the quantity
supplied of the commodity increases from 15
units to 16 units. This shows that the quantity
supplied increases less than proportionately to an increase in price of the commodity.
iv) Relatively elastic supply: If elasticity of

supply is greater than one i.e., when the quantity
supplied of a good changes substantially in
response to a small change in the price of the
good we say that supply is relatively elastic. The
diagram shows that the price increases in a
lesser proportion than the increase in quantity
supplied of a commodity denoting an elasticity
greater than 1.
v) Unitary elasticity: If the relative change in the

quantity supplied is exactly equal to the relative
change in the price, the supply is said to be
unitary elastic. Here the coefficient of elasticity of
supply is equal to one. The diagram shows that as
the price of the commodity increases from `2 to `4
the quantity supplied also increases from 2 units
to 4 units denoting a proportional change. Any
straight line supply curve passing through the origin will have an elasticity of one.
DETERMINANTS OF ELASTICITY OF SUPPLY

a) Behavior of cost of production: elasticity of supply depends on the change in the cost of
production upon producing addition quantity of output. If the cost decreases or remains
stable on producing an additional unit of output then the supply increases (elastic) on the

other hand if the cost of producing an addintional unit increases then the supply would not
increase (inelastic).
b) Time element: supply tends to relatively inelastic in the short run. However in the long
run the supply is elastic as new plants can be set up and production capacity can be
expanded.
c) Nature of commodity: supply of perishable goods tend to be less elastic as products
cannot be stored on the other hand supply of durable goods tends to be relatively elastic as
they can be stored.
d) Availability of facilities for expanding output: if producers have sufficient production
facilities, they would be able to increase their supply and therefore the supply would be
relatively elastic. On the other hand if the shortage of power, fuel or raw materials, the
output would expand slowly thus being inelastic.
e) Expectations regarding future prices: if the producers expect the rise in the prices of
the commodity then the supply of the commodity in the present would be less elastic and
vice-versa.

Chapter – 07 – Equilibrium
Equilibrium refers to a market situation where quantity demanded is equal to quantity supplied.
The intersection of demand and supply determines the equilibrium price. At this price the
amount that the buyers want to buy is equal to the amount that sellers want to sell. Only at the
equilibrium price, both the buyers and sellers are satisfied. Equilibrium price is also called
market clearing price.
The determination of market price is the central theme of micro economic analysis. Hence,
micro-economic theory is also also called price theory.
The following table explains the equilibrium price.
Supply and Demand Schedule

Price Quantity Demanded Quantity Supplied Impact on price
5 6 31 Downward
4 12 25 Downward
3 19 19 Equilibrium
2 25 12 Upward
1 31 6 Upward
The equilibrium between demand and supply is depicted in the diagram below. Demand and
Supply are in equilibrium at point E where the two curves intersect each other. It means that
only at price `3 the quantity demanded is equal to the quantity supplied. The equilibrium
quantity is 19 units and these are exchanged at price `3.
CHANGES IN DEMAND AND SUPPLY

The facts of real world, however, are such that other things (like income, tastes and preferences,
population, etc.) always change causing changes in demand and supply. The four main changes
in demand and supply are:
i) An increase (shift to the right) in demand;
ii) A decrease (shift to the left) in demand;

iii) An increase (shift to the right) in supply;

iv) A decrease (shift to the left) in supply.
i) An increase in demand: In figure 2, the original

demand curve is DD and supply curve is SS. At
equilibrium price OP, demand and supply are equal
to OQ. Now suppose the money income of the
consumer increases and the demand curve shifts to
D1D1 and the supply curve remains the same. We
will see that on the new demand curve D1D1 at OP
price demand increases to OQ2 while supply remains
the same i.e. OQ. Since supply is short of a demand,
price will go up to OP1. With the higher price supply will also shoot up and new equilibrium
between demand and supply will be reached. At this equilibrium point, OP1 is the price and
OQ1 is the quantity which is demanded and supplied.
Thus, we see that, as a result of an increase in demand, there is an increase in equilibrium
price, as a result of which the quantity sold and purchased also increases.
Decrease in Demand: The opposite will happen

when demand falls as a result of a fall in income,
while the supply remains the same. The demand
curve will shift to the left and become D1D1 while
the supply curve remains as it is. With the new
demand curve D1D1, at original price OP, OQ2 is
demanded and OQ is supplied. As the supply
exceeds demand, price will come down and
quantity demanded will go up. A new equilibrium
price OP1 will be settled in the market where demand OQ1 will be equal to supply OQ1.
Thus, with a decrease in demand, there is a decrease in the equilibrium price and quantity
demanded and supplied.
Increase in Supply: Let us now assume that demand does not change, but there is an
increase in supply say, because of improved technology.
The supply curve SS will shift to the right and become S1S1. At the original equilibrium price
OP, OQ is demanded and OQ2 is supplied (with new supply curve). Since the supply is
greater than the demand, the equilibrium price will go down and become OP1 at which OQ1

will be demanded and supplied. Thus, as a result of

an increase in supply with demand remaining the
same, the equilibrium price will go down and the
quantity demanded will go up.
Decrease in Supply: If because of some reason, there

is a decrease in supply we will find that equilibrium price
will go up, but the amount sold and purchased will go
down as shown in figure. As S shifts to S1 we find the
equilibrium E to E1 denoting an increase from P to P1
and a decrease in quantity from Q to Q1.
SIMULTANEOUS CHANGES IN DEMAND AND SUPPLY

Till now, we were considering the effect of a change either in demand or in supply on the
equilibrium price and quantity sold and purchased. There may be cases in which both the supply
and demand change at the same time. During a war, for example, shortage of goods will often
decrease supply while full employment causes high total wage payments which increase
demand.
We may discuss the changes in both demand and supply with the help of diagrams as below:
Simultaneous Change in Demand and Supply

Fig. 6 shows simultaneous change in demand and supply and its effects on the equilibrium price.
In the figure, the original demand curve DD and the supply curve SS meet at E at which OP is
the equilibrium price and OQ is the quantity bought and sold.
Fig. 6 (a), shows that increase in demand is equal to increase in supply. The new demand curve
D1D1 and S1S1 meet at E1. The new equilibrium price is equal to the old equilibrium price (OP).
Fig. 6 (b), shows that increase in demand is more than increase in supply. Hence, the new
equilibrium price OP1 is higher than the old equilibrium price OP. The opposite will happen i.e.
the equilibrium price will go down if there is a simultaneous fall in demand and supply and the
fall in demand is more than the fall in supply.
Fig. 6 (c), shows that supply increases in a greater proportion than demand. The new
equilibrium price will be less than the original equilibrium price. Conversely, if the fall in the
supply is more than proportionate to the fall in the demand, the equilibrium price will go up.

Chapter – 08 – Theory of Production
A layman understands the term ‘production’ as either growing crops or manufacturing of

articles or making some material etc. In economic sense, production refers to the process of
creating or adding utility into a matter or a thing in order to make it more useful to satisfy
human wants. Therefore, the work of lawyers, teachers, accountants, etc., also account as
production, since the services provided by them provide utility and satisfy the wants of the
people. In other words, production is any economic activity which is directed towards the
satisfaction of the wants of people by converting physical inputs into physical outputs.
In fact, the performance of an economy is judged by the level of its production. Those countries
which produce goods in large quantities are rich and those which produce little of them are
poor.
It should be noted that production should not be taken to mean as creation of matter because,
according to the fundamental law of science, man cannot create matter. What a man can do is
only to create or add utility. When a man produces a chair, he does not create the matter of
which the wood is composed of. He only transforms wood into a chair. By doing so, he adds
utility to wood which did not have utility before.
Creation of utility
Production consists of various processes to add utility to natural resources for gaining greater
satisfaction from them by:
i) Form utility: Most manufacturing processes consist of taking raw material and
transforming them into some items possessing utility, e.g., changing the form of iron ore
into a machine. This may be called conferring utility of form.
ii) Place utility: Changing the place of the resources, from the place where they are of little or
no use to another place where they are of greater use. This utility of place can be obtained
by:
1) Extraction from earth e.g., removal of coal, minerals, gold and other metal ores from
mines and supplying them to markets.
2) Transferring goods from where they give little or no satisfaction, to places where their
utility is more. Another example is: coal in coal mines have some use to farmers. But
when coal is transported to markets where human settlements are crowded like the city
centers, they afford more satisfaction to greater number of people, rather than to the
miners in the coal mines.

iii) Time utility: Making available materials at times when they are not normally available
e.g., harvested food grains are stored for use till next harvest. Canning of seasonal fruits is
undertaken to make them available during off season. This may be called conferring of
utility of time.
iv) Personal Utility: Making a commodity more useful, by application of skill to goods or
services. It involves making use of personal skills in the form of services like services of
doctors, interior decorators, event organizers, lawyers, accountants etc.
The fundamental purpose of all these activities is the same, namely to create utility in some
manner. So production is nothing but the creation of utilities in the form of goods and
services.
Example: In the production of a woolen suit, utility is created in some form or the other.
Firstly wool is changed into woolen cloth at the spinning and weaving mill (utility created by
changing the form). Then, it is taken to a place where it is to be sold (utility added by
transporting it). Since woolen clothes are used only in winter, they will be retained until such
time when they are required by purchasers (time utility). In the whole process, services of
various groups of people are utilized (as that of mill workers, shopkeepers, agents etc.) to
contribute to the enhancement of utility. Thus, the entire process of production is nothing
but creation of form utility, place utility, time utility and/or personal utility.
Factors of production
In the production process, a commodity has to pass through many stages before it ultimately
reaches the consumer. There are mainly four factors which help in the production process. They
are:
- Land
- Labour
- Capital
- Entrepreneur or enterprise or organization
All the above factors have to be used jointly to produce the goods and services. These factors are
collectively known as the factors of production. Now, let us discuss each of these factors in
detail.
Land: The term ‘land’ is used in a special sense in Economics. It does not mean soil or earth’s
surface alone, but refers to all free gifts of nature which would include besides the land, in
common parlance, natural resources, fertility of soil, water, air, natural vegetation etc. It
becomes difficult at times to state precisely as to what part of a given factor is due solely to the

gift of nature and what part belongs to human effort. Therefore, as a theoretical concept, we may
list the following characteristics which would qualify a given factor to be called land:
Characteristics of land:
a) Land is a free gift of nature: No human effort is required for the production of land. It
existed even before the evolution of mankind.
b) Supply of land is fixed: The total geographical area of land is fixed. The supply of land is
fixed. It can’t be increased or decreased according to our requirements.
c) Land is not mobile: The physical movement of land is impossible. Land can’t be shifted or
moved from one place to another place.
d) Land is indestructible: According to Ricardo, the production power of soil is
indestructible in the sense that the properties of land cannot be destroyed. Even if its fertility
gets depleted, it can be restored.
e) Land varies in quality: Land is not uniform in quality or fertility. No two pieces or plots
of land are uniform in fertility. Some lands will be more fertile and some will be less fertile.
f) Land is the primary and passive factor of production: All kind of economic activities
have to take place on land. Hence it is the primary factor of production. Left to itself, it will
not produce anything on its own, thus termed as passive factor of production.
g) It has different uses: Land is said to be a specific factor of production in the sense that it
does not yield any result unless human efforts are employed. Land varies in fertility and
uses.
Labour: The term ‘labour’, means mental or physical exertion directed to produce goods or
services. Labour refers to various types of human efforts which require the use of physical
exertion, skill and intellect. It is, however, difficult to say that in any human effort all the three
are not required in equal proportion; the proportion of each might vary. Labour, to have an
economic significance, must be one which is done with the motive of some economic reward.
Anything done out of love and affection, although very useful in increasing human well-being, is
not labour in the economic sense. It is for this reason that the services of a house-wife are not
treated as labour, while those of a maid servant are treated as labour. If a person sings before his
friends just for the sake of pleasure, it is not considered as labour despite the exertion involved
in it. On the other hand, if a person sings against payment of some fee, then this activity signifies
labour.
Characteristics of labour:

a) It is inseparable from the labourer: This means that only the labour is sold whereas
the producer of labour retains his capacity to work. Thus, labour cannot be separated from
the labourer.
b) Labour is perishable: Labour cannot be stored. A day’s work lost cannot be recovered by
working on the subsequent day. Whatever is lost in a day cannot be recovered wholly by
extra work next day. In other words, a labourer cannot store his labour and so he has no
reserve price for his labour.
c) Human Effort: Labour, as compared with other factors is different. It is connected with
human efforts whereas others are not directly connected with human efforts. As a result of
this, there are certain human and psychological considerations which may come across
unlike in the case of other factors.
d) It differs in efficiency: All labour is not equally productive. The efficiency of labour
depends on physical strength, skill, education, etc. However, efficiency can be improved by
giving proper training and motivating the labourers.
e) Labour is mobile: Labour move from one occupation to another because of several factors
like family and cultural background, educational and technical skills, life style, housing and
transport problems, language barriers, adaptability to new environments, etc.
f) Law of supply does not hold well in case of labour: Supply of labour and wage rate is
directly related i.e., as the wage rate increases, the labourer will put in more hours of work
and enjoy less hours of leisure. However, if the level of income rises beyond a certain level,
the labourer reduces the supply of labour and increase his hours of leisure i.e., he prefers to
have more rest than earning money.
g) Weak bargaining power: It is because the labourer is economically weak while the
employer is economically powerful although things have changed a lot in favour of labour
during the 20th century.
Capital: We may define capital as that part of wealth of an individual or community which is
used for further production of wealth. In fact, capital is a stock concept which yields a periodical
income which is a flow concept. It is necessary to understand the difference between capital and
wealth. Whereas wealth refers to all those goods and human qualities which are useful in
production, and which can be passed on for value, only a part of these goods and services can be
characterized as capital because if these resources are lying idle they will constitute wealth but
not capital. Capital has been rightly defined as ‘produced means of production’. This definition
distinguishes capital from both land and labour because both land and labour are not produced
factors. They are primary or original factors of production, but capital is not a primary or

original factor; it is a produced factor of production. Therefore, capital may well be defined as
manmade instruments of production. Machine tools and instruments, factories, dams, canals,
transport equipment etc., are some of the examples of capital. All of them are produced by man
to help in further production of goods.
Types of Capital:
a) Fixed capital is that which exists in a durable shape and renders a series of services over a
period of time. For example, tools, machines, etc.
b) Circulating capital is another form of capital which performs its function in production in
a single use and is not available for further use. For example, seeds, raw materials, etc.
c) Real capital refers to physical goods such as building, plant, machines, etc.
d) Human capital refers to human skill and ability. This is called human capital because a
good deal of investment has gone into creation of these abilities in humans.
e) Tangible capital can be perceived by senses whereas intangible capital is in the form of
certain rights and benefits which cannot be perceived by senses. For example, goodwill,
patent rights, etc.
f) Individual capital is the personal property owned by an individual or a group of
individuals.
g) Social Capital is what belongs to the society as a whole in the form of roads, bridges, etc.
Capital formation: Capital formation means creating more and more capital assets and
adding that to the existing stock of capital. Hence, it can be termed as a form of investment. In
order to accumulate capital goods, some current consumption has to be sacrificed. This is
because, if all that is produced is used for current consumption and nothing is stored for the
future, then the future productive capacity will decline. It is not only required for creating
additional productive capacity, but also for replacement and renovation of existing machinery
and equipment. It is prudent to cut down some of the present consumption and direct part of it
to the making of capital goods such as tools and instruments, machines and transport facilities,
plant and equipment etc. They will not only increase the efficacy of production efforts but also
will make possible the expansion of output of consumer goods in the future.
Stages of capital formation: We can say that capital can be accumulated through savings.
But savings alone is not responsible for capital formation because, if the savings of individual lie
idle, no capital formation takes place. Thus, the savings of all the individuals are accumulated
and invested in a profitable venture to fetch returns which would result in capital accumulation.
Thus, capital is accumulated in three stages.

1. Creation of savings: Savings are very essential for capital formation. However, the ability
to save depends upon various factors like:
Income of the individuals: Generally, higher the income, higher would be the ability to
save.
Willingness to save: An individual may have surplus income which he can save. But he
must have the willingness to create savings. Willingness to save depends upon the interest of
an individual to have a secure future.
Savings are done by the individuals or households, and Government saves by way of tax
collections and profits of PSU’s. It has been noticed that individuals of an underdeveloped
country use their income for current consumption rather that for future consumption. Thus,
the savings of an underdeveloped country is far lesser than those of developed countries.
This is why the developed countries become richer quickly when compared to
underdeveloped countries.
2. Mobilization of savings: If the savings of the individuals lie idle, they are of no use to the
economy. Thus, financial institution like banks must collect deposits of all the small
investors and make them available to the prospective investors to invest the money and
create capital.
3. Utilization of savings or investment: The savings must be made available to the

entrepreneurial class who are prepared to bear the risk of the business and invests them in
profitable ventures which would create new capital assets.
Entrepreneur: Having explained the three factors namely land, labour and capital, we
now turn to the explanation of the fourth important factor, namely, the entrepreneur. It is
not enough to say that production is a function of land, capital and labour. There must be
some factor which mobilises these factors, combines them in the right proportion, initiates
the process of production and bears the risks involved in it. This factor is known as the
entrepreneur.
Functions of an entrepreneur: An entrepreneur performs the following functions in
general:
i) Initiating a business enterprise and resource co-ordination: The first and the
foremost function of an entrepreneur is to initiate a business enterprise. For this, he has
to collect different factors of production such as labour, capital, land etc. and bring about
coordination among them. These various other factors of production are paid fixed

contractual remuneration: labour at fixed rate of wages, land or factory building at a

fixed rent for its use and capital at a fixed rate of interest. The surplus, if any, after all the
fixed costs and variable costs are met, accrues to the entrepreneur as his reward for his
efforts and risk-taking.
Thus, the reward for an entrepreneur, that is a profit, is not fixed. He may earn profits or
incur losses. Other factors get their payment irrespective of whether the entrepreneur
makes profits or losses.
ii) Risk bearing or uncertainty bearing: The ultimate responsibility for the success
and survival of business lies with the entrepreneur. What is planned and anticipated by
the entrepreneur may not come true and the actual course of events may differ from
what was anticipated and planned. The economy is dynamic and changes occurr
everyday Thus, the entrepreneur has to bear these financial risks. Apart from financial
risks, the entrepreneur also faces technological risks which arise due to the inventions
and improvements in techniques of production, making the existing techniques and
machines obsolete.
These risks which cannot be insured are also called uncertainties and the entrepreneur
earns profits because he bears uncertainty in a dynamic economy where changes occur
every day.
iii) Innovations: One of the important functions of an entrepreneur is to introduce

innovations. Innovations, in a very broad sense, include the introduction of new or
improved production methods, utilisation of new or improved sources of raw-materials,
adoption of new or improved forms of organisation, introduction of new or improved
products, opening of new or improved markets etc. According to Schumpeter, the task of
the entrepreneur is to continuously introduce new innovations.
Production function:
A simple words, production is a process of converting physical input into physical output. The
relationship between input and output expressed in the form of a mathematical equation is
called the production function. It states the maximum amount of output that can be produced
with the given amount of inputs or minimum inputs needed to produce a given quantity of
output. Inputs refer to the factor services which are used in production i.e. land, labour, capital
and enterprise. Output refers to the volume of goods produced. The production function is given
as:
Q = f (La, L, K, O)

Where,
Q = Quantity
L = Land
L = Labour
K = Capital
O = Organization
The production function can be classified into two groups/categories.
Short run production function

Short run is a period of time which is too short for a firm to install a new capital equipment to
increase production. In the short run, production will increase when more units of variable
factors are used with fixed factors. In short run, at least one factor is fixed. Short run production
function is known as “Law of Variable Proportions”. Functions are divided into two parts.
Namely:-
➢ Fixed inputs: are those factors, the quantity of which remains constant irrespective of the
level of output produced by a firm. Ex., land, building, etc.
➢ Variable inputs: are those factors, the quantity of which varies (only to a limited extent)
with variations in the levels of output produced by a firm. Ex, Wages, power, working hours
of the labourers etc.
Long run production function: Long run is a period of time in which all the factors of
production are variable. Long run production function is known as the “law of returns to scale”.
Assumptions of Production Function:

The production function is based on certain assumptions;
1. It is related to a particular unit of time.
2. The technical knowledge during that period of time remains constant.
3. The producer is using the best technique available.
Cobb-Douglas production function:

In economics, the Cobb-Douglas functional form of production functions is widely used to
represent the relationship of an output to inputs. It was proposed by Kunt Wick sell (1851-1926),
and tested against statistical evidence by Charles Cobb and Paul Douglas in 1928.
In 1928 Charles Cobb and Paul Douglas a published a study in which they modelled the growth
of the economy in manufacturing industry during the period 1899-1922. They considered a
simplified view of the economy in which production output is determined by the amount of

labour involved and the amount of capital invested. The conclusion drawn from this famous
statistical study is that labour contributed about 3/4 th and capital about 1/4th of the increase in
the manufacturing production. The function they used to model production was of the form:
Q = AK L1-
Where,
Q = total output/production,
L = Quantity of labour,
K= Amount of labour
A & ∞ are positive constants
Law of variable proportions

This Law shows the nature of rate of change in output due to a change in only one variable factor
of production. This Law is applicable during the short-run, when a firm can change its output by
changing only the variable factor (say labour), while the fixed factors of production remain
unchanged. In this case, the factor proportion (i.e. capital/ labour, K/L) will gradually fall with
an increase in L. Since K remains unchanged.
There exists three concepts,
“Total Product”, “Average Product”, “Marginal Product”
a) Total product: It indicates the amount of a particular product produced by any firm using
both fixed & variable factors of production during any particular time period e.g. a firm may
produce 30 units of a product per day by using one unit of capital (K) & 3 units of labour
(L). Since the fixed factor (K) remains unchanged during the short-run, we may call it the
total product of a variable factor. [TPL = Q]
b) Average Product: It implies output per unit of a variable factor. If total product = 30
units & three workers are employed to produce that output, then AP = 30/3, or APL =
Q/L.
c) Marginal product: It is the rate of change in total product or change in total product due
to one additional change in variable factor. MPL
During Short-run period we get three possible returns to a factor
Land Labour Total Marginal Average Returns to
(Acres) (No of works) Product Product Product factors
10 0 0 - -

10 1 5 5 5 Ist Stage
10 2 14 9 7 Increasing returns
10 3 30 16 10 to a factor
10 4 52 22 13
10 5 70 18 14
10 6 84 14 14
10 7 91 7 13 2nd Stage
10 8 96 5 12 Decreasing returns
10 9 96 0 10.6 to a factor
10 10 90 -6 3rd Stage negative returns
From the table it can be observed that initially, it shows ‘increasing returns to a variable
factor when a firm increases only variable factor, keeping other factors unchanged, the rate of
increase in output is more than that of variable factor. So MP L & APL both are increasing
where as MPL > APL (L<L*).
After a certain capacity point with increase in only variable factor, keeping other unchanged,
rate of output increases at diminishing rate & ultimately at maximum point rate of enhancement
becomes zero.
For L = OL, MPL = APL. For L>OL up to L2 (MPL<APL) & at L = OL2, MPL = 0 as
Q
=0
L
Three stages of production takes place –
1st Stage: Zero to APL maximum
2nd Stage: APL maximum to MPL = 0
3rd Stage: MPL is negative
Relationship between Average Product and Marginal Product: Both average product
and marginal product are derived from the total product. Average product is obtained by
dividing total product by the number of units of variable factor and marginal product is the
change in total product resulting from a unit increase in the quantity of variable factor. The
various points of relationship between average product and marginal product can be summed
up as follows:

i) When average product rises as a result of an increase in the quantity of variable input,
marginal product is more than the average product.
ii) When average product is maximum, marginal product is equal to average product. In other
words, the marginal product curve cuts the average product curve at its maximum.
iii) When average product falls, marginal product is less than the average product.
Table 1 and Figure 1 confirm the above points of relationship.

The law of variable proportions or the law of diminishing returns examines the production
function with one factor variable, keeping quantities of other factors fixed. In other words, it
refers to input-output relationship, when the output is increased by varying the quantity of one
input. This law operates in the short run ‘when all the factors of production cannot be increased
or decreased simultaneously (for example, we cannot build a plant or dismantle a plant in the
short run).
The law operates under certain assumptions which are as follows:

1. The state of technology is assumed to be given and unchanged. If there is any improvement
in technology, then marginal and average product may rise instead of falling.
2. There must be some inputs whose quantity is kept fixed. This law does not apply to cases
when all factors are proportionately varied. When all the factors are proportionately varied,
laws of returns to scale are applicable.
3. The law does not apply to those cases where the factors must be used in fixed proportions to
yield output. When the various factors are required to be used in fixed proportions, an
increase in one factor would not lead to any increase in output i.e., marginal product of the
variable factor will then be zero and not diminishing.
4. We consider only physical inputs and outputs and not economic profitability in monetary
terms. The law states that as we increase the quantity of one input which is combined with
other fixed inputs, the marginal physical productivity of the variable input must eventually
decline. In other words, an increase in some inputs relative to other fixed inputs will, in a
given state of technology, cause output to increase; but after a point, the extra output
resulting from the same addition of extra inputs will become less and less.
The behaviour of output when the varying quantity of one factor is combined with a fixed
quantity of the others can be divided into three distinct stages or laws. In order to
understand these three stages or laws, we may graphically illustrate the production function
with one variable factor.

In this figure, the quantity of variable factor is depicted on the X axis and on the Y-axis is
measured the Total Product (TP), Average Product (AP) and Marginal Product (MP). As the
figure shows TP curve goes on increasing up to a point and after that it starts declining. A
Pand MP curves first rise and then decline; MP curve starts declining earlier than the AP
curve. The behaviour of these Total, Average and Marginal Products of the variable factor
consequent on the increase in its amount is generally divided into three stages (laws) which
are explained below.
Stage 1: The Law of Increasing Returns: In this stage, total product increases at an
increasing rate upto a point (in figure upto point F), marginal product also rises and is
maximum at the point corresponding to F and average product goes on rising. From point F
onwards during the stage one, the total product goes on rising but at a diminishing rate.
Marginal product falls but is positive. The stage 1 ends where the AP curve reaches its
highest point.
Thus in the first stage the AP curve rises throughout whereas the marginal product curve
first rises and then starts falling after reaching its maximum. It is to be noted that the

marginal product although starts declining, remains greater than the average product
throughout the stage so that average product continues to rise.
Explanation of the law: The law of increasing returns operates because of following
reasons
1) In the beginning the quantity of fixed factors is abundant relative to the quantity of the
variable factor. As more units of variable factor are added to the constant quantity of the
fixed factors then the fixed factors are more intensively and effectively utilised i.e., the
efficiency of the fixed factors increases as additional units of the variable factors are
added to them. This causes the production to increase at a rapid rate. This happens
because, in the beginning some amount of fixed factor remained unutilised and,
therefore, when the variable factor is increased, fuller utilisation of the fixed factor
becomes possible and it results in increasing returns.
A question arises as to why the fixed factor is not initially taken in a quantity which
suits the available quantity of the variable factor. The answer is that, generally those
factors are taken as fixed which are indivisible. Indivisibility of a factor means that
due to technological requirements, a minimum amount of that factor must be
employed whatever the level of output.
Thus, as more units of the variable factor are employed to work with an indivisible fixed
factor, output greatly increases due to fuller utilisation of the latter.
2) The second reason why we get increasing returns at the initial stage is that as more units
of the variable factors are employed, the efficiency of the variable factors itself increases.
This is because with sufficient quantity of the variable factor introduction of division of
labour and specialisation becomes possible which results in higher productivity.
Stage 2: Law of diminishing returns: In stage 2, the total product continues to increase
at a diminishing rate until it reaches its maximum point H, where the second stage ends. In
this stage, both marginal product and average product of the variable factor are diminishing
but are positive. At the end of this stage i.e., at point M (corresponding to the highest point
H of the total product curve), the marginal product of the variable factor is zero. Stage 2, is
known as the stage of diminishing returns because both the average and marginal products
of the variable factors continuously fall during this stage. This stage is very important
because the firm will seek to produce in its range.

Explanation of the law: The question arises as to why we get diminishing returns after a
certain amount of the variable factor has been added to the fixed quantity of that factor. As
explained above, increasing returns occur primarily because of the more efficient use of fixed
factors as more units of the variable factor are combined to work with it. Once the point is
reached at which the amount of variable factor is sufficient to ensure efficient utilisation of
the fixed factor, any further increases in the variable factor will cause marginal and average
product to decline because the fixed factor then becomes inadequate relative to the quantity
of the variable factor. Continuing the above example, when four men were put to work on
one machine, the optimum combination was achieved. Now, if the fifth person is put on the
machine, his contribution will be nil. In other words, the marginal productivity will start
diminishing.
1) The phenomenon of diminishing returns, like that of increasing returns, rests upon the
indivisibility of the fixed factor. Just as the average product of the variable factor
increases in the first stage when better utilisation of the fixed indivisible factor is being
made, so the average product of the variable factor diminishes in the second stage when
the fixed indivisible factor is being worked too hard.
2) Another reason offered for the operation of the law of diminishing returns is the
imperfect substitutability of one factor for another.
Stage 3: Law of negative returns: In Stage 3, total product declines, MP is negative,

average product is diminishing. This stage is called the stage of negative returns since the
marginal product of the variable factor is negative during this stage.
Explanation the law: As the amount of the variable factor continues to be increased to a
constant quantity of the other, a stage is reached when the total product declines and
marginal product becomes negative.
1) The quantity of the variable factor becomes too excessive relative to the fixed factor so
that they get in each other’s ways with the result that the total output falls instead of
rising. In such a situation, a reduction in the units of the variable factor will increase the
total output.
Stage of Operation: An important question is in which stage a rational producer will

seek to produce. A rational producer will never produce in stage 3 where marginal
product of the variable factor is negative. This being so a producer can always increase
his output by reducing the amount of variable factor.

A rational producer will also not produce in stage 1 as he will not be making the best use
of the fixed factors and he will not be utilising fully the opportunities of increasing
production by increasing, the quantity of the variable factor whose average product
continues to rise throughout stage 1.
It is thus clear that a rational producer will never produce in stage 1 and stage 3. These
stages are called stages of economic absurdity or economic non-sense.
A rational producer will always produce in stage 2 where both the marginal product and
average product of the variable factors are diminishing. At which particular point in this
stage, the producer will decide to produce depends upon the prices of factors.
Stages Terms used TP AP MP
Starts from origin,
Starts from the
increases at an Increases, reaches
Increasing returns origin and then
Stage 1 increasing rate and a maximum and
to the factor increases till its
then increases at a then starts falling
maximum point
diminishing rate
Increases at a
Diminishing Falls continuously
diminishing rate till
Stage 2 returns to the Falls continuously till it is equal to
it reaches the
factor zero.
maximum point
Negative returns to
Stage 3 Falls Falls continuously It is negative
the factor
Long run production function – Law of returns to scale:

We shall study the behaviour of output in response to a change in the scale. A change in scale
means that all factors of production are increased or decreased in the same proportion. Returns
to scale may be constant, increasing or decreasing. If we increase all factors i.e., scale in a given
proportion and output increases in the same proportion, returns to scale are said to be constant.
Thus, if a doubling or trebling of all factors causes a doubling or trebling of output, returns to
scale are constant. But, if the increase in all factors leads to more than proportionate increase in
output, returns to scale are said to be increasing. Thus, if all factors are doubled and output
increases more than a double, then the returns to scale are said to be increasing. On the other
hand, if the increase in all factors leads to less than proportionate increase in output, returns to
scale are decreasing. It is needless to say that this law operates in the long run when all the
factors can be changed in the same proportion simultaneously.

Constant returns to scale: As stated above, constant returns to scale means that with the
increase in the scale in some proportion, output increases in the same proportion. It has been
found that production function for the economy as a whole corresponds to production function
exhibiting constant returns to scale. Also, it has been found that an individual firm passes
through a long phase of constant returns to scale in its lifetime.
Constant return to scale is otherwise called as “Linear Homogeneous Production Function”
Increasing returns to scale: As stated earlier, increasing returns to scale means that output
increases in a greater proportion than the increase in inputs. When a firm expands, increasing
returns to scale are obtained in the beginning. Another reason for increasing returns to scale is
the indivisibility of factors. Some factors are available in large and lumpy units and can,
therefore, be utilised with utmost efficiency at a large output. Returns to scale may also increase
because of greater possibilities of specialisation of land and machinery.
Decreasing returns to scale: When output increases in a smaller proportion with an

increase in all inputs, decreasing returns to scale are said to prevail. When a firm goes on
expanding by increasing all inputs, diminishing returns to scale set in. Decreasing returns to
scale eventually occur because of increasing difficulties of management, coordination and
control. When the firm has expanded to a very large size, it is difficult to manage it with the
same efficiency as before.
In the table given below we take labour and capital as factors of production.
Total Output Total Output Marginal Output
1K+2L 50 50
2K+4L 110 60
3K+6L 180 70
4K+8L 250 70
5K+10L 300 50
6K+12L 335 35
Observations:
The marginal output which is most important here
➢ Increases at a rapid rate then the rate of increase
in the input – in the 1st stage. Hence it is
increasing returns to scale.

➢ Increases in the same ratio as increase in the input – in the 2nd stage. Hence it is constant
returns to scale.
➢ Increases in a lesser proportion as you employ more and more of K & L – in the 3rd stage.
Hence it is decreasing return to scale.
Differences between law of variable portions and returns to scale:

Law of variable
Basis of difference Law of returns to scale
proportions
Time period Applies in the short run Applies in the long run
Variable and fixed Only variable factors are All factors are increased
factors changed units of fixed factors simultaneously. No distinction
remain the same between fixed and variable factors.
Stages There are 3 stages There are 3 stages
- Increasing returns - Increasing returns
- Diminishing returns - Constant returns
- Negative returns - Decreasing returns
PRODUCTION OPTIMISATION
Normally, a firm is interested to know what combination of factors of production (or inputs)
would minimise its cost of production. This can be known with the help of isoquants and isocost
lines.
Isoquants: Isoquants are similar to indifference curves of the theory of consumer behaviour.
An isoquant represents all those combinations of inputs which are capable of producing the
same level of output. Isoquants are also called equal-product or iso-product curves. Since an
equal-product curve represents all those combinations of inputs which yield an equal quantity of
output, the producer is indifferent between them. Therefore, another name for an isoquant is
production-indifference curve. The concept of isoquant can be easily understood with the help of
the following schedule.
Factor combination Factor L Factor K

A 1 12
B 2 08
C 3 05
D 4 03
E 5 02

An ISO – Quant Curve always slopes downward

from left to right i.e., It should always a Negative
Slope.
This is because, if producer wants to increase the
proportion of one factor, it is possible only by reducing the
proportion of another factor because of limited resources.
The negative slope of Isoquants implies substitutability
between the inputs. It means that if one of the inputs is
reduced, the other inputs has to be so increased that the
total output remains unaffected. To represent this concept, it should always slope downward. An
ISO- Quant will be always convex to the origin.The Law of Diminishing Marginal Rate of
Technical Substitution (MRTS) could be explained only if it is convex to the origin. The rate at
which one factor is substituted for another factor is known as Technical Substitution.
Iso-cost or Equal-cost Lines: Iso-cost line represents the prices of factors. It shows various
combinations of two factors which the firm can buy with given outlay. Suppose a firm has Rs.
100 to spend on the two factors L and K. If the price of factor L is Rs. 10 and that of K is Rs. 20,
the firm can spend its outlay on L and K in various ways. It can spend the entire amount on L
and thus buy 10 units of L and zero units of K or it can spend the entire outlay on K and buy 5
units of it with zero units of X factor. In between, it can have any combination of L and K.
Factor Cost of
Factor L Factor K Cost of K Total cost
combination L
A 0 0 5 100 100
B 2 20 4 80 100
C 4 40 3 60 100
D 6 60 2 40 100
E 8 80 1 20 100
F 10 100 0 0 100
We can show iso-cost line diagrammatically also. The X-

axis shows the units of factor L and Y-axis the units of
factor K. When entire Rs. 100 are spent on factor L we get
OC/Pk and when entire amount is spent on factor K we
get OC/PL. The straight line C/Pkto C/PL will pass

through all combinations of factors L and K which the firm can buy with outlay of Rs. 100. The
line C/Pkto C/PL is called iso-cost line.
K
Producer’s equilibrium can be obtained by two
ways:
a) Output maximization F
b) Cost minimization (Least Cost combination)

Ke e
a) Output maximization: IQ3
Figure (5) shows different level of output by IQ,

IQ2
Q
IQ1
L
map IQ is not permissible. Output is maximized Le
Fig. : 5
where two conditions are satisfied:
(1) Slope of IQ = Slope of cost line

MPL W
=
MPK r
[Necessary or 1st order condition]
(2) IQ is convex at the point of tangency [sufficient or 2nd order condition]
b) Cost minimization (Least Cost

combination)
(Capital)
Suppose the firm has decided to produce

1,000 units (represented by iso-quant P).
These can be produced by any factor
combination lying on P such as A, B, C, D, E,
etc. The cost of producing 1,000 units would
be minimum at the factor combination
represented by point C where the iso-cost line (Labour)
Fig. 6
MM1 is tangent to the given isoquant P. At all other points such as A, B, D, E the cost is
more as these points lie on higher iso-cost lines than MM1. Thus, the factor combination
represented by point C is the optimum combination for the producer. It represents the
least-cost of producing 1,000 units of output. It is thus clear that the tangency point of the
given isoquant with an iso-cost line represents the least cost combination of factors for
producing a given output.
Conditions of equilibrium:
(1) Slope of IQ = Slope of cost line

MPL W
=
MPK r
[Necessary or 1st order condition]
IQ is convex at the point of tangency [sufficient or 2nd order condition

Chapter – 09 – Theory of Cost
Meaning of cost
The number of resources used in the manufacturing of goods or rendering of services and
expressed in monetary terms is known as costs. These resources may be tangible like materials
or intangible like labour.
Meaning of cost analysis:

We have seen that production analysis is mainly concerned with the physical aspects of
production. In cost analysis, we study the financial aspects of production. In other words, cost
analysis refers to the study of behaviour of cost in relation to one or more production criteria,
viz,. seize of output, scale of operations, price of factors of production, etc.
Cost function:
It refers to the mathematical relationship between cost of a product and the various
determinants of costs. In cost function, the dependent variable is unit cost or total cost and the
independent variables are the prices of factor, scale of operations, technology, level of capacity
utilization etc.
Symbolically, the cost function is C = f (Q).
Where C = Cost and Q = Output
Cost concept:
In order to understand the cost function, we have to understand the various concept of cost as
below:
Explicit and Implicit Cost:

Explicit cost also known as direct cost, which is the actual expenditure incurred by a firm to
purchase or acquire the various inputs in needs during the production process. Explicit costs can
be estimated and calculated exactly and they can be accounted without any difficulty. E.g.
Wages, rents, etc.
Implicit cost is the cost which is not recognized in the books of accounts. It is also a part of the
opportunity cost. It is the monetary reward for all factors owned by the entrepreneur himself.
Implicit cost is also known as imputed cost. Implicit costs include:
- The normal return on capital invested by the entrepreneur in his own business.
- The wages or salary not paid to the entrepreneur, but could have been earned if the services
had been sold somewhere else.

Accounting costs and economic costs:

- Accounting costs are all the payments and charges made by the entrepreneur to the
suppliers of various productive factors. Accounting costs are also explicit costs.
- Economic costs not only take the accounting costs into consideration, but also include the
amount of money which the entrepreneur could have earned if he had invested his money
and sold his services and other factors in the next best alternative uses. Thus, economic costs
include both, accounting costs and implicit costs.
The concept of economic costs is very important because an entrepreneur is said to be
earning profits only when his revenues are able to cover both, the explicit as well as implicit
costs.
Note: Revenue refers to sales receipts.
Outlay costs and opportunity costs:
Outlay costs are those costs which involve financial expenditure and are recorded in the books
of accounts. These costs involve actual expenditure of funds. It is same as explicit costs.
Opportunity costs refers to the cost of the foregone opportunity. It can also be represented as
the difference between the opportunity selected and the opportunity rejected. These costs are
not recorded in the books of accounts. They are also known as alternative costs.
Example: A farmer who produces wheat can produce potatoes with the same factors.
Therefore, the opportunity cost of a quintal of wheat is the amount of output of potatoes given
up. These cost help is decision making in scarcity of resources.
Direct costs and indirect costs:
Direct costs are those costs which are readily identifiable and traceable to a particular product,
service, operation or a plant. For example, cost of raw material used in manufacture, wages paid
to workers of administration department. These costs are also known as traceable costs.
Indirect costs on the other hand are not readily identified or visibly traceable to a particular
product service, operation or plant. These are the common costs.
Example: factory rent and advertisement expenses. These costs are also known as non-
traceable costs.
Fixed and variable costs:

Fixed costs refer to all the money expenses incurred by the manufacturer irrespective of the
output level. They are also known as unavoidable contractual costs as they have to be paid as
long as the operations are going on. For example, rent of a factory building, interest on loans.
Fixed costs are those costs which do not vary either with expansion or contraction of output, up
to a certain level.
Variable costs refer to money expenses which vary directly and proportionately with the
output.
Example: Wages and cost of raw materials. It is left to the discretion of the management
whether to incur these costs or not. E.g. – If the production process is stopped for some time,
expense such as wages, cost of raw materials would not be incurred.
Sunk costs:
Sunk costs are those that do not alter by varying the nature or level of business activity. Sunk
costs are generally not taken into consideration in decision – making as they do not vary with
the changes in the future. Sunk costs are a part of the outlay/actual costs. E.g. – Amortisation of
past expenses such as depreciation.
Book costs:
The cost that has not been incurred in actual but are recorded in the books of accounts by
making the provision in the books. They are recorded to the take the advantage of tax. E.g.
Provision for taxation, Provision for bad debt.
Out of pocket cost: The cost incurred to meet the payment of outside parties is called ‘out of
pocket cost’. They fall in the category of out of pocket costs. E.g. Rent, wages, interest.
Incremental costs: These are the cost which incurred when there is a change in the level of
business activity. They are also called avoidable or differential costs. E.g. – deleting the product
from the product line.
Short run costs:

Short run total costs:
Short run is a period of time in which at least one
input is fixed and the output can be increased or
decreased by changing only the amount of variable
factors. A firm cannot change its plant, equipment
and scale of organization. In this period, certain
factors can be easily adjusted to increase/ decrease
the level of output. E.g. – If a firm wants to expand its production, it can purchase more raw
materials.

Total Fixed Cost (TFC)

As we have already studied, fixed costs do not vary with the output. These costs are also called as
sunk costs. The total fixed cost curve is shown as a straight line parallel to the X- axis, indicating
that, whatever may be the level of production, the fixed cost remains constant. E.g. – Expenses
incurred on fixed inputs like plant, machinery and tools etc.
Total Variable Cost (TVC)

Variable costs refer to those costs which vary with the
output. The total variable cost curve is inverse S- Shaped
and starts from the origin which shows that if
production is stopped, variable costs are not incurred.
As the production increases, the total variable cost also
increases. Initially, as more of the variable factor is
combined with the fixed factor, total productivity
increase at an increasing rate, and total variable cost
increases at a diminishing rate. But after this point, as more of the variable factor is combined
with the fixed factor, variable cost increases at an increasing rate. E.g. – Expenses incurred on
variable inputs like labour, raw materials, power and fuel etc.
Semi Variable cost:

There are some costs which are neither perfectly variable
nor absolutely fixed in relation to the changes in the size
of output. These are known as semi-variable costs. For
example: Electricity charges include both a fixed charge
and a charge based on consumption as shown as
diagram.
Stair – Step Variable Cost:

Some cost remain fixed over certain range of output,
but suddenly jump to a new higher level when output
goes beyond given limit. For example: Salary of a
foreman remains fixed and every one extra that the
foreman works, overtime should be paid. Let it be
100/- per hour. In this case the variable cost jumps a
new higher level of output, as shown in the following
diagram.

Total Cost (TC)

It is the total amount of money spent by the manufacturer
to produce a given level of output. Thus, it is the sum total
of total fixed cost and total variable cost.
Symbolically,
TC = TFC + TVC
TC = Cost per unit x Number of units manufactured
Short run total Cost Curves
Short run Average costs:
TC = F + f(Q)
f(Q) TC TFC TVC

 TC = F +  = +
Q Q Q Q Q Q
This implies AC or ATC = AFC + AVC
AFC is per unit of fixed cost & as quantity produced increases AFC keeps
on decreasing In fig1. By construction
OQ3 = 3OQ1, OQ2 = 2OQ1, OQ1 = ⅓ OQ3 & OQ1 = ½ OQ2
As one moves from Q1 to Q2 to Q3 slopes of ray keep on decreasing

i.e.
AFC2 = ½ AFC1 & AFC3 = ⅓ AFC1
In Fig (2), continuing this process we can find a locus AFC, which is downward sloped,
convex to the origin & Rectangular Hyperbola.
‘AVC’ is variable cost per unit of production. AVC normally falls as

output increases from zero to normal capacity output due to occurrence of
increasing returns (where cost increases at decreasing rate). But beyond
the normal capacity output, AVC will rise steeply because of the operations
of diminishing returns.
APL = Q/L, AVC = TVC/Q

i.e. AVC = W.L / Q
This implies AVC = W / APL ........ (1)
Equation (1) exhibits inverse relationship between APL & AVC where W is constant. In fig (3)
when APL is ‘dome’ shaped, AVC is ‘U’ shaped. Therefore, ‘U’ shaped AVC is due to Law of
variable proportion.
Further AC = AFC + AVC
AC can be found out by the combination of AFC & AVC. Intially,

when both AFC & AVC are falling, AC being the resultant factor also
falls. The point to be noted that even if AVC reaches minimum at
point ‘A’ but AFC steadily falls and therefore, AC is also ‘U’
shaped, where minimum point of ‘AC’ is in further north-east of
minimum point of AVC. Again, minimum point of AVC is in further south-west of minimum
point of AC.
Short - run marginal Costs:
Marginal cost is the addition made to the total cost by production of an additional unit of
output. MC is the rate of change in TC.
1) MC = TCn – TCn – 1 = TC/Q
MC = (TFCn + TVCn) – (TFCn – 1 + TVC n – 1)
MC = TFCn + TVCn – TFC n – 1 – TVC n – 1
MC = TVCn – TVC n – 1
MC = MVC [So MC depends on only variable cost during Short-run,

Period]
2) Relationship between MC & MPL
ΔTC ΔTVC
MC = =
ΔQ ΔQ
Δ  wL 
 MC =
ΔQ

w  ΔL 
 MC =
ΔQ
w ΔQ
 MC = sinceMPL =
MPL ΔL
Above equation shows inverse relationship between MC & MPL where ‘w’ is constant. In fig (1),
we get ‘MC’ as ‘U’ shaped, due to Law of variable proportion
Further, MC & AC relationship can be obtained by slope of the tangent of TC &

slope of the ray from the origin. In following figure we get:
(a) when AC is falling MC is below to AC :(MC <AC) (b) when AC is minimum for MC = AC
(c) when AC is rising, MC > AC: MC curve cuts the AC curve at the latter’s minimum point.
Relationship between AFC, AVC, AC & MC is shown in following table
Quantity TFC TVC TC AFC AVC AC MC

0 10 0 10 ∞ --
1 10 4 14 10 4 14 4
2 10 7 17 5 3.5 8.5 3
3 10 9 19 3.33 3 6.33 2
4 10 10 20 2.50 2.5 5 1
5 10 11 21 2.0 2.2 4.2 1
6 10 14 24 1.67 2.33 4.00 3

7 10 18 28 1.43 2.57 4.00 4

8 10 24 34 1.25 3.00 4.25 6
9 10 32 42 1.11 3.55 4.66 8
10 10 42 52 1.00 4.2 5.2 10
• Initially, when MC falls, AC follows. This means, when the two are falling, the rate of fall in
MC is greater than rate of fall in AC. Because the rate of fall in MC is attributed to a single
unit, whereas, in AC, the fall in MC is distributed over the entire output. Therefore,
AC decreases at a lower rate than MC.
• When MC increases, there is a phase where AC is still falling. This is because, the rate of
growth in MC is small and this is enough only to reduce the rate of decrease in AC.
• After a point as MC increases at a higher rate, AC also increases. again, MC leads in the
rise and AC follows. This indicates that when MC increases, AC also rises but at a slower
pace.
• The MC curve intersects AC at its minimum point. This is so because they are obtained from
the same TC function.
Long run average cost curve (LAC curve)

Long run is a period of time during which the firm can vary all its inputs. Thus, all the factors in
the long run are variable, unlike the short run, where one variable factor is fixed and others are
variable. For instance, in the short run, the firm’s location is fixed, but in the long run, the firm
can move from one place to another. A long run cost curve represents the functional relationship
between output and the long run cost of production. A long run average cost curve is made up of
many short run average cost curve as a business in long run will be able to change all its inputs.
Let us understand this with the help of a diagram. To understand how long run average cost
curve is derived we consider three short run average cost curves. Short run cost curves are also
called as plant curves. In the short run the firm can be operating on any short run average cost

curves given the size of the plant. Given the size of the plant, the firm will be increasing or
decreasing its output by changing the amount of the variable inputs. But in the long run, the
firm chooses with which size of plants or on which short average cost curve it should operate to
produce a given level of output so that total cost is minimum. This may be depicted in the form
of a diagram.
As firm changes its output from short run to long run it moves from one short period to another
by changing the plant size.
• In each period, it uses a SAC curve that is relevant to that plant size.
• Thus, by expanding the plant size, the firm tries to produce a larger output with
minimum possible average cost.
• SAC1, SAC2 SAC3 are short-run Average costs curves of 3 periods. These 3 periods
at a stretch become a long period for the firm.
These SACs are constituents of a LAC curve

• Each point on the LAC curve is tangent a SAC curve.
• Hence, the LAC curve represents not a few plant curves but it represents as many
plant curves as there are points on the LAC curves.
• A point on the LAC curve shows the plant size, output and the average cost.
As a whole, LAC is envelope of all SACs &

where each point on the curve shows least
possible cost for producing the corresponding
level of output. Therefore, LAC is called
‘planning curve’ & Saucer Shaped. It is to
be noted that LAC curve is not a tangent to the
minimum points of the SAC curves. When

LAC curve is declining it is tangent to the falling portions of the short run cost curves & when
the LAC curve is rising it is tangent to the rising portions of the short-run cost curves.
Thus for producing output-less than OQ* at the lowest possible unit cost of the
firm will construct the relevant plant & operate it at less than its full capacity, i.e., at
less than its minimum average cost of production. On the other hand, for output larger than
OQ*, the firm will construct a plant & operate it beyond its optimum capacity. OQ* is the
optimum output. This is because ‘OQ*’ is being produced at the minimum point of LAC &
corresponding SAC i.e., SAC2. Other plants are either used at less than full capacity or more than
their full capacity – only SAC2 is being operated at the minimum point. As a whole, LAC is
‘planning curve’ & helps the firm in the choice of the size of the plant for producing
a specific output at the least possible cost & it is flatter “U” shaped due economies
& diseconomies of scale.
Problem on cost:
1. Calculate TFC, TVC, AVC, AFC, AC and MC from the following information.
Units Total cost (TC)
0 50
1 130
2 180
3 190
4 220
5 270
Solution:
Units TC TFC TVC AFC AVC AC MC
0 50 50 0 0 0 0 0
1 130 50 80 50 80 130 80
2 180 50 50 25 25 90 50
3 190 50 10 16.67 3.3 63.33 10
4 220 50 30 12.5 7.5 55 30
5 270 50 50 10 10 54 50

The long run average cost curve initially falls with increase in output and after a certain point it
rises making a boat shape. Long-run Average cost
(LAC) curve is also called the planning curve of the
firm as it helps in choosing an appropriate a plant
on the decided level of output. The long-run avearge
cost curve is also called “Envelope curve”, because it
envelopes or supports a family of short run average
cost curves from below.
The figure depicting long-run average cost curve is

arrived at on the basis of traditional economic
analysis. It is flattened ‘U’ shaped. This type of curve could exist only when the state of
technology remains constant. But, the empirical evidence shows that the state of technology
changes in the long-run.
Therefore, modern firms face ‘L-shaped’ cost curve than ‘u-shaped’. The L shaped cost curve is
given below. According to the diagram, over AB range, the curve is perfectly flat. Over this range
all sizes of plant have the same minimum cost.
ECONOMIES AND DISECONOMIES OF SCALE
The Scale of Production

Production on a large scale is a very important feature of modern industrial society. As a
consequence, the size of business undertakings has greatly increased. Large-scale production
offers certain advantages which help in reducing the cost of production. Economies arising out
of large-scale production can be grouped into two categories; viz., internal economies and
external economies. Internal economies are those economies of production which accrue to the
firm when it expands its output, so that the cost of production would come down considerably
and place the firm in a better position to compete in the market effectively. Internal economies
arise purely due to endogenous factors relating to efficiency of the entrepreneur or his
managerial talents or the type of machinery used or the marketing strategy adopted. These
economies arise within the firm and are available exclusively to the expanding firm. On the other
hand, external economies are the benefits accruing to each member firm of the industry as a
result of expansion of the industry.
Internal Economies and Diseconomies: We saw that returns to scale increase in the initial
stages and after remaining constant for a while, they decrease. The question arises as to why we

get increasing returns to scale due to which cost falls and why after a certain point we get
decreasing returns to scale due to which cost rises. The answer is that initially a firm enjoys
internal economies of scale and beyond a certain limit it suffers from internal diseconomies of
scale. Internal economies and diseconomies are of the following main kinds:
i) Technical economies and diseconomies: Large-scale production is associated with
economies of superior techniques. As the firm increases its scale of operations, it becomes
possible to use more specialised and efficient form of all factors, specially capital equipment
and machinery. For producing higher levels of output, there is generally available a more
efficient machinery which when employed to produce a large output yields a lower cost per
unit of output. The firm is able to take advantage of composite technology whereby the whole
process of production of a commodity is done as one composite unit. Secondly, when the
scale of production is increased and the amount of labour and other factors become larger,
introduction of greater degree of division of labour and specialisation becomes possible and
as a result cost per unit declines. There are some advantages available to a large firm on
account of performance of a number of linked processes. The firm can reduce the
inconvenience and costs associated with the dependence on other firms by undertaking
various processes from the input supply stage to the final output stage.
However, beyond a certain point, a firm experiences net diseconomies of scale. This happens
because when the firm has reached a size large enough to allow utilisation of almost all the
possibilities of division of labour and employment of more efficient machinery, further
increase in the size of the plant will bring about high long-run cost because of difficulties of
management. When the scale of operations becomes too large, it becomes difficult for the
management to exercise control and to bring about proper coordination.
ii) Managerial economies and diseconomies: Managerial economies refer to reduction in

managerial costs. When output increases, specialisation and division of labour can be
applied to management. It becomes possible to divide its management into specialised
departments under specialised personnel, such as production manager, sales manager,
finance manager etc. If the scale of production increases further, each department can be
further sub-divided; for e.g. sales can be split into separate sections such as for advertising,
exports and customer service. Since individual activities come under the supervision of
specialists, management’s efficiency and productivity will greatly improve. Decentralisation
of decision making and mechanisation of managerial functions further enhance the

efficiency and productivity of managers. Thus, specialisation of management enables large

firms to achieve reduction in managerial costs.
However, as the scale of production increases beyond a certain limit, managerial

diseconomies set in. Communication at different levels such as between the managers and
labourers and among the managers become difficult resulting in delays in decision making
and implementation of decisions already made. Management finds it difficult to exercise
control and to bring in coordination among its various departments. The managerial
structure becomes more complex and is affected by greater bureaucracy, red tapism,
lengthening of communication lines and so on. All these affect the efficiency and productivity
of management and that of the firm itself.
iii) Commercial economies and diseconomies: Production of large volumes of goods

requires large amount of materials and components. A large firm is able to place bulk orders
for materials and components and enjoy lower prices for them. Economies can also be
achieved in marketing of the product. If the sales staff is not being worked to full capacity,
additional output can be sold at little or no extra cost. Moreover, large firms can benefit from
economies of advertising. As the scale of production increases, advertising costs per unit of
output fall. In addition, a large firm may also be able to sell its by-products or process it
profitably; something which might be unprofitable for a small firm. There are also economies
associated with transport and storage.
These economies become diseconomies after an optimum scale. For example, advertisement
expenditure and other marketing overheads will increase more than proportionately after
the optimum scale.
iv) Financial economies and diseconomies: A large firm has advantages over small firms
in matters related to procurement of finance for its business activities. It can, for instance,
offer better security to bankers and avail of advances with greater ease. On account of the
goodwill enjoyed by large firms, investors have greater confidence in them and therefore
would prefer their shares which can be readily sold on the stock exchange. A large firm can
thus raise capital at lower cost.
However, these costs of raising finance will rise more than proportionately after the
optimum scale of production. This may happen because of relatively greater dependence on
external finances.

v) Risk bearing economies and diseconomies: It is said that a large business with
diverse and multi- production capability is in a better position to withstand economic ups
and downs, and therefore, enjoys economies of risk bearing. However, risk may increase if
diversification, instead of giving a cover to economic disturbances, increases these.
External Economies and Diseconomies: Internal economies are economies enjoyed by

a firm on account of use of greater degree of division of labour and specialised machinery at
higher levels of output. They are internal in the sense that they accrue to the firm due to its
own efforts. Besides internal economies, there are external economies which are very
important for a firm. External economies and diseconomies are those economies and
diseconomies which accrue to firms as a result of expansion in the output of the whole
industry and they are not dependent on the output level of individual firms. They are
external in the sense that they accrue to firms not out of their internal situation but from
outside i.e. due to expansion of the industry. These are available to one or more of the firms
in the form of:
1. Cheaper raw materials and capital equipment: The expansion of an industry may
result in exploration of new and cheaper sources of raw material, machinery and other
types of capital equipments. Expansion of an industry results in greater demand for
various kinds of materials and capital equipments required by it. The firm can procure
these on a large scale at competitive prices from other industries. This reduces their cost
of production and consequently the prices of their output.
2. Technological external economies: When the whole industry expands, it may result
in the discovery of new technical knowledge and in accordance with that, the use of
improved and better machinery and processes than before. This will change the technical
co-efficient of production and enhance productivity of firms in the industry and reduce
their cost of production.
3. Development of skilled labour: When an industry expands in an area, the labourers
in that area are well accustomed with the different productive processes and tend to
learn a good deal from experience. As a result, with the growth of an industry in an area,
a pool of trained labour is developed which has a favourable effect on the level of
productivity and cost of the firms in that industry.
4. Growth of ancillary industries: Expansion of industry encourages the growth of a
number of ancillary industries which specialise in the production and supply of raw
materials, tools, machinery, components, repair services etc. Input prices go down in a
competitive market and the benefits of it accrue to all firms in the form of reduction in

cost of production. Likewise, new units may come up for processing or recycling of the
waste products of the industry. This will tend to reduce the cost of production in general.
5. Better transportation and marketing facilities: The expansion of an industry
resulting from entry of new firms may make possible the development of an efficient
transportation and marketing network. These will greatly reduce the cost of production
of the firms by avoiding the need for establishing and running these services by
themselves. Similarly, communication systems may get modernised resulting in better
and speedy information dissemination.
6. Economies of Information: Necessary information regarding technology, labour,
prices and products may be easily and cheaply made available to the firms on account of
publication of information booklets and bulletins by industry associations or by
governments in public interest.
However, external economies may cease if there are certain disadvantages which may
neutralise the advantages of expansion of an industry. We call them external
diseconomies. External diseconomies are disadvantages that originate outside the firm,
especially in the input markets. An example of external diseconomies is rise in various
factor prices. When an industry expands the requirement of various factors of
production, such as raw materials, capital goods, skilled labour etc. increases. Increasing
demand for inputs puts pressure on the input markets. This may result in an increase in
the prices of factors of production, especially when they are short in supply. Moreover,
too many firms in an industry at one place may also result in higher transportation cost,
marketing cost and high pollution control cost. The government may also, through its
location policy, prohibit or restrict the expansion

Chapter – 10 – Price Determination in Different Market
Meaning of market:
Market refers to an arrangement where buyers and sellers come into close contact with each
other for the purpose of exchanging their goods and services. A market need not be a place or a
locality where the commodities in question are exchanged but there has to be a contact between
the buyers and sellers so that goods and services are bought and sold at an agreed price.
Communication between the buyers and sells can also take place through telephone, fax,
telegram, internet, etc. In such cases too, a market is said to exist.
Example: Tele marketing channels sells many products and buyers across the country
purchases them. The Good would be dispatched to the buyer right at their doorstep and buyer
needs to pay only after the receipt of the goods.
Thus, the essential features of a market are as follows:

- Two parties in a market i.e., buyers and sellers.
- Contact between them (either directly or indirectly)
- A product which is demanded and sold
- Price of the commodity
- Willingness and ability to buy and sell.
Types of Market:
Markets can be classified on the basis of:
- Area
- Time
- Transaction
- Volume of business
- Status of sellers
- Competition
On the basis of area

On the basis of area, the market can be classified as follows:
Local Market: A local market for a product exists when buyers and sellers of a commodity
carry on business in a particular locality or village or area where the demand and supply
conditions are influenced by local factors only.
Example: Perishable goods like fruits and vegetables and huge commodities as required in
construction like bricks and stones.
Regional Market: Semi-durable commodities that are demanded and supplied over a region
have regional market.
National Market: When commodities are demanded and supplied throughout the country,
there is a national market. This is a market for durable goods and industrial items.
Example: Wheat, rice, cotton, motor bikes.
International Market: When demand and supply conditions are influenced at the global
level, there is an international market.
Example: Gold, silver, cell phones, handicrafts.
On the basis of time

Very short period market:
During this period, the supply of goods in the market is given and fixed. The period lasts for a
day or two. So, in a very short period, the market supply is perfectly inelastic because skilled
labour, capital and organization are fixed. The price of the commodity wholly depends on the
demand for the product. Consequently, supply of the product in this period cannot be varied in
response to changes in demand. For example: market for flowers, milk, vegetables and other
perishable products.
Short period market:

During the short period, the firm can adjust its output to changes in demand with the existing
plant and machinery. If demand increases, the firm will increase its output with intensive
utilization of plant and machineries. But the time is not sufficient to increase the size of the
plant. If the demand declines, the firm will adjust its output with less intensive utilization of its
equipment’s. Only variable factor can be varied, and fixed factors remain unaltered. As the time
is too short, new firms cannot enter into the industry or the existing one’s can’t leave the
industry.
Long period market:

Long period may be defined as the period sufficiently long enough to enable the industry to
adjust production and supply completely to a change in demand. The time is adequate to permit
new firm to enter into the industry or existing firms to leave the industry. A total adjustment of
demand and supply is possible, as all factors of production are variable in long run. The long run
normal price is the result of long run demand and supply of the industry.

Very long period market:

During this period, there will be sufficiently long time to introduce any kind of changes in
production system. Over a long period (Secular period), new sources of supply are discovered a
new methods of production are perfected. Hence long run prices will be relatively lower. In the
very long period, the equality between supply and demand will determine the equilibrium price.
Contrary to very short period, in the very long period, supply plays a more role in determining
the price.
On the basis of the nature of transaction.

Spot Market: Spot market refers to a market where goods are physically transacted on the
spot.
Future market: It is a market related to those transactions that involves contract of a future
date. Good and services are exchanged at some future date as per the predetermined price.
On the basis of regulation

Regulated market:
In this market, there a vigil check on the transactions and in case of any fraudulent transaction,
stringent measures are taken. The transactions in such a market are statutorily regulated so as
to put an end to unfair practices. Such a market may be for specific products or groups of
products.
Example: Stock Market
Unregulated market:
It is called as free market as there are no restrictions on the transactions.
On the basis of the volume of business

Wholesale market:
It is a market in which commodities are bought and sold in large quantities. Usually,
distributors and wholesalers buy in huge quantities and sell to retailers.
Retail Market:
It is a market in which commodities are bought and sold in small quantities. It is a market for
ultimate consumers.
On the basis of competition

Types of market structure:

The market structure depends upon the number of sellers in the market. There are different
situations in a market. Sometimes, there are large numbers of sellers, sometimes, a few and
sometimes, there is only one seller. Based on the number of sellers in a market, the market
structure can be classified as follows:
Perfect competition: Under this system, many sellers sell identical products to many buyers.
Example: Food grains, vegetable market
Monopoly:
It is a type of market in which there is a single seller of a product which has no substitutes.
Example: Railways, water transport
Oligopoly:
Under this, there are a few sellers selling homogeneous or similar products to many buyers.
Example: cold drinks, pharmaceutical products.
Duopoly:
This form of market consists of only two sellers selling identical products.
Monopolistic competition:
In this type of market, a large number of sellers sell differentiated products which are close, but
not perfect substitutes, to a large number of buyers.
Example: Market for soaps and detergents, cosmetics, biscuits, ice-creams.
Perfect Monopolistic
Basis Monopoly Oligopoly
competition competition
Number of
Many One Many A few
sellers
Close but not
Homogeneous
Differentiation No substitutes perfect Differentiated
products
substitutes
Free Entry and
Entry and exit Free entry/ exit Restricted Restricted
Exit
Control over
None Absolute control Some extent Small
price
Small Negative
Demand curve Horizontal Negative slope Kinked curve
slope

Concept of total revenue, average revenue and marginal revenue:

Meaning of revenue:
The amount of money which the firm receives by the sale of its output in the market is known as
its revenue. It is also known as ‘Sales Receipts’. There are three types of Revenue.
Total Revenue:
Total revenue refers to the total amount of money that a firm receives from the sale of its
products.
Mathematically, TR = P × Q
Where,
TR = Total Revenue
P = Price
Q = Quantity sold
Example: If the shopkeeper sold 10 boxes of chocolates each at `500/- then his total revenue
would be
TR = P×Q
= 500 x 10
TR = 5,000 Rs.
Average revenue:
Average revenue is the revenue per unit of the commodity sold. It is calculated by dividing the
total revenue by the number of units sold.
AR = TR / Q
Where,
AR = Average Revenue
TR = Total Revenue
Q = Quantity
Or
AR = P × Q/Q
Where
AR = Average Revenue
P = Price
Q = Quantity sold
Or,
AR = P

Thus, average revenue means price of the product.

Example: If the seller made revenue of `25000 selling 10 sarees, then the average revenue per
saree is
AR = TR / Q
= 25000 / 10
AR = Rs. 2,500/-
Marginal Revenue:
Marginal revenue is the addition made to the total revenue by selling one more unit of a
commodity
MR = Change in TR ÷ Change in Q
Or,
MR = TRn – TRn-1
Where,
Q = number of units
MRn = Marginal revenue of the nth unit
TRn = Total revenue of n units
TRn-1 = Total revenue of n-1 units
Example: If the total revenue of a merchant by selling 50 mobile phones is `5,00,000 and by
selling 51 mobiles phones, it is `5,20,000, then MR is
MR51 = TR at 51 – TR at 50
= 5,20,000 – 5,00,000
MR = `20,000
Relationship between Total revenue, Marginal revenue, Average revenue

Total revenue is the product of price & quantity sold.
TR = P X Q [ P = price of the commodity sold, Q = amount of product sold]
Marginal revenue is the rate of change in total revenue or, change in total revenue due to one
additional change in quantity sold.
ΔTR
MR = = TR n – TR n – 1
ΔQ
Average revenue is per unit of revenue earned or price of the commodity sold.

TR P.Q
AR = = =P
Q Q
[AR is the demand curve of firm]
The relationship between MR, AR & ep
 1 
MR = P  1 –  - - - - - - - (1)
 ep
 
In fig (1), when ep = 1, MR = 0 i.e.,
for Q = Q* Further, when ep<1,
MR = negative, i.e. for Q>Q*. Again, for ep>1, MR = positive, i.e. for Q<Q*.
A rational producer always prefers elastic portion of demand curve, i.e. for Q<Q*.

Chapter – 11 – Behavioral Principle
- A firm should not produce at all, if total revenue from its product does not equal or exceed
its total variable cost.
- If any unit of production adds more to revenue than to cost, it will increase profits. On the
other hand, if it adds more to cost, it will decrease the profits. Profits will maximum at the
point where additional revenue from a unit equal its additional cost. Thus, marginal cost
curve should cut the marginal revenue curve from below.
Price – Output determination under different market forms

We have studied the various types of market forms in the previous unit. In this unit, we shall see
how the price and output are determined under each of the market forms.
Perfect competition market:

As the name itself suggests perfect competition refers to the market situation where the
competition among the buyers and sellers will be in the most perfect form. As a market situation
it is quite distinct from other types and exhibits certain distinct peculiarities of its own. One
thing that government has to note that perfect competition market situation is only a theoretical
concept ad it is not found practically anywhere in the world. It is only a myth.
The important characteristics of perfect competition may be listed out as follows:
Large number of buyers and sellers:

This is an important characteristic of perfect competition. Since there are large number of
buyers and sellers in the market, each buyer buys so little and each seller sells so little that none
of them are in a position to influence the price in the market. Individual seller or buyer’s
contribution to the total demand or supply is negligible. Both have to sell and buy the goods at
the prevailing prices.
Hence in the perfect competition price is determined by the combined actions of all the buyers
and sellers in the market.
Existence of homogeneous product:

This characteristic implies that the product being sold by all the sellers in the market are
identical from the buyers’ point of view. The products are homogeneous/ identical in the sense
that are perfect substitutes. Hence no seller can change a price even slightly above the ruling
market price. If he does so, he will lose all his customers. This condition ensures a single/
uniform price for a particular product throughout the market.

Free entry and free exit of firms:

This characteristics implies that there should be absolute freedom for the firms either to enter or
to exit. If the industry is making super normal profit then new firms will enter and on the other
hand new firms will quit the industry if there are losses. Hence in the perfect competition, firms
can enjoy only normal profit in the long run.
Perfect competition market:

All the sellers and buyers have the perfect knowledge of the market. The buyers and the sellers
are fully aware of the prices that are being offered and accepted in different parts of the market.
Hence there is no necessary of incurring any expenditure on publicity or advertisement. This
condition ensures a single uniform price throughout the market.
Perfect mobility of the factors of production:

Perfect competition implies perfect mobility of the factors of production in between places and
employment, which they consider profitable and highly remunerative. This perfect mobility
ensures uniform cost of production, which in turn ensures a single uniform price throughout the
market.
Absence of transport cost:

This condition becomes very essential in order to have a single uniform price. A single uniform
price can not exist under perfect competition, if transport costs are taken into account.
Sometimes a distinction is observed between pure competition and perfect competition. The
American economists are particularly fond of using the term ‘Pure competition’. Many British
economists prefer to use the term ‘Perfect competition’. However the term pure competition is
used in a narrow sense. The fulfilment of the first three conditions stated above ensures pure
competition, where as for perfect competition all the six characteristics stated above need to be
fulfilled.
Price and output determination under perfect competition:

Equilibrium of the industry:
Industry consists of large number of independent firms. Each such firm in the industry produces
homogeneous products. When the total output of the industry is equal to the total demand and
when it has no incentive to expand or contract production, we say that the industry is in
equilibrium.
Under equilibrium condition the equilibrium price for a given product is determined by ‘Price
mechanism’. That is the interaction of the forces of demand and supply.

Determination of price:
In an open competitive market, it is the interaction between demand and supply that determines
prices.
This can be shown by the following schedule and diagram.
Price of commodity X Demand for commodity X
`1 50 Units
`2 35 Units
`3 15 Units
Market demand schedule is inversely related to the price. Hence the demand curve slopes
downwards from left to right.
Market Supply Schedule:

Price of commodity X Supply of commodity X
`1 15 Units
`2 35 Units
`3 50 Units
Market supply schedule is directly related to the price. Hence the supply curve slopes upwards
from left to right.
The above two tables if put together, gives use an idea of equilibrium price and output.
Price of commodity X Supply of commodity X Demand of commodity
`1 15 Units 50 Units
At `2 the quantity demanded is equal to quantity supplied. It is called as the Equilibrium Price.
The market demand and supply curves intersect each other at

point E, where the quantity demanded is equal to quantity
supplied. At any other point, either quantity demanded is
greater than quantity supplied or quantity supplied is more
than quantity demanded. Accordingly price will move up or
come down till it secures a balance between the two opposite
forces. `2 is the equilibrium price and 35 units is the
equilibrium quantity.

Equilibrium of a business firm:

A business firm is said to be in equilibrium when it maximizes its profit and has no intension
either to increase or decrease its output. Business firms in a perfect competition market are
‘Price takers’. This is because there are large number of firms in the market who are producing
identical or homogeneous product. As such these firms cannot influence the price in their
individual capacity. They have to accept the price fixed by the industry. A competitive firm thus
is not a price determinator but an output adjuster.
A business firm will produce that much output, where its profits are maximum. In perfect
competition whether the output is large or small, price per unit will remain the same. It is a
peculiar feature of such a market. Prices being fixed for all the units, the firms price will be equal
to average and marginal revenue {Price = Average revenue = Marginal revenue}. This can be
shown in the following table:
Average Marginal
Quantity sold Price per unit Total revenue
revenue revenue
8 2 16 2 2
10 2 20 2 2
12 2 24 2 2
14 2 28 2 2
16 2 32 2 2
Total Revenue = Price X Quantity {Total sales receipt}

Average Revenue = Total revenue / Quantity {revenue selling a single unit}
Marginal Revenue = Total revenuen-1. {n = Present unit, n-1 = previous unit} [Revenue
from selling an additional unit]
They cannot increase the price OP individually because of the fear of losing customers to other
firms. They do not try to sell the product below OP because they do not have any incentive for
lowering it. They will try to sell as much as they can at price OP. As such, P-line acts as demand
curve for the firm. Thus, the demand curve facing an individual firm in a perfectly competitive
market is a horizontal one at the level of market price set by the industry and firms have to
choose that level of output which yields maximum profit.
Profit maximization condition of perfectly Competitive firm:

Under perfectly competitive structure, due to product homogeneity, TR curve is upward linear
as in fig 1. At zero level of production. Profit = negative of F. With increase in production & sale
the gap of  − Pr ofit  = C − R keeps on decreasing. For Q = Q1 breakeven point is attained where
Profit = R(Q) – C(Q) = 0 i.e., R(Q) – C (Q) = O i.e., R(Q) = C(Q). At Q = Q*, Profit is maximized,
complying the following two conditions.
(i) Slope of TR = Slope of TC

ΔTR ΔTC
 =
ΔQ ΔQ
i.e., MR = MC [1st Order condition or
necessary condition]
ΔMC ΔMR
(ii) >
ΔQ ΔQ
i.e., Slope of MC > Slope of MR
[2nd Order condition or sufficient condition].
So equilibrium of firm can be obtained when it maximizes profit. The output which gives
maximum profit to the firm is called equilibrium output as it gives no incentive to the firm to
increase or decrease output.
In fig 2a, industry determines the price & due to product homogeneity & large no of buyers & sellers
firm cannot have influence on price & quantity & therefore, firm is a price taker. On the basis of that
firm sets the selling curve AR (which is parallel to the horizontal axis & converges to MR).
A rational firm maximizes profit till that point where last rupee spent on factor adds more to
revenue than to cost i.e. profit maximises at e2 point where two conditions are complied with:

i) Slope of TR = Slope of TC
ΔTR ΔTC
 =
ΔQ ΔQ
ΔMC ΔMR
ii) >
ΔQ ΔQ
a) Perfectly competitive firm may enjoy super-normal profit: In fig 1a, industry determines
the price & each firm has to accept the determined price to find out its profit maximizing output.
OP1 is the price & by complying the conditions of equilibrium, the output is ‘OQ1’.
TR = OP1e1Q1, TC = OC1L1Q1
i.e., Profit = OP1e1Q1 – OC1L1Q1 = C1P1e1L1 [Shaded zone in Fig 1b]
P>AC i.e., P.Q>AC. Q, i.e., TR>TC, i.e., TR – TC>O, which implies Profit > 0, Super -
normal Profit
b) Perfectly competitive firm may enjoy normal profit:

Due to change in overhead cost AC may increase or due to
decrease in price by the industry super-normal profit can be
decreased. There will be a situation where firm enjoys normal
profit or firm breaks even. In this case, AR curve becomes
tangent to AC. i.e P = minAC
P.Q = AC. Q, TR = TC, TR - TC = 0, Profit = 0
It is no profit & no loss Situation is known as ‘Break – Even point’.
Perfectly competitive firm incurs loss but continues

production: Normal profit is that part which is hidden in terms
of fixed cost. And perfectly competitive firm continues production
until P = min AVC
Here, P < AC > AVC i.e. P.Q. < AC. Q > AVC.Q
i.e. TR< TC > TVC
i.e. Though loss but money earned is greater than minimum

variable cost. So it sustains until P = min AVC.

AS a whole, we get five situations
a) P > min AC - Super normal profit
b) P = min AC - Normal Profit or Breakeven point
c) P < min AC > min AVC - Loss but continues production
d) P = min AVC -Shut down p pint
Short – run supply curve of perfectly competitive firm
Short – run is a period where some factors are fixed & firm operates on the same capacity point.
P = min AVC is origin of supply. For P < min Avc, firm is not able to cover the minimum variable
cost & then it will not continue production. Plotting different combinations of price & quantity
supplied as P = min AVC & P > min AVC, A, B, C points are obtained, each shows one-is-to-
one relationship between price & quantity supplied.
n n
a)  Si = 0 for
i=l
P  MinimumAVC b)  Si  0 for
i=l
P  MinimumAVC
The short-run supply curve is identical to positive portion of SMC curve.

Long run equilibrium of perfectly competitive firm
Long run is a period where all factors are variable in nature. Firm is able to change its existing
capacity or plant size. If existing firm enjoys super-normal profit, attracted by this new firms
take entry & industry supply keeps on increasing. Price decreases & this mechanism continues
until super-normal profit is wiped out.
[e5 point exhibits P = MR = AR = SAC = SMC = LMC = Min LAC]

At price = P1, perfectly competitive firm enjoys super- normal profit to the tune of C1P1e1L1 as shown
in fig 1b. Influenced by this, outsiders take entry. Industry supply curve shifts towards horizontal
axis. This mechanism continues until P = MR = AR = SAC = SMC = LMC = Min LAC. So, both
industry as well as firm are in equilibrium in long run, where firm enjoys normal profits.
Note: Perfect competition is a myth as:
i) Practically price does not remain constant.
ii) Perfect knowledge of the product or price is hardly found in the buyers & sellers.
iii) Customers may develop an irrational preference about certain product & sellers which may
curtail the perfect competition.
In real, free entry & exit are rarely found. Patents, huge investments, economies of large
scale of production etc. bound the entry

Chapter – 12 – Monopoly
The term ‘Monopoly’ is derived from two Greek words namely: Mono – Single and Poly – Seller.
If there is only one seller in the market, it is called as monopoly. This market situation is at the
opposite pole of perfect competition market. Monopoly can be defined as “A market situation,
where there is only one seller, who controls the entire supply of his product, which has no close
substitutes”. Pure monopoly is never found in practice. However, in public utilities such as
Railway transport, water and electricity, etc. we generally find monopoly.
Feature of the monopoly market:

A Single Seller: Monopoly means a single seller. It may be a person of a group of persons
united together in the form of cartels, pools, trusts, syndicates, associations etc., For example:
OPEC (Organization of petroleum exporting countries). This monopolist will have to complete
control over the supply of his products. Hence, monopoly market is known as “One firm
industry”.
No close substitutes: There will be no close substitutes for the products of the monopolist.
No other firm in an industry will be producing a similar product. The cross elasticity of demand
for the monopolist product is zero. The consumer will not have any other alternatives under
monopoly. Hence in Monopoly, there will be absence of competition.
He is the price-maker: The Monopolist is the price-maker. He decides the price of his good
or service. Since he is the only seller and there is no close substitute. Hence, he decides the price.
The consumers are either to buy the goods and services at the price fixed by the monopolist or to
go without it. A monopolist has dual power – both a price maker and output adjuster. But he
cannot exercise both these powers simultaneously / together, as he has no control over the
market demand.
Price discrimination: A monopolist in order to attract all range of consumers, practices price
discrimination. Charging different prices to the different buyers for a similar kind of product is
called as price discrimination. For example: A doctor may charge `250 for richer patients and
`100 for poorer patients for the same treatment.
Entry barriers: The entry of other firm is highly restricted in monopoly market situation.
Some of the important factors which acts as entry barriers are:
Natural factors: The nature itself has differentiated in allocating resources. For example:
petroleum products are available only in Arab countries. Jute can grow only in West Bengal.
Legal restrictions: Some companies through Law, posses the monopoly. For example:
Possessing Patents, Trademarks and Copyrights etc. The reasons to issue these is to encourage
innovations and creativity.
Business formation: Some business firms through forming business organizations like
Cartels, Pools, Syndicates, Trusts creates monopoly markets.
Investment factors: Some large players through their massive investments create monopoly.
For instance: TATA and MITTAL have made huge investments in the production of iron and
steel. Any new firm wants to enter in that field, will not be able to invest on par with them.
Existence of super normal profit:

In monopoly, the seller always enjoys the super-normal profit. The price charged by him will
always be more than the cost of production. Hence, he always enjoys the super-normal profit.
Monopoly power: It is the power of seller in setting the price in the market. Monopoly power
is influenced by the following characters:
- Barrier to entry
- Degree of product differentiation
- Number of competitors
Pure monopoly is rare because it is abstract to say that a thing has no substitutes. Generally,
everything has a substitute – may be close or remote.
Types of monopoly:
Perfect monopoly: It is the kind of monopoly where only one seller operates in the market
with having no close substitutes. Here there is absolutely no competition. This type of monopoly
in real market is very rare.
Simple monopoly: Here also single seller operates through the market with no close
substitutes. But, some remote substitutes can be found in the market. Here, seller will have very
small competition.
Discriminating monopoly: Here the monopolist charges different price to different

consumers for the same product. It prevails in more than one market.
Monopolist’s Revenue Curves:

Since the monopolist firm is assumed to be the only producer of a particular product, its
demand curve also shows the quantity that the monopolist will be able to sell.

Example: XYZ company is the single producer of a product, it faces the entire market demand
and hence the downwards sloping demand curve. i.e. in order to increase the sales, a firm is
reducing its price.
It can be better understood through the following table:
Quantity Price = AR Total Revenue Marginal Revenue
0 11 0 0
1 10 10 10
2 9 18 8
3 8 24 6
4 7 28 4
5 6 30 2
6 5 30 0
7 4 28 -2
8 3 24 -4
- In order to increase the sales, a firm is reducing its price.

Hence AR falls.
- As a result of fall in price, total revenue increases but at a
diminishing rate.
- Total Revenue will be highest when Marginal revenue is
zero.
- Total Revenue falls when Marginal revenue becomes
negative.
- Average Revenue and Marginal Revenue both declines
but fall in Marginal revenue is greater than fall in Average Revenue.
- The Average Revenue curve of the firm and the demand curve of the buyer is one and same.
It slopes downwards from left to right indicating that the seller can sell larger quantities only
at reduced prices.
- The Marginal Revenue curve is similar to that of Average Revenue curve. But Marginal
revenue is less than Average Revenue. It lies below the Average Revenue curve, which is half
way between Average revenue curve and the Y axis, i.e., it cuts the horizontal line between Y
axis and AR into two equal parts.
- Average Revenue cannot be zero but Marginal Revenue can be zero or even negative.

- If the seller wishes to charge `11, he can’t sell any unit alternatively, if he wishes to sell 7
units, his price can’t be higher than `4.
Profit maximizing conditions of monopoly

Sole objective is to maximize profit.
In monopoly, price is variable and therefore, total revenue curve
is dome-shaped. Profit maximizing conditions can be obtained
both by ‘TR – TC’ approach & by ‘Marginalistic View’.
In fig 1, profit at zero level of production is - ‘F’ (tune of fixed
cost). With increase in production and sale monopolist decreases
gap between cost & revenue & for Q = Q1, it breaks even (here profit = TR = TC = 0).
Profit is maximized where two conditions are satisfied:
(i) Slope of TR = Slope of TC
ΔTR ΔTC
 =
ΔQ ΔQ
i.e., MR = MC [1st Order condition or necessary
conditions]
ΔMC ΔMR
(ii) >
ΔQ ΔQ
i.e., Slope of MC > Slope of MR
[ 2nd Order condition or sufficient condition].
The marginalist principle can be obtained in fig2 where equilibrium is attained at ‘F’ point,
complying the same conditions. Monopolist’s demand curve or AR curve, P = a – bQ
2
i.e., TR = P.Q = aQ – bQ MR = a – 2bQ. MR is downward sloped with slope – 2b’ & profit
maximizing point is attained where MC cuts MR from below.
Step – 2: Different short run equilibrium of monopoly

Complying the two conditions MR = MC & slope of MC>Slope of MR we can find out different
situations of monopoly where it may or may not enjoy profit.
a) Monopolist with abnormal profit:
Monopolist may earn super-normal profit or abnormal profit if
P= AR > AC
 P. Q= AR.Q> AC.Q
 TR – TC > O

 Profit > O.
In fig 1 at Q = Q1 , price is greater than AC & the amount of super-
normal profit earned by monopolist is C1P1L1S1, as in Fig 1.
b) Monopolist may earn normal profit:
Monopolist may face the situation in short run, where it breaks
even. In fig. 2 equilibrium is attained at P = AC,
 P.Q = AC. Q  TR – TC = O  Profit is zero i.e., its total
revenue is equal to summation of fixed & variable cost, as in fig 2.
c) Monopolist may incur loss but continues production:

In short run, monopolist may outflow loss where the total
revenue earned is not sufficient to cover both fixed & variable
cost. i.e., P<AC  TR < TC  Profit < O. But it continues
production as it covers average variable cost, and it would go
for zero production when P < AVC.
Step – 3: Long – run equilibrium of monopolist

Long run is a period long enough to allow the monopolist to
adjust his plant size or use his existing plant at any level that
maximises profit. Since there are barriers to entry, new firms
cannot take entry & in the absence of competition, the
monopolist need not produce at the optimal level. He can
make equilibrium at any point of LAC. A to B shows under
utilised portion, B exhibits full- utilised point & ‘BC’ or
upward LAC displays over-utilised portion.
In fig2, longrun equilibrium is attained at ‘e’ point (which

is under utilised portion of LA(c). Conditions of
equilibrium. i) SMC (= LM(c) = MR ii) Slope of SMC (=
slope of LM(c) > slope of MR. He will not stay in
business if he makes losses in the long run. The plant site
& degree of utilisation will depend upon the Market
Demand.

Step – 4: Price Discriminating Monopoly

Price discrimination exists when the same product is sold at different prices to different
consumers. We take the case of identical product, produced at the same cost, which is sold
at different prices, depending on the preference of buyers, their income, their location & the
case of availability of substitutes. These factors give rise to demand curves with different
elasticities in the various sectors of the market of a firm. Different examples are:
a) Doctors charge lower price from poor & higher from rich.
b) Domestic electric meter has one charge whereas commercial meter has different charge.
c) Universities charge higher tution fees for evening class for working students than day
class from general students.
d) Telephone bill has price-blocking as per unit consumed.
e) A higher price for vegetables sold in posh localities than in general.
f) Railways separate high – value or relatively small – bulk commodities which can bear
higher freight charges from other categories of goods.
g) Some countries dump goods at low prices in foreign markets to capture them
h) A lower subscription is charged from student readers in case of certain journals.
Objectives of price discrimination:

− To earn maximum profit
− To dispose off surplus stock
− To enjoy economies of scale
− To capture foreign markets
− To secure equity through pricing
The necessary conditions of price-Discriminating monopolist are:

i) The market must be divided into sub-markets with different prices
ii) There must be effective separation of the sub-markets, so that no reselling can take place.
iii) The seller should have some control over then supply of his product i.e. monopoly
power in some from is necessary to discriminate price.
b) The profitability condition is: The price elasticity for the two different markets
should be different so that prices would be charged different.
There exists three degree of discrimination.
a) 3rd degree discrimination
b) 2nd degree discrimination
c) 1st degree discrimination

For 3rd degree discrimination, monopolist charges two prices in two sub-
markets.
Due to difference in elasticities marginal revenues are dissimilar in two sub-markets. In

fig 3 (= MR1 + MR2). Equilibrium output produced by price-discriminating monopolist
is OQm & is distributed to two sub-markets in such a manner that less elastic market
charges higher price & more elastic market charges lower price.
Here MR1 = MR2 , which implies the followings
1 1
P1 (1 - ) = P2 (1 - )
e1 e2
1
(1 -
)
P1 e2
 =
P2 (1 - 1 )
e1
1)When → e 1 = e 2 → P1 = P2 → (NoDiscrimination)
2)When → e 1 > e 2 → P1 < P2 → (Profitable)
3)When → e 1 < e 2 → P1 > P2 → (Profitable)
So, price discriminating monopolist exercises ‘3rd degree discrimination as he could
charge more price in less elastic demand & lower price in more elastic demand.
Further, ‘3’ discriminations can be shown by consumer’s surplus.
a) In 3rd degree discrimination we can observe two prices are charged & as a result,
part of consumer’s surplus is wiped out.
b) In 2nd degree discrimination we can observe that more than two prices are charged
commonly known as ‘price blocking’. More consumer’s surplus can be extracted.
c) In ‘1st degree discrimination’, monopolist charges ‘Reservation price’, or ‘Take-it-or-
leave-it’ price i.e. consumers do not have any other alternate but to consume at that
determined price. So monopolist is able to wipe out entire consumer’s surplus.

These ‘3’ situations can be shown by following figures

Chapter – 13 – Monopolistically Competitive Market
Concepts & features

The assumption of a homogeneous product & single product do not always fit the real world.
Advertising & other selling activities, practices widely used by businessmen, could not be
explained either by pure competition or by monopoly. Firms can charge different prices as per
different cost which results in ‘imperfect competition’. The monopolistic competition is the
important part of ‘imperfect competition’. The idea of monopolistic competition was popular-
ized by Prof Edwin H. Chamberlin (1933) ‘The Theory of Monopolistic Competition’:
‘A Reorientation of the Theory of value’.
The features of monopolistic competition are.

1) There are large number of buyers & sellers
2) Freedom of entry & exit
3) The principal goal is to maximize profits.
4) Firms also try to compete on the basis other than price
‘known as ‘non-price competition’ e.g. advertising,
product development, after sales service, better
distribution arrangement etc.
5) The products sold by the sellers are differentiated, yet they are close substitutes. i.e., in a
monopolistic competitive market, the products of different sellers are differentiated on the
basis of brands. These brands are generally so much advertised that a consumer starts
associating the brand with a particular manufacturer and type of brand loyalty is developed.
Product differentiation gives rise to an element of monopoly to the producer over the
competing product. As such, the producer of an individual brand can raise the price of his
product knowing that he will not lose all the customers to other brands because of absence of
perfect substitutability. Due to product differentiation, we
get, unlike any other market two selling curve Perceived or
Planned selling curve or demand curve & Actual or
Market
demand curve. Perceived or planned demand curve is
flatter in nature, i.e. eP>1 where selling is responsive to
change in price & ‘Actual dd curve’ is steeper in nature
which is obtained by the effect of market.

Step – 2: Short – run equilibrium of monopolistically competitive firm

During short-run firm operates within the existing capacity. The objective is to maximize profit,
which can be obtained at point ‘e’ where three conditions are complied with:
1) MC = MR
2) Slope of MC > Slope of MR
3) Perceived demand curve intersects Actual demand curve at equilibrium price
(L1)
In this figure we get ‘e’ as equilibrium point where the above three conditions are satisfied. The
monopolistically competitive firm fixes equilibrium price OP1 where the total revenue
= OP1L1Q1 and total cost = OP1L2Q1.
The total profit earned by monopolistically competitive firm is C1P1L1L2.

Long run equilibrium of monopolistically competitive firm
During long run period, as per Prof Chamberlin, both ‘new entry’ & price competition’
take place. As a result, the same quantity would be available at a lower price. Thus, the perceived
demand curve shifts to the downward direction. If price competition continues, then a situation
may arise when the perceived demand curve falls below the LAC (i.e., LAC>P), & each firm
would incur loss. Hence, some loss making firms would leave the market & actual market-
share of the remaining firms will rise. Hence, at a given price, the remaining firms begin to
perceive that they can sell more than before. So, perceived demand curve would also shift
upward. This mechanism would continue until equilibrium reaches at ‘e’ point where
monopolistically competitive firm enjoys normal profit & the long-run equilibrium
conditions are:
1) SMC = LMC = MR
2) Slope of SMC = Slope of LMC > Slope of MR
3) Perceived dd curve intersects actual dd
curve at equilibrium price
4) 4.Equilibrium is attained with excess
capacity.

Chapter – 14 – Oligopoly
Oligopoly is an important form of imperfect competition. It is often described as ‘competition

among a few’. When there are a few sellers in a market, oligopoly is said to exist.
Prof. Stigler defines oligopoly as “that situation in which a firm bases its market policy in part on
the expected behaviour of a few close rivals”.
Example: Cold drink industry, automobile industry
Types of oligopoly:
Pure/perfect and differentiated/imperfect oligopolies. Pure oligopoly is when the product is
homogeneous in nature.
Example: Aluminium industry
Differentiated or imperfect oligopoly is based on product differentiation. Example – automobile
industry.
Open and closed oligopolies:

In open oligopoly, there is free entry and exit firms. Whereas, in closed oligopoly, entry is
restricted.
Collusive and competitive oligopolies:

When firms of an oligopolistic market come to a common understanding or act in collusion with
each other in fixing price and output, it is collusive oligopoly. On the other hand, when there is a
lack of understanding between the firms and they compete with each other, it is known as
competitive oligopoly.
Partial or full oligopolies:

When there is one dominating leader firm, it would be the price leader and is known as partial
oligopoly. In full oligopoly, the market will be conspicuous by the absence of price leadership.
Partial or full oligopolies:

When there is one dominating leader firm, it would be the price leader and is known as partial
oligopoly. In full oligopoly, the market will be conspicuous by the absence of price leadership.
Characteristics of oligopoly:
A few sellers: Oligopoly comprises of a few sellers. It is different form monopoly which has
one seller, monopolistic competition which has many sellers and perfect competition which has
many sellers and perfect competition which has innumerable sellers.

Interdependence: There exists a close interdependence among firms. A single firm cannot
take independent decisions without considering the rivals’ reactions. This is because, if the
oligopolist lowers the price, his rivals will also lower their prices. On the other hand, if he
increases the price, the rivals will not, and therefore, he will lose customers.
Selling costs and advertisement: Under oligopoly, rival firms employ aggressive and
defensive marketing weapons. The purpose of this is to gain a greater share in the market or to
maximize its profits and minimize its losses. Firms incur expenditure on advertising a sales
promotion measures. The rivalry is related to non-price factors only. The objective of an
oligopolist is not necessarily to maximize profit. It is to capture a larger part in the share of the
market.
Group behaviour: Firms may realise the importance of mutual cooperation. They will have a
tendency of collusion. At the same time, the desire of each firm to earn maximum profit may
encourage competitive spirit. Thus, co-operative and collusive trend as well as competitive trend
would prevail in an oligopolistic market.
Price rigidity: Another important feature of oligopoly is price rigidity. Price is sticky or rigid at
the prevailing level due to the fear of reaction from the rival firms. If an oligopolistic firm lowers
its price, the price reduction will be followed by the rival firms. As a result, the firm loses its
customers. Expecting the same kind of reaction, if the oligopolistic firm raises the price, the rival
firms will not follow. This would result in losing customers. In both ways, the firm would face
difficulties. Hence, the price is rigid.
Price & Output determination in oligopoly market

There are different types of oligopolistic behaviour, & different formulation & different famous
models are provided by eminent economists like Prof
Augustin Cournot (Model of zero
conjectural variation), Prof Stackelbarg (Output
leadership model), Prof Fellner (Cartel or ‘Fraudulent
secret understanding), Prof Nash (By Game theoretic
Approach) Prof Paul. A Sweezy (Kinked demand
Model).
Our, Scope is ‘kinked demand model’. Prof Paul A.

Sweezy, in “Demand Under Conditions of ‘Oligopoly’ Journal of Political Economy

has given the concept of ‘kinked demand model’ In this case, product is homogeneous & each
oligopolist believes that if he lowers the price, his rivals will also lower the prices & that if he
raises the price, they will maintain their prices at the existing level.
So price remaining ‘sticky’ at a ‘determined level’ (OPe) in fig 1 &
the AR has two slopes AL (ep>1, Price unmatched zone) & LAR
(Price matched zone) eP<1.
Due to ‘kinked’ AR curve, MR is discontinuous in nature & length
of discontinuity depends on difference in elasticities at point ‘L’.
In fig (2) at ‘L’ pt, MR is discontinuous to the tune of ‘AB’.
Equilibrium of oligopoly under kinked demand model can be obtained by the

combination of MR, AR, SAC & SMC, as in fig (3).
The equilibrium is obtained at ‘e1’ point where, SMC curve
passes through the discontinuous portion of MR. So profit
is maximized if quantity is, fixed at OQe, i.e., as per rigid
price OPe.
In fig (3), oligopolist enjoys super-normal profit to the tune
of C1PeL1S1 as price is fixed at ‘kink’ situation. That is
why kinked demand model is also known as ‘Rigid price’
or ‘Sticky Price’ model.

Chapter – 15 – Business Cycle
Introduction
The rhythmic fluctuations in aggregate economic activity that an economy experiences over a
period of time are called business cycles or trade cycles. A trade cycle is composed of periods of
good trade characterised by rising prices and low unemployment percentage, altering with
periods of bad trade characterised by falling prices and high unemployment percentages. In
other words, business cycle refers to alternate expansion and contraction of overall business
activity as manifested in fluctuations in measures of aggregate economic activity, such as, gross
national product, employment and income.
A noteworthy characteristic of these economic fluctuations is that they are recurrent and occur
periodically. That is, they occur again and again but not always at regular intervals, nor are they
of the same length. It has been observed that some business cycles have been long, lasting for
several years while others have been short ending in two to three years.
Phases of Business Cycle

We have seen above that business cycles or the periodic booms and slumps in economic
activities reflect the upward and downward movements in economic variables. A typical
business cycle has four distinct phases. These are:
1. Expansion (also called Boom or Upswing)
2. Peak or boom or Prosperity
3. Contraction (also called Downswing or Recession)
4. Trough or Depression
Figure1 Phases of Business Cycle

Expansion: The expansion phase is characterised by increase in national output, employment,

aggregate demand, capital and consumer expenditure, sales, profits, rising stock prices and bank
credit. This state continues till there is full employment of resources and production is at its
maximum possible level using the available productive resources. There is altogether increasing
prosperity and people enjoy high standard of living due to high levels of consumer spending,
business confidence, production, factor incomes, profits and investment. The growth rate
eventually slows down and reaches its peak.
Peak: The term peak refers to the top or the highest point of the business cycle. In the later
stages of expansion, inputs are difficult to find as they are short of their demand and therefore
input prices increase. Output prices also rise rapidly leading to increased cost of living and
greater strain on fixed income earners. Consumers begin to review their consumption
expenditure on housing, durable goods etc. Actual demand stagnates.
Contraction: The economy cannot continue to grow endlessly. As mentioned above, once peak
is reached, increase in demand is halted and starts decreasing in certain sectors. During
contraction, there is fall in the levels of investment and employment. Producers do not
instantaneously recognise the pulse of the economy and continue anticipating higher levels of
demand, and therefore, maintain their existing levels of investment and production. The
consequence is a discrepancy or mismatch between demand and supply. Supply far exceeds
demand. Initially, this happens only in few sectors and at a slow pace, but rapidly spreads to all
sectors. Producers being aware of the fact that they have indulged in excessive investment and
over production, respond by holding back future investment plans, cancellation and stoppage of
orders for equipments and all types of inputs including labour. This in turn generates a chain of
reactions in the input markets and producers of capital goods and raw materials in turn respond
by cancelling and curtailing their orders. This is the turning point and the beginning of
recession.
Decrease in input demand pulls input prices down; incomes of wage and interest earners
gradually decline resulting in decreased demand for goods and services. Producers lower their
prices in order to dispose off their inventories and for meeting their financial obligations.
Consumers, in their turn, expect further decreases in prices and postpone their purchases. This
process gathers speed and recession becomes severe.
Trough and Depression: Depression is the severe form of recession and is characterized by
extremely sluggish economic activities. During this phase of the business cycle, growth rate
becomes negative and the level of national income and expenditure declines rapidly. Demand

for products and services decreases, prices are at their lowest and decline rapidly forcing firms
to shutdown several production facilities. Since companies are unable to sustain their work
force, there is mounting unemployment which leaves the consumers with very little disposable
income. A typical feature of depression is the fall in the interest rate. With lower rate of interest,
people’s demand for holding liquid money (i.e. in cash) increases.
Recovery: The economy cannot continue to contract endlessly. It reaches the lowest level of
economic activity called trough and then starts recovering. Trough generally lasts for some time
and marks the end of pessimism and the beginning of optimism. This reverses the process. The
process of reversal is initially felt in the labour market. The spurring of investment causes
recovery of the economy. This acts as a turning point from depression to expansion. As
investment rises, production increases, employment improves, income improves and consumers
begin to increase their expenditure. Increased spending causes increased aggregate demand and
in order to fulfil the demand more goods and services are produced.
Examples of Business Cycles

Great Depression of 1930: The world economy suffered the longest, deepest, and the most
widespread depression of the 20th century during 1930s. It started in the US and became
worldwide. The global GDP fell by around 15% between 1929 and 1932. Production, employment
and income fell. As far as the causes of Great Depression are concerned, there is difference of
opinion amongst economists. While British economist John Maynard Keynes regarded lower
aggregate expenditures in the economy to be the cause of massive decline in income and
employment, monetarists opined that the Great Depression was caused by the banking crisis
and low money supply. Many other economists blamed deflation, over- indebtedness, lower
profits and pessimism to be the main causes of Great Depression. Whatever may be the cause of
the depression, it caused wide spread distress in the world as production, employment, income
and expenditure fell. The economies of the world began recovering in 1933. Increased money
supply, huge international inflow of gold, increased governments’ spending due to World War II
etc., were some of the factors which helped economies slowly come out of recession and enter
the phase of expansion and upturn.
Information Technology bubble burst of 2000: Information Technology (IT) bubble or

Dot.Com bubble roughly covered the period 1997-2000. During this period, many new
Internet–based companies (commonly referred as dot-com companies) were started. The low
interest rates in 1998–99 encouraged the start-up internet companies to borrow from the
markets. Due to rapid growth of internet and seeing vast scope in this area, venture capitalists

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

Different business cycles differ in duration and intensity. But there are certain features which
they commonly exhibit:
a) Business cycles occur periodically although they do not exhibit the same regularity. The
duration of these cycles vary. The intensity of fluctuations also varies.

b) Business cycles have distinct phases of expansion, peak, contraction and trough. These
phases seldom display smoothness and regularity. The length of each phase is also not
definite.
c) Business cycles generally originate in free market economies. They are pervasive as well.
Disturbances in one or more sectors get easily transmitted to all other sectors.
d) Although all sectors are adversely affected by business cycles, some sectors such as capital
goods industries, durable consumer goods industry etc, are disproportionately affected.
Moreover, compared to agricultural sector, the industrials sector is more prone to the
adverse effects of trade cycles.
e) Business cycles are exceedingly complex phenomena; they do not have uniform
characteristics and causes. They are caused by varying factors. Therefore, it is difficult to
make an accurate prediction of trade cycles before their occurrence.
f) Repercussions of business cycles get simultaneously felt on nearly all economic variables viz.
output, employment, investment, consumption, interest, trade and price levels.
g) Business cycles are contagious and are international in character. They begin in one country
and mostly spread to other countries through trade relations. For example, the great
depression of 1930s in the USA and Great Britain affected almost all the countries, especially
the capitalist countries of the world.
h) Business cycles have serious consequences on the wellbeing of the society.
Causes of Business Cycles

Business Cycles may occur due to external causes or internal causes or a combination of both.
The 2001 recession was preceded by an absolute mania in dotcom and technology stocks, while
the 2007-09 recession followed a period of unprecedented speculation in the U.S. housing
market.
Internal Causes: The Internal causes or endogenous factors which may lead to boom or bust
are:
Fluctuations in Effective Demand: According to Keynes, fluctuations in economic activities

are due to fluctuations in aggregate effective demand (Effective demand refers to the willingness
and ability of consumers to purchase goods at different prices). In a free market economy,
where maximization of profits is the aim of businesses, a higher level of aggregate demand will
induce businessmen to produce more. As a result, there will be more output, income and
employment.

Thus, increase in aggregate effective demand causes conditions of expansion or boom and
decrease in aggregate effective demand causes conditions of recession or depression. (You will
study about these concepts in detail at Intermediate level in Economics for Finance.
Fluctuations in Investment: According to some economists, fluctuations in investments are

the prime cause of business cycles. Investment spending is considered to be the most volatile
component of the aggregate demand. Investments fluctuate quite often because of changes in
the profit expectations of entrepreneurs. New inventions may cause entrepreneurs to increase
investments in projects which are cost-efficient or more profit inducing. Or investment may rise
when the rate of interest is low in the economy. Increases in investment shift the aggregate
demand to the right, leading to an economic expansion. Decreases in investment have the
opposite effect.
Variations in government spending: Fluctuations in government spending with its impact

on aggregate economic activity result in business fluctuations. Government spending, especially
during and after wars, has destabilizing effects on the economy.
Macroeconomic policies: Macroeconomic policies (monetary and fiscal policies) also cause
business cycles. Expansionary policies, such as increased government spending and/or tax cuts,
are the most common method of boosting aggregate demand. This results in booms. Similarly,
softening of interest rates, often motivated by political motives, leads to inflationary effects and
decline in unemployment rates. Anti- inflationary measures, such as reduction in government
spending, increase in taxes and interest rates cause a downward pressure on the aggregate
demand and the economy slows down. At times, such slowdowns may be drastic, showing
negative growth rates and may ultimately end up in recession.
Money Supply: According to Hawtrey, trade cycle is a purely monetary phenomenon.
Unplanned changes in supply of money may cause business fluctuation in an economy. An
increase in the supply of money causes expansion in aggregate demand and in economic
activities. However, excessive increase of credit and money also set off inflation in the economy.
Capital is easily available, and therefore consumers and businesses alike can borrow at low rates.
This stimulates more demand, creating a virtuous circle of prosperity. On the other hand,
decrease in the supply of money may reverse the process and initiate recession in the economy.
Psychological factors: According to Pigou, modern business activities are based on the
anticipations of business community and are affected by waves of optimism or pessimism.
Business fluctuations are the outcome of these psychological states of mind of businessmen. If

entrepreneurs are optimistic about future market conditions, they make investments, and as a
result, the expansionary phase may begin. The opposite happens when entrepreneurs are
pessimistic about future market conditions. Investors tend to restrict their investments. With
reduced investments, employment, income and consumption also take a downturn and the
economy faces contraction in economic activities.
External Causes: The External causes or exogenous factors which may lead to boom or bust
are:
Wars: During war times, production of war goods, like weapons and arms etc., increases and
most of the resources of the country are diverted for their production. This affects the
production of other goods - capital and consumer goods. Fall in production causes fall in
income, profits and employment. This creates contraction in economic activity and may trigger
downturn in business cycle.
Post War Reconstruction: After war, the country begins to reconstruct itself. Houses, roads,
bridges etc. are built and economic activity begins to pick up. All these activities push up
effective demand due to which output, employment and income go up.
Technology shocks: Growing technology enables production of new and better products and
services. These products generally require huge investments for new technology adoption. This
leads to expansion of employment, income and profits etc. and give a boost to the economy. For
example, due to the advent of mobile phones, the telecom industry underwent a boom and there
was expansion of production, employment, income and profits.
Natural Factors: Weather cycles cause fluctuations in agricultural output which in turn cause
instability in the economies, especially those economies which are mainly agrarian. In the years
when there are draughts or excessive floods, agricultural output is badly affected. With reduced
agricultural output, incomes of farmers fall and therefore they reduce their demand for
industrial goods. Reduced production of food products also pushes up their prices and thus
reduces the income available for buying industrial goods. Reduced demand for industrial
products may cause industrial recession.
Population growth: If the growth rate of population is higher than the rate of economic
growth, there will be lesser savings in the economy. Fewer saving will reduce investment and as
a result, income and employment will also be less. With lesser employment and income, the
effective demand will be less, and overall, there will be slowdown in economic activities.

Relevance of Business Cycles

Business cycles affect all aspects of an economy. Understanding the business cycle is important
for businesses of all types as they affect the demand for their products and in turn their profits
which ultimately determines whether a business is successful or not. Knowledge regarding
business cycles and their inherent characteristics is important for a businessman to frame
appropriate policies. For example, the period of prosperity opens up new and superior
opportunities for investment, employment and production and thereby promotes business. In
contrast, a period of recession or depression reduces business opportunities and profits. A profit
maximising firm has to consider the nature of the economic environment while making business
decisions, especially those related to forward planning.
Business cycles have tremendous influence on business decisions. The stage of the business
cycle is crucial while making managerial decisions regarding expansion or down-sizing.
Businesses have to advantageously respond to the need to alter production levels relative to
demand. Different phases of the cycle require fluctuating levels of input use, especially labour
input. Firms should exercise the capability to expand or rationalize production operations so as
to suit the stage of the business cycle. Business managers need to work effectively to arrive at
sound strategic decisions in complex times across the whole business cycle, managing through
boom, downturn, recession and recovery.
Economy-wide trends can have significant impact on all types businesses. However, it should
be kept in mind that business cycles do not affect all sectors uniformly. Some businesses are
more vulnerable to changes in the business cycle than others. Businesses whose fortunes are
closely linked to the rate of economic growth are referred to as "cyclical" businesses. These
include fashion retailers, electrical goods, house-builders, restaurants, advertising, overseas tour
operators, construction and other infrastructure firms. During a boom, such businesses see a
strong demand for their products but during a slump, they usually suffer a sharp drop in
demand. It may also happen that some businesses actually benefit from an economic down turn.
This happens when their products are perceived by customers as representing good value for
money, or a cheaper alternative compared to more expensive products.
Overcoming the effects of economic downturns and recessions is one of the major challenges of
sustaining a business in the long-term. The phase of the business cycle is important for a new
business to decide on entry into the market. The stage of business cycle is also an important
determinant of the success of a new product launch. Surviving the sluggish business cycles
require businesses to plan and set policies with respect to product, prices and promotion.

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CA-Foundation: Economics Study Book

Prof. Sandip Sengupta

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1. Nature & Scope of Business Economics 01 – 18

2. Theory of Consumer Behavior 19 – 31

8. Theory of Production 93 – 112

9. Theory of Cost 113 – 127

10. Price Determination in Different Market 128 – 134

11. Behavioral Principles 135 – 142

12. Monopoly 143 – 150

13. Monopolistically Competitive Market 151 – 152

14. Oligopoly 153 – 155

15. Business Cycle 156 – 163

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Chapter – 01 – Nature and Scope of Business Economics

Consider the following situation.

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The two fundamental facts of economics are that:

Science of material well-being

“Economics is a study of mankind in the ordinary business of life. It examines that

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Science of choice making

His definition is as follows:

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Science of dynamic growth and development.

Samuelson’s definition is known as a modern definition of economics. It is a combination of

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Nature of Business Economics

The following points will describe the nature of Business Economics:

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Business Economics is generally normative or prescriptive in nature. It suggests the

Scope of Business Economics

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2. Macroeconomics applied to environmental or external issues

Central Economic Problems

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For whom to produce?

Market provision are to be made for economic growth.

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The salient features of market economy are as follows:

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A capitalist economy’s solutions:

Advantages of a capitalist economy:

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Disadvantages of a capitalist economy:

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Features of a socialist economy:

Advantages of a socialist economy:

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Disadvantages of a socialist economy:

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Features of a mixed economy:

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Merits of Mixed Economy