Economics Paper II – Microeconomics – II (English Version)-munotes

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1 Module I
1
PRODUCTION FUNCTION: CONCEPTS
AND TYPES
Unit Structure:
1.0 Objectives
1.1 Introduction
1.2 Concept of Production Function
1.3 Types of Production Function
1.4 Concepts of Total, Average and Marginal Product
1.5 Summary
1.6 Questions
1.0 OBJE CTIVES
 To know the concept of production function.
 To study the types of production function.
 To study the concepts of total, average and marginal product.
1.1 INTRODUCTION
The term ‘production’ is very important and broader concept in
economics. To meet the daily demand of a consumer production is
essential part. Production is a process by which various inputs are
combined and transformed into output of goods and services, for which
there is a demand in the market. In other words, Production is a process of
combining various material inputs and immaterial inputs in order to make
something for consumption. The essences of production are the creation of
utilities and the transformation of inputs or resources into output. Inputs
are the resources used in the production of goods and services the
important resources or input in production are land, labour, capital, and
entrepreneur. Production process creates economic well -being into the
nation. Thus, production is a process which creates utility and value in
exchange.
The theory of production function is concern with the problem in the
production process in a certain level of output. It analyses the relation
between cost and output and help the firm to determine its profit. All firms munotes.in

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2 that aim at maximizing thei r profit must make their decision regarding
production on the bases of the following three decision:
A. How much output to produce and supply in the market?
B. How to produce the product, i.e. which technique of production or
combination of production to used have to be decided?
C. How much quantity of input is demanded to produce the output of the
product?
Thus, the above three decisions are interrelated and have to be taken by
the firm during the production process.
1.2 MEANING OF PRODUCTION FUNCTION
In economics, a production function is the functional relationship between
physical output of a production process to physical inputs or factors of
production. In other words, production function denotes an efficient
combination of input and output. The fac tors which are used in the
production of goods and services are also called as agents of production.
Production function of a business firm is determined by the state of
technology. More specifically, production function shows the maximum
volume of physica l output available from a given set of inputs, or the
minimum set of inputs necessary to produce any given level of output.
Definition: With the above statements we can define the production
function as: “A production function refers to the functional re lationship,
under the given technology, between physical rates of input and output of
firm, per unit of time”.
Mathematically, production function can be express as: Q = f (N, L, K, E,
T, etc.)
1.3 TYPES OF PRODUCTION FUNCTION
I. The production function c an be broadly categorized into two based
on the time period i.e.
a) short run production function and
b) long run production function.
A) Short run production function: The short run is defined as the period
during which at least one of the inputs is fi xed. According to the
following short -run production function, labour is the only variable factor
input while the rest of the inputs are regarded as fixed. In other words, the
short run is a period in which the firm can adjust production by changing
varia ble factors such as materials and labour but cannot change fixed
factors such as land, capital, etc. Thus, in short -run some factors are fixed
and some are variable.
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Production Function: Concepts
and Types
3 B) Long run production function: The long run production function is
defined as the peri od of time in which all factors of production are
variable. In the long run there is no distinction between the fixed or
variable factor as all factors in the long run are variable.
II. The production function can also be classified on the basis of factor
proportion i.e.
a) Fixed proportion production function and
b) Variable proportion production function.
A. Fixed proportion production function : The fixed proportion
production function, also known as a Leontief Production Function
which implies the fixed factors of production function such as land,
labour, raw materials are used to produce a fixed quantity of an output
and these factors of production function cannot be substituted for the
other factors. In other words, in such factors of production functio n
fixed quantity of inputs is used to produce the fixed quantity of output.
All factors of production are fixed and cannot be substituted for one
another. The concept of fixed proportion production function can be
further expained with the help of a figure 1.1 as shown below:

Figure 1.1



B. Variable proportion production function : The variable proportion
production function supposes that the ratio in which the factors of
production such as labour and capital are used in a variable proportion.
Also, the d ifferent combinations of factors can be used to produce the
given quantity, thus, one factor can be substituted for the other factor.
In the case of variable proportion production function, the technical
Coefficient of production function is variable, i.e. the important
quantity of output can be achieved through the combination of munotes.in

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4 different quantities of factors of production, such as these factors can
be varied by substituting one factors to the other/ factors in its place.

The concept of variable proport ion production function can be further
explained from an isoquant curve, as shown in the Figure 1.2 below:

Figure 1.2


In the above diagram, the isoquant curves show that the different
combinations of factors of technical substitution shows that it can be
employed to get the required amount of output in the production process.
Thus, for the production of a given level of product, the input factors can
be substituted from another factor input.
1.4 CONCEPT OF TOTAL, AVERAGE AND MARGINAL
PRODUCT
In the ta ble the labour is consider as a variable factor and all other factors
are assumed to be constant according to the law. With the increase in the
variable factor i.e. labour there is a change in the level of TP, AP, and MP.
Total product: The total product is the total amount of output produced
by using all the variable input in a fixed proportion in production. The
total product increases with the increase in the unit of labour and reaches
to the maximum and they’re after decline with further more increase in the
variable factor.
Average product: The average product is the per unit of product
produced by the firm with the per unit of variable factor inputs. It is
obtained by dividing the total product by the unit of total variable factor.
The average produ ct increases initially and then decline.
Marginal product: Marginal product is the additional output produced by
an additional unit of variable factor. Marginal product increases and
thereafter falls when TU becomes maximum MU becomes zero and
further beco mes negative munotes.in

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Table No. 1.1
Relat ionship between Total Product, Average Product & Marginal
Product
Units of Variable
factor (LABOUR) Total Product
(TP) Average
Product (AP) Marginal
Product (MP)
0 0 0 -
1 5 5 5
2 12 6 7
3 27 9 15
4 48 12 21
5 75 15 27
6 80 13.33 15
7 91 13 11
8 98 12.5 7
9 98 10.8 0
10 92 9.2 -6

1.5 SUMMARY
In eco nomics, a production function is the functional relationship between
physical output of a production process to physical inputs or factors of
production.
Short -run produc tion function is a production function in which labour is
the only variable factor inp ut while the rest of the inputs are regarded as
fixed.
The long run production function is defined as the period of time in which
all factors of production are variable.
The total product is the total amount of output produced by using all the
variable inp ut in a fixed proportion in production.
The average product is the per unit of product produced by the firm with
the per unit of variable factor inputs.
Marginal product is the additional output produced by an additional unit of
variable factor.
1.6 QUESTI ONS
Q1. What are the types of production function?
Q2. Explain the concepts of Total, Average and Marginal Product by
giving tabular example.
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6 2
THEORY OF PRODUCTION &
PRODUCER’S EQUILIBRIUM
Unit Structure:
2.0 Objectives
2.1 Introduction
2.2 Short -run Production Function or the Law of variable Proportions
2.3 Long -run Production Function or the Laws of Returns to Scale
2.4 Produc er’s Equilibri um
2.5 Summary
2.6 Questions
2.0 OBJECTIVES
 To study the meaning and features of isoquants .
 To study the short -run and long -run production functions.
 Understand the concept of producer’s equilibrium.
2.1 INTRODUCTION
Production in economics r efers to the p rocess of transforming inputs into
output or creation of value. Thus by production we mean not only goods
put also services. Economics deals with the efficient use of inputs or
factors of production to produce goods and services. The concept of
production function is central to the theory of production. Production
function is defined as “the technological relation which connects factor
inputs and outputs”. It helps us to understand the relationship between the
use of inputs and the resulting o utput. ‘The pr oduction function is related
to a particular period of time. It expresses a flow of inputs resulting in a
flow of output in a specified time’. The production function is written as
under:
Q = f (L, K, R, S, λ, ν) (1)
Q = physical output, L = units of labour, K = units of capital, R = raw
materials, S = land input,
ν = returns to scale, λ = efficiency parameter. We shall now examine the
short -run and long -run production functions. munotes.in

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7 2.2 SHORT -RUN PRODUCTION FUNCTION OR THE
LAW OF VARIABLE P ROPORTIONS
In the short -run certain factors of production like the capital stock, plant
and equipment, land are held constant and the variable factor land is
changed to bring about changes in the output. We write such a production
functions as under:

(2)
This is the short -run production function. Here capital and land inputs are
held constant, while units of labour are variable. Thus, it is also described
as the law of variable proportions. Marshall defined the ‘law of variable
proporti ons as “if, gi ven the state of arts, successive units of a variable
input are combined with a fixed input (or fixed inputs), the returns, after a
point, will be less than proportionate”. G. J. Stigler defined this law as “as
equal increments of one input a re added, the inputs of other productive
services being held constant, beyond a certain point the resulting
increments of product will decrease, i.e., the products will diminish”. P.
A. Samuelson defined “increases 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 additions of extra
inputs will become less and less”. J. M. Cassels stated the law as “if, with
the same methods of production, successive ph ysical units of an input are
added to a constant physical quantity of another input (or fixed
combinations of other inputs), the total physical output obtained would
vary in magnitude through three distinct phases”. The law of variable
propor tions is based on the following assumptions:
2. The state of technology is given.
2. Factors of production are clearly classified as fixed and variable. Labor
is the variable factor, and capital and land are fixed inputs (as given in
(2) above).
3. It is p ossible to com bine the factors of production is variable
proportions. The production function is not of fixed proportions type.
4. Both inputs are required to produce the given output.
5. There are constant returns to scale.
Following Cassels definition we can delineate the three phases of change
in the output due to changes in variable input(s) as under:
Phase I: During this phase the total product would be increasing. There
would be two stages in this increase. In the first stage there would be an
absolu te increase in the output, i.e., the marginal product of the variable
input would be increasing. In the second, the marginal product would be
increasing at a decreasing rate. The marginal product would be greater
than the average product of the variable in put. During th is phase, the
relative rate of increase in the output would be greater than the relative munotes.in

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8 rate of increase in the variable input. At the end of this phase, the two rates
would be the same. At this point the marginal product equals the average
product of the variable input. This point represents the extensive margin of
production. Elasticity of output is used to explain the choice of a
rational producer. It is defined as:
vof oduct Averagevof oduct inal M
Qv
dvdQ
vdv
QdQevPrPr arg
ev = elasticity of output of variable input, v. dQ = the chan ge in output, Q
= output, dv = the change in variable input, v = units of variable input. In
this phase the elasticity of output is greater than 2.
Phase II: In the phase, though the total product is still increasing, it would
be at a decrea sing absolute rate that is the marginal product of the variable
input would be decreasing. The relative increase in output would be less
than the relative increase in the quantity of the input. The marginal
product would be less than the average product of the variable input. At
the end of this phase, the total product reaches its maximum, i.e., the
marginal product is zero. This point is known as the intensive margin of
production. In this phase the elasticity of output is less than one.
Phase III: in this phase the tot al product starts decreasing as the marginal
product of the variable input is negative. This is the ‘uneconomic’ or
‘irrational’ zone of production. The elasticity of output would be less than
one or negative in this phase. Table 4.1 shows the law with t he help of a
numerical example.
Table 2.1: Law of Variable Proportions
Units of
Variable
Input
(Labour) Total
Product
(TP) Average
Product
(AP) Marginal
Product
(MP) Output
Elasticity of
Labour
1 10 10 - -
2 25 12.5 15 2.2
3 45 15 20 2.33
4 63 15.75 18 2.14
5 73 14.6 10 0.68
6 79 13.17 6 0.45
7 79 12.29 0 0
8 74 9.25 -5 -0.54
Following Figure shows the law of variable proportions. munotes.in

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Figure 2.1 Law of Variable Proportion
In the above figure TP is the total product curve. This curve inc reases at
increasing rate in the OA portion indicating the increasing returns. In this
phase both the MP and AP rare rising with MP reaching its maximum and
then declining. At the end of this phase MP equals AP at its maximum and
continues to decline. This is at point A . Phase II is shown in the AB
portion of the total product curve. In the AB portion of the TP curve, the
output would be increasing at a decreasing rate since the MP is falling
while the AP also continues to decline. At point B, the TP curve reaches
its ma ximum and the MP cuts through the x -axis at point E. The marks the
end of phase II. After point B the total product is falling and the marginal
product turns negative. This is the uneconomic zone.
2.3 LONG -RUN PRODUCTION FUNCTION OR THE
LAWS OF RETURNS TO SCALE
Long -run refers to a period where the firm can alter all its inputs. In other
words, there are no fixed inputs in the long -run. Therefore, the returns to
scale studies the impact of proportionate change in all inputs on the
resulting ch anges in the o utput. It is important to note that the returns to
scale occur not only in case of different production functions, but they do
occur even when the production function is the same. We write the returns
to scale as: inputsallin changee oportionatoutputin changee oportionatrPrPr .
We can write th e returns to scale as:
hQ = f (λK, λL) (3)
The different possibilities are:
1) if h = λ the production function exhibits constant returns to scale.
2) If h >λ the production function exhibits increasing returns.
3) If h<λ the production function exhibits decreasing returns. munotes.in

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10 Like th e variable proportions, there are three distinct returns to scale. They
are as under:
A) Increasing Returns to Scale:
In the initial stages of production, as a firm increases all its inputs in equal
proportions, the resulting output will be increasing at a n increasing rate.
This is the phase of increasing returns to scale. Following are some of the
causes of the increasing returns to scale:
i) According to Joan Robinson, Lerner and Kinght, some of the inputs like
machinery are indivisible. Therefore, when o utput increases from a small
scale to a large scale, these factors are utilized better resulting in
increasing returns.
ii) Chamberlin did not agree with the views on indivisibilities. He argued
that as the level of output increases, it becomes increasingl y possible to
introduce specialization and this allows increasing returns even if the
factors are perfectly divisible. This is the case with some sophisticated
machinery which can be effectively used only when the production is
large.
iii) At times, inputs can be more efficiently used when the output is large
enough. For example, some of the latest locomotives can pull up to 45
wagons and are less efficient when the number of wagons is less than this.
B) Constant Returns to Scale:
In this case a proportion ate increase in inputs will result in an equally
proportionate increase in the output. For example if all the inputs are
doubled, the output will also be double. This type of production function is
called ‘production function of first degree’. According to E. A. G.
Robinson, a firm might be able to utilize its resources better. He argues
that the technical, financial, marketing, and ‘forces of risk and
fluctuations’ are responsible for firms experiencing constant returns to
scale.
C) Decreasing Returns to Scale:
When a firm expands beyond a particular scale it starts experiencing that
the increase in output is less than the proportionate change in its inputs -
this is the decreasing returns to scale. These occur because the firm will
find it difficult to co -ordinate the production activities when the size is too
large.
The concept of returns to scale is explained with the help of the
‘expansion path’. In Figure 4.2 x -axis shows labour input and y -axis
shows capital input. OR is the expansion path. This line s hows us the
returns to scale when the firm uses the same production process and still
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Figure 2.2
In the above figure A, B and C indicate increasing returns to scale (output
increasing more than the increase in inputs). A s inputs are increased,
output increases more than proportionately. Points D, and E, indicate
constant returns (output increasing in the same proportion as inputs).
Points F and G indicate decreasing returns since a given proportionate
change in output re quires more than proportionate change in the inputs.
Check your Progress :
2. What do you understand by production function?
2. Distinguish between short run and long run production function.
2.4 PRODUCER’S EQUILIBRIUM
The concept of producer’s equilibrium is analogous to the consumer’s
equilibrium. Producer’s equilibrium refers to the situation where the
producer maximizes his/her output for a given set of inputs or produces a
given output with the minimum possible inputs. Thus, it is also known as
the ‘le ast cost combination’. It is based on the concepts of a) isoquant and
b) factor price line. We shall now examine each of them.
2.4.1 The concept of an isoquant:
The concept of an isoquant was introduced by Edgeworth. This concept
shows the various combina tions of two inputs that give the same level of
output. Each isoquant shows a particular level of output measured in
physical terms. An isoquant measures the physical output that can be
obtained by combining the two inputs in various proportions. For examp le,
Q = (5K, 3L) and Q = (3K, 6L) indicates that to produce a given level of
output, Q, we can use 5 units of capital and 3 units of capital or
alternatively 3 units of capital and 6 units of labour. In other words, the
two factors are considered to be per fect substitutes and each unit of factor munotes.in

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12 is homogeneous. Figure 2.3 a) shows such a production function. The
production function can be of fixed proportions or of variable proportions.
In case of fixed proportions, it is not possible to combine the factor inputs
in any other way except one. This production function will be L -shaped.
Figure 2.3 b) shows this function. The Marginal Rate of Technical
Substitution (MRTS) shows the factor combinations. In case of variable
proportions production function, it is l ess than one and in case of fixed
proportions production function it is zero.
An isoquant never touches either of the two axes. This is because, when
the isoquant touches one of the axes, it indicates that at that point it is
possible to produce the given output with only one factor. Since this
contrary to the assumption that both the factors are required to produce a
given level of output, an isoquant cannot touch either of the axes. Figure
3.4 a) and b) shows this. In case of the former, the isoquant touc hes y -axis
indicating that at point E, no labour units are required to produce the given
level of output. In the later case it indicates that output can be produced
without any units of capital at point R. Both cases are ruled out.
Further, two isoquants d o not intersect. This is shown in Figure in 4.5. At
the point A, both the isoquants intersect. At this stage the two different
levels of output (100 and 120 units) can be produced using the same
combination of inputs. This is inconsistent with the propert y of each
isoquant measuring a particular level of output.
2.4.2 Iso -cost Line or Budget Line :
This is analogous to the price line of the indifference curve. In this case,
we measure the different units of the two inputs that can be obtained by
the produ cer for a given outlay. The slope of the iso -cost line is the ratio of
the prices of the two factors. Given the factor prices, outlay and a family
of isoquants, we can determine the equilibrium of the producer or the
optimum output that can be produced. Fi gure 2.3 shows the producer’s
equilibrium.

Figure 2.3 : Producer’s Equilibrium munotes.in

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13 At point E the slope of the isoquant equals the slope of the iso -cost line
(AB) at this point the MRTS K,L equals the ratio of factor prices:
rw
r wMPMP MP MP
KL K L   (1)
Therefore at E the firm produces maximum output with minimum cost
(using ol units of labour and ok units of capital). At any other point, the
ratios of marginal products and factors will not be the same (as at points C
and D). The following example explains the producer’s equilibrium.
Let the production function be Q = 50L0.75K0.25; Capital employed is 150
units; price of output is Rs. 150; wage rate is Rs. 50, and cost of capital is
Rs. 60. MP L = 25L-0.75 K0.25; and
MP K = 25L0.75K-0.25;
Therefore, MPMPKL= rw
LKKK25.0 0.7525.0 -0.75LL
2525 (2)
Or
(3)
L =
(4)
L = 180 (5)
Q = 50 × (1500.75) ×(1800.25) = 7849.47
TR = 7849.47×150 = 1,177,420.40
TC = 9000 + 9000 = 18,000
Total Profit = 11 77420.47 – 18000 = 1,168,420.47
Given the data, by producing 7849.47 units of output by employing 150
units of capital and 180 units of labour the firm makes a total profit of
1,168,420.47. This combination of factors is ‘the least cost’ or ‘profit
maximis ing’ output.
Check your Progress:
2. Explain the following concepts :
a) Iso quant curve b) Iso cost line
2.5 SUMMARY
 Production refers to the creation of utility.
 In short -run certain factors of production remain constant.
 In long -run all factors of pr oduction are variable. munotes.in

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14  Variable proportions are changes in output due to changes in the
variable factor.
 Returns to scale are due to proportionate change in all the factors of
production.
 Increasing returns to scale are due to factor indivisibilities and
improvements in efficiency.
 Cobb -Douglas production function allows for estimation of output
given the factor inputs and technology.
 Cobb -Douglas production function shows that industrial sector
experiences constant returns.
 Isoquant shows the level of outp ut that can be produced using a given
set of inputs.
 Isoquant can be convex to the origin or L -shaped.
 Iso-cost line shows the ratio of factor prices.
 Minimum cost of production ensures profit maximisation.
 Economies to scale arise due to better use of in puts.
 Diseconomies are due to managerial inefficiencies.
 Economies of scope involve changes in production processes.
2.6 QUESTIONS
1. Explain the concept of production function.
2. How do you distinguish between short -run and long -run production
functions?
3. What do you understand by ‘returns to factor’? Explain the law of
variable proportions.
4. Write a note on returns to scale.
5. Explain the main features of Cobb -Douglas production function.
6. What is least cost combination? Discuss the conditions for producer’s
equilibrium.
7. Explain the various economies of scale.
8. Write a note on economies of scope.

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15 Module II
3
COST ANALYSIS
Unit Structure:
3.0 Objectives
3.1 Concepts of Costs of Production
3.2 Short Run Costs
3.3 Long Run Costs
24 Learning Curve
3.5 Summary
3.6 Questions
3.0 OBJECTIVES
1. To understand the concepts of costs of production.
2. To understan d the nature of short -run and long -run costs of
production.
3. To understand the concept of learning curve.
3.1 CONCEPTS OF COSTS OF PRODUCTION
Cost of production refers to the resources - financial or real required to
produce a given quantity of output. This concept is central to economics
since resources are scarce, and they have alternative uses, a firm has to
ensure a proper use of its available resources. The idea of cost is different
in economics from the daily use of the term. We shall now examine the
different concepts of costs used in economics.
1. Money Costs: They refer to the money spent on procuring the various
factors of production that are required to obtain a given output. For
example, the wages paid to labour, the cost of raw materials, rent on
premises, and so on. This cost is considered for pricing decisions.
2. Real Costs: This refers to the sacrifices, physical and mental
privations that the entrepreneur and labour undergo in the process of
production. Marshall considered them to be important. Howe ver, given the
nature of these costs, they are subjective and hence not easy to measure.
3. Implicit Costs: They refer to the imputed value of factors of
production that are owned by the entrepreneur and are used in production. munotes.in

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16 There is no money payment for t hem. A popular example for this is the
capital invested by the producer. If the lends his funds instead of using
them for production, he would earn interest. The interest sacrificed is the
implicit cost of the capital. An important component of implicit co st is the
‘normal profit’. This refers to the minimum profit that the entrepreneur
must obtain to continue in production. This is the salary he will earn as a
manager instead of being an entrepreneur. Similarly the time spent by the
family members in the p roduction process is also an implicit cost. It is to
be noted that they are only imputed.
4. Explicit Costs: These are the payments made in cash to the various
factors of production. These are also known as ‘accounting costs’ since
they are the once consider ed in the balance sheets of the firms.
5. Economic Costs: These refer to the total cost of production measured
as in terms of the resources expended. Thus, economic costs are inclusive
of explicit and implicit costs. Thus the economic cost of production is
higher than the accounting cost of production. We write: Economic Cost =
Implicit Cost + Explicit Cost.
6. Opportunity Cost: As noted above, the resources being scarce it is
important to note that if they are employed for one use, they are not
available for a nother. Economics focuses on this aspect of cost of
production. Heberler defined opportunity cost as ‘the next best use
sacrificed’. We can see it both at the micro and macro level. If a household
spends more income on food, it will have lesser income for other
purposes. At the macro level, if the government decides to spend more on
defence, it will have lesser money for education or family welfare. It is
this opportunity cost that must be minimised by employing the resources
in a thoughtful way.
7. Private Co sts: These refer to the cost of a product to an individual
producer. The money spent on inputs is one example for this. The private
cost is paid by the user of the particular factor and thus is inclusive.
8. Social Costs: These are the costs that the society or economy as a
whole has to bear for the particular use of resources. For example, using a
private car may be convenient for an individual but the pollution caused
by this is a social cost - the consequences of a particular resource use will
have to be bor ne by the entire society. Industrial pollution is an important
social cost. In recent years, the cost -benefit analysis techniques are
developed to assess the social cost of production and consumption as well.
Check your Progress :
1. What is money cost of production?
3. Distinguish between Implicit cost and Explicit cost.

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17 3.2 SHORT -RUN COSTS
In the short -run certain inputs remain the same and certain inputs can be
changed according to the needs of the firm. The firm holds its fixed inputs
as constant an d uses the changes in the variable costs to bring about
changes in the output. Following are the different concepts of short -run
costs of production.
1. Fixed Costs or Sunk Costs: These are the costs incurred on fixed
factors of production. They remain the same irrespective of the level of
production. Plant and equipment, permanent staff, interest liabilities are
some of the fixed costs. According to Marshall, firms do not pay much
attention to these costs while considering production decisions in the
short -run.
3. Variable Costs or Prime Costs: These are the costs incurred on the
variable factors of production. Thus, they change with the level of
production. Expenditure on labour, fuel and electricity, raw materials and
transport costs are some of the impor tant variable costs.
3. Total Cost of Production: This refers to the total of fixed and variable
costs. We write: TC = TFC + TVC. Where TC is the total cost of
production; TFC is the total fixed cost and TVC is the total variable cost.
4. Average Cost: This is the cost of production per unit of output.
Thus AC = TC/Q = (TFC+TVC)/Q
5. Average Fixed Cost: This is the fixed cost per unit of output. AFC =
TFC/Q.
6. Average Variable Cost: This is the variable cost per unit of output:
AVC = TVC/Q
7. Marginal Cos t: This is the additional cost per unit of output. MC =
∂TC/∂Q or alternatively,
MC = TC n – TC n-1. In other words, marginal cost is change in the cost
when the firm increases its output by one extra unit. The following table
shows the relationship between different concepts of short -run costs.






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18 Table No. 3.1 Short -run Costs
Output Fixed
Cost
(TFC) Variable
Cost
(TVC) Total
Cost
(TC) Average
Fixed
Cost
(AFC) Average
Variable
Cost
(AVC) Average
Cost
(AC) Marginal
Cost
(MC)
10 100 75 175 10.0 7.5 17.5 --
20 100 100 200 5.0 5.0 10.0 25
30 100 145 245 3.3 3.1 8.2 45
40 100 205 305 3.5 5.25 7.6 60
50 100 275 375 3.0 5.5 7.5 70
60 100 380 480 1.7 6.3 8 105
70 100 490 590 1.4 7 8.4 110
80 100 600 700 1.3 7.5 8.8 110
90 100 735 835 1.1 8.2 9.2 135
100 100 890 990 1.0 8.9 9.9 155

From the above table we can infer the relationship between the various
short -run cost curves. The total fixed cost remains the same at all levels of
output. The total variable cost increases with the increase in the level of
output. Since the total cost is the total of these two, it also keeps increasing
as the level of output increases. Figure III.1 shows the relationship
between these three costs.

Figure 3.1
In the above figure x -axis shows the level of output and y -axis shows the
cost. TFC is the total fixed cost. TVC is the total variable cost. TC is the
total cost. The vertical distance between TVC and TC measures the fixed
cost.
We can show the behaviour of the average and marginal costs of
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19

Figure 3.2
In the above figure x -axis shows the level of output and y -axis shows the
different costs. AFC is the average fixed cost. As the level of output
increases, this keeps falling but never reaches zero since there is fixe d cost
at all levels of output. AVC is the average variable cost. It decreases
initially as production increases and starts increasing after a certain level
of production. It moves asymptotically towards AC, but never touches it
(since AFC>0 at all levels of production). AC the average cost of
production. AC starts increasing after the AVC. This is because; part of
the increase in AVC is offset by the falling AFC. The MC curve falls
faster than the AVC and AC and intersects both the curves from below at
their minimum point. MC increases faster than the AVC and AC after
their minimum points.
3.3 LONG RUN COST S
The long -run is a series of short -run. In the long -run the firm can change
all its factors of production in any given way. Hence in the lon g-run all
factors are variable and there are no fixed factors of production. The firm
can alter the way in which its combines its inputs. It can also decide on the
size of the plant. We can explain this with the help of an illustration. In
Figure III.3 we show the co st and size of a firm.

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20

Figure 3.3
If the firm expects to produce say, Q 1 of output, it should operate on its
SAC 1 which corresponds to this output. It is planning to sell Q 2 of output
it should have a plant size corresponding to SAC 3. If on the other hand it is
planning to sell Q 3 of output, its plant size should be corresponding to
SAC 3. The different sizes of the plants that correspond to different levels
of production give us the long -run average cost curve (LAC). Thus, LAC
is the envelo pe of the sh ort-run average cost curves. Due to the economies
and diseconomies of scale, the minimum points on the SACs will not lie
on the LAC. The minimum point of only one SAC will be the same as of
the minimum point of the LAC and this particular size was termed a s “the
optimum firm” by E. A. G. Robinson. As noted above the long -run
average cost curve reflects the economies and diseconomies of scale.
When the firm is experiencing the economies of scale, its costs will be
decreasing and hence the average cost will b e declining. As the firm
reaches the most efficient size, the average cost reaches its minimum.
Beyond this level of output the cost of production increases due to
diseconomies of scale. If the firm selects a size that is too small it will find
it difficul t to keep the cost low. Therefore, the firm would prefer to have a
larger size.
The long -run marginal cost curve (LMC) is not the envelope of the short -
run marginal cost curves (SMC). This is because the SMC applies to a
particular plant while the LMC app lies to all possible plant sizes. Each
point on the LMC is the SMC associated with the most cost -efficient pant.
SMC 1 therefore, intersects LMC at the output level Q 1 at which the SAC 1
is tangent to the LAC.
Check your Progress :
1. Distinguish bet ween Fixed C ost and Variable Cost
3.4 LEARNING CURVE
The concept of learning curve was based on the experience in aircraft
maintenance. It is also known as improvement/progress curve or learning -munotes.in

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21 by-doing. It is based on the experience that each time the ta sk is repeat ed;
decreasing amounts of labour input is required. It was developed by W. Z.
Hirsch to explain the process through which firms enjoy falling long -run
average cost, though there may not be increasing returns to scale. This is
possible when work ers and mana gers with experience, are able to absorb
new technological information. This happens due to the following reasons:
1) workers often taken longer to accomplish a given task the first few
times they do it. As they become more adept, their speed i ncreases. 2)
Managers learn to schedule the production process more effectively, from
the flow of materials to the organisation of the manufacturing itself. 3)
Engineers, with experience, will be able to produce designs that save costs
without increasing d efects. 4) O ver the time, the suppliers will be able to
provide materials at lower costs and pass on this advantage to the firm.
The learning curve shows the reduction in labour units required to produce
the cumulative output. The learning curve is based o n the follow ing
relationship:
L = A + BN-β (1).
where, N = cumulative units of output produced,
L = labour input per unit of output,
A, B are constants, with A showing the minimum labour input per unit of
output after all learning has taken place. In the equation, when β is
positive, as output gets larger and larger, L becomes arbitrarily close to A,
so that A represents the minimum labour per unit of output after all
learning has taken place.
Alternatively, the learning c urve can be shown as a liner function, i.e., as
output increases, the labour input requirement decreases at a uniform rate.
In such a case, the learning curve will be:
Y = a Xb (2).
where, Y = ma n hour per unit of output,
X = units of output,
a = intercept, theoretical labour requirement for the first unit of
output,
b = slope of the curve/ the rate of reduction in labour requirement.




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22 Following Figure shows the learning curve:

Figure 3.4 Learning Curve
In the above figure LC is the learning curve. It shows that as the
production increases the cost falls as lesser labour hours are required to
produce equivalent increases in output. This is because as managers and
workers become more experienced and more effective at using the
available plant and machinery, they will be able to turn out larger output.
The learning curve shows the extent to which hours of labour needed per
unit of output fall as the cumu lative output increases. Learning curve
helps to predict the labour requirement when output is doubled. The
following table explains the concept of learning.
Table No. 3.2
Cumulative
Output (N) Per-Unit Labour
Requirement for
each 10 units of
Output ( L) Total Labour
Requirement Learning
Percentage
10 1.00 10.0 --
20 0.80 18.0 (10.0+8.0) 80
30 0.70 25.0 (18.0+7.0) 38.9
40 0.64 31.4 (25.0+6.4) 25.6
50 0.60 37.4 (31.4+6.0) 19.1
60 0.56 43.0 (37.4+5.6) 14.9

It can be seen from the ab ove table th at the percentage of learning, or the
additional labour input required to double the output goes on increasing,
i.e., learning curve is downward sloping.
Learning curve is used in forecasting the future labour requirements. It is
also used in measuring th e improved proficiency of the operator as output munotes.in

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23 is increased in estimating reductions in manufacturing losses. It is also
used in stabilizing the designs and increasing the lots sizes. It is used in
improving the special tooling needed for pro duction and shifting from
manual to automation as additional production is required.
It is important to distinguish learning effects from the returns to scale.
Returns to scale implies, producing larger quantities for a given increase in
inputs. Whereas, learning cur ve results in lowering of the average cost
curve itself. Figure 3.5 helps to understand the two.

Figure 3.5
In the above diagram, x -axis shows the output and y -axis shows the cost
(per unit of output). The movement from A to B on AC 1 (initia l average
cost) indicates economies to scale and movement from A to C depicts the
learning effects which result in the average cost curve from AC 1 to AC 3.
The learning curve concept is useful when the firm has to calculate the
cost of producing a new produ ct. If a fir m is enjoying learning effects, the
total labour requirement for producing larger quantities of output increases
in smaller increments. Therefore, this concept is useful for a firm deciding
whether it would be profitable to enter an industry or not.
3.5 SUMMARY
 Real cost refers to the sacrifices made in the process of production.
 Implicit costs measure the imputed value of inputs owned by the
entrepreneur and used in production.
 Economic costs are broader than the accounting costs.
 Total Fixed Cost remains the same at all levels of output.
 AFC never becomes zero.
 MC is ‘U’ -shaped.
 MC intersects AC and AVC at their minimum points. munotes.in

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24  In long -run all factors of production are variable.
 LAC is a locus of all the short -run average cost curves.
 LMC shows the most efficient output of each size of the firm
3.6 QUESTIONS
1. Explain the concepts of money costs and real costs of production.
2. Distinguish between social costs and private costs.
3. The economic concept of costs is broader than the accounting co sts.
4. The short -run cost curves are ‘U’ -shaped.
5. Explain the derivation of the long -run average cost curve.





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25 4
REVENUE ANALYSIS
Unit Structure :
4.0 Objectives
4.1 Concepts of Revenue
4.2 The relationship between TR, AR and MR under Perfect Competition
4.3 The relationship between TR, AR and MR under Monopoly
4.4 Relationship between AR and MR curves
4.5 Questions
4.0 OBJECTIVES
 To study various concepts of revenue
 To study the relationship between TR, AR and MR under perfect
competition
 To study the relationship between TR, AR and MR under monopoly
4.1 CONCEPTS OF REVENUE
The term revenue refers to th e sales receipts obtained by a seller or a firm
by selling certain amount of a commodity. There are three concepts of
revenue used in economics.
A firm’s revenue is classified as under -
1. Total Revenue : - “Total revenue refers to the total amount of sale s
receipts received by a seller or a firm by selling certain amount of a
commodity over a period of time.” The total revenue is obtained by
multiplying the total quantity of a commodity sold by the price. Therefore,
symbolically expressed as TR = Q × P.
Where, TR= total revenue, Q = total quantity of a commodity sold and P =
price per unit of a commodity.
Total revenue depends upon two important factors i.e. total quantity of a
commodity sold and price per unit of a commodity. For example, a firm
sells 10 units of a commodity at a price of
10 per unit. Thus 10 × 10 =
100 is the total revenue. TR of a firm initially goes on increasing up to a
certain limit then after it starts falling.
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26 2. Average Revenue : - “It refers to the price or revenue per unit of a
commodity sold.” It can be obtained by dividing the TR by the total
number of units of a commodity sold (Q). It can be symbolically
expressed as AR = TR / Q .
Where, AR stands for Average Revenue. With the example, 100 / 10 = 10
is the average revenue.
4. Marginal Revenue – It may be defined as, “Net addition made to the
total revenue by selling one more additional unit of a commodity is called
as marginal revenue.” In other words net increase in total revenue is called
as marginal reven ue. It can be symbolically expressed as MR = ΔTR /
ΔQ. Where MR stands for Marginal Revenue, ΔTR = change in total
revenue and ΔQ = change in total quantity of a commodity sold.
For e.g. a seller obtains the total revenue of
90 from the sell of 9 units at
price of
10 per unit. If he increases his sales by one more additional unit
(9 to10) his total revenue increases from
90 to
100 the net change in
TR or MR =
10.
The relationship between TR, AR and MR are different under different
market condit ion.
4.2 THE RELATIONSHIP BETWEEN TR, AR AND MR
UNDER PERFECT COMPETITION
Under perfect competition an individual firm can not influence a given
market price. So a firm is a price - taker. Hence, the price remains constant
as more and more units are sold. Therefore, an addition made to the total
revenue by selling every additional unit of a commodity will always be
equal to the given market price. Hence the marginal revenue of a firm is
always equal to its average revenue.
Firms Demand Curve:
Under the cond ition of perfect competition, a firm’s demand curve is
perfectly elastic i.e. horizontal to ‘X’ axis at the height of the given market
price. So the average revenue of a firm is the same as the price, whatever
be the quantity sold. Hence a perfectly elasti c demand curve i.e. average
revenue curve is also called as marginal revenue curve. This is shown in
the following figure.
An Industry’s Demand Curve:
Under perfect competition an industry can sell more and more units of a
commodity only at a lower price. Hence, the demand curve slopes
downward from left to right towards ‘X’ axis. This is shown in the
following figure.

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27









Figure 4.1
The downward sloping demand curve DD is the demand curve of an
industry as shown in the above fig. 1 and th e horizontal DD curve is a
firm’s demand curve shows that demand for a commodity is perfectly
elastic at the given market price OP as shown in the figure No. 2.
The market price is determined by the total demand for and total supply of
the commodity in the market as a whole. This is shown in figure 1. The
demand curve slopes downward it shows that the market demand for a
commodity increases when its price is reduced and vice -versa.
The relationship between TR, AR and MR under perfect competition:
Let us a ssume that the price per unit of a commodity is
10. Hence the
AR is constant. The relationship between TR, AR and MR is shown in the
following table.
Revenue Schedule of a firm
Table No. 4.1
No. of units ofa
commodity Price
TR
Q × P AR
TR / Q MR
ΔTR / ΔQ
1 10 10 10 10
2 10 20 10 10
3 10 30 10 10
4 10 40 10 10
5 10 50 10 10
6 10 60 10 10
7 10 70 10 10 P DD Figure SS DY
O X Y
XO D D AR=MQuantity Quantity M Industry Firm Price P
Figure munotes.in

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28
The above table shows that TR increases at a constant rate as more and
more units are sold. It also shows that the MR of a firm is always equal t o
AR or price under perfect competition. We can show graphically the TR,
AR and MR in the following figure.








Figure 4.2
In this figure TR is the total revenue slopes upward to the right. The
horizontal DD curve is the AR as well as MR curve. This i s because the
MR curve coincides with the AR curve. It is parallel to the ‘X’ axis.
4.3 THE RELATIONSHIP BETWEEN TR, AR AND MR
UNDER MONOPOLY
Under monopoly the demand curve of a firm for its product slopes
downward from left to right. It shows that, such a monopoly firm can sell
more only at a lower price. Hence, its total revenue increases at
diminishing rate.
A monopoly firm can influence the price. It is a price -maker. A
monopolist can charge a high price only by reducing his market supply. A
monopolist can fix a high price of his product and sell whatever amount of
his product i.e. demanded by consumers.
A monopolist can sell more only by reducing the price of his product. The
price is also called AR. So as price is reduced to sell more the AR falls.
When the AR or price declines the MR also falls. So the net addition made
to the TR will be less than the price of AR. Hence, TR of a monopoly firm
increases at a diminishing rate. For example, suppose a monopoly firm
sells 3 units of a commodity at
8 per unit. Its total revenue will be
24.
If now it wants to sell 4th unit it will have to reduce the price to say
7
with this price its total revenue will be
28. Hence, the MR will be only

4 which is less than the price
7. This is shown in the followi ng table.
Y
O X 45U AR=MR TR D Quantity Price,
TR,
AT & D munotes.in

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29 Revenue Schedule of a Firm under Monopoly
Table No. 4.2
No. of units of
a commodity Price
TR
Q × P AR
TR / Q MR
ΔTR / ΔQ
1 10 10 10 10
2 9 18 9 8
3 8 24 8 6
4 7 28 7 4
5 6 30 6 2
6 5 30 5 0
7 4 28 4 -2

It can be seen in the above tabl e that as more and more units of a
commodity are sold the TR increases at a diminishing rate. It also shows
that as price is reduced the MR is less than AR. With the fall in MR the
gape between AR and MR goes on widening. This is because in order to
sell o ne more unit of a commodity the price per unit will have to be
reduced.








Figure 4.3
When the demand curve AR is sloping downward towards ‘X’ axis the
MR curve also slopes downward and is always below the AR curve. The
gap between AR and MR c urve goes on widening as the price is reduced.
This is shown in the figure.


Y
X O AMQuantity Pric
e
AR, MR T
6 30
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30 4.4 RELATIONSHIP BETWEEN AR AND MR CURVES
There is some geometrical relationship between AR and MR curves. The
important ones are as follows.
 Under Perfect Competition: - MR is always equal to AR from an
individual firm’s point of view. In this case the AR curve is horizontal
to the ‘X’ axis and the MR curve coincides with AR curve.






Figure 4.4

 Under Monopoly: - The AR curve has a negative slope. Hence, MR
curve lies below it. MR curve can cut the ‘X’ axis and enter the
negative quadrant. So MR can be zero or negative, but the AR curve
can not intersect the ‘X’ axis and enter the negative quadr ant. This is
because price or AR can never be zero or negative. See figure No. 6









 AR is a straight line or liner demand curve sloping downward
under monopoly: - MR curve is also a straight line sloping downward
from lef t to right. See figure No. 7. The MR curve is below the AR
curve it shows that under monopoly MR is less than price or AR. In
such a situation MR curve is exactly half a way between AR curve and AR=MR X O Y
Quantity
+ A
OPrice,
AR &
MR BY
O F
X Y
Q ECA
MA
MX- Output Figure 4.5 Figure 4.6 munotes.in

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31 ‘Y’ axis. This is because the MR falls twice than the fall i n price at
each level of output.
At OC price OQ amount is demanded thus we get F point on AR curve.
The line CF is drawn. The MR curve cuts the line CF at point B. CF is the
distance between ‘Y’ axis and AR curve. To prove this we have to prove
that CB = BF. It can be prove that triangle ACB and EFB are equal in area
and are also similar. So CB = BF. This indicates that point B is exactly in
the middle of the line CF since MR curve passes through the point B
which lies exactly half a way between AR curve a nd Y axis.
 If the AR curve is convex: - The MR curve which is below the AR
curve is close to the Y axis i.e. the MR curve is less than half way
between the Y axis and AR curve. This is shown in the figure No.8.








Quantity












X O Y
AR APYNEMR MQ Pric
eAR
,MR Figure 4.7
X O Y APN ME M A
Q Figure 4.8 munotes.in

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32 In the above diagram the distance between Y axis and MR curve is less
than half way between the Y axis and AR curve i.e. PM is less than MN or
the triangle APM is smaller than the triangle EMN.
 If AR curve is concave: - The MR curve which is below the AR curve
is clo ser to AR curve i.e. MR curve is more than half way between the
Y axis and AR curve. This is shown in the above figure No. 9.
In the diagram the distance between Y axis and MR curve is more than the
distance between MR curve and AR curve i.e. PM is more than MN or the
triangle APM is larger than EMN.
4.5 QUESTIONS

1. Explain the different concepts of Revenue.
2. Discuss the relationsh ip between TR, AR & MR under perfect
competition.
3. Discuss the relationship between TR, AR & MR under monopoly.



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33 Module III
5
FACTOR PRICING: RENT AND WAGE

Unit Structure:
5.0 Objectives
5.1 Introduction
5.2 Marginal Productivity Theory of Distribution
5.3 Rent
5.4 Ricardian Theory of Rent
5.5 Modern Theory of Rent
5.6 Quasi Rent
5.7 Modern Theory of Wages
5.8 Co llective Bargaining
5.9 Supply Curve of Labour
5.10 Questions
5.0 OBJECTIVES
 Explain the marginal productivity theory of distribution.
 To understand Ricardian Theory of Rent.
 To study Modern Theory of Rent and Quasi Rent.
 To understand the c oncept of wag es.
 To study modern theory of wages.
 To understand the concept of collective bargaining.
 To study the supply curve of labour.
5.1 INTRODUCTION
This unit will deliver you the detail knowledge of Marginal Productivity
Theory of Distribution, M eaning and Defi nitions of Rent, Ricardian
Theory of Rent, Modern Theory of Rent, the Concepts of Quasi Rent, munotes.in

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34 Meaning and Definitions of Wages, Modern Theory of Wages, Concept of
Collective Bargaining, the Supply Curve of Labour etc.
5.2 MARGINAL PRODUCTIV ITY THEORY OF
DISTRIBUTION
The marginal productivity theory of distri bution is developed by J. B.
Clark, at the end of the 19th century which provides a general explanation
of how the price (of the earnings) of a factor of production is determined.
In othe r words, it sug gests some broad principles regarding the
distribution of the national income among the four factors of production.
According to this theory, the price (or the earnings) of a factor tends to
equal the value of its marginal product. Thus, ren t is equal to t he value of
the marginal product (VMP) of land; wages are equal to the VMP of
labour and so on. The neo -classical economists have applied the same
principle of profit maximisation (MC = MR) to determine the factor price.
Just as an entrepren eur maximises h is total profits by equating MC and
MR, he also maximises profits by equating the marginal product of each
factor with its marginal cost.
Assumptions of the Theory:
The marginal productivity theory of distribution is based on the
following seven assumption s:
1. Perfect competition in both product and factor markets:
Firstly, the theory assumes the perfect competition in both product and
factor markets. It means that both the price of the product and the price of
the factor (say, labour) remai ns unchanged.
2. Operation of the law of diminishing returns:
Secondly, the theory assumes that the marginal product of a factor would
diminish as additional units of the factor are employed while keeping
other factors constant.
3. Homogeneity and divisibi lity of the factor:
Thirdly, all the units of a factor are assumed to be divisible and
homogeneous. It means that a factor can be divided into small units and
each unit of it will be of the same kind and of the same quality.
4. Operation of the law of substitution:
Fourthly, the theory assumes the possibility of the substitution of different
factors. It means that the factors like labour, capital and others can be
freely and easily substituted for one another. For example, land can be
substituted by labou r and labour by capital.
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Factor Pricing: Rent and Wage
35 5. Profit maximisation:
Fifthly, the employer is assumed to employ the different factors in such a
way and in such a proportion that he gets the maximum profits. This can
be achieved by employing each factor up to that level at whi ch the price of
each is equal to the value of its marginal product.
6. Full employment of factors:
Sixthly, the theory assumes full employment for factors. Otherwise, each
factor cannot be paid in accordance with its marginal product. If some
units of a pa rticular factor remain unemployed, they would be then willing
to accept the employment at a price less than the value of their marginal
product.
7. Exhaustion of the total product:
Finally, the theory assumes that the payment to each factor according to it s
marginal prod uctivity completely exhausts the total product, leaving
neither a surplus nor a deficit at the end.
Some Key Concepts:
The theory is also based on key certain concepts. These are the following:
1. MPP:
The first is marginal physical product o f a factor. The marginal physical
product (MPP) of a factor, say, of labour, is the increase in the total
product of the firm as additional workers are employed by it.
2. VMP:
The second concept is value of marginal product. If we multiply the MPP
of a fac tor by the pric e of the product, we would get the value of the
marginal product (VMP) of that factor.
3. MRP:
The third concept is marginal revenue product (MRP). Under perfect
competition, the VMP of the factor is equal to its marginal revenue
product (MR P), which is th e addition to the total revenue when more and
more units of a factor are added to the fixed amount of other factors, or
MRP = MPP x MR under perfect competition. It is simply MPP multiplied
by constant price, as P = MR. [VMP of a factor = MP P of the factor x
price of the product per unit, and MRP of a factor=MPP of the factor x
MR under perfect competition. So under perfect competition VMP of a
factor = MRP of that factor.]
The Essence of the Theory:
The theory states that the firm employs ea ch factor up to that number
where its price is equal to its VMP. Thus, wages tend to be equal to the
VMP of labour; interest is equal to VMP of capital and so on. By equating munotes.in

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36 VMP of each factor with its cost a profit - seeking firm maximises its total
profi ts. Let us ill ustrate the theory with reference to the determination of
the price of labour, i.e., wages.
Let us suppose that the price of the product is Rs. 5 (constant) and the
wages per unit of labour are Rs. 200 (constant). As the number of factors
other than labour remain unchanged, wages represent the marginal cost
(MC).
Table 5.1: Calculation of MPP, VMP and MRP of a Variable Factor
(Labour)
Land Capital Labour Total
Product MPP of
Labour VMP or
MRP of
Labour The Wage
Rate
AW = M W 1 unit 1 unit 1 unit 10 unit - - Rs. 20
1 unit 1 unit 2 unit 16 unit 6 unit Rs. 30 Rs. 20
1 unit 1 unit 3 unit 21 unit 5 unit Rs. 2 5 Rs. 20
1 unit 1 unit 4 unit 25 unit 4 unit Rs. 20 Rs. 20
1 unit 1 unit 5 unit 28 unit 3 unit Rs. 15 Rs. 20
1 unit 1 unit 6 unit 30 unit 2 unit Rs. 10 Rs. 20

Table 5.1 shows that at 2 or 3 labourers, the VMP or MRP of labour is
greater than wages; so the firm can ea rn more profits by employing an
additional labour. But at 5 or 6 labourers, the VMP or MRP of labour is
less than wages, so it would red uce the number of labourers. But when it
employs 4 labourers, the wage rate (Rs. 20) becomes equal to the VMP or
MRP of labour (also Rs . 20). Here the firm gets the maximum profits
because its marginal cost of labour (or marginal wage Rs. 12) is equal to
its marginal revenue (VMP or MRP, Rs. 20).
Thus, under the assumption of perfect competition a firm employs a factor
up to that number a t which the price of the factor is just equal to the value
of the marginal product (=MRP of the factor). In the same way it can be
shown that rent is equal to the VMP of land, interest is equal to the VMP
of capital, and so forth.
The theory may now be ill ustrated diagrammatically. See Fig. 12.2. Here
WW is the wage line indicating the constant rate of wages at each level of
employment (AW = MW. Here AW is average wage and MW is marginal
wage). The VMP line shows the value of marginal product curve of
labou r, and it goes downwards from left to right indicating diminishing
MPP of labour. Fig. 12.2 shows that the firm employs O L number of
labourers, because by doing so it equates the MRP of labour with the wage
ratio, and makes optimum purchase of labour. munotes.in

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Factor Pricing: Rent and Wage
37

Fig. 5.1 Wage Determination
Criticisms of the Theory:
The marginal productivity theory of distri bution has been subjected to a
number of criticisms:
1. In determination of marginal product:
Firstly, main product is a joint product — produced b y all the facto rs
jointly. Hence the marginal product of any particular factor (say, land or
labour) cannot be separately determined. As William Petty pointed out as
early in 1662: Labour is the father and active principle of wealth, as lands
are the mothe r.
2. Unrealist ic:
It is also shown that the employ ment of one additional unit of a factor may
cause an improvement in the whole of org anisation in which case the MPP
of the variable factors may increase. In such circumstances, if the factor is
paid in a ccordance with the VMP, the total product will get exhausted
before the distribution is completed. This is absurd. We cannot think of
such a situation in reality.
3. Market imperfection:
The theory assumes the existence of perfect competition, which is rar ely
found in th e real world. But E. Chamberlin has shown that the theory can
also be applied in the case of monopoly and imperfect compe tition, where
the marginal price of a factor would be equal to its MRP (not to its VMP).
4. Full employment:
Again, th e as sumption of full employment is also unrealistic. Full
employment is also a myth, not a reflection of reality.
5. Difficulties of factor substitution:
W. W. Leontief, the Nobel economist, denies the possibility of free
substitution of the factors always owing to the t echnical conditions of munotes.in

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38 production. In some products process, one factor cannot be substituted by
another. Moreover organi sation or entrepreneurship is a specific factor
which cannot be substituted by any other factor.
6. Emphasis on the dema nd side only:
The theory is one -sided as it ignores the supply side of a factor; it has
emphasised only the demand side i.e., the employ er’s side, hi the opinion
of Samuelson, the marginal productivity theory is simply a theory of one
aspect of the demand for productive services by the firm.
7. Inhuman theory:
Finally, the theory is often described as ‘inhuman’ as it treats human and
non-human factors in the same way for the determination of factor prices.
5.3 RENT
Rent has one meaning in popular usage and another related , but not
identical, in economic theory. To a layman, rent is a periodic payment
made regularly for the hire of a good or a service. But when interpreted in
economic terms, it is applied to payments made for factors of production
which are i n imperfectly e lastic supply with land as main example (stories
& Hague). The rent of a house, for instance, includes, beside the paymen ts
made for the use of land, elements of interest and depreciation on the sums
invested in the past. All these elements cann ot form the part of ‘pure of
economic rent’. Such a term, used colloquially, can be described as
‘contractual rent’. But economic re nt is a payment made for the use of
‘Scarce’ factor. Land being a fixed, is a leading example of ‘rent -earning’
factor. As P .W. Bell an d M.P.Todaro put it, “We many pay a homage to
the theory by calling this payment to a completely inelastic factor, as pur e
economic rent.”
a) Scarcity rent
Land earns rent is two forms. (1) Scarcity rent (2) differential rent. If the
plots of land are assum ed as homogeneous, both in their fertility, as well
as, their site then the limited supply of land in relation to their d emand
gives rise to a surplus, which is called as Scarcity rent .
b) Differential rent
If the land is taken as heterogeneous factor i. e. i f plots of land are
gradable, according to their fertility or site, then the limited supply
relatively to their demand, r esult in different rent.
5.4 RICARDIAN THEORY OF RENT
David Ricardo, an English classical economist, first developed a theory in
1817 to explain the origin and nature of economic rent.
Ricardo used the economic and rent to analyse a particular question. I n the
Napoleonic wars (18.05 -1815) there were large rise in corn and land
prices. munotes.in

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Factor Pricing: Rent and Wage
39 Did the rise in land prices force up t he price of cor n, or did the high price
of corn increase the demand for land and so push up land prices. Ricardo
defined rent as, “that portion of the produce of the earth which is paid to
the landlord for the use of the original and indestructible powers of the
soil.” I n his theory, rent is nothing but the producer’s surplus or
differential gain, and it is found in land only.
Assumptions of the Theory:
The Ricardian theory of rent is based on the following assumptions:
1. Rent of land arises due to the differ ences in the fe rtility or situation of
the different plots of land. It arises owing to the original and
indestructible powers of the soi l.

2. Ricardo assumes the operation of the law of diminishing marginal
returns in the case of cultivation of land. As the different plots of land
differ in fertility, the produce from the inferior plots of land diminishes
though the total cost of production in each plot of land is the same.

3. Ricardo looks at the supply of land from the standpoint of the society
as a whole.

4. In the Ricardian theory it is assumed that land, being a gift of nature,
has no supply price and no cost of production. So rent is not a part of
cost, and being so it does not and cannot enter into cost and price. This
means that from society’s point of vie w the entire re turn from land is a
surplus earning.
REASONS FOR EXISTENCE OF RENT
According to Ricardo rent arises for two main reasons:
(1) Scarcity of land as a factor and
(2) Differences in the fertility of the soil.
Scarcity Rent:
Ricardo assumed that land had only o ne use —to grow corn. This meant
that its supply was fixed, as shown in Figure 13.1. Hence the price of land
was totally d etermined by the demand for land. In other words, all the
price of a factor of production in perfectly inelastic supply is economic
rent—it has no transfer earnings.
Thus, it was the high price of corn which caused an increase in the
demand for land and a rise in its price, rather than the price of land
pushing up the price of corn. However, this analysis depends on the
assump tion that l and has only one use. In the real world a particular piece
of land can be put to many different uses. This means its supp ly for any
one use is elastic, so that it has transfer earnings. munotes.in

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40

Figure No. 5. 2: Earnings of a Factor in Fixed Supply
Differential Re nt:
According to Ricardo, rent of land arises because the different plots of
land have different degree of productive pow er; some lands are more
fertile than others. So there are different grades of land. The difference
between the produce o f the superior lands and that of the inferior lands is
rent—what is called differential rent. Let us illustrate the Ricardian
concept of differential rent.
Differential Rent on account of differences in the fertility of soil:
Ricardo assumes that the diffe rent grades of lands are cultivated gradually
in descending order —the first -grade land being cultivated at first, then the
second grade, after that the third grade and so on. With the increase in
population and with the consequent increase in the demand fo r agricultural
produce, inferior grades of lands are cultivated, creating a surplus or rent
for the superior grades. This is illustrated in Table 13.1.
Table 5.1: Calculation of Differential Rent

Table 5.1 shows the position of 3 different plots of land of equal size. The
total cost is the same for each plot of land. Let us assume that the order of munotes.in

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Factor Pricing: Rent and Wage
41 cultivation reaches the third sta ge when all the three plots of land of
different grades are cultivated and the market price has come to the level
of Rs. 5 per kg of wh eat.
The first -grade land, being the most fertile, produces 40 kg, the second
grade 70 kg and the third -grade land, being less fertile, only 20 kg. So, the
first-grade land earns a surplus or rent of Rs. 100, the second grade a rent
of Rs. 5 0 and the third one earns no surplus. The first two plots are called
the intra -marginal and the third one is the marginal (or no -rent) l and. This
simple example shows how the differences in the fertility of the different
plots of land create rent for the s uperior plots o f lands.
The concept of differential rent arising due to differences in the fertility of
different plots of land is illus trated in Fig. 5.2.

Figure No. 5. 3: Differential Rent
Here, AD, DG and GJ are three separate plots of land of the same size, but
of difference in fertility. The total produce of AD is ABCD, that of DG is
DEFG and that of GJ is GHIJ. The first and second plots of land generate
a surplus show by the shaded area, which represents the rent of the first
two plots of land. Sinc e the third plo t GJ has no surplus, it is marginal land
or no -rent land. Grade 4 (below -marginal) land will not be cultivated,
because r ent is negative (Rs. 25 in this example).
Rent and Price:
From the Ricardian theory we can show the relation between ren t (of land)
and price (of wheat). Since the market price of wheat is determined by
costs of the marginal producer and since, for this ma rginal producer, rents
are zero, Ricardo concluded that economic rent is not a determinant of
market price. Rather, pric e of wheat is d etermined solely by the market
demand for wheat and the availability of fertile land.
Deductions from the Theory:
If rent depends on price and on the superiority of rent-producing land over
marginal land, we can deduce the following:
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42 1. Impr oved methods of farming:
Improved methods of cultivation may lead to a fall in rent (demand
remaining unchanged). It is because increase d output on the superior
grades of land will make the cultivation of inferior grades of land
unnecessary.
2. Population grow th:
Populat ion growth is likely to lead to a rise in rent, since the increased
demand for land will bring poor quality land into cul tivation, thus
lowering the output of marginal land. Thus, if the price of food increases,
the rent of existing land wil l increase.
3. Improved transport facilities:
Improved transport facilities are likely to lead to a fall in rent. It is because
the outp ut of less fertile land of foreign countries may be able to com pete
more closely with the home produce. So , there will be no need to c ultivate
inferior home areas. As a result, the output of the mar ginal land rises and
rent falls.
Thus, it is difficult t o say whether or not rent increases with economic
progress. How ever, rent is likely to fall with economic pro gress if
popu lation grow th is unable to fully neutralise the effects of technological
progress and improvement in transport facilities.
Criticism s of the Theory:
Ricardian theory has been criticised on the following grounds:
1. Ricardo considers land as fixed in su pply. Of course , land is fixed in an
absolute sense. But land has alternative uses. So , the supply of land to
a particular use is not fi xed (inelastic). For example, the supply of
wheat land is not absolutely fixed at any given time.
2. Ricardo’s order of cultivation of lands is also not realistic. If the price of
wheat falls the marginal land need not necessarily go out of cultivation
first. Superior grades of land might cease to be cultivated if a fall in
the price of its output causes such land being dem ande d for other
purposes (e.g., for constructing houses).
3. The productivity of land does not depend entirely on fertility. It also
depends on such factors as position, investment and effective use of
capital.
4. Critics have pointed out that land does no t possess any o riginal and
indestructible powers, as the fertility of land gradually dimi nishes,
unless fertilisers are applied regular ly.
5. Ricardo’s assumption of no -rent land is unrealistic as, in reality; every
plot of land earns some rent, although the amount may be small. munotes.in

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Factor Pricing: Rent and Wage
43 6. Ricardo restricted rent to land only, but modern economists have shown
that rent arises in return to any fac tor of production, the supply of
which is inelastic.
7. According to Ricardo, rent does not enter into price (cost) but from the
point of view of an individual farm rent forms a part of cost and price.
Conclusion:
In spite of the various short comings of t he Ricardian theory, it cannot be
discarded —as Stonier and Hague remarked — “The concept of transfer
earnings helps to b ring the simple Ricardian theory of rent into closer
relation with reality.”
5.5 MODERN THEORY OF RENT
Modern theory of rent does not co nfine itself to the reward of only land as
a factor of production.
Rent in modern sense can arise in respect of any fact or of productio n, and
not merely land. Rent is a surplus. In the sense of surplus, rent is a
payment in excess of transfer earnings.
Transfer earnings mean the amount of money which any particular unit
could earn in its next best alternative use. Suppose a piece of land under
cotton is yielding Rs. 150 and its next best use wheat fetches Rs. 100. The
transfer earnings are Rs. 100 and, ther efore, in its present use it is giving a
surplus of Rs. 50.
We can also define transfer earnings as the minimum sum whic h mu st be
paid for a unit of a factor of production in order to induce it to staty in its
present use or employment. In the above exampl e, a sum of Rs. 100 at
least must be paid for the land under cotton in order to retain it under
cotton; otherwise it wil l shift to whea t, which is its next best alternative
use where it can fetch Rs. 100. Actually, this piece of land is earning Rs.
150, i. e., Rs. 50 extra or in excess of its transfer earnings. This is
economic rent. Economic rent in this sense is thus the d ifference betwe en
the present earnings and the transfer earnings.
This concept of rent is applicable not merely to land but also to all factors
of production i.e. labour, capital and entrepreneur’s earnings too. They can
all earn economic rent in the sense that the moder n economists use the
term ‘rent’.
How Rent arises:
Rent in the sense of surplus arises when the supply of land, or for th at
matter that any other factor service, is less than perfectly elastic.
From the point of elasticity of supply, there are three possib ilities:
(a) The supply may be perfectly elastic, which can be shown as a
horizontal straight line, as in Fig. 5.3 above. munotes.in

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44

Figure No. 5. 4: Determina tion of Rent un der Inelastic Supply of Land

Figure No. 5. 5: Determination of Rent under Elastic Supply of Land

Figure No. 5. 6: Deter mination of Rent under Elastic Supply of Land munotes.in

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Factor Pricing: Rent and Wage
45 (b) The supply of land may be absolutely inelastic. This is shown in Fig.
5.3 by a verti cal straight line.
(c) There is the situation in between these two extremes, i.e., it is elastic,
but not perfectly elast ic. This is shown in Fig. 5.4.
In these three conditions, rent as a surplus over transfer earnings will be
different.
If the supply is absolutely inelastic (see Fig. 5.3), the transfer earning is
zero, because land cannot be transferred to any use; the sup ply of land is
fixed, and it has only one use, whether it is used or not. In this case, the
entire income from land is s urplus, and hen ce rent.
When the supply of land is perfectly elastic, there will be no surplus and
the actual earnings and transfer earn ings will be equal. For example, for an
individual firm or farmer, the supply of land is perfectly elastic.
Suppose the supp ly is elast ic but not perfectly elastic, then a part of
income from land is rent (in the sense of surplus over transfer earnings),
and a part is not rent.
These three conditions are represented in the diagrams as mentioned
below:
In Fig. 5.3, DD is the demand curve a nd SS a vertical straight line fixed
supply curve. They intersect at E. Here OS is the quantity of land used.
OR (=SE) is the rent per unit and total earnings are OSER. Since land is
fixed in supply and cannot be transferred to any other use , its transfer
earnings are zero. Hence its entire earnings OSER are rent as surplus over
transfer earnings.
For the economy as a whole, land has no alternative use at all. Hence the
transfer earnings of land, from the point of view of economy as a whole,
are zero and al l the earnings are rent.
In Fig. 5.5, the supply curve SS of land is a horizontal straight line which
is perfectly elasti c. DD is the demand curve. The two intersect at E. In this
case, OM land is put to use. The rent per unit is OS (=EM) an d the total
earning is OMES. The transfer earning is also OMES. If this firm does not
pay OS rent, the land will be transferred to some other use or firm. Since
transfer earnings and actual earnings are equal, there is no surplus or rent.
In Fig. 5.7, SS s upply curve is somewhat elastic. It cuts DD demand curve
at E. In this case, OM land is used and the rent per unit is OR (= ME). The
total earnings are OMER and the transfer earnings are OMES. If we
deduct transfer earnings OMES from the actual earnings OM ER, we get
RES (shaded area). This is surplus or rent. munotes.in

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46

Figure No. 5.7: Rent as Surplus over Transfer Earnings
Surplus in Other Factors Too:
It should be bo rne in mind tha t the above analysis with regard to rent as
surplus over transfer earnings is applicable not only to the share of land,
but also to the shares of other factors, viz., wages, interest and profits. This
applies to all cases where the supply of a factor is le ss than perfectly
elastic. In such cases, a part of present earnings is the transfer earnings and
the remainder is econom ic rent.
Comparison between the Ricardian Theory and the Modern Theory
of Rent:
Now that we have studied the two main th eories of rent, viz., the Ricardian
theory (or the classical theory) and the modern theory of rent, we should
be in a position to distin guish between the two. We can see that both
theories regard rent as a surplus.
In Ricardo’s theory, the surplus is due t o superiority ( or natural differential
advantage) of the land in question over the marginal one. The superiority
may be due to either qu ality of the land or better situation. Also both
theories of rent have the same concept of land, i.e. a natural factor r ather
than a ma n-made factor like capital, but then where is the difference
between the two theories.
The difference between two is basi c and it lies in this that while Ricardo
takes agricultural land (the cultivation of which is subject to the law of
diminishing returns sooner or later), the modern economists, on the other
hand, do not confine the concept of rent to agricultural land only .
As we have said earlier, rent can arise in the sense of surplus in the case of
other factors of production also and ev en in a situati on of increasing
returns. Rent represents the opportunity cost or transfer earnings. In this
sense, rent is of a more gen eral nature applicable to all factors. That is why
it is said. “It (land rent) is leading specie of large genus”. That i s, land rent
is not a separate class by itself. It is only a prominent example of its type. munotes.in

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Factor Pricing: Rent and Wage
47 5.6 QUASI RENT
Quasi literally means ‘almos t’. Quasi - rent is, therefore, a payment which
is almost rent but is not exactly economic rent.
Similar abnormal earning s or surplus ma y also arise in the case of other
durable goods like houses and machines.
Similarly, quasi -rent may also arise due to a t emporary scarcity of a
particular kind of skill which can be increased only if enough time is
given.
From the Ricardian theory of rent, a person might conclude that rent is a
kind by itself and does not resemble any other payment. But this is not so.
The p eculiarity of land after all is that all its stock is fixed for ever. Rent
arises from this peculiarity. That is why Ben ham defines ren t as “a surplus
accruing to a specific factor, the supply of which is fixed.”
Now no other factor is permanently fixed li ke land. But whenever the
supply of any other factor is fixed even temporarily, its return resembles
rent and is called quasi-rent. Thu s, an element of rent is present in interest,
wages and profits, and is called quasi -rent. It lasts only for a short peri od
of time and disappears when conditions become normal.
This concept of quasi -rent was introduced in economic theory by
Marshall. It i s an extension of the Ricardian concept of rent to the short -
run earnings of capital equipment (such as machinery, buildi ngs), which is
in inelastic supply in the short -run, that is, whose supply cannot be
increased in the short period. For exam ple, during the last war merchant
shipping became scarce. New ships could not replace the lost ones quickly
as ships take long to bu ild. As a result, the existing vessels began to charge
high freights and earned exceptional profits.
These profits were temp orary, beca use had the need lasted long enough,
new- ships would have been constructed and profits reduced to normal.
Such abnormal earnings, during the period the supply of machines or ships
is fixed, are termed by Marshall as ‘quasi -rent’.
Quasi lite rally means ‘al most’. Quasi - rent is, therefore, a payment which
is almost rent but is not exactly economic rent. Similar abnormal earni ngs
or surplus may also arise in the case of other durable goods like houses
and machines. Similarly, quasi -rent may als o arise due to a temporary
scarcity of a particular kind of skill which can be increased only if enough
time is given.
It is the whole income and not extra income:
It may clearly be understood that quasi -rent stands for the whole of the
earnings or income rather than the additional income. This income some
agents of production yield when demand for them has suddenly increased,
while their supply cannot be increased readily in response to that increase
in demand. munotes.in

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48 Hence, quasi -rent is a short period concept. The adjoining d iagram (Fig.
5.8) shows quasi -rent. Here SS, a vertical straight line, is the absolutely
inelastic supply curve for machi nes. It cuts the demand curve DD at E. At
the price OP (=SE), OS machines are supplied. If, in the short run, demand
increases to D’D’, the price will go up to OP’ =SE’), but the supply of
machines remains OS.
Since the number of machines is fixed in the s hort-run, the transfer
earnings are zero, the whole earnings OSE’P’ are quasi -rent. But in the
long run, the supply of mach ines will in crease to OM, because the supply
is inelastic only in the short -run; it is perfectly elastic in the long run,
which is re presented by PL so that any number of machines can be
supplied at OP. The price now comes down to E”M (= OP). The quasi -rent
has vanish ed, because the price E” M just covers the supply price OP.

Figure No. 5.8: Quasi Rent
Rent, Quasi -rent and Interest:
Rent, we know, is a paym ent for the use of land. Quasi -rent is yielded by
machinery and capital equipment i.e. old invested capital or ‘sunk’ capital,
and in terest is the return on new investments of capital. They are all
fundamentally similar in that they are all scarce in - relation to dema nd for
them. They all yield a differential surplus arising from limitation of their
supply only the duration of the limit ation of supply varies.
For instance, land is permanently limited and its supply is absolutely
inelastic. That is why; it is put in a s eparate category. Since its supply is
limited permanently, it is a perennial source of surplus income called rent.
The su pply of machinery, etc., is, however, limited for a short period
because it takes some time to produce it. Its supply i s, therefore, el astic but
not so elastic i.e., it is less than perfectly elastic.
It also yields a surplus but only in the short -run. In the long run, more
machines can be produced and the surplus will disappear. This is quasi -
rent. On the other hand, the supp ly of new ca pital which yields interest is
perfectly elastic. It cannot, therefore, yield any surplus. Thus, we find that
rent, quasi -rent and interest are practically the same. They are derived
from assets which differ only in the duration for which t heir supply is munotes.in

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Factor Pricing: Rent and Wage
49 limited. The difference between them is only a matter of degree and not of
kind.
As Marshall observes, “that which is righ tly regarded as interest on free or
floating capital or on new investments of capital is more properly treated
as a sor t of rent—a quas i-rent on old investments of capital. And there is
no sharp line of distinction between floating capital and that which h as
been sunk for a special branch of production, nor between new and old
investments of capital; each group shades into the other gradu ally.”
Rent is from land whose supply is inelastic absolutely, quasi -rent from
sunken capital whose supply is inelastic t emporarily and interest from
floating capital whose supply is perfectly elastic. But all these differential
surpluses a re fundamentally similar. That is why it is said that “Rent is
leading specie of a large genus.”
Incomes from investments, whether in per manent assets like land or in
semi -permanent things like machines or in perishable articles, are
absolutely alike from the point of vie w of working of economic principles.
The principle of scarcity is the basic principle which is applicable in all
cases. H ence, rent, quasi -rent and interest are essentially similar.
Rent Element in Wages and Profits:
We know that skilled la bour producing e ssential goods earns abnormal
wages in times of war. This is due to the - scarcity of trained labour. Such
extra earnings, too, resemble rent. The case of organisation is not
different. For instance, if a health resort becomes very popular a ll at once,
the hotel -owners there will make good profits till new hotel -keepers are
attracted, and profits are reduced to the normal rat e. During this short
period, organization will earn surplus income resembling rent.
Just as some lands are more fertile than others, si milarly some people are
superior to others. A Laurel or a Hardy differs from a wayside joker. A
Raj Kapoor on the screen will earn much more than a second rate actor.
AH trades make extra payment to really gifted people. Special incomes
due to these gifts are called Rent of Ability or “Personal Rent”.
It, thus, follows from the above discussion that land rent does not form a
separate class by itself. It is only a prominent example of its kind. Or, as
Marshall describes it, “It is a leading s pecie of a large genus.” Element of
rent is present at times in wages, interest and profits.
5.7 MODERN THEORY OF WAGES
Modern theory of wages regards wages as a price of labour and all other
prices determined by the usual supply and demand analysis. Accor ding to
this app roach, wages are determined by the interaction of market forces of
demand and supply.

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50 Demand for Labour:
The demand for l abour comes from the entrepreneurs as it is used for the
production of goods and services. Thus, the demand for labour depe nds
upon the productivity of labour i.e., the higher the productivity of labour,
the greater will be the demand for it from employers . Thus, demand for
labour depends upon the marginal productivity of labour; since the
marginal productivity of labour w ill slope downwa rds after a stage, the
demand curve of labour will also slope downward.
Factors Affecting the Demand for Labour:
1. Techn ological Changes:
Technological changes influence the marginal productivity of labour.
Therefore, these changes also in fluence the dema nd for labour.
2. Derived Demand:
Demand for labour is a derived demand. It means that demand for labour
depends upon the demand for goods and services which it produces. If at
any given time the demand for a particular commodity produced b y the
labour is high, it is natural that the demand for labour shall also be high.
Hence, the greater is the consumer demand for the prod uct, the higher will
be the demand for the labour to produce that commodity.
3. Proportion of Labour:
The demand for la bour also depend s upon the proportion in which labour
is mixed with other factors of production. When a small amount of labour
is engaged in the production of a product, the demand for that type of
labour is inelastic. For instance, the demand for labour f or operating
automatic machines or latest machines in large scale factories is inelastic.
4. Cost of other Factors:
The demand for labour depends upon the cost of other factors of
production which can be used as substitute for labour. If substitute factors
are costly, the entrepreneur will naturally substitute labour in place of
costly factor.
In such a case the demand for labour will be hi gh. If the prices of
substitute factors which can be used in place of labour have declined, the
substitute factor will be used in place of labour. Hence, the demand for
labour will decline.



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51 This can be shown with the help of Fig. 5.9:

Figure No. 5. 9
In Fig. 5.8 number of labourers has been measured on OX -axis and the
wage rate on Y -axis. DD is the industry’s demand curve. It slopes
downward from left to righ t indicating that when wages are low, demand
for labourers increases and when the wage rate tends to increase, demand
for labour decrea ses.
Supply of Labour:
Supply of labour in an economy depends upon both economic as well as
non-economic factors. Economi c factors influencing the supply of labour
comprises of existing employment, desire to increase monetary income,
bargaining power of th e labou rers, size of population, income distribution
etc. while the non -economic factors consist of family affection, soc ial
conditions, domestic environment etc.
Psychological factors also affect the supply of labour. It is only due to the
psychological f actors that a worker decides how much time he should
devote to work and how much to leisure. Moreover, the supply of labo ur
also depends on the elasticity.
The supply of labour for a firm is perfectly elastic, so, the firm at current
wages can employ as ma ny work ers as it wishes. On the contrary the
nature of supply of labour for an industry is not infinitely elastic. Thus, it
cannot employ more and more labourers at the current wage rate. The
industry can do so by attracting labourers from other industries by offering
them higher wages. Following diagram clears this point more vividly. munotes.in

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52

Figure No. 5. 10
In Fig. 5.10 hours supplied has been taken on X -axis and wages on Y -axis.
SS is the backward bending supply curve. OW relates to the initial wage
rate. When the wage rate is OW’, the hours supplied are OX 1. The
maximum working hours are OX at wage rate OW. Now suppose the
wage rate increases to OW”, in that case hours supplied will d ecrease to
OX 1. Thus, we may conclude that like other factors of production, supply
curve of labour is also upward sloping from left to right.
Factors Affecting Supply of Labour :
1. Size of Population:
The supply of labour depends upo n several factors. In the first place, the
supply at any given time depends upon the number of labourers in the
country. This, in itself is a result of the size of population and that
proportion of this population which is called working population.
The si ze of population is determined b y the difference in birth rate and the
death rate. The proportion of total population whi ch is called working
population depends upon occupational distribution, level of technical
advancement, conservation and mobility of la bour.
2. Efficiency of Labour:
The supply of labour does not merely depend upon the size of population.
It also depends u pon the efficiency of labour. Efficiency depends upon
several factors like hours of working, service and working conditions,
wage rates , economic incentives and other cond itions that have a bearing
upon the working ability of labour.
3. Mobility of Labour:
The supply of labour also depends upon the mobility of labour. If the
labour is less mobile either because the means of transport are not
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53 are climatic, language or traditional hindra nces, then it follows that supply
of labour shall be highly limited.
5.8 COLLECTIVE BARGAINING
Collective bargaining is a techniques ad opted by the unions and employer s
to bring about a compromise in their conflicting interest. It is called as
‘collective’ because the employees meet the employers, through their
selective representatives to discuss their problems. It is unlike the
individu al bargaining where the individu als seek to sort out the differences
directly with the management.
Collective bargaining is a broader concept. It does not only look to the
economic relations between the employees and employers, but it is a
technique where by an inferior social class or g roup carries on a never
slackening pressure for a bigger share in the social sovereignty as well as
for more welfare, security and liberty for its individual members.
However, in this lesson, we concern ourselves with the li mited aspect of
collective barga ining i.e. whether trade unions can succeed in raising the
wages of workers. And whether union members do better than workers in
unorganized industries.
There is an inconclusive debate on the issue of wage determination
through collective bargaining. For instance, a study of wages, by Paul
Douglas show that union had a positive effect on wage s. It indicates that
union members obtained a rise in wages after the formation of union. But
country evidence is provided by the study of Albert Rees. In this study o f
basic steel industry for a period from 1945 to 1948, he concludes that rise
in wages du ring this period should be attributed to other factors than
collective bargaining. Hence, it would have been possible for wages to rise
even faster in absence of colle ctive bargaining.
5.9 SUPPLY CURVE OF LABOUR
It is important to know how many hours a wo rker will be willing to work
at different wage rates. When the real wage rate increases, the individual
will be pulled in two opposite directions. The real wage rate i s the relative
price of leisure which has to be given up for doing work to earn income.
As real wage rate rises, leisure becomes relatively more expensive (in
terms of income foregone) and this induces the individual to subs titute
work (or income) for leis ure. This is called substitution effect of the rise in
real wage and induces the individu al to work more hours (i.e. supply more
labour) to earn more income.
But the increase in the real wage rate also makes the individual r icher, that
is, his income incre ases. This increase in income tends to make the
individual to consume more of all commodi ties including leisure. This is
called income effect of the rise in wage rate which tends to increase
leisure and reduce number of work hours (i.e. reduce labour suppl y. The
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54 is larger than its income effect and therefore individuals work for more
hours (that is, supply more labour) at a higher wage rate.
However, beyond a certain higher real wa ge and number of hours worked,
leisure becomes more desirable and income effect outweighs substitution
effect, and as a result supply of labour decreases beyond a certain higher
wage rate.
In what follows we shall explain ho w we derive a supply curve of la bour
of an individual and of the economy as a whole in all these circumstances.
Thus, whe ther an individual will supply more work - effort or less as a
result of the rise in the wage rate depends upon the relative strengths o f the
income and substitution ef fects.
The changes in the work -effort or labour supplied by an individual worker
due to t he changes in the wage rate is illustrated in Fig. 33.1(a) To begin
with, the wage line is AW 1 the slope of the wage line indicates the wage
rate per hour.
With wage l ine AW 1, the individual is in equilibrium at point Q on
indifference curve I 1 and is work ing AL 1 hours in a week. Suppose the
wage rate rises so that the new wage line is AW 2 with wage line AW 2, the
individual is in equilibr ium at point R on the indiffer ence curve I 2, and is
now working AL 2 hours which are more than before.
If the wage rate f urther rises so that the new wage line is AW 3, the
individual moves to the point S on indifference curve I 3 and works
AL 3 hours which a re more than AL 1 or AL 2. Suppose the wage rate further
rises so that the wage line is AW 4. With wage line AW 4, the indivi dual is
in equilibrium at point T and works AL 4 hours.
If points Q, R, S and Tare connected, we get what is called wage offer
curve whi ch shows the number of hours tha t an individual offers to work
at various wage rates. It should be noted that the wage of fer curve, strictly
speaking, is not the supply curve of labour though it provides the same
information as the supply curve of labour.
The supply curve of labour is ob tained when the wage rate is directly
represented on the Y -axis and labour (i.e. work eff ort) supplied at various
w age rates on the X -axis reading from left to right. In Fig. 5.2 the supply
curve of labour has been drawn fr om the information gained from F ig. 5.1.
Let the wage line AW 1 represent the wage rate equal to P 1, wage line
AW 2 represe nts wage rate P 2, wage line AW 3 represents wage rate P 3 and
wage line AW 4 represent wage rate P 4. It will be seen that as the wage rate
rises from P 1 to P 4 and as a re sult the wage line shifts from AW 1 to
AW 4 the number of hours worked, that is, the amount of labour supplied
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55

FIG 5. 11 : Wage Offer Curve
As a result, the supply curve of labour in Fig. 5.2 is upw ard sloping. The
indifference map d epicted in Fig. 5.1 is such that the substitution effect of
the rise in the wage rate is stronger than the income effect of the rise in the
wage rate so that the work - effort supplied increases as the wage rate rises.

Fig 5.12 : Upward Stoping supply curve of labour
Backward -Sloping Supply Curve of Labour:
But the supply curve of labour i s not always upward sloping. When an
individual prefers leisure to income, then the supply of labour (number of
hours worked) by an ind ividual will decrease as the wage rate rises. This is
because in such a case income effect which tends to reduce the work effort
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56 In Fig. 5.11 such an indifference map is shown which yields a backward
sloping supply curv e of labour which indicates that the number of hours
worked per week decreases as th e wage rate rises. AW 1, AW 2, AW 3 and
AW 4 are the wage lines when the wages rates are P 1, P 2, P 3 and
P4 respectively.
Q, R, S and Tare t he equilibrium points with the wage l ines AW 1, AW 2,
AW 3 and AW 4 respectively. It will be noticed from Fig. 33.3(a) that w hen
the wage rate rises and as a consequence the wage line shifts from AW 1 to
AW 4 the number of hours worked per week decreases from AL 1 to AL 4.
In Fig. 33.3(b) supply curv e of labour is drawn with K -axis representing
the hourly wage rate and X -axis repres enting number of hours worked per
week at various wage rates. It will be seen from Fig. 33.3(b) as the wage
rate rises from P 1 to P 4 the supply of labour (i.e., number of h ours worked
per week) decreases from OL 1 to OL 4. In other words, the supply curve of
labour slopes backward, that is, slopes upward from right to left. It should
be noted that it is the nature or pattern of indifference curves between
income and leisure th at yields backward sloping supply curve.

Figure No. 5.13 : Backward Bending Supply Curve Labour
A glance at Fig.5. 13(a) and Fig. 5 .13(b) will reveal that the nature of
indifference curves in the two is different. As s aid above, the nature of
indifference curves depends upon the relative preference between income
and leisure.
In Fig. 5 .13(a) indifference curves between income and leisure are such
that the individual’s preference for leisure is relatively greater than fo r
income. In this case, when the wage rate rises the indiv idual enjoys more
leisure and accordingly reduces the number of hours worked per week.
But it sometimes happens that as the hourly wage rate rises from a very
low level to a reasonably good level, t he number of hours worked per munotes.in

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57 week rises and as the hourly wage rate rises further, the number of hours
worked per week d ecreases.
This may be the case of an individual who has some more or less fixed
minimum wants for goods and services which he can satis fy with a certain
money income. When the wage rate is so l ow t hat he is not earning
sufficient money income, then to sati sfy his more or less fixed minimum
wants for goods and services, his preference for income will be relatively
greater than that for lei sure and, therefore, when the wage rate rises the
individu al will work more hours per week.
When the wage rate has risen to a level which is sufficient to yield a
sufficient money income for satisfying his fixed minimum wants, then for
further increases in wage rate the number of hours worked per week will
decrea se because now the individual can afford to have more leisure a nd
also earn an income sufficient to meet his minimum wants for goods and
services.
It follows from above that up to a certain wage rat e the supply curve will
slope upward from left to right an d then for further increases in the wage
rate the supply curve of labour will slope back ward.
5.10 QUESTIONS
1. Explain the marginal productivity theory of distribution with the
help of diagram.
2. Explain t he Ricardian Theory of Rent with the help of diagram.
3. Explain the Modern Theory of Rent in detail.
4. Give the definition o f wages and explain the modern theory of
wages.
5. Write a note on collective bargaining.
6. Write a note on the su pply curve of labour.

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58 6
FACTOR PRICING: INTEREST AND
PROFIT
Unit Structure:
6.0 Objectives
6.1 Interest
6.2 Classical Theory of Interest
6.3 Loanable Fund Theory of Interest
6.4 Profit
6.5 Risk Theory of Profit
6.6 Uncertainty Theory of Profit
6.7 Innovation Theory of Prof it
6.8 Questions
6.0 OBJECTIVES
 To study the meaning of interest.
 To explain the classical theory of interest and loanable fund theory of
interest.
 To study the meaning of profit.
 To study the risk theory of profit.
 To study the uncertainty theory of pr ofit.
 To study the innovation theory of profit.
6.1 INTEREST
In simple words, interest means the reward for the use of capital. It is also
called the income of the owner of capital for lending it.
In other words, it is the price paid by the borrower of mo ney to its lender.
Now, question arises, why interest is paid?
The answer follows:
We know that people keep their money in three forms:
(i) In banks
(ii) In bonds, securities or debentures
(iii) In cash. munotes.in

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59 The third form has the advantage that this amount ca n be used at any time.
Therefore, when one person parts with this amount, he gets a price which
is known as interest.
Definitions:
The concept of interest can be explained in a number of ways as
under:
“Interest is the price paid for the use of capital in any market.” -Marshall
“Interest is a reward for parting with liquidity for a specified period.” -
J.M. Keynes
“Interest is the price paid for the hire of loan capital.” -Cairncross
“Interest is the income which goes to the lender of capital by virtue of it s
productivity as a reward for its abstinence.” -Carver
6.2 CLASSICAL THEORY OF INTEREST
The classical theory of interest also known as the demand and supply
theory was propounded by the economists like Marshall and Fisher.
Later on, Pigou, Cassel, Knight and Taussig worked to modify the theory.
According to this theory rate of interest is determined by the intersection
of demand and supply of savings. It is called the real theory of interest in
the sense that it explains the determination of interest by an alyzing the real
factors like savings and investment. Therefore, classical economists
maintained that interest is a price paid for the supply of savings.
Demand for Savings:
Demand for savings comes from those who want to invest in business
activities. Dem and for investment is derived demand. Any factor of
production is demanded for its productivity. The demand for the factor is
high when there are higher expectations from it.Since, all the factors are
not equally productive, so, capital demand will be high for more
productive uses first and then gradually with the increase in its supply,
will shift to less productive uses.
Therefore, classical economists maintained that with the aid of capital
facilities we turn out more goods per man -hour than when we prod uce
with bare hands or with scant tools. Moreover, marginal productivity of
the business goes on decreasing with more and more doses of investment
of savings in his business venture. It is due to the operation of the law of
diminishing returns.
Now a very important question arises is that how much capital a person
will demand because when a person borrows money he has to pay interest
on it. The answer according to this theory is that demand for capital can be
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60 the interest paid on it. Thus, if marginal productivity of capital is more
than the interest paid, then it is beneficial to borrow money and vice -versa.
Equilibrium will prevail at a point where marginal productivity of capital
equals the rate of interest. This shows that there exists inverse relationship
between demand for capital and the interest rate.
This fact can be made clear with the help of the following table 6.1
and diagram 6.1:
Table No. 6.1

It is clear from the table 6.2 that rate of interest and savings have a
positive relationship. As the rate of interest increases, savings will also
increase. On the other hand, a fall in rate of interest leads to a decrease in
savings. When the rate of interest is 10%, the savings are of Rs. 1000
crores.

Figure No. 6.1
In the successive periods, as rate of interest falls from 10% to 5%, the total
savings also decline. Suppose as the rate of interest falls to 5%, savings
also decrease to Rs. 400 crores.
In Fig. 6.1 savings have been represented on X -axis and interest rate on Y -
axis. SS is the supply curve which moves upward f rom left to right. It
shows that supply of savings is interest elastic. Higher the interest rate,
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61 are Rs. 400 crores. As the interest rate increa ses to 10% people are
persuaded to sa ve more and the money savings rise to Rs. 1000 crores.
This signifies that there is a direct relationship between savings and the
rate of interest.
Equilibrium Rate of Interest:
According to classical theory, equilibriu m interest rate is restored at a
poin t where demand for and supply of capital are equal i.e.
Table No. 6.2

The table 3 reveals that equilibrium rate of int erest will be determined at a
point where demand fo r and supply of capital are equal. As is clear from
the table that equilibrium interest rate 8% is determined because at this
level demand for and the supply of capital are equal i.e. Rs. 700 crores.
Now, if the rate of interest increases to 10%, investmen t is Rs. 500 crores
and savings are of Rs. 1000 crores i.e. savings exceed the investment. On
the other hand, if the rate of interest falls to 5% investment is Rs. 1000
crores and savings are Rs. 400 crore s.
This fact is clearer from the diagram below:

Figure No. 6.2 munotes.in

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62 In Fig. 6.2, rate of interest is determined by the intersection of demand and
supply curves. Equilibrium is restored at point E which determines rate of
interest as 8% and demand and supply of capital as Rs. 700 crores. Now, if
the rate of interest increases to 10% supply of savings exceeds the demand
for capital i.e. supply is more than demand. T his will lead to a fall in
interest rate to the level of 8%.
On the other hand, when the interest rate falls to 6%, demand for savings
exceeds the supply of savings which will push up the rate of interest to
restore an equilibrium rate i.e. 8%. Therefore, rate of interest is in
equilibrium only at a point where the demand for capital equals the supply
of capital.
Criticism:
The classical theory of rate of interest has been criticized on the basis
of the following shortcomings as discussed below:
1. Indeterm inate Theory:
Keynes has maintained that the classical theory is ind eterminate in the
sense that it fails to determine the interest rate. In this theory, interest is
determined by the equality of demand and supply. But the position of
savings varies with t he income level. Thus, unless we know the income,
interest rate cann ot be determined.
2. Fixed Level of Income:
Classical theory assumes that the level of income remains constant. But in
actual practice income changes with a small change in investment. Thu s, it
is not correct to assume a fixed level of income.
3. Long Run:
Classical theory determines the interest rate through the interaction of
demand and supply of capital in the long run. Keynes pointed out that in
the long run we all are dead. Therefore, there was an urgent need of a
theory which determines rate of intere st in the short -run.
4. Full Employment:
This theory assumes that there is full employment of resources in the
economy. But, in reality, unemployment or less than full employment is a
gene ral situation. Full employment is only an abnormal case… Thus, this
theory does not apply to the present world.
5. Savings and Investment:
Classical economists assume that savings and investment are interring
dependent. But actually, investment changes, in come also changes which
leads to a change in savings. Thus, both are interdependent on each other. munotes.in

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63 6. Ignores Monetary Factors:
Classical theory takes into consideration only the real factors for
determining the rate of interest and ignores the monetary fa ctors.
6.3 LOANABLE FUNDS THEORY OF INTEREST
The neo -classical theor y of interest or loanable funds theory of interest
owes its origin to the Swedish economist Knut Wicksell.
Later on, economists like Ohlin, Myrdal, Lindahl, Robertson and J. Viner
have con siderably contributed to this theory.
According to this theory, rate of interest is determined by the demand for
and supply of loanable funds. In this regard this theory is more realistic
and broader than the classical theory of interest.
Demand for Loanab le Funds:
Loanable funds theory differs from the classical theory in the explanation
of demand for loanable funds.
According to this theory demand for loanable funds arises for the
following three purposes viz.; Investment, hoarding and dissaving:
1. Inves tment (I):
The main source of demand for loanable funds is the deman d for
investment. Investment refers to the expenditure for the purchase of
making of new capital goods including inventories. The price of obtaining
such funds for the purpose of these inv estments depends on the rate of
interest. An entrepreneur while deci ding upon the investment is to
compare the expected return from an investment with the rate of interest.
If the rate of interest is low, the demand for loanable funds for investment
purpos es will be high and vice - versa. This shows that there is an inverse
relationship between the demands for loanable funds for investment to the
rate of interest.
2. Hoarding (H):
The demand for loanable funds is also made up by those people who want
to hoar d it as idle cash balances to satisfy their desire for liquidity. Th e
demand for loanable funds for hoarding purpose is a decreasing function
of the rate of interest. At low rate of interest demand for loanable funds for
hoarding will be more and vice -versa.
3. Dissaving (DS):
Dissaving’s is opposite to an act of savings. This demand comes from the
people at that time when they want to spend beyond their current income.
Like hoarding it is also a decreasing function of interest rate.
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64 Supply of Loanable Fund s:
The supply of loanable funds is derived from the basic four sourc es as
savings, dishoarding, disinvestment and bank credit.
They are explained as:
1. Savings (S):
Savings constitute the most important source of the supply of loanable
funds. Savings is t he difference between the income and expenditure.
Since, income is a ssumed to remain unchanged, so the amount of savings
varies with the rate of interest. Individuals as well as business firms will
save more at a higher rate of interest and vice -versa.
2. Dishoarding (DH):
Dishoarding is another important source of the sup ply of loanable funds.
Generally, individuals may dishoard money from the past hoardings at a
higher rate of interest. Thus, at a higher interest rate, idle cash balances of
the past becom e the active balances at present and become available for
investment . If the rate of interest is low dishoarding would be negligible.
3. Disinvestment (DI):
Disinvestment occurs when the existing stock of capital is allowed to wear
out without being replac ed by new capital equipment. Disinvestment will
be high when the pre sent interest rate provides better returns in
comparison to present earnings. Thus, high rate of interest leads to higher
disinvestment and so on.
4. Bank Money (BM):
Banking system consti tutes another source of the supply of loanable funds.
The banks adva nce loans to the businessmen through the process of credit
creation. The money created by the banks adds to the supply of loanable
funds.
Determination of Rate of Interest:
According to lo anable funds theory, equilibrium rate of interest is that
which brin gs equality between the demand for and supply of loanable
funds. In other words, equilibrium interest rate is determined at a point
where the demand for loanable funds curve intersects the supply curve of
loanable funds. It can be shown with the help of a Figure 4. munotes.in

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65

Figure No. 6.3
The rate of interest is determined at the point of intersectio n of the two
curves —the supply of loanable funds curve (SL) and the demand for
loanable funds curve, DL. Fig. 4 shows that the equilibrium rate of interest
is EM; at this rate, the demand for loanable funds is equal to the supply of
loanable funds i.e. OM.
Criticism:
Although, loanable funds theory is superior to classical theory, yet,
critics have criticised it on the following grounds:
1. Full Employment:
Keynes opined that loanable funds theory is based on the unrealistic
assumption of full employment. A s such, this theory also suffers from the
defects as the classical theory does.
2. Indeterminate:
Like classical theory, loanable funds theory is also indeterminate. This
theory assumes that savings and income both are independent. But savings
depend on in come. As the income changes savings also change and so
does the supply of loanable funds.
3. Impracticable:
This theory assumes savings, hoarding, investment etc. to be related to
interest rate. But in actual practice investment is not only affected by
interest rate but also by the marginal efficiency of capital whose affect has
been ign ored.
4. Unsatisfactory Integration of Real and Monetary Factors:
This theory makes an attempt to integrate the monetary as well as real
factors as the determinants of inter est rate. But, the critics have maintained
that these factors cannot be integrated in the form of the schedule as is
evident from the frame work of this theory.
5. Constancy of National Income:
Loanable funds theory rests on the assumption that the level o f national
income remains unchanged. In reality, due to the change in investment,
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66 Improvement over the Classical Theory:
Loanable funds theory is considered to be an improvement over the
classical theory on the follow ing aspects:
1. Loanable funds theory recognizes the importance of hoarding as a fa ctor
affecting the interest rate which the classical theory has completely
overlooked.
2. Loanable funds theory links together liquidity preference, quantity of
money, savin gs and investment.
3. Loanable funds theory takes into consideration the role of ba nk credit
which acts as a very important source of loanable funds.
6.4 PROFIT
Profit is the financial benefit realized from the business activity when the
revenues generated exceeds the costs and expenses incurred in the
operation of such activities. Simpl y, the total cost deducted from total
revenue yields profit.
The profits of the organization depend on the successful management of
business operations, i.e., how well an en trepreneur manages the risks and
uncertainties of the firm. Although the profits ar e directly linked to the
entrepreneur and his functions, several economists have given their varied
views on origin, nature and role of profit. Till date, there is no comple te
consensus among the economists with respect to the true nature and origin
of pro fit. Due to this, several theories of profit came into existence.
6.5 RISK THEORY OF PROFIT
Hawley’s Risk Theory of Profit was propounded by F.B. Hawley, who
believed that those who have the risk taking ability in the dynamic
production have a sound claim on the reward, called as profit. Simply,
profit is the price that society pays to assume the business risk .
The risk in business may arise due to several factors, Viz. Obso lescence of
a product, non -availability of crucial materials, sudden fall in the pr ices,
introduction of a better substitute by the competitor, risk due to war, fire
or any other natural calamity.
Hawley’s risk theory of profit is based on the notion that the businessman
would expect adequate compensation in excess of the actuarial value ,
i.e., premium on calculable risk , for assuming the risk. Every
entrepreneur strives to gain in excess of wages of the management for
bearing the business risk.
The major r eason behind the Hawley’s opinion that profit should be
maintained over and above t he actuarial risk is that the assumption of risk
is annoying ; it leads to trouble, anxiety, and disutilities among the
businessman of several kinds. Thus, assuming risk gran ts entrepreneur a
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67 According to Hawley, the profit consists of two parts : One representing
the compensation for the actuarial loss suffered due to several classes of
risks assumed by the entrepreneur; Second part represents the inducement
to bear the consequences due to the exposure to risk in the entrepreneurial
adventures.
Hawley’s risk theory of profit is based on the assumption that profits arise
from the factor ownership, as long as the ownership invo lves risk.
Hawley believed that an entrepreneur must assume risks to qualify for th e
additional rewards (profit). On the contrary, if he avoids the risk by
insuring against it, then he would cease to be an entrepreneur and would
not be entitled to profits. Thus, it can be concluded that it is the uninsured
risk from which the profit aris es and until the product is sold an
entrepreneur’s amount of reward cannot be determined. Hence, in
Hawley’s opinion, the profit is a residue and therefore his theory is als o
called a
Thus, it can be concluded that it is the uninsured risk from which the p rofit
arises and until the product is sold an entrepreneur’s amount of reward
cannot be determined. Hence, in Hawley’s opinion, the profit is a residue
and therefore his the ory is also called a Residual Theory of Profit .
6.6 UNCERTAINTY THEORY OF PROFIT
The Knight’s Theory of Profit was proposed by Frank. H. Knight, who
believed profit as a reward for uncertainty -bearing, not to risk bearing.
Simply, profit is the residual r eturn to the entrepreneur for bearing the
uncertainty in business.
Knight had made a clear distinction between the risk and uncertainty. The
risk can be classified as a calculable and non-calculable risk. The
calculable risks are those whose probability of occurrence can be
anticipated through a statistical data. Such as risks due to the fire, theft, or
accident are calculable and hence can be insured in exchange for a
premium. Such amount of premium can be added to the total cost of
production.
While the n on-calculable risks are those whose probability of occurrence
cannot be determined. Such as the strategies of a competitor cannot be
accurately assessed as well as the cost of eliminating the completion
cannot be precisely calculated. Thus, the risk elemen t of such events is not
insurable. This incalculable area of risk is the uncertaint y.
Due to the uncertainty of events, the decision -making becomes a crucial
function of an entrepreneur or manager. If the decisions prove to be
correct by the subsequent eve nts, an entrepreneur makes a profit and vice -
versa. Thus, the Knight’s theory of pr ofit is based on the premise that
profit arises out of the decisions made under the conditions of uncertainty.
Knight believes that profit might arise out of the decisions m ade
concerning the state of the market, such as decisions with respect to
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68 holding stocks that might result in the windfall gains, decisions taken to
introduce new product and technique, e tc.
The major criticism of the knight’s theory of profit is, the total profit of an
entrepreneur cannot be completely attributed to uncertainty alone. There
are several functions that also contribute to the total profit such as
innovation, bargaining, coor dination of business activities, etc.
6.7 THE INNOVATION THEORY OF PROFIT
The Innov ation Theory of Profit was proposed by Joseph. A.
Schumpeter, who believed that an entrepreneur can earn economic profits
by introducing successful innovations .
In other wor ds, innovation theory of profit posits that the main function of
an entrepreneur is to introduce innovations and the profit in the form of
reward is given for his performance. According to Schumpeter,
innovation refers to any new policy that an entreprene ur undertakes
to reduce the overall cost of production or increase the demand for h is
products.
Thus, innovation can be classified into two categories; The first
category includes all those activities which reduce the overall cost of
production such as the introduction of a new method or technique of
production, the introduction of new m achinery, innovative methods of
organizing the industry, etc.
The second category of innovation includes all such activities which
increase the demand for a product. Such as the introduction of a new
commodity or new quality goods, the emergence or opening of a new
market, finding new sources of raw material, a new variety or a design of
the product, etc.
The innovation theory of profit posits that the entrepreneur gains
profit if his innovation is successful either in reducing the overall cost of
productio n or increasing the demand for his product. Often, the profits
earned are for a shorter duration as the competitors imitate the innovation,
thereby ceasing the innovation to be new or novice. Earlier, the
entrepreneur was enjoying a monopoly position in th e market as
innovation was confined to himself and was earning larger profits. But
after some time, with the others imitating the innovation, the profits
started disappearin g.
An entrepreneur can earn larger profits for a longer duration if the law
allows him to patent his innovation. Such as a design of a product is
patented to discourage others to imitate it. Over the time, the supply of
factors remaining the same, the fact or prices tend to rise as a result of
which the cost of production also increases. On the other hand, with the
firms adopting innovations the supply of good sand services increases and
their prices fall. Thus, on one hand the output per unit cost
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Factor Pricing: Interest and
Profit
69 There is a point of time w hen the difference between the costs and receipts
gets disappear. Thus, the profit in excess of the normal profit disappears.
This innovation process continues and also the profits continue to appear
or disappear.
6.8 QUESTIONS
1. Give the meaning of interest a nd explain the classical theory of interest
with the help of diagram.
2. With the help of diagram explain the loanable fund theory of interest.
3. Give the meaning of profit a nd explain the risk theory of profit with
the help of diagram.
4. Explain the uncertainty theory of profit with the help of diagram.
5. With the help of diagram explain the innovation theory of profit.


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69 Module IV
7
INTRODUCTION TO EQUILIBRIUM
Unit Structure:
7.0 Objectives
7.1 Analysis of Equilibrium of a firm
7.2 Conditions of Equilibrium of a firm: Marginal cost and Marginal
Revenue Approach
7.2.1 Conditions for the equilibrium or profit maximization of a firm
under perfect competition
7.2.2 Conditions for the equilibrium or profit maximization of a firm
under monopoly
7.3 Questions
7.0 OBJECTIVES
 To study the conditions of equilibrium of a firm.
 To study the features of perfect competition.
 To study the meaning and determination of equilibrium price under
perfect competition.
 To study how a firm attains an equilibrium in the short run and long
run under perfect competition.
 To study the short run and long run equilibrium of an industry under
perfect c ompetition.
7.1 CONCEPT OF EQUILIBRIUM
Introduction -
A firm is said to be in equilibrium when it has no tendency either to
increase or to decrease its output. In this chapter we shall explain general
conditions for the equilibrium of the firm under all t ypes of market.
There are two approaches regarding the equilibrium or profit
maximization of a firm firstly, is total revenue and total cost approach and
secondly, marginal revenue and marginal cost approach.
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70 Conditions of Equilibrium of a Firm: Total Rev enue and Total Cost
Approach -
The firm is in equilibrium when it maximizes its total profits (π). Total
profit is the difference between total revenue (TR) and total cost (TC).
Symbolically,
π = TR – TC
Max. π = Max. the positive difference (TR - TC).
Graphically, maximization of total profits is illustrated in the following
diagram.

Y TC
TR
B

TR, TC, Break -even
profit Point
& loss
A Profits

Losses



O Q
XA XB
Π


π = 0 π = 0
O Q
Losses XA Xπ m XB Losses

Output π
Figure 7.1
Where,
TR = Total revenue curve is a straight positively slopping line
from the origin increasing in the same proportion as
sales. It shows that the firm is a price - taker and can sell
any amount of output at the going market price
TC = Total cost curve which is inverse - S shaped starting from
the level of fixed cost, reflecting the law of variable
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71 π = Total profit curve. It is obtained by subtracting TC form
TR at each level of output.
Xπm = Output showing maxi mum profit. At this level of outp ut,
the vertical distance between TR and TC curves is
maximum. In other words, both TR and TC curves have
same slope at this output level.
Points A & B = At these points TR = TC and the firm break even i.e.
profit is zero .
Losses = The firm icurrs losses from origin till XA level of output and
beyond XB level of output because TC is mote than TR. It is shown by
shaded areas.
7.2 CONDITIONS OF EQUILIBRIUM OF A FIRM:
MARGINAL COST AND MARGINAL REVENUE
APPROACH -
7.3.1 Conditions for the equilibrium or profit maximization of a firm
under perfect competition -
A firm is in equilibrium when its MR is equal to MC. This approach is
called as MR -MC equality approach. A firm attains equilibrium i.e. it
maximizes its pro fit and minimizes its losses when its MR is equal to its
MC.
So long as MR is greater than MC, the residual profits would be less than
maximum. In such a situation, every additional unit of output will add to
the total revenue of the firm than to its total cost. Hence, the total profit
would go on rising or losses would go on falling, with an increase in its
output and sale. When MR is equal to MC no more units will be produced.
If the output is increased beyond this point, MC will be greater than MR
i.e. it would add more to the total cost of the firm than to its total revenue.
In such a case its residual profits will be less than maximum or its losses
would rise. When MR is equal to MC the difference between TR and TC
would be maximum. Hence, a firm will be in equilibrium when MR is
equal to MC.
Under the condition of prefect competition the demand curve of a firm is
perfectly elastic i.e. horizontal straight line to the ‘X’ axis at the height of
the given market price. Hence, under perfect competition th e price or AR
is always equal to MR. A perfectly elastic demand curve is called as AR
as well as MR curve.
There are two conditions for the equilibrium or profit maximization of a
firm.
1. MR of a firm must be equal to its MC.
2. MC curve must cut MR curve from below not from above. munotes.in

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72 The conditions for the equilibrium or profit maximization of a firm
under perfect competition can be explained with the help of
following diagram.


Y
MC > MR MC
Price, AR MR > MC
MR, MC E 1
& profit A R T P H AR= MR


E


O M Q 1 Q Q 2 X
Units of output

Figure 7.2

In the d iagram the horizontal line AH is the demand curve. It represents
AR and MR. Suppose that MC is the marginal cost curve. It intersects the
MR curve from above at point ‘R’ and from below at point ‘P’. When MC
curve intersect MR curve from above at point R’ MR is equal to MC with
an output of OM units. But point ‘R’ is not point of stable equilibrium.
This is because by increasing the output beyond OM units it can add more
to its TR than to its TC. So , its residual profit will increase.
It is only at point ‘E ’ where the MC curve intersects the MR curve from
below that the firm attains a stable equilibrium. This is because the last
unit produced ads to the TR which is equal to the cost of producing that
unit. Here, the firm gets maximum profits.
So, at the outp ut of OQ units MR is equal to MC and MC curve rises and
intersects the MR curve from below at point ‘P’. The output of OQ units is
a profit maximization output. The area REP is the maximum profit area.
If it produces less than OQ units, say OQ 1 units MC wi ll be less than MR.
So, the profit will increase by an area of TEP when the output is increased
up to OQ units. On the other hand, any output beyond OQ units say OQ 2
units, will reduce profits by an area of ‘PHE’ for MC is greater than MR.
Hence, the pro fits will increase until the output is contracted to OQ unit.
At point ‘E’ there is a stable equilibrium. This is because at point ‘P’ MR
is equal to MC and MC curve intersect the MR curve from below OQ is
the equilibrium output. Prof. Samuelson calls the point ‘P’ as the best
profit point.

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73 7.2.2 Conditions for the equilibrium or profit maximization of a firm
under monopoly -
A monopoly firm will also be in equilibrium when it maximizes its profits
or minimizes its losses. A monopoly firm is in equ ilibrium when MR is
equal to MC. This approach is called as MR - MC equality approach.

A firm is in equilibrium when MR is equal to MC. When MR is equal to
MC, the firm would enjoy maximum total profit. Here the difference
between TR and TC is maximum. Thi s is shown in the following figure.

Y

R
P1 MC
Price, P2
revenue Profit Loss
& cost A P B

MR

O H N1 M Q X
Units of output

Figure 7.3

In this figure MR is marginal revenue curve slopes downward from left to
right. MC is the marginal cost curve falls in the beginning and then rises.
At first, the MC curve intersects the MR curve from above at point ‘R’
when MR is equal to MC. It would produce OH units. But it can not
maximize its profit at this point. This point ‘R’ is the breakdown point.
When the output is increased beyond OH units MC becomes less than MR
and there are residual profits. It would increase its output until the MC
curve intersects the MR curve from below at point ‘P’ where MR is equal
to MC and the mo nopoly firm attains equilibrium and enjoys maximum
profits. OM is the equilibrium output.

It shows that up to the OM units of output MR is more than MC and thus,
each unit provides profit.

If it produces less than OM units say ON1 , MR is great er than MC by
AP1. This is because while MC is AN, MR is P1N. So the profit would be
less than maximum. The profits can still be increased. They are increased
by expanding the production so long as MR is greater than MC but with
OM unit MR is equal to MC and profits are increased by PAP1 Here the
total profits are maximized. RAP is the maximum profit area. Thus, with
output OM it would maximize its profits.

IF the output is increased beyond OM units MC is greater than MR, s o its
profit would be reduced, if OQ units are produced the MC is P2Q while munotes.in

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74 MR is BQ. Thus, the net loss is BP2 and the total loss is PBP2. So the
output must be decrease until the output OM is reached at which MR is
equal to MC. Hence, the equality betwee n MR and MC is a necessary
condition for the equilibrium of a monopoly firm, but it is not sufficient
condition. The sufficient condition is that the MC curve must intersect the
MR curve form below, at point ‘P’ where the stable equilibrium is
attained.

7.3 QUESTIONS

1. Explain fully the concept of Break -even analysis.
2. Explain the condition of Total Revenue and Total Cost approach to
attain equilibrium of a firm.
3. Discuss the profit maximization condition of a firm under perfect
competition.
4. Discuss con ditions for the equilibrium of a firm under monopoly








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75 8
EQUILIBRIUM OF FIRM AND INDUSTRY
UNDER PERFECT COMPETITION
Unit Structure:
8.0 Objectives
8.1 Introduction of perfect competition
8.2 Equilibrium
8.3 Equilibrium of a firm
8.3.1 Short run equilibrium of a firm
8.3.2 Long run equilibrium of a firm
8.4 Equilibrium of an industry
8.4.1 Short run equilibrium of an industry
8.4.2 Long run equilibrium of an industry
8.5 Questions
8.0 OBJECTIVES
 To study the features of perfect competition.
 To study the meaning and determination of equilibrium price under
perfect competition.
 To study how a firm attains an equilibrium in the short run and long
run under perfect competition.
 To study the short run and long run equilibrium of an industry under
perfect competition.
8.1 INTRODUCTION OF PERFECT COMPETITION
A firm is an individual production unit which produces particular type of a
commodity. Under perfect competition the term industry refers to a group
of firms which produce a homogeneous or identical product. So all firms
producing a particular identical commodit y are together called industry.
Perfect competition is one type of market structure. Perfect competition
may be defined as, ‘that market situation, in which there are large number
of firms producing homogeneous product, there is free entry and free exit,
perfect knowledge on the part of buyer, perfect mobility of factors of
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76 Features: -
The main features of perfect competition are as follows.
1. Large number of buyers and sellers: There are so many buyers and
sellers that no individual buyer or seller can influence the price of a
commodity in the market. Any change in output supplied by a single firm
will not affect the total output of an industry. A producer can sell whatever
output he produces at the given pri ce. So , a firm is a price taker. Similarly,
no individual buyer can influence the price of the commodity by his
decision to vary the amount that he would like to buy.
2. Homogenous product: Firms in the market produce homogeneous
products. Homogeneity of a product implies that one unit of the product is
a perfect substitute for another. The products are identical in quality,
shape, size, colour, design, packing etc. There cross elasticity is infinity.
Since the products are identical buyers make no differ ence between
sellers.
3. Free entry and free exit: Industry is characterized by freedom of free
entry and exit of firms, In a perfectly competitive market, there are no
barriers to movement in and out of an industry.
4. Perfect knowledge: All buyers an d sellers have a complete
knowledge of the market conditions; viz; prevailing market prices, quality
of the product sold, availability of factors of production etc. Information is
free and costless. Under there conditions there are no uncertainty about
future development in the market. Advertising has no role to play in the
perfectly competitive market.
5. Perfect mobility of factors of production : The factors of production
can move easily from one firm to another. Workers can move between
jobs and between places.
6. Absence of transportation cost: All goods are produced locally.
Therefore, transportation costs are zero.
As already mentioned above when the first three assumptions are satisfied,
there exists pure competition.
The competition becomes perfect when three additional assumptions are
satisfied.
8.2 EQUILIBRIUM
Equilibrium literally means a state of balance or a state of rest or position
of no change. In economics, the term equilibrium means the state in which
there is no tendency on the part of co nsumers and producers to change.
It may be defined as, ‘when two opposite forces balanced each other on a
particular object, that object is said to be in a state of equilibrium.’ Two
factors determining equilibrium price - are demand and supply. munotes.in

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Equilibrium of Firm and
Industry Under Perfect
Competition
77 Thus, equil ibrium price is the price at which demand and supply are equal
to each other. At this price, there are no incentives to change.
Determination of Equilibrium Price:
Equilibrium price is determined by the equality between demand and
supply. At this price, Q uantity demanded = Quantity supplied.
Prof. Marshall compared demand and supply to the two blades of a pair of
scissors. It shows that it is not blade that cuts the cloth. Both the blades
together, do it. Similarly, it is not demand or supply alone that de termines
the price of a commodity. Together through interaction they determine the
equilibrium price of a commodity.
The process of determination of equilibrium price can be explained under
three heads.
1. Demand - A commodity is demanded because it has u tility and satisfies
human want. The law of demand states that there is an inverse relationship
between price and quantity demanded of a commodity. Higher the price,
lower is the demand and vice versa. The aim of the consumer is to
maximize his satisfactio n.
2. Supply - The law of supply states that there is a direct relationship
between the price and quantity supplied of a commodity. More the price,
more will be the supply and vice versa. The aim of the producer is to
maximize profits.
3. Equilibrium bet ween demand and supply - The forces of demand and
supply determine the price of a commodity. There is a conflict in the aim
of producers and consumers. Producers want to sell the goods at the
highest price to maximize profit and consumer want to buy the goo ds at
the lowest price to maximize satisfaction.
Equilibrium price will be determined where quantity demanded is equal to
quantity supplied. This is called market price. A demand and supply
schedule and curve will show the determination of equilibrium pric e.
Table No. 8.1 Demand - supply schedule of Salt
Price ` (per k.g.) Demand (k.g./month) Supply (k.g./month)
10 1 5
9 2 4
8 3 3
7 4 2
6 5 1
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78 Figure No. 8.1 Equilibrium Price

Y
10 D S

9

Price 8 E DD = SS

7

6 S D


0 1 2 3 4 5 X

Demand and Supply

In the above table demand and supply of salt at different prices are shown.
Equilibrium price is fixed at
3 where quantity demanded and the
quantity supplied are equal i.e. equal to 3 units.
In Fig. 01 quantit y demanded and supplied are measured on the X axis and
price on the Y axis. DD is the downward sloping demand curve and SS is
the upward sloping supply curve. Both these curves intersect each other at
point ‘E’ which is the equilibrium point and it implies that at price of
6,
demand is 3 units and supply is also 3 units. Thus equilibrium price is
6.
Effects of Changes in Demand and Supply on Equilibrium Price: -
Equilibrium price is derived by that point where quantity demanded is
equal to quantity suppli ed. Therefore, if either demand changes or supply
changes or both change, equilibrium price and output will change. The
effect of changes in demand and supply on equilibrium price and output
can be explained as follows.
Changes in Demand: -
Changes in dem and take place due to changes in prices of related goods,
income, fashion, tastes and habits of the consumers etc. When demand
changes, demand curve shifts. Due to changes or shifts in demand curve,
supply curve remaining the same, there is a change in the equilibrium
price and output. Demand may (a) increase or (b) decrease.
(a) Increase in demand: - When demand of a commodity increases,
while supply remains constant, equilibrium price will increase. At the
same time, quantity sold and purchased will also inc rease. This is shown
in Fig. No. 02


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Equilibrium of Firm and
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79
Y D 1 Y D S

D S D1

P1 E1 P E

Price
P E P 1 E1
D1 S D
S D1
D

O Q Q1 X O Q1 Q X

Demand & supply Demand & supply

Fig. No. 8.2 Increase in Demand Fig. No. 8.3 Decrease in Demand
In the original situation, the DD and SS curv es intersect at point E at this
equilibrium point the equilibrium price is OP and output is OQ. While
supply remain constant, if the demand increases the demand curve shifts
from DD to D 1D1. The new equilibrium is established at point E 1. The
equilibrium p rice goes up from OP to OP 1 and output from OQ to OQ 1.
Therefore, when demand curve shifts upwards, equilibrium price and
output increases.
(b) Decrease in demand: If the demand of a commodity decreases,
while supply remains constant, the equilibrium price an d output will fall.
This is shown in the Fig. No. 3.
In Fig. 3 quantity demanded and supplied are shown on the X axis and
price of commodity on the Y axis. DD is the original demand curve. SS is
the original supply curve, E is the equilibrium point. Decrea se in demand
is shown by downward shift of DD curve to D 1D1. New demand curve
intersects the supply curve at point E 1. Equilibrium price falls from OP to
OP 1 and output falls from OQ to OQ 1. Therefore, when demand curve
shifts downwards both equilibrium pr ice and output falls.
Changes in Supply: -
Like demand, supply of a commodity also changes. Changes in supply
take place due to chages in the cost of production, production techniques,
etc. Due to changes in supply, supply curve shifts. It may (a) In crease of
(b) Decrease.


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80 Y Y
S1
D S D
Price S 1 S

E P1 E1 P
P1 E1 P E

S S 1 D
S1 D S

O Q Q 1 X O Q 1 Q X
Demand & supply Demand & supply
Fig. No. 8.4 Increase in Supply Fig. No. 8.5 Decrease in Supply
(a) Increase in Supply: - If the supply of a commodity increases, while
demand remains constant, equilibrium price will fall. This is shown in Fig.
4. In the figure, quantity dem anded and supplied is shown on the X axis
and price on Y axis. DD is the original demand curve. SS is the original
supply curve. E is the original equilibrium point. SS increase to S 1S1. New
supply curve cuts demand curve DD at point E 1, which is the new
equilibrium point. At this equilibrium point, price falls from OP to OP 1
and quantity demanded and supplied rises from OQ to OQ 1. Thus, if
supply increases, while demand is constant, equilibrium price will
decrease and quantity supplied will increase.
(b) Decrease in Supply: - If the supply of a commodity decreases, while
demand remain constant, equilibrium price will increase. It is shown in
Fig. 5. In the figure, quantity demanded and supplied are shown on the X
axis and price of a commodity on the Y axis . DD is the original demand
curve. SS is the original supply curve. E is the original equilibrium point.
Supply decreases to S1S1. New supply curve cuts the demand curve DD at
E1, which is the new equilibrium point. Equilibrium price has gone up
form OP to OP1 and the quantity supplied decreased from OQ to OQ1.
Thus, if supply decreases, while demand remains constant, equilibrium
price will rise and output will fall.
8.3 EQUILIBRIUM OF A FIRM IN THE SHORT RUN
AND LONG RUN
Under perfect competition a firm ha s to fulfill two conditions for the short
run and long run equilibrium of a firm.
1. MR is equal to MC.
2. MC curve should cut MR curve from below.
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Equilibrium of Firm and
Industry Under Perfect
Competition
81 For the purpose of the study equilibrium of a firm or price - output
determination by a firm can be studied under two heads - short run
equilibrium and long run equilibrium. Let us first study the short run
equilibrium.
8.3.1 Short run equilibrium of a firm:
A short run equilibrium of a firm under homogenous and heterogynous
cost conditions is reached as under. There a re three possibilities of short
run equilibrium of a firm.
1. Excess profit 2. Normal profit and 3. Loss.
A firm has to fulfill two conditions for the short run equilibrium of a firm.
We can explain the above three possibilities and two conditions with the
help of following figure.

SRMC
Y P 1 AC
M1 AR 1= MR 1
H S E
M P AR= MR

N P 2 AR 2= MR 2
Price,
revenue
& cost


O Q2 Q Q1 X
Units of output
Fig. No. 8.6
In the above diagram ‘X’ axis represent units of output and ‘Y’ axis
represent price, revenue and cost. There are horizontal AR and MR curves.
‘SMRC’ curve intersects MR curve at three points P, P 1 and P 2. OQ
commodities are pro duced at OM price. OQ1 commodities are produced at
OM 1 price and OQ 2 commodities are produced at ON price.
* At point ‘P’ - SRMC = MR & AR = AC.
At this point AR = AC, so at this equilibrium point OQ commodities are
produced at OM price. Hence, the firm is in short run equilibrium and
enjoys only normal profit.
* At point ‘P1’ - MR = MC and AR > AC.
The excess profit and loss is determined by the difference between AR and
AC. At this equilibrium point OQ1 commodities are produced at OM1
price. Hence, some firms in the industry enjoy e xcess profit shown by the
area ‘M 1P1EH’.
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82 At this equilibrium point OQ2 commodities are produced at ON price.
Hence firm would suffer a loss at a price which is less than AC shown by
the area ‘MSP 2N’.
In short ther e are three possibilities depending upon AR and AC.
8.3.2 Long run equilibrium of a firm:
In the long run the equilibrium of a firm under homogenous and
heterogeneous cost condition is explained as under.
In the long run all the factors of production can b e changed. In the short
run some loss making firms would leave the industry in the long run. The
excess profit is divided among the firms in a same proportion. Hence, in
the long run no one firm would enjoy excess profit or suffer a loss.
The long run equ ilibrium of a firm is attained by the equality between MR
= MC and AR = AC. This is explained with the help of the following
diagram.

Y LRMC
LRAC
Price,
AR & E
MR P AR= MR







O Q X
Units of output
Fig. No. 8.7
In the above diagr am ‘X’ axis represent units of output and ‘Y’ axis
represent price, revenue and cost. LRMC curve intersect AR = MR curve
at point ‘E’ from below. This equilibrium point shows that both the AR =
AC and MR = MC. This equilibrium point also shows that no one firm
would earn excess profit or suffer a loss. Here each and every firm in the
long run enjoys only normal profit. Hence the firm will be in a stable
equilibrium.
7.4 EQUILIBRIUM OF AN INDUSTRY
Industry simply means a group of firms producing a particul ar type of a
commodity.
The equilibrium of an industry in the short run and in the long run can be
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Equilibrium of Firm and
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83 8.4.1 Short run equilibrium:
An industry which consists o f large number of firms producing identical
product is to be in equilibrium. Under perfect competition in order to
attain an equilibrium three conditions must be fulfilled by the industry.
The conditions are -
1. Every firm must be in equilibrium i.e. MR of ev ery firm must be equal
to its MC. The MC curve of every firm must cut its MR curve from
below.
2. Industry as a whole must be in equilibrium i.e. the AR of every firm
should be equal to its AC. However, in the short run industry may not
be in a stable equilib rium because, the AR of every firm may not
necessarily be equal to its AC.
3. The short run sub normal price in the industry is in equilibrium, when
the short run demand and short run industry’s supply are equal.
8.4.2 Long run equilibrium:
In the long run a n industry would be in a stable equilibrium when every
firm enjoys only norm al profit. In the long run an industry has to fulfill
three conditions. They are -
1. MR of every firm must be equal to its MC. The MC curve of every
firm must cut its MR curve from below.
2. The AR of every firm must be equal to its AC.
When AR = AC the numbe r of firms in the long run industry would
remain constant and the industry would attain a stable equilibrium.
In the case the AR is more of less than AC the industry would not be in a
stable equilibrium. When AR is greater than AC the existing firms would
enjoy excess profit. This would induce new firms to enter the industry.
The output would increase and the price would come down until it is equal
to AC. On the other hand, when AR is less than AC some existing firms
would suffer losses. This would force s ome of them to leave the industry.
Hence the output would decrease and the price would rise until it becomes
equal to AC.
When AR is equal to AC the industry as well as every firm will be in a
stable equilibrium. In such a situation the number of firms in the industry
and its output would remain constant.
3. The long run normal price in the industry is in equilibrium when the
long run demand and long run industry’s supply are equal.


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84 8.5 QUESTIONS

1. Explain the features of perfect competition.
2. Discuss how equ ilibrium price is determined under perfect
competition.
3. Explain how a firm under perfect competition attains an equilibrium in
the short run.
4. How a firm under perfect competition a ttains an equilibrium in the
long run. Discuss
5. Describe the equilibrium con dition of the industry in the short run and
long run under perfect competition.

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85 9
EQUILIBRIUM UNDER MONOPOLY
MARKET & MONOPOLISTIC
COMPETITION
Unit Structure:
9.0 Objectives
9.1 Introduction of monopoly
9.2 Types of Monopoly
9.3 Equilibrium of a firm
9.3.1 Short run equilibrium
9.3.2 Long run equilibrium
9.4 Introduction of monopoli stic competition
9.4.1 Features / Characteristics
9.5 Equilibrium or Price -output determination of the firm under
monopolistic competition
9.5.1 Short run equilibrium
9.5.2 Long run equilibrium
9.6 Product differentiation
9.7 Selling Costs
9.8 Wastes of Monopolistic Competition
9.9 Questions
9.0 OBJECTIVES
 To study the meaning and types of monopoly.
 To study the equilibrium of a monopoly firm in the short run and long
run.
 To study the meaning and features of monopolistic competition.
 To understand the equilibrium of a firm in the short run and long run
under monopolistic competition.
 To study the concepts of product differentiation and selling cost.
 To study the wastes of monopolistic competition. munotes.in

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86 9.1 INTRODUCTION OF MONOPOLY
The term ‘Monopoly’ consis t of two words ‘Mono’ and ‘poly’. Mono
means single, poly means seller. Thus, when there is only one seller of a
commodity in the market can be called as monopoly market. There is
various definition of ‘monopoly’ given by various economists. Prof.
Lerner d efines it as, ‘any seller who is confronted with a falling demand
curve for his product.’
The Monopoly refers to, ‘that market situation in which there is only one
firm (seller) in the market, that has a control over the supply of a
commodity and which ha s no close substitutes for its product in the
market.’
It is to be noted here that in practice we rarely come across the pure
monopoly (single seller) except in case of government monopolies. When
we refer to monopoly, normally we have ‘lesser degree of co mpetition’ in
our mind rather than complete absence of competition.
Features of Monopoly -
The above definitions help us in determining certain broad features of
monopoly market.
1. Single Seller – There is only one producer/firm/seller of the product in
the m arket. Obviously, he has complete control over the supply of the
commodity.
2. Absence of perfect substitutes – In a monopoly market the product of a
monopolist does not have perfect or close substitutes.
3. Price Maker – A monopolist is a price maker and not a price taker. It
means that monopolist himself is in a position to decide the price. He
does not have to accept the price in the market.
4. Profit Maximization – Unlike a competitor seller, the monopolist
necessarily aims at earning maximum profits. As Marsha ll puts it the
price setting by a monopolist is not just for covering the cost of
production but is essentially for earning maximum net revenues.
5. Firm and Industry – As pointed out earlier in a monopoly market,
there is no distinction between a firm and a n industry. The monopolist
firm is itself the industry.
6. Falling Demand Curve – As Prof. Lerner points out that a monopolist
is always confronted by a falling demand curve which means that he
gets a fairly inelastic demand curve for his product.
Thus, a mar ket characterized by all the above features is a monopoly
market.

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Market & Monopolistic
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87 9.2 TYPES OF MONOPOLY
Monopoly may be classified into various types. These types of monopoly
are based on various criteria. The main types can be described in the
following manner.
1. Pure m onopoly and Imperfect monopoly : The classification of
monopoly into pure and imperfect is based on degree of competition in
the market. Pure monopoly is said to exist when there is no
competition at all in the market. It is possible only if there are no
substitutes for the monopolist’s product. On the other hand, imperfect
monopoly implies a market where the monopolist may have a few
substitutes though the substitutes may not be absolute or perfect
substitutes.
2. Private and Public Monopolies: This classifica tion is made on the
basis of the ownership of monopoly firm. Private monopoly refers to a
monopoly firm owned by a private individual. Public monopoly, on
the other hand is a firm owned, managed and controlled by Govt.
There are certain types of activity w hich are exclusively meant for
public undertaking. Indian Railway or Post can be cited as examples of
such public monopolies.
3. Natural, legal, technological and joint monopolies: This
classification is based on the sources of getting monopoly power by
firms .
Natural monopolies refer to a situation where, by advantageous
location, age -old reputation etc. the firm derives a monopoly power.
Legal monopolies arise out of legal sanctions for patents trade - marks
etc. The other firms are forbidden to make use of p atents and trade -
marks already given to certain firms.
Technological monopolies refer to the monopoly power gained by
certain firms because of their technological expertise.
Joint monopolies are enjoyed by certain firms who come together with
a definite o bjective and form combinations like cartels, trusts etc.
4. Simple Monopoly and Discriminating Monopoly: Such a
classification is made on the basis of the pricing policies adopted by
the monopoly firms. Simple monopoly has a uniform price policy for
all custo mers while the discriminating monopoly firms charges
different prices from different customers for the same product.
9.3 EQUILIBRIUM OF A FIRM
In order to understand the price output determination or equilibrium of a
firm in a monopoly market in the sho rt run and in the long run we shall
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88 1. Monopoly of a seller.
2. Perfect competition among the buyer.
3. No close substitutes.
4. Profit maximization.
With the above assumption we shall now first deal with the short run
equilibrium of a fir m under monopoly.
9.3.1 SHORT RUN EQUILIBRIUM
It may be recalled here that in the monopoly market AR and MR differs
from each other. This is on account of price variations. It should also be
noted here that for a monopoly firm AR curve represents the deman d
curve. The AR curve also denotes the price under any market situation as
AR is equal to price. The equilibrium condition is equality of MR and
MC. The monopoly price may be greater than, equal to or less than AC
which may lead to excess profits, no profi t no loss and loss respectively.
This means there are three possibilities in the short run equilibrium. The
figure No. 11.1, 11.2, and 11.3 will make it clear.

Y Y

MC MC


P R AC P R

C T AC
Price E E
Revenue
& cost
MR AR MR AR

O Q X O Q X
Unit of output Unit of output
MR = MC & AR > AC MR = MC & AR = AC
Figure 9.1 Figure 9.2





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Market & Monopolistic
Compet ition
89 Y
MC

C T AC

P R
Price,
revenue
& cost E

MR AR

O Q X
Units of output
MR = MC & AC > AR

Figure No. 9.3

The above figure No. 9.1 shows that X axis represent units of ou tput and
Y axis represent price, revenue and cost. MC is the marginal cost curve
which intersects MR curve at point ‘E’. At this equilibrium point AR
average revenue is more than AC average cost. At point ‘E’ OQ units are
produced and sold at OP price. The average cost of OQ units of output is
OC which is less than average revenue or price OP. The average revenue
curve AR lies above the AC average cost curve. This enables the
monopolist to earn excess profits shown be the area PRTC.
The figure No. 9.2 show s that MC curve intersects MR curve at point ‘E’.
Point ‘E’ is the equilibrium point. At this equilibrium level AC average
cost curve is tangent to AR average revenue curve. This shows that at
point ‘E’ not only MR = MC but also AR = AC, OQ units are produ ced at
OP price. The average cost of OQ units is equal to average revenue or
price OP. Hence at this output the monopolist is able to earn only normal
profit i.e. no loss no profit.
The above figure No. 9.3 shows that at point ‘E’ the monopoly firm att ains
equilibrium. At this equilibrium point the average cost curve AC lies
above the AR average revenue curve which shows that average cost is
greater than average revenue. At point ‘E’ OQ units are produced and sold
at OP price. The average cost at OQ uni ts is OC which is more than the
average revenue or price OP. Hence, firm has to bear a loss shown by the
area PCTR.
9.3.2 Long run equilibrium :
The long run equilibrium of the monopoly firm is attained at point ‘E’
where LMR and LMC curves intersects ea ch other. In the long run the
firm can change the variable as well as fixed factors of production. The
monopolist will try to maximize profits to the extent possible.
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90 In the long run the monopolist will earn supernormal or excess profits. In
any case he will not earn normal profit or bear the losses. The following
figure shows the condition of excess profit earning and long run
equilibrium.
Y
LMC

P R LAC

C T
Price,
revenue E
& cost
LMR LAR

O Q X
Units of output
MR = MC & AR > AC

Figure No. 9.4

The above figure No. 9.4 shows that units of output is measured on X axis
and price , revenue and cost are measured on Y axis. LMC is the marginal
cost curve which intersects LMR curve at point ‘E’. At this equilibrium
point AR average revenue is more than LAC average cost. At point ‘E’
OQ units are produced and sold at OP price. The aver age cost of OQ units
of output is OC which is less than average revenue or price OP. The
average revenue curve AR lies above the AC average cost curve. This
enables the monopolist to earn excess profit shown be the area PRTC. It
should be remembered that t he elasticity of demand decides the price. If
the demand is elastic lower price will be set and if the demand is more
inelastic the price would be higher.
9.4 INTRODUCTION OF MONOPOLISTIC
COMPETITION
The term ‘monopolistic competition’ is used interchangea ble with the term
‘imperfect competition’.
The concept of ‘Monopolistic Competition’ was introduced by Prof. E. H.
Chamberlin in his book, ‘Theory of Monopolistic Competition’.
Monopolistic Competition refers to that market situation,’ where there is
large number of sellers producing a commodity with their own
peculiarities.’ This means the commodity is not identical or homogeneous.
There is product differentiation. Each producer is producing a different
type of a commodity than the others.
Monopolistic Co mpetition strictly means a market with competitive
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91 9.4.1 Features/ Characteristics:
1. Large Number of Firms: Monopolistic competition is characterized
by a large number of firms producing a similar product. Each firm wi ll
have a definite group of customers and enjoys a some sort of
monopoly in respect of the particular group of customer. Each firm has
to face competition from the other firms. Therefore, each firm has to
make efforts for maintaining and increasing its mar ket share. As the
number of firms is large, each firm produces a relatively smaller share
of the total market supply.

2. Product differentiation: The large number of firms under
monopolistic competition produces differentiated products which are
relatively c lose substitutes for each other but not perfectly substitutes.
Each firm, in order to attract maximum buyers will have its own
peculiarities of the product which distinguishes its product from other
similar products in the market. This is called as product differentiation.
Product differentiation may occur in many ways. The firm may have
its own quality, Brand - name, material used, packing, appearance,
fragrance, shape, technology etc. of the commodity.

3. Easy entry and exit: The entry in and exit from such a market is not
very difficult. There are no such restrictions on the entry and exit of
firms. Though each faces competition, is independent in case of price
and output decisions.

4. Selling costs: The market is characterized by selling costs. In order to
attract and better known to the customers the firm has to go for sales
promotion activities like advertising, free service and buy one and get
one more free etc. For this each firm requires to be incurred huge
amount of money. These expenses are called as se lling costs.

5. Sloping demand curve: Each firm under this type of market has a
downward sloping demand curve because the demand for a
commodity of a monopolistic competitive firm is more elastic. The
demand curve is less steep than the demand curve of a mo nopoly firm.

6. Concept of Group: Professor Chamberlin used the word group
instead of industry. Under monopolistic competition, there is
heterogeneity and therefore he has used the concept of group to imply
a collection of firms producing closely related but not homogeneous
goods. Under monopolistic competition, due to qualitative differences
and buyers’ preferences, there are wide divergences in the curves of
cost of production and a variety of demand curves. The result is
heterogeneity of prices and variati ons over a wide range of output and
in profits.


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92 9.5 EQUILIBRIUM OR PRICE -OUTPUT
DETERMINATION OF THE FIRM UNDER
MONOPOLISTIC COMPETITION

The monopolistic competition pricing can be divided into twp broad
categories, short run equilibrium of a firm and long run equilibrium of a
firm. We deal each of them separately.
9.5.1 Short run equilibrium :
Like any other type of market the equilibrium of a firm under
monopolistic competition will be established where the MR is equal to
MC. In the short run period, the firm may make profits, incur losses or
may have no profit no loss situation.
The demand curve of a firm under monopolistic competition may differ in
its elasticity from firm to firm. However, it will neither be perfectly elastic
nor perfectly inelastic . The slope of AR curve may therefore vary
accordingly. We can understand the three possibilities of short run
equilibrium with the help of following diagrams.

Y SMC Y SMC
SAC
C SAC C P P
A B
Price, e
revenue, e SAR SAR
costs
SMR SMR

O Q Output X O Q Output X

Figure 9.5 Figure 9.6


Y SAC
A B SMC
P C
SAVC e
SAR
SMR

O Q Output X

Figure 9.7 munotes.in

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93 The ab ove three diagrams shows that there are three possibilities of short
run equilibrium of a firm in the monopolistic competition.
Fig. 9.5 shows that, SMC curve cuts the SMR curve at point ‘e’ when the
average cost is OA or QB and the price or average revenu e is OP. The
price or average revenue is more than the average cost and hence the firm
enjoys profits as shown by the area PCBA.
In Fig. 9.6 the SMR = SMC and SAC curve is tangent to SAR curve and
hence the firm earns only normal profit. It means the firm neither earns
excess profits nor does it incur any losses.
In Fig. 9.7 the SMR = SMC, SAVC curve is tangent to SAR curve and
SAC lies above the SAR. It means that average cost is more than the
average revenue hence the firm has to incur losses shown by t he area
ABCP but its price or average revenue is just sufficient to take care of the
average variable costs.
Thus, the short run equilibrium may enable this firm in monopolistic
competition to earn profits, to sustain losses and with no profit no loss
situation.
9.5.2 Long run equilibrium:
If the firm is earning supernormal profits, more firms will enter the
‘group’ in the long -run. If the firm is incurring losses, firms will leave the
group in the long -run. If the firm is making no loss no profit in t he short
run, it will continue to remain in the same position in the long -run.

Y MC LAC
C
P c 1
Price,
revenue, e
costs LAR

MR

O Q Q 1 Output X

Figure 9.8

In the long -run, at point ‘e’ the LAC long run average cost curve become
tangent to the LAR long run average revenue curve or the demand curve.
Since at this point, the slope of the AR and AC curves is equal to the MR
and MC curves will intersect ver tically below it. This is shown by point
‘e’ in the following diagram.
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94 The long -run equilibrium conditions are - MR = MC and AR = AC.
As the firm is earning just normal profit, there is no tendency for the
number of firms in the group to change. Thus, the long run equilibrium of
the firm implies equilibrium for the group as a whole also.
Since the long run equilibrium is shown by the tangency between the AR
and AC curves; it implies that the equilibrium output OQ will necessarily
be less than the least cos t output OQ 1. This is true because a downward
sloping AR curve can be tangential to U shaped AC curve at some point to
the left of the minimum point (c 1). It means that in the long run economies
of scale are not fully exploited by the firm and there is exc ess or unutilized
capacity equal to OQ 1 amount of output.
9.6 PRODUCT DIFFERENTIATION
Monopolistic competition is characterized by product differentiation and
selling costs. Product differentiation emerges out of the typical nature of
competition in such m arket. Each individual firm in a group producing a
particular type of commodity has to face the competition from the other
firms in the group. The competition is of two types i.e. price competition
and product differentiation.
Price competition is reflecte d in the individual price setting of a firm. The
firm may set a slightly lower price than its rivals for inducing the buyers to
purchases its product. Thus price decisions are independently taken by
every firm.
Product competition is reflected in the produ ct differentiation. Product
differentiation implies the special features introduced by the firm so as to
distinguish its product from the other similar products in the market.
It may occur in many ways. The firm may have its own physical features
of the pr oduct such as color, shape, appearance, size, fragrance etc. which
may be helpful in giving some distinction to its product.
The firm may also have a different technique of production or other
qualities of the product. Sometimes the brand - name, trade - mark, packing
etc. are also used for product differentiation.
The product differentiation is a specific character introduced by each
individual firm in the monopolistic competition.
9.7 SELLING COSTS
The firm in order to bring its distinguishing character to the notice of the
customer has to spend on advertising and publicity of its product through
other methods of sales promotion. Most of the firms spend on advertising
on radio and television. The modern age is in fact an age of advertisement
hence the fir m has to spend sizeable amount of money on advertisements.
The market in the modern days has changed in such a manner that the
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Market & Monopolistic
Compet ition
95 the market with pre - determined choice of the product s, mostly formed by
the advertisements. Considering this the firms have to spend a lot on
publicity, if they have to induce the customers to buy their product. They
try to impress upon the customer the specialties of differentiating qualities
of their prod uct. The expenses incurred on such sales promotion activities
are called as selling costs.
Prof. Chamberlin has defined selling costs as, “costs incurred in order to
alter the position or shape of the demand curve for a product.”
9.8 WASTES OF MONOPOLI STIC COMPETITION
Under monopolistic competition there are several wastes and both the
consumers and factors of production are exploited. These wastes have
been pointed out by Prof. Chamberlin. The wastes are -
1 Excess Capacity - Under monopolistic competition a firm’s
equilibrium output is less than the optimum output. The average cost at
the equilibrium level is more than minimum. There is excess or unused
capacity, which is a waste in monopolistic competition.
2 High Price for the Consume r- Under monopolistic competition a
consumer has to pay a higher price for a product than under perfect
competition even in the long run period. Though the firm is earning
only normal profits the price paid by the consumer is more than that
under perfect competition.
3 Selling Co st- Under monopolistic competition extra expenditure is
incurred by firms on competitive advertising to increase individual
sales. The advertising is considered as a waste under monopolistic
competition because it leads to wasteful competition among rival firms
and increase cost which is not necessary in the market. This cost is
passed on to the consumers in the form of higher price. Thus,
competitive advertising is a clear waste of resources.
4 Unemployment - In monopolistic competition, the problem of
unemp loyment is created due to many reasons. One of these is the fact
that the productive capacity is not fully utilized under monopolistic
competition and therefore, employment is not increased. Further, in
order to maintain high prices, production is sacrific ed and this may
create cyclical unemployment.
5 Lack of Specialization - Since there are many rival firms producing
similar but not identical products the scope for large scale production
is limited by smallness of size. There is inadequate specialization an d a
firm can not reap the advantages or economies of large scale
production. Thus consumers are deprived of the fruits of specialization
and large scale production.
6 Cross Transport - There is a waste of cross transport under
monopolistic competition. The pr oduct of Calcutta manufacturer may
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96 Calcutta. The consumers have to pay an increased price, which would
include transport costs. If the Calcutta producer serves the Calcutta
market and Mumbai producer serves the Mumbai market, transport
cost can be avoided and consumers would be benefitted. But this does
not happen because of product differentiation and every rival producer
likes to capture the market throughout India.
9.9 QUESTIONS
1. Explain the features of monopoly.
2. What are the various types of monopoly.
3. Explain how a monopolist attains an equilibrium in the short run.
4. Discuss long run equilibrium of a monopoly firm.
5. Explain the characteristic features of monopolistic competition.
6. Explain how a firm attains an equilibrium in the short run and long run
under monopolistic competition.
7. Discuss the wastes of monopolistic competition.


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